In my life before DFJ, I spent eight years with Garage (initially a boutique investment bank called Garage.com, which then morphed into a seed-stage venture capital firm, Garage Technology Ventures, making $250k-$500k investments in seed and early-stage technology companies). We used to have a saying back then that “small is beautiful.” Perhaps, if we were bigger, we would have said “big is impactful.” I had seen the trend, however, of smaller funds raise increasingly larger and larger subsequent funds. I used to wonder why. By the way, prior to the late 90s, there were no billion-dollar venture funds, and although the average size has come down in the last few years, generally speaking, there are still much larger funds than used to exist prior to the mid-late 90s. I am going to try and explain (not justify) the existence of larger funds and why even when funds start out smaller, they inevitably grow in size over time.
It really all boils down to simple math, so let me dive into that right off the bat. Let us say I raise my first fund MJ I (I like the sound of it and let me know if you would like to invest in it), which amounts to $50 million because I am an early-stage VC and I would like to invest $1 million or so initially into a company and reserve another $3 million for follow-on rounds, which will lead to about 12-14 investments out of that fund.
Typically, there needs to be a team, rather than an individual, managing the fund, and typically, by design or coincidence, three individuals come together (Helion, Nexus, IDG, IUV and others are examples in the Indian context, as is DFJ, by the way). A fund usually has, what is referred to as 2/20 economics, which means that the General Partners (GPs) who actively manage the fund and make investments earn an annual management fee of 2 per cent of the fund (for MJ I for example, it would be $1 million per year). That management fee pays for the operations of that fund (salaries, rent, utilities, etc.). The 20 refers to the percentage split of the investment profits that GPs get to enjoy. So, if MJ I doubles (or returns 100 per cent), the GPs of the fund would keep 20 per cent of the $50 million or $10 million while the Limited Partners (LPs) receive 80 per cent of the profit or $40 million. Remember that the initial invested amount ($50 million) goes back to the LPs before GPs get to keep a dime. There are slight nuances and exceptions to the structure, depending on who has negotiating leverage. Some funds that are in the top decile can get 3/30 economics with all sorts of other GP-friendly terms. On the other hand, if the LPs have all the leverage, there can be some GP-unfriendly terms.
Typically, a smaller fund tends to focus on seed or very early-stage investments. A first-time fund, unless managed by incredibly well-connected managers with a proven track record (with another fund), will typically be of a smaller size. And given that there typically need to be 10-15 companies to be considered a decent portfolio, investments from that initial small fund are obviously smaller in size, leading to early-stage investments.
A fund usually has an investment horizon of three years (meaning that the fund is committed in three years, although a chunk of the fund will be deployed/invested over a longer time horizon, as and when investee companies raise future rounds of financing). After the three-year time period, there are no new investments that can be made out of the fund and the GPs have to embark on raising a new fund, ideally not allowing a capital gap between the end of the prior fund and beginning of a new one. It’s non-trivial to raise the second fund, since the first fund will not have shown any exit. Typical exit horizons can be 7-8 years. So if a fund is focused on seed-stage investments, and let us say it’s a 2007 vintage fund, then by 2010 (when the GPs have to embark on raising Fund II), the initial seed-stage investments may have only raised a Series A or B, but be nowhere close to exits. The LPs have to roll the dice since they won’t actually see exits/results for another 3-4 years from the first fund. Let us assume that they are able to raise Fund II and make another 15 early-stage investments. Now there is a 30-company portfolio, with still three GPs and potentially 10 board seats each. By the way, a manageable number of board seats, especially in India, is about 5-6. So suddenly, at the end of two funds, there is a sizable portfolio and bandwidth becomes an issue. The only way to continue to manage, while being an early-stage fund, is to add to the team – so that there can be better load balance and there can be someone looking at new deals, rather than purely managing a burgeoning portfolio. But adding to the team means greater expense. Greater expense means that management fees have to increase. The only real way to that end-goal is to have a larger fund.
The other dilemma that VCs face is that as a larger fund is raised, the number of portfolio companies cannot necessarily grow linearly. “Let me splain” (as Cheech and Chong once said). With a $50 million fund and a $4 million per company capital allocation, it would result in roughly 12 companies. Now, due to the reasons described above, if the new fund is $100 million in size, the same $4 million-per-company theory breaks down (the $100 million fund cannot have 25 companies necessarily). As a result, the capital allocation per company increases to keep the number of companies in the portfolio relatively constant ($8 million allocation per company will result in a 12-company portfolio in the $100 million fund). So, not only has the fund size increased due to need for higher management fees to handle a growing headcount, but the investment thesis fundamentally changes with a larger fund.
The above is a generalisation to prove a point, but there are exceptions to every rule. There are certain funds that stay to their knitting in terms of size and fund investment thesis, and have figured out how to maintain a steady board load. As an aside, there are funds in the USA with virtually multi-hundred existing portfolio companies and 12-15 board seats per partner (at that point, the partner not only has no bandwidth for new deals, but probably doesn’t even know the names of all companies that he/she is on the board of).
One final point, which is a point of tension and contention within the VC community is the trade-off between management fees (2-3 per cent) and carry (20-30 per cent). As larger funds get raised and management fees pile up, greed does set in. An argument can be made, for example, that partners have gotten incredibly wealthy not as much due to the success of their investments but because of their share of the management fees. Let me illustrate. Let us say if a fund has $500 million Fund I, 2.5 per cent management fee would yield $12.5 million annually. These management fees typically have a 7-10 year horizon (the fund usually gets 2.5 per cent for the first 3-4 years and then the fee reduces by 0.25-0.5 per cent every year for the remainder of the 7-year term). Now if the VC firm raises another $500 million Fund II, then another $12.5 million gets piled on the top of the fees from Fund I. That is a windfall for the GPs who now have $20-25 million per year rather than $12.5 million per year in fees from which they need to run the firm and pay themselves. If a firm can continue to raise new funds every three years, and potentially raise bigger funds, one can easily see how the management fees go sky high and Bentleys/Maseratis start lining Sand Hill Road in the USA.
An ideal way for GPs and LPs to be aligned is to reduce management fees and increase ‘carry’ with the latter completely driven by investment success, which is the business GPs are supposed to be in. Over the past few years, adjustments are taking place in the overall GP-LP relationship and the subsequent economics that GPs enjoy. The 3/30 arrangements are relatively rare and even the 2.5/25 structure have moved downstream to 2/20, but with triggers to bump it back to a higher split, if a certain return threshold is met.
Bottom line: Given the number of resumes I get from graduates from some of the top schools in the world, it’s clear that there is a perception of sexiness and glamour associated with the VC world. But in addition to the portfolio headaches that go on, there is a love-hate relationship that does exist between GPs and LPs, and there are critical balance acts that continue day in and day out – having to do with fund sizes, investment theses and the like. Reality is that just like entrepreneurs, VCs deal with situations that are sometimes within and sometimes out of their control. In an ideal world, the number of active portfolio companies stays steady (i.e., new investments are offset by equal number of exits). But that is never the case. As a result, situations described in this piece arise. So, either a larger fund has to be raised to pay for additional headcount, and/or sector/stage focus has to shift. And above everything, fundamental aspects of fear and greed are continuously at work that will then drive the management fee and carry discussions, and lead to tense situations between GPs and LPs. So, although the perception is a daily golf outings and extremely comfortable lifestyle, the reality can be somewhat different.