This week came with some big fundraising news as EQT Ventures closed its third fund on roughly $1.1 billion, a 66.7% increase in size from its predecessor.
While 2022 has seen the venture ecosystem take a turn for the worse—with fewer and smaller deals and exits—fund sizes continue to get bigger as LPs seek out experienced managers to help them weather the storm.
The median size of US VC funds has grown 38.9% from last year to stand at $50 million in Q3 2022. While some of these vehicles began fundraising before the downturn, the numbers suggest that capital commitments have yet to dry up.
As the saying goes, the bigger the better. But does that necessarily hold true for VC fund returns?
US vehicles under $250 million have significantly outperformed those above that threshold over the past four quarters, according to PitchBook’s 2022 Global Fund Performance Report.
One reason for this is that it is simply more difficult to generate big returns with a large fund.
Say you have $100 million to invest and you divide it equally among 10 startups, with a 10% stake in each. To generate 3x—returning $300 million—each portfolio company would need to provide an individual exit value of at least $300 million for you to get your return of $30 million from each company. In all likelihood, half of those investments will fail, so the exits for those remaining need to be even bigger.
Now imagine trying to accomplish the same feat with a billion-dollar fund. You would need several multibillion-dollar exits, which would be a stretch even in good times, but is incredibly hard in a climate like our current one.
Another reason is that, with deal sizes in the later stages shrinking and exit activity slowing—particularly for IPOs, which have seen their value fall from $670.4 billion in 2021 to $29.9 billion this year—there aren’t as many places for GPs to put their money and even fewer opportunities to make it back.
Some critics also say the incentives for managers of large funds are skewed toward accumulating assets instead of maximizing returns.
VCs receive a management fee from their LPs, which typically amounts to 2% of the aggregate commitments during the investment period. Bigger funds generate higher fees, regardless of how they perform. Smaller funds, on the other hand, would need to focus more on portfolio performance to generate cash through carried interest.
While this is all true, it does seem counterintuitive for a GP to chase fees and ignore portfolio returns, given that the fund’s LPs would be less likely to commit capital to a future vehicle if its predecessors performed poorly.
So, on the surface, it seems better for an LP to put money into a smaller fund, right? Maybe, but maybe not. After all, returns are just one part of the story.
Big is beautiful
Although smaller funds may produce better returns in some cases, larger vehicles are theoretically less risky to invest in.
A large fund does typically have a more proven track record than smaller counterparts. The more successful a VC is, the more capital an LP will want to commit to its funds. With the downturn starting to bite, LPs are likely looking for managers with experience navigating different market climates.
And a large firm typically offers LPs more and better resources. The Andreessen Horowitzs or General Atlantics of the world have greater networks and research capabilities, providing access to higher-quality deal flows.
There’s also more opportunity for follow-on funding, which allows VCs to increase ownership stakes in their best-performing portfolio companies over time and maximize returns at exit. Further, the ability to invest across multiple stages and sectors offers portfolio diversification that could further reduce risk. Sacrificing some returns for increased stability is an attractive choice for many LPs.
And while the downturn may make it harder for large funds to achieve the required blockbuster exits, smaller vehicles are not immune to the challenges presented by the current market.
Having less capital will typically mean smaller ticket sizes and stakes in startups. In the event of a down round, these smaller funds have a greater risk of being eliminated from the cap table. They are also more diluted as startups stay private longer due to a lack of attractive exit opportunities.
When all is said and done, not all large funds are bad and not all small ones are good—or vice versa. But one thing is for sure: If the current downturn persists, then pain will be felt by all.
Featured image by Jenna O’Malley/PitchBook News
Learn more about our editorial standards.
