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A guide to size in venture funds
No, it's not smaller the better and it's not one size fits all
The default answer to the question of how much to raise for a venture fund is as much as you can. Still, some GPs have the luxury to make a deliberate choice, and this is where things get interesting. It takes foresight for GPs to imagine the strategy over a decade to decide on the right size. And, it takes discipline to compromise on AUM, hence bigger fees, when it’s the right thing to do.
From an LP’s perspective, the smaller the better is the conventional wisdom. There’s historical data to suggest that most outlier funds have been fairly small, and it’s tempting to generalize this across time and markets in a linear fashion, buying into the conventional wisdom.
We don’t think it’s so easy. When it comes to investing, Wouter always says “It’s simple but it’s hard.” Another Dutchman of slightly lower prominence, Johann Cruyff, also had a quote along the same lines: “Playing football is very simple, but playing simple football is the hardest thing there is.”
What’s simple? Funds with outlier performance are likelier to be small and early-stage funds of few GPs, and we often prefer to partner with such funds at Nomads.
What’s hard? In a power-law environment, there are no checklists, and there are always exceptions. And oftentimes, exceptions yield more than the rules. Hence, it’s crucial not to see the fund size as a magic number, but as the determinant of some key variables of the portfolio strategy, like the number of companies and entry valuation-ownership. And, it’s crucial to define what’s small afresh with every new opportunity.
Anyways, long story short, we have a slightly more nuanced take on fund size, and this article shares that perspective.
It’s misleading to look in the rearview mirror
When it comes to the use of data in venture, simple induction is often misleading (here I outline the broader set of problems with the misuse of data in venture) because of many reasons including:
The $100m fund of 2000 is not representative of the $100m fund of 2023. Outcomes are observed with a minimum of 10-12 year lag during which many consequential things (higher valuations, different types of businesses and macro conditions, etc.) change with implications on the right fund size.
One cannot rely on averages or linear mathematical specifications when it comes to samples with power law distributions. One’s eyes and common sense usually trick her.
Venture funds are low in sample size to the degree that it’s dangerous to make inferences. Further, there’s selection bias in the datasets of vendors. There’s also survivorship bias given some of the best funds graduate to become family offices and the worst fail to raise successive funds.
Fund size is endogenous and many factors interfere with one’s fund size vs. return analysis. GPs succeed or fail to raise funds of a certain size because of a reason, so it’s not only the size that’s different across funds of different sizes. Funds of >$200m might have a systematically better selection lens or lower hunger, being the real reason behind the difference in performance rather than size.
In perspective, it’s not straightforward to argue a <$10m fund of 2023 vintage will perform better than a >$200m fund of 2023 vintage just because the average performance of a dozen <$10m funds of 2000-2010 vintages is better than the average performance of a dozen >$200m funds of 2000-2010 vintages.
Given poor data and decades-long feedback cycles, the best is to independently analyze each case in light of today’s realities and see what makes a good strategy for the particular GP team.
Always bottoms up, not categorical
The world would be a smooth but dull place if we could accurately categorize everything to a checklist, <$30m→ very good, <$100m → good, <$200m→ okay, >$200m→ bad. Some do, but we don’t appreciate this given the world we live in is more exciting and complicated than that and fractal in nature. Zoom in as you might, the complexity lives on.
Fund size is not a magical number that is important in isolation. It’s just an independent variable that determines some key dependent variables like the number of companies in the portfolio, entry valuation-ownership, and available follow-on reserves.
It’s not the exact number of $100m in size that matters, but rather the implied strategy of, i.e. 20 initial seed checks of $2.5m to be written over 2 years for 15% ownership that results in 5 decisions per year and 8-10 board positions per GP (assuming two GPs), and $50m in follow-on reserves to double down on 3-5 select companies in Series A-B.
Then in light of the market within which the fund is playing (US generalist, deep tech, India, Africa, etc. are all dramatically different from each other), one can test the relevant assumptions one by one including:
Whether it’s plausible for the GP to make 5 decisions per year and sit on 10 boards. In the given context of the number of decisions and relationships, a $100m fund might actually make sense whereas a $20m fund that writes 100 small checks per year might not.
Whether the target allocation and ownership make sense in light of today’s market. Larger checks require better access and few GPs have it. Big funds compete to own enough of a few great companies or, if unsuccessful, compromise on ownership.
Whether the GP can be material enough for the company given ownership and the number of companies in the portfolio. If the GP matters to the company, she’ll have a better likelihood of accessing allocation and asymmetric information for follow-on rounds.
Whether ‘both’ GPs have exceptional judgment and work well together. The conditional probability of multiple people being exceptional and working well over a decade is significantly lower than the probability of a solo GP being exceptional. Great investors are rare, and it’s not trivial to assume that one’s ex-co-founder, employee, or college friend is one.
The world is different than decades ago
The venture market had a good ride during the first two decades of the 2000s. Especially during the first decade, angels and micro-fund GPs were able to catalyze pre-seed and seed rounds and/or invest at very favorable valuations with small capital contributions.
In today’s market, many billion-dollar funds come earlier and earlier to dominate most seed and many pre-seed rounds, and there are 100s of newly emerged mid-sized pre-seed/seed funds. They name the round and set the price, and let some others chip in for the remaining $100-200k without any material influence on the company or proper access to downstream rounds and information.
The valuation determines how much one pays to own x% of the company, and the lead investor sets the price. Unfortunately, for a $10m fund writing checks to seed rounds led by multi-billion funds at fat prices, the math isn’t really different than a multi-billion fund. Not being able to catalyze a round, there will be many instances where one won’t be able to capitalize on seeing a company first, and will have to take the opportunity to market and be a price-taker if lucky enough to be given allocation.
The returns don’t decrease linearly in size
The conventional wisdom says the smaller the better, but at Nomads we often appreciate a minimum viable size given the right conditions for the market and for the GP. So, it’s not necessarily a straight curve where returns decrease linearly in size, it has its ups and downs.
Alpha is rare in investing and if one is looking to find and capture it, one needs to be able to create her own rounds and price those. Determining the time and the price is key to capturing alpha while buying the asset. (This assumes one isn’t after some sort of structural arbitrate which is also possible in private markets, especially in emerging categories or in favorable macrocycles, but rather one is after alpha via superior investment judgment.)
With a minimum viable size (i.e., one might argue it’s $50-60m for generalist US-European seed strategies), a GP can start to lead and price rounds, be material for her companies, and with good enough reserves, leverage downstream asymmetry in information and access. Smart follow-ons are another way to alpha where one creates moments where one knows a lot about a given company and deploys sizeably to pre-empt Series A-B or bridge rounds at great prices before the world awakens to the opportunity.
It’s possible but very challenging to scale
There are a few ways to scale and most scaling firms do all. The first is to write bigger checks, which implies owning a bigger % of companies and/or deploying more in later stages. Only a handful of venture firms have the brand and reputation to secure a significant concession on ownership in a competitive market. Given this limit, larger checks imply a shift to the later stage that compresses returns assuming a constant upside.
Keeping the check size constant, the fund needs to write more checks and serve a bigger portfolio with increasing fund size. There’s a limit to how much a solo GP can scale on this front and to how many golden eggs a single GP can lay, so one usually builds a team. And, it’s hard to build teams without diluting the initial GPs judgment, ambition, and presence. There are incredible horizontal teams but it’s a simple fact that the conditional probability of multiple people being exceptional and working well over a decade is significantly lower than the probability of a solo GP being exceptional. Vertically, there are multiple problems like ensuring the right incentives, high-quality decisions and information transfer across the team, and the great experience for founders.
It’s hard to scale, and in the history of venture, only a few firms like Sequoia and Founders Fund achieved scale without yielding to mediocrity. There are only a handful of Don Valentines or Peter Thiels in the world to hire and incentivize many A+ investors long enough.
Everything is a moving target
Venture is an incredibly dynamic market and it’s easier to break dependencies compared to public markets-broader PE given it’s upstream of company creation. With changing opportunities, the next year’s founders just do things differently and the investors and LPs need to follow through. Everything is a moving target in the venture from what makes a good company to the right size for a venture fund. It’s also getting more and more fragmented (into verticals, stages, regions, etc.) as time passes which makes it hard to generalize things.
It takes an open mind to get rid of categories and lazy generalizations to evaluate every opportunity in isolation, but still leverage one’s previous learnings. And even when one categorizes things, these are just conjectures waiting to be refuted as time passes, not checklists to be treasured.
So, as in this write-up, the best one can hope to come up with are new perspectives that will hopefully guide us long enough to some good decisions, not magic numbers or checklists. And every day, we’ll wake up to find new instances where our previous models and perspectives don’t apply, these fresh moments of discovery where some of us will follow through and some of us will simply ignore.