Venture capital (VC) is not a game for average players. In this industry, you either win BIG or you don’t win at all. Hovering in the middle ground only means you are not generating enough returns for your investors, the limited partners (LPs), to make it worth their trouble. Interestingly, almost all the top-performing VC managers run small funds. Several even manage micro funds. None of them are billion-dollar megafunds. Perhaps what is even more surprising is that most of these VC managers (also called General Partners, or GPs) are newcomers to the fund game, the so-called emerging managers. They have never run more than two funds prior, if at all.
Despite their proven capacity to drive home outsized returns, emerging GPs have historically had a hard time raising money. Most professional LPs manage very large funds and have historically struggled to make the small allocations new funds seek. They also tend to do due diligence on industry reference and team track record of investments, which emerging funds by nature don’t really have.
The situation is particularly bad for European emerging funds because European LP investors tend to be very conservative and risk averse. Consequently, the industry is stacked against small funds and new funds managers, which may appear to be too risky for the LPs.
To complicate things even further, the industry is possibly one of the most opaque, non-diverse, and expensive to get in, which favours “the same old players” versus the “new kids in the block”.
A bunch of GPs and LPs, however, are now actively working to change the status quo. After the early success from last year, they are bringing forward a new format of “affordable event” dedicated specifically to connecting emerging managers in Venture Capital and the open-minded LPs who are open to investing in them.
Will this be enough to make a change? Let’s find out…
The best funds are small, and the best managers are “new” to the game
First, let’s clarify one thing. When we say “top performers” we really are referring to TOP top performers, the ones in the upper, single-digit percentile in terms of returns. We know this because several sources confirm it. Pitchbook, for example has return data on 3,981 VC funds below $2B in size. (It’s a premium platform, but Shai Goldman from Silicon Valley Bank recently published some of this data on Twitter.)
Of all the above funds tracked by Pitchbook:
- Only 57 hit 5X+ returns to investors (1.4%).
- 88 hit 4x+ (2.2%).
- 187 hit 3x+ (4.7%).
- 532 reached a 2x+ (13.3%).
- 1807 returned 1x+ (45.4%).
Based on this, a “top performer” would be a top-13% fund manager.
Cambridge Associates tells us a rosier story because they focus on the IRR (i.e. the ‘annualised’ return on actual cash deployed). Since funds draw down committed capital over time, this helps more managers make it into the top. Even here, though, performance is only ‘passable’ for the top 50% of the funds analysed, whereas it becomes ‘top’ only in the top quartile (top 25%).
Irrespective of which source or metric we use, the following is clear: Many VC funds don’t even return the full amount of capital that was contributed by their LP investors.
It is also clear that small funds run by emerging managers are the ones that make up most of the best returners.
Pitchbook tells us that of the 57 funds that had 5x returns to LPs, only 10 of those were funds that were larger than $200M in size. 65% of the funds that generated a 5x DPI are below USD100M. Smaller funds outperform the megafunds and this may partly account for why emerging managers are where you want to put money in as an investor.
As funds grow older, they also tend to increase in size, but their returns decline. Furthermore, Cambridge Associates data confirms that new and developing fund managers consistently rank as some of the best performers.
Since they run some of the best performing funds, you would think that small and emerging fund managers are much-sought-after targets by investors. But there is a painful reality.
Most Institutional LPs don’t invest in these funds
There is virtually no platform for General Partners (GPs) nor for the smaller LPs to meet with small fund managers, even if they were interested to invest in these funds. (SuperReturn & similar events are expensive, focused on PE, and attract precisely the type of GPs and LPs who don’t fit the small/emerging profile)
The whole industry is secretive and based on old-fashioned (and expensive) methods of connection and fundraising. As it is, these approaches are ill-suited for a Covid-19 world, hamper a merit-based distribution of capital, and consequently discourage diversity. In VC, this is pretty much as bad as it gets.
Thankfully, there is ALLOCATE.
A group of 20 volunteers are organising a new industry event event called ALLOCATE ( https://allocate.gp ), with the idea of being the opposite of the European status quo. I’m one of them and I can tell you: it’s a tough game, but the early feedback we are receiving is encouraging from both GPs and LPs.
ALLOCATE is super-affordable (not for profit) and aimed specifically at this under-served market of emerging managers and small LPs. The event and its “pitch format” were inspired by similar initiatives in the US (eg. RAISE). The goal is to disrupt and democratise the capital allocation to VCs in Europe by allowing more diversity, lower barrier to entry, and a more meritocratic and open VC arena.
The original ideators, GPs at Luminous Ventures and 7 Percent, managed to put together an in-person event last year, where over 200 LPs and emerging GPs were able to connect. This year Allocate goes online on 17-18-19 November, but will it make a difference? Will it manage to open a new way for VCs and LPs to meet and channel more capital and in a more meritocratic way within the European ecosystem?
We shall soon see.