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Why Large VC Funds Underperform Smaller Ones



For individual investors or limited partners (LPs) looking to invest in venture capital, one of the most important decisions is choosing the right fund size. While the biggest name "mega-funds" may seem alluring, data shows that smaller VC funds have consistently outperformed their larger counterparts.



The Superior Returns of Smaller Funds


Multiple research studies over the years have confirmed that smaller venture capital funds generate better returns on average than larger funds. There are a few key reasons behind the underperformance of mega-funds compared to smaller, more nimble players:


  • Availability of Deals: The number of compelling venture investment opportunities, especially at the early stage, is inherently limited. Once a fund gets too large, say over $500 million, it becomes very difficult to find enough high-quality deals to fully deploy that massive amount of capital. Smaller funds don't face the same scarcity of deal flow.

  • Ability to Add Value: One way top VCs generate outsized returns is through hands-on support and involvement with their portfolio companies when needed. This hands-on approach becomes increasingly difficult to scale as fund sizes grow larger. The investment partners at a smaller fund can pay closer attention to each company.

  • Overhang Effect: When a large fund makes an investment, it often has to reserve a huge amount of additional capital to support follow-on rounds for that company down the road. This creates an "overhang" effect where a significant portion of the fund's capital gets tied up, limiting its ability to make new investments.


Incentive Misalignment from Management Fees


Another factor driving the underperformance of mega-funds is the potential incentive misalignment stemming from how fund managers are compensated. VC fund managers earn two types of compensation:


  • A management fee, usually around 2% of committed capital

  • A share of future profits called carried interest or "carry," typically 20%


For smaller funds under $500 million or so, the primary incentive for generating strong returns comes from earning a lucrative carry on any profits. However, for mega-funds over $1 billion, the annual 2% management fee alone can amount to $20 million per year or more in virtually guaranteed fees - whether the fund's returns are good or not. With such massive annual fees baked in, some critics argue that mega-fund managers may be incentivized to simply raise increasingly larger funds rather than prioritizing top-tier returns for investors. With a lower carry incentive, there is less pressure to score big exits and realize profits. It's also worth noting that negotiating fees for VC fund investments is quite common, particularly for LPs with significant capital commitments. So while the standard "2 and 20" fee structure persists, there can be variances. Some funds have shifted to lower annual management fees but higher carried interest percentages to better align incentives.


Fund Size and Concentration Risk


Another drawback of mega-funds is that their massive size often forces them to take larger ownership stakes and concentrate more capital into a smaller number of companies. This increases their exposure if any of those heavily-backed companies run into trouble. Smaller funds can spread their bets across a larger number of companies.


The Virtues of Specialization


Many of the top performing smaller VC funds are quite specialized, focusing their efforts on a particular industry, technology, or geographic region where they have deep expertise. This specialization allows the partners to develop incredible domain knowledge and leverage proprietary networks in their focus area. In contrast, the generalist approach taken by many mega-funds can be a disadvantage.


Later Stage Growth Equity


While smaller early-stage VC funds have outperformed larger funds on average, the opposite pattern holds true for larger growth equity funds focused on later stage investments. Funds over $1 billion in size have actually tended to outperform their smaller peers in the growth equity category. This is partly due to the increased deal opportunity set available at the later stages.


Research shows that past performance is a reasonable predictor of future performance persistence for VC funds of all sizes. So LPs should closely examine the actual track records of the specific managers they plan to back, regardless of fund size. Strong performing micro VCs under $100M in fund size have demonstrated an impressive ability to consistently replicate their success across new, larger funds over time. The takeaway for LPs is clear - when investing in VC, smaller and more focused may very well be better. While brand name mega-funds can seem alluring, the historical data indicates that LPs have a better chance of earning superior returns by backing smaller, more nimble venture players. Avoid huge funds where the fee incentives may not be fully aligned with top performance.

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