How Venture Capital Fund Size Impacts Fund Returns

Over the past decade, venture capital has generated extraordinary returns compared to alternative asset classes, attracting increasing capital inflows from institutional investors. However, as fundraising and fund sizes ballooned during the ZIRP era, venture funds’ return and ownership math got harder. VC is driven by ‘power laws’ — a handful of investments drive the bulk of returns. As a result, identifying and securing attractive ownership positions in any given vintage’s ‘winners’ proves essential for VC managers, which becomes harder with larger fund sizes that are usually forced to invest at later stages.

Given the fund economics at play in smaller and larger venture capital funds, it’s not surprising that smaller funds have historically demonstrated superior performance compared to their larger counterparts. Research conducted by Sante Ventures reveals that a mere 17% of venture capital funds exceeding $750 million have achieved a 2.5x TVPI ratio or greater, in contrast to 25% of funds smaller than $350 million.

This dynamic is supported by a variety of research and studies. A Cambridge Associates’ analysis spanning from 1996 to 2015 highlights that seed and Series A investments boasted the most favorable median net IRRs. Additionally, a study conducted by PitchBook illustrates that seed-stage investments exhibited a median DPI ratio of 4.5x, surpassing the DPI performance of investments across all stages from 2011 to 2020.

How the Return Profiles of Different Fund Sizes Correlate with LP Commitments

With smaller funds proving to yield higher returns, one might naturally expect LPs to gravitate toward these opportunities. However, the reality is more nuanced. For allocators, mastering manager selection has long been a critical component of effectively implementing a VC investing strategy, and the wide dispersion of performance among VC managers makes this a challenging task. As previously mentioned, venture return distributions demonstrate a significant positive skewness — a handful of exceptional performers significantly influence overall returns in any given vintage.

Over the past decade, the influx of managers into the VC arena has largely been concentrated in the lower spectrum of fund sizes. A StepStone analysis shows that since 2018, over 3,000 US-based funds have been raised with fund sizes under $300 million, with 38% less than $25 million and 53% less than $50 million. Very few managers who graduate to funds IV and beyond maintain a small fund size across subsequent fundraises, meaning the large majority of smaller funds are held by emerging managers. 

While smaller fund sizes may correlate with better returns, there’s a much wider variety of funds to choose from at the lower end of the market, and the limited performance track record and wide return dispersion of these funds add complexity for allocators. For an LP, evaluating smaller funds or emerging managers requires them to pick a needle from a haystack, leaving zero room for error in manager selection. Consequently, most LPs hesitate to commit to smaller, emerging funds, as they inherently entail greater variability and risk compared to established brands with a track record of identifying exceptional companies and delivering returns.

Moreover, consistency holds its own allure. Not all LPs seek outsized returns, and the internal dynamics of various institutions factor in — LPs face consequences for failure rather than rewards for success. In this context, the appeal of investing in well-known funds is hard to overlook, which is clearly evident in today’s environment, where the rate of emerging managers able to raise a Fund II successfully is at an all-time low.

Returning a larger fund certainly involves tackling more complex return equations, but there are many firms up to the task. Brand-name large funds have already proven the ability to generate attractive returns despite larger fund sizes, and data indicates that “established” managers have, in fact, outperformed emerging managers in certain vintages.

All is to say, fund size isn’t a one-size-fits-all formula. Central to the conversation is the imperative for GPs to own and adhere to their strategy, selecting fund sizes accordingly. There’s not one model or approach that should necessarily find adoption across the industry. Varying LPs will have different portfolio construction or allocation mandates that align best with certain fund sizes.

A pension that has to write very large checks may be better off with a more established manager, while a fund of funds tasked with accessing early-stage venture returns for their constituents may seek out smaller shops and balance risk across a number of managers. Further, certain fund sizes best align with a GP’s expertise or enable the necessary investment amounts for capital-intensive sectors. 

Technology offers crucial visibility for both LPs and GPs as they manage funds of all sizes. For GPs, streamlining workflows and consolidating all portfolio company data in a single source of truth offers a solution to identify value creation opportunities and prioritize high-performing investments. Similarly, for LPs, access to underlying portfolio data clarifies their ownership in a fund’s top-performing companies and gives confidence in future manager selection decisions.