Big Funds Grow Bigger

Mega funds are capturing a larger share of venture capital fundraising than at almost any time since these billion-dollar-plus funds emerged 14 years ago. The question is whether they can make good money in a shrinking industry?

Seven of these monster funds have closed in the past year-and-a-half, roping in more than a third of all venture capital raised from January 2011 through June 2012. Only in 2006 has the concentration been higher. And that’s only because a pair of large growth-stage funds from Summit Partners and Oak Investment Partners, with $5.7 billion in combined commitments, lifted the total six years ago.

The recent trend is more pronounced if it includes firms that raised multiple smaller funds over the period that when combined add up to more than $1 billion. This includes Kleiner Perkins Caufield & Byers, Index Ventures, Accel Partners and IDG-Accel. Even Sequoia, which raised its $1.36 billion Sequoia Capital 2010, added a separate $950 million growth fund in 2012.

Add in these funds and 56% of the capital raised since the start of 2011 has gone into the hands of big-money firms.

In the second quarter, 38 U.S.-based venture funds raised $5.9 billion in commitments, but the five largest funds accounted for nearly 80% of the cash in the three-month period.

Without a doubt, the industry is undergoing a shakeout, with a sharp decrease in the number of mid-sized funds being raised and large funds the seeming beneficiaries.

Meanwhile, the investment ecosystem is seeing a jump in the demand for capital as stage-agnostic dealmaking spreads. Partnerships looking at expansion and later-stage financings require more money to scale rapidly expanding growth companies that now take longer to reach the IPO window. And they are actively prowling for deals, not just domestically but abroad.

The big debate unfolding is whether these massive funds can generate attractive returns. Not surprisingly, the answer is as important as any in venture these days. With the industry still in the LP doghouse and returns depressed since the end of the dot-com boom, the performance of these funds could dictate whether investors return to the asset class.

A good deal of skepticism about their prospects persists, and not without good reason. A $1 billion fund with a 4x target needs to generate $4 billion in cash, a lot of liquidity by any measure. A big strike, such as Facebook or Google, might guarantee success. But how many of these big black swan wins are there?

With big funds, “what you’re really saying is that you’re betting each firm is going to have one of those black swan exits per fund,” says Floodgate Fund Managing Partner Mike Maples Jr. “The industry seems to running an experiment: Can you make money on $1 billion-plus funds if there are a few enough guys doing them?”

Many of venture’s biggest names are not waiting for the answer. Since the start of 2011, New Enterprise Associates, Institutional Venture Partners, Andreessen Horowitz, Bessemer Venture Partners, Khosla Ventures, J.P. Morgan Chase and Sequoia Capital have each raised funds of $1 billion or more, garnering combined commitments of $10.8 billion, or 35% of all venture capital raised through June, according to data from VCJ publisher Thomson Reuters.

GPs and LPs show little disagreement as to the reason. The industry is adjusting to a shifting market place and big firms are acting more like crossover funds, willing to overlook high valuations and generous deal terms to get into the hottest deals with the greatest momentum. Fueling their interest are massive billion-dollar opportunities in social, mobile, cloud and elsewhere, with technology development moving at high speed.

“Capital supply has finally equalized with responsible demand,” says Tim Guleri, a managing director at Sierra Ventures. “Money is being raised for the right strategies and for the right reasons.”

These shifts helped spark a migration away from mid-sized funds, especially those seen as unable to compete with larger funds. In 2006, 41 funds of $250 million to $800 million were raised, according to data from Thomson Reuters. The following year, 45 secured commitments. Only 16 did in 2011 and just 10 in the first half of 2012, the data show.

“We think we’ll make money for our investors. We’ve been able to do this historically. We think we can continue to do that.”

Ed Colloton

Partner

Bessemer Venture Partners

In short, consolidation is taking hold in a fragmented business, just as it has to varying degrees across the finance industry and PE more broadly. Venture firms willing to embrace the change by taking on the complexity of managing multiple practice groups and in more than one country are the ones rising to the top. The firms with better track records, better reporting, better client service and better transparency are getting the money while weaker competitors are falling away, notes T. Bondurant French, CEO of Adams Street Partners.

“This is just part of the natural maturation” of the business, French says. “It’s part of the bigger picture.”

Perhaps the poster child for large funds is New Enterprise Associates, which has raised five funds, each over $1 billion, since 2000, including the $2.5 billion fund 13 in 2009 and the $2.6 billion fund 14 this year. Performance has been solid. The IRR for 2004 fund 11 is 8.07% and for 2006 fund 12, 12.22%, according to a 2011 portfolio report from the California State Teachers’ Retirement System.

Looking ahead, French—an investor in NEA funds—says assessing a large fund’s ability to make money is best done on a case-by-case basis.

“There is not extra worry” just because a fund is large, he says.

Other LPs and GPs take a broader, structural approach. Floodgate’s Maples, for one, says an exponential relationship exists among portfolio exits, with the best exit returning more profit than all the others combined, perhaps as much as 50% of a fund’s return. The second best exit is half as big, and the third will fall again by half.

To apply this to large funds suggests a $1 billion fund shooting for a 3x return and cash distributions of $3 billion must have a portfolio company exit of $1.5 billion. It is a tall order.

Accel’s Facebook holdings meet this requirement. The firm sold 57.7 million shares for about $2.2 billion in the company’s IPO. It appears to hold additional shares worth roughly that much.

Few other recent exits match up. Yelp, a top hit for Bessemer, is worth $305 million to the firm at the Sept. 14 price of $26.18, if no stock has been sold since the IPO.

This year’s successful offerings by Palo Alto Networks and ServiceNow come closer to the mark. Greylock’s 13.8 million Palo Alto Networks shares are worth about $924 million at their Sept. 14 price of $66.99. Sequoia’s 23.9 million ServiceNow shares are worth $934 million, if they are still held. Nice returns, but not quite billion-dollar paybacks.

Yet the math may be more complex than that. Take that $1 billion fund with the 3x target and say that it invests an average of $30 million in 36 companies over its three-year life. It is multi stage, so its batting average will vary among its later, growth and early-stage bets. If 80% of growth and later-stage companies can be expected to provide some return on investment, then perhaps the overall portfolio hit rate reaches 70 percent.

That means 25 companies will provide some level of return. If 18 of these can produce a 3x return, or average outcomes of $90 million each, the fund earns $1.6 billion. If five companies return 6x, or on average $180 million, this amounts to $900 million.

If the final two wild card companies deliver 10x, the fund returns $3.1 billion without a Facebook in its portfolio.

Fund managers are confident they can get the hits. IVP’s new $1 billion fund is “about the right size fund for what we are doing,” says General Partner Norm Fogelsong. The firm plans to stick to 10 to 12 investments a year with an average of $25 million to $30 million in each deal.

“We have a very high batting average,” he adds, with only three write offs in the firm’s previous 93 investments. “We’re looking for a 95% on base ratio.”

Ed Colloton, a partner at Bessemer, also is confident the firm can make money on the $1.6 billion fund it raised last year. Two key changes in the past decade have increased its opportunities.

First, it expanded to new geographies, with 35% to 40% of capital now going overseas compared with about 10% to 15% in the 1990s. It also became more stage-agnostic and grew from seven partners to 13.

“We think we’ll make money for our investors,” Colloton says. “We’ve been able to do this historically. We think we can continue to do that.”

Mark Boslet can be reached at mark.boslet@thomsonreuters.com. He tweets at @mgboz.

Photo: U.S. money printing plates. Reuters/Shannon Stapleton