Size Does Matter –

With many private equity firms returning to the market late this year and next year to raise their first “post-bubble” funds, managers are struggling to determine the ideal target size for their next fund. Meanwhile, many limited partners have publicly signaled their bias for smaller funds with several notable institutions, ending longstanding relationships with managers who failed to reduce their capital base to the degree these LPs desired.

At the same time, institutions such as CalSTRS, MassPRIM, GKM and the Crossroads Group, among others, have announced or expanded their “Emerging Manager” programs to target newer groups. Emerging Manager allocations started with a qualitative focus, with institutions seeking newer, more aggressive and “hungrier” managers who had the experience but not the wealth or complacency they feared the bubble might have created in older groups.

Now LPs are beginning to focus on the quantitative question of fund size. How, they ask, can a $500 million or even $300 million fund return 3x their capital in the current environment? Increasingly they are realizing that private equity style returns many not be achievable with such large funds, especially for early-stage funds. This LP focus on smaller funds is not a fad. Historically, smaller private equity funds have outperformed many of their larger peers with the same industry and stage focus.

This effect has persisted and is most evident in buyout funds over the last 15 years. Smaller funds demonstrate higher pooled returns on a cumulative basis. From the early 1980s through the mid 1990s, approximately 95% of all funds raised within venture were smaller than $150 million. Giga “early stage” venture funds (over $500 million) did not emerge until the late 90s. Performance of these types of “early stage” funds is not fully developed, according to both Venture Economics and studies by the Crossroads Group. Many now believe that results of early-stage venture, like buyouts, are increasingly and negatively linked to fund size.

Many LPs recognize that the industry’s most notable success came from small funds. Benchmark Capital’s first fund, which is considered one of the best-performing venture funds ever, was a $110 million fund. ComVentures’ first and most successful fund was $75 million. Kleiner Perkins’ funds, up until 1994 (seven funds), were all below $200 million, as were Sequoia’s first six funds (up until 1998). The performance of these funds was clearly linked to vintage year effects. But did fund size also affect their performance?

Less Is More

At the core of this issue is the age-old concept of getting more with less. During the bubble, many private equity firms inverted the historical investment pyramid (see chart: David Whips Goliath) by giving startups large amounts of capital up front in so-called “fully funded syndicates,” only to find that the idea or product concept was a bust. In fact, as companies failed to achieve their “get big fast” strategy, follow-on rounds became subsequently smaller as the dreams disappeared and investors sought to prolong the runway of their companies, often only to see them eventually expire.

Historically, seed or Series A rounds raised just enough money to sustain projects to pre-established milestones that reduced the risk and raised the probability of success. Subsequent rounds would then raise more capital, with an implied assumption that investors would follow and back their winners and kill their losers.

Historically, investors would only put large pools of capital to risk when startups met milestones that justified additional capital exposure. Venture capital has always been about lighting a forest fire with a match, not about pouring gasoline on a tree and lighting it with a blowtorch. If you give a startup more money, it will be spent. As we will see shortly, the same holds true for private equity firms themselves.

Secondly, with successful venture exits capped in a $100 million to $200 million range for the foreseeable future, startups that raise more than $25 million in their lifetime are unlikely to provide anywhere near the expected return for the asset class. So limited and controlled capital infusions are not only a good idea; they are the only way investors can manage the inherent risks and rewards of the asset class.

While many managers will agree with these precepts, the reality on the street is quite different. A large number of Series A deals continue to raise $10 million or more, with little regard for milestones or risk management. Many investors will justify these deals with the need to provide companies with sufficient runway to keep them focused on running their business instead of raising capital. Others will point to competing deals that are raising large amounts of capital and the need to compete effectively in the product marketplace. These arguments give rise to a new question: “If your competitor is willing to jump off a bridge, should you?”

Some of the best deals ever funded were done with small checks. EBay’s Series A was $3 million and it only raised $5 million of private equity (from a $100 million fund). Today’s former “gigafunds,” with $300 million to $500 million under management, are no longer able to write small checks for $500,000 to $1 million. By contrast, funds smaller than $100 million can easily fund these deals in a sane syndicate and maintain ownership over time. If a startup needs a lot more than $25 million and is unable to raise follow-on capital from outside sources in late 2004 to 2005, it shouldn’t get funded at all. With this strategy in mind, it is much easier to see how a $75 million to $100 million fund with a few great hits can return 3x-5x investor capital.

A key factor in the large fund vs. small fund debate is focus and time. Smaller funds can afford to write small checks for a project and focus very keenly on that company. Most investors agree that it is only possible for a single partner to sit on up to five active boards of directors. In the bubble it was common to find managers sitting on 10 or more boards.

Assume there is a new Vintage 2003-2004 fund with $300 million under management with five investment professionals and it has an investment period of four years. Also assume that each investment partner continues to have responsibility for five prior portfolio companies (which technically means they actually do not have any bandwidth for new deals, but we can ignore that for a moment). Let’s assume also that approximately $200 million must be invested during the first three years, with the remainder going to follow-on reserves. It becomes easy to see how even today’s new “small” funds are unable to write checks of $500,000 to $1 million without the danger of partner overload.

How Big Is Small?

If fund size is such a meaningful factor in private equity returns, why have large funds persisted past the bubble period and why is a $300 million fund considered small in this vintage period? The answer is alignment. While many firms have reduced fund sizes and restructured fees in support of this smaller fund trend, in most cases these reductions have not been large enough, as demonstrated by second and sometimes third reductions. Many have noted the perverse effects of management fees on GP incentives: Because of the uncertainty (and scale) of liquidity options, GP compensation is more immediately linked to fund size than it is to the success of the portfolio.

But the challenge to downsizing former gigafunds runs deeper. For a fund to effectively scale down to a rational size it must not only significantly streamline operations and compensation, it must also reduce its number of investment partners. If it does so, LPs may rightfully ask questions about platform stability, motivation and attribution and may question their willingness to back the fund.

Despite public and private protest, LPs have effectively incited managers to maintain their cost, compensation, organizational structure and raise very large funds, even though the definition of large has changed. While LPs understand the need to reduce fund size, they only want it done at the expense of other limited partners’ future commitment amounts, not their own. After all, they still need to put money to work.

What began as a focus on Emerging Managers and their hunger is shifting to a focus on fund size. Many LPs have come to understand that private equity managers, like the portfolio companies they back, behave differently with excess capital and feel the pressure to invest all they have – and that’s not always in the best interest of their investors. Many LPs have come to realize that less is more in private equity and that managers need to stay focused on capital efficient deals that can generate above-average returns in a market that will continue to cap exits at $100 million to $200 million for the foreseeable future.

Fund size and focus are critical to the time and bandwidth needed to move companies through their lifecycle. The misalignment of larger early-stage funds with their LPs is a phenomenon that only truly smaller funds can address. In private equity, size does matter, and less is truly more.

Bart Schachter is a founder and Managing Partner of Blueprint Ventures and George Hoyem is a Partner with Blueprint, an early stage technology investor in San Francisco. Brien Smith is a Director with the Crossroads Group, a fund-of-funds manager in Dallas .