By Anik Bose, Benhamou Global Ventures
For the past few years, it has been the rise of the VC mega fund. Sequoia Capital has raised more than six across its global growth fund, U.S. and China funds, while firms like Battery Ventures and Khosla Ventures have raised $1 billion or more across multiple vehicles.
Some industry pundits claim that VC firms are building their war chests to compete with SoftBank’s initial $100 billion Vision Fund or its second fund, which is expected to raise at least $108 billion. Others point out that the mega fund trend is driven by the super-sized financing rounds for unicorns, combined with the extended duration of venture-backed companies staying private.
Economies of scale
Economies of Scale is one of the most basic concepts of economics. Intel is a good example in the technology sector. Andy Grove, former president and CEO, came to fully understand this concept as computing transitioned into a horizontal, commoditized industry.
As he says in his book Only the Paranoid Survive: “The fundamental implication of this model was — and is — that the player with the largest share of a horizontal layer is the one who wins. As this realization sunk in at Intel, it … provided further encouragement for our drive toward high volume and low cost in our microprocessor business: toward improving our scale and scope.”
While strategies employing economies of scale have played out successfully over a range of industries including telecommunications, pharmaceuticals and automotive, the closer parallel for capital is the broader private equity sector.
In 2018, over $750 billion was raised, an increase of more than $30 billion from the year before, a run that stretches back to 2009. What’s intriguing is that growth has been driven entirely by one sub-asset class: mega funds. Mega funds now account for 15 percent of all funds raised within private equity. In 2017, Apollo closed the largest buyout fund ever at $24.7 billion, and KKR gathered $13.9 billion for the biggest ever North American PE pool.
According to Antoine Drean, an adviser and entrepreneur in private equity: “Larger mainstream funds competing against each other are having a tougher time producing the kind of outsize returns for which PE – historically characterized by smaller funds and inefficient markets – is celebrated. … A barbell investing style is expected to take firm root in 2018, with limited partners putting large sums to work in big funds, but seeking a bigger bang for their buck by investing smaller sums in alternative PE.”
The impact of unicorn investing
Last year, investors put a record amount of capital into unicorns, VC-backed companies valued at $1 billion or more. Worldwide, a staggering $134.5 billion went into unicorn companies in 2018, up 51 percent year-over-year, according to Crunchbase.
While unicorns are raising big rounds, there is mixed data if the group as a whole will produce outsized returns for investors participating in later stages, as some unicorns trade down post IPO. By and large, earlier stage investors are netting large returns from IPO exits. In 2017, 15 venture-funded companies with private valuations of a billion dollars or more doubled 2016 levels. Unicorn exit value has ramped steadily over the past several years. As of early May, and even excluding Uber, 2019 had already yielded $57 billion in total exit value.
Acquisition activity, meanwhile, was weaker: only seven recorded M&A exits involved unicorns in 2017, down from 10 in 2016. AppDynamics was the highest performing exit at 95 percent over its last private valuation. For the remaining seven companies that exited, all appear to have been below or at their last private valuation.
Valuation Inflation is a natural consequence of mega funds.
According to Aly Jeddy of McKinsey: “The rise in deal volume has been driven more by the increase in the average ticket size of deals than it has been by the count.”
This increase in valuations will likely have an adverse impact on performance.
Success comes in all sizes. A Cambridge Associates analysis shows that venture funds of less than $500 million accounted for half of the value creation across most years (1995-2012), which is consistent with the barbell trend that occurred in the private equity sector.
To achieve performance goals, LPs will need to balance their venture portfolio between mega funds and smaller higher alpha funds.
It is also clear that one size will not fit all LPs. It is unlikely that every LP will be able to write minimum check sizes required by mega funds.
Processes will become more important. To deliver consistency at scale, larger funds will need more formal processes, and recognize that good process do not create stars, but eliminating dogs yields to process. The focus on eliminating the left-hand side of the returns distribution through rigorous processes will take hold in more and more firms.
While investments in later stage unicorns may lend themselves to scale, it is seldom the case in early stage investing. The key success factors for early stage investing are very different than mega funds. These factors include entrepreneur deal flow, deep understanding of leading edge tech and how they affect markets, and company building skills relevant to challenges faced by young startups. Such competencies are people-dependent and difficult to scale exponentially.
We are in the midst of an unprecedented technology disruption, the digital transformation of the enterprise. The value creation opportunity for next generation software startups is a significant. A company will not need to become unicorn to deliver top quartile returns.
We expect that the mega fund will become an important segment of the venture asset class, especially for later stage investments, but one size will not fit all. Mega funds and smaller early stage funds are two very different segments that, when executed effectively, they can complement each other instead of compete.
To achieve performance goals, LPs will need to balance their venture portfolio between mega funds and smaller, high alpha early stage funds, creating a barbell industry structure similar to what has evolved in the broader private equity sector.
Anik Bose is a general partner at Benhamou Global Ventures, an early stage venture firm with deep Silicon Valley roots with an exclusive focus investing in enterprise 4.0 startups in global markets. He can be reached at Anik@BenhamouGlobalVentures.com.