Financial returns on investments in venture capital funds have been poor for the last decade. Since the 1999 vintage year, the median internal rate of return has not reached 3 percent for any vintage year and has been negative in nine of those years.
These poor returns have many investors in venture capital funds—university endowments, pension funds, banks, insurance companies, family offices, and wealthy individuals—wondering whether to keep allocating capital to this investment class. And it has those investors still putting money into venture capital trying to figure out whether some types of VCs are more successful than others.
Analysts have found that certain “brand name” venture capital firms have typically outperformed the industry average, and that investing at certain stages is more profitable than investing at others. But a recent study by SVB Capital identified another important dimension of venture capital fund performance: fund size.
The SVB capital report showed that venture capital funds of between $50 and $250 million generate higher returns than funds of more than $250 million. In particular, the best performing funds fall between $50 and $150 million. (The study didn’t include funds with less than $50 million in capital.)
The report argues that smaller VC funds should generate higher returns for investors for four reasons:
- The venture capitalists in small funds are more motivated to generate returns since the fees they receive for managing capital are smaller.
- Small-fund VCs have better sector and geographic expertise, which allows them to get better deals.
- Small funds can earn a high return if they identify just a handful of winning investments, rather than having to identify many successful start-ups to make money.
- Small fund expertise makes them good partners for top tier funds, allowing them to join better syndicates.
Despite the better performance of small venture capital funds, the report shows that the average size of a venture capital fund has remained large. The study shows that in the aftermath of the bursting of the tech bubble, the size of venture capital funds fell for a couple of years, but that it grew again from 2003 and 2007. Since 2007, the average fund size has fallen, but it remains high by historical standards.
While the SVB Capital report’s analysis appears sound and their arguments are logical, their findings pose a puzzle for limited partners. If smaller venture capital funds perform better, why don’t venture capitalists shrink the size of their funds?
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Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool’s Gold: The Truth Behind Angel Investing in America; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.