Fidelity Comes to VC

The shakeout and consolidation in the venture business continues forward at a strong pace. Brand and scale are increasingly driving success. The larger the venture firm, the greater the in-house domain expertise and the wider the breadth of deals in each vertical. In an effort to simplify the guessing involved with picking funds, institutional LP’s continue to flock to brand name funds. Just last year, Oak and NEA accounted, by themselves, for 20% of all capital raised.

In a recent San Jose Business Journal article, VC Funds Find Size Matters, they write:

"In the first three quarters of 2006, funds under $100 million captured
the least amount of capital in the 14 years that VentureOne of San
Francisco has collected such data. Once the norm, these investment
pools garnered just 29 percent of the $19.6 billion that has poured
into the asset class so far this year. In addition, the median fund
size has ballooned to nearly $200 million today, a far cry from a
decade ago when $81 million was the median."

This is not a surprise to me given that nearly every other asset class has seen a number of major Brands arise at the top end, an array of focused boutique firms on the low end and the middle market generally getting squeezed out of the business. This has happened in mutual funds, brokerage firms, insurance and is starting in Buyouts and Hedge Funds.

 

My father-in-law was on Wall Street for over 30 years. He once showed me a tombstone page from the late 1960’s with over 65 different small or mid-sized brokerage firms. This number winnowed down during the 1970’s and 1980’s. Globalization hit and firms were forced to merge to get international scale. Today, you have a handful of brand name firms like Goldman, Merrill and such as well as an array of boutiques.

Humans are creatures of habit and tend to drift to Brand. If in doubt, go with the brand that you know or have heard of…Fidelity mutual funds, Merrill Lynch Private Banking or AIG insurance. If you are an entrepreneur, there are a handful of funds that most will put on their list such as Sequoia, Kleiner, Benchmark, DFJ and such. They then add to the list other groups that they may have heard about from publications or from associates. Likewise, if you asked most institutional investors what funds were on their approved hit list, you would often see the same 20-30 names come up time and again. As a result, these funds are oversubscribed time and time again.

Scale plays a key role in the venture business. With more partners and more deals in the portfolio, a larger fund will have a deeper array of resources and domain expertise to draw from. They can also write big checks and play lead regardless of raise amounts…this puts them in the Alpha Dog role. If a group has had two or three successes in a given vertical, they not only get a reputation for their actitivity in that sector, but they also have access (or know where) to more resources, teams and companies in it. They know the scuttlebutt in the industry, are plugged into its inner circles and have "alumni" CEO’s from past deals that are at the heart of these sectors. Entrepreneurs like being backed by the investor(s) behind XYZ Corp (say Google)…call it guilt by association.

These firms are now raising $500-800m funds with the later stage guys (TCV, Menlo, etc) raising $1-2B funds. You also have new funds spinning out from these brand groups raising $150-300m funds. LP’s view them as an extension of the mother fund they spun out of. Because many of the LP’s also have the 10/10 or 20/10 rule (need to put out at least $10m and don’t want more than 10% of the fund), they are limited to $100+m funds and $300-500m is even better since they can get more money deployed while also having more co-investors in the boat (how can this fund be bad if there are 20 other major LP’s…right?).

However, the sub-$100m fund is getting squeezed. You have either $30-50m high networth funds or possibly $75-100m specialized funds, but by and large, LP’s are focused higher up.

Ironically, the larger funds have not historically performed as well as their smaller brethren. Large funds need to deploy larger sums per deal. However, if anything, the exit valuations have been contracting due to the weak IPO market.

"Historically, these firms, which typically do seed rounds and A rounds,
have outperformed large funds. At 10- and 20-year horizons, early/seed
stage VCs returned at 36.9 percent and 20.5 percent respectively,
according to data from NVCA and Thomson Financial. By comparison, later
stage VCs, typically bigger, returned at 9.5 percent at year 10 and
13.7 percent at year 20."

So, consolidation will continue in the industry while returns will compress. Many funds will be forced to move later stage or out (Summit started as a VC firm and is now predominantly a buyout/late stage shop). New fund groups will arise on the lower end to target the "abandoned" seed stage, but the total dollars there will continue to be dwarfed by the bigger fund efforts.

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