Kevin Lalande, who founded two companies before attending business school, said he joined Austin Ventures in 2000 because it had a “better brand than any at the time” and was a great place to learn how to identify promising startups.
But the next year, Austin Ventures raised a $1.5 billion fund — only the sixth $1 billion-plus venture fund at the time. Lalande said that was a mistake, one that is still made today. It raised too much money and couldn’t keep up its performance, even with its respected brand and talent.
“That’s a lesson that the industry seems to have gotten better at over the last few years or over the last couple of decades, but then it constantly regresses. There is an assumption that somehow if you can raise a bigger fund, it must mean you have a better track record, or a better firm, or a better brand,” Lalande said.
“You don’t want to be too small, subscale and sort of relegated to the minor leagues. But in venture in particular, bigger is not better, better is better. And once you have a fund of a sufficient size, if it’s much bigger than that, it gets statistically more and more difficult to generate great returns,” he explained.
Lalande, who founded healthcare and life sciences-focused Santé Ventures in 2006, continues to ask himself: how big is too big for a fund? The firm published research in 2011, updated it in 2018 and released another report on Thursday answering that question again. As a small firm, Santé Ventures clearly has an interest in the answer, but its analysis is based on publicly available data.
Although the amount of venture capital funneling into huge funds has increased, the performance of the largest ones, with the presumed advantages of scale, brand, and experience, has lagged smaller ones.
Only 17 percent of venture funds larger than $750 million have returned to investors more than 2.5-times the total value to paid-in capital, after fees and expenses. Meanwhile, 25 percent of funds smaller than $350 million achieved the same, according to an analysis of PitchBook data on more than 1,300 funds dating back to 1978 by Santé. Put another way: a smaller fund is roughly 50 percent more likely to return more than 2.5-times TVPI than a large one.
Other research also reveals the difference between small and big fund performance. Revere, a platform investors use to discover and perform due diligence on more than 250 early-stage venture firms with relatively small funds, found that its group of small VCs outperform larger peers. When comparing the TVPI of its median and top-quartile managers, Revere said they routinely beat groups of the most respected and known VCs that tend to have large funds and are recommended by investment consultants.
The performance gap between small and large funds is even wider when considering the cumulative internal rate of return. Larger funds have an average IRR of 9.7 percent, compared to the average 17.4 percent IIR of smaller ones, according to the Santé report.
Santé’s latest research supports the firm’s decision to stay a certain size. Today, it manages a total of $800 million in assets across four venture funds and a hedge fund strategy. It plans to close its fifth fund early next year.
“I genuinely think this is the best way that venture should be organized and practiced. If Sante didn’t exist, I still think this is the right way for venture and it’s something that I’m passionate about,” Lalande said.
The largest funds are facing harder times in 2024, too, observers say. Historically low interest rates for the decade leading up to last year distorted the venture ecosystem. Deal volume and valuations climbed to stratospheric levels in 2020 and 2021 and supported the huge funds along the way. In 2021, 1,397 U.S.-based venture funds raised $157.8 billion and in 2022, 1,057 funds raised $168.3 billion (more than twice the number of funds and more than four times the capital raised 10 years ago), according to PitchBook. Now, higher interest rates and a slower economy have made fundraising hard; half way through 2023, just 197 funds raised $27.6 billion.
But even while there is less money raised and being invested, deals are happening. They are just smaller. There will be 2,186 venture investments in companies in 2023, up from 2,071 last year, based on the first half of the year and PitchBook’s projections. But just $40 billion is projected to be invested in 2023, far below the $56.6 billion invested last year and the more than $80 billion invested in 2021. Late-stage and growth funds are having the most trouble raising and putting their capital to work because of the gap between them and startups on valuation, VCs say.
“As much as everybody’s talked about how venture capital activity has slowed, it’s because 2020 and then 2021 were preposterous. A lot of these companies do need to just go away because there’s too many of them and they are too marginal,” Lalande said about VC firms big and small.
Jack Selby, managing director at Peter Thiel’s family office, Thiel Capital, and a managing partner at AZ-VC, a Phoenix-based venture firm that has raised a $110 million fund targeting early-stage companies, also predicts there will be a culling of VC firms next year. The estimated 10,000 VC firms globally could shrink to 7,000 soon “and look out below,” Selby said.
There are going to be “zombie” funds that don’t have the ability to raise new capital, struggle to draw their commitments from investors, and just get by on their management fees and hope markets reverse course.
“It wouldn’t surprise me when we truly reach the bottom, the numbers down to two or three [thousand],” Selby said about the number of VC firms. “I think there’s a long way to go and it’s just getting started.”
