Are megafunds killing venture capital?

In the days of yore, $214 million would have been a decent-sized venture capital fund.

American VC heavyweight Andreessen Horowitz’s first fund in 2009 was $300 million, Peter Thiel’s first three Founders Fund vehicles ranged from $200 million to $250 million, and even as recently as Q3 2022, the median US fund size it was still a mere $50 million.

Yet $214 million is how much Sequoia gambled and lost on a single investment in the infamous cryptocurrency startup. FTX. This single investment was as large as many early VC funds, and the Sequoia fund itself that backed FTX was over $8 billion in size.

Redwood described FTX (in a now deleted article) as “a company that could very well end up creating the dominant all-in-one financial superapp of the future.” The gushing phrase recalls what Softbank’s Masayoshi Son said about WeWork in 2017: “We are delighted to support WeWork as they unleash a new wave of productivity around the world.” Two years later, in 2019, the $100 billion vision fund took a $4.6 billion hit on that investment.

Is there a link between bigger funds, with more cash to spend, and these massive losses?

The capital is concentrated in mega-funds

It’s not just Sequoia and Softbank that have gotten big. VC of $1 billion or more have received 60% of the capital so far this year, up from 34% in 2021. On the other hand, newer and smaller funds are being phased out, despite evidence usually exceed.

Capital is becoming increasingly concentrated in a few hundred mega-funds around the world, with the Top 20 Venture Capital Brands now managing more than 200,000 million dollars, which translates into 10% of total venture capital assets globally.

The ratio would likely be even more skewed if we counted on so-called “venture capital outsiders”: companies like Softbank, Tiger Global, Partner Fund Management, Thoma Bravo, and other private equity and hedge funds that have invested billions in the venture capital game recently.

And as megafunds grow, they ultimately face the same challenge: how to spend that money and earn a return. Time to do some math…

Size Matters

In CV size if it matters due to, (a) mathematics and (b) access.

Let’s look at the math first. venture capital outflows follows a power law distribution: 20% of a fund’s portfolio will normally account for more than 90% of its returns. 25% to 50% will return nothing or almost that.

If you had a $100 million fund and wanted to triple your money (a benchmark VCs typically look for), each portfolio company would have to have an opportunity to return the entire fund. For example, if you managed to defend a 10% stake in a $1 billion exit, that company would earn you $100 million, which was your original fund. A result of $20 billion, like figma, would give him $1 billion even if his stake was only 5%.

What if you had a fund of $8 billion? In that case, a result of $1 billion only returns you 20% of your fund. And the $100 million unicorn outing? A failure that does not move the needle.

The second problem that comes with size is access.

Dealroom data suggests that the most successful “unicorn hunters” — VCs backing $1 billion+ startups — are the ones to invest in these early-stage companies first. But to get into an early round, or even a Series A, you need to be able to deploy capital at such stages and the size of the tickets you’re writing needs to be significant to your fund.

Herein lies the access problem: Seed rounds are typically only a few million dollars in size. The median of Series A is approximately $10 million in the US Y even less in Europe. Whether your fund is $50 million or even $100 million, seed checks are still significant. But if your fund is a billion-dollar mega-fund, those tickets aren’t worth your time.

Are megafunds killing off venture capital?

All of this means that we are now at a point where, for big VC funds, a startup making a profit of more than $1 billion is meaningless. To achieve a 3-5x return, mega-funds need startups that can:

1. take on hundreds of millions or even billions in investments, and
2. exit north of $50 billion dollars.

If you look at all the public tech companies today, less than 50 They have achieved that assessment.

So when you meet a founder who is attracting global PR, you’re poised to raise massive amounts of cash, and to quote Sequoia’s deleted article again, he’s presenting you with a “vision about the future of money itself, with a total addressable market of every single person on the entire planet,” large investors are tempted. They are tempted to jump on the hype bandwagon and “Uber” it. (Uber’s market cap, by the way, is just over $50 billion).

masayoshi son supposedly got on the wagon after just 28 minutes of meeting WeWork’s Adam Neumann.

Sequoia did it with Sam Bankman-Fried, even though the “son of a bitch was playing League of Legends the whole meeting.” The remark was an ironic harbinger of his disastrous rule-breaking that led to the company’s collapse.

This mentality and the concentration of capital in a handful of funds is creating a widening funding gap between the founders these funds support and everyone else. What’s more, the biggest funds are creating a close network of advertising in their quest to engineer the next $50+ billion Uber, which means that they naturally end up investing in many of the same companies.

The slowdown in the technology market will only accelerate these forces.

Francesco Perticarari is managing partner of Silicon Roundabout Ventures.