In the venture business, and private equity more broadly, the J-Curve is a well-known phenomenon. It says that venture funds tend to produce negative returns in the early years as capital is deployed but as the portfolio matures and some liquidity is achieved, returns turn positive. Unfortunately in recent years, the average level of this positive return has been underwhelming to say the least.
Naturally, this has caused a number of GPs and LPs to question whether venture is broken. What’s clear is that while average returns in the venture industry over the past decade have been terrible (and perhaps will only marginally improve), there are funds that have clearly outperformed. So what exactly is going on here?
One generally accepted theory, originally proposed by Andy Rachleff, partner emeritus at Benchmark, is that every year 15 companies are created that reach $100m+ in annual revenue, and it’s these companies that generate the lion’s share of aggregate venture returns. Recently, our friend Elad Gil blogged about the incredibly short list of companies that reach $5B and $10B or more in enterprise value.
So the number of breakout successes of this magnitude is exceedingly small suggesting that the number of “winning” venture funds must also be small. This line of thinking has led institutional investors to concentrate their venture portfolios in an increasingly small number of firms. But as LP demand for this select set of funds has grown, so has the size of these funds. And in venture, size is the enemy of returns, as Bill Gurley recently remarked. The fact is that large funds have historically underperformed by a wide margin. According to this SVB study, smaller venture funds, defined as less than $250m, are 7 times more likely to return 3x than large funds (returning 3 times called capital being generally regarded as a very successful venture fund return).
Enter the U-Curve.
Using the simple illustration above, which is a riff on an isoquant curve, the #1 goal for any venture fund is to get into the purple area.
The challenge is that for larger funds, it becomes mandatory to invest in several of the next billion dollar winners to have any hope of generating a 3x net return on the entire portfolio. History suggests it’s pretty hard to do. This is the right side of the chart.
On the other end of the fund size spectrum, angels increase the odds of being part of one of the big winners through broad portfolio diversification. However, most angel investments result in relatively small ownership in any given company. So again, if a 3x or better return on the portfolio is the goal, and the percentage ownership is small, an outcome must be very large to have meaningful impact on the fund. See the left portion of the graph.
Between these two extremes are smaller, focused venture funds. I’ll define these as funds in the $75m to $250m range that typically target meaningful ownership stakes in each underlying investment. Structurally, this is where I think the sweet spot is. In this middle zone, billion dollar outcomes aren’t required in order to produce a winning fund. This is where the jump into the purple zone is shortest. Of course this doesn’t mean homerun investments aren’t targeted or desired, they just aren’t required to get into the purple zone. And if this type of fund does have a billion dollar exit, the fund return will look more like 5x or better. Given how few super homeruns are hit every year, it’s best to have a fund structure that is built for success with or without them.