In the VC/PE industry the typical maxim is that in the typical 2 and 20 model (2% management fee + 20% carry - often above a hurdle of 7 -8%) a fund must be of a size of >£50m to be viable. This means that at 2% management fee a fund of £50m has £1m to run itself for the year. With this you can pay 2-3 partners (very well), have a couple of associates and rent offices, fly around etc etc. Plus the returns (the 20% carry) are attractive enough to share amongst this small team to stick around. Many LPs (Limited Partners - fund investors) will not support a fund unless it reaches this minimum size. They are doubtful as to whether below this size the fund economics can hold a team together. Also with £50m you can support 10-15 companies and reserve capital for follow-ons, down rounds etc and thus maintain the required portfolio effect whilst having reserves. Below this amount you are capital constrained either on portfolio size or ability to follow.
Over the past 5 years - raising a first time sizeable VC fund has been nigh impossible (unless you are a big name entrepreneur who can put in most of the money yourself). I should know – I gave it a brief shot and pulled back once I saw the carnage. Many have persisted and found that while they could get support for £10-20m could not get above the £50m critical mass. Typically to analyse a fund we focus on the 4 Ps – Performance, Process, Pipeline and People. Most people trying to raise VC funds fall down on the first P – Performance AKA track record. Many first time hopeful fund managers are entrepreneurs come good who now want to be VCs and have only one company (their own) on their track record, lower level management from other funds who cannot claim fully all the deals they worked on, Angel groups who have had some success and now want to manage larger capital to back their own deals all the way. All of the above groups struggle with an institutional grade track record i.e that a large pension fund would be happy with.
Many of the managers who went to raise a larger fund and struggled have in my opinion taken a very brave route and decided to run a smaller fund (<£25m) or run a deal by deal carry type model (we call it Fund Lite). Their ethos is: We handpick 3-4 of our best deals from our pipeline – invest the capital we have – trust that we can show returns quickly and then raise an optimum sized fund. This is a risky strategy as - you are living and trying to run a management team on relative peanuts (in comparson to your competitors in the larger funds), you cannot follow on easily and are giving away the required portfolio effect (i.e if 1 in ten deals in VC does really well – where does that leave you if you can only invest in 5?) or they maintain the portfollio effect(>12 deals) but cannot back winners or prop up their struggling companies with a lack of capital.
I keep a close eye on how these smaller funds are doing – they can’t all win. They are typically earlier stage (up to and including series A) – the Series B gap (which we have written on before) looms large. The winners will be the best company pickers (as in an investment management area) – and they will then have a track record to proceed to a larger fund.
By John Rowland, Managing Partner