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When I was raising money as a startup founder, I didn't pay much attention to the size of a VC fund that I was raising from. I assumed that money from a $50M, $100M or $500M fund would behave similarly. The only thing I was vaguely aware of was that larger funds tend to put in larger checks. Thus, if I was only raising a couple of million dollars, I wouldn't bother with big funds unless I was open to them taking the entire round. Now, sitting on the other side of the table as an investor, I have come to realize that there is more to it. The size of a fund reveals a lot about the incentives driving its money and money managers.
Let's compare a $100M fund with a $300M fund. Both funds have a lifespan of seven years, common in the crypto industry, and charge their Limited Partners (LPs) a 2% annual management fee with a 20% carried interest. For simplicity, let's assume there's no capital recycling for reinvestment.
LP: Stands for limited partners which invest in VC funds. They are typically university endowments, foundations, family offices, fund of funds and high net worth individuals.
GP: Stands for General Partners which is the person or entity that manages a VC fund's investments and makes decisions about how to allocate the fund's capital.
Carried interests: Also known as "carry", is a portion of the return from an VC fund that is paid to its GP. 20% is an industry standard and is designed as a performance bonus for the GP.
Annual management fee: A percentage, typically 2%, of the total asset under management that is paid to the GP every year in order to cover the salaries of the GP, team and other operational stuff.
I run a simulation of the potential fund returns and its impact on the earnings of the GPs:
What this spreadsheet illustrates is a contrast in incentive structures between two GPs: To earn the same amount of money ($102M), the GP of a $100M fund must achieve a 5.4X return, whereas the other GP only needs a 2X return. This discrepancy arises because a significant portion of the former's compensation comes from carried interest while the latter's is primarily from management fees. Carried interest depends on fund performance, but management fees are paid annually, regardless of performance. Over seven years, these 2% annual fees accumulate substantially!
"Show me the incentive and I will show you the outcome."
-- Charlie Munger
All things being equal, I believe that small funds are more motivated to take significant risks with their investments compared to large funds. These smaller funds understand that they must invest in companies at an earlier stage, make contrarian bets, and target sectors that are yet to become popular. If they pursue the same "hot" themes as larger funds, they won't be able to generate exceptional returns. This is especially true for funds under $50M, often the first institutional fund for a manager. These managers likely feel as much pressure to prove themselves as first-time startup CEOs. However, I'm not suggesting that managing large funds is simpler. Large funds come with their own set of unique challenges, which we might explore in a separate post.
Beyond financial incentives, smaller funds typically receive lower annual management fees, which restricts their capacity to employ a large team of associates or analysts. As a result, the leadership team is more likely to be directly engaged in scouting for investment opportunities. As an entrepreneur, having a direct line of communication with the partners is preferable. In contrast, larger funds, with their affordability to hire more staff, often have more layers in their organization and communication chain.
I am not here to claim that small funds are better than large funds or vice versa. Instead, I see it as a question of which type of fund is better suited for different phases of a startup's journey. If your startup idea is considered 'weird', 'unpopular', or 'crazy', you might find a much better chance of securing funding from small funds and building a rapport with the investor.
Agree or disagree? Let me know what you think. Holla me at @huangkuan
When I was raising money as a startup founder, I didn't pay much attention to the size of a VC fund that I was raising from. I assumed that money from a $50M, $100M or $500M fund would behave similarly. The only thing I was vaguely aware of was that larger funds tend to put in larger checks. Thus, if I was only raising a couple of million dollars, I wouldn't bother with big funds unless I was open to them taking the entire round. Now, sitting on the other side of the table as an investor, I have come to realize that there is more to it. The size of a fund reveals a lot about the incentives driving its money and money managers.
Let's compare a $100M fund with a $300M fund. Both funds have a lifespan of seven years, common in the crypto industry, and charge their Limited Partners (LPs) a 2% annual management fee with a 20% carried interest. For simplicity, let's assume there's no capital recycling for reinvestment.
LP: Stands for limited partners which invest in VC funds. They are typically university endowments, foundations, family offices, fund of funds and high net worth individuals.
GP: Stands for General Partners which is the person or entity that manages a VC fund's investments and makes decisions about how to allocate the fund's capital.
Carried interests: Also known as "carry", is a portion of the return from an VC fund that is paid to its GP. 20% is an industry standard and is designed as a performance bonus for the GP.
Annual management fee: A percentage, typically 2%, of the total asset under management that is paid to the GP every year in order to cover the salaries of the GP, team and other operational stuff.
I run a simulation of the potential fund returns and its impact on the earnings of the GPs:
What this spreadsheet illustrates is a contrast in incentive structures between two GPs: To earn the same amount of money ($102M), the GP of a $100M fund must achieve a 5.4X return, whereas the other GP only needs a 2X return. This discrepancy arises because a significant portion of the former's compensation comes from carried interest while the latter's is primarily from management fees. Carried interest depends on fund performance, but management fees are paid annually, regardless of performance. Over seven years, these 2% annual fees accumulate substantially!
"Show me the incentive and I will show you the outcome."
-- Charlie Munger
All things being equal, I believe that small funds are more motivated to take significant risks with their investments compared to large funds. These smaller funds understand that they must invest in companies at an earlier stage, make contrarian bets, and target sectors that are yet to become popular. If they pursue the same "hot" themes as larger funds, they won't be able to generate exceptional returns. This is especially true for funds under $50M, often the first institutional fund for a manager. These managers likely feel as much pressure to prove themselves as first-time startup CEOs. However, I'm not suggesting that managing large funds is simpler. Large funds come with their own set of unique challenges, which we might explore in a separate post.
Beyond financial incentives, smaller funds typically receive lower annual management fees, which restricts their capacity to employ a large team of associates or analysts. As a result, the leadership team is more likely to be directly engaged in scouting for investment opportunities. As an entrepreneur, having a direct line of communication with the partners is preferable. In contrast, larger funds, with their affordability to hire more staff, often have more layers in their organization and communication chain.
I am not here to claim that small funds are better than large funds or vice versa. Instead, I see it as a question of which type of fund is better suited for different phases of a startup's journey. If your startup idea is considered 'weird', 'unpopular', or 'crazy', you might find a much better chance of securing funding from small funds and building a rapport with the investor.
Agree or disagree? Let me know what you think. Holla me at @huangkuan
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