Watch the fund size

Ever-growing fund sizes can put pressure on GPs to invest in bigger deals, which can lead to strategy drift, and generally lower returns, writes Mike Chalfen.

Successful venture funds often find themselves able to raise more capital for a new fund than they could for previous funds.

That’s not surprising. You might think that the more capital a fund can raise the better for everyone. This is not necessarily the case.

A fund that raises more capital than it originally plans might be forced by the sheer weight of capital to look for larger investments, possibly more than an investee needs, probably at higher prices, often in larger companies – in other words to change their strategy. If that fund’s team has little experience of these larger deals, deployment pace for the new, larger fund can be slow.

Mike
Chalfen

This scenario highlights a conflict that is common across the industry: does a GP’s asset gathering strategy (which drives fees) distort the investment strategy (which drives returns)? It’s certainly a question that any investor contemplating committing capital to a private equity fund should ask.

At the recent EVCA summit in Geneva, one of the most respected endowment managers, David Swenson of Yale, repeated an observation based on twenty-five years of data that “size is the enemy of performance”. The audience nodded sagely. Yet LPs and GPs across Europe and the US have colluded in letting fund size and fund strategy get out of kilter. 

The top of the PE market in 2006-2007 saw the creation of too many bloated funds. The current private equity overhang is clearly to be regretted for most stakeholders relying on investment returns as opposed to firm income to create wealth.

There are clearly examples, however, of firms that have had the discipline to scale successfully, firms like TA Associates and Apax Partners (where I was a Partner). It took Apax three fund cycles to craft a team that had the right skills mix to deploy a mega-fund. And, post-succession, its new leadership made two decisions that were critical to the effectiveness of its transition.

First, they did not increase the fund size for Apax Europe VI (2005), giving themselves breathing room to get the organisation right. Second, the team has retained its long-standing bias toward growth businesses, which has provided strategic continuity. 

Another example I can talk about is my current firm (Advent Venture Partners). We have had a different experience from Apax but are also taking a measured approach to getting it right. Delayed succession and a tough fundraising saw the fund size halved. When we eventually completed succession, the new generation of GPs managing the firm took the opportunity to look at fund size and strategy with fresh eyes.

We decided that we needed to raise the bar on asset quality, follow-on discipline, and capital efficiency. The ability to diligently execute a clear strategy is essential, and investors will no doubt see the benefits in performance. Compared to prior funds, twice the proportion of our current fund is invested in proven businesses.

We have also halved the average valuation paid while selecting the most distinctive businesses. We’re not the only ones seeing results from this strategy. Other firms that are successfully focusing on carefully crafted smaller funds with distinctive strategies include OpenView Venture Partners and Edison Venture Fund.

This isn’t to say that firms shouldn’t be flexible with both fund size and strategy. Firms should adopt a strategy that works across a range of fund sizes; if a fund ends up 25 percent larger or 25 percent smaller than previous funds, this shouldn’t require a firm to change its investment approach. And smart GPs will hone their strategy over time and should of course have the chance to react to market dynamics. 

But experience shows that a team’s track record is less relevant if investment approach materially changes. So we GPs shouldn’t have a free pass on strategy. The major lesson from the last five years is that substantially increasing fund size is a major determinant in strategy drift, and cannot be shown to be positive for fund returns.   

Mike Chalfen is a partner with Advent Venture Partners.