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Attack of the Mega Funds!

Posted on June 20, 2006

After hearing about and reporting on Oak’s latest fund, the largest VC fund ever raised at $2.56B, I thought it was time to talk about where all this money is going to go. The short answer, I have no idea. It seems to me that more and more VC money is being raised while the amount of good investments is decreasing. Even good investments could be spoiled by VCs who want to inject too much cash into them. Also, as investors raise more and more money the amount they need to put to work in each deal grows pushing them later and later stage where they may not fair as well (Oak is a great example of this). Why would VCs raise so much money if they know that it will be hard to find good investments for all of it and will push them away from their core competency you ask? Again, short answer, greed.

While I think that some VCs who are out there raising more money genuinely believe they will find a lot of good investments I also believe that some are doing it simply because they can and it will make them more money. (Sidebar: I know some great VCs who are great guys to boot so this is not a slam to the industry at all. These are just some observations which will hopefully spur discussion that will help us all learn and grow.) At this time, a discussion on how VCs make money is in order. If you already know about this please skip the next few paragraphs and head to the conclusion.

When VCs raise money from Limited Partners (LPs) they do not actually take the money all at one and throw into a giant lockbox until they are ready to invest. They actually call capital (in what are appropriately termed “capital calls”) in chunks when they have investments to make. This is important to note because VCs, for the most part, only take their management fee percentage (their steady paycheck) off of the called capital, not the total. So, the more capital called, the more management fee they make. VCs are incentivized to put more capital to work because they get more money in return for it. This may not always work in the Limited Partners favor since the VC (aka General Partner) may find investments like just to get money out the door and management fees coming in.

However, there is a counter balance to the management fee structure. While VCs can do quite well with management fees, they usually need their investments to do well in order to become very wealthy. Here’s why they need investments to pay off (this is the norm but there are exceptions). Typically the VC puts in about 1% of the total fund capital and the LPs put in 99%. In this example, let’s say the total fund size is $100 (LPs puts in $99 and the VC puts in $1). Now, the VC heads out and invests in 2 companies. Down the road the VC sells the first for $100 and the proceeds are split 99/1. Now, everyone is paid back (they are even). Here is where the VC can make some serious cash on what is called carried interest.

After the VC has paid back the LPs they start splitting all returns 80/20 with 20% going to the VC. So, even though the VC only puts up 1% of the capital they now stand to get 20% of the second investment’s proceeds at sale. The VC then sells company 2 for $200 and they take $40 while paying the LPs $160. You can see how the VC ends up with a better percentage return overall as a result of the carried interest while the LPs still do quite well.

Back to mega funds. Now we have seen that there are checks and balances in place that work to keep the VC in the mindset of making good investments. So, what’s the problem with mega funds? There may not be a problem, only time will tell. However, it seems to me that there the amount of quality investments is decreasing while the amount of money to put into companies is rapidly increasing. This may not cause investors to lose money in the end of the day but it may cause them to underperform. For example, if the VC fund returns 10% per year and I could have got 8% in the public markets for far less risk then the fund wasn’t really worth it. Especially considering the management fees are much higher than those of a mutual fund.

I am excited to see what happens with the mega funds over time but I have to think that the disciplined investors who didn’t raise a ton of cash just because they could will win out at the end of the day (assuming they are tapped in and have good deal flow of course).

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2 Comments so far
  1. […] As I mentioned in my post a while back on mega funds, I am excited to see how this all pans out. This is an interesting time for VCs and for entrepreneurs and, while there will be a lot shake ups in the industry, I also think there is a lot of opportunity to be had if you know where to look. August 04th 2006 Posted to VC, Business […]

  2. Green_Monkey23 October 13, 2006 7:07 am

    Sorry for your time…. Why i can’t see images on this resource?
    My Browser is: Opera.
    Thank you.