The Barbell Strategy

Posted on April 9, 2007

Barbells Jeff Bussgang posted on a new strategy a couple months ago that some VCs are starting to employ. The barbell strategy, as it is becoming known (at least in Boston), is a strategy that it allows VCs to keep one foot in early stage deals while being able to continue to grow their assets under management and invest in later stage deals as a result of the growth.

As I have alluded to before on this blog the VC funds are continuing to grow bigger and bigger over time which makes it continually harder for them to cut checks smaller than $10mm - $20mm. This, of course, puts them out of range of early stage companies that they want to invest in. The problem is that the VC funds want to keep bringing in more assets to manage because they make money from management fees which are usually taken as a percentage of their assets under management. Let’s turn to Jeff for a quick sum up of the issue at hand:

…the historical data shows that the >10x return opportunities lie in the early-stage, Series A deals, where less money is invested at a lower price. These companies commonly are looking to raise only $4-6 million at a time, often split between two firms. Thus, VCs have a conundrum - whether to stay focused on early stage, where it’s harder to put big money to work (and therefore earn big fees), or focus on later stage deals, where it’s harder to generate 10x returns.

The barbell strategy is one of the first attempts to combat this issue by simply allowing firms to do some early stage deals (with partners who have a specialty in early stage) where they hope to make >10x while also growing their assets under management and doing later stage deals (again, with partners who have a specialty in late stage investments) where they would hope to take home a 3 - 5x return.

What’s the problem then? Seems OK doesn’t it? Well, not entirely. LPs (aka Investors) don’t like this type of strategy and view it as risky. They would prefer it if a VC fund would stick to a investment size (and geography, market sector, etc.) and stay there rather than wander across boundaries and make investments in different company stages. Typically when VCs roam around performance falls off since they are simply not specialists in each and every area around. In the end of the day the LPs want to work on their own portfolio diversification and do not want VCs trying to do it for them.

If you think about it for a minute the LPs have a great point. Think of the mutual fund industry as a comparison. Sure there are blended funds but most of the time you want a certain type of fund. Perhaps you’re looking for large-cap value fund to balance out your small-cap growth heavy portfolio. In that case you’ll want the manager of that fund to stick to his strategy once you’ve invested since you’ve already slotted him into your portfolio in order to properly diversify yourself and he moves off strategy your diversification will suffer. Of course mutual funds don’t have the same problem VCs do in that raising more money, for the most part, doesn’t force a change in the style of investing.

As Jeff points out in his post, scaling VC funds may simply not work. They are much different animals to mutual funds and hedge funds. Perhaps this is something that just needs to be accepted by early stage VCs. That said, the LPs may someday change their minds if a firm can effectively pull off the barbell strategy. We’ll have to wait and see.