Our Syndicate Fund is a venture-focused strategic fund of funds.
Our work puts us in contact with funds across the country. All told, we talk to a lot of fund managers… and hear a lot of the same buzzwords.
“Top quartile performance.”
“Access to deal flow.”
“Top tier syndication partners.”
However, rarely do managers specifically talk about one of the top things on LPs minds — returning capital.
While this is not the only thing we consider when evaluating VC managers, it is a critical component. We’ve talked to more than 500 VC managers, and I can count on both hands the number of them who have provided insights into how their fund and their portfolio are optimized to provide risk-adjusted venture returns.
Most managers we talk to are in a standard cycle of raising larger and larger funds without thinking through “right-sizing” based on their investment framework. If a manager’s last fund was $75 million, then they want to raise $100 million. If their last fund was $200 million, they want to raise $400 million, and so on and so forth.
However, the real question should be “what is the right sized fund based on my current investment strategy?”
how is this going to improve returns to LPs? How does the manager plan to use the additional capital? And again, how will this affect ultimate returns?
Hearing a manager define their fund size based on providing risk-adjusted returns to their investors is insightful and rare. For example:
“Our hardcap is $75 million because raising more than that doesn’t work for our fund strategy,”
“We want to get our ownership in early to create higher returns at the early stage to gain better returns on our winners.”
When we go through diligence with a new manager, we are always trying to understand the likelihood that they will be able to provide risk-adjusted return of capital. In VC land, this is usually around 3X invested capital over a 12-year period.
A portfolio model helps us approach this with the VC. It helps us understand how they are thinking about the return profile of their investments before they write a check and it provides transparency/insight on returns back to the LP. Chris Douvos with Venture Investment Associates writes about the importance of thoughtful portfolio construction at SuperLP.
The best insights are provided when a manager reviews their portfolio construction model with us and talks about how their portfolio is optimized for risk and return — check sizes, ownership, follow-ons, and losses. One of the best I’ve seen included consideration for multiple compression in the follow-on checks and dilution in later rounds. In today’s environment with more private capital in larger and later rounds, this is critically important.
Delivering a net 3X return is HARD to do. Samir Kaji at First Republic Bank recently ran the numbers to show how hard it actually is to produce a 3X return. It takes preparation. The work is more than a buzzword. Even a manager with an incredible acumen as an operator or with the ability to get into hot deal from an established, proprietary network still may not produce a 3X return. Looking at historical VC returns, even the average top quartile fund doesn’t provide a 3X return.
In the end, optimizing portfolio construction is something that needs to be thought through before the first check is written. Thinking about this at the outset is a necessary step in the process.
About the Author
Sarah Anderson, Fund Manager. Anderson joined Cintrifuse in March 2013 and manages our Syndicate Fund, a job that includes meeting and working with many new venture managers around the country.