The classic investment disclaimer, “past results are not an indicator of future success,” is never more important than when considering established fund managers against emerging fund managers.
Venture capital is a space where going with the hot hand isn’t the smartest move. Nearly 18% of first-time funds nab an internal rate of return (IRR) of 25% while later funds only exceed that number about 12% of the time, according to Pitchbook research.
Newer managers - defined here as having three or fewer funds under their belt- have some inherent advantages. They frequently have spun out of larger funds, bringing years of experience working with and learning from the heavy hitters at large firms. They’re highly motivated with the knowledge that the IRR of their early funds is the key indicator of success that makes it possible to recruit new LPs and increase check sizes from follow-on LPs for their subsequent funds. They can bring innovative new ideas to the table by striking out on their own, helping recognize trends that more established funds may be too large to react to quickly.
Here’s three more reasons why emerging managers consistently hit home runs:
Smaller Check Sizes
The math is more favorable for smaller funds. A smaller fund means smaller checks, which naturally makes generating higher returns a little easier. You’re more likely to exit at $100 million than something like $1 billion. When you scale up a fund size, you either have to invest in more companies or make bigger investments. The former stretches your human capital and the latter could put you in a much different market from where you’ve found prior success.
More Attention to Fewer Investments
We’re strong believers in actively managed funds, where fund managers don’t just give startups cash, but they offer expertise through board seats or technical assistance to ensure venture-backed companies thrive. Gridline has a cohort of top notch experienced investors, and we’ve benefited from their active involvement, industry expertise and network.
That model doesn’t scale well when human capital is limited. Diminishing returns can be a real problem in labor-intensive tasks like building companies. Limited attention is one of the big drivers of the wide dispersion in returns you see across private equity, with investments underperforming substantially when firms have a large number of simultaneous investments.
Asset management consultant MJ Hudson noted in a 2018 report that while management fees for larger funds are falling, the size of funds have increased so substantially that these fees represent a “significant profit center.”
That can create misalignment between fund managers and their investors. Established managers raising mega-funds, who may have fees coming in from prior funds as well, may not feel the same pressure to hit a home run and cash in on their performance fee. They can return nothing to investors and still earn plenty thanks to the size of the fund.
Emerging managers not only have a smaller share of their income coming from management fees, but they’re trying to build a personal brand to justify bigger, successive funds. You can only do that with a strong performance.
Emerging managers are grinders, hungry for success the way a young underdog is against a perennial winner in the sports world. This tightly aligns their goals with LPs - a strong return means both the manager and their partners win.