Are Megafunds Destroying VC?

You will read details about whether are Megafunds destroying VC? Two hundred fourteen million dollars would have been a sizable VC pool in the old days. Even as recently as the third quarter of 2022, the median US fund size was still barely $50 million, despite the fact that US VC heavyweight Andreessen Horowitz’s first fund in 2009 was $300 million and Peter Thiel’s first three Founders Fund vehicles oscillated between $200 million and $250 million.

Even still Sequoia wasted $214 million betting all on the now-infamous cryptocurrency firm FTX. The Sequoia fund that supported FTX was more than $8bn, making this one investment larger than many of the earlier VC firms.

The now-deleted post from Sequoia touted FTX as “a firm that may very well end up inventing the dominating all-in-one financial super app of the future.” That hyperbole is reminiscent of what Masayoshi Son, CEO of Softbank, said about WeWork in 2017: “We are happy to assist WeWork as they… unleash a new wave of productivity around the world.” The $100 billion Vision Fund lost $4.6 billion on the investment two years later, in 2019.

Is there a correlation between larger funds’ ability to incur such huge losses because of their greater access to capital?

Megafunds become the Primary Focus for Investors

There are many other successful companies than Sequoia and Softbank. 60 percent of the funding this year has gone to VCs with a valuation of $1 billion or more, up from 34 percent in 2021. However, there is evidence that newer, smaller funds typically outperform, but these funds are being forced out of the market.

The top 20 VC brands currently manage more than $200bn, which is equivalent to 10% of total VC assets globally, while the number of global megafunds continues to shrink.

Suppose we include private equity and hedge funds like Softbank, Tiger Global, Partner Fund Management, Thoma Bravo and others, who have poured billions into the VC game recently. In that case, the ratio is likely to be even more skewed.

And as megafunds expand, they all face the same problem: how to invest all that money profitably. Time for some mental arithmetic…

One Must Consider The Size

In venture capital, the scale does matter due to (a) mathematics and (b) accessibility.

Examine the numbers first. When it comes to venture capital exits, the power law distribution holds true: typically, 20% of a fund’s portfolio will account for more than 90% of its returns. As much as a quarter to half of all investments will yield almost nothing.

Each portfolio firm would need to have a chance at returning the entire $100 million investment if that were the goal (a benchmark VCs normally strive for). For instance, if you invested $100 million and successfully defended a 10% ownership in a company that eventually sold for $1 billion, you would receive $100 million plus your initial investment. Even with a 5% stake, you would win $1 billion from a $20 billion outcome like Figma.

What would you do with an $8 billion budget, though? This means that even a $1 billion outcome only returns $2,000, or 20% of the original investment. Where did you get that $100 million from a unicorn exit? A complete and utter failure that does not even register.

As a result size accessibility becomes a second issue
As a result size accessibility becomes a second issue

As a Result Size Accessibility becomes a Second Issue

According to Dealroom’s analysis of VC funding for startups valued at $1 bn or more, the most successful “unicorn hunters” are those that invest in the company at the seed stage. However, getting into a seed round or even a Series A requires capital deployment at those stages at ticket sizes that are important to the fund.

The barrier to entry is the relatively small size of seed rounds, which average a few million dollars. In the United States, the typical Series A is under $10 million; in Europe, it’s significantly lower. Seed checks remain useful whether your fund is $50 million or $100 million. However, if your fund is a megafund of $1 billion or more, you can safely disregard those tickets.

Are Megafunds Destroying VC?

Because of this, huge VC funds no longer place any value on a startup that generates $1 billion or more in revenue. Megafunds require startups that can do the following to get a 3–5x return:

  • Incur hundreds of millions or billions in debt and sell for more than $50 billion.
  • Less than half of all publicly traded technology companies today are worth that much.

Large investors are enticed when they meet a founder who is attracting global PR, is prepared to raise huge piles of cash, and is pitching them a “vision about the future of money itself—with a total addressable market of every person on the entire planet,” to paraphrase Sequoia’s deleted article again. They are tempted to ride the wave of popularity and “make an Uber” from it. (Uber is valued at slightly over $50bn, by the way.)  Masayoshi Son supposedly joined the team after only 28 minutes of talking to WeWork’s Adam Neumann.

In spite of Sam Bankman-“fucker Fried’s was playing League of Legends through the entire meeting,” Sequoia did with him. The irony of the remark was that his destructive, rules-don’t-apply mentality ultimately contributed to the company’s demise.

This way of thinking, combined with the concentration of money in a small number of funds, is widening the financial gap between the founders backed by these funds and everyone else. Even more, so larger investors are building an interconnected web of hype in an effort to design the next $50 billion-plus Uber which leads them to invest in many of the same companies.

Due to the tech industry recession, these tendencies will only increase in intensity.

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