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Vencap's Sion Evans on big vs. small funds, manager selection, performance & portfolio concentration

Tune in for some thought-provoking opinions (or truths?) on the ongoing LinkedIn debate about big vs. small funds 🤐 don't miss the show notes, very cool stats on the VenCap portfolio in this one.

Jul 04, 2024

Transcript

In this episode of the EUVC podcast, Andreas discusses with Sion Evans, Senior Investment Manager at VenCap, currently investing out of a $340M fund with $2.0bn in total AUM.

VenCap was founded in 1987 and is one of the longest-established FoFs around. They are headquartered in the UK and are backing the leading Tier 1 firms from globally — with just 12 core relationships! They count 47 underlying unicorns with notable mentions being the likes of Google, Facebook, Airbnb, Coinbase, ByteDance, and Stripe.

In today’s discussion, we're talking about manager selection and big versus small funds, a topic we're constantly debating on LinkedIn, as well as how Sion and Andreas thinks about fund sizing in Europe.

Sion emphasizes that good funds outperform, regardless of their size, and whatever the strategy, manager selection is the most important factor in venture. Crazy stats in the show notes below!

Takeaways

Manager selection is the most important factor for LPs in driving performance.
Good funds outperform, regardless of their size.
Data analysis should be done with caution, considering the context and caveats behind the data.
Fund sizing and portfolio construction depend on the specific investment strategy and goals of the LP.
Performance dispersion is a challenge in venture capital, but selecting the right managers can lead to consistent returns.
Concentration in portfolios is important for maximizing returns, while over-diversification can hinder performance.
Secondary investments provide opportunities to access top companies and managers.

Watch it here or add it to your episodes on Apple or Spotify 🎧

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The upcoming 0100 Conference Mediterranean presents a unique opportunity for private equity and venture capital LPs and GPs to meet and develop meaningful relationships.

Attendees will include major industry firms such as the European Investment Fund (EIF), Tikehau Capital, Vencap, Arcano Partners, Amundi-Alpha Associates, P101, United Ventures, Merseyside Pension Fund, and many more.

Learn more

Chapters:

00:11 Overview of VenCap's Investment Strategy
03:13 Debating Big vs. Small Funds
04:50 The Importance of Manager Selection
05:42 Analyzing Fund Performance Data
09:39 Fund Sizing in Europe
14:46 VenCap's Global Investment Approach
26:40 Fund Size and Investment Strategy
27:58 Fund Sizes and Portfolio Construction
28:35 Early Stage vs. Growth Stage Strategies
29:02 Global Investment Approach
30:08 Performance Consistency Across Strategies
31:21 Risk and Return in Venture Capital
32:31 Building and Maintaining Relationships
35:14 Performance Dispersion in Venture Capital
44:11 Secondary Investments and Strategy
49:17 Reflections and Personal Insights

✍️ Show notes

Big funds vs. small funds

Generally don’t like it, there are so many issues with data quality, how you phrase the question, what are you actually trying to measure and how does it map to your portfolio level performance
A bigger question, when you take a step back, is does it matter?
We ran the PB data, looking at the pooled performance of funds raised from 2000 to 2016, split by quartile of size. The split between top and bottom performers was 0.2-0.3x. We compared this to our Core Manager funds from the same period, the delta was over 1.5x. The results were similar for DPI.
What this tells me is that any variation in outcome in fund size is dominated by manager selection. Manager selection is the single most important factor in producing performance for LPs
You also need to be careful and read the footnotes when anyone’s posting data online. Lots of the datasets I’ve seen looks at absolute fund sizes going back to the 1970s, that’s really not representative of the industry today, so much less helpful in dictating future strategy. A $50m fund was also pretty big back when the industry was starting.
The framing also implies “all else being equal”, which it never is in venture. If I managed a very small VC fund, the returns would be terrible, because no good entrepreneur should take money from me! Even if you were convinced that small funds outperform

Fund sizing in Europe

Venture capital is all about fund returners, that is, a single investment that returns the entire committed capital of the fund.
Whether your fund size is $100m or $1bn, what are you underwriting in terms of exit size and ownership at exit? How good are you at concentrating capital into your winners? Does this tally with what you’ve done before?
I’d have much more faith in a manger that’s consistently returned large funds to do it again, than someone with a small fund and no track record – or worse, a track record of failing to do so
Again, we’re back to fund sizes being a red herring. Great funds outperform, not small ones.

VenCap’s view on Europe

We don’t allocate on a top down basis, so we don’t have a strong house view on any particular geography.
This sounds strange, but it’s all about the quality of the manager. We’ve made this mistake before, setting different buckets, then ending up adding managers that are weaker than what we could add in another geography due to artificial constraints
You can’t paint by numbers in VC, making the right call on geography/sector/stage means nothing if you’re not in the right companies
This approach has served us well, taking us into Asia 20 years ago, into LLMs in 2019, into later stage VC after the financial crisis etc
Bringing this back to Europe, historically we have got the vast majority of our exposure from two tier 1 firms –they have done a great job, and continue to do so! They have given us exposure to the companies that matter coming out of Europe. The ones that are part of the top 1% of exits globally.

What excites you about Europe?

Going back to being led by our managers, we’re seeing a number of our core relationships open offices in Europe. This is a very good sign for the ecosystem
Our managers are aggressive in spending time and dedicating resources to the best opportunities. This is usually driven by where the best entrepreneurs are spending their time, or what the specific needs are for the very best companies
This also means that our lookt-hrough allocation to Europe is increasing, even if that exposure isn’t coming from a “European” firm or fund. It also means that this isn’t a deliberate decision by us as an LP to increase our exposure to Europe

How to join VenCap?

It’s a tough list to join, but we have very straightforward criteria: Have you consistently accessed top 1% companies? Have you consistently produced fund returners? And if the answer is yes, do we think this will continue going forward.
Now the answers here will look different if you’re at fund 3 vs 13, but the general principles are the same. Fund 3 has historically been the earliest we’ve gone, at this stage you won’t have demonstrated the consistent fund returners, but you should have strong evidence that you’re on the right path
In practice, this means our investment universe is very small. Most of our investment sourcing, if you can call it that, is outbound. Generally it’s accessing firms that are highly access constrained, or identifying firms that will be if they keep the current trajectory
To get kicked out it’s also very simple, applying the same principles
In practice, we probably drop on average a manager a cycle, sometimes more. When we drop a manager they are usually still oversubscribed, with a strong track record. Recent reasons have included issues with generational transition (a cliché, but it happens), not producing enough return for the risk being taken, and failure to properly follow on adequately when you access a top 1% company.
The last point is very important. Our best managers are very good at knowing when they have a real winner on their hands, then backing up the truck, often from multiple vehicles. If you don’t follow on properly, we’ve seen cases where funds that should have been 5-10x+ turn out at 3x. Still a good outcome, but a disappointment relatively speaking.

How co-investing dynamics work?

We haven’t been active in co-investments historically, however it’s something we discuss pretty frequently. Instead let’s talk about secondaries, which would have a lot of overlap in terms of why we’d get excited.
To go back to our view on what creates value in venture, it’s the top 1% of companies, so when we look at secondaries (or potential co-investments), they have to be consistent with this thesis
So we’d be looking to access the very best assets, not get a decent deal on something that’s merely “good”. Quality trumps price every time
We have a structural advantage when it comes to secondaries given that we’re investors in highly access restrictive funds, so are whitelisted buyers. We also have strong views on the trajectory of specific funds and companies, whereas people who don’t spend 100% of their time in VC will find both challenging.
This also widens our opportunity set to funds we haven’t backed that have a significant exposure to a company we know and like via our 12 Core Managers

Performance dispersion in venture.

This is exactly what it means when we say power law!
Venture is HARD, really hard. As your numbers demonstrate, only a small number of managers will produce the returns that adequately compensate investors for the risk taken, and only a tiny subset of those will generate the returns of 5x that everyone aspires to
We compared these numbers to our Core Managers for vintages between 2000 and 2015
80% had returned 1x DPI, 24% over 3x and 13% over 5x DPI. This is significantly higher than the industry numbers
We’ve also looked at the distribution of returns within our Core Manager portfolio from inception to 2019. This is over 100 funds that we’ve made primary commitments to, and only funds we’ve actually invested in.
The upper quartile is currently just over 4x, and the upper decile just under 7x. But while that’s great, the more interesting side is on the left tail, with a lower quartile of just under 2x, and a lower decile of 1.3x.
This includes funds invested at the height of the dotcom bubble and just before the financial crisis. It’s shows remarkably consistent performance, minimising downside while retaining the explosive upside. These funds have produced an aggregate 3.4x net back to us, and that’s real performance over multiple cycles.

Tips & tricks for GPs and LPs.

We have our approach, but are not dogmatic, I’m not going to sit here and say that our strategy is the only way to produce consistent performance as an LP
I’d say make sure that your strategy is well grounded in data, not wish thinking. As an example, if you think that every fund will deliver the 3x+ advertised, you’re going to have a bad time.
It’s the same of GPs. We have managers that are small boutique firms, and those that are large, scaled platforms – both can produce exceptional returns! However, if a manager came to us saying they’re going to run an early stage strategy with a 10% loss rate (and we’ve seen this!) … you’re going to have a bad time

Diversification vs portfolio overlap.

Dave’s right, we’re about diamonds, as opposed to diamonds in the rough.
When it comes to diversification in VC, you have to be very careful. At the risk of repeating myself, it’s all about the quality of the managers. The drop off from tier 1 managers to tier 2 is steep, much steeper than you’d think. We know because we’ve made this mistake in the past!
What this means is increasing you diversification in venture can kill your portfolio level returns. Having some 5-10x+ funds, while the rest of your portfolio loses money means you’ll be left with nice anecdotes, at the expense of overall returns
So what does this mean for LPs? Given that 1% of exits generate the majority of exit value, you need to be concentrated in these companies. Anything else will destroy value.
We’re diversified by stage, sector and geography, as I mentioned earlier, but this is driven by following the best managers, as opposed to us making top down allocation decisions and filling different buckets. Again, we’ve made this mistake before.
How to evaluate if this is working? We looked at the top 20 exits since 2018, we’re in 17 of them. You don’t need to back all the managers to get into the best companies, just the best ones.
Note that this means it’s hard for us to expand our business, our own fund sizes are strictly driven by our capacity with our managers. The easiest thing for us to do would be to double our manager count, then double our fund size, but this would come at the expense of returns so isn’t something we’d consider.

AI influence in venture.

It’s clearly the hottest part of the market, but also has incredible potential. The nice thing is we’re not making any allocation decisions to AI specifically, we’re backing generalist managers who will evaluate these opportunities against all other sectors.
This also means we were early to the party, with one of our managers writing the first venture cheque into OpenAI in 2019. This was well before we were thinking about LLMs and generative AI – as it should be. Today we also have exposure to Anthropic, Mistral and Cohere, to name but a few in the LLM space.
It’s interesting to note that our managers have strong opinions on things like open vs closed source, or where value will accrue on the infrastructure/applications continuum. The whole sector is moving so fast it’s impossible for an LP to stay on the cutting edge.
When talking about valuations, or timescales, and the impact of returns, it’s again going to come down to being in the right companies. We’ve seen venture backed companies reach $100bn in the private markets, and multiple trillions on the public markets. If you think a company has a good chance of achieving this sort of scale, you need to act with conviction.
It’s easy to justify any bad behaviour through such a lens, but we’re backing managers who have often backed these kinds of companies before
It also means the distribution of returns will be incredibly skewed, with the best companies creating staggering returns, and the merely good ones incinerating vast amounts of capital

3 biggest learnings from last 10 years in your life

… The size of outcomes can consistently surprise on the upside, often by an order of magnitude
… This translates into later stage venture performance, which can go significantly above 3x net, which is not what we originally underwrote
… I’ve consistently underestimated the importance of personal relationships, in both investing and fundraising – this is despite always believing they were important!

Advice for your 10 year younger self

… Make genuine connections with people, it will help your career and make the job a lot more fun
… Agency is incredibly important, if you want to do something, you can normally just do it!

Tips & tricks for emerging VCs fundraising

… Pinch of salt, as we don’t back emerging GPs…
… Understand what individual prospective LPs want, it can save a lot of time and effort. The answer won’t always be what you think
… Send short low touch updates a few times a year, but containing real information

One counterintuitive thing learned in venture

… Sometimes the best addition is via subtraction. This may not be counterintuitive for some, but it’s very powerful.
… This runs against our innate desire to move on to the “shiny new thing”, whether that’s a new VC fund I could find, a new company to back, or anything else. Often you’d get more reward by narrowing your focus. Our 12 manager group may get stronger by cutting a name, rather than adding to the list. (Despite this process being much less exciting)

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