Micro-VCs: A worthwhile investment?
Pasarn Intarangsi, Cristina Moldovan, Robin Szustkowki,
Vivienne Xu
Executive Summary
This article presents a top-down analysis of the Micro-VC space in the US and Europe, defined as venture capital funds under $100 million. The article seeks to answer the key question of whether Micro-VC funds represent an attractive investment opportunity for institutional LPs, and what sets apart the best performing funds. Starting with industry sizing and aggregate performance results, a mix of quantitative and qualitative analyses were utilised to construct arguments for and against Micro-VC as a category, before presenting our ultimate recommendation.
A significant limitation of this paper is that reliable performance information for specific funds was not available, especially for many of the best known Micro-VCs today. Instead, the micro-VC fund model has been analysed from a theoretical standpoint to identify some of the key levers that determine fund-level performance. These levers were fund size, loss ratios (influenced either by superior investment selection or by portfolio management and approach to follow-on reserves), ownership percentage in winners, and the enterprise value of winners. All have to work together in tandem to result in strong fund-level returns. This analysis can be used as a framework to evaluate new Micro-VC investment opportunities, which in the long run may be more informative than identifying a list of currently compelling funds.
Credits
This article has been written by Cristina Moldovan, Robin Szustkowki, Vivienne Xu and I as part of an MBA paper. Special thanks to Elizabeth“Beezer”Clarkson who provided us with guiding questions and advice, and Associate Professor Vikas Aggarwal for supervisions and guidance. We have also drawn valuable insights from Samir Kaji’s article published on Medium.
Disclaimers
Note that this article was originally written in 2017. This version of the article has not been officially reviewed or edited by the school, the professor or the individual mentioned. Names of individuals interviewed and the associated entities have been or removed or anonymised and the article will focus only on insights drawn from the interviews.
Any comments and suggestions to further improve this analysis are welcomed, especially from the broader VC and LP community. I hope this could article will be useful to both LPs when thinking about investing and VCs when thinking about setting up a fund or funding raising. You can email me at pasarn@gmail.com for comments or even if you are just keen to discuss.
I. Overview of Recent Micro-VC Fundraising Trends
The past several years have brought about a proliferation of Micro-VC funds, particularly in the U.S. The pace of fund formation and new firm formation has been relentless and continues to accelerate. The tables below depict the number of funds and total capital raised in both the U.S. and in Europe by funds under $100 million in recent years.
Data Source: Preqin 2016
The capital raised by U.S. Micro-VC funds has grown at a 23.3% CAGR over the 7 years to 2016, compared to a 16.3% CAGR for the aggregate U.S. Venture Capital space. The 5 years to 2016 have seen an even more pronounced pick-up in activity, with Micro-VC fundraising growing at a 32.0% CAGR, compared to 24.5% for the aggregate industry. Furthermore, as the table below demonstrates, the pace of U.S. Micro-VC fundraising is amplified by a large number of new firms being formed each year and entering the market. This has led to a very crowded space, and LPs that were previously bullish on the investment opportunity are starting to question whether “Micro-VC game has played out.”
In Europe, the Micro-VC trend has been muted, with fundraising activity consistently at $1.5–2.0 billion raised annually by a steady number of firms. In contrast, overall European Venture Capital fundraising has been growing at a 14.7% CAGR over the 5 years to 2016, indicating that Micro-VC as a model has yet to take hold in a big way, and that “traditional” funds are driving European market growth instead. However, there may be a hidden piece of good news behind this trend: as Cendana’s Michael Kim recently observed[1], for the Micro-VC category to make sense, a strong ecosystem of follow-on investors (traditional venture firms) is required. In Europe, the traditional venture ecosystem is still building up, meaning that the opportunity for Micro-VC funds there may improve in the future.
II. Micro-VC Fund Performance
In aggregate, Micro-VC fund performance has mimicked that of the broader Venture Capital asset class, and the return patterns for the two fund types move in tandem (implying that Micro-VC as a category is unlikely to be a strong diversifier for an LP’s venture capital portfolio). The charts below illustrate the return distribution of Micro-VC and all VC funds by vintage year, including median results, top and bottom quartile cut-offs, and top and bottom 5% cut-offs; results are shown from the perspective of both Net IRR and Net Multiple.
Data Source: Cambridge Associates 2016
While the return patterns for Micro-VC and traditional VC funds indeed appear similar to one another, Micro-VC funds seem to consistently underperform their traditional VC counterparts at each breakpoint in the return distribution. The tables below illustrate these return differences for vintages 2007–2014 (excluding younger vintages as their results are not yet meaningful.)
Data Source: Cambridge Associates
The Micro-VC underperformance is pervasive throughout the entire return distribution, but is particularly pronounced at the extremes of the distribution, where the top and bottom 5% Micro-VCs significantly underperform each year, particularly using the Net IRR metric (which makes sense, given that Micro-VCs tend to invest earlier in the company lifecycle and consequently have longer average holding periods.) Therefore, from a manager selection standpoint, it would be a difficult argument to make that identifying the best Micro-VC funds will result in superior performance compared to a more traditional approach to venture capital.
However, this analysis is subject to an important caveat, as there is substantial bias in the dataset. On the one hand, the data exhibits survivorship bias, as poorly performing funds are less likely to report their results, leading to them being excluded from calculations. This issue affects both Micro-VC and traditional VC funds. On the other hand, the best funds also have little incentive to publicly report their results, as they do not need this information to help their fundraising; the Cambridge Associates database partly alleviates this issue, as all funds used by Cambridge clients get included in the benchmark, thereby including some of the top tier venture funds. However, this is not a great solution when it comes to Micro-VC funds, as their LP base consists less of large institutions (which may be Cambridge clients) but more of high-net-worth individuals. Due to these LP base differences, Cambridge may not have access to some of the best performing Micro-VCs, thereby biasing the results and under-stating Micro-VC benchmarks. Therefore, the conclusions from the analysis above must be taken with a grain of salt.
III. Qualitative analysis
Several interviews, calls and meetings have been conducted to learn more about the Micro-VC. The key takeaways are outlined below.
Micro-VC Landscape
- The US has seen accelerated Micro-VC fundraising trend in the past 10 years and some of the key drivers are: 1) the improved capital efficiency for start-ups has made small size checks more meaningful; 2) some traditional funds have moved upmarket and left more opportunities in investing in seed stages; 3) The VC industry was underperforming in the past 10 years. Without enough sizable exits, the smaller funds tend to outpace larger funds.
- Many micro-VCs in the US have generated a lot of buzz and have good brands but often the good performances are driven by unrealised marks, stale prices, and market exuberance.
- In Europe, the story is different. Seed stage investing is less competitive and the demand is bigger than supply.
Stay Micro VS Grow Fund Size
- Some high-performing funds have chosen to stay at the same level. Those funds found their niche and want to stay in the space and write small checks. They are not interested in raising a bigger size fund. There are also investors who consider this more of a ‘lifestyle business’ and are not interested in growing the fund size.
- On the other hand, some funds aim to demonstrate repeatable success, build a track record and have the ambition to raise larger funds down the road. Micro-VCs have to be very disciplined with respect to check size. They’ll get good ownership stakes early on, but as investments mature and raise follow-on capital, the Micro-VCs can’t keep up. They will either impacted by sizable dilution or end up in unfavourable share classes. To confront this issue some firms have moved up in fund size to have more capital for follow-on investments.
- There’s a limit for fund size to go up by stretching on different dimensions without changing the investment dynamics. As fund size goes up, incentives shift. Firms end up competing against larger VCs and risk to be the “short-stacked at the poker table”.
Investment Strategy
The trend has shifted from being a generalist to being a specialist and it’s very important to bring unique capabilities and a sharp focus to be perceived as attractive to start-ups. The focus could be a vertical, a domain, a function, a geography or a team. We have spoken to a number of Micro-VCs to learn about their investment strategies, which are as follows:
- A UK based fund prioritises calibre of the team (which translates into the ability to pivot) over business model and always take a board seat.
- A Europe based fund focuses on cybersecurity and has a rigorous analytical approach to selecting and processing deals.
- A UK based fund focuses on marketplaces businesses and is stage and geography agnostic.
- A US based fund focuses on insurtech, specifically on innovation, customer engagement and data analytics at pre-seed and seed stage.
- Many European funds emphasize a geographic focus as it can be harder for outsiders to access the deal flow in the area.
Portfolio Construction
- As investment matures, Micro-VCs face the risk of getting massive dilution or ending up in unfavourable share classes. Some funds insist on negotiating the ability to transfer their pro-rata rights to later funds or to LP co-invest.
- Some funds focus on value creation to ensure good exit opportunities and worry less about the dilution at a later stage. A US based fund we interviewed intends to save 50% for follow on but focus on choosing a diversified portfolio to sufficiently address the topics in a vertical, including different type of entrepreneurs and relevant geography, and playing an active role to set the start-ups for success.
LP Perspective
- Both in the US and Europe Micro-VCs raise money from high and ultra high net worth individuals. In the US, there’s typically institutional investment for a fund size over $30million.
- Some European funds also received commitments from state-sponsored entities.
- Some larger funds have now set up “discovery funds” and allocate some funds to these vehicles to get an early look at compelling seed stage deals to create a pipeline of “core” investments.
IV. Micro VC managers that ‘stay micro’ vs ‘graduate’
Scope and methodology
A fund that ‘graduates’ is defined as a Micro-VC fund which subsequently raised one or more fund(s) over US$100m level. A fund that ‘stays small’ is defined as a Micro-VC fund that never raised a fund above US$100. In order to observe the evolution of funds over time, the analysis focus only on funds that have raised 3 funds or more in the past.
The scope of the study is limited to funds that
1. Raised its first fund after 2000
2. Have raised 3 or more funds
3. Raised at least one fund over the past 10 years to screen out inactive funds
Research suggests that Micro-VCs tend to either specialise in being small and operate within thier niche or operate with an ambition to be large from the start. This, in turn, impacts the fund’s strategy and the types of business they pursue. Some funds are not interested in searching for the next unicorn as they will not be able to follow on in the subsequent funding rounds. Others look for unicorns with an expectation of raising a larger round to follow on.
Analysis for Europe
In Europe, 65% of Micro-VC funds ‘stay small’ while 24% ‘graduate’.
Amongst the funds that ‘graduate’, 12 out of 13 funds did so before their third fund (i.e. raise>$100m US by Fund II). This could be an indication of having early wins or the ability to establish itself as a sector specialist in an area with a large opportunity set.
Broadly speaking, funds that ‘graduate’ tend to have mandates which focus on either large economies (Germany or France) or have a broad geographic focus (Nordic, Western Europe, all Europe). A smaller proportion of funds started off in a smaller geography but subsequently broaden their geographic focus as they raise larger funds (e.g. from Nordic to western Europe, etc).
Conversely, a large proportion (50%) of funds that stay small tend to focus on a single country. Many of these are smaller economies (Portugal, Hungary and emerging markets). This is consistent with funds whose strategy is to focus on its niche markets, stay small and optimise their returns.
Lastly, in the ‘Other’ category, 11% of the funds graduated but subsequently raised smaller funds. These smaller funds tend to be more specialised than the previous funds, suggesting that these managers have found more profitable sector niches and decided to focus on those. (e.g. going from broad life sciences sector to focus on medtech).
Analysis for the US
In the US, the results are very similar to Europe where 70% of Micro-VC ‘stay small’ and 23% ‘graduate’.
Amongst the funds that eventually ‘graduate’, over 75% did so before their third funds. This is similar to the trend we observe in Europe.
Two funds managed to go from being a Micro-VC to eventually raise a fund larger than $500m. One fund started its first fund with $10m and subsequently managed to raised a $700m fund after 7 years and 5 funds. Another fund started its first fund with $50m and subsequently managed to raised a $1,300m fund after 11 years and 6 funds. These are funds that had ambitions to become big from the start and were successful at doing so. This is particularly difficult to achieve as it requires fund managers to evolve from competing for deals with smaller funds to compete with larger and more established players.
V. Portfolio Construction Considerations
There are several levers fund managers can employ to generate strong fund-level returns. We will analyse each lever in detail to assess the robustness of the Micro-VC fund model.
1. Seek meaningful ownership stakes in large companies
The most obvious path to strong fund-level performance is to invest in portfolio companies that grow to large enterprise values and to own meaningful percentage shares of these companies at exit. The former (company-picking skill) is due to a combination of solid investment judgment, strong deal flow and a healthy dose of luck, while the latter (ownership % at exit) has a lot to do with portfolio management and follow-on reserve allocation. As Micro-VC investor Samir Kaji first demonstrated[2], these two dimensions must come together to drive fund-level returns, a task which becomes more difficult as fund size increases. Using Samir’s framework[3], a model was constructed to demonstrate how much aggregate enterprise value “winners” in a given fund must generate to arrive at a 3x Net Multiple (a very good result, especially in the context of the benchmark returns presented above!), as a function of fund size and ownership %.
Data Source: internal analysis
The table above demonstrates that achieving a 3x net return is generally difficult, and that outsized exit is mandatory especially at larger fund sizes to achieve this. For example, a $50 million fund must invest in companies that will be worth $7 billion, if the fund manager expects to have 2.5% ownership at investment exit. However, a 2.5% stake may not be achievable if these companies require multiple large rounds of financing and the fund does not have adequate reserves for these follow-on investments. Seed-stage investors can easily get diluted at subsequent financing rounds and can end up with ownership stakes under 1% in their winners. In that case, the same $50 million would have to be invested in companies that will be worth a combined $35 billion, which is highly unlikely.
Based on this model, Micro-VC funds face steep odds to succeed. An alternative model may be more sustainable, whereby the manager invests in companies with lower ambitions but which require less capital to get off the ground, meaning that the manager’s ownership share can be quite high at exit and suffer much less dilution. For example, if the manager were to own 10% of its winners, a $30 million fund would only need to generate $1 billion in enterprise value to return 3x net, significantly lessening the burden on any one company to exit at “unicorn” level. For an LP investing in Micro-VC funds, this model may be more lucrative over the long term, even while being less “glamorous.”
2. The trade-off between portfolio loss ratio and aggregate MoM on winners
Fund level returns depend on two key attributes: the proportion of total capital invested in companies that end up as write-offs (“loss ratio”) and the aggregate result (measured as a gross multiple of invested capital) for the remaining companies. To increase fund level returns, GPs should either decrease their loss ratio or increase the result for winners, as the model below illustrates[4].
Data Source: internal analysis
According to this model, reducing the loss ratio can take a substantial amount of pressure off the performance of winners, and can enable managers to achieve robust fund-level returns without having to rely on astronomical outcomes from their winners. A frequently cited analysis by Correlation Ventures[5] claims that only 4% of all venture-backed deals returned over 10x capital; therefore, running a fund model that heavily depends on successes of this magnitude (captured by the blue zone on the chart above) seems unsustainable. LPs should screen for managers that exhibit the portfolio management skill to minimise their loss ratios.
3. Levers for controlling loss ratio: company selection vs. capital allocation
A venture capital’s loss ratio depends on two factors: the number of investments written off as a percentage of the total number of investments, and the average initial amount invested in each investment as a % of average check size. Below is an example of this concept.
Data Source: internal analysis
These two strategies are pursued by different types of venture capitalists. On one hand, managers who pursue “Scenario 1” are “Pickers”: they seek to minimise the number of investments written off, i.e. they generate their returns through individual company selection. For this strategy to be successful, these managers must rely on high-quality deal flow, coupled with strong investment judgment and a detailed investment screening process. On the other hand, managers who pursue “Scenario 2” are “Harvesters”: they make small initial investments into many companies and use their follow-on reserves to back the winners that emerge over time, i.e. they generate their returns through portfolio management. For this strategy to succeed, managers must practice rigorous reserve management and must exhibit strong investment judgment across the portfolio company lifecycle.
In reality, venture capitalists exhibit both Picker and Harvester characteristics, but each firm may tilt more towards one approach than the other. These characteristics can work together to drastically reduce loss ratios in a fund, as the chart below illustrates. Venture capitalists clearly seek to be in the top left corner of the chart, where loss ratios are lowest. However, Pickers focus more on moving up along the Y axis, while Harvesters focus more on moving to left along the X axis.
Data Source: internal analysis
VI. Conclusion: To invest or not to invest? That is the question
Based on the analyses presented above, the following investment case emerges for Micro-VC funds:
Reasons to Invest (“Bull Case”)
- Micro-VCs occupy an important place in the broader VC ecosystem, and participating firms can get an early seat at the table for creating meaningful businesses.
- A handful of Micro-VC firms have generated much “buzz” substantiated by impressive exits, earning them a spot on the Midas List. (Ten such firms are on the 2017 list.)
- Some Micro-VC funds are very focused on a particular market niche, compared to more generalist early stage firms. This may afford them significant competitive advantages in terms of deal flow and domain expertise.
- Seed and early stage investing (on which Micro-VCs focus) have the highest potential to generate strong realised returns.
- Firms that do not rely on “unicorn” exits to drive their fund results may generate strong track records with less ownership dilution.
Reasons NOT to Invest (“Bear Case”)
- The space has become overcrowded in the U.S., making it more competitive and harder to identify winners. In Europe, the space is less crowded, but also unproven.
- It is difficult to generate compelling returns in a repeatable way, based on fund model analyses. Portfolio/reserve management is key.
- Holding periods are long, depressing IRRs. Returns may underperform traditional VC without diversifying the risk.
- Fund sizing creates a double bind: (1) if chose to stay “micro”, won’t “move the needle” for a large LP; (2) if “graduate” to larger fund size, model changes and must compete directly against traditional top tier firms.
- Small fund sizes may confront either alignment issues (LP base composition) or structural issues (European funds with substantial state backing.)
Summary
In aggregate, these arguments suggest that Micro-VC as a category today may not be an attractive opportunity in the U.S. However, this analysis was performed in a very top-down way; of course, the possibility exists that some individual Micro-VC funds (in all likelihood niche players with specific domain expertise) may end up posting exceptional returns, and a savvy LP should not write the U.S. Micro-VC space off entirely based on this analysis, but rather, they should just be aware of the headwinds it faces. In Europe, the answer is quite different, and we recommend a “wait and see” approach with respect to this geography (but meet with prospective firms and understand the key players better while waiting). If the broader VC ecosystem continues on its current trajectory, European Micro-VCs could play an increasingly important role and could become compelling investment opportunities down the road.
[1] https://techcrunch.com/2017/04/05/cendana-capital-which-funds-15-top-seed-stage-groups-just-raised-a-ton-of-capital/
[2] https://medium.com/vcdium/micro-vc-smaller-is-better-but-the-math-is-still-really-hard-c0cd4f62ccc2
[3] Assumptions: management fee 2% for 10 years, other fund expenses recycled; carried interest 20%.
[4] Assumptions on fees and carry same as in previously discussed model.
[5] https://www.sethlevine.com/archives/2014/08/venture-outcomes-are-even-more-skewed-than-you-think.html
