1) Few deploy money to monolithically to Venture (sequoia and PIPES).
2) Deploy money freely across their investment networks (thereby behaving like an index), and thus mitigate risk across those funds actively.
3) Deploy money in the same fragmented fashion as subprime VCs, meaning their risk to money ratio has turned subprime as well, skewing large funds differently.

So, as the old saying goes, not everything that can be counted can be counted on….but nice try

You’re looking across a dataset that has an enormous amount of volatility among vintage year averages at the same time that the mix among fund sizes also moves a great deal. If you don’t control for these together you can get a very misleading result. Indeed, your analysis defines “large funds” as >$250M. But I believe there are no such funds at all prior to 1991 so nearly half the vintages in your sample don’t have a single data point in one of your buckets.

A simple test. Take a look at page 7 of this Cambridge Associates data.

https://www.cambridgeassociates.com/pdf/Venture%20Capital%20Index.pdf

If what you’re saying is true, that larger funds systemically underperform smaller funds after controlling for vintage year, then the capital-weighted average IRRs (what CA calls the “Pooled Return”) should generally be lower than the unweighted arithmetic mean IRRs from the funds in those vintage years (since larger funds will be given greater weights in the former).

But in 87% of the vintage years you reference the reverse is true: the capital weighted returns are higher meaning that, on average, larger funds must actually be outperforming smaller funds in that vintage year! The average across all the years (weighting each vintage year equally, thereby controlling mix changes) is over 800 bps!

Lerner and Hardymon’s analysis is more relevant as it does attempt to control for vintage year, but even they are prisoners of history. There were no >$1B funds for most of the sample. They didn’t really appear until 1999 when returns for the whole industry (small funds too) began to tank. So now returns are lower… is that because $1B got raised or because there’s too much money overall? Had someone raised a $1B in a great vintage year like 1993 would it really have underperformed?

That’s not what the data since 2000 actually suggest… the $1B+ funds are doing just fine relative to their vintage year peers. They just don’t get the benefit of getting to average in blockbuster IRRs from the mid 1990s vintages since no such funds were in the historical dataset. Accel is #2 on your list… are they really lagging with Facebook and Groupon in the portfolio? And Felda Hardymon’s own BVP is right at the top of the list… do you really think he interprets his own analysis as a condemnation of $1B+ funds?

The most important takeaway, though, is all of this is rounding error compared to things like a firm’s track record (which is highly predictive of future return in VC, unlike in other asset classes). So the industry should stop focusing on it so much. What really matters is aggregate capital going into the industry, and that has continued to fall even as it has collected in fewer, larger funds.

What you describe is a self-re-enforcing cycle: enthusiasm for internet stocks drives the perceived value of intermediate milestones (growth in subscribers for a website, for example, long before any meaningful revenue, let alone profit, is generated) – even when reality shows that most of those that had positive early milestones never reached it to profitability. People focus on the few that do make it. With that enthusiasm, up rounds are common and the overall (that is realised + unrealised) return looks good. So the enthusiasm is further stoked.

The reverse happens in healthcare. Everyone focuses on the failures of what had been seen as promising Phase II products when they get to Phase III (like Pfizer’s Alzheimer’s drug dimebon) or to market (like Dendreon’s Sipucel-T). So intermediate milestones get under-valued, down rounds are the norm, making the overall (including unrealised) return look weak. So the negativity is seen as justified.

All this goes to prove is that in VC investing, as in general investing, its not just (maybe not even mainly) about finding the technical successes, its about finding the thing everyone else is excited about. If there is a plentiful supply of “greater fools” your returns will be stellar. And there seem to be (today at least) a bigger population of “greater fools” in internet stocks than healthcare ones.

Just one caveat: I think its dangerous to assume that the private companies that are still active but haven’t been sold (the unrealised pool) will achieve the same return as the realised pool. Again, human nature being what it is, people are much slower to crystallise losses than gains (see the section on Prof Gaba’s work at INSEAD in this blog post: http://www.tcpinnovations.com/drugbaron/?p=152) so the active but unrealised pool will be enriched in “living dead” companies where hope rather than expectation of success is sustaining them in almost suspended animation. I don’t think that changes your thesis, but its important to bear in mind (and its probably worse in healthcare than internet stocks, because the capital already deployed by these living-dead companies is higher, so the crystallisation of the loss would be more painful).

If this is the problem for the healthcare VC sector (and I agree that it is), and if you predict its only going to get worse (and I agree with that too), then what do we do?

The best solution I have seen is to take out the need for intermediate valuation altogether – assemble the coalition of VC investors that have the depth of pocket to see the venture all the way to the end from day one. If your series A investors will carry you through to exit the distortion of down (and up) rounds in the unrealised pool disappears. The new capital goes in at a pre-money of 1x as long as the investor syndicate continues to believe in the value of the company and the whole thing breathes more easily. As the ecosystem of early stage healthcare venture investors contracts, this ‘cradle-to-grave’ syndicate model is surely the only way forward – because competitive series B’s are so much a buyers market that the ‘price’ of the external valuation event is always a step mark-down. So don’t even go there…

Of course, its difficult to do with any precision because the dataset is really too small. To get enough numbers to be meaningful you have to group together apples and oranges: tech funds, mixed funds, healthcare funds; US funds and worldwide; 1980s, 90s, 2000s and so on. By grouping everything together you must hide some significant variation between these groups.

Thats shown up by the data on IRR split into fund die “chunks” of $50M – the pattern just can’t be real (with two large outliers at $100-$150M and $400-$450M. What that is is just noise, caused by some massive outliers. Thats what happens when the group sizes are smaller, and it precludes any sensitive analysis of the factors they control returns.

But the overall conclusion has to be right: small funds show greater returns.

The question you didn’t really address was why that is?

Let me offer a couple of suggestions to start with:

In the early 1990s, I always remember Kevin Kinsella telling me about the early Avalon funds from the 1980s that had such high returns. With the early funds, capital was severely limiting so the investors had to be VERY careful with it. Every start-up was as leanly financed as possible. Everyone knew that every dollar had to count. The results were impressive. But as the fame of the fund grew, and more and more people wanted to be exposed to such high returns, capital was no longer limiting: now it was top ideas to invest in that became limited. To get so much capital to work, the bite sizes had to become larger. Instead of the investor telling the entrepreneur to use as little as capital as possible, they wanted to push as much at them as they could. And so returns fell. Bottom line: if you are aiming for 5x multiple, its a lot easier to reduce the cost by $1 than add $5 to the selling price.

The other factor at play is the kind of investments you can make (and maybe have to make) if you have a large fund to invest. In healthcare (where I come from) this means investing in later stage, capital intensive programmes if you have to get a lot of capital to work. Twenty years ago, these were perceived as safer than early stage (cheap) plays, because most of the technical risk had been removed. Not today. Commercial risk (that is, that the technology works but will anyone buy the resulting product?) dominates these late stage plays, and its a big problem. The problem is magnified by buy-outs – if large companies snap up early stage companies with world-beating technology, then the ones that stay private to consume the capital of the mega-VC funds are really the “silver medal companies” – the ones that weren’t good enough to be a buy-out target. And these “silver medal companies” consume vast quantities of capital only to deliver to the marketplace a product that disappoints in terms of sales, and therefore disappoints in terms of returns to investors http://www.tcpinnovations.com/drugbaron/?p=152

Small funds can’t afford to invest in these later stage opportunities. They have to go for the lean small early stage bet that sizzles with promise and potential, and which ultimately yields the best returns. By contrast, the returns of the mega-funds must be dominated by the large, flabby investments in “silver medalists” that flatter to deceive.