Big funds, small funds, and the changing tide

Or, where to look when most investors have turned salespeople and rates begin to rise

Fair caution, I’m talking my book here.

We invest in small funds, often the non-consensus alpha type Frank Rotman mentions, and we’re quite far out on the risk curve (taking large stakes, sometimes backing very early career GPs or very frontier domains)

There’s recently been a buzz about the changing dynamics of venture and a slowdown in emerging manager funding broadly - Gil Dibner at Angular Ventures covered it all with hyperlinks here. Mostly we think the noise is, to quote Gil “a nothingburger”. Everyone is selling some narrative; the intention behind everyone’s buzz is to frame their strategy as perfectly suited to financing the current thing.

The summary of most takes is that a lot of folk, big and small, rode low-interest-rate-driven beta to some good TVPI in 2021 and raised a lot of money. These folk are in trouble because the marks of their companies are inflated (the founders raised a lot of money too), and now LPs are reckoning with lower than expected DPI and their own over-eagerness. So they pull back, play it safer and invest in [BigNameFund].

I don’t think this is the best response.

Firstly, rates have been falling for the last two decades. The amount of money going to venture has 10x’d, and the combination of more efficient pricing and a limited amount of great deals means that - for two decades - the hot got hotter. The rising tide has kept seed graduation rates steadily around 45%, but it’s also meant that consensus deals get bid up heavily at Series A as the dopamine and social capital of an up-round encourages junior investors to look for consensus. The last two decades have awarded sourcing the best deals, and winning access to them, so big funds hired and trained for this. This dynamic has created a generation of investors who are excellent networkers and salespeople, but fairly limited pickers.

Secondly, in venture, AUM is the equilibrium lever. There’s a social compact around the “2 and 20”, which legendarily started with Phoenician traders asking for one-fifth of the carry of their cargo profits. Most funds are reluctant to ask for more, and so grow profits through scaling instead. But there are only so many great founders, or unique insights a GP can have in a given 3 year deployment period.¹ The more money they (and other GPs) deploy to an insight, the more the insight alpha erodes. Big funds are forced to look for deals which can both accommodate large checks and have potentially enormous outcomes. So they invest in companies with pedigreed teams, obvious markets, and which could be enormous, but which also raise big dilutive rounds and have a lot of expectation baked into their valuations.²

So, what do most investors being average pickers and big funds being alpha-constrained have to do with the slowdown in emerging manager funding? They make it a good time to invest in non-consensus alpha type small funds.

There are broadly two types of emerging fund managers: those who co-invest alongside big funds, and those who invest before them. A slowdown in funding for the mostly co-investing managers is chilled. The founders they back will probably get backed anyway. They play an important ‘greasing the wheels’ role, connecting and sometimes surfacing companies for big funds, but are rarely formative for founders.³

If a small fund is taking punchy bets, with unique insights, they are likely benefitted by a pullback in venture funding provided they can raise their fund. At seed, having smaller funds means that each unique insight you have has a greater impact on your fund MOIC.⁴ They have less access constraints and smaller teams which means more freedom for independent decisions. In a less liquid environment, they’d face less competition, their signal would mean more to big funds, and since they are not usually investing behind consensus narratives, their money would be worth more to founders.⁵ However, finding these funds requires going far out the risk curve - usually something like SaaS in San Francisco is too efficiently priced.⁶

Last year, the seed graduation rates dropped to around 20% and interest rates are at a 24 year high. The tide has clearly gone out. Yet does this really make it worse for small, high-conviction funds? Venture is meant to be the riskiest asset class, where conviction matters the most. With the big funds now facing deployment pressure, doing more expensive deals, and having trained a generation of investors to source and sell rather than pick, the field is more open than most think. In our view, the question shouldn’t be “what happens to emerging managers when LPs pull back, play it safe, and invest in [BigNameFund]?”. As LPs, we should be asking ourselves if the big funds will offer venture-returns at all.

Jacob Hendrik Pierneef, N’tabeni (1930), finding beauty in the wilder highlands

Thanks to Mario, Mike, Koko, John, Yavuzhan and, as always, my beautiful wife for the thoughts that went into shaping this.

1. I like Yavuzhan’s definition of unique insights as “having original theories of the world that lead one’s nose to the right places, questions, and eventually the recognition the greatness...”

2. There are obviously compounding loops driven by public awareness and brand flywheels for big funds, but looking at their returns, they’re a reliable 3-4x on average (using returns data on leading FOFs as a proxy). This is more like hedge funds (consistent, capped, scale-driven alpha) than their pod shops (inconsistent, insight-driven alpha).

3. Co-investing alongside big funds can also be framed as having conviction in magnitude (ie. you pay up for one hot deal because you think this founder is even more exceptional than the market gives her credit for). For example, Thrive investing in OpenAI at $100bn. Usually these are the hardest deals both to identify and access, as the market (big funds) are better trained to pattern match to these.

4. The success of the Tiger Cubs (or, more recently, Grayhound) is a real argument that you can manage lots and be a good picker at the later stage if you’re concentrated. The point I’m making is less “you have to be small” and more “look for GPs with a high insight-to-AUM ratio so as to not dilute good ideas with mid ones”. Since it’s harder to get an edge at the later stage (given the visibility of growth stage deals and sophistication levels of larger investors), being small while investing early stage is just better table selection.

5. This could be pre-consensus founders (eg. Koko funding Etched; Jonathan funding True Anomaly or Castelion). It could be pre-consensus domains (Rahul and Pixxel, an Indian satellite imaging company, or Mike and RunwayML, the AI video company). Or it could be complex, yet-misunderstood business models (like John/Eddie and Floodbase, selling flood insurance, or Sun Day, a car wash rollup).

6. I want to be clear, I’m not saying LPs should necessarily invest in specialist, frontier managers. Trend level conviction is not an investment thesis, and even if it were, LP checks are far too blunt an instrument to index a sector. Investing with emerging managers requires parsing their real unique insights (for instance: why did they invest in this specific team and not their competitor with the same narrative and more pedigree?) and getting comfortable that they’ll nail the transitory period of non-consensus to consensus.