Winning! or Losing? A Look Into the Super-Fund Movement

It’s become something of a bromide in Silicon Valley that pouring as much money into a relatively few break-out companies as quickly as possible is the only way to win in venture capital.

In an interview with this reporter in 2009, Marc Andreessen made a strong case for this winner’s circle school of investment. He told me how Andy Rachleff, a former VC at Benchmark Capital who now teaches at Stanford, did an analysis of industry returns.

“Basically, between roughly the mid-‘80s and the mid-2000s—a good cross-section of time across a couple of different cycles—what [Rachleff] found is that there are about 15 companies a year that are founded in the tech industry that will eventually get to $100 million in annual revenue,” Andreessen said. “Those companies in total represent a very large percentage of the returns to venture capital. His data show that they [accounted for] 97% of all public returns, which is a good proxy for all returns. So those are the companies that matter. Those are the companies that have a big impact on the world. Those are the companies building foundational technology. Those are the companies that generate all the venture returns.”

This reasoning formed the basis upon which Andreessen Horowitz raised its first fund, and it has undoubtedly inspired Kleiner Perkins Caufield & Byers, Accel Partners, and Greylock Partners to raise massive new funds. Yet surprisingly, there are big questions surrounding this widely accepted belief.

First, Rachleff’s analysis has literally vanished; he lost all of the data on the topic when his computer’s hard disk crashed in 2006. “I was not able to recover the disk at the time it crashed, so I had to throw it away,” Rachleff wrote me in an email yesterday.

Then, there’s the anecdotal evidence. “Ten to 15 [breakout] companies [formed each year]? I think that’s a big number,” says Jim Feuille, a former investment banker head who has been a general partner at Crosslink Capital since 2002. “If you think about the big names that everyone is chasing after – Twitter, LinkedIn, Facebook, Zynga – it’s a handful of names that were started in different years and broke out in different years.”

Even assuming that Rachleff’s data was spot on, LPs have cause for concern over the trend. After all, it’s not just early-stage venture firms now focusing on a small number of very large, high-profile investments, but numerous other investor groups, too, including traditional late-stage players, hedge funds, and the high-net-worth banking clients of connected banks like JPMorgan and Goldman. All that attention isn’t just driving up prices; it may drive down returns for those late to the party, too.

“Maybe it’s a totally new world and old rules don’t apply,” says Harvard professor Josh Lerner. “But historically, as groups significantly increase their fund size, returns deteriorate. The tendencies are pretty clear in the data.”

One “can see the benefits for GPs – that’s evident,” Lerner says of large funds and late-stage deals. “It’s a little harder to see the benefits to LPs. If there are all these great companies being created, it’s not clear why [the country’s top venture capital firms] aren’t investing in them at the early stages, when they have a shot at returning 100x or 1000x their investment, rather than trying to get 3x or 5x returns.”

When in 2009, Digital Sky Technologies spent $200 million to acquire a 1.96 percent stake in Facebook at a $10 billion valuation (a position to which it later added), it was a masterstroke, one that has already likely provided the Russian investment group with a 7x return on its investment. But how often do such deals come along?

Notably, Benchmark, to which Rachleff maintains close ties, doesn’t appear to be wrestling with that question. Though the firm raised more than $1 billion at the height of the boom, including a $750 million U.S. fund and a $500 million European fund, Benchmark long ago refocused its attention on early-stage venture in the U.S., and it’s keeping it there.

The firm could easily follow the same path as its peers by, say, plowing more money into Twitter, whose third round of financing it led in 2009 at a $250 million valuation. Instead, Benchmark closed its seventh fund in January with just $425 million — $75 million less than it collected for its sixth fund.

Yesterday, I asked general partner Bill Gurley why that is. “Because we busted our butts to get that [billion dollars] into positive territory,” he said. “We don’t want to do that again.”