Size Matters: Funding Ventures in a Healthy Interest Rate Environment

VC funds are highly differentiated from each other with respect to stage, size, sector, geographic, and other elements of strategy. Fund size has emerged as one of the clearest factors influencing returns, and this may be especially true in the type of non-zero interest rate policy environment that’s the historical norm, and to which we’ve been returning since early 2022. 

How Interest Rate Policy Affects Venture Returns

Over the past decade and a half, the world of venture capital has experienced significant shifts, reshaping the relationship between fund size and returns. One of the most transformative factors has been the era of Zero Interest Rate Policy (ZIRP), which prevailed for over a decade. ZIRP changed the dynamics of investing by making capital more readily available and affordable.

Additionally, the prolonged period of low interest rates created a unique environment that encouraged startups, like Facebook, to stay private for more extended periods while scaling to astonishing valuations. These companies eventually went public with massive market capitalizations, yes, but the broad availability of cheap money from ZIRP also contributed to incredible value accretion post-IPO for these and similar companies, for example: 

• Facebook: Went public with a $100 billion valuation and has since multiplied its value by 8x in just 11 years.
• Google: Launched its IPO with a $25 billion market cap and has grown to an astonishing $1.5 trillion in 19 years, representing a staggering 60x increase.
• Amazon: Initially went public with a modest $500 million market cap but has surged to a colossal $1.3 trillion in 25 years, surpassing a mind-blowing 2000x increase.

These examples illustrate how private investors enjoyed higher returns due to the prolonged stay of these tech giants in the private sphere. VC funds commonly distribute both cash and stock to LPs upon liquidation of equity via IPO, and this type of extreme value accretion post-IPO gave rise to more and larger growth stage and crossover VC funds. 

Measuring Venture Capital Success

While higher rates of return on larger fund sizes have been a feature of this abnormal ZIRP landscape, a crucial metric to track across economic cycles in venture capital is the Distributed to Paid-In (DPI) ratio. DPI reflects the actual returns that investors receive relative to their initial investments. Recent data indicates that the venture capital industry has struggled to achieve DPI ratios exceeding 1x, even in a highly liquid environment.

This low DPI ratio suggests that, despite the attractive returns on paper, many venture capital funds are struggling to distribute realized gains to their investors, which raises concerns about fund performance and sustainability. But look more closely, and you’ll find that this difficulty is far more pronounced among larger VC funds. 

For example, a previous version of our fundraising pitch deck shared this data from a 2010 report on small size VC fund returns from SVB Capital: 

Source: SVB Capital’s Dialing Down: Venture Capital Returns to Smaller Sized Funds  

One of our advisors who worked at Cambridge Associates shared with us that only one private fund over $200M in size from their database from before 2008 had returned more than net 3x to investors, while many under that size had. 

Adaptation and Scaling Back

In response to a return to business as usual, many VC funds will scale back in size. Smaller fund sizes are becoming more attractive as they allow funds to maintain a more concentrated portfolio and focus on delivering substantial returns on a smaller capital base. It's easier to achieve a 5x return on a $50 million fund than on a $150 million fund. For example, Cendana Capital, a strong fund of seed funds, just closed on their new $470M fund, their largest yet, after performing well above average over the prior several funds. 

Conclusion

The relationship between VC fund size and returns has evolved in response to changing market conditions. While ZIRP and the prolonged stay of startups in the private markets have allowed for higher returns on larger fund sizes in recent years, we anticipate that the focus will shift to the DPI ratio as a more reliable measure of success in a more capital constrained environment.