VC Fund Models — A European Fund of Funds (FoF) Investor Perspective
There are VC funds and then there are VC funds: nuances differ greatly per fund but have a large impact on fund performance over time. Given the fact that in VC “the best seeds bear the most fruits” or in VC language “the strong power law return distribution” it is important for VCs, LPs and even founders to understand the nuances between VC fund models that are used to increase the chances of success.
“It is very natural for investors to just focus on the individual deals that they are chasing. What sets apart more experienced teams is a very deliberate and dynamic approach to looking at the portfolio / fund model angle as well”
In recent years the development of the European VC ecosystem has been mainly driven by the increasing quality of the ventures, fuelled by the growing experience of (serial) entrepreneurs. These developments together with a strong economic cycle has resulted in a prosperous 10-year period for VCs in which they were able to invest in great companies such as UiPath, Klarna, Hopin, WeFox, Transferwise, Flixbus, Revolut and N26. The experience gained by fund managers during this period resulted in the improvement and sharpening of their investment strategies and fund models.
“The science in portfolio construction is in understanding how much concentration is appropriate for a given strategy and target return profile. The art is knowing where to place that concentration. At the early stage, where Valar invests, if you get both of those things right, you can produce legendary returns.” James Fitzgerald, Founding Partner at Valar Ventures
Developments in fund models
We define three investment models that are used by VCs, as well as the add-ons that finalise the models, together forming the overall investment fund model. The fund model can be used to identify the operational model of a VC and to compare VC funds based on their investment strategy and activity. This may come in handy for VCs that want to learn more about the different fund models, for LPs searching for specific VC funds and for founders looking for the right value-add investor(s) in their upcoming funding round.
The investment models and their value adds
We have identified three investment models. At the core of the different models is the portfolio construction and the level of organisation. The portfolio construction is the result of the focus and strategy of a VC which consists of the following components:
The investment models are based on the portfolio construction and are on a linear scale with the number of investments of the fund. This resulted in the following investment models; the high-conviction model with a low amount of (core) investments (4 to 10), the high-volume model with a high amount of investments (40 to 100) and the classical/institutional model in between the previous two with 10 to 40 investments per fund.
In addition to the investment models are the add-ons that finalise the investment and operational model of the fund, including the added value of the investor.
The way the fund approaches venture is embedded in their organisational set-up which ranges from highly to very loosely structured/organized. The alignment of the approach, set-up and structure is what makes a fund capable of consistent strong performance, if each element is best practice in its own.
Explanation of the four investment models
Model 1 — The “Classical Institutional”
The classical VC model was originally derived from Private Equity, a much older and further developed asset class than VC, especially in Europe. Institutional investors such as pension funds, asset managers and other large institutional investors (but also the first generation of VCs) tend to prefer the classical model as they know how it works from a risk/return perspective. Institutional investors hold on to these models making the classical/institutional model the most common and straightforward of the three models, with 10 to 40 investments per fund. The classical models transformed a bit over the years into more institutionalised models that are optimised for risk, having its effect on the potential return (therefore also referred to as “institutional model”).
A risk related policy that is introduced by institutional investors is for instance the 10% rule. Implying that a maximum of 10% of the total fund can be invested in one single company in the portfolio. However, VCs have been creative in order to mitigate the effect of the 10% rule using separate opportunity funds to keep investing in their best portfolio companies in later stage rounds, transferring pro-rata rights to their opportunity fund. Another interesting development that has evolved over the years is the increasing amount of follow-on capital that VCs reserve for their winners, a development some EU VCs have learned the hard way.
Characteristics — Classical Institutional model
Amount of portfolio companies: 10 to 40
Initial ticket size range as % of the fund: 0,5 to 3%
Initial / follow-on ratio’s: 50/50 or 40/60
Max exposure per venture: 10%
Most common stage(s): All stages
Risk level: Medium
Model #2 — The High Volume model
The high-volume model is a model that has become more popular as an investment strategy in recent years as it allows funds of various sizes deploy large amounts of smaller investment cheques to establish follow-on winners. Funds using a high-volume model invest with relatively small amounts of capital relative to their fund size (typically under €500,000) in a large amount of companies. The fund actively monitors the portfolio and tracks the winners for follow-on investment. Some people refer to this model as a “spray and pray” strategy, but analysis of the funds that use this model shows that not only performance of these funds is strong, they are also highly organised and structured due to their experience with managing a large portfolio.
Key for the high-volume model is to acquire an initial stake, typically between 5% and 10%, and reserve sufficient follow-on capital in order to prevent dilution and to execute an effective ‘follow-the-winners-strategy’. Some people see the high-volume model as risky whilst in fact there is a large base of companies of which the performance can actively be monitored. Follow-on capital can, in theory, be allocated more effectively and with a lower risk compared to the classical model or high-conviction model. In this model, to become successful, discipline in for example valuation and an effective follow-on strategy is key in order to concentrate the large reserve into the right companies.
“Seedcamp was in a very privileged position in 2007 to seek alpha in Europe by crafting a very specific fund strategy. Our high-volume portfolio construction, careful selection of LPs, platform development and most critically our brand values and network created a powerful flywheel effect that has kept growing 14 years on, 400 companies later”
Characteristics — High-volume model
Amount of portfolio companies: 40 to 100
Initial ticket size range as % of the fund: 0,1 to 1,0%
Initial / follow-on ratio’s: 30/70
Max exposure per venture: 10%
Most common stage(s): Pre-seed; seed; series A
Risk level: Relatively low
Model #3 — The High Conviction Model
The high-conviction model is a model in which the fund invests in only a few portfolio companies, ranging from a minimum of 4 to a maximum of 10 core investments. The model works best when significant follow-on capital is available to aggressively follow-on in subsequent rounds using super-pro-rata’s. This strategy is theoretically too risky in seed stage as the risk for failures is too high in seed. The model is scarcer since it requires LPs that are willing to accept a higher level of risk, while most LPs are risk averse by nature and do not necessarily need to take these risks in order to meet their target returns. Hence, institutional investors usually do not invest in such models because of the risk and the relatively large amount of capital allocation per venture.
For the high conviction model there is no 10% rule and even up to 30% of the fund can flow into the single best company of the portfolio. This way the return pattern of the entire fund shows similarities to the return profile of a venture instead of a fund. Therefore, the fund has the potential to achieve 5 to 10x instead of 3 to 5x for a good performing fund.
Characteristics — High-conviction model
Amount of portfolio companies: 4 to 10
Initial ticket size range as % of the fund: 5 to 10%
Initial / follow-on ratio’s: 40 / 60
Max exposure per venture: 30%
Most common stage(s): Early / later / growth
Risk level: Relatively high
Add-ons to the investment models (for value creation)
Every VC has their own way of providing added value to their portfolio companies. The add-ons as described in this part finalise the investment models of the different VC firms and gives insight in what way VCs add value to their portfolio. We’ve identified five add-ons that are commonly used to add value to ventures during their journey.
One general value creation method that we haven’t included is the knowledge & experience of the VCs and their team members as we consider this as an added value that all (good) investors will leverage towards their ventures and it’s not really an ‘add-on’.
- Network — one of the strongest but also the most informal add-on is the network of the VCs. Some of the older European top VCs such as Index, Accel, Northzone, Holtzbrinck and LocalGlobe can really make a difference by opening up their network for their ventures. They get their portfolio companies in front of CEO’s of large (enterprise) clients but also at other top-tier VCs for follow-on funding. However, not every VC is capable of truly leveraging their network. In practice formalisation of networks is rare, and many VCs often do not live up to their ‘network’-promise.
However, we do see formalisation of networks on an increasing basis, especially at VCs that also invest in other VC funds or funds that effectively their (corporate) LPs. Leveraging the VCs network works for every investment model, however one could argue that the efforts and attention decreases when the size of the portfolio increases. But one could also argue the opposite, the larger the portfolio, the larger the network of the VC. - Platform / community — many VCs start a platform/community as a communication tool for their ventures to interact with one another. Besides an online platform or other communication method VCs often organise events to stimulate interaction between the founders of different ventures. Founders experience this as very helpful as it lowers the threshold to interact with other founders that experience the same problems or already went through the same hoops and cycles. Events that we often encounter are retreats in the Alps, on an island or some other desolated places (mostly in nature) where people can be together undisturbed.
VCs that successfully create a platform/community as add-on to their fund model are among many others Speedinvest, Seedcamp and Connect Ventures. The value add of the platforms and communities increases with a growing size of the portfolio (more connections to make and more similarities between ventures) and are therefore a better fit with funds using a high volume or classical/institutionalised model. - Operational services — some VCs, especially the VCs that are more hands-on, offer specific services to their ventures in order to create value. These services are often aimed at assisting the founders in time consuming processes such as hiring and fundraising so the founders can focus on the core business of the company. Other services that are common are the assistance in costly support functions (finance, tax, legal) for which no full-time employees are yet required considering the phase of the company.
The addition of services is helpful for all fund models, but efficiency and quality depend on the capacity and availability of the service providers that can be negatively impacted by a growing portfolio (if the service is not easily scalable). Examples of operational services are: HR & recruitment, M&A & fundraising, Supporting functions (finance, tax, legal) and Business development & marketing. - Venture partners — one of the best ways for investors to increase the value of their ventures is by using a hands-on approach in order to actively assist the founders. However, at most VCs the investment team does not have the time or the skills to actively assist the entrepreneurs. Therefore, VCs often hire venture partners (also frequently referred to as Entrepreneurs-In-Residence) with an entrepreneurial background. These venture partners will have an active role at the ventures in order to add value during their journey. Venture partners that can add the most value are venture partners that have experience in managing and scaling a venture in the same stage and sector as the ventures they assist.
Therefore, venture partners are most ideally founders or ex-founders themselves in the same or an adjacent industry as the venture that they work for as venture partner. Venture partners are an effective add-on for every fund, although a high-volume model requires a large amount of venture partners which can make it economically less attractive for the investment team as the result of a larger team (costs) and split economics (carry). - Growth capital / Opportunity funds — an additional development in the market is the use of opportunity funds. EU VCs, especially the more established ones, are increasingly raising opportunity funds in order to follow-on in the winners of their portfolio in later stage rounds. Many funds, that are fully invested or reached the 10% hurdle still have pro-rata rights in later- and growth stage rounds. They have the possibility to transfer the pro-rata rights to other funds in order to capitalise on these investment opportunities using their privileged access as result of the pro-rata rights. Returns of these opportunity funds can be interesting as the investments primarily target the best companies of the underlying portfolio(’s) of the VC.
Furthermore, the lifetime of these opportunity funds are often much shorter (5 to 7 years instead of 10 to 12 years) because the fund will invest in later- and growth stage companies that are closer to their exit. The existence of an opportunity fund is also of value for the portfolio companies of a VC because there is additional capital reserved for the growth rounds of the portfolio which makes it easier to raise capital. But, only the best portfolio companies will get access to this capital. Opportunity funds are a good add-on for every investment model, but a larger portfolio provides more investment opportunities making it more effective in theory. An additional development around opportunity funds is the increasing interest of LPs to co-invest along their GPs. Many institutional investors have set up entire strategies around co-investments in order to boost the return of their portfolio’s.
Models and their fit in different stages
- High volume is most effective in seed and early stage because, when applying to later stages, the model will get very capital intensive. Softbank’s Vision Fund is the only fund able to use a high-volume approach in later/growth stage. The effectiveness of the model increases with the amount of portfolio companies since the fund managers can track more companies and make a better selection of winners. In early stage, say series A, when invested in 50 to 100 companies, then initial tickets should be between €2,0 and €5,0 million to acquire a decent stake, resulting in a fund of 100 to 500 million without reserving any follow-on capital.
- High conviction is too risky when applying to seed stage but works from series A and onwards. The model is pretty common in late and growth stage but very few investors are able to make this model work in an early stage as investments must be spot on because there is little room for failures. The high conviction model can generate very large returns when applied to early stage (especially series A) as the potential for fund returners will be very high. Whereas in later and growth stage the returns will be much lower.
- The classical model works basically in every stage as the model is optimized for risk and return.
Risk levels of the different models
The strategy of a fund should be aligned with the risk level that the fund and its investors (LPs) are willing to take. A high conviction model can be riskier than a high volume model depending on the funds strategy and execution. High volume and the classical model will tend to form a statistical average, in which the winner can compensate many losses. An effective follow-on capital allocation into the best portfolio companies is essential to mitigate this effect.
A recent development in EU VC is the increasing amount of follow-on capital that funds reserve. We’ve seen funds reserving up to 70% of the total fund for follow-on investments. Reserving more follow-on capital for the winners will potentially increase the returns of the fund but only if winners are present in the portfolio and if the capital is effectively allocated.
The impact of LPs on the models
Institutional LPs (pension funds, Asset managers, Insurers, Banks, etc.) most often demand different risk levels from a VC fund than for instance angel investors and family offices. However, in practice GPs tend to raise bigger funds over time which also changes the composition of the LPs in the fund.
Where initially (fund 1 and 2), the GPs where backed by a close network of risk takers (angels, HNWI, family offices, etc.) investing all 0,1 to 1 million, they now need institutional LPs investing tickets of 10+ million to reach their target fund size. But along with these institutional LPs come restrictions that impact the risk/return of the fund and potentially the performance of the fund. The typical approach of an institutional LP is not very innovative and VC savvy, therefore in some cases limiting the performance.
Conclusion
There are three different investment models which are basically a distinction based on the construction of the portfolio, the investment strategy and the amount of companies in the portfolio. These investment models can be completed with different add-ons for value creation. Both the investment models and the add-ons can be used to identify different type of VCs and to give more insight in how VCs operate from an investment and operational perspective but more importantly, how they add value to their portfolio companies.
Second, in practice, most VCs tend to choose for quantity in search for the reduction of the risk of the portfolio, having its effect on the performance. This movement towards risk reducing measures is often the result of GPs raising bigger funds which requires more institutional LPs that are able to invest larger tickets.
Third, the strategy of a fund should be aligned with the risk that the fund and its LPs are willing to take combined with the background and expertise of the team. Funds with a higher risk level and higher return target often tend to go for a model with a high conviction to effectively follow-the-winner. Institutional measures such as a 10% cap can limit the performance of the fund but also reduces the risk. Hence, it is a balance between return driving and risk reducing measures.
Fourth, the development and optimisation of the fund models tend to go slow due to the fairly long lifetime (10–12 years) of VC funds. With most important lessons often showing themselves at the end of the fund’s lifetime.
Finally, VCs have the best shot at success if they follow through on their model of choice and try to deviate as little a possible from each of the characteristics. Ultimately that is what constitutes to a fund that is sustainable.
