Navigating the Modern VC Ecosystem: Megafunds, Return Rivalries, and Investment Strategies
Addressing Evolving VC Trends & Fundamentals
👋 Hello friends,
Thank you for joining this week's edition of Brainwaves. I'm Drew Jackson, and today we're exploring:
Evolving VC Trends & Fundamentals
Key Question: What emerging trends or underlying fundamentals are influencing the modern venture capital ecosystem?
Thesis: By understanding the strategic role of megafunds, the impact of competition on returns, and the varied motivations behind investment decisions, we can better understand and achieve success in this rapidly evolving industry.
Credit Toptal
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Time to Read: 20 minutes.
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Venture capital has rapidly evolved and expanded throughout the last couple of decades into a full-fledged industry. Throughout its development, many of the core characteristics and fundamental properties of the industry and the players within it have drastically changed to fit emerging trends, shortcomings, and ultimately increase success rates within the industry.
As such, our knowledge of the modern principles and aspects of the industry may be missing key developments or potentially may be fundamentally skewed by our historical thinking.
The purpose of this essay today is to begin to acknowledge and address some of the aspects of the modern venture capital industry and any misconceptions we may have, revolving around three key questions:
Is the emergence of “megafunds” in VC a good occurrence?
Do VC firms cannibalize other VC firms’ returns?
Why do VCs invest in the companies they do?
Credit The Fearless Heart
Is the emergence of “megafunds” in VC a good occurrence?
The concept of a “megafund” is a recent development in venture capital, referring to a small subset of venture capital firms with the following characteristics:
A large amount of assets under management, usually $10B+
Investing in high-value, large-scale deals (i.e., they don’t just perform lots of tiny deals)
International presence
Diversified investment strategies, usually including the various VC sub-buckets (pre-seed, seed, Series A-E, etc.) - some funds also have growth and buyout arms
Institutional prestige
The trend of raising larger and larger funds began around the early 2010s, particularly among Silicon Valley investors who were trying to capture more of the fast-expanding technology market.
Berber Jin, a journalist for the Wall Street Journal, wrote in 2023, “As startups swelled in size, venture capitalists wrote massive checks to companies that looked little like the scrappy young businesses that the venture industry was designed to support.”
That all came to a head during the 2021 expansion, which led to many companies achieving what some would consider “astronomical” valuations purely because these megafunds had money to deploy and there were opportunities to do so. Subsequently, this strategy backfired as the market constricted (and threatened to crash), leaving megafunds with overvalued stakes in struggling businesses with no immediate exit opportunities.
This turn of events led many to criticize megafunds in general. For instance, some have argued that these large funds are terrible for returns and exist solely to generate management fees (2% annual on $10B+ is a large amount of operating income).
The rationale behind this claim, on the surface, seems sound. It’s harder to generate outsized returns (the goal of VC firms) on larger pools of capital than it is with smaller pools of capital. However, there is an incredibly valuable role these megafunds play within the venture capital lifecycle.
Megafunds are great at providing downstream capital to fund the winners of the previous rounds. For example, a company might receive an investment from an average-sized venture capital firm for their seed round, raising $3M (at a $60M valuation). Then they might raise their Series A with the same firm, raising another $15M (at a $150M valuation). But even after they deployed all the money they raised, they haven’t fully built out their business model and secured their niche. So, what do they do when they need money again?
At this point, they’re going to be too big for average venture capital firms. Additionally, they can’t just necessarily go to a private equity firm and get bought out since they’re still too risky. A bank won’t loan them the money they need since, again, they’re too risky. So where can they go?
Megafunds are the answer. Some companies need hundreds of millions of dollars to get to the point at which they can be profitable. Packy explains this perfectly:
Without megafunds operating at the Series A and beyond, more companies would fail before they have the chance to go public, which would lower overall returns to LPs. That, in turn, would mean that small, early-stage funds couldn’t take the types of risks they need to take to generate those outsized returns and give the wildest ideas a chance.
So, to assert that megafunds don’t have their place in the market or that they aren’t valuable is a misleading claim.
Referring back to the initial opposition that these larger funds will have a difficult time returning their capital to their limited partners, that viewpoint has more concrete evidence to back it up, but in true venture fashion, we’re going to be subject to hopes, dreams, and aspirations.
Packy outlines this argument in one of his recent posts, describing an optimistic viewpoint of the situation. He states:
In a great interview with Jack Altman, First Round’s Josh Koppelman, who has kept his funds relatively small and generated excellent returns by doing so, talked about what he calls the Venture Arrogance Score: how much of the total value created by startups does your fund need to capture to 3x or 4x the fund? For a $7 billion fund, that’s something like half of the past decade’s average annual startup value created, when no fund has consistently captured more than 10%.
To translate this business-speak into plain English, Jack Altman is claiming that for a $7B fund to return 3x-4x the fund size ($21 - $28B), they would have to be responsible for around 50% of the historical average annual startup value created. However, no fund has consistently been able to capture more than 10%. So, according to this rough math, returns of this scale couldn’t be feasible.
Packy makes the leap of faith, asserting that he believes the solution to this quandary will simply be that the pie (in this case, the annual startup value created in the future) will have to be much larger in the next decade than it was in the past. This means it needs to be around an order of magnitude bigger; in other words, if the historical average was $1B, the new annual amount would need to be at least $10B.
Is that possible? This would require a compound growth rate of 58% (for a 5-year fund) to 25% (for a 10-year fund). In other words, this would require venture capital to perform like venture capital (i.e., outsized performances with no diminishing marginal returns).
To generate these types of returns, megafunds need to invest in companies with the potential for truly massive outcomes (higher likelihood of 20x+ returns), but this can come at the expense of risk (risk vs. return), introducing a paradox wherein these megafunds can actually be more risky than traditional funds.
This is one of the major points of opposition concerning megafunds: opponents believe that they simply cannot achieve these rates of return and that there won’t be this magnitude increase in market size in the near future.
Packy explains that, in order to make these claims, you have to argue against some of the foundational principles of venture capital (which he believes is a preposterous argument):
You need to argue that the VCs that have been among the best at predicting the future over the past decade no longer are, or that they’re just good at seeing the future for the companies they back but not the industry they work in, or that they’re just milking that past success to generate fees. All of them, all at once.
In summary, the key to this argument lies in whether you think these megafunds can continue to perform as venture capital funds have in the past (despite their size) or whether you think there are diminishing marginal returns to fund size in venture capital.
So far, the recent data isn’t hopeful. In his publication East Wind, Kevin Zhang, an engineer turned venture capital investor and startup founder, describes the data behind these megafunds thus far:
One of the things that’s been frequently discussed has been that the VC industry as a whole “over-raised” on the promise of high returns (especially when funds were smaller & there were a smaller number of funds), leading to a situation now where a large number of funds are:
Competing for a limited number of deals that can actually be considered “fund returners”
… in a high interest environment where revenue multiples for both public and private companies were crushed in 2022 (though we’re seeing a bounce back in 2023), leading to lower outcomes
… even as VCs, with larger pools of capital, pay up for deals resulting in lower ownership
As a result, there has been both a decline in DPI (distributions to paid in capital, which is the dollars actually paid back to limited partners) as well as TVPI (total value to paid in capital, which includes DPI, as well as gains that have yet to be realized).
Besides the availability of higher-round capital access and the potential for standard returns (although this is controversial), megafunds provide a couple of other key benefits. Firstly, they contribute greatly to the sheer volume of capital available to startups (even if that capital is concentrated in a couple of key sources). Secondly, the presence of larger funding rounds can instill confidence in founders—if you receive a large investment from a reputable megafund, it can serve as a strong signal of validation, making it easier for startups to attract top talent and future funding.
However well argued, the above explanation doesn’t address one of the main concerns we highlighted above: that megafunds exist primarily to generate management fees.
Given the standard 2-and-20 structure, referring to 2% of the fund size as a management fee per year and 20% of the net profits attributable to the venture capital company, a $4B fund would generate around $80M in annual management fees.
This is a substantial, relatively guaranteed income stream, which critics have argued can reduce the urgency for general partners (the everyday investors at the venture capital firm) to prioritize maximizing the exit returns of their portfolio (to gain 20% of the profit share of successful exits).
This, however, isn’t the only major criticism of the emergence of megafunds. There are two additional downsides to megafunds, which go hand-in-hand: the limited investable universe and reduced exit opportunities.
To deploy billions of dollars, megafunds are inherently going to favor and choose larger deal sizes. It simply isn’t feasible to invest $10B in $1M portions (that would require 10,000 investments). Even in $10M portions, that’s 1,000 investments, for $100M portions, that’s 100 investments, and so on. So, to achieve some sort of logistical feasibility, you’ll probably see these funds invest in anywhere from 10 to 250 investments (for an average value of $1B or $40M per investment). The problem here is that there’s a limited number of companies even capable of raising hundreds of millions of dollars, especially when multiple megafunds need to deploy their capital.
Similarly, once invested in these companies, venture capital firms are hoping that a solid portion of their investments will grow aggressively in size. Given that these are already large investments and large companies, the number of potential acquirers is incredibly limited. How many firms can make a $1B+ acquisition?
Unfortunately, to make their money back for their LPs, VC firms need to exit their investments somehow. Given their sizes, they are often dependent on a successful IPO or a stunningly massive acquisition, both of which are tightly correlated to market conditions, leaving the VC firms vulnerable to systematic risks they can’t control on humongous investments they need to pan out—between a rock and a hard place.
Credit Slimstock
Do VC firms cannibalize other VC firms’ returns?
To outline the full extent of this question, we need to outline a few assumptions. First, we’re assuming each venture capital firm has perfect or near-perfect information about the companies raising money at any given moment (and those going to raise money, etc.). Second, we’re assuming each venture capital firm has perfect or near-perfect access to at least bid on the rounds being raised.
By deploying these assumptions, we can conclude that any VC firm knows about and can bid on any company’s fundraising round. In this case, the venture capital market would become similar to that of the public equities market. For example, everyone has all of the public information about Apple and its shares, and everyone has the opportunity to bid on (and in this case, immediately purchase) shares of Apple.
Going back to venture capital, if we hold the assumptions above, then venture capital funding rounds will begin to perform like public equity shares, subject to the basic economic forces of supply and demand.
Breaking this claim down further, the first outcome of these assumptions, particularly via the perfect information assumption, is that venture capital investors know with relative certainty which companies will be better investments than others. Given this information, venture investors could create a spectrum on which every company lies, describing from “best” to “worst” which companies are better investments than others.
If we hold that every venture capital firm knows this, and given our second assumption that every VC company has access to every funding round, then we can conclude that the “best” company to invest in will receive the most number of bids, and as the companies decrease in quality, the number of bids decreases in quantity.
See where we’re going? As such, in order to beat out all the other investors that are also vying to invest in the “best” company, venture capital firms will need to give more and more favorable terms (to be picked over another firm, assuming all firms are equal).
So, the conclusion from our wild utopian scenario is that when there are multiple venture capital firms bidding to get onto a company’s fundraising round, concessions need to be made in order to win the bid. These concessions lower the rate of return that venture capital firms then receive from the company upon exiting.
Essentially, the competitiveness built into the venture capital industry, as each firm strives to invest in the “best” companies, cannibalizes each other’s returns.
Granted, this was concluded using some hefty assumptions, but even when you relax them, this principle still holds.
For instance, take the perfect information assumption, which states that every VC firm knows about every funding round out there. In the real world, this assumption isn’t exactly true; however, there is a very close resemblance. For companies that know or consider themselves to be one of the “best” investments, there is often widespread information about their next round.
When raising or planning to raise their next round, any founder worth their salt should be reaching out to any relevant venture capital firms to let them know that they are planning a round. They will be providing the information to the venture capital firms.
On another note, any venture capital investor worth their salt will be proactively reaching out to the “best” companies out there to preemptively get the information for when their next round will be.
So, for the “best” and even many times the “average” companies, there will be “adequate” information present, either via founder outreach, competitive intelligence tools (Pitchbook, Crunchbase, etc.), scouts, angel investors, reputations, and many more sources.
Furthermore, unless they’re too far into their process, most founders won’t reject a VC firm coming to the table to place a competing bid—it only works in their favor. So that assumption still holds.
Long story short, venture capital firms, in the pursuit of superior and outsized returns, in pursuit of investing in the best of the best, cannibalize each other’s returns through their competitiveness.
Granted, each venture capital firm does bring different value to the table (network, expertise, follow-on funding abilities), so they aren’t always just competing on price. While this is true, the core premise of competitive bidding still holds, especially for the “best” deals. VCs do and will try to differentiate on value-add, but for most sought-after deals, it often still comes down to price/terms.
Additionally, besides cannibalizing via competitive bidding processes, venture capital firms cannibalize each other in other ways (listed below for brevity’s sake):
Competition for talent acquisition
Competition for limited partner fundraising
Credit InformationWeek
Why do VCs invest in the companies they do?
The most popular rationale you’ll see for why venture capital firms invest in the companies they do throughout popular research, venture capital websites, generative AI sources, the 24-hr newscycle, and almost anything else related to venture capital is the following: Venture capital firms invest in the companies they believe will have the maximum percentage of maximizing the dollars returned from the investment.
This explanation includes two key parts. Firstly, and arguably the more important of the two, venture capital funds want investments with the highest likelihood of returning money to the investors (even if that’s just $1).
To properly explain the nuances of this statement would probably take an entire essay itself, but here’s an attempt at a concise overview. What this statement is not is an individualistic viewpoint of the investments made and their potential returns. That would look more like the following: Venture capital funds want every investment to return at least $1 (i.e., not return $0, i.e., not go bankrupt or get liquidated, etc.). This would be more along the lines of private equity (smaller number of bets, fewer can go wrong).
In contrast, the statement offered above is more of an aggregate viewpoint. To rephrase it in these terms: venture capital funds want the aggregate average investment to return at least $1. But that’s not just it—ultimately, VCs want to make money on these investments. At a bare minimum, they need to be returning the initial capital to their limited partners.
This is where the second portion of our explanation comes into play, specifically concerning investments with the opportunity to maximize the dollars returned. In a perfect world, every company invested in would return a profit, but that’s just not the VC way (more of a private equity play). Instead, many of them even struggle to return the initial investment amount, while a select few have outsized returns that compensate for the others.
So, if we were to modify our ongoing statement once more given this information, it would probably look similar to the following: venture capital funds want the aggregate investment return to be at least the initial investment amount, ideally exponentially surpassing the initial investment amount.
How do they do this? Investing in the companies they believe will have the maximum percentage of maximizing the dollars returned from the investment.
Here’s a quick example built to easily illustrate this point—try to determine which investment the VC fund will pick (assuming ceteris paribus):
Company A: More than likely to go to $0, but a small chance to return $1B
Company B: More than likely to return $1M, but a small chance to return $10M
Which would the VC investor pick?
More often than not, a VC investor would invest in Company A. Remember, venture capital is about taking many of these bets (so even if many go to $0, if a couple go really big, that makes up for the rest of them—making the aggregate investment return bigger than the initial investment amount). In our case, we could rephrase that to say that VCs prefer a small chance of $1B over a relatively large chance of $1-$10M.
A possible framework that VCs could employ here to evaluate investment opportunities would be to create a matrix of each company’s expected return. This would be a summation of the potential values of the company multiplied by the percentage of that value on exit, as shown below:
Expected Return for Company A:
50% chance that the company is worth $0 upon exit
25% chance that the company is worth $1M upon exit
15% chance that the company is worth $10M upon exit
9% chance that the company is worth $100M upon exit
5% chance that the company is worth $500M upon exit
0.9% chance that the company is worth $1B upon exit
0.1% chance that the company is worth $10B upon exit
Multiplying each percentage by the expected value would generate an expected return. Summing these expected returns would project the company to be worth an expected ~$55M upon exit.
The key to this framework is what we’ve been harping on in this section: companies with a larger chance of returning a large dollar amount will achieve a larger expected value. To rephrase our statement for clarity, we could state: Venture capital firms invest in companies that offer the highest expected value.
However, this is much more easily said than done because we’ve overlooked a key assumption here: you have perfect information and perfect foresight and therefore can perfectly predict the expected value of each company perfectly (therefore also being able to perfectly predict the percent that the company returns money and the nominal dollar amount that the company will be worth). In other words, this framework assumes you know which companies are going to be winners and losers perfectly.
Unfortunately, to employ the popular cliche, venture capital investing is much more of an art than a science. The 'art' of venture capital lies precisely in navigating the uncertainty and the lack of perfect foresight, where success hinges on a blend of skill, judgment, and indeed, a significant element of luck.
There are an infinite number of causes that influence the probability of return and the nominal value of return for an investment. Whole libraries of material have been written to analyze, dissect, and provide “expert” guidance on this topic. For instance, I read a fascinating one the other day, written by Jerry Neumann in his publication Reaction Wheel:
He argues that investors almost always invest in startups whose products are better than their competitors’ products. On the surface level, this sounds like a great proposition, but Jerry believes otherwise because these are bets on companies that already have competitors.
In his opinion, it’s much better to invest in companies that are entering new markets (i.e., they don’t have any existing direct competitors). These opportunities are rife with uncertainty and unpredictability (a perfect space for venture capital). In Jerry’s words:
This is similar to something Clayton Christensen noticed in The Innovator’s Dilemma. Christensen looked at the survival rates of new disk drive companies and found that startups going into new markets are far more likely to be successful than startups just using new technology.
This is very similar to Peter Thiel’s writing in Zero to One.
So, bringing us full circle back to the question at hand, why do VCs invest in the companies they do?
For the majority of traditional venture capital investors, the above rationale holds true. These investors are trying to maximize their returns by making calculated investments, considering the probabilities of payback and the nominal potential dollars of return. Gemini estimates this is around 60-70% of the venture capital industry.
However, for three select groups of VC investors (making up the remaining 30-40% of venture capital firms), this framework doesn’t completely explain their rationales for investing in the companies they do: strategic investors, impact investors, and personal values-driven investors.
Strategic investors, a category comprised mainly of corporate venture capital firms (e.g., Google Ventures, which is an in-house venture arm at Google and uses Google’s money to invest in companies on behalf of Google), invest in companies not just for direct financial return, but for strategic benefits that align with a larger corporate agenda. Gemini estimates that strategic investors comprise 15-25% of the venture capital industry.
These corporate venture capital arms often invest in startups for a couple of reasons:
Gain early access to innovation: Investing to identify emerging technologies or business models that could disrupt their company or industry or otherwise create new opportunities (e.g., Meta Ventures invests in an upcoming VR technology that could threaten their Meta Quest VR headsets).
Build an ecosystem: Investing to support companies that complement their existing products or services, expanding their market reach or improving their offerings (e.g., Salesforce Ventures has invested in many platforms that support or work off of the Salesforce ecosystem).
Talent acquisition: Investing to poach talent or assimilate talent into the larger enterprise (e.g., OpenAI Ventures invests in a new Stanford AI startup to poach their best talent).
Market intelligence: Investing to further understand market trends, competitive landscapes, and customer needs (e.g., Google Ventures invests in a consumer products brand to gain more information for a potential product expansion).
Granted, these venture arms often want to have good financial returns, but these issues aren’t usually the primary driver. In many cases, they will tolerate a lower rate of return if the strategic benefits are good enough.
Impact investors (also known as mission-driven VC) are standalone funds that invest in companies primarily because they provide or contribute to societal good. Gemini estimates these firms make up 5-10% of the total venture capital industry, but it’s a fast-growing segment.
These funds have a dual mandate: maximize financial returns (usually aiming for market-competitive returns) and generate a positive, measurable societal impact. Examples of sectors these firms invest in could be climate change startups, healthcare access companies, education entrepreneurs, and financial inclusion firms.
A key driver for this shift to impact investing is the demand from Limited Partners (pension funds, university endowments, family offices, etc.) to invest in companies that align with their values and generate positive societal outcomes alongside financial ones.
Many companies in this space offer a “blended-value” proposition, an idea that refers to how economic, social, and environmental components of value are often interrelated. Companies that solve a societal or environmental problem may, in the long run, build a stronger business and ultimately prove to provide better financial returns.
Lastly, personal bias, while not necessarily an explicit category, still influences the companies that investors invest in. VC investors might invest in companies due to personal connections, a belief in the founder’s vision, or an emotional resonance with a problem, even if the “expected value” of that company isn’t necessarily as large as other opportunities. Gemini estimates that this makes up less than 5% of total venture capital investments.
While this personal bias certainly exists (it’s incredibly difficult to find a truly impartial investor), venture capital investors are ultimately accountable to their Limited Partners. An investor consistently investing due to bias and not necessarily underlying financial rationale will likely struggle to succeed in the industry.
So, to summarize all of the above, we see rationales for investments fall into one of 3 major buckets: maximizing expected value and return potential, opportunity for societal benefit, and/or access to proprietary technology, information, knowledge, personnel, resources, etc.
Credit Vecteezy
Navigating the Modern Venture Capital Ecosystem
The venture capital industry is no longer the niche domain it once was. It’s a rapidly maturing force, constantly adapting to new market dynamics, trends, and technological advancements. As we’ve explored, understanding these shifts, particularly the rise of megafunds, the inherent cannibalization of returns, and the diverse investment rationale of venture capital investors, is crucial for anyone seeking to thrive in or simply comprehend this complex ecosystem.
The emergence of megafunds, while controversial in terms of their ability to generate traditional or outsized returns, clearly plays a vital role in providing the crucial downstream capital that enables promising companies to reach their full potential. Yet, their sheer size also presents challenges, limiting their investable universe and creating dependence on massive exit opportunities.
Furthermore, the competitive nature of venture capital (firms competing with other firms for the best investments, talent, opportunities, and returns) inevitably leads to a degree of cannibalization, where firms contesting for the most coveted deals can drive up valuations (and favorable returns), diluting their own potential returns.
While value-added services are a relevant differentiator, the underlying economic forces often bring competitive bidding auctions back to terms of price. This competitive tension is a fundamental characteristic of the industry, shaping how VCs engage with each other and which deals they end up pursuing.
Finally, while the pursuit of maximum expected financial return remains the primary driver for the majority of venture capital investments, other motivations continue to gain traction among investors and limited partners. Strategic investors leverage VC to gain competitive advantages, impact investors seek both financial and societal good, and even personal biases can influence decisions. This multifaceted approach to investment opportunities highlights the evolving priorities and broader societal roles that venture capital now embraces.
The venture capital industry will undoubtedly continue to rapidly evolve (the only constant is change). By understanding a few of the core dynamics—the strategic role of megafunds, the impact of competition on returns, and the varied motivations behind decisions—we can better anticipate future trends and navigate this ever-changing landscape.
That’s all for today. I’ll be back in your inbox on Saturday with The Saturday Morning Newsletter.
Thanks for reading,
Drew Jackson
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