Venture returns come from a handful of outliers, and the fund's own fees and carry take a large slice before the LP sees anything.
13 min read · Level 4
The power law is usually presented as the exciting part of venture, and I think it should be read as the humbling part. It means your result as an LP depends on a manager being in the right one or two companies, at the right ownership, and holding on long enough - and that most of what you will hear about a fund's portfolio in any given year is noise relative to that. It also means diversification across managers and vintages does more for an individual LP than any amount of analysis of a single fund's current portfolio.
A venture fund makes money when a small number of its companies are sold or listed for many times what the fund paid. Most companies return little or nothing. This is not a sign of a bad fund; it is the normal shape of the asset class, described as a power law.
Take a 100,000,000 fund that charges a 2% annual management fee on committed capital for 10 years, and 20% carried interest on profits:
Committed capital 100,000,000 Management fees (2% x 10 years) 20,000,000 Available to invest 80,000,000
It invests 3,200,000 in each of 25 companies. The outcomes:
Companies Outcome Returned 15 zero 0 6 1x 19,200,000 3 5x 48,000,000 1 54x 172,800,000 Total 240,000,000
The gross result is 3.0x on invested capital. One company produced 172,800,000 of 240,000,000, which is 72% of everything returned. Remove it and the fund returns 67,200,000 on 100,000,000 committed - a loss.
Now the LP's share. Profit over committed capital is 240,000,000 - 100,000,000 = 140,000,000. Carry at 20% is 28,000,000. The LPs receive 240,000,000 - 28,000,000 = 212,000,000, or 2.12x on what they committed. A 3.0x portfolio became a 2.12x investment.
Because it tells you what you are really betting on. A venture fund is not a basket of steady growers; it is a search for one or two companies that pay for everything else. A manager who cannot find those, or does not own enough of them when they appear, will lose money even if most companies do fine.
It also shows how much of the gross result the structure consumes. Fees and carry are not a small haircut in venture - they routinely take a third or more of the gross profit, and the fee part is paid whether or not the fund succeeds.
And it explains why headline numbers mislead. Funds often quote gross multiples on invested capital. The number that matters to you is net multiple on committed capital, after fees and carry.
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Same fund, two ways of stating the result.
Gross multiple on invested capital 240,000,000 / 80,000,000 = 3.0x Net multiple on committed capital 212,000,000 / 100,000,000 = 2.12x
What the LP gave up. Had the full 100,000,000 been invested at 3.0x with no fees or carry, it would have returned 300,000,000. The LPs got 212,000,000. The 88,000,000 gap is made of two parts:
20,000,000 of fees that was never invested, which at 3.0x would have been 60,000,000 Carry 28,000,000 Total cost of the structure 88,000,000
The fragile part. If the 54x company had instead returned 10x (32,000,000), total proceeds would be 99,200,000 and the LPs would get back less than they committed. The whole outcome turned on one exit.
Judging a fund by its gross multiple or by how many of its companies are doing well. Neither tells you what you will receive. A fund with 20 healthy companies and no outlier can lose money; a fund with 20 failures and one outlier can triple.
Ask for net multiple and net IRR after fees and carry, on committed capital. If the manager quotes only gross figures on invested capital, compute the difference yourself as shown here.
Multiply the fee rate by years and by the base it is charged on. A 2% fee for ten years is 20% of commitment, before any returns.
If a prior fund's result depended on a single exit, the manager may have been lucky or skilled; either way the next fund needs another outlier to do the same.
When reading any fund's performance claims, comparing managers, or deciding whether expected returns justify a decade of illiquidity.
Do not apply these illustrative figures as a forecast. Real fund outcomes vary enormously, and many funds return less than their committed capital.
Industry return data consistently show that a large share of venture funds return less than their committed capital net of fees, while a small share of funds produce most of the asset class's returns. Within successful funds, a single company often accounts for most of the proceeds. LPs reviewing strong funds frequently find that removing the top exit turns the result negative.
When evaluating a track record, recompute it without the best company. What remains is the part more likely to repeat.
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