January 13, 2022
Historically, LPs seeking alpha have typically looked to invest with brand-name VC firms while avoiding emerging or smaller managers given the potential risks. However, what is seemingly unknown to many is that the tide appears to be turning, with Micro-VC funds increasingly representing a sizable portion of achievable alpha.
Put simply, this venture return equation should not be ignored.
The Alphabet Is Changing and Making Room for Micro-VC
The traditional VC financing continuum has broadened over the past several years. Companies staying private longer, the horizontal integration of technology and innovation across industries, and a friendlier environment for company creation are a few reasons for this shift. Compared with a decade ago, early-stage technology companies are raising nearly three times as many rounds prior to a Series A. The increased expectation for companies to exhibit stronger traction and operating metrics has led to raising the bar for Series A deals, resulting in larger checks and funding rounds, further enlarging the Seed category. The idea of a single financing round has been replaced, and Seed itself is no longer one category. Institutional Seed has displaced angel investors, with Micro-VC funds emerging as a new venture subcategory to accommodate these new rounds of pre-Seed, post-Seed and smaller series.
Once a company reaches Series A, brand name matters. The venture managers that have built reputable names over a long period have a huge advantage in accessing and winning deals. Often, these managers choose not to enter pre-Seed rounds, given their larger fund sizes and the number of portfolio companies they are already managing. This opens the window and provides an opportunity for Micro-VC managers that are raising smaller funds and often seek a more hands-on approach with their investments.
- They invest earlier than Series A–focused managers where it becomes more competitive, without sacrificing ownership.
- The universe of these managers has grown over the last five years, typically raising fund sizes between $40 million and $250 million.
- Micro-VC managers tend to benefit from being early movers, as they are able to set the tone, gain higher ownership and develop strong engagement and relationships before the Series A groups get involved.
Ultimately, the ability to garner an information and relationship advantage results in optionality for subsequent financing that would ordinarily be difficult to access as a new LP.
Multiple Ways to Win
As we think about the extended financing continuum wherein Seed has become the new Series A, the risk-return profile has proven to be similar. The perception that investing in unproven, high-loss strategies is a binary proposition is a misconception when considering the evolving VC landscape with Seed and Early Stage being far more versatile. The historical lottery approach to constructing a VC portfolio has since evolved and been replaced with a more thoughtful, measured and risk-adverse approach. This methodology has best been afforded to scaled platform investors that possess the informational, resource and relationship advantages to assist with sourcing and diligence. In the 1990s, the typical venture fund had a loss ratio of more than 50%, but since then, this figure has decreased considerably to roughly 20%, according to Cambridge Associates data. The time and capital involved in determining whether a company is viable has also fallen over the past few decades, further contributing to venture’s attractive risk-return profile.
Emerging managers are also known as “first-time funds;” however, these funds are often led by investors who are either spinning out of brand-name VC firms or entrepreneurs with strong track records of investing and creating companies.
Micro-VC managers are made up of a subset of individuals and groups that are innovative and have a clear vision of market opportunities. The multifaceted approach has led to far-reaching opportunities to pursue strategies that have historically been overlooked or are still emerging. We believe this dynamic has materialized in such a way that there are multiple ways to win within Micro-VC funds. This is evident in the distinct players listed below who represent different niches, ultimately building diversification while remaining one-dimensional.
- Manager spinouts—high performers departing venture firms to start their own fund. Spinning out of a brand-name firm often attracts LP attention; therefore relationships, experience, individual track records and using the right platform can help an LP be a spinout’s first call.
- Venture studios—investors looking to play a pivotal role in company formation by providing access to their unique skills, experience and networks. This can lead to large ownership stakes due to their active involvement in company creation.
- Unloved geographies—geographies outside the mainstream global venture centers can lead to accessing differentiated deal flow and avoiding crowded, competitive markets like New York or San Francisco.
- Subsector expertise—deep expertise, networks, and experience in individual sectors.
- Solo general partners—the best solo GPs often come with solid track records and, importantly, strong personal brands with entrepreneurs. Because they have increasingly become disruptive to more bureaucratic organizations, it is important for a VC portfolio to consider solo GP exposure while balancing the key-person risk.
