Venture

Why Some New Mega-funds May Make Sense

It’s a busy moment for new funds. As Crunchbase News has reported, VC shops like Scale Venture Partners, Index Ventures, and Lightspeed Venture Partners are raising huge new funds. And smaller firms like High Alpha and Ashton Kutcher’s fund are raising, too.

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Notably, however, the pace and scale of activity in tech—huge funds, huge rounds, and big valuations—aren’t scaring off players that are slightly less traditional when it comes to startup investment.

Vista Equity Partners, to pick an example, recently made news by describing the process by which it picks up software companies, strips out costs, and fires up growth to drive its own returns. The firm views software companies as fungible.

And Vista Equity isn’t alone in thinking that software companies are investments that are repeatably winnable.

Insight Venture Partners announced today that it has a new $6.3 billion fund. The venture shop has grown its fund sizes and investing purview over time. Per the Wall Street Journal’s coverage of the new capital vehicle, Insight can now invest all around the startup lifecycle:

More recently, Insight increasingly has used its technology expertise to fund both businesses looking for venture-capital backing as well as buyout and take-private transactions typically requiring more capital.

Insight Venture Partner’s new fund can invest across the lifecycle of software companies. That gives it enormous range.1

Returns

But even with its wide mandate, it’s easy to wonder if there are enough potential on-theme investments in the market for Insight to manage a good rate of return for its enormous new fund.

Other venture players are flush with capital, and there are even-larger vehicles in the market that can scoop up deals and raise prices—competition is fierce and Insight has to find a host of companies to invest into if it wants to fully deploy its new fund.

Can the firm find enough profitable investments for its new fund to generate strong returns?

I asked that question on Twitter and ended up picking up some notes from well-known venture capitalist and general SaaS guru Jason Lemkin that are worth sharing. (The SF Chronicle’s Owen Thomas and Forbes’ Alex Konrad helped out as well).

Instead of making your life irksome by embedding tweets, here’s the short version of our conversation, which changed my views slightly regarding the potential efficacy of funds at this scale:

  • Contention: It won’t be possible for funds of this scale to generate venture-scale returns (source).
  • Initial rebuttals: Downside protection is underrated (source), and most of Insight’s cash will go to buyouts, not venture deals (source).
  • Key argument that funds of this scale can work out:
    • The size of the fund can work out if the investing firm aims for 30 percent or greater ownership in portfolio companies. With double-up investments, the firm can reach a twenty percent internal rate of return (IRR) under certian conditions (source).
    • The Insight model works when you can deploy oodles of capital into winning companies (source).
    • What sort of companies count as winning? The startups that Insight will want to invest in are likely SaaS companies that have reached the $10 million annual recurring revenue mark and are growing at 100 percent yearly (source).
    • And there are hundreds and hundreds of companies that fit that mold (source).

Under certain conditions, I think that Lemkin’s argument that huge funds can generate strong returns makes sense. If you can get lots of capital into quickly growing SaaS companies, you can ride them to a strong IRR result. My counterpoint that there weren’t enough SaaS companies of sufficient quality for the concept to work, per the VC, was wrong.

But you can write the bear case easily. If there are fewer quality SaaS companies than expected, software company valuations slip, or exits diminish, Insight’s model could struggle.

In its favor, Insight has enough cash to be patient. If the market for exits slows, it may be able to wait for the market to recover before it pushes for liquidity for its investments. It can do so as it can put more money into the startups to tide them over.

Time Will Tell

What we’ve learned from the above is that while it will be hard for all of the new mega-funds to generate proper returns, mega-funds that focus on software investments with an eye towards big, long-term positions in growing startups might be ok in the end.

The results will speak for themselves, but I’m now a bit less skeptical. Not entirely so, by any means, but less than before.

  1. According to Forbes coverage, the company’s partners have a lot of their own money tied up in the new fund, so this isn’t merely a gamble with OPM.
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