Let’s start with public market funds to understand this a little better.
Everything else being the same, the ability of a fund to deliver returns to its investors diminishes as the fund size increases. The big assumption here is “everything else is the same” – which includes the competence of the fund manager, the timing of the investments made out of the fund, and a host of other factors.
Let’s just think about the logic. The investment opportunities in the market can be classified into three categories, namely:
- The really attractive ones (either value or growth): and they are few in number
- The average ones: most would fall into this category
- The duds: a good number would fall into this category as well
If the fund size is large then there is no way the investments can be limited to the first category of opportunities. The fund needs to invest in the other two categories as well. And some of the investments in the third category could be a total washout and neutralize the gains from the investments in the first category.
So, as an LP, one needs to be a little wary of investing in very large funds.
The obvious question is why would anyone raise a large fund if the likelihood of returns is not high? The answer to this question holds the key to the way the investing world operates – the 2:20 principle. Every year 2 percent of the fund goes to pay for the expenses, including the salaries of the managing team. And the 20 percent is a form of gain share when the investments are liquidated (called ‘carry’ in the investing world parlance). The 2 percent is a guaranteed payout and the 20 percent has a risk component. So, the bigger the fund size, the bigger the guaranteed payouts that the managing team can grant themselves! The motive is clear.
Don’t the LPs, who are expected to be smart, get this? They do, but some of them are very wealthy and this is just a part of their portfolio. Their life becomes easy if they invest in a fund of funds (where they do not have to bother about investing in multiple funds; the fund of funds does it for them) or in a couple of large funds.
Now, let’s come to SoftBank and look at their SoftBank Vision Fund. The fund size is an astounding $100 billion. Obviously the LPs have been chosen carefully – Saudi Arabia, Abu Dhabi and many such entities and individuals who have themselves had huge windfalls and do not know how to deploy their large riches. A grand vision has been sold to these LPs, with the SoftBank investment in Alibaba being the centerpiece of their ability to spot large opportunities. With this fund size, the investments therefore have to be real big bets – the kind that no one really knows how they would play out. The latest investment of $2.5 billion in Flipkart is just an example. If SoftBank has to return even a 2x multiple on this investment to its LPs, and if we assume valuations by then will be a multiple of profit (and not GMV), then Flipkart needs to make a profit of at least $2.0 billion. Who knows when Flipkart can make this kind of profit.
In addition, SoftBank always needs to make an entry at a late stage where the product market fit has been established beyond doubt, and hence the valuations are already steep and hyped. Therefore, the ability to get multiples on their investments is further constrained.
In my opinion, SoftBank will find it difficult to deliver even a 2x multiple over the life of the fund.
But who cares. The LPs don’t, and the startups that get funded by SoftBank are delighted beyond measure and will be on cloud nine!
Disclaimer: These are my personal views and do not represent the views of my employers or of YourStory.
(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)