E432 | Ertan Can, Multiple Capital: Investing in Micro Funds For Outlier Returns

0:00Welcome back, everyone, to the Europe PBC Podcast. Today, I have Ertan Chan with us, and we're going to talk, Ertan, of course, for an LP and fund and fund investor from Multiple Capital, the founding partner there. We are going to talk all about why micro funds are actually worth the hassle. And after that, after Ertan having given a presentation on this topic, which is only 10 minutes, so we won't ask you to sit through something too long. If you watch this or listen to this, you might consider walking over to your computer or grabbing your phone and watching it on EU.VC just to see the slideshow that Arsene has going with it.

0:35But if not, you'll be all right as well. He describes it quite well in the voiceover. after that we go into a long conversation about the pros and cons of small slash micro vcs and whether a normal lp in europe so to say would be wise to invest into these funds or not i hope you enjoyed this episode as much as i did making it

1:02tear down this wall it's more than just an ally this is a union of values Let's start acting. This show is not investment advice and the hosts of this episode may be invested in the funds and companies featured. Mr. Ertan, welcome back on the European Easy Podcast. Hi, Andreas. So Ertan, today we're going to do something a bit different because I invited you to come to Go West together with my good friend Sophia from the Go West team. and we did so because we wanted someone to come talk about the power of micro funds from the LP perspective and you accepted the invitation to do that and that is exactly what we're going to do now so we're going to do the LP perspective on why micro funds are worth it as an LP some might even say the best strategy for an LP if you want to achieve alpha in venture and I basically just want to allow you to go directly into the presentation you give us that 10-15 minute presentation.

2:09And then after that, we have a conversation on the back of it. Are you up for it? Perfect. Yes, absolutely. Let me start with the presentation then. It's around 10 to 15 slides about fund size in the end and why fund size makes so much sense in venture. So one of the data sets is that 75 % of funds with a multiple of 3x or more were small funds. That's three and four. So that's really a lot in percentage that are part of that 3X world. Here we're talking, and I think that is repeating now, we're talking mostly about pitch book and pre-quant data. And I personally think that pitch book and pre-quant data, first of all, sometimes is outdated.

2:52But second of all, never covers really what we call micro VCs a lot. So even there, it's limited to 10 to 250 million. So rather a larger set of what we wouldn't call micro VCs anymore. But even with that larger set, the percentage of 3x and better funds is 3 out of 4 or 75%. We think that the numbers are even better if the funds get smaller. So if PitchBook would have the data on funds, let's say up to 50 million and not 250 million. So probably most of you know that statistics, a lot of other people shared that in the last month. Here again, it's just very visible that small funds, in this case, not small funds, but emerging managers.

3:37And I will come in a second why emerging managers are most of the time small funds. But here you can see that emerging managers are most of the time outperforming larger funds. Same thing here again. We think that Cambridge Associates, you know, not even tracks most of the small funds. So it still is relatively limited. And even with that limited database of small funds, in this case, small funds outperform over a long period. In most cases, we're talking here about top 10 funds and all the other funds. Now, why are emerging managers small funds? Or why is that such a big correlation between that?

4:22So first-time funds raise on average way smaller funds. It's very logical, right? And we think that first-time funds and emerging managers is more or less the same thing. So first-time funds, usually, or even second-time funds, in most cases, raise on average much smaller funds. So for us, micro-VCs mostly are first and second and sometimes, you know, fund three. but it's mostly what others would call emerging managers. But we would consider, for example, a fund that is fund number four or fund number five if it's still a small fund. Again, looking at another pitch book data set, the majority of outperformer funds, 65 % are below 100 million fund size.

5:06So what is an outperformer fund in that data set? It's 5x plus DPI funds. Again, another data set showing that 65 % of 5X DPI funds are below 100 million. And then even another 17.5 % are between 100 and 200 million. Still, for many, would be considered smaller funds. So I would say, you know, together it's more than 80 % performing 5X or more are relatively small funds. Here, we've broke it down. 10 funds were larger than 200 million fund size out of the data set. 10 funds were 100 to 200 and 37 funds were below 100 million. Same thing here again. We think PitchBook does not cover the lower end well enough.

5:55If they would cover the lower end of small funds well enough, the numbers would look probably even much better than that. This is a very old statistic, but still, I think, is one of the most interesting visuals showing how funds perform when they are getting larger. So this is a Kauffman Foundation data set. It's already from 2012, so it's more than 10 years old. But it shows one thing very interestingly. You know, the percentage of funds that are, when looking above on this data set, it's large funds above 250 million. the percentage of funds below 1x, 1x to 1.5x, and then getting better and better.

6:37And you see like it's only 1 % that are 5x and plus. And if you look at smaller funds, which they summarize in 50 to 250 million funds, you see that the numbers are getting much, much better. So you have a higher percentage of those funds being, you know, performing 5x, 3 to 5x, 3x, et cetera. Or in other words, 51 % of the larger funds perform less than 1x based on the Kauffman Foundation data set from 2012. And almost 50 % of the smaller funds perform on the better end, which is above 1.5x. So that's still, in my opinion, a very interesting data set and still probably similar today when we look at the markets and see how the markets have performed.

7:30Another from Prequin, same thing with Prequin. If you look at the Prequin data set, most of our funds that we invested in are not even covered in Prequin. So they are missing a lot on the lower end. But still, the data shows something very similar, which is, you know, smaller funds below 100 million and funds between 100 and 400 million. And if you look at that data, interestingly, I mean, there is a kind of, you know, focus on that even 100 to 200, 100 to 400 million funds, because in the data sets of Prequin and PitchBook and Cambridge Associates, this is probably the lower end, you know, 100 million plus is the lower end of smaller VC funds that they really cover.

8:13And that's why you see, in many cases, similar returns for these kind of funds. We think if they would cover the smaller end good enough, the numbers would look different. But even though that is the case, you see that the smaller it gets, the better typically it gets when it comes to performance. Old statistic here from the Kauffman Foundation, but interestingly, very similar outcomes. if you look at the real outliers, there is a concentration on smaller funds on the smaller end, right? We have visualized this here. Whereas if you look at larger funds, you see that even above 1.5x, there is like nothing.

8:57And on the second page, you see that Kaufman Foundation, at least, had no single$1 billion larger fund returning more than 2x after fees. So that's very interesting. And here again, the smallest end you can see has those outlier returns, whereas the larger it gets, we always draw something like a line here. The larger it gets, the more difficult it gets to pay back good returns. A lot of people speak about volatility and stability of returns of smaller funds. If you look at the horizon pooled IRR returns, and everyone knows I'm not a big fan of IRR, but if you look at the pooled IRR returns, again, based on Cambridge Associates here, it looks rather relatively consistent, you know, what you have in returns here.

9:52The pooled IRR, which means all IRRs for small funds below 100 million, is still relatively concentrated. As you know, we are a fund of funds, so we believe in our portfolio of small funds, not in one single or one or two or three. We think it's very difficult to select the best fund. We try to select the best funds or some of the best funds and ideally hitting some of the outliers. But in general, if you look at the total market, the returns are relatively stable. That's what this data set shows. And then this is another data set about the rise of micro-BCs. So funds that were raised, in this case, even below 50 million.

10:33So it's a huge increase. Everyone knows that. We think this data, again, from PitchBook is very, very limited. We think that the real number is probably three to four times higher if you really count in all the funds that want to raise a 10 million, a 5 million, a 50 million fund. I think it's just natural or logical that PitchBook can't have them all on their platform. Even us. So it took us almost five years until PitchBook took us into their platform. So I think for most new funds, it's not the typical thing to be on PitchBook. One thing that many people don't look at or never looked at is the management fee site.

11:17And we can see that small funds, and again, this is on average, small funds have typically more like the 2 % or 2.2 to 2.5 % percentages. As you can see, most are around 2 % because they start and they have to have usually a standard fee model. And so you see that increase in fees, the larger the funds get. And here you see like the blue ones are the majority of funds. when the funds are getting larger, the majority of funds seem to have more like 2.5%. Why? Because they can. So many of the super branded funds that are oversubscribed and getting larger and larger ask for higher fees. And that is something that was quite interesting for us that the smaller and no one talks about that, but this is a huge benefit for a small fund that the fees are not 2.5 % or 2 % because the fees make a lot of difference if the funds are also larger compared to smaller funds.

12:25So you see that trend very clearly that bigger funds, probably all the brand name bigger funds have usually higher fees than the average of the smaller funds. This is a lot of tax, but I'd like to focus on only one thing here. Small funds need lower exit valuations than larger funds. I think this is common sense. And we just calculated in some examples, and we think that the valuation of a fund returner in a small fund has to be around$250 million. Valuation of a fund returner of$100 million fund has to be almost three times that number,$670 million. And for a$300 million fund, you need a$1.5 billion exit.

13:07As all of us and you and me know, we don't have a lot of 1.5 billion exits. So again, it's a plus for smaller funds. If you have a smaller fund, your exit returns proceeds don't need to be huge. You can return funds with far less smaller or far smaller exits. And I think that's my last slide. It's about Samir Kaji, who posted something on his newsletter. How should LPs think about VC fund says, and I think he summarized one thing about small cap venture. And small cap venture for him are, again, funds up to 250 million. But what he says is, you know, the highest return potential with corresponding volatility have small funds.

13:53Manager selection is crucial. It's probably best suited for maximum return seeking portfolios. Now, what he has not mentioned is the thing that, you know, the combination of manager selection and return seeking and high return potential is even better if it's a portfolio of small funds. So if you build either yourself or through a fund, if you buy a portfolio of small funds, I think you also answer that part, which is volatility. And so we can see in our portfolio, for example, that with a larger portfolio of small funds, the volatility is very much limited or reduced. And so you can benefit from what it is probably what venture capital initially was, buying very early with small amounts and benefiting a huge, if it is an outcome, that is huge.

14:46So this is my presentation. Thank you, Arten. Thank you. There's a bunch of knowledge in there that I think many of our regular listeners on the podcast have heard many times and seen many times. It's a debate that's ongoing on LinkedIn constantly. But there are some things that I would love to ask you to maybe dig a bit more into and get a bit more controversial on or just more candid on. And one of them is, if I asked you, where do you see most people most often getting it wrong? And here I mean, from the LP perspective, getting it wrong when they're thinking about large funds versus small funds.

15:26That's a good question. So getting it wrong. I think one thing is that large funds typically have a much, much more solid brand, are much more recognized as a brand, have a much longer story that they can offer. And also success stories. If you were a successful fund in the past with your smaller or initial funds, you have the success story already today and can present it and say, you know, we were invested in the past in this company and that company that became a Decacorn or a Unicorn. This helps many of the larger funds today to be more present within potential investors, LPs, also within multipliers like fund placement agents, banks, people who are willing to place you, the moon first of this world.

16:14So they are selling brands. They're selling not really returns or future returns. I think that is probably a misperception or not a misperception, but a difference between LPs accessing larger funds versus smaller funds. What do they do wrong when they... I think it's not about wrongdoing here or getting it wrong. I think it's about not doing it. It's a lot of work. It's a lot of effort to invest in small funds because they are not known. So you have a lot of them. It's like seed rounds or angel rounds. You have a multiple of seed rounds versus A or B rounds. And it's super difficult to select and pick the right ones, in my opinion.

17:01For funds, it's not as difficult as for seed rounds because you don't have 10 ,000 seed rounds a year, but you still have 500 to 1 ,000 funds a year where you have to do a selection. And I think this is probably the biggest wrongdoing that LPs are not taking the resource, the time, to look into the whole market and do a selection. So when you think about what Samir wrote in his newsletter, it's manager selection is crucial. So to do manager selection and small funds, in my opinion, you have to do the work of meeting and seeing a lot of small funds and then deciding based on what you've seen on what to choose.

17:42What is the magic number for an LP? Where would you say that a family office should be comfortable underwriting a fund manager? Yeah. So the number of fund managers per year. Yeah, and time dedicated, so on. What does the setup for an LP look like before they should start dabbling into small funds, so to say? Yeah. So we think to cover the European market, you should look at 500 to 1 ,000 funds a year. Some year, things that is 200 to 300 funds a year to do five investments per year. We think five investments is not enough to cover a market, every vintage. We think it's rather a 10, you know, 10 is the number, but something between 5 and 10 is probably a good size, right?

18:30So if you want to cover something like Europe, if you go global, it's a different number, right? So because you have to do 5 to 10 funds in the US, if you do 5 to 10 funds in Europe, at least to cover the US and Europe, and probably the rest of the world, another 5 funds. And it's a different work. Even we don't do really globally sourcing every fund in the micro worlds. It's just impossible for a smaller player like us and for most players in the world, in my opinion. So the right number, I would say, is five to 10 bets every vintage in micro VCs. And probably for doing this, you need to look at something like 300 to 900 or 300 to 1000 funds to do the five to 10 bets.

19:13So here I'm being devil's advocate, and maybe a lot of people will hate me for it. But you see a lot of emerging managers, VC managers, not fund-of-fund managers, but VC managers on LinkedIn a bit talking to the LP crowd that this is why you should do emerging managers. And then they come with all the multiple and returns arguments that you have. But I just always feel like, well, if you then look at the average LP that they're engaging with and the setup they have, they're not meeting 300 to 1 ,000 funds every year. They're not making team bets every year. So I actually think that from the asset manager perspective or the deploying sites perspective, there are many good reasons to not maybe do as many small micro funds as we in the ecosystem would like them to.

20:10The many reasons not to do many small micro funds? Why do you think that's it? In the sense that those reasons are not connected to the asset class, so to say, but they're connected to their own internal processes and their own work in the asset class. Meaning that the majority of the LPs that allocate to venture do not meet as many managers as you described. They do not have enough time. They do not do as many bets as you described. And for that reason, even regardless of everything else, we might say, well, if you do do a pure VC fund investing strategy and you do dedicate all the time in the world, so to say, to meet everyone, then it makes sense to do a micro strategy.

21:01Yes. But given the setup that they have, they would actually probably be better off capturing that exposure by the likes of Multiple and Isomer and all our funder funds that do the work that you described. And then if they want direct exposure as well, they do some of the more established funds. So I think what you're talking is also about the risk perception of venture. First of all, yes, I agree with you that most LPs wouldn't take the time and the resource to screen enough funds to do a selection of micro VCs. First of all, they wouldn't meet as many. And second, they wouldn't do enough commitments.

21:47So even if they would meet 100, they wouldn't do five per year, which would not be good because 100 would be just a fraction of the market. Okay. But let's say they meet 100. They would still probably most of them not do five investments per year. So it's kind of lacking. And I agree with that. The question is, what is the alternative? So the alternative could be investing into a platform fund, you know, a larger brand, where they feel more secure, less volatility, less dispersion of returns, etc. But here again, data shows that even larger funds don't always promise this kind of solid return that you would expect.

22:24So even with larger funds, you would have to diversify, of course, usually. And even if you would diversify with larger funds, it would still underperform compared to smaller funds. Now, the other alternative is to invest in funder funds like Isomero or Multiple. And it's one of my next posts, by the way, in the fundraising series. But what I realized is, and you know that as well, there probably today in Europe alone, probably something like 40 to 50 new funder funds. I don't know if all of them are investable. But for an LP, even looking at 40 to 50 funder funds, you know, and compare funder funds would be a task that most LPs wouldn't have time or resources to do.

23:10So I'm not talking about funds or direct, which is another layer of, you know, different risk. Because, you know, if you invest direct, even a C round or D round, which you would consider a super low risk, can fail, right? But so what I've realized, most LPs not even like, don't forget looking at the whole market of VC funds, large or small cap. Forget about that. They're not even able to look at the whole market of fund of funds to select one or two right fund of funds for their portfolio mix. I think it's already a task for most family offices, for example, to do that one. And that would be probably the more logical answer instead of screening or meeting 20 managers and doing two investments and thinking, oh, now we have deployed into micro-resist.

24:02There is a difference, by the way. I think if someone, whatever the reason, doesn't want to do a micro fund, sorry, a fund of funds, you know, like us. And there are several reasons why people are not, you know, I think the best alternative, and I'm not recommending here any fund, but the best alternative would be still a fund that is highly diversified. Right. So that does something like 100 to 300 investments in a fund, in a fund, in one, in one single fund. And there is, I think it's another data set that we want to publish publicly in the next week's month. There is even, interestingly, if you look at all those funds that have this high diversification, you can literally see how they perform on average really well.

24:50So on average, you have a better bet if you find a fund that invests in 300 companies or 100 companies every year, even though it's a spray and pray model. So that's the biggest difference, I think, between a fund-to-fund and a fund that invests in 300 companies, you know, in one single fund. Because 300 companies means you have to be broadly investing and you don't know, you're not concentrated in any of the investments that you do. Whereas a fund-to-fund invests in a single manager and the single manager is very concentrated in what he selects. Usually, you know, we invest in concentrated funds and they, again, are very concentrated in the picks.

25:24So we consider our portfolio much more concentrated in selecting the companies compared to a single fund. But I would recommend rather this kind of shears, prey and prey fund versus any single fund if you don't build a portfolio of funds. Just to comment on that, we have a full session happening in not too long, only on this constant debate that's also in the market about the concentration you want in a venture fund. So whether you want to do spray and pray models, as some might call them, or you want to go much more concentrate. So we're doing the pros and cons of that, reserve strategies, all of it into one.

26:05Andres, the reason why I mentioned it or said this is because it's closest, the spray and pray fund is closest to a portfolio of companies, you know, large enough. So that is the reason why I think if you're not building a portfolio yourself by selecting several funds or investing into a fund of funds who does this selection for you, then the closest to that diversified model is a spray and pray fund that does 100 investments per year. And on top of this, now we're just talking the numbers game, right? But there's also the point that most micro funds are specialists either in a geo or in a vertical.

26:44So if you do a micro fund bet, you don't just have exposure to venture, you have exposure to B2B SaaS in Denmark or something like that. Most often, unless you do the more established players that are most often, at least in a plus 100 million size range. I agree. There's another thing I wanted to ask you. David Clark from Vencap, of course, is one of the big voices in this conversation always. And he is saying, and I wanted to ask you about this, that the data you touched on in your presentation as well, the data is always with quite some lag, always five years or more old. And a lot has happened in the market since 2019.

27:29So where do you see the venture market moving? And do you see it pilling in the favor of more micro funds or for strategies directed at micro funds? Or do you see it bifurcating so that only the very best small micro funds will be able to keep deploying that type of strategy, but then we'll have more of the larger hybrid crossover funds, that type of thing? Where do you see the European market moving? I think there are some tendencies from the biggest backers of funds in Europe, the public institutions. There are some trends, tendencies to back more or to create bigger funds with the mindset of, you know, Europe needs more growth funds, late stage funds.

28:13And so I think because of that, there will be more 1 billion funds coming into the market in the next years, being focused on later stages and growth rounds. That's a fact. That's more or less a fact because it's already decided and this will come to the market. I like the comments and the posts of David from Vencap because he's putting a different perspective. and it's very interesting. I mean, of course, all of us have an interest because we do a specific business and his interest is different because BankUp has a slightly different business model than we do, of course. And of course, we are claiming small funds are performing better at the same time.

28:55He claims it doesn't matter if it's small or big, it's about the best managers. To be honest, I don't know who the best managers will be in the future. I truly believe that it's very difficult to pick the best managers today. And if it's pickable, so if it's visible today, then it's definitely not a small fund because a lot of others will have the same opinion about that fund, right? So it will be a rather a large and even larger fund than five or 10 years ago. This is, by the way, the reason, you know, if I show those data, which is the available data, which is five years, six years old. I think today it's probably even And the thesis of the data that we are showing is probably more the case today even compared to 5 to 10 years ago because the fund's getting larger.

29:45You know, if you think about Insight, just to name one name, Insight, I think the last fund was a 20 billion fund. The fund before was a 4 or 5 billion fund. So, you know, when talking in sizes, that's almost unimaginable. I don't understand how they will return this kind of number, you know, 20 billion. And maybe inside us will return that. But others who raised similar large funds or quadrupled, tripled their fund sizes, all of them, it will be just almost impossible to meet the return claims, the expectations. and if all of them will return this kind of expectations, then imagine what will happen to the micro-VCs because all the micro-VCs will be earlier in these companies.