I read the article Dirty Secret: Venture Reserves are Not Always a Good Thing. It inspired me to do some research on the success rate of VCs who keep reserve funds.
Reserve Allocation in Early-Stage VC Funds: Emerging Manager Dynamics
Early-stage venture capital (VC) funds allocate reserves to support portfolio companies in subsequent funding rounds. However, due to unique challenges and constraints, expectations for emerging managers can differ significantly from established funds.
Typical Reserve Ratios
Most VC funds reserve 30-40% of their total capital for follow-on investments, with the remaining 60-70% allocated to initial investments. However, emerging managers often adopt lower reserve ratios, ranging from 0-50%, to prioritize portfolio diversification while maintaining some follow-on capacity.
For example:
– Form Ventures reserves 50% for follow-ons
– Some seed funds opt for no reserves, instead using Special Purpose Vehicles (SPVs) for breakout companies
LP Expectations for Emerging Managers
Limited Partners (LPs) generally do not mandate strict reserve ratios for emerging managers. Instead, they focus on alignment with the fund’s thesis and track record. Smaller funds ($10M-$50M) often lean towards higher initial allocations (60-80%). This approach helps build a diversified portfolio. A single outlier can disproportionately impact returns.
To illustrate:
– A $50M fund with 50% reserves requires a $1B exit to return the fund
– The same fund with no reserves reduces the threshold to $666M
Trade-offs and Challenges
Power Law Dynamics: Reserves help maintain ownership in top performers but over-allocating risks under-diversification. For instance, Ulu Ventures’ $10M fund achieved a 5x return with no reserves by front-loading capital into early winners.
Fund Size Constraints: Emerging managers with limited capital may prioritize initial investments over reserves. For example, a $10M fund targeting 30 investments might allocate $250K per company upfront, leaving no reserves.
Exceptions and Trends
Sector-Specific Strategies: Deep-tech or capital-intensive sectors may demand higher reserves (50-60%) to support extended R&D phases.
LP Co-Investment Opportunities: Emerging managers often lack reserves for full pro-rata participation, creating co-investment avenues for LPs at reduced fees.
Strategies for Managing Limited Reserves
1. Selective Follow-ons: Reserve capital for top-performing companies only
2. SPV Utilization: Create SPVs for additional follow-on opportunities, offering deal-by-deal carry
3.LP Co-investment: Provide co-investment rights to LPs for larger follow-on rounds
4. Pro-rata Rights: Negotiate pro-rata rights even with smaller initial checks to maintain ownership in future rounds
Impact on Returns
The reserve strategy can significantly impact fund performance:
– Successful reserve deployment can boost returns by allowing VCs to double down on winners
– Ineffective reserve allocation can potentially bring down fund multiples
VC returns typically follow a power law distribution. In high-performing funds with returns of 5x or more, the top company in each fund’s portfolio is often held. This is at an average Multiple on Cost of about 90x. The second-best company is held at ~25x. The average mark for the remaining investments is typically around 1x.
Conclusion
Emerging managers are not universally expected to adhere to a 1/3 initial, 2/3 reserve model. Instead, reserve strategies depend on fund size, sector focus, and risk appetite. While reserves remain critical for ownership retention, many emerging funds prioritize diversification and lean on alternative structures (e.g., SPVs) to compensate for limited follow-on capital.
LPs evaluate these trade-offs alongside the manager’s ability to identify and scale outliers efficiently. Reserves effectively generate Total Portfolio Value Increase (TPVI) if the VC skillfully identifies top-performing companies. The VC’s skill is crucial for success. The VC must also support them. To succeed with reserve strategies, VCs need to identify top companies accurately. They must allocate substantial reserves to maintain high multiples on the overall fund.
“A rising tide floats all boats….. only when the tide goes out do you discover who’s been swimming naked.”
Warren Buffett