How Mega Funds are Reshaping Founder-VC Incentives

Venture capital has been built on a simple yet powerful principle: alignment of incentives. For years, this alignment between founders and VCs was straightforward - both parties benefited from the success of a company, with founders seeking to build great businesses and investors aiming for substantial returns. But as the size of venture funds has ballooned, particularly with the rise of mega-funds, that alignment is beginning to shift. Bill Gurley, Brad Gerstner, and Jamin Ball recently discussed this evolving dynamic on the BG2 podcast, and it’s worth examining how the landscape is changing.

The Traditional Alignment

In the past, venture capital was a much smaller, more concentrated business. A fund with $400 million in assets under management (AUM) was considered significant, and the incentives for general partners (GPs) and founders were aligned. VCs made money through their 20% carry, which is a share of the profits once the fund exits its investments. The objective was clear: maximize the value of the investments to increase the fund’s profits, and the founders also benefited from this success, often receiving significant financial rewards if their companies grew.

In this model, both VCs and founders had their financial futures tied directly to the success of the companies they backed. The better the outcome for the company, the better it was for everyone involved. It was simple, effective, and mutually beneficial.

The Rise of Mega Funds

Fast forward to today, and the dynamics have changed, largely due to the growth of mega funds. These funds now have billions in assets under management, often in the $4 - 5 billion range. While this has undoubtedly allowed VCs to fund more companies and deploy more capital, it has also introduced a significant shift in how wealth is generated within the venture industry.

The biggest change comes from the shift in focus from carry to management fees. In a $4 billion fund, management fees alone can generate $80 million a year - substantially more than what would have been expected from a smaller fund. A managing partner at these large funds can earn $10 - $15 million annually just from fees, regardless of the performance of the portfolio companies. This creates an interesting question for GPs: with such a steady and substantial income, why wouldn’t you focus on maximizing management fees rather than the carry?

Not Necessarily a Negative Shift

Let’s be clear: this shift isn’t inherently negative, nor is it a sign that GPs are neglecting their responsibility to founders. In fact, the ability to generate consistent management fees provides more stability to the fund, which can help them weather market volatility. It also allows them to take a longer-term view on the performance of their investments. With management fees generating a solid income base, GPs can afford to be patient, take calculated risks, and focus on nurturing investments without being as immediately pressured to deliver explosive returns.

However, the challenge is that this new dynamic has created a subtle misalignment in incentives. When a GP earns a substantial portion of their income from fees, the drive to maximize carry - the 20% share of profits that comes from the fund’s success - can lose some of its urgency. In theory, this could lead to quicker capital deployment, potentially overcapitalizing startups or inflating valuations, as mega funds may focus more on the immediate deployment of capital to secure management fees rather than nurturing long - term growth.

Overcapitalization and the Rise of Zombie Unicorns

One of the byproducts of this shift is overcapitalization. AI startups, in particular, have been flooded with capital from mega-funds, resulting in inflated valuations and excess cash in early-stage companies. This can create a phenomenon known as “zombie unicorns” - companies that have large valuations but little to no exit strategy or real growth potential. These companies may be stuck at a valuation that’s not reflective of their true worth, and if they hadn’t been inundated with capital, they may have grown more organically.

The key issue here is that while more money might seem like an opportunity for growth, it can lead to the pressure of chasing hyper-growth to justify those inflated valuations, which might not be sustainable in the long term. For the founders, the challenge is that the capital they’ve raised could ultimately constrain their ability to find an exit that allows them to achieve a meaningful return. This is where the misalignment becomes more apparent - founders may want a more modest exit that would still be life-changing, but they’re now stuck in a situation where the preference stack of investors demands a much larger outcome to satisfy their expectations.

The Call Option Mentality

Another challenge is the “call option mentality” that arises with mega funds. The larger the fund, the more bets they can afford to make, and the less they need any individual investment to be a home run. The goal becomes finding a few massive successes - just one company that becomes the next Google or Meta can make the entire fund profitable. This creates a situation where VCs can afford to make many bets, but founders, by nature of their single investment, cannot afford to fail.

For founders, this has created additional pressure to achieve outsized returns. Their incentives are now more closely tied to achieving extreme outcomes, often to the detriment of more moderate, sustainable growth paths. The problem is that these "call options" encourage extreme growth expectations, which may not always be in the best interest of the company or its long - term success.

Can Mega Funds Deliver Comparable Returns?

This brings us to a bigger question: Can mega funds deliver the kinds of returns that smaller, more traditional venture funds have historically achieved? According to data from StepStone, the top 5% of funds earn about a 4.5x cash-on-cash return on average. But with the sheer size of today’s funds, there is growing concern about whether they can match this performance. Many LPs (limited partners) - including pension funds and sovereign wealth funds - are prioritizing downside protection over high-growth venture returns, which could make it harder for mega funds to hit the kinds of returns top-tier funds have historically seen.

That said, newer LPs aren’t always focused on the same type of returns. For them, venture capital may be seen as a strategic investment rather than a purely financial play, allowing larger funds to find their place in the market.

A Complex Shift, Not a Crisis

The rise of mega-funds and the shift in how GPs earn their income is a complex change in the venture landscape. While the potential for misalignment of incentives exists, it’s not necessarily a sign of doom for the industry. In many ways, these larger funds can offer more stability and flexibility, allowing GPs to take a longer-term view and reduce the pressure for immediate returns. The key issue is balancing the incentives between rapid capital deployment, long-term growth, and maintaining alignment with founders.

As with any shift in the market, there are winners and losers. Some companies will benefit from the influx of capital, while others will struggle with overvaluation. The real question will be whether mega funds can continue to deliver the kinds of returns that have historically defined the venture capital world. But one thing is clear: the venture capital ecosystem is evolving, and it’s important to continue to monitor how these incentives evolve in the years to come.

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