Back in 2021, at our annual meeting, we spoke about the craziness of what was then going on in VC. We featured a quote from podcaster/investor Chamath Palihapitiya.

This quote is from August 2021, but here’s how it’s relevant today. A small number of firms never took their foot off the gas–just eight of them accounted for half of all LP commitments to venture capital this year, raising an average of $3.8B each. This isn’t an anomaly. Here is the capital accumulation trend over the last several years showing how LP concentration has increased in recent history from 2021, when emerging managers increased the diversity of LP commitments, to today, with fewer firms demanding more capital.

Firms are also “going back to the store” more frequently, too. General Catalyst pulled in $6B just this year after raising over a billion dollars last year. Andreesen Horowitz has raised over $13B across multiple funds in the last four years. Funds are getting bigger, raising faster, and deploying more rapidly than ever before. Just like a black hole which sucks in as much mass as it can, a few firms with critical mass are absorbing the majority of LP commitments. But while black hole fund managers are indeed collecting enormous fees, the path to generating great returns is entirely unclear.

Like most things in life, behavior emerges from incentives. Most LPs instinctively understand the financial incentives for black hole GPs–the “enormous fees” talked about above–but let’s put some math around it. Instead of what LPs want–DPI–let’s talk in terms of GP economics. I’m going to introduce a new metric here, the carried interest multiple, which is the amount of carried interest compensation relative to management fees. A carried interest multiple of 1, for example, means that the GP takes home in carried interest the same amount that it makes in fees. The carried interest multiple will vary from DPI based on carry terms like hurdle-based stepups, catch-up participation, and payback provisions. You can get a sense of how motivated a GP is to generate returns based on the exit value of a portfolio required to generate a high carried interest multiple. Here is a simple example for commitment levels of various sizes using a typical “2 and 20%” structure with an average portfolio company ownership of 10% at exit.

Notice that I intentionally use the term Commitments instead of Fund Size. That’s because LPs, at least in principle, commit to firms and not funds. If firms come back year after year to raise funds, it makes more sense to think of those funds as a single commitment. If you think a firm can own 20% on average, divide the Exit EV figures in half.

The leftmost column depicts a firm that has raised a single $100M fund, which will collect $20M in management fees over its life. In order for the GP to make 10x that amount, or $200M in carried interest, its portfolio will collectively need to exit for $11B, a difficult but achievable target. You could conceivably hit that number with a single company–over 50 companies have exited for over $10B in the last 7 years.

Looking at the largest commitment on the right, the story is flipped. For a $10B series of funds, the firm will pull in $2B worth of management fees. To merely double their compensation, they would need $220B of collective exit value. It should be obvious that owning 10% of $220B at a time when you can liquidate your positions would be an unprecedented achievement for a venture capital firm. There has never been a US VC-backed company that has IPO’d or been acquired for over $100B, and only two private companies (OpenAI and SpaceX) have cleared that hurdle in private, outside-led financing rounds. If a $10B exit is considered a “grand slam,” this firm would need an astonishing ability to repeatedly select winners and negotiate sufficient ownership. In other words, to make $2B, this general partnership just needs to show up for work. To make another $2B in carried interest, it would have to accomplish a feat that no one has ever come close to achieving. Here are the top 10 VC-backed exits and outside-led private financings by enterprise value. Looking at this, how many firms can really own 10% of $220B of enterprise value at exit?

The counter-argument is that, because companies are staying private longer, they have more ability to generate massive EV before exiting. Even though Stripe could have gone public many years ago, it might dwarf the largest IPO in history because it’s had time to mature in the private markets. But this is all theoretical physics. There is no precedent to suggest that multi-hundred-billion dollar exits will happen frequently enough to generate significant DPI across many black hole firms. Getting the $10B commitment to just a 2x DPI would require a massive change in the way companies generate liquidity for investors.

The inevitable consequence of this is that LPs looking for outsized returns will have to find them in smaller vehicles or other asset classes. This threatens the longevity of these black hole firms. You would expect that the managing partners would want to position their firms to exist for decades to come. You would want them to not just generate great returns but to be grooming the next generation of leadership. Instead, you’re seeing the opposite. Returns have been underwhelming, and the junior talent corps is setting sail for opportunities that have a longer lifespan.

The bottom line is that black hole funds represent almost a completely different asset class from early stage venture capital. They stand very little chance of generating an IRR that investors expect from VC. Yes, they have the ability to absorb large commitments, and if that’s what an LP needs, then you’ve found your partner. But for those seeking the possibility of repeatedly reaping high DPI returns, black hole funds probably aren’t the answer.