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Venture Capitalists Get Paid Well to Lose Money

Diane Mulcahy is a Senior Fellow at the Ewing Marion Kauffman Foundation and author of the widely read report We Have Met the Enemy…and He is Us. In a recent post, after the 2013 annual industry performance data from Cambridge Associates shows that venture capital continues to underperform the S&P 500, NASDAQ and Russell 2000, Diane points out that the ongoing poor performance of venture capital firms should be an obvious problem for institutional investors. Furthermore, she states that we should try to understand the “real problem” -[which] is how little of a problem this persistent underperformance is for VCs themselves.

There are four major issues that Diane wants to bring into our attention:

1. VCs aren’t paid to generate great returns.

1. VCs aren’t paid to generate great returns.

LPs pay VCs like asset managers, not investors. LPs generally pay VCs a 2% annual fee on committed capital (which may step down nominally after the end of a 4- or 5-year investment period), and 20% carry on any investment profits. The 2% fee is cash compensation, paid annually, regardless of VC firm investment activity or performance. This fixed 2% fee structure creates the incentive to accumulate and manage more assets. The larger the fund, the larger the fee stream. Raising bigger subsequent funds allows VCs to lock in larger, and cumulative, fixed cash compensation. The 20% carry, in contrast, is paid sporadically (if there’s any generated), not until several years after the fund is raised, and is directly tied to investment performance (or lack thereof). Given the persistent poor performance of the industry, there are many VCs who haven’t received a carry check in a decade, or if they are newer to the industry, ever. These VCs live entirely on the fee stream. Fees, it turns out, are the lifeblood of the VC industry, not the blockbuster returns and carry that the traditional VC narrative suggests

2. VCs are paid very well when they underperform.

2. VCs are paid very well when they underperform.

VCs have a great gig. They raise a fund, and lock in a minimum of 10 years of fixed, fee-based compensation. Three or four years later they raise a second fund, based largely on unrealized returns of the existing fund. Usually the subsequent fund is larger, so the VC locks in another 10 years of larger, fixed, fee-based compensation in addition to the remaining fees from the current fund. And so on. Assume it takes three or four funds for poor returns to start catching up with a VC firm. By then, investors have already paid for nearly two decades of high levels of fixed, fee-based compensation, regardless of investment returns. And the fee-based compensation isn’t trivial – in all but the smallest funds, the partners make high six, and more often seven, figures in fixed cash compensation. Investors have perpetuated a compensation structure where VCs can generate significant personal income over their career, even when they make no money for their LPs. This payment structure perpetuates the economic misalignment between VCs and LPs, fails to create strong incentives to generate outsized returns, and, most importantly, insulates VCs economically from their own investment underperformance.

3. VCs barely invest in their own funds.

3. VCs barely invest in their own funds.

The “market standard” is for VCs to personally invest 1% of the fund size, and for investors to contribute the remaining 99%. It’s an interesting split, considering that, to hear VCs tell it in a pitch meeting, there is no better place to invest your money than in their fund. Pick up any pitch deck, slide presentation or private placement memorandum and read about the optimistic projections about the VC industry, the fund’s unique strategy, the incredible market and technology trends that support the strategy, and the impressive team of investors that generates “top quartile” returns. The future has really never looked better! Yet, when it comes time to close the fund, there’s hardly a VC checkbook in sight. In fact, many VCs don’t even invest in their fund from their personal assets, instead contributing their investment via their share of the management fees.

4. The VC industry has failed to innovate.

4. The VC industry has failed to innovate.

The business model and economic structure of the VC partnership has remained stagnant for the past two decades. Despite enormous changes in the industry — more funds, more capital, bigger funds, lower costs to start companies, poor returns – investors have failed to change the basic economic structure of the VC fund, even when it’s clearly in their economic interest. VCs have hardly taken the lead on “creative destruction” in the industry either, but as we’ve seen, the high levels of asset management style fees and the continuous gush of capital into ever-larger VC funds provides little economic incentive for them to do so.

Given these four issues, Diane proposed the industry to cut fees dramatically, structure compensation so salaries are small and carry checks matter, and stop paying VCs to raise larger funds. LPs can pay VCs to do what they say they will: generate returns well in excess of the public markets.

To read the full article, please see here.

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