IF VENTURE’S BROKEN, WHAT’S THE FIX? | PART 1 of 2
If Venture Is Broken, What’s the Fix? | Part 1 of 2
By Harshitha Kilari and Joel Camacho
The venture capital industry, according to the Ewing Marion Kauffman Foundation, is broken. In a now seminal article originally published in May of 2012, the Kauffman Foundation’s investment team chastises venture firms for being too big, delivering subpar returns, and remaining stuck in the past. They note that in their twenty-year history of investing in venture funds, only 20% of a 100 total investments “generated returns that beat a public-market equivalent by more than 3 percent annually.”¹ Moreover, after considering the “cumulative effect of fees, carry, and the uneven nature of venture investing, 78% did not achieve returns [that were] sufficient [enough a] reward for patient, expensive, long-term investing.”¹
Surprisingly though, they place the blame for industry’s plight squarely at their own feet. It is they, along with other LPs — institutional or otherwise — who “should shoulder blame for the broken…model as they have created the conditions for the chronic misallocation of capital.”¹ These conditions are the direct result of misaligned incentives between GPs and LPs.
This lack of alignment between GPs and LPs can be best understood as falling into one of two categories: fund economics and lack of transparency.
In Part 1 of this article, we’ll dig into the former; Part 2 (to follow) will cover the latter. The 2 and 20 venture fee structure has been “the industry standard for so long that it’s difficult to trace its origins or rationale.” As such, fund economics haven’t changed much. What has changed — and dramatically so — is size. Today, there are “more funds, more money, bigger funds, and bigger deals but very little creative destruction around how funds are structured, capital is raised, or VCs are paid.”¹
In fact, “instead of innovating with new carry structures, the best-performing VCs tend to raise both the management fee and the carry.” In other words, LPs may see venture fees as Veblen goods. Like Hermès handbags and Rolls-Royce Phantoms — conspicuous consumption products whose demands quizzically rise in tandem with prices — venture funds seem to be more attractive to LPs as their fee structures become more aggressive, almost as if higher fees signal higher quality funds and lower fees lower quality funds. This approach — which is steeped in history and accepted as given but also irrational — is particularly problematic against a backdrop of bigger and bigger funds with more and more money.
Bigger funds with more money translate into higher management fee revenue without the fund necessarily incurring higher operational expenses. As the Kauffman Foundation puts it:
For smaller funds, a 2% fee might be a reasonable way to cover fund expenses. But the impact of fee income is most misaligning in the expanding universe of $1B+ funds, a fund size that generates $20M per year in fees from a single fund, whether there are five partners of 25, one office or ten, positive returns or losses.
And this fails to consider the impact of management fee revenue from raising multiple funds (for which the incentive is very strong making, making VCs quasi-professional fundraisers who tend to raise a fund every 24–36 months). Needless to say, earning management fee revenues on multiple large funds at any given point in time does little to incentivize VCs to deliver superior performance.
This GP-LP misalignment around fund economics can be rebalanced through LPs: (1) being more receptive to fee models beyond the traditional 2 and 20, and (2) considering a more holistic, net worth-based analysis of GPs capital contribution to the fund.
Many GPs — including first-time fund managers — want to innovate in the fee structure arena but quickly revert back to the 2 and 20 in an effort to ease fundraising process with and send the right signals to LPs. By creating a culture of open dialogue, LPs will be able to see and invest in funds with more favorable fee structures and incentives better aligned to the fund’s performance.²
Today, most GPs contribute 1% of the overall fund in personal capital. The Kauffman Foundation suggests looking for funds where GPs contribute closer to 5%. This is one of areas in which we disagree with the Kauffman Foundation’s investment team. We propose an assessment of GPs capital contribution as a percent of their net worth — the higher the percentage the better, the more attractive the investment (with respect to that one metric). This method takes into consideration how much the GPs are not only ‘putting on the line,’ but also how much they’re motivated by the carry. This more holistic, net worth-based assessment of GPs contributed capital would help identify smaller fund managers with huge incentives to see the fund succeed. By placing far greater importance on the carry, they will operate the fund more efficiently and use the management fee wisely.
In Part Two of this series, we’ll continue this discussion by further exploring the second source of GP-LP misalignment: the lack of transparency.
Authors’ Note: Harshitha Kilari and I, along with our third partner Jonhnson Nakano, founded Decipher Capital with a vision of building the next generation of venture capital. We do not accept the status quo. We improve upon it.
Note to Founders: If you are looking to raise capital for a project that is innovating within the blockchain space, begin the conversation with us by telling us more about you and your project at www.submit.decipher.capital/info.
No stage in your founder journey is too early to start a conversation with us!
¹ Diane Mulcahy, Bill Weeks, Harold S. Bradley. “WE HAVE MET THE ENEMY…AND HE IS US. Lessons from Twenty Years of the Kauffman Foundation’s Investments in Venture Capital Funds and The Triumph of Hope over Experience.” Ewing Marion Kauffman Foundation. May 2012.
² Preqin. “Up & Away: Launching a First-Time Venture Fund.” Preqin Alternative Assets Data. November 2017.
IF VENTURE’S BROKEN, WHAT’S THE FIX? | PART 1 of 2 was originally published in Hacker Noon on Medium, where people are continuing the conversation by highlighting and responding to this story.