Originally published on Harvard Business Review - Courtesy of HBR
Author: By Diane Mulcahy- Diane 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. She is an adjunct lecturer at Babson College, and frequent writer and speaker about venture capital investing.
2013 had all the signs of being a comeback year for venture capital. Booming public equities and a recovered IPO market generated record portfolio company exits and distributions from VC funds. The industry realized its highest returns since the Internet boom.
Yet 2013 annual industry performance data from Cambridge Associates shows that venture capital continues to underperform the S&P 500, NASDAQ and Russell 2000.
The industry’s persistent inability to outperform public equities is a disappointment to investors, and a very real threat to the sustainability of the VC industry as we know it. A VC firm is, first and foremost, an investment vehicle created to generate returns for investors that exceed those available in the fully liquid, low cost public equity markets. If that objective is persistently left unaccomplished, investors will allocate their capital elsewhere.
The ongoing poor performance of venture capital firms should be an obvious problem for institutional investors. The public pension funds, endowments, and foundations (called limited partners, or LPs) that foot the bill for the industry through their investments in VC funds do so to realize the outsized returns that VC claims to provide. LPs expect to be paid well to assume the high fees (2% annual fees on committed capital) and long illiquidity (minimum 10 years) of investing in private equities. A minimally viable venture rate of return is 300-500 basis points of outperformance above the public markets, a level of returns that investors haven’t consistently seen since the late 1990s, despite optimists’ predictions of promising technology trends, a smaller “right-sized” VC industry, improving exit markets, and incredible investment opportunities.
There are, of course, individual firms that succeed in generating venture rates of return. But they are too small in size and too few in number to make up for the vast majority of funds that fail to generate attractive returns (or any returns) for investors. They are also inaccessible to institutional investors looking to make either new or large commitments in hopes of generating above-market performance in their portfolio.
But the bigger problem – and the real problem for investors – is how little of a problem this persistent underperformance is for VCs themselves. LPs have created and perpetuate an industry of such structural economic misalignment that VCs can underperform and not only survive, but thrive.
To understand how we got here, we need to understand four major issues:
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.
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. A recent article quoted several VCs supporting the idea that entrepreneurs should be paid $100k (or less) per year until their companies are profitable. What if LPs structured VC compensation that way? Investors would see lower fees and would stop paying well for underperformance, and VCs would rely on their investment performance and carry to generate high compensation. LPs would pay VCs well, through carry, when they do what they say they will: generate great returns in excess of the public markets.
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.
Last year I spoke at a conference to an audience of VCs. During our discussion about VC commitment levels, one frustrated VC raised his hand and asked “how much do I have to commit to make my investors happy?” That question reveals the most common attitude I encounter among VCs; they don’t ask how much they can invest, but rather, how little. They seek a minimum, not a maximum. When it comes time to put their own money where their mouth is, there’s a surprising lack of both interest and capital. Investors are well served to pay greater attention to this phenomenon, and watch what VCs do, rather than listen only to what they say.
What is the optimum level of VC commit? Well, it depends. It depends on the partners in the fund, their prior levels of success, their personal balance sheets, and their stage in life. The point of the VC commit is to ensure that each of the partners has a meaningful (to them) investment in the fund. One percent is rarely meaningful. I’ve argued previously that it makes sense to start (and preferably end) the conversation at a 5-10% commitment level, modifying the range, either up or down, to take into account personal asset levels and circumstances of the team. If the partners aren’t enthusiastically committing meaningful capital to their own fund, LPs should assume that the fund is too big, the investment strategy is too risky or unproven, or that the VCs do not have confidence in their own ability to generate the returns they promise. Investors should run, not walk away, from such funds.
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.
VCs’ behavior may not be laudable, but it’s understandable. Any changes, then, must come from investors. The good news – and there is some – is that change is starting to occur. The increasing prevalence of small VC funds significantly reduces, and can even eliminate, the misaligning effect of the fat fees that dominate the large funds. It’s very hard to be a $100m fund and coast off the economics of underperformance. Not so for a $1 billion fund. The online investment platform AngelList and its emerging group of syndicates forgo fees in favor of carry, such that the investment upside and downside are shared by VCs and LPs alike. (Disclosure: the Kauffman Foundation, where I am a Fellow, is an investor in AngelList). The absence of fees puts VCs and angels on the same footing as their investors and more perfectly aligns interests.
We’re also seeing some evidence that VCs aren’t entirely insulated from their own underperformance. The latest National Venture Capital Association yearbook (2013) indicates that the number of VC funds has fallen 25% in the last decade, and the number of VC firms has declined 8%. Even more dramatically, the number of VC professionals has fallen 60%. But these are small numbers relative to the size of the underperformance problem.
LPs can certainly do a better job of paying VCs to act less like asset managers and more like investors. We can 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. Until we do that, the enemy of better performance is us.