some other fixed figure, which would make vital smaller venture funds uneconomic, a better approach would be negotiated operating budgets. Partnerships should lay out their planned operating expenses for their investors as part of fund-raising. What is really required to run the fund? Reach agreement on that budgetary figure, and make it part of the contract with investors. Investors can eliminate the incentive to raise larger funds purely for the purpose of larger fees and higher salaries, thus better aligning investors and a fund’s managing partners.
Next up, limited partners should drive a harder bargain on when and how they get paid on successful investments. Traditionally, limited partners in a venture fund get 99% of the fund’s returns (these are typically paid quarterly) until they are fully repaid their original investment, at which point the split goes to 80% to investors and 20% to the fund’s partnership. The trouble with that is two-fold. First, it permits the partnership to get paid before it’s obvious that the fund will return its original capital. Second, it ignores the costs of management fees in paying carry.
What would be a better approach? One improvement would be for limited partners to get 100% of a fund’s returns until they are fully repaid their original investment. That way, a fund’s general partners wouldn’t be pre-paid on a fund that may or may not end up performing. Second, once carry is being paid on the fund, it should first have management fees deducted from it. In combination, these two changes would help realign a fund’s partnership with its investors.
There are many other fiduciary changes that prudent limited partners could drive. For example, they could ask that general partners personally invest more of the fund’s total committed capital. Historically that figure has been around 1% of assets, but raising it substantially would further improve alignment between limited and general partners. There could also be more evergreen funds created, in that way reducing the investment timing gamesmanship that goes with overlapping funds and fund lifecycles that is too complicated to go into here. There are still other examples, but the point is that opportunities for improving the relationship and alignment between limited and general partners are legion. It merely requires desire and action from limited partners.
It is time limited partners exercised more influence over their venture capital investees. While that may have been hard in the past, with limited partners skittish about pushing too hard for fear they would be kept out of the best funds, such is no longer the case. Instead, even some formerly high-flying funds will be fund-raising on bended knee over the next year. Conditions have conspired to create a great opportunity for limited partners to drive overdue change in a relationship that has become dated and dysfunctional. It will help make a better and more modern venture capital industry.
