The venture capital model is being remade. It must happen from the ground up, via its relationship with entrepreneurs, as Daphne Zohar has previously described here. But it must also happen from the top down, via its relationship with limited partners (the investors in venture funds).
Limited partners in venture capital funds aren’t very happy these days. After a decade of indifferent performance, 10-year returns for venture capital as an asset class are set to turn negative this year when the last of the dot-com exits disappear from the rolls. When that happens, the industry’s main performance peg will no longer hold up the venture capital marketing tent. Limited partners will find it even harder to allocate money to venture capital, and funds will find it more difficult than ever to raise money.
[Editor’s note: This article by San Diego Xconomist Paul Kedrosky continues the thread started last month by Boston Xconomist Daphne Zohar in Venture Model Makeover & Diet Plan—Step One]
Of course, that doesn’t mean that investors should abandon venture capital. There will always be good performance available from skilled investors adept at making early investments in illiquid private companies in emerging growth markets. The venture capital industry is not disappearing, nor is investor interest in the asset class. There is, however, an opportunity for investors to force change on a broken industry— there are specific changes that limited partners should force on partners at venture funds.
One perennial problem at venture funds flows from the compensation system. The standard compensation model for venture capitalists is “2 and 20”: Partners get a management fee of 2% of the assets under management, and then earn 20% (the “carry”) of any investing gains. To understand one reason why that model needs to change, it helps to take a walk through the math. On a $100-million fund, a 2% management fee provides $2 million in annual income for the partners, come good investing or bad. Given a reasonable numbers of partners, associates, administrative personnel, and office expenses, that isn’t anywhere near penury, but it isn’t entirely unreasonable either.
If you scale the fund size up, however, the same cannot be said. A 2% fee on a $500 million venture fund means $10 million in annual fees for the partnership. But you don’t have five times the operating expenses on a $500 million fund that you do on a $100 million fund. Costs go up, but nowhere near that much. What happens to the extra money? It typically turns into higher salaries for the partners, with it being common for senior partners at some of the largest venture funds to receive seven-figure incomes from fees alone. That is, of course, egregious and wrong, enabling partners to become at least moderately wealthy without making a single successful investment. It is a serious misalignment of incentives between limited and general partners.
What is the solution? Rather than shrinking the management fee percentage from 2% to
