Venture Model Makeover & Diet Plan—Step Two

Paul Kedrosky10/8/09Follow @pkedrosky

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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 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.

Paul Kedrosky, a senior fellow at the Kauffman Foundation, is an investor, essayist, technology analyst, and entrepreneur. Follow @pkedrosky