VC Insanity: How the economics of venture funds explain the crazy things VCs do | Hacker News Reader

VC Insanity: How the economics of venture funds explain the crazy things VCs do

danshapiro.com

99 pointsdanshapiro19 comments

Fee harvesting is one of the more annoying things about big funds.

Most funds take their full 2% (or whatever) a year for the entire committed fund size, hence the motivation to raise larger and larger funds. At that point, the fee is rather juicy especially when they're collecting fees from 2 or more active funds (assuming they raise a new fund every 3 years or so). Even if they don't get into carry, the partners can live pretty well, though their returns might not justify it.

There's a need for more lean VCs to complement the lean startups that are emerging now. Fee-driven funds that are too large to maneuver wind up making poor decisions.

I couldn't agree more. I have seen too many fund managers succumb to the temptation of ever larger funds (and salaries), leading to inadvertent but fundamental changes in investing practices (more mgt fee/partner => more dollars to deploy per partner => bigger investments in each portfolio company => not venture capital anymore), though I hope those days are passing as the industry contracts. When salaries get big, the incentive to take investment risk declines (the upside value of carried interest is less than the downside risk of losing the LP base).

Some hedge funds have reduced the maintenance fee and increased the carry because they could count on continuing success.

What a mess of perverse incentives. I can understand how the best VCs can get away with insisting on such terms from their LPs, but how are the rest of the VCs able to get away with it?

Actually the best VCs get even better terms - e.g. 3-30. But I've heard VCs say that anyone who comes out with sub-market terms in their fund has a positioning problem: the best returns come from a tiny number of firms, and the returns dwarf the management fees, so LPs are entirely concerned with quality and only minimally with cost.

Were I a limited partner, I can't imagine giving such terms to any VCs lacking a stellar track record. I understand why the rest of the VCs would want to position themselves thusly, I just don't understand how they can actually find LPs willing to go along with it.

A lot of them can't, and we'll see the fallout from that over the next several years!

Interesting analysis. Hopefully some VCs will backup the line of reasoning.

It would also explain why the new type of programs like YC is exploring other economic incentives that is more aligned with the entrepreneurs.

>> Rule number two is that there’s no recycling. Once they cash out of a deal, the money goes away -- never to be invested, for the rest of the decade.

What is the rationale behind this? This sounds insane, and results in some more insanity that the author is trying to explain with this one!

This isn't actually strict. There are funds that don't cash out. They are called "evergreen" funds, and are rare but do exist.

Part of the issue is that funds are judged and compared by their IRR.

I'm an LP in eight funds. I don't care about IRR, just absolute return, and would love to see more evergreen funds.

Finally, some of the funds that I am in do recycle returns if the return was under some multiplier. Anything under, say, 1.5x does not go back to the investor.

Yep - it's more common to see a multiple for recycling in the sense you can recycle money 1.25x, after which the money goes back to the investor. This is generally done to provide liquidity to investors. Many investors prefer liquidity, nothing more or less.

Thanks, that's great info! One of the funds (arguably two or three, depending on definitions) in my last company was structured as an evergreen fund. It's a good model, but tends to be common in funds that only have one LP.

I don't know, but I have a guess. Investors model VC returns very carefully and use them in their portfolio to achieve a certain kind of risk profile. That model is based on each dollar being invested once. If it's invested more than once, the model gets exceptionally complicated.

But like I say in the article - I'm not an expert in this stuff; I'm just a well motivated student. I hope someone from a firm will weigh in with a more definitive answer.

This was one of the most informative articles I read on the subject by the way. Thanks so much!

This is not always the case. In my experience, it's much more common to see recycling allowed up to a certain amount, then the capital would be returned to the LP after that point to provide liquidity back to the LP.

Much more concisely explained in PG's "A Unified Theory of VC Suckage": http://www.paulgraham.com/venturecapital.html

PG's is also far more entertaining to read.

Strong disagree. That's one of Graham's more informative essays, and it is of course more carefully written, but it's also missing a lot of the vivid detail that that article has.

This article's worth it for the "3.6x" explanation alone.

Read both.

"3.6x" math is not accurate. If I have time, I'll write a longer explanation (full disclosure - I'm a partner at a VC firm). Short version - returns are calculated from the moment of investment to the moment of exit, so getting a 2x in 1 year is a 100% IRR. You do not spread it out over 10 years. LPs get their money back and deploy it in other asset classes, so the return clock for those dollars has stopped.

Yes, management fees go out every year (at least for the first five or so years), so that works against short holds, but for the most part a fast exit is never a bad thing, unless the cash on cash multiple is really low.

There's a tension in both funds and LPs as to which metric is more important, IRR (which rewards fast exits, even at low multiples) or multiple of invested capital (which rewards holding out for more cash out, even if it takes a lot longer). GPs generally have an incentive for the latter. LPs sometimes prefer the former.

To the original author, if you're a HN reader - most people, myself included, would happily share our perspective as fund managers. It would have been worthwhile for you to do so, before you posted the blog post. Understanding fund economics is definitely a good thing for entrepreneurs, and I applaud those like Fred Wilson that have tried to make it more transparent, but don't count on blog posts from Fred or others to fill in all the gaps; go out and ask some people yourself.

Thanks for the pointer! It's a great read and I hadn't seen it before. I couldn't find any good resources that explained VC behavior in terms of concrete economics, so I wrote this - hopefully there's enough novel information in it to be of use.

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