The venture capital model is broken, and this damning report explains why | Hacker News Reader

The venture capital model is broken, and this damning report explains why

geekwire.com

93 pointsusername353 comments

Ouch:

Longer fund lives are an expensive trend for LPs, who often are asked to pay additional management fees for a fund that extends beyond ten years. Many funds have several companies left in the fund at the ten-year mark, and demand additional fees, frequently based on the value of the portfolio (e.g., 1.5 percent of the cost basis of the remaining portfolio). The alternative available to LPs is to receive a FedEx package of private company share certificates. Which of the two evils is lesser?

Context: VCs market funds to LP with a lifetime of 10 years, but usually can't liquidate all their holdings in that time frame; they apparently then go on to charge management fees during "overtime".

Given that investors were already paying ~2% management fees during the life of the fund, paying a few points a year while the VCs try to liquidate the remaining assets doesn't seem like that big a deal. The remaining assets are probably less than 10% of the original fund size in terms of their cost basis, so you're talking about an ongoing fee that's less than 10% of what they were already paying.

The alternative would be to fire-sale the assets when the fund closes, which would probably cost the investors a lot more.

The report that they link is well-worth reading in order to understand the VC ecosystem.

tl;dr of the linked report:

* Somebody who relies on VCs to invest their money has finally noticed that VCs fail to beat the market over 10 years.

* They think the fault lies at the investor-VC interface: The way VCs are compensated is broken, and the way VCs report the performance of the portfolio is opaque.

* They make recommendations, which will never be adopted because it would expose and publicize the true VC returns.

Regarding your third point, if I was a VC that was beating the market - and there actually are many - I'd be happy to share my info and put pressure on the weaker VC's to expose themselves.

> and there actually are many

But not with regularity, which is why they don't do it.

Even Sequoia, which seems to have a golden halo around here, had the partners pony up funds in order to keep some funds positive.

> Even Sequoia, which seems to have a golden halo around here, had the partners pony up funds in order to keep some funds positive.

Can you clarify what you mean here? Adding capital to a fund doesn't impact the return of the fund. And separately, I think you're factually wrong. (aside, I'm an entrepreneur funded by sequoia)

> Adding capital to a fund doesn't impact the return of the fund.

You know that, I know that, but the folks who do the investment want to see the dollars returned be greater than the dollars invested. Otherwise, they also look like they are mismanaging money.

And separately, I think you're factually wrong.

Why?

(aside, I'm an entrepreneur funded by sequoia)

You think they'd advertise such things to you?

Edit: Apparently they do --

Leone noted that Sequoia has never had a fund that has lost money. There was one time when things were looking like they may go that way in 2002, so the Sequoia partners got out their checkbooks so that no one could say that they lost money investing with Sequoia Capital.

http://techcrunch.com/2011/09/12/doug-leone/

Yes, that's right: That's Leone saying the partners needed to bail out the fund, because their investments were negative. I give him points for honestly admitting that they blew it bad enough to kick back money. Of course, subtract points for the way in which he stated it, requiring carefully parsed words Sequoia has never had a fund that has lost money.

If I were an investor and saw that type of behavior, I would put my money with them. That's a great move. I'd reinvest if the guy said 'we messed up, we're compensating you for it.' Of course if there were any pattern or regularity to the failures I might not continue to invest. But if it happens once and that's the response? I am impressed.

> But if it happens once

Thank god, we're finally getting past the "Good VCs never lose money" mantra around here.

And of course that is a different type of pricing model that this report is in favour of. Not sure that it will take off among the other firms though.

Surely most users of this site already knew only the top VC funds make money. The Kauffman Foundation certainly should have. But that doesn't mean the VC model is broken, just that there are a lot of lame firms using this model as well as the good ones.

You'd be better off replying to a post of the actual Kauffman report than the summary on "Geekwire.com". From the beginning of the report:

Recommendation 1: Abolish VC Mandates: The allocations to VC that investment committees set and approve are a primary reason LPs keep investing in VC despite its persistent underperformance since the late 1990s. Returns data is very clear: it doesn’t make sense to invest in anything but a tiny group of ten or twenty top-performing VC funds. Fund of funds, which layer fees on top of underperformance, are rarely an effective solution. In the absence of access to top VC funds, institutional investors may need to accept that investing in small cap public equities is better for long-term investment returns than investing in second- or third-tier VC funds.

Kauffman isn't disagreeing with you, but is observing that LPs are often required to allocate capital into VC as an asset class, and can thus be required to plow money into huge and underperforming funds because it's too difficult to get enough money into the smaller funds that do outperform the market.

You can read just a couple pages into this report and see that they're on the same page you are in this regard, right?

Obviously they're "on the same page" now. But they must not have understood the sharp dropoff in VC performance when they invested in mediocre funds, or they would not have done it.

That's not necessarily true. The Kauffman Foundation is a non-profit whose purpose is to support entrepreneurship. Investing in VC may accomplish that goal, even if the investment loses money. Heck, it may have been worth it from a research point of view, just to gather the data that went into this report.

I think the point of the report is that system as now does not force "lame" firms to improve.

In other words, top VC funds will be top VC funds - the improving rules will not influence them. The question is: Is there a better system to force bad VCs to improve (or to make them bankrupt faster so they can be replaced with better ones)?

The report also cites Landmark's simulated auction of carried interest, which showed that they might be able to collect 42.5% carried interest if they actually implemented such an innovation. That'd be wonderful for Landmark, and democratizing as well, since it'd shift investment in oversubscribed, top-tier funds away from cozy relationships, and towards those who value that investment most highly.

As such, this really isn't a report saying 'VCs make too much money', but rather that standard LP/VC terms overcompensate poor VCs and undercompensate top-tier VCs, and that this is unlikely to change unless LPs change their behavior en masse. There were numerous examples of GPs who were open to innovations in the VC/LP relationship, but didn't pursue them because of intransigent LPs.

The article isn't talking about the fact that most VCs don't make returns. It tries to analyze the reason this is happening.

According to the article, that the reason is misaligned incentives - the VCs get lots of money when they raise lots of money, regardless of whether they get a return on their investment.

I think it's important to distinguish the "VC model" (meaning investing LP money in early stage companies) with the current compensation models that are prevalent in the industry. The first is alive and well. The latter is broken.

>> In essence, the report suggest that VCs get paid “to build funds, not build companies.”

Sometimes it seems like the whole financial sector is just one long series of perverse incentives strung together. But I guess it doesn't make the news when it works the way it is supposed to.

Note this which appears on the last page:

"Several peers listened to our list of topics andresponded by cautioning us that “this is a relationship business,” implying a view that we are better off accepting the status quo and being in misaligned, under performing VC relationships than pursing negotiations for better terms."

"this is a relationship business" is a frequent phenomenon in sales and even in lawyer client relationships. Lawyers become friends of their clients and this prevents the clients from easily doing something that isn't in the best interest of the lawyer. Large ticket salesmen frequently wine and dine clients (including sports tickets and if you believe some accounts prostitutes). Specialty doctors entertain primary care physicians (well at least in the old days they did) in order to maintain a flow of patients. The very clear intent of all of that is to protect a legacy system and prevent you from entering into a relationship with another entity that may actually be better for you. This happens even in cases where the person being sold is spending their own money. But when people are spending someone elses money all bets are off.

LPs need a two-tiered investing model. It's true, outside of the very few top performers, everyone else is a loser. Unfortunately, once in a while, a loser, or more likely, a new fund hits a home run. They should have a portion allocated to investing in new funds with less capital at risk.

The 2 and 20 is also only a problem for bigger funds. For smaller funds ($40mm for instance), it's not really an issue. Assuming two partners, that's $250k annually for each, leaving 300k for office and misc expenses. Not getting "VC rich" with those kinds of dollars. It's when a 2 and 20 fund raises a 500mm or 1b fund that the 2 and 20 causes the base salary to be excessive.

What do you expect when half the VCs say they invest using "their gut"? as if "feeling" a company is going to be successful is a valid metric. In any case if you fail more than once it's obvious your gut isn't very precise and you should use other methods.

Anyway, that the system is broken is hardly something new, have you all forgotten "The canary is dead" slides from TheFunded? and it was 4 years ago!

What I'm asking is: does it matters? When those slides were released it was all doom and gloom, wantrepreneurs were going to disappear, nobody was going to be able to raise funding, etc...

And nothing happened, which is not me saying it doesn't matters, just that it seems no-one cares.

The VC market is one where the buyers of VC funds (LPs such as Kaufmann) have a lot less information than the sellers (the VCs themselves) - a market with a high degree of information asymmetry. In "a market where sellers have more information than buyers about product quality can contract into an adverse selection of low-quality products."

http://www.nobelprize.org/nobel_prizes/economics/laureates/2...

LPs commit money to new funds before the first investment is ever made. What type of information does the seller (VC) have that the buyer (LP) does not?

Not totally correct. VC firms often have many concurrent funds. So while they're investing out of fund 1, they're raising for fund 2.

And they're using Fund 1 early returns (often paper returns) to make the case for why the LP should invest in Fund 2.

Felix Salmon summed up the phenomena well here:

"In reality, reported returns peak very early on, in month 16 — which just happens to coincide with the point at which the GPs tend to start going out on sales calls, trying to raise their next fund. Of course, at month 16, none of the returns are realized: they’re driven instead by increases in portfolio-company valuations, and those valuations are set by the GPs themselves."

His article here - http://blogs.reuters.com/felix-salmon/2012/05/07/how-venture...

One of the challenges is that the buyer (LP) is usually managing billions of dollars (e.g. a pension fund or large endowment), and venture is only a tiny fraction (a couple of percent) of his total asset base. It's difficult for those LPs to have expertise in an asset class that is such a small portion of the portfolio. The obvious objective criteria is past performance but understanding the potential of a team requires a deeper understanding of what makes firms successful.

> The obvious objective criteria is past performance

Considering that this criteria has been debunked for prices of public companies, I'd be amazed if it were true for private companies.

I'm gonna take a flying guess that the correlation studies have not been done like they have for public, due to the opaqueness of private pricing.

The studies have been done, and there is a much stronger correlation between past performance and future performance in private equity than in the public markets. In the public markets for active fund managers, there is almost no correlation. For vc funds, there is a decent correlation. My hypothesis is that the reason for the difference is information inefficiency. In the public markets, everyone is oerating with the same information, so it's hard to create a sustained advantage. In the private markets, one fund may have access to information (seeing companies no one else sees, knowing customer or acquirers, etc). Success often begets success because funds with successes get positive press which leads more entrepreneurs to go to them.

> The studies have been done, and there is a much stronger correlation between past performance and future performance in private equity than in the public markets.

Very interesting. Link?

BTW: Were the prices self-reported?

I can't find links to the papers themselves, but the research was published by Lerner and Stahlman at HBS. They looked at firms that had top quartile venture funds and then looked to see what percentage of them remained in the top quartile in the subsequent fund. For public market managers, the measure was the same but on a year over year basis rather than fund over fund.

My guess that the answer to that will be "past performance".

But as the cliche goes, "past performance is not indicative of future results".

Additionally my guess is that creative accounting could make that data near worthless in many cases.

Kaufmann isn't a LP, they are a foundation setup to study and promote entrepreneurship.

Kaufmann is both. They have an endowment, and invest part of that with a bunch of VC funds, in which they are LPs.

You could swap out VC funds with hedge funds and the article would pretty much be the same.

Not really. There's a couple things hedge funds have to deal with that VCs don't - generally, it's easier to track the market value of their portfolios, so they have to show performance on a quarterly or annual basis. Also, the lockups for investors are much shorter (~2 years) so you can get out of an underperforming fund, whereas with a VC you're generally locked in from the start to the end of the fund. (Secondary markets do exist, but at a large discount.)

The majority of hedge funds offer quarterly or monthly liquidity (partly because this is what the fund-of-funds industry demanded).

However, many hedgefunds have the concept of 'gating' - where if everyone rushes for the door at the same time, the fund can restrict outflows. This is to let them to unwind illiquid investments without causing market disruption (to enable them to treat the people leaving on a fair basis as the people who stay : The portfolio doesn't have to just sell off the liquid positions to satisfy cash withdrawals, leaving tougher ones behind).

I think kyt's point is that 2%+20% causes the same mis-alignent of incentives for hedge funds.

Maybe, but even the compensation structures behind that 2/20 are wildly different between the two groups. Hedge funds have two things I've never heard of in a VC fund: benchmarks against market returns, and high-water marks. So while the headline of how they are compensated seems similar, the reality of how they get compensated isn't. Also, what a hedge fund does (assuming it's investing in traded securities) is generally far more scalable than what a VC fund does - doubling the size of a hedge fund may just mean doubling the average trade, whereas for a VC it means you have to either double the number of deals per partner or chase deals in a much later stage where round sizes are larger.

"assuming it's investing in traded securities"

Which is only a percentage of funds under management. The hedge fund industry invests in wildly diverse sectors, securities etc. VC'S can be treated as just another hedge fund sector.

If you can't get basic facts right (e.g.: lockups are not ~2 year - corrected by mdda), it is difficult to pay any attention to your opinions.

The other major problems arising out of "black box" investing also applies to hedge funds.

Lockups can range widely among hedge funds, and can even be different from investors in the same hedge fund when implemented via side letters, with some of the more desirable hedge funds requiring multi-year lockups, especially for side vehicles that invest in less liquid instruments. The two-year period has historical reasons, in that you could avoid certain SEC requirements by setting that as your lockup. Funds also do longer lockups so that they can issue fixed-term debt rather than depending on loans from banks.

The percentage of hedge funds fund invested in illiquid investments is generally small... that's something you'd see a PE fund do (buying private companies) but in most cases, a hedge fund does not want to buy something they can't sell with a phone call. Probably the closest would be the distressed guys who might buy untradeable bonds in the hopes of converting or getting a workout.

My point was they don't (generally) have the ~7 year effective lockups associated with VC funds, where there's a staged calldown over the first 2-3 years and then you get paid back (hopefully) starting with year 5 or so.

If you want to continue the thread, back i up with data. E.g. Deutsche Bank's Alternative Investment Survey: http://www.db.com/medien/en/downloads/2008_Alternative_Inves...

That shows the diversity of strategies (although not funds managed per investment category). "The SEC started regulating funds with less than a two year lockup" I.e. a pecularity to the US.

Effectively, SEC regulations like Dodd-Frank impact large funds worldwide, because you're subject to them if you have more than a small number of US investors. (I think it's 15.)

That survey isn't particularly good data. For one thing, it conflates Fund of Funds with other hedge funds, which is pretty questionable given that they're really a separate class with different fee and performance expectations.

> That survey isn't particularly good data. For one thing, it conflates Fund of Funds with other hedge funds, which is pretty questionable given that they're really a separate class with different fee and performance expectations.

DeutscheBank is a bunch of kids and that particular report is questionable??? I hope you don't work in funds management.

> Effectively, SEC regulations like Dodd-Frank impact large funds worldwide, because you're subject to them if you have more than a small number of US investors. (I think it's 15.)

See http://www.google.com/?q=master+feeder. Hedge funds that want to accept money from US and EU investors are structured to avoid the US regulations for the EU investors (for many more reasons than lock-up periods - e.g. look at the graphs of lockup periods broken down by investor country???!).

It is almost the defining feature of hedge funds that every fund is different. A hedge fund is defined by the class of investor it aims at (institutional and/or qualified investors) - everything else is variable - hedge funds are diverse in almost all other dimensions (although some things are common e.g. 2 and 20).

Returning back to the original point:

"You could swap out VC funds with hedge funds and the article would pretty much be the same."

Very true. The variation within the hedge fund industry is more than the variation between a VC fund and any average hedge fund. IMHO 90% of the article applies to hedge fund investors. The issues of the 2% management fee, the human factors of the fund managers, and the issues to do with transparency (black box) are all relevant to many hedge funds.

The only reason I am answering you is because I hate seeing the standard misconceptions about hedge funds being promulgated.

Interested to know if you have data to support this. Thanks.

Read "The Hedge Fund Mirage" by Simon Lack

I'm not saying that hedge funds are great either. I'm just saying you can't swap one for the other - they're different beasts.

I think the binary nature of the VC model is a big part of the problem. I don't know what the alternative's going to look like (crowd-funding?) but right now we have a two-caste system. There are "the funded" and the cold and hungry. The inside and the outside. Losers and winners selected before a single one of either side has had an opportunity to accomplish much of anything. There are a lot of things that could be said about this model, but I think it's pretty clear that it's not good for technology. As we see, most of this bubble is in "social media" VC darlings with mediocre leadership and MBA culture... and still little investment is going into Real Technology startups founded by actual engineers.

A VC cash infusion puts someone from one category into the other immediately. Someone goes from being (in terms of VC-istan social status) a beggar to a baronet in an afternoon. It's really an all-or-nothing game being played. Making it a million times worse is that VCs usually talk to each other about the deals they're making, which means that one VC's opinion influences the multitude. If there were more independence among VC decisions, we'd see an order of magnitude more good startups getting funded.

I think VCs tend to get distracted by their kingmaking powers as well. It's no longer about delivering the best returns for their client. It's about using that magic wand to be "cool" and minting the right baronets, the ones who will use the press access and social status they get from being Funded to make that VC (individually) seem more stylish. Like Tyrion Lannister, they just (::sniff::) want to be loved.

If this is what you or anyone else reading this worries about when they go to sleep at night I strongly suggest you start a business that is bootstrappable instead of the next social network.

"which means that one VC's opinion influences the multitude."

But if the idea is to make money and spread the risk among many "bets" that makes plenty of sense.

"If there were more independence among VC decisions, we'd see an order of magnitude more good startups getting funded."

I think you are overestimating the influence of any single person. PG trying to get USV to invest in Airbnb comes to mind.

Taking an investment that others have decided is good and deciding if you agree is much simpler than doing the same without that social proof. Added: and filter.

It's easy to bash projects that fail. Wall Street is stuck in this place where they keep investing in the same boring business they have been for decades. They set unreal expectations, that cause firms to fudge numbers, leading to bail outs. Wall Street is short sighted and doesn't look at the big picture. Hell, if I was part of the largest (corporate) welfare class as well, I would bash failed ventures as well.

Fortunately, I am not tied to group think, so I can be as creative as I would like to be. VC's are great. They take chances, and are willing to invest in things that are more than likely to fail than be successful. Discovery is the ultimate reward, and I am more than happy to lose money so long as it leads to a discovery that helps society as a whole.

VC's allow for experimentation, and even if the experiment fails, lessons are always learned. It's amazing how narrow minded business people are. Personally, I feel that knowledge gained is priceless and far outweighs short term profits. Thank you VC's for taking chances and for willing to think outside the box.

TL;DR: Knowledge is the ultimate return on investment.

VCs are great if they're funding your startup. That's not what this article (and report) are about - they're about how VCs don't really serve their real clients, the LPs who invest in them.

This matters - those LPs are generally large state and corporate pension funds, who may be investing YOUR retirement money. Many funds are underfunded and now are trying to chase yields, because they have always projected 7-8% annual returns across the fund and the traditional stock and bond markets have not been consistently providing that. So they're dumping more money into PE and VC funds in a (potentially disastrous) game of catch-up, because they alternative would be admitting defeat and the need to either cut benefits or massively increase funding of the pensions.

Sorry but this argument is some combination of naive, inane and/or b.s. VCs are financial investors and their investors (the LPs like Kaufmann) who give them money are expecting a return. Discovery, social good, changing the world and other euphemisms don't cut it for them as that is not what they are sold. They are sold a story of high risk, high reward, and per these #s, that was not what was generated.

TL;DR: Until pension funds and endowments are happy to be compensated in rainbows and hugs, returns are the only thing that matter.

Ironically enough it looks like you are just as wrong as GP.

"The Kauffman Foundation was created to encourage entrepreneurship"

http://blogs.reuters.com/felix-salmon/2012/05/07/how-venture...

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