Hey, Fred, the VC Model is Broken | Hacker News Reader

Hey, Fred, the VC Model is Broken

thefunded.com

33 pointspj20 comments

I've always thought Warren Buffett's early partnership model was far more intelligent (for the LP at least): he received nothing if he delivered less than a 6% per year return, which he justified because it was a reasonable rate an investor could achieve at low risk, and 25% of all profits above and beyond that 6%. He only ever earned anything if he was generating returns for his clients.

I've never understood what justification GPs use to charge 2% management fees. Imagine you could just sit around and earn 2% on other peoples' money, year in and year out! If your fund is big enough, actually earning returns on your LP's invested dollars is just a way to get richer, but not necessary to get rich.

The comment makes a great point about management fees:

"Well, most venture capitalists have started to optimize for management fees versus carried interest, or sharing in the profits generated. It simply makes sense to raise larger funds every two or three years so that each partner can earn $2 or $3 million a year in guaranteed fees. With exits taking longer and failures rampant, praying to generate personal returns from the carry after paying back your principle is unrealistic."

Which reminds me of a similar observation from the world of hedge funds:

"Typically, hedge-fund managers charge their clients a management fee equal to two per cent of the amount they invest, plus twenty per cent of any profits that the fund generates. (This fee structure is known as 'two and twenty.')"

"If a fund manager does well, he gets to keep a large portion of the profits he makes using his clients’ money; if he does poorly, he still receives the generous management fees, at least until his clients withdraw their money, which isn’t always easy to do."

(http://www.newyorker.com/reporting/2007/07/02/070702fa_fact_...)

Management fees are a necessary component of an investment fund, unless you want to allow only independently wealthy investment advisors to launch new funds. That's fine for Marc Andreesen and Fred Wilson, but I'd like to think we don't want to push young, hungry VCs out of the business. 2% isn't the right number after a certain size (Does it cost twice as much to run a $200m fund as a $100m fund? No!), but some level of fees makes sense.

We need smarter LPs, not a whole new model. There's always going to be brain-dead money that will invest under whatever fee structure is prevalent. Until they stop plowing money into $200m+ funds without asking "Why do you need all those management fees?", VCs will keep lining up to take their money.

Smart LPs can drive incremental changes like pushing management fees down on large funds. And that's all the OP is asking for, really; not scrapping the VC model.

I agree; LPs have the power to change the model.

This guy's own math makes it clear that a VC who invested well could make a lot more from the carry (the returns of the investments) than the management fee. And the better VCs do try to do that, even if many of the worse ones are in it for the fees. Which implies exactly what Fred said: the model isn't broken, individual VCs are.

If the system of incentives enables bad VCs to make a lot of money, then the system is broken by virtue of the existence of these bad VCs.

The quantity of bad VCs seems like evidenced it's broken. If 5% were bad, that'd be one thing. My perception is that it's more like 80%+ are "bad".

Greg McAdoo stated at Startup School 2008 that of the 400+ VC firms in Silicon Valley, only 15 are profitable (3.75%).

http://omnisio.com/startupschool08/greg-mcadoo-partner-at-se...

If true, that is totally outrageous.

Yes, that's true. But that doesn't mean there is something wrong with the fee structure. Most of the money-losing firms would still have lost money even if they charged zero fees.

The real problem is simply that most VCs are lousy investors. But it's not uncommon for most practitioners in a field to be bad at it. Most artists are bad, for example.

The point where the VC business is broken is where LPs meet GPs. Credulous LPs give money to incompetent GPs. It's not the VC model that's broken, but the LPs' judgement.

Most LPs shouldn't be investing in VC. They do it in imitation of LPs past who've made lots of money that way, like big university endowments and certain family funds, but they don't know what they're doing, choose badly, and end up losing their money.

A lot of them will probably pull back now, which will mean a lot of the worst performing VCs will disappear. Which is exactly what Fred has been saying. The problem is not the VC model per se, but inexperienced LPs' undiscriminating appetite for VC funds.

(Yet again, the macroexpansion problem. http://news.ycombinator.com/item?id=685713)

The current fee structure allows bad VCs to survive. Just because it works in the ideal case doesn't mean it's not a bug in the system. Wouldn't it be an improvement if the industry standard fee structure only rewarded profitability?

I think at this point it's semantics. 'What do you mean broken?' I would classify your above comment as an explanation of how & why the model is problematic.

I actually do agree that it's not the fee structure that's necessarily the problem. There's no reason that VCs should take 100% of the risk together with their investors.

It's not accurate to describe that situation by saying the model is broken, because by that standard every investment model is broken. The bad VCs are simply tricking their LPs by selling them bad investments. That happens with every other form of investment, from land to equity to hedge funds.

No more IPOs or (lately) acquisitions, lots of funds failing to return principal, and yet those VCs still making money. Sounds like a broken model to me.

Maybe this does point to a broader problem? Isn't this the kind of shenanigans that led to the current downturn?

What evidence do you have that the current lack of IPOs is due to the fee structure of VCs?

All the evidence I know of suggests otherwise. VCs had the same fee structure back when there were lots of IPOs.

The lack of IPOs is not due to the fee structure of VCs. The incentive model however, continues to compensate them extremely well even though the LP's profit model is broken by SoX. Which would seem to mean that the system as a whole is broken, and that the VCs incentives are now a problem. This would seem to suggest that these incentives need to be reformed to fix the system.

More likely though is that VC will simply crash like housing before any reform happens.

You generalize about every investment model, but can you name vehicles where the '2 and 20' fee structure is standard?

It's really only hedge funds and VC funds.

But the real problem with the '2 and 20' (especially in a bad economic climate) is that VCs have less incentive to care about how their portfolio actually performs.

1. Nobody else targets such high returns.

2. If investment banks structured themselves as hedge funds, they would have a higher payout. Employee compensation routinely hits 50% of pretax profit. Assuming a bank gets an average return on equity of 10%, and bonuses are as large as salaries (lots of small bonuses, a couple really huge ones), that's a 5 and 25 bonus structure. Damn.

That's the argument funds use to justify their fee structure to their LPs.

In most cases, the LPs do worse than anticipated specifically b/c of the '2 and 20' fees.

As Harry Kat said in the New Yorker article:

"They are charging more than they are adding. I'm not saying they don't have skill; I’m just saying they don't have enough skill to make up for two and twenty."

That's why sites like The Funded are valuable. Behavior implies the goals of the VCs, and rewarding those with their eye on the bigger prize (and punishing the others) is good.

Reply on news.ycombinator.com