…Or Assuredly We Shall All Hang Separately

"We must all hang together, or assuredly we shall all hang separately." — Benjamin Franklin at the signing of the Declaration of Independence

Dan Primack set off an interesting dialog around his article Radically Reinventing Venture Capital. There is a growing wave of articles about new or revised models and debate around what went wrong.  He described a suggestion by one Boston VC who proposes that LP’s think about funding individual VC’s as single partner entities. These are all interesting and thoughtful discussions, but I believe that they are over thinking things. I offer that the heart of our issues rest in our industry’s compensation incentives mixed with a fine market melt down.

Venture capital used to be a business about creating revolutionary businesses to change the world for the better. Wealth was driven by carry, the GP’s share of profitable investments. Investor, entrepreneur and VC were aligned, all focused on profitable investing. This has broken down.

The LP community has moved aggressively into alternative assets to kick start unfunded obligations. Furthermore, consultants, advisors and staff have concentrated this capital on a shrinking list of investment firms.

At the same time, market disruptions have basically shut down the IPO world and the VC’s main escape hatch. With public options diminished, acquisition multiples have declined, which has reduced the frequency and size of investment exits. For example, while investments normally take 3-6 years for exit, in this environment, only 20% of deals have exited since 2003. This had backed up VC’s portfolios.

The toxic result is that VC’s look increasingly to management fees instead of carry for compensation. This breaks the alignment between LP & GP. This incents & focuses VC’s on raising larger funds, more often and deploying it quickly.  If a group raises $800m every two years, it adds management fee in $20m per year chunks. Three funds, eight partners leads to $6-8m/yr per partner in just fees. Carry is a nice to have versus need to have.

As long as LP’s go along with this, things won’t change. Unless the money drives this, behavior & incentives won’t change. They need to regain the alignment between their interests and the VC’s.  One heretical idea would be to move current compensation from being based on assets under management to salary based with escalators. By relatively fixing the current compensation regardless of assets (increase it for new hires), VC’s will have less incentive to raise capital for the sake of driving current fee. Rather, they will be focused more on the carry. Granted, carry grows with fund size assuming returns are the same, but we all know that returns suffer when funds are too big and are deployed too quickly. So, there is some governing factor to imprudent asset accumulation.

I also liked the structure of Warren Buffett’s first funds. He established a base rate (say a 6% return) upon which no carry was charged. So, the first 6% of IRR is free which makes sense, as venture’s goal is to drive alpha above more conservative asset classes. Unlike with hurdle rates, he did not have a “catch-up” after 6%. Rather, he charged 25% of the profit above the 6%. So, a VC is worse off (from a traditional 20% carry) until IRR’s in the low teens and then better off above the low teens. This gave no bonus for poor results and superior compensation for strong results.

I don’t know if the LP community has the appetite for this kind of approach regarding fees. They are fighting to get allocation into a narrowing list of venture firms so are unlikely to rock the boat for fear of exclusion. They are, unfortunately, in for a rude awakening if they can’t find another way to align their interest with those they entrust their capital.