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Venture Capital's Structural Mess

There have been a few more posts recently describing structural problems in the venture capital business.

Fred Wilson called out VCs who claimed that they need to own at least xx% of a company to justify an investment.  xx is usually 20% or more.  Most VCs think this way because they have a large fund and want to have a manageable number of investments to worry about.  Each deal may need to ultimately represent $10-15M over time.  In order to justify that, you may need to own 25% of a company (or invest in much later stage companies).

Josh Kopelman explained why big funds will have trouble generating strong returns for the large bulk of money they have.  Here's a great quote:

Take a $400M venture fund.  In order to get a 20% return in 6 years, they need to triple the fund -- or return $1.2B.  Add in fees/carry and you now have to return $1.5B.  Assuming that the fund owns 20% of their portfolio companies on exit, they need to create $7.5B of market value.  So assume that one VC invested in Skype, Myspace and Youtube in the same fund - they would be just halfway to their goal.

Both of these posts are worth reading in full.  I'm going to cover some trends from the VC's investors on down that highlight structural problems in the industry.

Most VCs raise money from ranges of institutional investors (endowments, 'funds of funds' which manage large pools of capital for other investors, pension funds, wealthy individuals, etc.).  Collectively, these are the Limited Partners in a venture fund, which is managed by the General Partners.  There are several issues impacting LPs these days:

  • There has been a long term trend of lots of capital being available to invest, and therefore a desire to invest more into venture capital.  As every LP increased their allocation to venture capital, they ended up increasing the amount they wanted to invest in a fund.  Some LPs have minimums of $20M up to $50M (present economic difficulties excluded).
  • LPs often don't want to be more than 10% of a fund.  So, their minimum investment levels imply fund sizes of $200-$500M, at a minimum.
  • However, LPs also don't like large fund sizes because they think that the VC General Partners make too much money from their fees (typically 2% of committed capital per year).  So, here's the first conflict -- we have to invest $20M or it isn't worth our time, but we don't want you to have a large fund (or at least not a large fee income).
  • As Josh pointed out, it's hard to make money with a big fund as you need many big exits.  This gets easier with a small fund as the sizes of wins required goes down proportionally.  But, small funds aren't interesting to many LPs as they can't invest money in them to be worth their time.
  • And, in today's economic climate, there is a shortage of liquid assets available for LPs to use to meet their existing fund commitments let alone make new ones.  That's one reason why new fund commitments are so low.  Also, with VC returns being fairly low for the past decade, many LPs are moving out of venture capital or lowering their allocation, except for commitments to proven very top-tier funds.

There is also a structural problem with compensation.  As you might know, VC General Partners get a salary from their management fee and then a piece of the upside on the aggregation of the deals in the fund.  Typically, the partners would split 20% of the profits in the fund (not in each deal).  The whole fund has to be above water for this to happen, and some top VCs have a 'carried interest' of 25% or even 30%.  LPs are trying get everyone pushed back down to 20% if they possibly can.

Many LPs are compensated in the same way.  They get a management fee from their investors and then get some level of 'carry' if their fund is profitable in the aggregate.  If you think about this, it compensates everyone for achieving fund multiple, regardless of how long it takes to get there.  You might think that an LP would be thrilled if they could send you all of their money and you could reliably return 1.25x their money in 12 months.  Logic would assume that they would do that year after year.  But, their compensation system keeps them from doing that.  They'd only make 6.125% of the committed capital as a profit (you'd have to generate a 31.25% return, keeping 20% of it, 6.125%, and sending them the remaining 25%).

They'd rather let you hold the money for 5-8 years in hopes that you can return 2-3x their money, even if it means that you might lose half their money.  That doesn't make much sense, but that's the basis of LP and GP compensation.  If you generate a 2x eventually (to net 2x, the VC has to generate 2.25x and keep .25x for themselves as your carry), and raise a new fund that tries to do this every few years, you can eventually earn more money.  But, chances are something that can generate a 2x return can also lose half its value.  And, that's what's been happening in the venture space.  LPs and GPs are trying to generate high returns and living with the losses.  The glut of capital in the sector is one factor in driving down returns.  For the VCs and LPs, their high management fees buffer this for them, but their ultimate investors are getting tired of it.

I expect there to be lots of changes.  Foremost, capital will continue to drain out of the venture capital space.  Second, there will be pressure on the venture fund terms, pushing down management fees so that the GPs only make significant money if the investors are also earning a profit.  This will force the GPS to do the math that Josh Kopelman did and raise a smaller fund.  That will force many funds ts close and many people to leave the business.  Ultimately, it will be a healthier market, but it will take some time and a lot of gnashing of teeth before it gets sorted out.


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