Hey, Fred, the VC Model is Broken

by pj • 17 years ago

33 20 17 years ago

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_...)

mediaman• 17 years ago

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.

pg4• 17 years ago

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.

rjurney4• 17 years ago

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.

staunch2• 17 years ago

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".

pg4• 17 years ago

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.

ivankirigin• 17 years ago

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.

ispivey• 17 years ago

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.

dpapathanasiou4• 17 years ago

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

Hey, Fred, the VC Model is Broken

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