— An Op-ed by Andrew Vo
As a former portfolio manager at J.P. Morgan where my investment team would review hundreds of private equity and venture capital funds, I have developed a good sense of the common characteristics of investment managers who can deliver top-decile returns.
Which brings me to the following bold claim, as this article will serve as the final prerequisite — the other being “The Math for Silicon Valley is Broken” — before the much-anticipated publication on why “Silicon Valley is Broken.”
Venture Capitalists should not earn any Management Fee as it creates a significant conflict of interest for their Investors, as the Management Fee itself becomes a significant driver of the VC’s revenue, thus incentivizing them to gather more assets, instead of delivering on exceptional returns for investors.
Management Fees and the 80/20 Rule of Venture Capital
The Pareto Principle (also known as the 80/20 rule) states that, for many events, roughly 80% of the effects come from 20% of the causes. The Pareto Principle also applies to Venture Capital Economics, which we shall call the “80/20 Rule of Venture Capital.”
For example, let’s do a simple analysis of a “Mega-Sized” one-billion-dollar Venture Capital Fund that has successfully raised capital from institutional investors (pensions, endowments, and foundations) and accredited investors (family offices, private banking clients, angels, and HNW individuals).
Translated in real dollars, just for raising a billion dollars, the Venture Capitalists collect 2% or $20 million annually or $200 million in total over a 10-year life of a typical fund.
Divided among say five General Partners or “GPs”, that’s a guaranteed $4 million salary for each Venture Capitalist for 10 years, and in total each Venture Capitalist walks away with $40 million for a single fund.
As a point of reference, according to the Bureau of Labor Statistics, the median wage for workers in the United States in the first quarter of 2019 was $905 per week or $47,060 per year for a 40-hour workweek.
Venture Capitalists earn 85X the average annual salary of an average American worker on just the management fee from raising this one fund, without any investing a single dollar.
Ironically, many of these average Americans are government employees who rely on, and indirectly self-fund, their public pension plan, the same public pension that often misallocates capital to Venture Capitalists who earn 85X the salary of the government employees who partly funded them.
The innocuous and ubiquitous “2% Management Fee” that Venture Capitalists charge just to accept investor capital on the claim of generating superior returns, equates to a massive 20% Fee over the 10-year life of a typical Venture Capital Fund, before the Venture Capitalists takes another 20% Carry or Profits.
Different funds have different management fees, but if you are taking off a standard 20 cents for every dollar before you even put it to work, that narrows your margins room considerably, so much so it becomes a Herculean task to beat the returns of the stock market as highlighted in this seminal op-ed here.
For funds like FF Ventures or Ribbit Capital that routinely perform in the top-quartile (typically defined as 2.5x or above of “money on invested capital”), it hardly matters.
But for a $100mm fund doing say 1.5x return, before fees are accounted for, management fees can make a huge difference in investor returns, which brings us to the Venture Capitalists raising funds larger than a billion dollars, the so-called “Mega-Sized VCs.”
Mega-Sized VCs are more Incentivized to be Asset Gatherers
Without getting into the Math, which you can review here on the op-ed on why “The Math of Silicon Vallet is Broken”, let’s first understand how the most sophisticated Investors screen investment managers like Venture Capital Funds.
Typically, sophisticated investors at large investment banks like Goldman Sachs, J.P. Morgan (where I was a portfolio manager), and Blackstone, categorize investment managers into two buckets: Performance Generators and Asset Gatherers.
Performance Generators are managers that focus on generating novel investment ideas to produce exceptional returns for investors. These managers tend to have a “boutique, fundamental mentality” and dedicated significant resources to research, analysis, and portfolio construction, often with a “differentiated investment edge.”
Simply stated, Performance Generators are the type of investment managers Investors should be allocating their capital.
Asset Gatherers, on the other hand, are those firms that expend a large portion of their investor’s capital on product development, marketing and sales. These managers often paint great narratives about their large organizational structure and their vast array of product offerings. Asset Gatherers make money by gathering more money.
Simply stated, Asset Gatherers are the type of investment managers Investors should avoid when allocating their capital.
Returning to the mega-sized funds, for illustrative purposes only, let’s pick Partners Group, a Swiss-based “private markets manager” that recently reported the following results.
Partners Group reports H1 2019 financials: strong increase in revenues from management fees in conjunction with lower performance fees result in moderate EBIT growth.
Note the emphasis on strong revenues from Management Fees and lower revenues from Performance Fees.
Let’s dig a little deeper.
In May 2018, Partners Group announced that they raised EUR 2 billion for a “private real estate secondaries program”, which is a type of real estate investment. What is relevant though, is this fund has a VC style of charging fees for their investors / limited partners, with a probable management fee of around 1–2%.
Let’s be conservative and say its 1.5% management fee on average for this 2 billion fund.
Well, with a 1.5% fee on committed capital, this manager is locking in $30 million a year for 10 years — a guaranteed revenue stream of $300 million just for raising the fund. In this case, this illustrative manager is getting rich off the management fee, and — if everything works out well — super-rich off the carry.
Note: this example is just for illustrative purposes only and does not reflect the nature of Partners Group of any kind. Please consult an investment professional before making any investment decisions.
What is happening right now is that many of the Mega-Sized VCs understand that Investors / Limited Partners are starting to realize that there is “too much money chasing after too few deals” — the only outcome of which is abysmall returns for VC funds with recent “vintage years.”
Thus many of these Mega-Sized VCs are scrambling to raise another Fund so they can continue to generate guaranteed revenue stream off of the management fees before Investors take their money elsewhere.
Case in point: Kleiner Perkins, founded in 1972 in Menlo Park, is arguably the flag-bearer for the Venture Capital’s “Whaling model of investment” — which is to bet that in a fund of ten companies, one of them will end up being a “Unicorn” 150x investment.
As highlighted in this article, Kleiner Perkins burned through $600mm in 2019, and is now raising another, presumably larger fund, this year, even in the wake of the visionary female, tech investor Mary Meeker’s departure from the firm for “uncited reasons.”
Okay, so now we understand Venture Capitalists, especially the ones with Mega-Sized Funds, are getting rich off Management Fees.
What should Investors do to incentivize Venture Capitalists to be Performance Generators instead of Asset Gatherers?
VCs should be compensated for Returns, not Asset Gathering
The largest asset owners are pensions like the Government Pension Fund of Norway with USD 1 trillion in assets or the California Public Employees’ Retirement System (CalPERS) with USD 400 billion in assets.
In order for this grave misallocation of capital to Venture Capitalists, it is imperative that the Chief Investment Officers (CIOs) and Portfolio Managers (PMs) at large asset owners — Pensions, Endowments and Foundations — need their investment resources on determining whether VCs are Performance Generators or Asset Gatherers.
Dear CIOs and PMs: please start evaluating a Venture Capitalists’ real job, which should be to outperform the public equity markets (the stock market) Net-of-Fees.
You are doing significant harm for your beneficiaries — typically retirees with pension plans — and not fulfilling your Fiduciary Responsibilities, by allocating to Asset Gatherers with flashy sales presentations, rather than Performance Generators that actually seek to deliver outperformance.
Simply stated, CIOs and PMs should only allocate capital to Performance Generating VCs who have have a strong track record of identifying the “Needle” (a Unicorn) in the “Haystack” (early-stage companies).
That is why, we at Aidos, believe that Management Fees in Venture Capital should be eliminated, and Venture Capitalists should only earn revenue based on delivering on returns for their investors.
Thus, we propose two solutions for the broken economics of Venture Capital Investing.
- Carry-Only Fee Model: No Management Fee for Venture Capitalists, but more upside if they deliver on outperformance (say 30–40% carry vs. the standard 20%).
- Profit-Sharing Deal Agreements: Venture Capitalists are compensated on a deal-by-deal basis for the portfolio companies they pick and only earn revenue on a profit-sharing basis with the investors / limited partners.
Final observation: a common practice among Venture Capitalists is to appoint themselves as a “Board Member” for their portfolio companies. This makes sense given their stake, but becomes a conflict of interest when one realizes that “Board Members” are often compensated both in cash (not insignificant) and options or restricted stock units (RSUs) totaling to 0.25%-1.5% of the portfolio company.
So in essence, once a VC invests in a portfolio company, which is financed by investor money, that money is used to provide additional compensation for the Venture Capitalist, in addition to the management fees being collected.
But remember the restricted stock units (RSUs) collected by the Venture Capitalists by appointing themselves as Board Members?
You may have figured it out by now.
By accumulating RSUs in all of their underlying portfolio companies, Venture Capitalists are building up a personal Venture Capital Fund for themselves, at the detriment of the Founders, through the unnecessary dilution by the VCs.
Final Thoughts on Broken Venture Capital Economics
Fundamentally, this severe misalignment of interest between Venture Capitalists and their Investors / LPs is the same Principal-Agent Problem that exists between the CEOs of publicly-traded companys and the company’s Shareholders.
The Principal-Agent Problem is also responsible for the greedy behavior of investment bankers at Lehman Brothers who packaged toxic mortgage-backed securities (MBS) and collateralized debt obligations (CDOs). Then CEO Richard “Dick” Fuld was incentivized by short-term bonuses to encourage his top investment bankers to package and sell these toxic securities, which was responsible for the collapse of Lehman Brothers in 2008, which triggered the last Global Financial Crisis.
Fortunately, for publicly-traded companies, there is often an independent Board of Directors that can remove the CEO. Unfortunately, for Investors / LPs in Venture Capital Funds, no such mechanism exists to correct the greedy tendencies of Venture Capitalists.
Are you starting to understanding why the Economics of Venture Capital is all set up for the Venture Capitalist's benefit, often to the detriment of Investors, Founders, and the Employees of the Founders’ companies?
Stay tuned for the much-anticipated release of the op-ed on “Silicon Valley is Broken.”
By Andrew Vo, CFA
Founder and CEO of Aidos
About Aidos:
Aidos provides a range of advisory, capital raising, and investment services for our clients in the venture capital ecosystem. These services are delivered through the following products: Aidos, Athena, Adelphos, and Atlas.
With an overarching social impact mission, Aidos has five lines of businesses:
- Aidos: an equity crowd investing platform for early-stage startups.
- Athena: a knowledge database for exceptional founders and entrepreneurs.
- Adelphos: an exclusive network connecting exceptional co-founders.
- Atlas: a visionary project to tokenize portfolio companies in venture capital.
- Advisory: a consultant agency for founders and investors in venture capital.
Source: Aidos Inc.
Related Links
https://medium.com/@aidosnyc/the-math-behind-why-silicon-valley-is-broken-8f4d54844e91
— Published on February 18, 2020
