If Venture’s Broken, What’s the Fix? | Part 2 of 2
by Harshitha Kilari & Joel Camacho
In Part 1 of this article, we looked at the venture capital industry through the lens of the Ewing Marion Kauffman Foundation. According to them, venture capital is a broken industry. In a now seminal article originally published in May of 2012, the Kauffman Foundation’s investment team chastises venture firms for being too big, delivering subpar returns, and remaining stuck in the past. They note that in their twenty-year history of investing in venture funds, only 20% of a 100 total investments “generated returns that beat a public-market equivalent by more than 3 percent annually.”¹ Moreover, after considering the “cumulative effect of fees, carry, and the uneven nature of venture investing, 78% did not achieve returns [that were] sufficient [enough a] reward for patient, expensive, long-term investing.”¹
Surprisingly though, they place the blame for industry’s plight squarely at their own feet. It is they, along with other LPs — institutional or otherwise — who “should shoulder blame for the broken…model as they have created the conditions for the chronic misallocation of capital.”¹ These conditions are the direct result of misaligned incentives between GPs and LPs.
This lack of alignment between GPs and LPs can be best understood as falling into one of two categories: fund economics and lack of transparency. In Part 1 of this article, we dug into the former. Here — in Part 2 — we cover the latter.
Venture capital firms are black boxes. In an industry shrouded in secrecy — whether it be with respect to deal flow or strategy — venture capitalists have long been known to keep mum publicly and only share information privately (if at all). This holds true both for companies into which they invest and for LPs from whom they solicit investment.
Performance data are chief amongst the information that’s closely guarded. Some cases are so extreme that funds have opted to sever relationships with long-term investors rather than to disclose returns. As Ann Grimes notes in an article in the Wall Street Journal, Sequoia Capital severed its 22-year relationship with the University of Southern California, and then with the University of Michigan, to keep their performance figures from being disclosed.² This behavior isn’t unique to Sequoia. Benchmark and Charles River partners are amongst the funds that have done the same. That said, there are some GPs — notably Fred Wilson at USV and Gerry Langeler at OVP — who have come out in support of performance disclosures.¹
While data around returns is the most closely guarded, compensation data is a close second. The irony is that GPs fully understand the importance of disclosing both performance and compensation data. After all, they require deep and comprehensive assessments of both when making investments. It’s a must-have when funds deploy capital, but not when they raise it, making the maxim ’do as I say, not as I do’ come out in full-force when considering firms’ informational transparency.¹ We, at Decipher Capital, are acutely aware of this incentive for hypocrisy, which is why we’ve made a concerted effort from day one to inculcate the values of transparency, openness, and accountability into our fund and its LP relationships.
All this said, it’s important to remember that, in cases where these values aren’t embraced voluntarily by funds, LPs are not powerless. They can create change and realign currently misaligned incentives.
Change is hard and change takes time. This is especially true in an industry laden with incumbents, each with their own long history of ‘how-things-have-always-been-done.’ But LPs can create change by changing the way they allocate capital. An effective strategy to enact this change might be for LPs to focus on investing in new funds and first-time fund managers.
By doing this, LPs are forgoing the long-term relationships where terms are dictated by tradition in favor of new ones where they have more leverage. This allows them to mandate transparency from the start. This not only starts creating a culture of data-driven openness, it increases the overall level of competition in the fund space, hopefully eventually incentivizing incumbent funds to follow suit.
Moreover, first-time funds tend to outperform their larger, more established peers. According to Preqin’s Up & Away: Launching a First Time Venture Capital Fund — a study devoted to examining this phenomenon — first-time funds net IRRs is closer to 20%, while median net IRR for non-first-time funds was less than 10%.³
By leveraging their ability to control the way they allocate capital to GPs, LPs can not only start to fix the broken venture capital industry, but also potentially increase their overall portfolio returns.
Citations:
¹ Diane Mulcahy, Bill Weeks, Harold S. Bradley. “WE HAVE MET THE ENEMY…AND HE IS US. Lessons from Twenty Years of the Kauffman Foundation’s Investments in Venture Capital Funds and The Triumph of Hope over Experience.” Ewing Marion Kauffman Foundation. May 2012.
² Ann Grimes. “VCs scramble to keep their numbers secret.” Wall Street Journal. May 11, 2004.
³ Preqin. “Up & Away: Launching a First-Time Venture Fund.” Preqin Alternative Assets Data. November 2017.
Since I was a co-author on this post, please see below for a disclaimer regarding views presented above.
Thank you,
Joel
Disclaimer. This post is intended for informational purposes only. The views expressed in this post are not, and should not be construed as, investment advice or recommendations. This document is not an offer, nor the solicitation of an offer, to buy or sell any of the assets mentioned herein. All opinions in this post are my own and do not represent, in any manner, the views of CMX Capital or affiliated companies.
