azeem.azhar

Fred Wilson has started a fascinating debate on VC and whether it is sustainable. The debate has been picked up by The Deal.

In a free market, money will flow to asset classes with the right characteristics, as you saw.
One thing that seems to be mis-priced around venture is the illiquidity premium (10 years is a long lock up).
The second is the tail risk of venture investing. Since we know that venture returns are not normally distributed (not even with high kurtosis) but are powerlaw distributed, our typical models for asset allocation don’t work. These are based on an assumption of a Gaussian which is a bad approximation for liquid assets like equities (as recent months have shown) and a terrible one for venture.
The allocation models of investors in venture funds assumed differently. Indeed, the tail risk of the asset class generated a notionally high option value making venture funds more interesting to allocation models of LPs.

Frankly, if I was a pension fund and I couldn’t get into one of the fifty firms (in which I included both of yours), I wouldn’t come close to the venture class.

There is another angle on the issue of the over-allocation of funding to venture capital firms. Very bright, persuasive people get into VC because it is a fantastic business. Even if you don’t enjoy the notion of working with tech firms or brilliant entrepreneurs, as an asset management business a two per cent management fee makes for a decent lifestyle even with zero return. Needless to say lots of smart bright people are drawn to it, creating lots of smart, persuasive PPMs floating around the pension fund world and lots of funds drawn in.

One way of addressing this over-allocation would be for successful funds to reduce their management fees and perhaps increase the allocation of success fees. That way LPs would see the signal of low management fees as successful funds, thereby eschewing funds charging higher management fees. VC would become relatively less attractive to GPs, reducing the number of funds and hence the over investment in the class.

Reverse logic. But I think it’ll work.

Originally posted as a comment by azeemazhar on A VC using Disqus.

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