azeem.azhar

It’s worth understanding how LPs pay VCs in other to understand what kind of risks VCs are paid to take.

LPs (or VC investors) are typically pension funds, endowments and occasionally family offices who are investing over a long-time horizon in a variety of asset classes. Because of their time horizon (that is they are looking to build wealth over generations) they can get into longer term investments such as timber, farmland or VC.

These LPs can get stock market returns and bond returns through equity and bond holdings. So they turn to alternatives for two main things:

1. Diversification: don’t put all your eggs in one basket. VC is an interesting asset class in that it diversifies over time (relative to equity markets)

2. Juice: VC, smart guys with money investing in smart geeks, should surely create markets, disrupt industries, yadda, yadda, yadda.

In my example, Hullabaloo Capital Partners, a $101m fund where LPs have invested $100m and the partners themselves have invested $1m. There is a 2% management fee, and a 20% carried interest fee on returns beyond an 8% preferred return. The fund has a 12 year term. The partners are allowed to reinvest any gains from quick exits but all gains after year seven must be paid back.

Hullabaloo’s partners invest over four years and typically wait five years for liquidity. After year six their management fee tapers off.

The accounts. A $100m fund might have 3 partners, an associate or two and three support staff, which would be paid out of a $2m a year management fee (which would taper to nothing by year nine). So each partner might reasonably take about a $300k salary, leaving the better part of $1m to pay support staff, offices, travel and inescapable legal bills.

Now, $300k is a good salary if you live in the mid-West. If you live in NYC you’ll be hard pushed to manage schools fees, pilates classes, etc. Ok, I’m kidding. In this

environment any salary that puts you in the top 1% is great, but remember, partners in investment firms are smart, at the top of their game and in demand.

Now this table makes sense. Essentially, the VC is being pushed to produce outsize returns by his LPs. And so heavily incentivised to do so. The reason the IRR figures look so good is because the VC is highly leveraged. They deploy 1% of the capital by receive 20% of the return, based on their performance. They have skin in their game and if all goes to plan they will be compensated for their expertise.

The bonus numbers are stark.

There is an inflection point. In my model this inflection point happens somewhere between 11 and 13% return where a few points of performance amplify VC returns by a factor of 25.

GPs whose underlying investments grow at a 12% annualised clip would see a carried interest payment of $535k after nine years.

Those whose underlying investments grow at a 13% clip would see a carried interest payment of $12.9m after nine years. Now that’s VC money.

But also note that total management fees over this period are $16m, so even in this model, around 60% of a VCs compensation is not performance related. That 13% clip corresponds to a return to partners of 10.8% which is respectable but below the 15.5% mean the NVCA reports. I disregard those numbers anyway, because outside the top quartile the bulk of firms are money losing (it is just the KP and Sequoia et al bump up returns).

As an investor I would also have to ask questions. Why am I paying $28m to investment mangers to lock-up my money for the better part of a decade, to return 10.8% and have an appreciable chance of blowing up and returning nothing or losing everything? Fiduciary duty springs to mind. (The real answer is that the LP’s agents drank too much from the hose of Fama-French while at the same B-school as the GPs.)

(The section below was added on 6 May followind Fred Wilson’s comment on hurdle rates).

For a fund without a preferred return (or hurdle rate), the numbers are significantly more attractive because the multiplicative effect of the carry is available at all levels of return. Those numbers are quite scintillating.

If LPs receive a return of 1.76% over the life of the fund, GPs (excluding management fee) receive 22.69%; or close to $1.89m.

If LPs receive a return of 7.7%, GPs receive a return of 49.91% or close to $8.9m–which strikes me as outsize returns for mediocre performance. In particular as the LPs will only see a $33.9m cash-on-cash return for their $100m commitment.

How many funds operate without hurdle rates? It is hard to say. Fred Wilson has raised seven funds without a hurdle. In an extensive study of 122 European Private Placement Memoranda from the late 90s and early 00s, Schmidt and Wahrenberg find that 50% of funds operated without a hurdle rate and the remainded had hurdle rates of between 5 and 15%, with the mode hurdle rate being 8%.) My models show that a hurdle rate of 5%, means that GPs start to really earn carry at levels of return which give their LPs a return of 6.5% (which is equity like).

Schmidt and Wahrenberg go on to say that they find US and European markets quite different, with US funds being better at aligning managers compensation with fund performance that European funds. And in particular, that the better a funds reputation is, the better its performance skew is.

So the argument may run–that a fund which can raise money from LPs without a hurdle rate needs to be an established fund, with a track record of success and partners who stand to lose more by losing their reputations than anything else. High performing partners are therefore highly aligned to continuing to perform well.

(end section)

The problem with this model is that not everyone is in a market with outsized returns. Sorry. It just isn’t the case. Europeans have hunted, generally in vain, for the next billion dollar exit. Fred points to the general undersupply of these exits relative to the money in the market.

Incentives count, as we discovered from the hedge fund and credit industry. It is hard to believe that 2 and 20, over fixed duration funds can be the only way (or best way) of organising and incenting venture investors.

I also find it immensely plausible to believe that LPs do not, in general, drive the right bargain around this. We have seen this with the hedgies. People don’t challenge fees and fee structures, they don’t do their due diligence around the market they are targeting.

So it is exciting to see new models emerge such as the Y Combinator, Launchbox &  Betworks models. I don’t know enough about them but their fund size will be too small to support a 2/20 model.

It si a tricky problem. Hullabaloo needs to think hard about how to solve it.They obviously deserve to be compensated appropriately for the value they create. But are they in a market which can support outsize returns? Or is there an incentive model that might work better for them?

My hunch is–and I am open to suggestions–that other models might be appropriate for different industries, geographies and stages. If you know of any other models that are in use or being tested then please join in the conversation.

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