
Hey, Fred, the VC Model is Broken - pj
http://thefunded.com/funds/item/5723
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mediaman
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.

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dpapathanasiou
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_...](http://www.newyorker.com/reporting/2007/07/02/070702fa_fact_cassidy))

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ispivey
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.

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

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pg
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.

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rjurney
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.

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pg
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.

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dpapathanasiou
You generalize about every investment model, but can you name vehicles where
the '2 and 20' fee structure is standard?

It's really only hedge funds and VC funds.

But the real problem with the '2 and 20' (especially in a bad economic
climate) is that VCs have less incentive to care about how their portfolio
actually performs.

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byrneseyeview
1\. Nobody else targets such high returns.

2\. If investment banks structured themselves as hedge funds, they would have
a higher payout. Employee compensation routinely hits 50% of pretax profit.
Assuming a bank gets an average return on equity of 10%, and bonuses are as
large as salaries (lots of small bonuses, a couple really huge ones), that's a
5 and 25 bonus structure. _Damn_.

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dpapathanasiou
That's the argument funds use to justify their fee structure to their LPs.

In most cases, the LPs do worse than anticipated specifically b/c of the '2
and 20' fees.

As Harry Kat said in the New Yorker article:

" _They are charging more than they are adding. I'm not saying they don't have
skill; I’m just saying they don't have enough skill to make up for two and
twenty._ "

