
The venture capital model is broken, and this damning report explains why - username3
http://www.geekwire.com/2012/venture-capital-model-broken-damning-report-explains/
======
tptacek
Ouch:

 _Longer fund lives are an expensive trend for LPs, who often are asked to pay
additional management fees for a fund that extends beyond ten years. Many
funds have several companies left in the fund at the ten-year mark, and demand
additional fees, frequently based on the value of the portfolio (e.g., 1.5
percent of the cost basis of the remaining portfolio). The alternative
available to LPs is to receive a FedEx package of private company share
certificates. Which of the two evils is lesser?_

Context: VCs market funds to LP with a lifetime of 10 years, but usually can't
liquidate all their holdings in that time frame; they apparently then go on to
charge management fees during "overtime".

~~~
tomkarlo
Given that investors were already paying ~2% management fees during the life
of the fund, paying a few points a year while the VCs try to liquidate the
remaining assets doesn't seem like that big a deal. The remaining assets are
probably less than 10% of the original fund size in terms of their cost basis,
so you're talking about an ongoing fee that's less than 10% of what they were
already paying.

The alternative would be to fire-sale the assets when the fund closes, which
would probably cost the investors a lot more.

------
jpdoctor
The report that they link is well-worth reading in order to understand the VC
ecosystem.

tl;dr of the linked report:

* Somebody who relies on VCs to invest their money has finally noticed that VCs fail to beat the market over 10 years.

* They think the fault lies at the investor-VC interface: The way VCs are compensated is broken, and the way VCs report the performance of the portfolio is opaque.

* They make recommendations, which will never be adopted because it would expose and publicize the true VC returns.

~~~
j2labs
Regarding your third point, if I was a VC that was beating the market - and
there actually are many - I'd be happy to share my info and put pressure on
the weaker VC's to expose themselves.

~~~
jpdoctor
> _and there actually are many_

But not with regularity, which is why they don't do it.

Even Sequoia, which seems to have a golden halo around here, had the partners
pony up funds in order to keep some funds positive.

~~~
davidu
> Even Sequoia, which seems to have a golden halo around here, had the
> partners pony up funds in order to keep some funds positive.

Can you clarify what you mean here? Adding capital to a fund doesn't impact
the return of the fund. And separately, I think you're factually wrong.
(aside, I'm an entrepreneur funded by sequoia)

~~~
jpdoctor
> _Adding capital to a fund doesn't impact the return of the fund._

You know that, I know that, but the folks who do the investment want to see
the dollars returned be greater than the dollars invested. Otherwise, they
also look like they are mismanaging money.

 _And separately, I think you're factually wrong._

Why?

 _(aside, I'm an entrepreneur funded by sequoia)_

You think they'd advertise such things to you?

Edit: Apparently they do --

 _Leone noted that Sequoia has never had a fund that has lost money. There was
one time when things were looking like they may go that way in 2002, so the
Sequoia partners got out their checkbooks so that no one could say that they
lost money investing with Sequoia Capital._

<http://techcrunch.com/2011/09/12/doug-leone/>

Yes, that's right: That's Leone saying the partners needed to bail out the
fund, because their investments were negative. I give him points for honestly
admitting that they blew it bad enough to kick back money. Of course, subtract
points for the way in which he stated it, requiring carefully parsed words
_Sequoia has never had a fund that has lost money_.

~~~
ohashi
If I were an investor and saw that type of behavior, I would put my money with
them. That's a great move. I'd reinvest if the guy said 'we messed up, we're
compensating you for it.' Of course if there were any pattern or regularity to
the failures I might not continue to invest. But if it happens once and that's
the response? I am impressed.

~~~
jpdoctor
> _But if it happens once_

Thank god, we're finally getting past the "Good VCs never lose money" mantra
around here.

------
pg
Surely most users of this site already knew only the top VC funds make money.
The Kauffman Foundation certainly should have. But that doesn't mean the VC
_model_ is broken, just that there are a lot of lame firms using this model as
well as the good ones.

~~~
tptacek
You'd be better off replying to a post of the actual Kauffman report than the
summary on "Geekwire.com". From the beginning of the report:

 _Recommendation 1: Abolish VC Mandates: The allocations to VC that investment
committees set and approve are a primary reason LPs keep investing in VC
despite its persistent underperformance since the late 1990s. Returns data is
very clear: it doesn’t make sense to invest in anything but a tiny group of
ten or twenty top-performing VC funds. Fund of funds, which layer fees on top
of underperformance, are rarely an effective solution. In the absence of
access to top VC funds, institutional investors may need to accept that
investing in small cap public equities is better for long-term investment
returns than investing in second- or third-tier VC funds._

Kauffman isn't disagreeing with you, but is observing that LPs are often
required to allocate capital into VC as an asset class, and can thus be
required to plow money into huge and underperforming funds because it's too
difficult to get enough money into the smaller funds that do outperform the
market.

You can read just a couple pages into this report and see that they're on the
same page you are in this regard, right?

~~~
pg
Obviously they're "on the same page" now. But they must not have understood
the sharp dropoff in VC performance when they invested in mediocre funds, or
they would not have done it.

~~~
cwp
That's not necessarily true. The Kauffman Foundation is a non-profit whose
purpose is to support entrepreneurship. Investing in VC may accomplish that
goal, even if the investment loses money. Heck, it may have been worth it from
a research point of view, just to gather the data that went into this report.

------
rauljara
>> In essence, the report suggest that VCs get paid “to build funds, not build
companies.”

Sometimes it seems like the whole financial sector is just one long series of
perverse incentives strung together. But I guess it doesn't make the news when
it works the way it is supposed to.

------
larrys
Note this which appears on the last page:

"Several peers listened to our list of topics andresponded by cautioning us
that “this is a relationship business,” implying a view that we are better off
accepting the status quo and being in misaligned, under performing VC
relationships than pursing negotiations for better terms."

"this is a relationship business" is a frequent phenomenon in sales and even
in lawyer client relationships. Lawyers become friends of their clients and
this prevents the clients from easily doing something that isn't in the best
interest of the lawyer. Large ticket salesmen frequently wine and dine clients
(including sports tickets and if you believe some accounts prostitutes).
Specialty doctors entertain primary care physicians (well at least in the old
days they did) in order to maintain a flow of patients. The very clear intent
of all of that is to protect a legacy system and prevent you from entering
into a relationship with another entity that may actually be better for you.
This happens even in cases where the person being sold is spending their own
money. But when people are spending someone elses money all bets are off.

------
davidu
LPs need a two-tiered investing model. It's true, outside of the very few top
performers, everyone else is a loser. Unfortunately, once in a while, a loser,
or more likely, a new fund hits a home run. They should have a portion
allocated to investing in new funds with less capital at risk.

The 2 and 20 is also only a problem for bigger funds. For smaller funds ($40mm
for instance), it's not really an issue. Assuming two partners, that's $250k
annually for each, leaving 300k for office and misc expenses. Not getting "VC
rich" with those kinds of dollars. It's when a 2 and 20 fund raises a 500mm or
1b fund that the 2 and 20 causes the base salary to be excessive.

------
JVIDEL
What do you expect when half the VCs say they invest using "their gut"? as if
"feeling" a company is going to be successful is a valid metric. In any case
if you fail more than once it's obvious your gut isn't very precise and you
should use other methods.

Anyway, that the system is broken is hardly something new, have you all
forgotten "The canary is dead" slides from TheFunded? and it was 4 years ago!

What I'm asking is: does it matters? When those slides were released it was
all doom and gloom, wantrepreneurs were going to disappear, nobody was going
to be able to raise funding, etc...

And nothing happened, which is not me saying it doesn't matters, just that it
seems no-one cares.

------
asanwal
The VC market is one where the buyers of VC funds (LPs such as Kaufmann) have
a lot less information than the sellers (the VCs themselves) - a market with a
high degree of information asymmetry. In "a market where sellers have more
information than buyers about product quality can contract into an adverse
selection of low-quality products."

[http://www.nobelprize.org/nobel_prizes/economics/laureates/2...](http://www.nobelprize.org/nobel_prizes/economics/laureates/2001/press.html)

~~~
jstanderfer
LPs commit money to new funds before the first investment is ever made. What
type of information does the seller (VC) have that the buyer (LP) does not?

~~~
pge
One of the challenges is that the buyer (LP) is usually managing billions of
dollars (e.g. a pension fund or large endowment), and venture is only a tiny
fraction (a couple of percent) of his total asset base. It's difficult for
those LPs to have expertise in an asset class that is such a small portion of
the portfolio. The obvious objective criteria is past performance but
understanding the potential of a team requires a deeper understanding of what
makes firms successful.

~~~
jpdoctor
> _The obvious objective criteria is past performance_

Considering that this criteria has been debunked for prices of public
companies, I'd be amazed if it were true for private companies.

I'm gonna take a flying guess that the correlation studies have not been done
like they have for public, due to the opaqueness of private pricing.

~~~
pge
The studies have been done, and there is a much stronger correlation between
past performance and future performance in private equity than in the public
markets. In the public markets for active fund managers, there is almost no
correlation. For vc funds, there is a decent correlation. My hypothesis is
that the reason for the difference is information inefficiency. In the public
markets, everyone is oerating with the same information, so it's hard to
create a sustained advantage. In the private markets, one fund may have access
to information (seeing companies no one else sees, knowing customer or
acquirers, etc). Success often begets success because funds with successes get
positive press which leads more entrepreneurs to go to them.

~~~
jpdoctor
> _The studies have been done, and there is a much stronger correlation
> between past performance and future performance in private equity than in
> the public markets._

Very interesting. Link?

BTW: Were the prices self-reported?

~~~
pge
I can't find links to the papers themselves, but the research was published by
Lerner and Stahlman at HBS. They looked at firms that had top quartile venture
funds and then looked to see what percentage of them remained in the top
quartile in the subsequent fund. For public market managers, the measure was
the same but on a year over year basis rather than fund over fund.

------
kyt
You could swap out VC funds with hedge funds and the article would pretty much
be the same.

~~~
tomkarlo
Not really. There's a couple things hedge funds have to deal with that VCs
don't - generally, it's easier to track the market value of their portfolios,
so they have to show performance on a quarterly or annual basis. Also, the
lockups for investors are much shorter (~2 years) so you can get out of an
underperforming fund, whereas with a VC you're generally locked in from the
start to the end of the fund. (Secondary markets do exist, but at a large
discount.)

~~~
robocat
I think kyt's point is that 2%+20% causes the same mis-alignent of incentives
for hedge funds.

~~~
tomkarlo
Maybe, but even the compensation structures behind that 2/20 are wildly
different between the two groups. Hedge funds have two things I've never heard
of in a VC fund: benchmarks against market returns, and high-water marks. So
while the headline of how they are compensated seems similar, the reality of
how they get compensated isn't. Also, what a hedge fund does (assuming it's
investing in traded securities) is generally far more scalable than what a VC
fund does - doubling the size of a hedge fund may just mean doubling the
average trade, whereas for a VC it means you have to either double the number
of deals per partner or chase deals in a much later stage where round sizes
are larger.

~~~
robocat
"assuming it's investing in traded securities"

Which is only a percentage of funds under management. The hedge fund industry
invests in wildly diverse sectors, securities etc. VC'S can be treated as just
another hedge fund sector.

If you can't get basic facts right (e.g.: lockups are not ~2 year - corrected
by mdda), it is difficult to pay any attention to your opinions.

The other major problems arising out of "black box" investing also applies to
hedge funds.

~~~
robocat
If you want to continue the thread, back i up with data. E.g. Deutsche Bank's
Alternative Investment Survey:
[http://www.db.com/medien/en/downloads/2008_Alternative_Inves...](http://www.db.com/medien/en/downloads/2008_Alternative_Investment_Survey.pdf)

That shows the diversity of strategies (although not funds managed per
investment category). "The SEC started regulating funds with less than a two
year lockup" I.e. a pecularity to the US.

~~~
tomkarlo
Effectively, SEC regulations like Dodd-Frank impact large funds worldwide,
because you're subject to them if you have more than a small number of US
investors. (I think it's 15.)

That survey isn't particularly good data. For one thing, it conflates Fund of
Funds with other hedge funds, which is pretty questionable given that they're
really a separate class with different fee and performance expectations.

~~~
robocat
> That survey isn't particularly good data. For one thing, it conflates Fund
> of Funds with other hedge funds, which is pretty questionable given that
> they're really a separate class with different fee and performance
> expectations.

DeutscheBank is a bunch of kids and that particular report is questionable???
I hope _you_ don't work in funds management.

> Effectively, SEC regulations like Dodd-Frank impact large funds worldwide,
> because you're subject to them if you have more than a small number of US
> investors. (I think it's 15.)

See <http://www.google.com/?q=master+feeder>. Hedge funds that want to accept
money from US and EU investors are structured to _avoid_ the US regulations
for the EU investors (for many more reasons than lock-up periods - e.g. _look_
at the graphs of lockup periods broken down by investor country???!).

It is almost the defining feature of hedge funds that every fund is different.
A hedge fund is _defined_ by the class of investor it aims at (institutional
and/or qualified investors) - everything else is variable - hedge funds are
diverse in almost all other dimensions (although some things are common e.g. 2
and 20).

Returning back to the original point:

"You could swap out VC funds with hedge funds and the article would pretty
much be the same."

Very true. The variation within the hedge fund industry is more than the
variation between a VC fund and any average hedge fund. IMHO 90% of the
article applies to hedge fund investors. The issues of the 2% management fee,
the human factors of the fund managers, and the issues to do with transparency
(black box) are all relevant to many hedge funds.

The only reason I am answering you is because I hate seeing the standard
misconceptions about hedge funds being promulgated.

------
michaelochurch
I think the binary nature of the VC model is a big part of the problem. I
don't know what the alternative's going to look like (crowd-funding?) but
right now we have a two-caste system. There are "the funded" and the cold and
hungry. The inside and the outside. Losers and winners selected before a
single one of either side has had an opportunity to accomplish much of
anything. There are a lot of things that could be said about this model, but I
think it's pretty clear that it's _not_ good for technology. As we see, most
of this bubble is in "social media" VC darlings with mediocre leadership and
MBA culture... and still little investment is going into Real Technology
startups founded by actual engineers.

A VC cash infusion puts someone from one category into the other immediately.
Someone goes from being (in terms of VC-istan social status) a beggar to a
baronet in an afternoon. It's really an all-or-nothing game being played.
Making it a million times worse is that VCs usually talk to each other about
the deals they're making, which means that one VC's opinion influences the
multitude. If there were more independence among VC decisions, we'd see an
order of magnitude more good startups getting funded.

I think VCs tend to get distracted by their kingmaking powers as well. It's no
longer about delivering the best returns for their client. It's about using
that magic wand to be "cool" and minting the _right_ baronets, the ones who
will use the press access and social status they get from being Funded to make
that VC (individually) seem more stylish. Like Tyrion Lannister, they just
(::sniff::) want to be loved.

~~~
gravitronic
If this is what you or anyone else reading this worries about when they go to
sleep at night I strongly suggest you start a business that is bootstrappable
instead of the next social network.

------
magicjuand
It's easy to bash projects that fail. Wall Street is stuck in this place where
they keep investing in the same boring business they have been for decades.
They set unreal expectations, that cause firms to fudge numbers, leading to
bail outs. Wall Street is short sighted and doesn't look at the big picture.
Hell, if I was part of the largest (corporate) welfare class as well, I would
bash failed ventures as well.

Fortunately, I am not tied to group think, so I can be as creative as I would
like to be. VC's are great. They take chances, and are willing to invest in
things that are more than likely to fail than be successful. Discovery is the
ultimate reward, and I am more than happy to lose money so long as it leads to
a discovery that helps society as a whole.

VC's allow for experimentation, and even if the experiment fails, lessons are
always learned. It's amazing how narrow minded business people are.
Personally, I feel that knowledge gained is priceless and far outweighs short
term profits. Thank you VC's for taking chances and for willing to think
outside the box.

TL;DR: Knowledge is the ultimate return on investment.

~~~
asanwal
Sorry but this argument is some combination of naive, inane and/or b.s. VCs
are financial investors and their investors (the LPs like Kaufmann) who give
them money are expecting a return. Discovery, social good, changing the world
and other euphemisms don't cut it for them as that is not what they are sold.
They are sold a story of high risk, high reward, and per these #s, that was
not what was generated.

TL;DR: Until pension funds and endowments are happy to be compensated in
rainbows and hugs, returns are the only thing that matter.

~~~
robocat
Ironically enough it looks like you are just as wrong as GP.

"The Kauffman Foundation was created to encourage entrepreneurship"

[http://blogs.reuters.com/felix-salmon/2012/05/07/how-
venture...](http://blogs.reuters.com/felix-salmon/2012/05/07/how-venture-
capital-is-broken/)

