
Venture Capitalists Get Paid Well to Lose Money - prostoalex
http://blogs.hbr.org/2014/08/venture-capitalists-get-paid-well-to-lose-money/
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msandford
"If that objective (above market returns) is persistently left unaccomplished,
investors will allocate their capital elsewhere."

And that could well be the end of the article folks. VC as an industry has too
much money so it doesn't generate good returns. This shouldn't be shocking to
anyone.

If say GE generates $8.8b in dividends ($0.22 per share per quarter and 10b
shares) and it's priced at $10 a share that's an 8.8% yearly return! But if
the stock price is $50 a share it's only 1.76% return which isn't as
impressive.

The only difference in those two scenarios is how much money is chasing GE's
dividends.

The returns to VC are too small because the pool of talented, motivated
individuals to start companies isn't getting bigger anywhere near as fast as
the cost to do so has fallen. That means that VCs are over-paying for the
companies that they can buy into (because they have to do SOMETHING with the
money) and because they buy into more companies that won't necessarily be
successful.

VCs (the human beings) don't scale the same way the companies they're
investing in do. The whole idea of VC was that money was scarce and a person
could only make a few bets so they could afford to spend a lot of time with
each of their portfolio companies. As the amount of money needed has crept
down I suspect that the number of investments has crept up and that means less
time to go around and probably less good outcomes.

When it "only" takes $500k to take a swing with a company a VC can afford to
look at it as a calculated bet that might pay off rather than an investment
which needs care & feeding to be successful.

tl;dr the landscape shifted under VCs with the dropping price of starting a
company and not all of them know how to successfully operate in this new
world.

Just in case this comes across overly negative I don't hate VCs at all. I
think that VC as a whole is great. I'm sure some of the individuals aren't all
that great but as an industry I think its fantastic. But as an industry it
might end up shrinking, too.

~~~
baddox
That all makes sense, but you didn't propose an explanation for why people are
choosing to put their money into VC rather than an apparently better-
performing investment.

~~~
msandford
Other responses are "people like to gamble" and "they THINK they'll make more
money in VC" and both of those are really good explanations.

I think there are other explanations too. I'm sure there's a lot of prestige
that goes with being an LP in a VC fund. It's a diversified investment that
isn't going to be as correlated with the market as say GE will be. If the VC
fund you invest in under-performs there's really no way out except to wait it
out and not invest in the next fund they raise. That sounds like a bug but it
might be a feature since money managers are often under pressure to perform
and putting money into a VC basically locks it up. That means decisions about
what to do with that money don't have to be made regularly which could be a
nice little bonus.

> why people are choosing to put their money into VC rather than an apparently
> better-performing investment.

Basically because the future is unknowable and there are plenty of VCs who do
well. I saw some chart where the top x% (I can't remember nor can I find it)
of VC get basically all the returns. Because VC is so unevenly distributed
there's a small chance that the probably under-performing fund you invest in
MIGHT be one of the break-out VCs that'll end up capturing a large portion of
industry returns rather than being paid well to lose money. And if your job is
to manage money that might be an attractive proposition; prestige, excitement,
diversification, a 10 year set-it-and-forget-it investment, and a small chance
of making a big return.

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confluence
You'd be surprised at how many different careers pay very well to lose a lot
of money. Are CEOs really worth 100x a line engineer? Especially when they
oversee the gutting or collapse of their company? Probably not. With most
employees salary is tied directly to their output: How much can you get done?
With higher level employees it seems to be: How much can you get away with?

With the recent revelations of tech company wage cartels and systematic
collusion against employees in SV by execs, I feel like the latter statement
is somewhat accurate. It pays to take more than you return.

~~~
iopq
If the CEO can make the company lose only 1 billion this year compared to
losing 2 billion if another guy had the job... then he's worth 1 billion to
the company. Is paying him a few million really that big of a deal?

~~~
confluence
Another thing:

> _Is paying him a few million really that big of a deal?_

Paying anyone, anything, is supposed to be a huge deal. Employees get fired
for sub performing for even a few weeks to a month! And we're not talking
millions of dollars here, we're talking thousands. How can anyone think of "a
few million" as an afterthought? That's easily the salary of 50 people. If the
CEO deserves it, show us how that he is better than the 50 people we could
have hired. And I mean what he specifically did, and not the 10,000 engineers
under him.

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vonklaus
Technology is very winner take all. Like peter theil says, last mover
advantage is high. Google has largely ended the race for the market to develop
search, and microsoft was the last enterprise operating system. So the top VCs
typically have access to the top entrepreneurs. However, this is a huge
industry and the best VCs and the best entrepreneurs are in minority.

So the rest of the companies, most of which are not great or innovative, get
funded by finance VCs who want to maximize return, but are not as connected,
knowledgeable or high-profile as someone like DFJ or Sequia. Basically the A
team entrepreneurs get funded by the A team VCs and everyone lese pretty much
get's beaten by them.

Good VCs make money for their LPs which is why it is so hard to get into those
funds.

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rayiner
Relevant:
[http://www.law.harvard.edu/programs/lwp/Session%20III%20-%20...](http://www.law.harvard.edu/programs/lwp/Session%20III%20-%20Lerner%20FINAL.pdf).

Private equity (venture capital and buyouts) hasn't done particularly well
over the past few decades. Some big wins, but also some spectacular failures
(e.g. $45 billion EFH buyout that ended in bankruptcy). The above analysis
shows that there is a huge difference in performance between funds, and the
gap is persistent. The problem is, the good funds can't absorb a fraction of
the money institutional investors are looking to put in these asset classes.

Why would VC's give up their 2 and 20 when there is just so much money
floating around?

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im3w1l
2 and 20 refers to a yearly fee of 2 % of assets, plus 20 % of profits that
year.

~~~
GCA10
In fact, the top-performing funds now charge 2.5% and 30%.

~~~
michaelochurch
Let me guess: "top-performing" means "comparable to an index fund".

~~~
tptacek
Your comment was intended as snark, but in fact asset allocation is more
complicated than analyzing year over year returns and comparing them to a
benchmark. Investors might put money into an asset class that performs near an
index fund, and pay more to do it, simply to have some funds allocated into an
asset that isn't correlated with the index. Or the volatility characteristics
of the asset classes might be important.

~~~
selmnoo
A small remark: thank you for not replying to what you deem to be "snark" with
just more snark, but rather instead replying with something that can be
replied to with a substantive comment rather than a continual exchange of ad
hominems or something.

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boomzilla
This explains the crazy valuations we are seeing now. I've always been
wondering who is benefiting from the huge valuations: definitely not the
employees and to some extent, the founders, as all their worth are not liquid.
So the ones benefiting from the high valuations are VCs, who has incentives to
raise bigger and bigger funds.

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lotsofmangos
_" A VC firm is, first and foremost, an investment vehicle created to generate
returns for investors that exceed those available in the fully liquid, low
cost public equity markets. If that objective is persistently left
unaccomplished, investors will allocate their capital elsewhere."_

Presumably the level of returns in the equity market is somewhat dependent on
the amount of new business entering the equity market and therefore the on the
amount of VC capital available, so it doesn't necessarily follow that you do
expect to see massive profits from your overall VC investment if you are a
large enough investor to consider it to be part of safeguarding your equity
investments.

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dkfmn
They also get paid exceptionally well to generate exceptional returns, so they
make money either way. There is a relatively common saying in finance that 2 &
20 is the best business model that exists.

As for LP returns, if you're not investing in a top quartile (or decile) fund,
you're wasting your time. There is still some turnover in which firms perform
but it's relatively consistent.

Edit: I've skimmed the article, the other thing that isn't mentioned is that
the 2% management fee is generally paid back to investors out of profits (if
there are any).

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gopalv
The incentives are setup that way.

If I were a VC with money from clients with me, telling them that I'm holding
out for a good investment is a great way to lose them next year.

Money un-invested is stale capital that will definitely not earn anything
back. That money could be lost on a venture - but nothing ventured, nothing
gained.

In some sense, they're really paid well to not hold back on investing it -
only to be penalized if they do not assume risk on behalf of the client.

~~~
prostoalex
> If I were a VC with money from clients with me, telling them that I'm
> holding out for a good investment is a great way to lose them next year.

VC inflows tend to be locked in after the fund has been raised.

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michaelochurch
VCs provide access to small growth businesses and will never have a lack of
passive investors because that sector "should be" a great profit engine. When
one set of passive investors tires out due to the funds' mediocre performance,
there'll be another set of suckers coming down the line.

The most underreported self-dealing by the VC class isn't the 2-and-20, but
the revolving door between VC firms and overpaid executive positions at VC-
funded companies. Being a partner at a VC means you get a lot of executive
positions to hand out to your B-school friends who turned out to be
underachievers. This means that a bunch of people will owe you favors, 10
years down the line. This type of personal draw-out (funding suboptimal
businesses to win future favors from founders and other VCs, rather than the
best) is also impossible to prove or even measure.

VCs draw a decent salary for themselves, but the personal career benefits of
being a king-maker (which are impossible to track) are even bigger. The savvy
ones essentially assure that they'll become two- or three-digit millionaires
(billions is unpredictable and hard to assure; you typically have to go all-in
on your own company) in the next bubble cycle. You can't not get rich if
you're a VC, and for 95-99% of these guys, I could do their jobs better and
I'm a 31-year-old relative nobody.

For better or worse, they're the main (and perhaps the only reliable one)
valve between top talent and the ocean of passive capital seeking better
returns than what index funds offer, and they're not going to give that up.

It's a Cheap Votes Problem. Why is it illegal to sell one's vote? Because,
even if the statistical power of one vote is low, the statistical power of a
bloc of votes can be quite high (voting blocs grow quadratically in
contribution to variance). If you allow vote-buying, the people who aggregate
cheap votes gain a ridiculous amount of power. This was a major problem in the
Gilded Age. Venture capitalists are cheap vote aggregators when it comes to
passive capital and high-talent business formation.

~~~
dkfmn
"Being a partner at a VC means you get a lot of executive positions to hand
out to your B-school friends who turned out to be underachievers"

You clearly have a bone to pick with the industry and that's fine. But no VC
hands out executive roles to anyone they don't believe to be top talent;
they'd destroy their own career, reputation, and compromise the returns of
their fund.

Now, they could very well be wrong about somebody and give a job to a C-
player but that'd be an honest mistake.

~~~
michaelochurch
_But no VC hands out executive roles to anyone they don 't believe to be top
talent; they'd destroy their own career, reputation, and compromise the
returns of their fund._

Well, then they're just really awful at judging talent, because founder
quality is at an inexcusable low.

I doubt they'd destroy their careers by placing incompetent people in these
startups. Why? Most of them fail anyway, and that's part of the design. Also,
most non-founder executive roles are sinecures.

~~~
fearless
How do you measure founder quality? Most startups have some amount of traction
when they raise VC funding. Either hundreds of thousands of users or $1M or
more in revenue, especially with the bar for Series A getting consistently
higher. That would speak to the quality of founders increasesing over time,
not decreasing.

