Venture capitalists here in Silicon Valley are feeling pretty good. Returns are starting to trend up. High-profile exits are common. Fundraising for general partners is getting easier. There’s even a rush of new VCs looking to launch first-time funds. And while I’d normally be happy to see new entrants — new funds often mean new models — I’m not happy. Too many of these new VCs are "me-too" players; looking to replicate the best-of-breed VCs in the Valley rather than trying things that are fundamentally new.
And that’s actually quite problematic. Why? The last thing this industry needs is a new crop of the same thing. The high-profile exits that we're all supposed to be cheering haven’t generally translated into better risk-adjusted returns for LPs. As of June 2014 the VC industry has managed to eke out a whopping 18 basis points of “value add” over the Russell 2000 — over the past ten years! Are those 18 bps worth the fees, lockups and illiquidity of VC? Nope. In fact, most LPs want 400 to 600 bps over public market comps, per year, to justify venture capital as an asset class. So it’s remarkable to see VCs bragging about anything right now.
The traditional models of venture capital continue to fail the broad community of investors. To be fair, over the past decade new models have been launched to try to better align the interests of the VCs with the entrepreneurs; let’s call this VC 2.0 (see Founders Fund, A16Z, ffVC, and so on), but these models haven't yet addressed the needs and interests of the broader investment community (i.e. the funders or LPs). And this raises an important question: What should VC 3.0 look like? In my view, VC 3.0 is about connecting the funders with the founders in the most streamlined, cost-effective mechanism available. Only when we can do that will the promise of Silicon Valley riches be realized for the broad community of LPs in venture funds.
Ironically, VCs will tell you that any industry with unhappy customers and highly profitable incumbents is ripe for disruption. It’s time for VCs to look in the mirror.
But before I discuss ways in which LPs might catalyze real creative destruction in the VC ecosystem, let’s start by flagging up the key problems I see in this asset class today:
Fees: Everybody has a sense of what the fee structures are for the top VCs: 2.5 percent base and 30 percent carry. I know it’s a common theme, but I believe that many of the industry’s problems can be found in the problematic incentives this structure creates. But rather than spend too much time focusing on these odd incentives (which I touch on below), let me instead offer you an analogy as to why I believe these fees are not justified: Let's say the "river of capitalism" here in Silicon Valley is flowing at 20 mph. It's doing so because of the legacy of the 1800s gold rush (James Lick, Lester Pelton, etc.); the influence of Stanford and Berkeley, the funding from NASA and Lockheed, the role of William Shockley and the “Traitorous Eight”; the founding of companies like Hewlett-Packard, IBM and Apple; the culture of risk taking; the welcoming immigration policies; and so on and so forth. Venture capitalists, for their part, spotted a fast-moving river and, to their credit, jumped in, adding another 2–3 mph to the downward path of the flow. Relative to the ground, then, VCs here in the Valley can swim up to 23 mph! That's remarkably fast — faster than anywhere else in the world — which is why we see so many game-changing companies coming out of our "river." But the problem with VCs is that they want to get paid for swimming 23 mph, when really they are only swimming 3 mph.
Path Dependence: Lucky investors look smart; smart investors develop brands. Top entrepreneurs want the top-brand VCs because it’s validation that their idea is sound. Many don’t need VC money, and they often don’t need much help either. But the brand-name VCs signal legitimacy to the broader marketplace. As such, these brands fall into a very favorable, path-dependent position: being lucky and appearing to be good allows you to be good for real. How can upstart VCs (which might offer more-aligned terms) hope to compete with this kind of competitive advantage? Moreover, how can anyone trust a track record developed while working for a brand VC? I personally wouldn’t have great faith in any mid-level partners looking to set up a new shop on the back of brand-name performance (not that you’ll actually get to see audited performance numbers, as these funds use secrecy to reinforce their privileged positions). Once ex-brand VCs are on their own, the top entrepreneurs may stop coming to them. And so the power of the brands is reinforced, which gives them even more pricing power over the marketplace (see above).
Alignment: LPs want GPs to invest with their interests in mind. But because of the fee structures and path dependence, most GPs end up being permitted to maximize their own interests, and the interests of LPs is often a distant third (after the entrepreneurs they back and themselves). The size of funds is one illustration of this misalignment. Asset managers of all stripes have a big incentive to increase the assets under management, but in VC there is considerable evidence that fund size is negatively correlated to fund returns (see the Kauffman report). Put simply, big funds perform worse. And yet many VCs will push hard to get as much capital in the door as they can, even offering different funds with different mandates (seed, early, growth, green-growth, digital-growth, etc.). Layering these funds offers GPs big paychecks through fees even if the carry checks never materialize.
Distortion: If you’re running a $500 million fund with a 2.5 percent base fee and a premium carry, generating a good internal rate of return requires returning 2.5–3-times invested capital back to LPs. But even returning 1x (i.e., zero percent return) requires generating $625 million in profits (assuming a 10-year fund). In order to deliver a 3x, then, you’d need a handful of portfolio companies with enterprise values in the billions. In other words, instead of swinging your bat with a view to hitting singles and doubles — and cheering when the ball goes out of the park — VCs today are, in Babe Ruth fashion, calling their shots. They are pointing that finger out to center field and swinging with all they've got. But calling shots doesn’t necessarily work well; when you’re swinging for the fences you're using an approach that can often result in strikeouts.
Interference: The need to generate massive, billion-dollar exits (as above) has driven VCs to become unhelpful partners for some entrepreneurs, pushing them to "go big or go home." As such, many entrepreneurs have come to view VCs as more destructive than helpful. Here’s an all-too-frequent view I hear about VCs today: “Every smart CEO and CTO I’ve known has viewed VC money as a deal with the devil: In exchange for the money, you commit to constant interference and endless pressure to deliver the goods earlier rather than better.” In addition, this focus on billion-dollar exits — instead of being happy with hundred million-dollar exits — means that VC money isn’t flowing where it should.
In sum, despite the positive vibe you see around the VC industry today, I’d argue that the VC industry is not yet ready for a renaissance — it’s ripe for disruption. The big question, then, is how do we shift the VC industry into something that is more aligned with the LPs; how do we create a generation of “Funders Funds” that truly deliver on the promise of Silicon Valley for pensions, endowments, foundations and other capital providers?
To start, LPs need to act like investors and stop being allocators. If you’re job is to fill buckets full of VC, you’ve already lost. This isn’t the type of asset class in which you can spread money thinly across many managers; you’ll pay alpha fees for beta returns to an underperforming asset class. Rather, LPs should think about innovative and thoughtful ways to deploy capital. Much of this will require mounting challenges to the existing business models, but it will also call on some VCs to break rank and partner with innovative LPs in new ways.
Aside from new and innovative LP/GP partnerships, I also believe that LPs are going to have to begin doing things on their own. They need to spin out teams — from VCs, but also from other types of investment vehicles, such as family offices or corporate ventures — and they are going to have to dabble in direct investments. Crazy? Nah. With the Giants I work with, we’ve already been doing these things. In fact, I can think of three institutional investors that are in the process of seeding or spinning out new venture firms right now; all three are here in North America. Anyway, I could rattle off many other funds trying to do creative things: The Municipal Employees’ Retirement System of Michigan is making direct investments in local companies. Singapore’s Temasek launched a new group, the Enterprise Development Group, to seed managers. The Ontario Municipal Employees Retirement System, The Wellcome Trust, and AIMCo have been doing interesting things as well. The list goes on, and it will soon be getting longer.
Most GPs I talk to genuinely believe that LPs are not capable of doing creative things in this space. For them, it’s a self-evident truth that what they do could never be done by the likes of a public pension. I personally disagree, but let's accept that as a given. The reality is that they actually don’t have to do the same job. All they need to do is find other people to do the same job, on better terms. That, my friends, is not as hard as GPs would have you believe.
Anyway, given that LPs are increasingly interested in seeding new GPs, here’s my list of areas I think they should focus on to ensure success:
Governance: These vehicles should have governance arrangements (i.e., independence) that set them up for commercial success. It’s fine to impose certain constraints on strategy — it is very common for venture funds to raise capital based on specific industries or geographies — but the GPs need the flexibility to generate high returns. This is basic but as you’ll see below, I’m all for governments, universities and companies to use their own inherent advantages to drive high returns. But that only works if the governance is right.
Talent: This is an extension of governance; you have to be able to recruit the teams to ensure the success of these vehicles. By no means am I saying that you need to hire mainstream VCs — I’d personally go the other way — I am however saying that you need people that have been around the block as an entrepreneur or investor and know how to keep the train on the rails. This means paying fair compensation. If you pay bananas, you get monkeys. But you also shouldn’t believe VCs when they tell you that you have to pay them premium carry; the convention today demands it but the future won’t support it. As I said, VCs want to get paid for swimming 23 mph, when really they are only swimming 3 mph.
Lower Fees: If you bring the fees down, you change the entire incentive structure for the GPs, which is a good thing. We may ask the new VCs to look for doubles and triples rather than grand slams. And this focus may, in some cases, lead to gross returns that are somewhat lower. But the net returns we hope will still be higher. And the return per unit of risk should also be higher. Who’s going to take all the crazy risks, then, ask all the VCs reading this? The same people that are taking it today: angels, super angels, universities, companies, and so on.
Unfair Advantages: LPs seeding GPs should look for unfair advantages — like the kind that existing GPs enjoy thanks to path dependence — and exploit them. This may be an exclusionary right associated with IP development or proprietary research outputs (e.g., government ventures, university ventures or corporate ventures). I think it’s a good thing that some sovereign development funds and even universities are trying to catalyze and capture some of the value that’s being created within their own ecosystems through new venture vehicles. Why wouldn’t you? Again, if you have the governance and team, this would seem to be an unfair advantage. Use it!
Smart Beta: I’d suggest that there are a lot of VC strategies that can be automated and run based on a series of heuristics and triggers. Don’t kid yourself: most of the top VCs today operate in this manner. Here’s what they want to know: Who are the other VCs in the syndicate? How big is the target market? Has the management team had a successful exit? Are the off-list references stellar? You could almost put brand-name VCs on autopilot sometimes.
Specialize: LPs should think thoughtfully about informational advantages and focus on specific verticals (education, health care, finance). As the world becomes complex, generalist platforms will struggle to adapt to new industrial opportunities — see the experience of VCs with green energy companies. It pays to have domain expertise.
Commitment: LPs shouldn’t let GPs get away with taking a loan from future fee revenue to make a personal commitment to the GP. I’d like to see GPs put big personal stakes into the fund. This will hopefully drive the management team to sustain “high-intensity work” for 12-24 months.
Ethics: Obvious and critical. Never overlook ethical transgressions; it’s a heuristic for long-term success.
Anyway, let me sum up with a bit of a step back: Perhaps the best thing that VCs can be doing today is asking themselves who their customers really are. Seriously. Remember the saying, “The customer is always right”? I’d wager most VCs would say that their primary customers are the entrepreneurs they work with to build businesses. I understand the logic, but that’s not really true. The customers are the LPs that fund the partnerships and the underlying businesses. But today the LPs aren’t happy. And so something's going to have to change.
