Venture capital is a crucial driver of innovation and economic dynamism. Its thus troubling to see so many public pension and sovereign funds scaling back their venture allocations. I get why its happening; returns have been abysmal. I just cant help thinking these funds these long-term investors are throwing the baby out with the bathwater. And thats why I argued back in January that institutional investors should start thinking creatively (and critically) about the structures and vehicles used to access this asset class rather than dropping the asset class altogether.
And then this happened: I sat down early this morning with my latte and began reading the Kauffman Foundations new report on the VC industry. And. It. Was. Awesome.
Listen, Im a nerd about this stuff. Ill own up to that fact and, moreover, I recognize that there are certain papers that I love that some people will find...well...nerdy. But this one is different. If you havent yet read it, its time to do so. In fact, if I could I would shake the hands of Diane Mulcahy, Bill Weeks and Harold S. Bradley for taking the time to make public their internal research and findings in this report:
Why did this report affect me so? The authors recognize that much of the problem with the VC industry has nothing to do with the VCs who are just being good capitalists and maximizing their profits but has everything to do with the abdication of responsibility, the poor governance, and (dare I say) the sheer laziness of the LPs (i.e., pensions, sovereigns, endowments, etc.) to actually do their job correctly and negotiate terms! Heres a blurb:
Is it the VC model thats broken, or the LP investment model? Our conclusion is that the LP investment model is broken. Too many LPs invest too much capital in underperforming VC funds and on misaligned terms.
We believe that to really understand and constructively address whats broken in VC, we need to follow the money. And the money trail leads right to the LP boardroom, where investment committees oversee venture capital investing. Its in the boardroom that VC allocations are created, VC fund performance is evaluated, investment consultants are heard, and investment decisions are approved.
Can you hear that, readers? Yeah? Thats music going into my ears. And here comes some more:
To fix whats broken in the LP investment model, institutional investors will need to become more selective and more disciplined investors in venture capital funds. The best investors will negotiate better alignment, transparency, governance, and terms that take into account the skewed distribution of VC fund returns.
Couldnt agree more with all that. I might even go farther: LPs should start thinking about vehicles that can offer access to venture capital outside of the partnership model. For example, the LLC that was launched by TIAA-CREF this week to help investors access agriculture could be a useful model to consider.
Anyway, I think part of the reason this paper so moved me was because the authors clearly struggled to explain to some of their peers why these issues which appear so obvious actually matter. Consider this section:
We talked with a number of LPs who did not agree with the arguments we make in this paper, or didnt get why we think theyre important. During our discussion about VC firm economics, one LP said that he didnt worry about management fees or firm budgets because those guys have to make a living too, so it just wasnt a big issue for him to explore during due diligence. Another LP said that negotiating alternatives to 2 and 20 isnt worth the energy. Several peers listened to our list of topics and responded 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, underperforming VC relationships than pursing negotiations for better terms.
Diane, Bill, and Harold friends welcome to my world. This is a place where rock-solid logic about the misaligned nature of VC mandates can be shattered on the face of equally misaligned interests embedded in the employment contracts within the LP itself.
Its frustrating, right? When you know something that you are convinced will help your peers better do their job...but theyre not listening. And why arent they listening? Because that would upset their comfortable status quo.
And so who loses? Its quite simple: The elderly that rely on pensions. The students that rely on endowments. The charities that rely on foundations. And so on. Grrrrr. It almost makes you want to tell the world what you know? Maybe even write a report about it? Yeah...I know how you feel.