Disrupted Venture Capital - Part I: The Industry - Returns, Fees, Structure

Venture Capital is changing  as many long-standing practices are mutating or being completely disrupted by technology and new business models... Just like any other industry!

The idea is to approach the forces that are changing the Industry in 3 articles.

1. The Industry- Returns, Fees, Structures
2. MoneyBall and Spread and Pray
3. Seed Funding: Accelerators, Crowd-funding, Super Angels

1- The Industry - Returns, Fees, Structures

The evidence is there and it is hard to deny it: over the past 10 years, Venture Capital has not given its investors the appropriate return for the risks it entails. 

The biggest and most compelling piece of evidence is the report prepared by the Kaufmann Foundation, based on the 88 top tier VC Funds they invested in over the past 20 years. Their conclusions and solutions might be debatable, but the symptoms are undeniable as reflected by the data from the Kaufmann Foundation, Prequin and Cambridge Associates:

• Only 20% of the Funds got the targeted 3pp better returns than an investment in the Russel 2000 Small Cap, a relevant benchmark, in the Kaufmann report
• Only 38% of the Funds got better returns than an investment in the Russel 2000 Small Cap
• The Kaufmann Funds have returned on average 1.31x; well bellow the target 2x.
• The Median IRR has been bellow 10% every year for the past 15 years according to Prequin data
• The Pooled Return of Early Stage Investment has returned 6% vs 10% by the Russell 2000 over the past 10 years according to Cambridge Associates

The Industry has clearly underperformed over the past decade. 

A meaningful caveat is that, according to Cambridge Associates, Venture Capital has returned an astonishing 28% over the past 20 years against a 9% return by the Russell 2000. Clearly, the bad performance can be attributed to phenomena that occurred solely over the past 10-15 years.

So, what happened?

There are a number of possible explanations for the dreadful performance of the past decade, mainly capital cycles and/or technology cycles.

The first is the most cited cause for these results. The increased offer of funds in the industry drove prices up and returns down. A simple supply and demand explanation.

National Venture Capital Association - Yearbook 2013

The technology cycle theory claims that the 90s where a great era due to the IT and Internet revolution and we have not had an equivalent technology boom since. This hypothesis  is a lot more difficult to assess than the capital cycle one. The only evidence we have is a big fall in the number of IPOs. However, this could mean a) yes, less fantastic new technology b) more M&A exits c) less market appetite.

National Venture Capital Association - Yearbook 2013

The latter reason for the low IPOs is also the base for an argument in itself. Maybe it is not that this decade was bad, but that the 90s where uniquely good. The last decade of the XXth cenntuy saw a market/IPO bubble for technology firms that drove valuations to unrealistic exits. The VC Funds got great returns, but the public markets´ investors got burned. Therefore, the theory goes, VC returns will never be that good again.

The truth is probably a combination of all of the above hypothesis. Venture Capital had very good returns in the 90s, but that was due to a technology shock and a market bubble. Subsequently, investors invested heavily in the early 2000s searching for the same success, only to see low returns because of the absence of the key drivers of the previous decade and the new abundance of capital.


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The poor returns have pushed many investment experts, including the Kaufmann Foundation, into a belief that the industry is broken and that its structure and fees need to change.

The most common structure in Venture Capital is the famous 2/20 -2% Management Fees and 20% Carry-. Before, when we analyzed the possible causes for bad performance, we did not mention Fees as one of the causes because it was present both when VC gave great returns and when it did not. That does not mean that structures could not be improved to diminish rent seeking and generate better incentives, but they are clearly not the reason behind performance.

One of the main conclusions from the analysis made by the Kaufmann Foundation, and shared by Harvard Prof Josh Lerner of Harvard, is that funds over 300MM underperform. At the same time, running a big fund has almost the exact same costs as running a small one making the 2% management fee much more valuable for the General Partners. Consequently, there are big incentives for funds to try and raise bigger funds in a rent-seeking behavior, even if returns do not justify them.

The easiest way LPs could address this issue is by simply not investing in big funds. Alternatively, they could demand from the Funds  fixed cost management fees, lower percentage management fees or budget-based management fees.

Another even stronger conclusion is that the distribution of returns is very skewed with a small proportion of the funds providing a big upside and a lot of funds barely breaking even.

This has driven some investors to propose a non-linear carry structure with carry rising as returns go up and diminishing as it goes down. It is a stretch to argue that this new structure will provide further incentives for GPs to invest wisely and work harder, since 20% carry of a successful portfolio is already a lot more money than management fees. If anything making carry lower in the 5-15% returns bucket would bring down incentives to perform better once within those moderate returns.

Also, this proposal would very likely be prejudicial for LPs since most of their returns are focused on the funds that perform the best and they are now giving those funds a higher proportion of their returns. Maybe this structure could be implemented by raising payments very little in the upper tier, but bringing them down a lot in the lower tier. In lots of ways this is the way it is already being used since most partnerships have a hurdle rate that distributes carry only after returning investors a sensible rate of return; a straight forward application of this tiered-carry proposal.

If anything, some incentives should be created for GPs to add value to their portfolios even if at some point of the funds´ life they are highly unlikely to get paid carry as it is mostly the case according to data. For example, GPs could get paid smaller total carry (say 10%); but be paid 0.5% carry for individual ventures; keeping incentives aligned  in all possible scenarios and partially avoiding the discontinuities of thresholds. This structure addresses the real problem -the 90% that underperform- instead of looking for solutions within the successful group

The final part of the structure is the GP commitment that is a good way to align interests and should remain the norm.

Maybe the problem has not been the way VC are invested in, the amount they invest or their incentives; but the way they invest in and help their portfolio companies. We will look at the new ways VCs are investing in the Part II of this report.

In conclusion, yes we can make small tweaks here and there to make VC´s structure and fees more efficient; but it has little relationship to the bad returns of the last decade.To get better returns, LPs should:

1. Invest more selectively without bucket allocations
2. Invest in markets with lower competition (i.e. Latin America, Eastern Europe)
3. Invest in funds with the right size, costs and incentives 

Some resources and other opinions:

www.kauffman.org/uploadedFiles/vc-enemy-is-us-report.pdf‎

http://pandodaily.com/2013/06/24/venture-capitalist-bill-draper-takes-the-long-view-of-history-2/
http://blogs.reuters.com/felix-salmon/2012/05/07/how-venture-capital-is-broken/
http://blogs.wsj.com/venturecapital/2012/05/08/kauffman-foundation-bashes-vcs-for-poor-performance-urges-lps-to-take-charge/
http://freddestin.com/2012/05/kauffman-report-broken-vc-guilty-lps.html

Financial Risk in Latin America: Beyond Country-Risk Analysis

The financial risk of investing in Latin America is usually misrepresented because of a tendency to synthesize all the risks in a "country risk" analysis.

The most simple way this is implemented is by selecting target countries deemed for investment because of their general risk configuration.Another common analysis of an investment includes building an earnings projection and producing a discount rate. The discount rate is where the risk is accounted for and it is built by adding to the comparable rate from a US company, a "country risk" factor based on the sovereign spread over treasuries.

However, this represents an oversimplification of the risks associated to investments, mainly: Firm Risk, Macroeconomic Risk and Political Risk. 

I have little objections to the analysis of firm risk per se since it is not where the country risk usually comes in. However, the interaction between certain sectors/ firms and other risks should be accounted for.

When investors usually talk about investing in a country, its Macroeconomics are the first thing they look at: GDP growth, Inflation, Real Interest Rate, Probability of Default, etc. However, not every company is equally exposed to these macro trends.

For example, exporters have little exposure to the local GDP, but are exposed to the volatility of the Real Exchange Rate. Even within exporters, Capital or Land intensive companies -i.e. Farms, Metals- are less exposed to Exchange Rates than Human Capital intensive companies -i.e. Business Process Outsourcing-.

Also, the cash flow stress associated to this risk can be stabilized by hedging in the financial markets; but markets are not deep enough to hedge currency or GDP risk for long periods.

To sum up, Macroeconomic risk is based on the company´s exposure to a local economy which is not necessarily only the country where it produces and the risk can be reduced (or exacerbated) by correctly managing it in the financial markets.

Political risk is even more subtle since a company is evidently exposed to the local politics that can expropriate, tax, regulate, declare war, etc. Some extreme events, like war, affect every company alike but are very unusual and have barely ever occurred in Latin America in the past 3 decades.

The main political risk in Latin America is a market disruption (expropriation, regulation, tax), that is why the most "market friendly" governments in the region are the ones foreign investors usually target. This targeting  has three main shortcomings.

Firstly, this analysis overestimates the duration of the political processes in Latin America, extrapolating current government behavior into future decisions.

Also, even if market friendliness is a good proxy for political risk, it overlooks some other associated risks. For instance, Peru and Colombia are the new vedettes of the Latin Financial Markets for their market-oriented governments and their high growth rates. However, in Perú police brutality is a big problem and in some regions in Colombia security risk is still an issue.

Finally, the political risk in every sector and industry is very different in each country. For example, Brazil has more political risk than Chile; but investing in Apparel Retailing in Brazil has much less political risk than investing in Copper Mining in Chile; not only for Copper´s general political risk, but for its cornerstone role in the Chilean Economy. There are differences even within mining: being a supplier to mining companies is a much safer bet than being directly involved in the industry.

In conclusion, yes there are some countries that are more risky than other, but the risk of a company or project should be fully analyzed without simplifications and investors should focus on the level of each risk they are willing to take.


PS: Thks to James Knight of Pionero Partners for his input