Getting Paid to Lose

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Getting Paid to Lose

Venture capital firms and hedge fund managers are highly compensated by investors who expect better returns than they could get from the market. As long as those investments beat the market, the high costs seem justified.

But that is not what is happening. Investments in VC funds and hedge funds have been underperforming the market, even while the fund managers’ earnings are soaring.

  • According to 2013 annual industry performance data from Cambridge Associates, investments in VC funds returned less than the S&P 500, NASDAQ and Russell 2000.1
  • Also trending lower, the HFR Equity Hedge Fund Index has gone down 5.9 percent since 2010, compared with a 61 percent gain in the S&P 500.

The limited partners (LPs) that invest in venture capital—typically public pension funds, endowments, and foundations—need to receive a minimum rate of return of 300 to 500 basis points above the public equity markets to offset the costs, but that hasn’t occurred since the late 1990s.

As Diane Mulcahy, Senior Fellow at the Ewing Marion Kauffman Foundation, points out in a recent Harvard Business Review blog, the underlying problem is that there’s nothing in the compensation of VCs that motivates them to generate outsized returns.2 LPs typically pay VCs “2&20”—a 2 percent annual fee on committed capital, and 20 percent “carry” on any investment profits.

The VC earns the 2 percent fee each year, regardless of how the fund performs. The incentive, therefore, is not to maximize each fund’s performance, but instead to keep accumulating and managing more assets. The more money invested in the fund, the more fees the VC earns. (The more funds launched, the more fees generated.) When you consider that the LPs have to agree to lock up their investments for a minimum of 10 years, the VCs receive a steady stream of income for at least a decade for each fund they raise.

While the 20 percent carry should motivate VCs to generate high returns, the reality is that any earnings from this commission are not paid until many years later, if ever...

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