Venture Capital Notes

Compensation Structure in VC firms: 1. Problems with placement agents: * Corruption especially with people who have special connections to the firm * Placement agent role - getting personal kickbacks for directing them to investment vehicles * Calpers fraud problem with pension funds and personal incentives 2. Compensation * 2nd five years of venture capital firms is called – harvesting – don’t have to work that hard, essentially let the investments run themselves * Management fees should decline over time, lower during harvesting season * Carried interest – where VC’s make their money * GP’s prefer to split the profits, 20-80 from the start so that way the GP’s will get money right away * Problem – if the fund really underperforms in later years, the GP’s still got compensation from the first exit even if it didn’t deserve it * Industry norm is to have a hurdle rate, and until the hurdle rate is reached, GP’s don’t get carried interest – norm is 8 percent * In a case with low LT interest rates, should the hurdle rate still be 8 percent, because in this environment, the GP’s will find it more and more difficult to generate carried interest * Carried interest is mainly for partners * Good to see compensation decline for poor years in the VC industry (2009) * Issues in PE compensation: * Growing fund size over time * Percentage of mgmt. fees increase with fund size, but in theory there should be economies of sale * In reality, mgmt. fees are not decreasing * very attractive, because the larger the fund you have, the more money you make * Consequences: * Incentives to raise larger funds – excessively large/larger than optimal * Can be detrimental to performance * Invest in lower quality start-ups * Spread too thin (VC’s are active investors) * HOWEVER: