HBR’s article hides a sinister and lasting side-effect from the continued under-performance of venture capital.
“Venture capitalists get paid well to lose money” is the title of a recent article in Harvard Business Review reiterating the problems in venture capital – as the arbitrage of innovation – we never addressed and keeps suffocating outlier entrepreneurs.
In the article, Diane Mulcahy, author of “We have met the enemy … and he is us,” and Senior Fellow at the Ewing Marion Kauffman Foundation describes the spiraling consequences of mediocre financial under-performance plaguing the financial sector. And it is good to be reminded of that reality against the backdrop of the false positivity by which some venture capitalists want you to forget about their deplorable past conveniently.
Venture capital still underperforms the S&P 500, NASDAQ, and Russell 2000, according to the author, despite posting its highest returns since the previous venture-bubble burst.
Now, it is tempting to engage in statistical warfare on what these performance numbers mean. With statistics, you can prove anything you are biased to, could be the endless defense on either side of the bias spectrum. Some finance reporters will have a field day perpetuating their analysis as breaking news. But I am not interested in the evolution of significant change in venture capital; for not the microeconomics of venture capital is broken, but its macro-economics are.
Frankly, venture capital with access to remarkable entrepreneurial resources, a massive greenfield of technology buyers, and the immediacy of instant internet distribution should have outperformed any (100-year old) asset-class by a long shot. Absolute returns should be measured against the total addressable market, in which venture capital performance is easily surpassed by less nimble corporate innovation during the same period, even underperforming consumer adoption of consumer technology products.
Venture capital performance will not improve, as the author appears to suggest, by changing the monetary incentive of general partners. For nothing but a venture capitalist’s God-given talent will change his propensity for foresight (or lack thereof) needed to spot great outlier ideas. And the opposite of the article’s title, of not getting paid well to lose money, is also not an option.
Alignment on the downside will not generate more upside; in the same way, better hindsight does not lead to better foresight.
The mindless populism of subprime venture capital yields the implicit shift of money and risk away from prime, with prime quietly discarded as the nuisance of a (false) negative. The real loss incurred by subprime venture capital, therefore, is a systematic dumbing down of our outlier entrepreneurial capacity, unwilling to submit to a subprime arbiter of innovation. A culture of groundbreaking entrepreneurs we, by venture capital’s subprime thesis (drenched in advertising schemes), no longer recognize.
So, to refocus the gist of the HBR article from spiraling consequence to root-cause of venture capital’s poor performance, I added no fewer than fourteen (update: now 25) comments. Let me know in the comment section here if I succeeded in shining some light on the cause.
Here are the first fourteen, see them all in the comment section of the original article.
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Matt:
Very interesting. I wonder – do you see more transparent VC markets such as AngelList providing pressure against the captive investment market described here? Does even crowdfunding present an alternative to VC firms more interested in generating fees than returns?
Georges van Hoegaerden to Matt:
No. The success of outlier innovation is based on the diligent and committed deployment of upside risk. Angellist and crowdfunding fragment the deployment of risk and money (by spoon-feeding entrepreneurs to protect downside), and therefore by economic principle, can only consistently produce subprime returns. Risk equals returns.
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AlphaDave:
Technology innovation is cyclical. The high tech VC returns in the late ’90s were the subject of many articles about the industry and caused a big increase in the number of firms. I think we are still feeling the effects of the bubble that was created. Because funds have a 10-year life and information about individual VC fund performance is sometimes shrouded in explanations that seem exculpatory, investor reaction has been slow. The VC industry in the U.S. still requires more downsizing.
Georges van Hoegaerden to AlphaDave:
Nonsense. Fundraising is cyclical. Innovation is hierarchical based on the establishment of socioeconomic value. The classic defense from confounding consequence with the cause of venture capital’s sub-priming.
AlphaDave to Georges van Hoegaerden:
Nope. You are wrong. Innovation is cyclical, and funds last for ten years. Can you name any technology innovations in the 2000s that rival the boom on the Internet, wireless, and optical that occurred in the ’90s? Many of the funds that started in the late ’90s and had good returns as a consequence of all boats rising are having trouble in a non-Internet boom market. We still have a glut of funds.
Georges van Hoegaerden to AlphaDave:
You are confounding consequence with cause. Venture has turned subprime 20-years ago (first in bull, now in bear). As such, not the performance of the funds is relevant, but the lack of socioeconomic value we create that secures a renewable evolution of mankind.
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Pejman Nozad:
Our fund “Pejman Mar Ventures” is close to $50M and has Zero management fees to partners and %20 carry. My partner and I make zero salaries with no other benefits, and we have invested a lot of our own money.
From day one, we aligned our interest with our founders and LP’s.
Georges van Hoegaerden to Pejman Nozad:
Nice. That’s like a waiter working on tips only. From experience, I know that does not make a great waiter. Just a nervous pleasing one.
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pointsnfigures:
Brad Feld talks about recycling management fees. I think mgmt fees should be treated as a draw. Investors get them back on exits before fund mgrs get paid.
Georges van Hoegaerden to pointsnfigures:
Venture Capital investing requires the diligent deployment of foresight. Adjusting management fees will not improve a general partner’s ability to envision foresight. So, adjusting the dials on existing VCs is a hopeless consequence stemming from an ignorance to cause.
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Jay Jay Deng:
I am also shocked at the lack of innovation in VC compensation. I think I am the only one out there who is crazy enough to have a no management fee structure in my upcoming fund.
Georges van Hoegaerden to Jay Jay Deng:
Fragmentation of risk and money is a consequence of general partners’ inability to successfully engage in the deployment of upside risk.
I am in favor of innovation in the venture model, but not one that merely deepens the fragmentation and protection of downside. So, your “solution” attempts to dodge the snowballs from an avalanche that should have never existed. It will not prevent the venture avalanche from occurring and will not stop the erosion of prime innovation tagged today by subprime venture capital as false negatives.
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LookAtThisIdiot:
Capitalism continues to be a hilarious trainwreck that just keeps crashing.
Georges van Hoegaerden to LookAtThisIdiot:
No, capitalism is just fine. But capitalism void of a meritocracy (an economic principle) is indeed a guaranteed train wreck.
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Vladimir Marakhonov:
Having about 15 years of experience in PE in Russia (in Russia it is the same as VC, often even worse), I may add to this some remarks. I worked in Western companies, so I think that in spite of “Russian specialities” the general trends were quite common.
1. Among the investment managers I was the only person having an industrial management experience. Therefore our GP bosses used me as a hand-on manager when something went seriously wrong in our portfolio companies. And every time taking the CEO’s position, I realized, that if I had been there half of a year ago, I would have easily corrected the situation in the very beginning because a lot of indicators were flashing red light already. But those indicators were not seen by the investment managers. First of all, because they didn’t have any industrial experience and payed no attention to some small tips, intuitively being caught by the glance of industrial people. And, second, because from inside many things are visible much better than from outside.
2. The conflict of interest between management fee and fund investor’s goals really exists. And sometimes it is enhanced by the fact, that, to show his/her performance, an investment manager needs to invest in rush. As one guy told me once: “if I invest in a bad company, I will be fired in 5-6 years. But if I do not invest at all, I will be fired right now.” Guess, what have he chosen.
3. The methods of investment management at present are similar to the work of a credit manager in bank. The same reading of a lot of different reports from books and management accounting, late reaction to coming problems etc. But the goals of investment manager and credit manager are quite different. Credit manager looks for getting his bank’s money back, and he doesnt care about company growth, capitalization increase etc. And he is protected by covenants, pledges etc. Investment manager must provide the capitalization growth and if not, no covenants and pledges will save the case.
4. And last but not least: the very conservative approach of PE tops. When, using my experience, I worked out a conception of portfolio management with more hands-on, I didn’t meet any positive reaction at all. Discussing it with tops of investment arms of largest banks and investment funds I often heared from them: “Yes, it is interesting, but we have alredy the methodics which everybody uses. And we do not want introduce any changes”. May be it was due to the present situation in Russian investment business, which is not the best, not to say more. But probably most of people just doesn’t see the problem so far.
Georges van Hoegaerden to Vladimir Marakhonov:
Private equity and venture capital are polar opposites in terms of risk profile, even though asset managers throw them in the same asset allocation pot. Venture capital is about investing before the chasm (Geoffrey Moore) and private equity is about investing after. So, we should not be using investment models from the private equity sector to invest in venture (or vice versa). The rest of your thesis hinges on the confounding of both.
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sakky:
To be fair to VC, absolute returns are not the only criteria by which institutional investors choose to invest in VC or any other asset class for that matter. Institutional investors are also interested in diversification as garnered by returns that are uncorrelated with that of other asset classes in the investors’ portfolio.
Granted, I don’t know how uncorrelated venture capital returns are with the remainder of the portfolio of the typical institutional investor. But that would be an interesting number that would help to determine whether institutional investors should divest from VC or not.
Georges van Hoegaerden to sakky:
The point is that venture capital should outperform any other asset class, by virtue of technology buyer Greenfield, immediacy (by internet distribution), and entrepreneurial resources available.
It’s quite embarrassing to compare it to 100-year old asset classes with quite mature underlying metrics and use the “best-of-the-worst” as a measuring stick.
Venture capital should be measured on its gaping opportunity (its total addressable market), rather than asset classes with completely different risk profiles and return expectations.
sakky to Georges van Hoegaerden:
I’m not sure that I can agree that venture capital must always outperform any other asset class, or should be judged as such. In principle, an asset class can provide financial value through diversification – entailing non-correlated returns with other asset classes – even if its absolute returns are subpar. The vast majority of the capital provided to the VC industry comes from institutional investors, and, whether we agree with it or not, those investors prize diversification. Indeed, that is why many such institutional investors invest in gold, timber, art, and myriad other asset classes not because their absolute returns are necessarily the highest but because they purport to offer diversification. {Whether those asset classes actually provide such diversification is an entirely different question.}
Now, if somebody could demonstrate the venture capital provides poor absolute returns *and* poor diversification, then that would indeed be a serious indictment of venture capital as an asset class. But poor absolute returns *alone* doesn’t quite prove that case.
After all, most new technologies fail, most entrepreneurs fail, many (probably most) greenfield projects fail. It’s therefore not clear that we should a-priori expect that venture capital must necessarily enjoy above-average returns. An uncorrelated return might well be enough to justify VC as a viable asset class.
Georges van Hoegaerden to sakky:
Asset managers deploy top-level diversification as they do in multiple asset classes today to manage their risk. But they should not deploy bottom-heavy diversification, in venture capital consisting of more than ten levels, to managers they explicitly hired to understand the risk in the sector. Bottom-heavy diversification is a sign of having hired the wrong managers.
The risk deployed in venture is excessively diversified and fragmented, and chock full of collusion deploys the antithesis of risk needed to drive outlier success. And once the whole value-chain of money deployed to a sector is diversified to the nth degree, no one can or everyone should be held accountable by what Joe Dear (RIP) of CalPERS called, the worst asset class as far as returns.
And the diversification of risk, thanks to the mindless swirling of inevitable consequences, is getting worse, not better.
sakky to Georges van Hoegaerden:
For the purposes of elucidating whether venture capital is a worthy asset class for asset managers, the relevant issue on the table is not what asset managers *ought* to want, but what they *actually* want. And the fact is, asset managers want not just absolute returns but also diversification. So long as venture capital is delivering diversification, then the absolute returns that venture capital produces becomes less important, at least from the point of view of the asset managers.
Now, if you want to argue that asset managers ought to change what they want, then you should take it up with them. But until they actually agree to enact such a change, then venture capital may continue to be a viable asset class for those asset managers primarily through the deliver of diversification even if the returns are subpar.
Georges van Hoegaerden to sakky:
My point is asset managers want outlier returns from a sector to which they deploy outlier risk. They have not gotten those returns, fewer than 35 VC firms produce sustainable venture style returns, less than 5 monolithic to venture is my assertion. So, they are not getting either.
Risk equals returns. And thus they must change the construct of their deployment of risk top-down if they want to see change or bite the bullet they’ve been biting for the last 15 years and be prepared to lose the one-digit percentage of total assets under management.
As the author says: the enemy of better performance is “themselves”.
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Bryan Hassin:
This is crazy talk. If you make VC pay contingent on performance, you’d be asking VCs to do something with which they are not at all comfortable: take risk!
Georges van Hoegaerden to Bryan Hassin:
In all fairness, the problem does not just lie with VC. It is bigger than that.
The value-chain of distribution of money and risk from asset manager to venture capitalist to entrepreneur consists of ten levels of bottom-heavy diversification (read avoidance) of risk.
No adjustment to merely the dials at the bottom of that value-chain will make up for the avoidance of risk that has turned venture capital into venture trading.
The risk profile deployed by the aforementioned mechanism is incompatible with the pursuit of risk that makes a startup become an outlier. Let alone the risk deployed by general partners who cannot even envision a better future for themselves or their start-ups.
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Srikanth Rajagopalan:
This is a surprisingly one-sided view of venture capital – as merely an investment vehicle.
VCs provide entrepreneurs capital that allows them to build businesses without having to worry about short-term profitability.
At least that’s the theory.
As an erstwhile entrepreneur, I’ve been frustrated by how little VCs care to understand the business, and their inability to stay invested for the long term. A typical VC firm has a 7 year investment horizon. By year 5 they’re pushing the entrepreneur to show a path to a 5X – 10X valuation. At a time when the entrepreneur should focus on creating long term value, the investor has the opposite incentive – short term valuation, driven by a need to show spectacular exits to the LPs who view VCs as nothing but an investment vehicle.
For every successful startup that is today a big organization, there are perhaps a hundred failed startups that were pushed by VCs to sacrifice value creation for valuation.
Frank to Srikanth Rajagopalan:
Entrepreneurs aren’t a VC’s customer, people like the author are – she’s one of their investors. As Dan Primack has noted, entrepreneurs are the *product* of the venture industry.
Georges van Hoegaerden to Frank:
Subprime entrepreneurs are the product of venture’s continued sub priming. Subprime entrepreneurs and subprime investors are made for each other. Prime entrepreneurs succeed despite not because of venture capital. Elon Musk is a great example of that.
The theory determines what can be observed (Einstein), and I am more worried about the trashing of false negatives that do not fit the mold of subprime venture capital than how much money we (all) lose. Cultural destruction of innovative capacity we took years to cultivate is a more serious implication of the Silicon Valley emperors continuing to lose its clothes.
But venture is fixable when we build a system that forces it to deploy risk, rather than to avoid it. Held accountable by a meritocracy it lacks today.
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Sabre Collier:
but aren’t the VC returns much better in emerging markets, such as sub-saharan Africa? nevertheless, in any market, high fees are only justified by high returns to investors
Georges van Hoegaerden to Sabre Collier:
The point is: by virtue of Greenfield, an immediacy of impact (the internet as distribution) technology innovation supported by venture capitalists should outperform any (100-year old) asset class by a long shot.
It doesn’t. It underperforms corporate innovation AND underperforms the rate of technology adoption. Which means the arbiter that decides what innovation gets to see the light of day is broken.
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