A compensation scheme masquerading as an asset class

Since leaving my job in the hospital, I've had many chances to advise new start-ups on their strategies and business prospects.  I've met thoughtful and interesting people with ideas and technologies that have the potential to improve patient care, assist in managing data in the health care arena, empower individuals, bend the health care cost curve, and the like.  Some, though, are just flying in outer space, unguided, with a clever idea that has no commercial potential.

I've also had a chance to view the interaction between those folks and potential venture capital investors and to meet a number of the VC folks.  Again, many are thoughtful and intelligent, with a clear sense of investment strategy, managerial and governance skills, and excellent due diligence capabilities.  Some, though, are also flying in outer space, unguided, with poor commercial acumen and not likely to serve their investors well.

Back in May, my observations about the latter groups of entrepreneurs and venture capitalists were confirmed by a report prepared by the the Ewing Marion Kauffman Foundation.  Entitled, "We Have Met the Enemy … And He is Us," it is based on a comprehensive analysis of the Kauffman Foundation's more than 20 years of experience investing in nearly 100 VC funds. The summary:  Over 60% of the firms failed to receive returns that were available from public markets; 78% did not achieve returns "sufficient to reward us for patient, expensive, long term investing;" only 20% generated returns that beat a public-market equivalent by more than 3 percent annually; and "only four of thirty venture capital funds with committed capital of more than $400 million delivered returns better than those available from a publicly traded small cap common stock index."

In this article, the Foundation lays out other conclusions and offers advice to the institutional investors that serve as the major source of funds for VCs.

The authors call upon institutional investment committees to require deeper due diligence of VC investments and more rigorous data analysis of VC portfolio performance relative to the public markets. The authors also urge limited partner investors to charge more for providing capital to risk assets by insisting on preferred investment returns before sharing profits with general partners – as is often the practice with buyout and growth investment firms. 

"Investments in venture capital funds should be measured against the naïve alternative investment – publicly traded small company stocks," said Diane Mulcahy, director of private equity at the Kauffman Foundation and the paper's lead author.

So where is the money going?  To compensate the VC managers!

The Foundation found that the most significant excess returns earned from venture capital occurred in funds raised prior to 1996, and those funds averaged $96 million in committed capital. Many of those successful funds led managers to raise successively larger funds; which significantly eroded returns and maximized general partner profits through fee-based income at the expense of limited partner success.

"The result is that institutional investors end up paying general partners – who typically commit only 1 percent of partner dollars to a new fund while LPs commit the remaining 99 percent – quite handsomely to build funds, not build companies," said Mulcahy. 

As the report notes:

The most significant misalignment occurs because LPs don’t pay VCs to do what they say they will—generate returns that exceed the public market. Instead, VCs typically are paid a 2 percent management fee on committed capital and a 20 percent profit-sharing structure (known as “2 and 20”). This pays VCs more for raising bigger funds, and in many cases allows them to lock in high levels of fee-based personal income even when the general partner fails to return investor capital.

This prompted a colleague to say to me, "So this is really a compensation scheme masquerading as an asset class."

Health care is now viewed as the "live" investment arena, and in a low-yield environment, there is a lot of cash sloshing around looking for a better return.  Portfolio managers should understand risk-reward tradeoffs, but they should also look at the underlying investment strategy, cost structure, and incentive structure of specific VCs.  What appears to be a particular risk-reward profile of investments may be offset by internal structural agreements that shift risk away from the VC firm and onto the investor.  What appears to be a particular risk-reward investment profile may also be offset by a tendency to place easily available money in firms that really offer very little potential for commercial success.

It does the health care world no good to have gobs of money go to intermediaries and new ventures that have no real potential.  There are some great entrepreneurs and great VC firms out there.  It is worth taking the time to find them.