Venture Capital Notes

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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:
* They won’t push it too far because of reputation and because they care about carried interest because they relies solely on performance * Incentives to be too conservative in order to raise future funds * Will not be able to afford a new fund in five years if you underperform – makes GP’s more conservative – LP’s will want firms to take on some risk to gain higher returns * all of these are agency problems – principal/agent problems * Transaction fees

* Wall street Journal Article:
* On average LBO funds can expect to collect $10.35 in management fees for every $100 they manage, slightly more than half as much $5.41 for every 100 dollars comes from carried interest (just the average, a top performing firm would have much larger carried interest) * This should be the opposite, carried interest should be the bulk * Reasons for this: management fees are too high and carried interest is too low – bad news for LPs * Wall street journal suggests that they simply do not have the bargaining power and that is the answer for why VCs aren’t having lower mgmt. fees * Private equity firms have a lot of bargaining power because they outperform the public markets so they don’t have to reduce management fees * Variable Fees:

* Carried interest
* Monitoring for exit transaction fees (buy-outs)
* Fixed Fees:
* Mgmt. fees
* Entry transaction fees (only for buy-outs)
* Compensation Structure must be designed so that VC’s have incentives * GP compensation is a function of fund performance
* Issues in in PE compensation (cont.) :
* Unintended risk-shifting incentives caused by the standard mgmt. fee + carry compensation structure * Limited downside because they receive mgmt. fees regardless of performance, and if they can increase the volatility in the portfolio they can increase the value, and they take more risk * Incentive to...
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