VC and private equity compensation is typically paid out using a 2 percent annual management fee on capital committed to the fund and 20 percent of the profits each time a portfolio company is sold. It is known as the 2 and 20 model. According to National Venture Capital Association, 2-and-20 has indeed stood the test of time and seems to be the right mix for the majority of firms and LPs.
There is a problem in the intersection of the 2 percent part of that equation and large venture funds, however. For example, a fund with $1 billion in capital can generate $20 million in annual management fees to a venture firm, completely independent of the quality of investments in the fund.
Kauffman Foundation Report
Kauffman Foundation published a report in May 2012, titled “We Have Met the Enemy….And He Is Us” on the state of the Venture Capital market with a focus on the GP-LP relationship. This analytical report highlights a series of lessons from 20-years of venture investing by the Foundation. The report received a lot of coverage in the media and should be required reading for those interested in the venture ecosystem.
One of the major conclusions from the report is that the 2-and-20 compensation structure for venture capital funds is a one-size-fits-all approach that mis-aligns incentives and can help VCs to get paid handsomely while their funds perform abysmally.
Some of the respondents interviewed for the report said they’d be amenable to changing how they’re compensated, and there’s even some realization within the industry that 2-and-20 has created bad incentives.
Possible new compensation structure
For high-demand funds, a new compensation structure could actually help them generate even more profits. For example, a top fund could hold an auction that initiates a bidding war between would-be investors, perhaps generating a 30 percent cut of profits on exits instead of 20. That would then potentially enable the fund to decrease the 2 part of the equation and better align its own priorities with those of its investors.
According to the report, the industry may move toward a ‘budget-based’ replacement for the 2 percent management fee. Under this scenario, Venture Capitalists would agree to manage a fund for a fixed cost that covers salaries, rent and other overhead items, which would remove much of the incentive to raise larger and larger funds.
As for the 20 percent payout, a better structure would pay VCs a percentage of profits only after the fund’s returns exceed an agreed-upon public markets benchmark. In this model, a fund that generates returns 3 percent greater than a public benchmark could take a 20 percent cut of profits for itself. If returns exceed public markets by 6 percent, for instance, the fund could take a 25 percent cut of profit.
However, investors in venture funds are afraid that if they become vocal about changing VCs’ compensation structure, they’ll get frozen out of the best funds. Negotiating a departure from 2-and-20 with one venture investment may invite questions as to why LPs didn’t negotiate similar deals with all the venture funds they plow cash into.
The commitment to 2-and-20 remains, and unless there’s an outcry from LPs, there’s little reason to think it will change.
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