A clash of incentives within VC

LPs vs GPs vs junior VCs

The incentives of Limited Partners (LPs), General Partners (GPs), and their employed investment team members don't always align. Many GPs aim for short-term growth of assets under management (AUM), whereas it's common for junior VCs (employed investment team members) to push through as many "hot" deals as possible, an approach that enables them to possibly later associate themselves with high-profile outcomes.

VCs earn a performance-based carried interest (the "carry"), typically 20% of profits after LPs have recouped their initial investment, along with an annual 2% management fee on the AUM for each active fund. Throughout the last bull cycle, and especially towards the end, we saw an increase in the number of mega funds, and teams that expanded their head-counts significantly. The overarching incentive among many of these firms was clear: grow the firm's AUM and collect a higher management fee.

Although the above is the standard model today, Sequoia has reportedly deviated from this norm on several funds, restructuring their management fee as a function of deployed capital rather than committed capital. According to Reuters, "The changes in the fee structure, communicated to investors in December, allow LPs who committed capital to Sequoia's crypto and ecosystem funds launched early last year to pay management fees based on capital deployed, rather than the common model of capital under management that applies to other Sequoia funds." Regardless, there is still a clear incentive to deploy capital sooner rather than later, such that the 2% is applied to a larger sum. 

Leading up to 2022, up-rounds were far more common than they are today, even when actual growth and progress at the individual company level hadn't necessarily been achieved. It seemed as if everyone's portfolio was being marked up left and right, sometimes just months or weeks after their initial investments. This resulted in many firms indicating strong paper-returns, enabling them to raise larger subsequent funds much sooner than expected.

With more capital under management, more must be deployed, leading to team growth and increased deal velocity. Some firms managed to reduce their deployment periods from typically three years to just one year.

Junior investment team members often have a small, if any, share of the carry, and unlike GPs, they aren't required to commit capital to the fund. They typically lack meaningful "skin in the game," despite being the ones to spearhead sourcing and diligence efforts, as more senior team members often play a less active role in these activities. VC is a power-law driven asset class, where a small number of investments tend to drive the majority of a fund’s returns. The more attempts made, the higher the likelihood that a few will become high-profile deals in the future. Therefore, the desire among junior VCs to optimize the number of deals done is understandable. But as with most things, quantity often comes at the expense of quality.

The objective isn't only to do more deals but also to do more “hot deals," i.e., deals that are very competitive to get allocations in. This is somewhat counterintuitive given that outlier returns are often generated by ideas that, at the time of initial investment, are non-consensus. However, given how long it can take to know whether an investment will yield a meaningful return, knowledge of, and access to competitive rounds have emerged as proxies for investment acumen. Judging by the past few years, this seems like a questionable proxy. 

This situation, combined with the focus on both personal brand/reputation and short-term compensation, creates a disconnect between the incentives of junior investors and the capital entrusted to their firms by LPs.

Add to this the noise surrounding certain hyped trends, which further enabled an environment for firms to rapidly deploy capital. Themes like web3 or, more recently, “AI," have seen an influx of capital, sometimes with minimal scrutiny. Some firms even repositioned themselves overnight to align with the current trend de jour.

All this reminds me of a line in a memo by Howard Marks of Oaktree Capital Management where he discusses trading. Although the context in which he wrote it is slightly different, I believe it has relevance here as well: "When I was a boy, there was a popular saying: Don’t just sit there; do something. But for investing, I’d invert it: Don’t just do something; sit there."

It seems like the industry is waking up to this. During 2020 and 2021, a lot of capital was deployed at unsustainable rates and at peak valuations. What looked like top-decile paper returns for many firms are now fading as an increasing number of startups are either shutting down, being sold for parts, or raising down-rounds. Rapid capital deployment as a means to getting to the next fund sooner no longer works as it used to.

What's the solution to this potential misalignment of interests? I don’t have the answers, but for the time being, perhaps those firms that exhibit the highest alignment of GP/LP interests are those deliberately opting for modest fund sizes, operating with lean teams, and distributing ownership in a manner that makes it challenging to detach from any specific deal. A consistent emphasis on quality and a long-term orientation across the entire portfolio remains key in such formats.