William Cohan’s recent cover story in Fortune argued that “a reckoning is coming in the tech world.” That prediction may or may not come true, as research shows that even expert forecasts are often wrong. But whether or not Cohan’s prediction is correct, high enterprise valuations and IPO problems won’t affect the VC or private equity industries very much.
That’s because investment managers long ago mastered an important skill—the ability to gather assets under a compensation structure that makes them money almost regardless of how their investments perform. Here’s how it works.
As everyone knows, VCs and private equity funds—the two are often lumped together in both industry reporting and academic research—collect 2% on all assets under management, and 20% of the gains the funds earn.
For many reasons, including low interest rates on fixed income investments, inconsistent stock market returns over the past decade, and effective marketing of their products, the alternative investment industry has been on a tear. According to Prequin, which publishes research on the industry, private equity and venture capital assets soared from some $1.2 trillion in December 2008, to $2.6 trillion in June 2014, an increase of more than 100% in just six years.
Two percent of the $2.6 trillion asset base is $50 billion in fees collected each year. No wonder that managers of alternative asset funds are among the most highly compensated people on the planet.
VC and private equity also seem firmly planted on a path to expansion, notwithstanding California’s pensions system’s decision to reduce its exposure to alternative investment products. Prequin’s report notes that “investor appetite for the asset class remains robust and many LPs (limited partners) are below their target allocations.” And in 2014, 994 funds raised more $495 billion—that’s half a trillion dollars—in just one year.
Moreover, research suggests that VC compensation is not highly related to fund performance. For instance, a study of 419 venture capital partnerships formed between 1978 and 1992, co-authored by Harvard professor Josh Lerner, reported that the mean level of “base” compensation—management fees—averaged around 18%, while the sensitivity of compensation to performance—the amount total compensation grew if the asset growth rate went from 20% to 21%—was only about 4.5%. The study concluded that there was “no relation between incentive compensation and performance,” and noted that base fees—the fees for overseeing assets not tied to performance—“are a significant fraction of venture capitalist’s compensation.”
But does performance affect the ability of funds to attract (and retain) assets?
Although research coauthored by University of Chicago professor Steven Kaplan shows that “better performing partnerships are more likely to raise follow-on funds and larger funds,” it is nonetheless the case that there are diminishing returns to performance, “so top performing partnerships grow proportionally less than average performers.” In other words, many funds are able to raise capital effectively almost regardless of their relative performance.
Cohan’s analysis in Fortune focused on the poor performance of companies such as Twitter, Zynga, Groupon, and others whose stock prices have tanked after going public. But this share price decline is a problem only for those who bought at the public offering or invested shortly before the companies went public. Typically, VC investments are made early in companies’ development and at much lower valuations. Therefore, VC—and for that matter, early employee—returns are stunningly wonderful whether the equilibrium enterprise value turns out to be $10 billion or “only” $2 billion. When I recently asked a former Stanford student now running his own small private VC fund how he could afford a house in one of the most expensive areas of San Francisco, his reply was that he had a job running the Indian operation for Zynga for a while. His options earned him a lot of money, notwithstanding Zynga’s subsequent struggles.
And lest you think that liquidity concerns constrain the ability of private investors to get their money out of alternative investments, there are markets to trade both unregistered securities and interests in VC portfolios.
Because of the soaring value of assets under management and a compensation structure that bases rewards on the amount of those assets and not just performance, partners in the VC and private equity world enjoy enormous pay packages, with little sign of trouble on the horizon. Commentators need to not confuse what happens to VC’s and their counterparts with what happens to those who buy investments as the VC’s are exiting.
Jeffrey Pfeffer is Thomas D. Dee II Professor of Organizational Behavior at the Graduate School of Business, Stanford University. His latest book is Leadership BS: Fixing Workplaces and Careers One Truth at a Time.