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02/20/2006

Hedge Funds, Venture Capital and The 25% Solution

If you put your ear to the ground on Sand Hill Road these days you can just hear them.  They are the faint rumblings of a potentially massive sea change in the venture capital industry.  Originating, of all places, on the east coast and traveling across the country at an ever quickening pace, the epicenter of these rumblings can be found somewhere between 40th and 60th Street on the east side of Manhattan.  Those familiar with commercial real estate trends will recognize that this epicenter just happens to correspond with the world’s largest concentration of hedge funds.  The correlation is no coincidence.

Hedge funds now have hundreds of billions of dollars under management and increasingly fewer public places to put them.  As the buyout industry has already discovered, this over supply of capital is rapidly spilling over from the public world into the private world and causing all kinds of disruptions in the process.  The supply of capital is such that the hedge funds are not likely to stop with buyouts, indeed it’s only a matter of time before they start making their presence felt in the venture capital market.  Very quietly some initial beachheads have already been established by a number of hedge funds, such as DeShaw.  More funds are rumored to be following in their footsteps and there are several examples of funds dipping their toes in the late stage end of the VC market a bit lately.

Inside their cozy, redwood-lined conference rooms, most West Coast VCs are either too insulated to hear the distant rumblings or convinced that this is just another wave of hapless VC carpet baggers destined to quickly fall upon the clubby ramparts of Silicon Valley.  However most of the VCs don’t realize that hedge funds have no intention of storming the gates with a bunch of ex-traders in black Armani suits, rather they intend to “hollow out” the best VC firms with a powerful weapon heretofore unknown in Silicon Valley: the 25% solution.

A Simple Question of Economics
The economics behind Venture Capital partnerships are pretty simple.  The baseline fee structure in the industry is a 2% management fee and a 20% share of any profits (known as the carry).  The best firms get a 3% fee and a 30% carry.  A few rare birds do even better than that.   While some firms split the profits equally between the partners, most skew the GP split to favor the more senior (though not necessarily the most successful) partners.  Because, due to the time intensive nature of venture investing, it is not easy to generate a lot of operating leverage at VC firms, there tends to be a high correlation between the assets under management and the number of partners in a firm.  As the number of partners and the assets under management grow, the ability of any one return to really “move the needle” in terms of generating significant profits diminishes significantly while the return of the overall portfolio becomes much more likely to just hit the average return of the category. 

What this means is that growing assets under management is a double edged sword for most VC firms because it inevitably leads to greater dilution and lower returns.  This dynamic dictates that as firms grow in size, the senior partners tend to become much more attuned to the management fees than to the carry because they typically have direct control over the management fees and can basically dictate an outsized annuity to themselves in the form of disproportionate management fees, while convincing the junior partners that they are not being too greedy because there is not a huge difference in the GP profit split.  If you are wondering why many VC firms seem to be rapidly increasing assets under management and building bigger partnerships even though it appears that the industry already has more than enough capital, wonder no more, this is the answer.

Now there is nothing inherently wrong with this structure (many partnerships tend to work like this), however it has in many ways help create a huge opening for hedge funds to get into the business.

A Different World
The economics in the hedge fund industry are very different from venture capital.  While the standard fees charged by hedge funds are somewhat similar (a 1-2% management fee and around a 20% carry) there is a lot more variability reflecting the much more diverse set of investment approaches and managers.  Some program trading funds charge less than average because they are designed to deliver single digit returns with very little risk, while some other funds charge significantly higher fees either due to past performance or the dynamics of their particular niche.  For example, one of the most successful long/short equity funds charges no management fees, but a 50% carry.

What’s perhaps most important about hedge funds relative to venture funds is how hedge funds allocate ownership of the profits.   Unlike venture funds, hedge funds tend to be much more closely held with 100% of the profits often held by just a few individuals and in many cases held by just a single founder.  Hedge funds can get away with this inequality for several reasons:

  1. They generate mostly short term gains so there are few tax benefits to owning a piece of the general partner vs. just getting a large bonus.
  2. They have much greater operating leverage than VC funds because they can often profitably invest tens if not hundreds of millions in a single investment idea and because they take no operating role in their investments, the average PM can manage a much larger number of ideas than the average VC.
  3. They offer, in comparison to VC funds, very generous profit sharing splits to their Portfolio Managers. (PMs are the hedge fund equivalent of a VC partner)

The 25% Solution
From a practical perspective what this all boils down to is that hedge funds can offer an individual PM around a 25% share of the profits they generate on “their portfolio”.  While some PMs get more and some get less, 25% is roughly “market” right now.  This profit share compares very favorably to most large VC funds where the share of profits is generally smaller.   In fact, a 25% share of the profits is probably a higher share of the profits than many of the best known partners at the best known VC firms receive.  Even better, these profits are typically paid independent of other PMs and on a “rain or shine” basis meaning that PMs are paid their profits independent of how the overall firm does which enables them to be paid their full share even if some of the other PMs in the fund didn’t pull their weight.  Finally, there are generally no clawbacks in hedge funds, which means PMs never have to worry about paying back profits should future performance turn sour.

Compare this to VCs who almost always have “communal” carry where one partner’s poor performance can significantly reduce or eliminate the profits for the all the others and where the threat of clawbacks is very real and it’s easy to see that for a VC willing to bet the farm on their own performance, the 25% solution is likely to look very attractive.

The true beauty of the 25% solution is that it is infinitely replicable and results in no incremental dilution to the GP.  Thus the founder or founders of the hedge fund can grow assets to the moon and still have a 75% share of profits.  Therefore what looks to be an very generous profit share from a single VC’s perspective is actually still heavily skewed to the founders.

The Opportunity
Putting two and two together, it is easy to see how hedge funds could rapidly gain a major presence in Silicon Valley.  Not only do they have the capital, but they have the economics that should allow them to recruit many of the top performing partners, especially the younger generation of “up and coming” partners that are on the losing side of the fee and profit skew.

The ironic thing is that most hedge funds will probably do this as almost an afterthought.  With some funds having gross exposures in the tens of billions of dollars, they could dedicate just a few percent of their assets to venture and become a major player overnight.  While the direct returns on such funds probably wouldn’t move their own needles, the private market information flow that the hedge funds would gain access to could be worth a few hundred basis points of edge on their public holdings, which is nothing to sneeze at when your are levered 2-1 on $10BN.  Thus, the day a hedge fund walks down Sand Hill Road offering the “25% solution” is the day that those rumblings of change might just become a full blown earthquake.

February 20, 2006 in Venture Capital | Permalink

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The thoughts and opinions on this blog are mine and mine alone and not affiliated in any way with Inductive Capital LP, San Andreas Capital LLC, or any other company I am involved with. Nothing written in this blog should be considered investment, tax, legal,financial or any other kind of advice. These writings, misinformed as they may be, are just my personal opinions.