Imagine that a real estate agency charged you a management fee just for listing your property, independently of whether it managed to sell it. You might worry that the agency won’t work hard enough to sell your property, as it would collect a fee regardless. You might even worry that the agency would focus more energy on finding more properties to list, in order to collect more fees, than on selling yours. That’s why most real-estate agencies operate on a “no sale, no fee” basis.
Unlike real estate agencies, venture capital firms make money regardless of their results. Over the life of a ten-year fund, the VC firm collects a total of around 15% of the fund’s size in management fees, at a rate of 2% a year during the first five years and 1% afterward. From a typical $100-million fund, for example, the VC firm collects $15 million in management fees.
A great way for VC firms to make more money is to raise a new, separate fund quickly after the previous one. And that’s exactly what they do: On average, VC firms raise a new fund every 2.25 years. This has led to the rise of mega-VC firms. Andreessen Horowitz, currently the world’s largest VC firm, raised a multitude of funds for a total of $35 billion during a seven-year period. In just one year, the record-breaking 2021, it raised “a $4.5 billion crypto fund, a $5 billion growth fund, a $2.5 billion venture fund, and a $1.5 billion bio fund.” The firm collects half a billion dollars a year just from management fees. Sequoia Capital, the second-largest VC firm, has raised $28 billion across several funds so far and also collects hundreds of millions in management fees every year.
The administrative costs of running each extra fund aren’t too high for the VC firm, so much of the additional management fees translate into profits. In his book Venture Deals, venture capitalist Brad Feld explains, “Although venture capital firms tend to grow head count as they raise new funds, this isn’t always the case and the head count rarely grows in direct proportion to the increased management fees. As a result, the senior partners of the venture capital firm see their base compensation rise with each additional fund.”
Receiving such a high compensation independently of results has made a lot of people doubtful of VCs’ incentives. Businessman Charlie Munger explained:
Back in 2000, venture-capital funds raised $100 billion and put it into Internet startups — $100 billion! They would have been better off taking at least $50 billion of it, putting it into bushel baskets and lighting it on fire with an acetylene torch. That’s the kind of madness you get with fee-driven investment management. Everyone wants to be an investment manager, raise the maximum amount of money, trade like mad with one another, and then just scrape the fees off the top. I know one guy, he’s extremely smart and a very capable investor. I asked him, ‘What returns do you tell your institutional clients you will earn for them?’ He said, ‘20%.’ I couldn’t believe it, because he knows that’s impossible. But he said, ‘Charlie, if I gave them a lower number, they wouldn’t give me any money to invest!’ The investment management business is insane.https://www.wsj.com/articles/BL-MBB-26843
An LP (= investor in VC fund) published a report saying that when you give money to VCs “you get what you pay for,” suggesting that VCs are paid well “to build funds, not build companies.” The report explained:
The most significant misalignment occurs because LPs don’t pay VCs to do what they say they will—generate returns that exceed the public market. Instead, VCs typically are paid a 2 percent management fee on committed capital and a 20 percent profit-sharing structure (known as “2 and 20”). This pays VCs more for raising bigger funds, and in many cases allows them to lock in high levels of fee-based personal income even when the general partner fails to return investor capital.The Kauffman report
In 2022, a Fortune article explained that critics “accuse Andreessen Horowitz of stacking fees, or raising so much money that it can profit off management fees alone without relying on carry—or its cut of the actual performance of its investments. As the firm expands into different areas of the financial markets, its growing catalog of assets should generate ever more management fees.”
If VCs generated good results overall, it would be hard to believe they’d be highly motivated by management fees, as the 20% cut on profits they make from successful investments could be much higher. However, as we saw in another post, the performance of VC funds isn’t that great overall, so management fees are a sizable portion of VC firms’ income. Professor of Law Katherine Litvak studied 68 venture capital funds and found out that “about half of total VC compensation comes from the non-risky management fee.” She concluded, “VC compensation is less performance-based than commonly believed.” Even the founder of a venture capital firm admitted, “Most funds never return enough profit for their managers to see a dime of the 20% carried interest. Instead, the management fees are how they get paid.”
One would think that, in the long run, focusing on management fees and underdelivering to the LPs would be career ending for a VC manager. However, some people have argued the contrary: because LPs “rely on relationships when making investment decisions,” they’re likely to continue working with managers they know even if their past results weren’t great.
High management fees have made some people believe that VCs use questionable tactics to raise more and more funds. Some have even compared them with Ponzi schemes.