The fees that LPs pay to venture capitalists will only change if a top-tier VC fund volunteers to give its investors a discount.
We’ll never know what would have happened had Andreessen Horowitz taken a different tact with their donations to charity announcement and instead offered their investors a discount on fees. Fees and creating the right incentive alignment between LPs and GPs remain a lightning rod in the illiquid alternative universe in which venture capital operates. Had AH dropped their fees and carry by half to a 1% fee base / 10% carry vehicle (assuming this got them to their “1/2” target of donations); it would have been the Waterloo which would force other VCs to react and thereby changed that industry forever – a bigger deal by far than the Instagram exit.
GPs don’t currently compete on pricing; groups that offer discount are instead viewed as signaling that they are of a lower quality and are unable to attract LP commitments. If a group of AH’s caliber and reputation had offered a discount on fees and carry, other GPs, given the tough fund raising environment, would have been forced to react.
Instagram and Charity
There are two types of investment mistakes a fund can make; they can write a check into a company that turns out to be a bad deal (believe the deal is good, deal turns out to be bad), a classic Type 1 error in statistics. The other kind of mistake is to pass on a deal that turns out to be good; one of my favorite professors at Kenan Flagler would reminisce about how he had passed on investing in AOL while at USVP. This is a Type 2 error – you believe the deal is bad and it turns out to be good.
Most VC Type 2 errors never see the light of day. It is difficult for LPs to diligence which deals a GP has passed on, and usually the timeframe it takes to get proven wrong prohibits that information being relevant to any investment in a new fund.
Andreesen Horrowitz’s decision to not re-up with Instagram due to similarity to a sister portfolio company is completely reasonable and happens all the time. It was a good business decision which prevented a good financial decision from becoming a great financial decision. It is unusual for that bad decision from a financial standpoint to arise so quickly and publicly; the New York Times article thoroughly walked through that impact shortly after their $1 Bn exit to Facebook. Afterwards AH did some unusual things, which is not shocking given that they have been an unusual GP since their inception.
The first unusual thing they did was talk about the deal – most GPs would simply have kept their mouth shut (this would have been my advice to them).
The second was that they simultaneously announced that several of the founders and their families would be giving a significant portion of their earnings from their funds to charity. This appeared to be something that had been in development for quite some time, however, with the timing of the announcement it also looked like AH was trying to use this to combat any negative press from the Instagram / NY Times article.
I am not personally an LP in AH, nor have I had any on-the-record conversations with LPs who are; however, if this were me on an LP advisory board and a fund did something similar, it wouldn’t sit well. The GP is basically saying, “we’re going to make so much money off of this vehicle, that we are going to announce right now that we don’t need all of it.” In that circumstance, it would seem wise to perhaps offer a discount, or reduction in fees, to the investors (aka customers) who put you in business in the first place.
The timing of this announcement also seems poor; if I were an LP that had just committed to AH’s most recent, much larger fund, I would want to have learned about this decision prior to making a commitment to their fund. If this had been in the works for a while, it would have been a good item to share and a major signal to LPs who may now be in the position of explaining this commitment to their investment committees. For all I know, AH did all of the above, offered fee discounts, etc. and their LPs were fine with it.
Change VC Fees Forever
GPs don’t compete on pricing. Having personally reviewed over 2,000 funds, any group that attempted to provide their LPs a discount as an incentive to invest merely wound up signaling that they were a lower quality group. It was extremely unusual to see groups charge less than 2/20; I recall fewer than five – none of which were able to raise a fund to my knowledge. For different types of entities, such as co-invest or special purpose vehicles, other fee structures such as 1/5 or 1/10 are more common.
AH missed a golden opportunity to change fee discounting from being a negative indicator of quality to an opportunity for their LPs to make their own, tax-advantaged commitments to charity. For those charities that are LPs, this clearly would have been attractive.
AH’s impact on the Valley’s venture capital landscape has been significant. They are a new entrant who has raised significant capital, attracted top tier partners with long histories in the market and done so during a time period when most of their peers are struggling to raise money. They did this not by rising through a firm and growing from principal to partner and showing long maturation over time, but by bringing fresh new ideas to an industry that has been resistant to change. Other GPs are clearly intimidated by their ability to attract the top companies and also significant investments. Had AH changed their compensation structure, other funds would have been forced to react to that change and the ripple would be dramatic.
Hopefully another opportunity presents itself to change how that industry is compensated and another GP of AH’s caliber will be able to act on it.