Are VCs incentivized to lose money?  This is the provocative assertion made recently (and again) by Kaufman Foundation Senior Fellow Diane Mulcahy in the Harvard Business Review.  Some of us who are interested in this issue probably recall the equally incendiary piece she co-authored in 2012 for KF boldly entitled “We Have Met The Enemy… And He Is Us”.

In a nutshell, Ms. Mulcahy contends that the VC industry has performed terribly for more than a decade, but individual VCs are nevertheless richly compensated because of asset based management fees. She cites performance data from Cambridge Associates showing the VC asset class underperforming the S&P 500, NASDAQ and the Russell 2000 in all periods over the five years ended December 31, 2013.

Some commentators have questioned the reliability of the data cited by Ms. Mulcahey and thus challenge her premise that VCs have underperformed the major indexes.  Dan Primack of Fortune.com, for example, contends that the 93 VC funds in the sample constitute less than 25% of the total number of funds raised in the years covered (2009 -2011), and since Cambridge Associates will not disclose the names of the included funds, there is no way of knowing whether the sample is skewed toward the larger funds whose performance tends to trail that of smaller funds.   In any event, although VC performance has lagged large and small public company indexes in all periods over the five years ended December 31, 2013, the Cambridge Associates study also shows that venture has significantly outperformed public equities over the longer term.

At the heart of Ms. Mulcahey’s indictment is the annual management fee that almost every GP receives, which is typically 2% of funds committed (which often shifts after the expiration of a three-four year investment period to 2% of investments held).  Although funds also pay GPs carried interest of usually 20% of profits, this fee is directly tied to investment performance, is seldom earned and not paid until several years after the fund is raised.  Ms. Mulcahey argues that the management fee distorts incentives and misaligns interests between GPs and LPs, particularly as fund size increases.  She contends that the management fee motivates GPs to seek to raise larger funds to generate higher management fees.

“Given the persistent poor performance of the industry, there are many VCs who haven’t received a carry check in a decade, or if they are newer to the industry, ever. These VCs live entirely on the [management] fee stream. [Management] fees, it turns out, are the lifeblood of the VC industry, not the blockbuster returns and carry that the traditional VC narrative suggests.”

 “VCs have a great gig. They raise a fund, and lock in a minimum of 10 years of fixed, fee-based compensation. Three or four years later they raise a second fund, based largely on unrealized returns of the existing fund. Usually the subsequent fund is larger, so the VC locks in another 10 years of larger, fixed, fee-based compensation in addition to the remaining fees from the current fund. And so on.”

All this, it seems, is a vindication of the smaller VC fund model.  Smaller funds deliver superior results at least in part because their GPs cannot rely solely on the 2% management fee and remain highly incentivized to create profitable fund returns.  This is particularly the case with respect to GPs with meaningful skin in the game in the form of larger capital commitments (i.e., higher than the 1% benchmark).  Conversely, large fund GPs can earn significantly greater compensation per GP partner from the 2% annual management fee and are theoretically less motivated by the prospect of carried interest.  Another point here is that inasmuch as large funds need to return billions of dollars to beat the indexes, there is a perverse incentive for them to go for home runs in the form of billion-dollar exits, and thus the specter of spectacular losses is far greater.

The incentive  to create larger funds only exists if the number of the fund firm’s partners remains the same: higher management fee dollars spread over the same number of partners equals higher management fees per partner.  But the reality is that VC funds don’t scale very well (which is ironic in that VCs seek to invest in companies that do).  The reason is that, assuming the number of GP partners remains the same or doesn’t grow proportionately with any increase in LP committed capital in the fund, a larger fund will either have to invest more dollars per portfolio company (and keep the number of portfolio company investments the same) or invest in more portfolio companies.  The larger investments strategy would necessarily mean later stage companies with much higher valuations and lower reward potential.  Conversely, investing in more portfolio companies would mean less GP partner time that could be devoted to each portfolio company which in turn theoretically means less value to the companies.

So, can the VC industry innovate from within by creating fee structures that better align the interests of LPs and GPs while still preserving enough incentives for VCs to create funds and invest in innovative young companies?  The reality is that innovation is not likely to originate with the LPs, even though they seemingly have the most to gain from reform, because there remains enormous competition to get into the top performing funds which tend to be oversubscribed.  LPs would rather stay silent on the management fee issue than risk being shut out of those funds.  Reform is not likely to originate with GPs either, and not only because it would be against their self-interest to reduce their management fees.  There’s a sort of Catch-22 for non-brand name fund organizers, who believe offering a lower percentage management fee or some practical, budget based fee would convey an impression of inexperience or undesirability, and make it more challenging to raise a fund.