Venture capital firms seem to be huge scams

Venture capitalists maintain a heroic self-image even as other elements of the financial services industry have fallen into a degree of discredit. These guys aren’t just shuffling money around — they’re providing the financial sinews of innovation! But Diane Mulcahy of Babson College and the Kauffman Foundation says the entire sector is basically a huge scam.

She points out that the VC sector underperforms all the broad public stock indexes. You’d be better off investing your money in a nice S&P 500 index fund than with a sexy venture capital outfit. It’s less risky, and the returns are higher.

But even though VC funds are a bad bet, venture capitalist fund managers end up doing just fine. That’s because in addition to collecting 20 percent of profits from their investments, they also reap 2 percent of the total quantity of funds under management as fees. Since the nature of the venture capital game is that it takes a long time for the investments to pay off, if you raise a big fund you’ll make plenty of money just waiting to see how things pan out. Mulcahy explains:

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. Assume it takes three or four funds for poor returns to start catching up with a VC firm. By then, investors have already paid for nearly two decades of high levels of fixed, fee-based compensation, regardless of investment returns. And the fee-based compensation isn’t trivial — in all but the smallest funds, the partners make high six, and more often seven, figures in fixed cash compensation.

Nice work if you can get it. And of course, since the stock market generally goes up over time, it’s easy to generate investment profits while still drastically underperforming the market as a whole.

Mulcahy treats it as self-evidently bad that VC managers make money by serving their clients poorly, and it certainly is for those clients. But there’s a case to be made that these silver-tongued con artists are integral to American greatness. After all, if everyone did “the right thing” with their money and invested it in low-fee diversified index funds, the entire process of startup financing and innovation would come grinding to a halt. The stock market would be completely failing at its ostensible purpose of channeling capital to productive investments.

Startups need equity capital to thrive, and yet investing equity capital in startups is a bad idea. But what if you created a whole industry where the basis of competition wasn’t really investment judgment? What if instead the key skill was simply persuading people to throw a lot of money into the maw? Well, you’d get something like the “bad” incentives Mulcahy identifies. By being good at talking people into throwing their money away, venture capitalists bring us the Googles and Ubers and Buzzfeeds (and, yes, Vox Media) that make the economy a dynamic place. Without them, we’d all be worse off. The important thing is that you personally (or your university endowment or pension fund) should stay away. But if someone else wants to throw their money away chasing the dragon of innovation, you should cheer.

I would recommend Chapter 12 of Keynes’ General Theory but add the cautionary note that nobody has come up with anything better in the intervening 80 years.