Why VCs get rich even when they make bad investments
By Michael Hennigan, Finfacts founder and editor
Aug 29, 2014 - 6:02 AM

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Last year had the potential to show that US venture capital firms (VCs) were set to have a bumper year with booming public equities and a recovered IPO market which generated record portfolio company exits and distributions from VC funds, according to a manager of a portfolio of endowment investments in VC and private equity funds.

However, annual industry performance data from Cambridge Associates shows that venture capital continues to underperform the S&P 500, NASDAQ and Russell 2000.

In an article for Harvard Business Review's Blog Network, Diane Mulcahy, an Irish American  who is a Kauffman Foundation (America's leading entrepreneurship think-tank) senior fellow, outlines the economic misalignment of the VC industry, which allows VCs to enjoy high levels of fee-based compensation, even when their funds perform poorly

Mulcahy notes that VC funds persistently underperform the fully liquid, low cost public equity markets, yet VCs themselves continue to receive high levels of fee-based compensation.

She questions whether institutional investors should continue to pay VCs well regardless of return performance, and offers recommendations for how investors in venture capital funds can hold VCs more accountable.

Mulcahy writes: "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."

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