Dear SaaStr: Why Do VCs Make So Much Money?

Q: Dear SaaStr: Why Do VCs Make So Much Money?

They don’t all make so much money, but they can indeed be very well paid.

  • First, VC is pretty hard to do well. Beating Nasdaq each year by a material margin isn’t easy. In fact, historically most VC firms haven’t done this. Even in the best of times, Nasdaq often beats most VC firms after costs — and with no illiquidity at all.
  • Second, the “carry” model is well-entrenched as a way to partially align interests. It’s not perfect at all. But the idea of paying 20% of the gains on investments to an investor that can beat the public markets by 50% or more is well established. No gains, no hurdle hit, then no profit sharing.  It’s not perfect, subject to some games, and has other issues.  But it pays very well for outsized performance.
  • Third, fees are a real issue — but it’s an expensive asset class. In the end, LPs are OK paying fees, especially when they are paid back ahead of any carry and profits. Importantly, in the end, fees don’t matter in the top funds, which deliver insane returns after all fees and costs.
  • Fourth, managers that can’t do this ultimately lose the backing of their LPs. Not always overnight, but they lose their own investors if they can’t deliver.
  • Finally, the best, the very best VC and PE firms can deliver insane returns. Not most of them. But Sequoia has multiple 10x net funds in a row now. Top PE funds can deliver 25%+ IRR net after all fees, again and again. That’s worth paying up for.

The real issue is the mediocre are paid too well. It’s endemic to the structure of the asset class, and it puts a lot of pressure on LPs to cherry-pick top managers.

(investing image from here)

Published on March 30, 2022

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