The Venture Capital Fee Structure That Produces the Highest Returns

Withholding fees until after managers beat a target return could actually result in worse performance, according to a study of venture capital managers.

Private equity and venture capital general partners are typically paid carried interest on their funds’ gains in one of two ways: upon exiting each deal — even if the fund hasn’t earned enough for investors to break even — or only after invested capital and fees are returned to investors, generally once the fund’s peformance has met a hurdle rate. Researchers Niklas Heuther from Indiana University, David Robinson of Duke University, Soenke Sievers from the University of Paderborn, and Thomas Hartmann-Wendels of the University of Cologne refer to the latter approach as “whole-fund carry provisions” — and they find that, contrary to popular belief, delayed fees, which are generally seen as an incentive for managers to beat a target return, may lead to worse returns than if managers hadn’t been subject to a hurdle rate.

In apaperposted last month on research database SSRN, the group showed that general partners who are paid carried interest on a deal-by-deal basis — receiving their share of the return as they exit investments, instead of after they meet a benchmark return for the fund — bested hurdle rate-using peers on a gross and net-of-fee basis.

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The findings were based on a study of 85 U.S.-based venture capital funds raised between 1992 and 2005.

“Whole-fund provisions induce general partners to exit early,” the authors explained. “They wish to return invested capital as quickly as possible so that they can begin earning carried interest.”

These early exits, the researchers found, undermined overall fund performance. On average, managers that were paid after they beat their benchmark earned a PME, or return compared to the public market equivalent, of 0.638 after fees. Managers without hurdle rates earned produced an average PME of 0.967.

The authors noted that this difference in performance could be skewed by the fact that the best-performing general partners have the most power in negotiating fee contracts, and are therefore less likely to agree to “LP-friendly” terms like hurdle rates. Still, the researchers concluded that fee terms that “seem superficially to be desirable for limited partners are not obviously better.”

“Venture investors get what they pay for, at least on average,” they wrote.