Foundation questions LP/GP relationship

A limited partner has called into question the very structure of the LP/GP relationship, suggesting that LPs are to blame for creating “conditions for the chronic misallocation of capital”.

The Kauffman Foundation, a $1.8 billion institution, published a study in May focused on the organisation’s venture capital portfolio. To be clear, the recommendations and criticisms in the study, which was published in May, all relate to venture capital. However, many of the endowment’s complaints have to do with fundamental issues of the LP/GP partnership, including transparency, reliability of performance data and fee structures.

“To fix what’s broken in the LP investment model, institutional investors will need to become more selective and more disciplined investors in venture capital funds,” the study said. “The best investors will negotiate better alignment, transparency, governance and terms that take into account the skewed distribution of [venture capital] returns.”

The best investors will negotiate better alignment, transparency, governance and terms that take into account the skewed distribution of [venture capital] returns. Kauffman Foundation

No one from Kauffman was available for comment Wednesday. One market source, who wished to remain anonymous, said it was a stretch to implicate the entire industry based on findings from one LP's venture portfolio.

“To the extent the [LP/GP relationship] is not working you would think firms wouldn’t be able to raise funds under that structure, and firms are raising funds under that structure,” the market source said.

Kauffman found that while paying a routine 2 percent management fee and 20 percent incentive fee, performance of venture funds have not lived up to expectations; so much in fact that Kauffman said venture managers have not delivered on their promises.

In Kauffman’s venture portfolio, which encompasses about $249 million invested or committed to venture and growth equity funds, 20 out of 100 funds generated returns that beat a public-market equivalent by more than 3 percent annually, and half of those funds began investing prior to 1995.

The majority of funds in the portfolio – 62 out of 100 – failed to exceed returns available from public markets after fees and carried interest was paid out. Of 88 venture funds in the portfolio, 66 failed to deliver expected venture rates of return in the first 27 months (prior to serial fundraises).

“The cumulative effect of fees, carry and the uneven nature of venture investing ultimately left us with 69 funds (78 percent) that did not achieve returns sufficient to reward us for patient, expensive, long-term investing,” Kauffman said in the study.

Exacerbating the problem is that LPs regularly commit to venture funds without requiring information about GP compensation, carry structure, ownership and firm-level income, expenses or profits, the study said.

Going forward, Kauffman will be investing in high quality venture funds of less than $400 million in which the GP commits at least 5 percent of capital; move more into direct investing to avoid fees and carried interest payouts; co-invest with seasoned investors and move some of its capital invested in venture to the public markets.

“There are not enough strong VC investors with above market returns to absorb even our limited investment

There are not enough strong VC investors with above market returns to absorb even our limited investment capital. Kauffman

capital,” the endowment said.

Interestingly, Kauffman presented its finding to numerous LPs and found widely divergent views on the state of the LP/GP partnership. While some agreed with Kauffman's ideas, others believed the 2 and 20 model to be appropriate, while some remained passive despite misgivings to avoid “rocking the boat”, Kauffman said.

“Several peers listened to our list of topics and responded by cautioning us that “this is a relationship business”, implying a view that we are better off accepting the status quo and being in misaligned, underperforming VC relationships than pursuing negotiations for better terms”, Kauffman said.

This plays into the idea that sources have been talking about recently that there seems to be a “fragmentation” among a formerly unified LP community based on views of the best ways to invest in private equity.

Be sure to check out the July edition of PE Manager which will explore the merits of a budget-based fee model.