March 14 2015
by John Backus

VC Fundraising: The Law of Unintended Consequences

I recently returned from a terrific fundraising trip to Australia. A few observations from this wonderful, remote (at least from the USA), big land mass but small population size country. They do retirement right. Some 20 years ago they required that all employers contribute 9% (increasing to 12%) of an employee’s salary to a retirement account. And this money is paid in cash to a number of “superannuation” funds which either the employer or the employee can choose. Much like with a 401K or IRA in the USA, employees can choose their risk tolerance and weight their accounts accordingly.

These Super funds are piling up cash, and helping to drive a sustained bull market in Australian equities. It is a model the USA should look at, because our social security model is broken. What we do is contribute around 15% (employer + employee) of our paychecks, and send the money to the Federal Government, which uses it for current year expenses and creates an accounting entry into a virtual Social Security “fund.” Imagine instead if all of that cash contributed by employees and employers could be privately managed, putting real cash into real new businesses, assets, equities, infrastructure, and bonds. It would be great for our economy.

Regardless of which side of the political spectrum you lean towards, it is hard to argue with Australia’s success with the Super funds.

But I did see one dark side. And that is where the law of unintended consequences come to play. The Aussie SuperFunds focus on and disclose both returns and fees in detail. Sounds great. I am all for transparencey. But what is a fee? In the Australian Super Fund world, it is the sum of any management fees, any performance fees (such as carried interest with venture funds), any other direct expenses, plus any look through fees (such as the double layer of fees incurred in a venture capital fund of funds — which are rapidly disappearing in Aussie Super portfolios.)

So what? You say….Transparency is good. And again, I agree. But because “performance fees” such as carried interest can get really big when a fund is really successful, the appearance of fees (outside the context of the returns) also becomes big, and the Super Funds end up being ranked poorly on the fee spectrum, without any explanation that the fees were performance based fees that were generated by terrific returns.

An extreme example: Lets say a $5B Super Fund put $250M a few years ago into a basket of the best performing PE and VC funds. After all that is only 5% of their portfolio. And lets say those VC & PE funds delivered a 5X, turing that $250M into $1.25B. That is a $800M net gain. Not bad for a $5B portfolio. 16% return from that investment bundle alone. The problem is that with a 20% performance fee, the “expenses” were $200M, or 4%. And that 4% sits on top of other fees and expenses which collectively average under, say 1%. This mythical fund would rank at the top of performance rankings, but dead last in expenses. And would be excoriated in the press for the extravagant fees it is paying.

This of course is in the category that I call a “high class problem.”

As a result, many of the Super Funds are dramatically limiting their exposure to any investments with performance based fees. Hedge funds. Buyout funds. Venture Capital funds. Real Estate funds. They would rather have lower returns, along with everyone else, and not be “called out” for having presumable high expenses. Not the best way to maximize pension values for employees.

But I predict the pendulum, which has swung too far, will move back in the next 3–5 years to more of a focus on simply net investment return. Or perhaps a breakout of returns and expenses by public securities as well as private securities.

What do you think?

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