Hacker Turned VC Can a hacker go to the darkside?

At Tuck I have taken a couple of classes on VC investing, and though they have done a good job teaching deal structure they never really delved into how a fund was structured or managed. This may be because it varies greatly from firm to firm, but it meant that I really didn’t understand a lot of how a fund was actually operated. So today I had lunch with the funds operations controller, in an attempt to learn a bit more about the inner works of a VC partnership.

The standard fee structure for PE and hedge funds is 2/20, the LP’s take 2% of the fund to run the day to day operations, and 20% of the profits. Now a fund with a proven track record may be able to get better terms, it is rumored that some of the top VC funds got 35% at the height of the bubble, but as a rule of thumb 2 and 20 prevails.

Lunch led to a couple of insights that I found to be interesting, the first is that the 2% isn’t always on the amount committed, but instead is sometimes on net asset value (NAV). The thinking by LP’s is that they should have to pay 2% on money that has already been invested and returned. Of course this makes it more difficult for the VC, since the amount of money they have to ‘keep the lights on’ is now variable, so they prefer the more static, and lucrative, 2% of fund size.

The second thing I learned seems obvious in retrospect, but it had never occurred to me before now. If you’re taking a fee of %2 of the fund each year, that turns out to be 20% of 10 years. So some of the money received from early wins will need to be recycled back into the fund to get to deploying 100% of the funds value.

Very interesting stuff that I didn’t hear about in school.   

For Spring Break I went to visit an old friend in Thailand, I had a great time lounging around, going to the weekend market, and doing a bit of work on his startup on the side. On the flight back to New York I ended up getting seated next to a gentleman who had been in Thailand to race his two person yacht. We struck up a conversation, and he asked what I did and I said I was in business school.

Him: "It must be tough finding a job with the current credit crises."

Me: "Well, I’m interested in venture capital, and fortunately that is counter cyclical."

Him: "Actually venture capital is counter cyclical in an expanding credit market, when credit is contracting like it is now it becomes cyclical."

Me: "What exactly is it that you do?"

So it turns out he does risk management for the wealthy at large banks such as Morgan Stanley. Needless to say I was a bit bummed, but then again his job is to forecast the gloomiest scenario and then protect his clients from that. It probably doesn’t lead one to see the cup as half full.

Today Brad Feld had a post regarding contrary views on the future of venture capital. There was one piece of it that particularly caught my eye:

Merrill Lynch’s chief strategist Richard Bernstein in "Some thoughts on alternative investments (6/23/08)" says "The growth in alternative investments seems linked to the growth of the credit crisis" but then goes on to say "There may be two areas of alternative investments that seem relatively attractive in the current financial environment.  In both cases, these are areas that might benefit from the tightening of global credit.  The first is early-stage venture capital.  … If return-on-investment does indeed tend to be higher when capital is scarce, the significant tightening of traditional credit funding to smaller companies seems to make early-stage venture capital strategies more attractive."

So now I have heard opposite opinions on the affect of a credit crunch on venture investing. I’m curious to find out which of these is the accepted wisdom.