As I was on a flight to Europe, I started reading "The Quants," a book on the origins of quantitative investing.
While reading, I came across a paragraph about Ed Thorp and his hedge fund's fee structure.
Rather than use the traditional 2/20 structure, Thorp's investors paid the funds expenses.
This got me thinking, specifically, in the context of early-stage VC funds.
I kept looping back to these questions (and I'll attempt to answer them):
Why would a sub-$50MM fund adopt the same model as a top-tier hedge fund?
What are the possible outcomes of a budget-based fee structure for micro VC funds?
Regarding the first question, funds use this model because historically, it just works. For $50MM+ funds, this model works quite well. For sub-$50MM funds, eh, not so much.
I guess the real question here is, why aren't micro-VC funds getting creative with the fee structure?
Is it because of potential pushback from LPs? Is it because of certain incentives like carry? Is it because other models likely won't work? I don't know.
I find it absurd that partners have to be scrappy and/or have to ask for a higher percentage management fee just to keep the lights on because of some contrived dollar amount.
Instead of the 2/20 model, I think micro-VC funds should use a budget-based fee structure based on forecasted expenses.
In my head, this means that huge expenses (GP salaries, employee salaries, legal and accounting fees, office space, etc.) should be paid for by the LPs, regardless of the dollar amount.
In this case, the management fee would no longer be a fixed number. And it can be greater than or less than the 2 & 20 equivalent.
For example, if I close a $20MM fund and estimate that the annual expenses will be $300k, the 2 & 20 equivalent will be $400k. Because 2% x 20M is $400k.
In this case, the budget-based fee structure is less than the 2 & 20 equivalent.
I imagine this model working a few ways. One way is to pool capital together for each expense, in a syndicate-like manner, as each payment comes up. Another approach could be to raise an amount upfront, specifically for the management fee.
Heading to the second question, the hopeful result of this budget-based fee model is that:
GPs will have enough money to live normally, the fund's organizational expenses will be covered, and all worries about the lights going out will vanish
GPs will receive a higher percentage of carry
The dynamics between GP‘s and LP’s will change as incentives become more aligned
With these potential outcomes, there can be some pushback. One could ask, what happens when a GP exceeds the 2 & 20 equivalent? And what does that mean for the percentage of carry?
I don't know the answer to those yet, but I look forward to diving more into this topic and figuring out whether or not this structure is economically feasible for everyone.