E365: Stanford GSB Professor on Venture Capital’s Manager Incentives

0:00Ilya, you're the David S. Lobel professor at Stanford at the GSB at the business school. You're a leading researcher on private equity. Right before we started recording, I asked you about two and a half and 30 and which part of that LP should negotiate on. And you told me neither. Why is that? Well, you asked me a slightly different question. You asked me what is the difference between two and a half and 30 and two 20. Okay. How many basis points in PME? Okay. And my response was, you can calculate or you can estimate the basis points, but that really will not help smart investors. Because typically, you do not choose between 2.5 and 30 and 20.

0:38You're typically really given what you have and you're then a price taker, or you can negotiate and then you're at least partial price maker. And so the question is, if you're a price taker, do you walk away or not? Or if you're a price maker, you can negotiate. And then if you can negotiate, negotiate on what? And from this point of view, 2.5 and 30 is not very helpful because the question is, well, 2.5 of what? It turns out that whether it's 2 or 2.5 is less important than if it is 2.5 or 2 of the committed capital, of the invested capital, of the managed capital, some combination, and specifically whether it changes over time.

1:16For example, other things equal, I definitely would prefer 2.5 of the committed capital that goes into managed capital after year 5 compared to 1.5, forget about 2, 1.5 of committed capital for 10 plus 3 years. So I think the base is very important. Now, that is just an example, of course, there are many other things. The same is 30. Now, are things equal? Of course, I would prefer 20 to 30 as an investor. But in this case, I have to ask a question. How can it be that other things equal? Incentives drive behavior. When I work with large LPs, I always tell them, look, incentives drive behavior and incentives of your incentives drive behavior, but also incentives of fund managers that you invest in.

2:04So 20 and 30 create very different incentives. they create very different risk return profile, and there is a selection of fund managers. So that would be my one response to this. So it's very difficult to compare other things equally. Let's start with the incentives. Why is there such different incentives for a manager making 20 % carry versus 30 % carry? What is carry? Carry is an option. And as with any option, those who have a long position in an option, such as fund managers, would rather prefer high risk. So that if you have a 20 % carry, you actually prefer high risk than many other investors in the world.

2:41But if you go from 20 % to 30%, you prefer even higher risk. So as a result of this, as an investor, you have to ask yourself a question whether you're okay with that specific fund manager taking higher risk. Because typically what happens is that, what is 30 %? Well, 30 % results because a manager who was on 20 % performed very well. And then that manager says, well, guys, I really delivered returns for you. So now it's going to be maybe 25 % or maybe a step up to 30%. But if the manager is the same and the manager delivered great returns on 20, the question is whether this manager will behave exactly the same when you move that manager from 20 to 30 and you have a step up and whether the risk profile of that manager will change, which will affect the persistence of returns.

3:33So I think the word persistence data is critical. At the end of the day, you invest in successful fund managers on expectation, on belief, on wish that they continue to be. The future performance is determined by past performance. The opposite of that disclaimer, right? This is really interesting because this is what LPs believe. That's what the market very often believes, that future performance is a function of past performance. So let me clarify this, okay? Because I think this is one of those, I work with LPs, but also I'm teaching the, one of the classes I teach at Stanford for my MBA students is private equity class, the economics of the private equity industry.

4:10And by the way, when I say private equity in our conversation today, I also mean venture capital. Okay. So, and we go very carefully over all possible mistakes or inefficiencies that LPs commit that may affect their returns. So one is the following. you should not think about whether future performance is a function of past performance because you really care about future net performance at the end of the day you're an investor if the future gross performance is great but the fund manager takes all the gross and you have zero net you're not going to be happy but as a function of gross performance so that is very important let me repeat this because i think in my experience with working with many lps but also with my students, it's very often unclear.

4:56The question is whether your future expected net performance is a function or will depend or how it will depend on the past gross performance, not past net performance. And so this is where our discussion about incentives and about carry comes into play. You said something, and I want to play devil's advocate on that, which is you said 30 % carry will incentivize somebody to take more risk. Is that a positive or a negative incentive? That depends. So LPs should think about broadly two things. One is risk-reaching profile of a specific manager. So if you were, David, working for me at 20 % carry, okay, and you succeeded, and now you increased 30%, out of each dollar you lose for me, you're still taking nothing.

5:45It was zero, zero. Out of each dollar you make for me, okay, I'm simplifying, you now will take 30 cents. as opposed to 20 cents. So this creates dramatic optionality, dramatically higher than for 20 cents on the dollar. And this - What's the intuition around that? Why is that dramatically higher? Well, 30 % is 50 % higher. Actually, what is really interesting is that because it's nonlinear, nonlinear meaning that, so if you can see my hand, so if you lose money, it's zero. So the fund managers don't lose their own money. I mean, they commit capital, but let's ignore this, okay? But if you take 20%, it's like this.

6:27That's the angle of 20%. And that is the angle of 30%. And that only is amplified by tiered carry, where you have certain tiers over certain structures. That even dramatically increases that. Well, tiered structure introduces wrinkles on this. But the intuition is the same. That increases the risk-taking. Well, it increases the other things equal predisposition to take risk. Now, it does not mean by itself that risk is, as you said, bad. because it's risk return profile. High risk can mean better return on the risk-adjusted basis, okay? But, and that is, I think, big difference between private equity and many other investment spaces, which is investors, fund managers, fund managers specialize.

7:14And as you increase risk - In theory? Oh, I would say it's in practice. Absolutely. In practice. Do you think the large VC firms are specialized? Well, so many VC firms specialize, many PE firms specialize, absolutely. Now, if you take about the giants, they may not specialize, but their funds specialize. Absolutely. There's no doubt about this. The team. And in fact, many success. So if you look at the correlation of specialization success, those that are very specialized, other things are more likely to be successful. So that proves out in the data, because a lot of people have this intuition that that's something.

7:47That is the data definition. What's the research on that? Oh, there is a lot of research. There is a lot of research by my colleagues, but also I've done this and I show the specialization to my students every year. We compare the specialization of both for VC, for buyouts, that if, and that's important for our risk discussion, is that persistence tends to disappear. And there's a special name for it. It's called style drift. when managers kind of go and do something else. And going back to risk, this is where I would like LPs to think. If they move from 20 % to 30%, then that manager is going to increase risk.

8:26But the question is whether it also means that there's going to be a style drift. Because what does it mean, high risk? Now, in buyouts, it might mean high leverage. But more likely than not, it's actually investing in different kinds of portfolio assets, underlying portfolio companies. That intuition, why is it if I'm a biotech investor, crypto investor, or even a AI investor or defense investor, why, if I want to increase my risk, should I go into another sector? What's intuition around that? I'm not really sure whether you should, but that's likely what you're going to do. Because high carry means you like high risk.

9:07High risk means that you would like to invest in assets with higher volatility, high exposure. Okay. Now, what does it mean, assets with high volatility? Well, it's a different profile of assets. Let's think about the stock market. If I would like to invest in low volatility assets, I might invest in, let's say, the so-called, at least in the past, dividend kings, electricity utilities, whatever. But if I would like to invest in dramatically high volatility assets, I will invest maybe in tech companies. Now, the same intuition holds for private assets. Again, I think it's important to understand the chain here.

9:41the chain of intuitive thought. So if we move from 20 % to 30 % carry, incentives drive behavior, fund managers have predisposition to be interested in high-risk assets. And the question is, how these high-risk assets will materialize? Will they materialize in different portfolio composition? Will they materialize in different structure of assets? So that depends. But going back to your original question, you asked me, so would investors prefer 30 % or 20 % carry If everything else, let's say, stays the same, like management fee, whatever. And there's no right answer for this. And this is, I think, going back to the allocation of capital and private equity and the specific fund manager selection.

10:22It depends. But it depends in a helpful way because, in fact, there are many methods that smart LPs can use to separate those managers that not just deserve 30%, But the net expected return on the risk-adjusted basis is still going to be high relative to the market, relative to the market expectation. Alpha. Higher return without higher. Higher return. Higher return, right? And still could be higher for some managers, but definitely not for all. So let's say you're an endowment and you have the perfect governance structure. You're completely unbounded by investment committee and you're in the tail end of your career and you just want to, say you work for Stanford's endowment, you just want to return the most amount of capital to Stanford on a risk-adjusted basis and you want to invest in venture capital.

11:11What are one or two smart strategies? Well, first of all, a side note, what you're describing might not be the perfect corporate governance, but let's... Let's double click on that. Okay. What is a perfect corporate governance? Is it just a single family office investing their own money? No, what I mean is perfect governance structure is the structure that is built, again, around understanding that incentives drive behavior. On the one hand, you would like to have the flexibility so that decision makers managing money can make decisions that maximize risk-adjusted return and allocation. On the other hand, you would like to have a structure where there is control and where there is an opportunity to account for the decisions that are made.

11:54You know, the biggest challenge in financial markets, especially in private equity, is that you might need to wait for years and years and years before the returns are materialized and before the quality of your decisions become clear. So the moment you mentioned at the tail of your career, which I interpret is that, well, you're going to make investments. But in fact, it's the subsequent generation will realize that. Let's assume that you had this angel investor that was completely aligned with the university and had no ego and just wanted to have the best returning portfolio investor. What would he or she do?

12:27First of all, I think that it overall could be very high risk risk on strategy. I think if you look at historically at venture, venture has returned on the risk-adjusted basis higher than the market. And there are many, many few spaces, many few spaces in the financial industry that have demonstrated clear persistence. And based on the absolute, on relative, on the PME basis, et cetera, and venture is really one of them. Actually, maybe kind of more or less the only one that persistently demonstrated that. I asked this very question to Eric Poirier, CEO of Adapar. Is venture capital the best performing asset class of all time?

13:08And he said, no, sports teams, but it's number two. So if you had invested in sports teams over the last 20, 30 years, obviously that's very difficult to access asset. But joking aside, venture capital appears to have this persistence over, what, 40, 50 years? Yes, at least over 40 years. So, you know, that's actually not a joke because it's a very important question. What is an asset class? One can claim that sports teams is an investment, of course, niche, but is it an asset class? Now, by the way, some people, including some in Silicon Valley, say, tell me, well, venture is not an asset class because it's relatively small.

13:43It used to be relatively inaccessible. And, you know, there's something into this. Tell me more. Well, let's think about this. So in the stock market, if you believe in a mutual fund manager, well, you just invest in the mutual fund manager. okay and the future fund manager just takes on my money in the venture if you really believe in a specific fund manager there is no guarantee that that fund manager will take your money so almost the opposite if it's a good fan fund manager almost guaranteed that they will not take your money well it depends on who you are depends on the who you are it depends and so as a result of this there is a not always the equilibrium between supply and demand and that's a interesting question by itself why that is the case but but as a result of that it's not the same asset class as for example public market so i would say some private equity real estate investments but to your question about venture so my first answer would be that it's actually i think likely a good decision to invest in venture so another way it's a good neighborhood in general and then if you want to find where to invest in that neighborhood where would you where would you invest expert calls have always been one of the most powerful ways to build conviction but But today, investors are asked to cover more companies, move faster, and do it with leaner teams.

14:59With AlphaSense AI-led expert calls, their TGIS call service team sources experts based on your research criteria and lets the AI interviewer get to work. The magic is in the AI interviewer, purpose-built and knowledgeable-based information to conduct high-quality context-rich conversations on your behalf, acting as a trusted extension of your team. Then they take it one step further. Your call transcripts flow natively into your AlphaSense experience and become querible, searchable, and comparable. So your primary insights plug directly into earnings preps, digital work streams, and pitch books with zero tool switching.

15:33And with AlphaSense expert call services, the AI-led expert calls are just one option because we know the importance of a hybrid expert research approach. AI for coverage and efficiency. Humans for complexity and conviction. It's the institutional edge that scales research without scaling headcount. For hedge funds, that means validating thesis assumptions across dozens of experts before earnings instead of a handful. For private equity, it means faster pre-IOI scans and deeper commercial diligence. For investment banks and asset managers, it means pulling real operator perspectives straight into models and sector positioning without disconnected tools or manual handoffs.

16:10All of it lives inside the AlphaSense platform, trusted by 75 % of the world's top hedge funds, alongside filings, broker research, news, and more than 240 ,000 expert call transcripts, turning raw conversations into comparable, auditable insight. Take advantage of AlphaSense AI-led expert calls now. The first to see wins. The rest follow. Learn more at alpha-sense.com slash how I invest. I like rephrasing questions. Of course. I'm a little bit maybe too professorial, but when I talk to, when I answer questions of my students, but also LPs that I work with, or fund managers that I work with, I very often rephrase questions.

16:48So you ask me where, I actually would rephrase it as how. That's more important. Because where suggests to me, like, you know, in robotics or in, you know, that's data center, et cetera. And that changes very frequently. I can tell you right now, but by the time it will be aired or six weeks down the road, somebody is going to listen to this, this will change. But the answer to how question does not change, at least as frequently. So first is that I would think about how you should diversify in venture. Because in my experience, this is where I think many LPs make, I would say, strategic mistakes.

17:28So on the one hand, you would like to diversify. You don't want, if you're an LP, to invest in a very, very small number of venture funds, however great they are. Because, especially in venture, there's a very high degree of volatility among funds, which means that if you invest in a specific fund, you might be very disappointed. Even if previously that fund had a great outcome. Okay? That fund manager had a great outcome. And that could be noise. It doesn't mean that the manager is bad. Well, it can mean that the manager is no longer great, but it can also be noise. So the noise adventure is definitely larger than in many other financial assets.

18:05There's no doubt about that. So as a result of this, you would like to diversify. However, and that is something important, in the stock markets, very often we say, we tell our students in the basic finance classes, you know, you have to diversify as much as possible, okay, like invest in whatever, S &P 500. And if you look at statistics, you know, passive investment has gained dramatic, including among large institutions, including large LPs, okay? well, I think in venture, just diversification to the same extent will not work. So you would like to diversify, but you would like to diversify very meaningfully.

18:36So at the end of the day, you need to have a reasonable but limited number of fund manager relationships. Now, how many of that depends on the size of your investor example. but I would say for a very large investor that decided to invest, let's say, hundreds of millions of dollars in the venture space or billions of dollars in the venture space over the course of the years, it would be at least 15 to 25 relationships. And how depends not only on deciding in which specific manager to invest, in which specific industry or stage to invest or which specific geography, but the correlation. So the relationship between these fund managers.

19:18I think that is critically important. And in my experience, this is what many LPs underestimate. So they spend a lot of time thinking about whether to invest in individual managers. So they spend a lot of time with individual managers. They do spend a lot of time on their allocation decisions. We haven't yet mentioned the denominator effect, but they spend quite a bit of time about that, okay? The overall allocation. And also maybe where to invest, like geography or whatever, venture versus private. They spend much less time, much less effort in what I believe is very highly productive activity, thinking about correlation across their venture and more broadly, private equity portfolio.

20:04And that's kind of the free lunch in venture. If you could get the same returns with lower correlation, that's what you're looking for. Well, there's almost no free lunch in the world of finance. But yes, it's going to be a more efficient decision. So you want low correlation. You would like to reduce the correlation. Absolutely. You would like to reduce the correlation. But again, the way you reduce the correlation in many other markets is just by effectively increasing the number of assets you manage. And in venture, it doesn't work this way. So therefore, you have to think correlation thinking in venture, I would say, is much more strategic than in many other assets.

20:45Because it's more difficult to implement. because it is, I would say, there's both art and science. Also given the access opportunities you have and I think given also what exact information you observe about all the fund managers. Perhaps a dumb question, but let's say you're in 15 to 20. There are no dumb questions that I tell my students. There could be dumb answers there. Let's say you invest in this 15 to 20 manager portfolio that you mentioned, this canonical portfolio, and you have this larger set of portfolio companies, let's just call it 300 to 400. How would one go about figuring out whether there's correlation between these assets?

21:22Is this a tool? Is this some AI-assisted process? Well, now everything's AI-assisted, so that's not right. So economics is the same. AI is basically helping you with the data processing. So the answer is the following, is that first it depends on the quality of your information. Let's assume that you invest in the manager under the expectations that the manager will not have a style drift, which means that the manager will continue pursuing the same strategy. Like if the manager was investing in, you know, series B2C SaaS companies, then the manager will be investing in series B2C SaaS companies with certain modifications in the next fund, okay?

21:59So that allows, in fact, to look at the correlation that this asset class had vis-a-vis the rest of your portfolio, but vis-a-vis also other fund managers that you invest. And I think that is really important because if you look at, let's say, adding another manager to your portfolio. And if you look at that manager in isolation, you may conclude that that manager may not be that great, especially maybe then if you have 2.530 or something like this. And looking at isolation, that might be true. But maybe that manager is investing in something that you don't have yet exposure to. So let's say you're investing in the venture, but you have not had exposure to crypto assets or blockchain assets, let's say.

22:41And maybe you didn't because it's a very new asset class you haven't been exposed to. And also maybe because you thought that economics is against you because it's costly to invest in better managers because of high demand. This all might be true, but correlation-wise, it actually, this asset class might be really beneficial given your portfolio. And again, I think that this is where many, many investors do not pay enough attention. When you find something that just fits right, you end up wearing it more than anything else. And for me lately, that's been my rag and bone Miramar jeans. What really stood out to me is that they look like traditional denim, but honestly feel more like sweatpants.

23:23They've got that clean structured look, but with a level of comfort that makes them easy to wear all day. I've been wearing them pretty consistently, whether I'm recording, traveling, or just out there during the day. and they become one of those go-to pieces I don't really have to think about. Even after long days, they don't feel restrictive, which is something I didn't realize I was missing until I started wearing them regularly. With Rag & Bone, it's not just about one pair of jeans. It's about having reliable staples in your closet. You could dress them up a bit or keep it casual, and they just work.

23:50The washes are clean, the cut is sharp, and they hold up really well over time. It's that balance of comfort and structure that makes them stand out compared to most jeans. If you're looking to upgrade your denim, I definitely recommend checking out Rag & Bone Miramar jeans. You get 20 % off site-wide at www.rag-bone.com using code INVEST. Again, that's 20 % off at www.rag-bone.com with code INVEST. When you find something that just fits right, you end up wearing it more than anything else. And for me lately, that's been my Rag & Bone Miramar jeans. What really stood out to me is that they look like traditional denim, but honestly feel more like sweatpants.

24:29They've got that clean, structured look, but with a level of comfort that makes them easy to wear all day. I've been wearing them pretty consistently, whether I'm recording, traveling, or just out there during the day, and they become one of those go-to pieces I don't really have to think about. Even after long days, they don't feel restrictive, which is something I didn't realize I was missing until I started wearing them regularly. With Rag & Bone, it's not just about one pair of jeans. It's about having reliable staples in your closet. You could dress them up a bit or keep it casual, and they just work.

24:56The washes are clean, the cut is sharp, and they hold up really well over time. It's that balance of comfort and structure that makes them stand out compared to most jeans. If you're looking to upgrade your denim, I definitely recommend checking out Rag & Bone Miramar jeans. You get 20 % off site-wide at www.rag-bone.com using code INVEST. Again, that's 20 % off at www.rag-bone.com with code INVEST. Support for today's episode comes from Square, the all-in-one way for business owners to take payments, book appointments, manage staff, and keep everything running in one place. Whether you're selling lattes, cutting hair, running a boutique, or managing a service business, Square helps you run your business without running yourself into the ground.

25:38I was actually thinking about this other day when I stopped by a local cafe here. They use Square and everything just works. Checkout is fast, receipts are instant, and sometimes I even get loyalty rewards automatically. There's something about businesses that use Square. They just feel more put together. The experience is smoother for them and it's smoother for me as a customer. Square makes it easy to sell wherever your customers are in store, online, on your phone, or even at pop-ups and everything stays synced in real time. You could track sales, manage inventory, book appointments, and see reports instantly whether you're in your shop or on the go.

26:14And when you make a sale, you don't have to wait days to get paid. Square gives you fast access to your earnings through Square checking. They also have built-in tools like loyalty and marketing, so your best customers keep coming back. And right now, you can get up to$200 off Square hardware when you sign up at square.com slash go slash how I invest. At Square, you get all the tools to run your business with none of the contracts nor complexity. Run your business smarter with Square. Get started today. And as many things in life, there's trade-offs. And a lot of these sector funds, for better or for worse, they become sector funds after there's a couple of breakouts the first couple of generations.