Theoretically, the investors in VCPE funds are, like investors in publicly traded securities, sufficiently well diversified to ignore idiosyncratic risk. However, the actual managers of the funds are not, even in theory, well diversified, for two reasons:
- Direct compensation from profits - 2% + 20%
- Desire to establish a track record to allow/facilitate future fund-raising
Combined, the two financial considerations above likely add up to a substantial portion of the fund managers' wealth, eliminating the possibility of diversification. Theoretically, this would cause the managers to be more risk-averse than their investors, particularly when it comes to idiosyncratic risk. While it could be argued that the fund itself is fairly diversified, there are two problems with this: limited investment set (small number of companies) and weight adjustments (a VC fund might become 50+% (by market value) invested in one company if that company is doing very well and others are not.
Has anyone come across research regarding this conflict of interest? Personal experience in terms of investment/port-co operation decisions?
" eliminating the possibility of diversification." this is just a false premise to begin with. also, if you ask the guys at calpers, they'd probably PREFER that their PE fund managers be more risk-averse.
The lack of 'diversification' will incentivise the manager to work as hard as possible to generate strong returns, it is unlikely that it will make them more defensive.
And if the fund fails (i.e. no carry, possible clawbacks and diminished ability to fundraise) your logic goes nowhere. Go back to the drawing board. You might have an argument if you correlated poor returns to increased fund size. However, I assume most LPs already know megafunds have crap returns (in general) and a heavy management fee.
Well if the fund fails, then in theory there would be some other interesting dynamics. Since the managers have, essentially, a deep out of the money call option on the carry, they would aim to spike volatility to increase option value - much like over-levered equity holders do in a distressed company, by taking large risks. Of course, this would be partially offset (or more than offset) by the track record argument, since losing X% of your fund is not as bad as losing more...
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