Friday, September 24, 2004
Victor Fleischer (UCLA) presents The Missing Preferred Return today at UCLA at 12:30 pm PST. Here is part of the abstract:
Managers of leveraged buyout funds, real estate funds, hedge funds, and other private equity funds give their investors an 8% preferred return on their investment before they take a share of any additional profits. Venture capitalists, on the other hand, offer no preferred return. Instead, VCs take their cut from the first dollar of nominal profits. They offer no feature that would account for the time value of the investment, nor do they index their compensation to an industry benchmark. This disparity between venture capital funds and other private equity funds is especially striking because the contracts that determine fund organization and compensation are otherwise very similar. This Article examines the mystery of this missing preferred return.
The missing preferred return is troubling because it suggests that agency costs pose a greater problem in venture capital than previously thought. Are VCs sneakily extracting rents from their investors by failing to offer a preferred return? Conventional explanations for the missing preferred return are unsatisfying. Using option theory, I argue that a preferred return would better align incentives between VCs and their investors. Option theory further reveals even better alternatives to the status quo. For example, one might replace the managers’ profits interest, also known as the “carried interest”or “carry,” with a fixed percentage of the fund, thereby giving the manager something to lose on the downside as well as something to gain on the upside. If the goal of the carried interest is to line up the financial incentives of the VCs with the investment goals of their limited partners, venture capital fund agreements miss their target. None of the usual suspects like bargaining power, boardroom culture, camouflaging rent extraction or cognitive bias offers an entirely satisfactory explanation. A more promising explanation may lurk in a dark corner of the tax law: an IRS administrative pronouncement concerning the taxation of a profits interest in a partnership.
