Skin In The Venture Capital Game
“If you do not take risks for your opinion, you are nothing.” —Nassim Nicholas Taleb
Venture capital (VC) is a complicated business with probability theory at its heart. Basically, you are swinging at the fences with a wide dispersion of potential outcomes and returns, just like in baseball—from home run to strikeout.
“Skin in the game” alludes to the vested interest of the VC manager in his fund. As private equity and VC funds are invariably structured as partnerships, the manager’s participation in the equity at risk is determined by the commitment of the general partner (GP) of the fund as a share of total commitments. Historically, GP commitments tended to be 1% for tax reasons, as this was the minimum requirement set by the IRS to get favorable treatment as a fund.
The fund management business is prone to agency conflict as the manager’s interests might deviate from the economic interests of his investors. This is mitigated to a degree by fiduciary duties imposed through regulation; however, “skin in the game” creates more alignment—especially on the downside—and is the crudest and simplest tool to ensure that the VC manager acts in the best interest of all his limited partners.
In order to understand how “skin in the game” impacts VC manager behavior, we have to look at the math underlying their investment strategy. In the most basic form, the total return generated by funds is defined as the sum of the mathematical expectation of all the bets managers make. Their strategy determines key variables in this equation and can be evaluated through its impact on the formula of expected return:
• Number/Sizes Of Bets: On one end of the spectrum is spray and pray—aiming to maximize the number of bets to the detriment of the quality of each bet—with the expectation that a handful of bets will make up for losses incurred. The other end of the spectrum is extreme selectivity with few carefully placed larger bets aiming to minimize losses, which has traditionally been the model for private equity players.
• Risk/Return Profile For Each Bet (best described by a probability function of expected outcomes): The accuracy of the profiles is a strategic choice. Most managers seek their competitive advantage by improving the understanding of risk using superior information aimed at skewing the outcomes toward better returns per unit of risk. Examples include: specialization (industry, geo or otherwise), focusing on follow-ons (where you benefit from observing the performance of the investment over time) and using “big data” in the investment process, enhancing the amount of data input and/or the quality of the evaluation function.
• Setting The Target Return Of Each Bet: In its purest form, this happens through the selection function. Managers can target a 100x return for each investment and in the process accept a large probability of failure. Targeting a modest return generally leads to a lower probability of loss. Ultimately, the manager’s strategy defines how much total risk they take and what target return they expect for each unit of risk.
Let’s Compare The Behavior Of Two Extreme VC Managers
Manager A plays only with their own money—full skin in the game. They may or may not have a high appetite for risk, depending on their background. Risk tolerance is determined by the dollar loss they are willing to risk for every dollar of expected gain.
Manager B is fully funded by third-party limited partners—zero personal skin in the game. As a result, the second manager has an option-like payoff, where their option premium is the opportunity cost, while they capture a portion of gains (usually 20%) through carried interest. As a result, Manager B is prone to maximizing the number of bets, minimizing opportunity costs by making decisions quickly to the detriment of risk evaluation. They aim for higher target returns by accepting more risks.
A textbook example describes Manager B being predisposed to selecting an investment with a 10% probability of a 100x return over an investment with a 50% probability of a 20x return, even though the mathematical expectation is 10x for both. It’s like playing at a casino with someone else’s money. Such behavior is only tempered by opportunity costs and potential damage to the manager’s reputation impacting his future ability to raise money and swing again.
How much skin in the game is necessary to keep the VC manager honest and to make sure his risk tolerance is rational? The mathematical answer needs to consider the value of reputation. The practical answer seems to suggest that the VC industry underestimated the importance of having skin in the game for quite some time, but is finally catching up. GP commitments have been rising steadily over the past decades and are now in the 2%-5% range for 80% of the firms.
However, there is a flip side to every coin. If GP commitments become too large, the GP could pursue its own interests even if they contradict the interests of the partnership. Many GPs rely on funding their commitments from exits and carry earned on previous funds, and this can become tricky in a tough market environment. Incidentally, I observed such a situation in the 2008 crisis as a semi-captive fund manager’s GP made the fund impotent, rejecting further investments in a great market because that would have triggered a default on the GP’s commitment.
In my personal opinion, the optimal participation is around 10%. This aligns interests while granting sufficient freedom for the manager to take risks. After all, as Nassim Nicholas Taleb so aptly quipped in his book Skin in the Game, opinion only matters if you put your money where your mouth is.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.