The Twitter investment and the decline of venture capital

There has been a lot of talk the past few days about Twitter raising $100M at a $1B valuation.  To understand what is going on from the investor side, you need to know about David Swensen, the man who (inadvertently) destroyed venture capital.

Mr. Swensen manages Yale University’s endowment and is the inventor of the so-called “Yale Model.”  Basically this is a model for people who manage the largest pools of capital in the world – universities, pension funds, wealthy family funds, etc.  The major idea behind the Yale Model is to put significant portions of one’s fund into “alternative asset classes” like venture capital.   Yale had phenomenal returns for many years (until this year, which was a disaster) and thus was copied by fund managers around the world.  This created demand to invest hundreds of billions of dollars into VC funds.  This in turn radically increased competition amongst VCs, thereby driving down their returns (public pension funds like California’s release the returns of their VC investments and they aren’t pretty).

What this means is that there are lots of VCs out there with huge funds and very little chance of getting “carry” (performance fees), since most will have negative returns (and they know it).  So instead they are collecting management fees (typically, 2% of the fund for 10 years, so 20% of the total fund).  They need to justify collecting these fees, which is why if you hang out with VCs you’ll often hear them talk about needing to “put more money to work.”  I would bet that the new investors were the ones arguing for Twitter to raise more and more money, even if it meant a higher valuation.  I’ve seen it happen many times.

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