On Zombie VC funds in France

May 14, 2013
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Zombie-VC

Exactly ten days ago the yearly ritual of ‘Woodstock for Capitalists’ took place. Also known as the annual shareholders meeting of Berkshire Hathaway, this may well represent the only public company’s shareholders meeting whose promise of attendance can be the sole reason for investors to purchase a share of its stock. Of course, another reason is the unparalleled financial performance of the company led by arguably the greatest investors of all time: Charlie Munger and Warren Buffet.

I enjoy reading Buffet’s yearly letter to shareholders in introduction of BRK’s annual report. And while I’m still sifting through some of the euphoria of the shareholder meeting for his customary pearls of wisdom, one gem struck me as particularly relevant for stakeholders in the current state of France’s VC market, to paraphrase Buffet:

If consumers try to invest in every product pitched to them, they will do very well for their money manager and not very well for themselves.

French taxpayers tempted to blindly plow their savings into tax-optimization products, I’m thinking of you. Undoubtedly due to a burdensome fiscal environment, France boasts one of the largest and most developed industries of tax advisory intermediaries in Europe. For anyone owing income or wealth tax in France, a panoply of financial products exists to help them reduce the tax bill: charities, support for the arts, overseas territory investments, real estate schemes, and even tech VC funds. I’ve already written extensively about this last option – so-called retail VC funds – so I won’t rehash all the gory details.

However, I believe that we have entered a phase where many of these retail funds have become Zombie VCs. Danielle Morill wrote a trenchant piece on Zombie VC funds, complete with warnings for startups and even a list of candidates for the zombie status. I also recommend Fred Destin’s follow-up to this piece with his handy guidelines for entrepreneurs to spot an active VC firm.

Beyond the relevance for startups raising money, in France a wariness of zombie VCs is also relevant for taxpayers considering investing in such a fund.

Danielle and Fred explain it eloquently (and these recent pieces in The Economist and the FT add some additional color, or should I say pallor?). But in a nutshell, a zombie VC is a fund that has stopped or severely curtailed the lifeblood of its business: investing in startups promising high potential, and culling those that don’t, all in the pursuit of financial performance.

When a VC runs out of money, it of course can no longer invest in new companies. Often those entering zombie status will preserve their remaining funds to support their existing portfolio.

The nature of France’s retail VC model, however, makes the onset of zombie status particularly acute. First, retail VC funds operate on a yearly, even semi-annual, fundraising cycle (whereas conventional institutional VCs raise larger funds on average every 5~7 years). The precipitous decline in retail VC fundraising (due largely to fiscal changes discussed here), combined with the economic downturn, has suddenly thrust the majority of France’s VC sector into risk of zombie status.

To make matters worse, a French retail VC zombie has little zombiepackincentive to cull the underperformers in their portfolio. Better to keep such firms on drip financing status, just alive enough to justify continued billing of management fees to the funds’ investors (once a portfolio firm is written off, the VC can no longer charge management fees on that asset). The result is the creation of a class of Zombie Startups and a huge disservice to the funds’ investors who are paying fees to someone to throw good money after bad.

As the FT points out, “The problem with these ‘zombie’ funds is that if nothing is happening with a private equity fund, the very concept of charging a 1.5% to 2% fee for managing it deserves to be challenged.” (2.5% to 4% in France, by the way).

Taxpayers: do your research before sticking your necks out.

Photo courtesy of Founderscode