Investing Billions - E365: Stanford GSB Professor on Venture Capital’s Manager Incentives

Episode Date: May 8, 2026

What if the biggest mistake in venture investing isn’t picking the wrong fund—but misunderstanding incentives and behavior? In this episode, I sit down with Ilya Strebulaev, Professor of Finance and Private Equity at Stanford GSB, to discuss how incentives, biases, and portfolio construction shape outcomes in venture capital. Ilya explains why fee structures matter less than how they’re designed, how carry changes risk-taking behavior, and why persistence in venture is real but often misunderstood. We also explore diversification, correlation across managers, and the hidden decision-making biases that drive both LPs and GPs, from escalation of commitment to style drift.

You're the David S. Lobel professor at Stanford at the GSP at the business school. You're leading researcher on private equity. Right before you started recording, I asked you about two and a half and 30 and which part of that LP should negotiate on. And you told me neither. Why is that? Well, you asked me a slightly different question. You asked me, what is the difference between 2.5.30 into 20? How many basis points in PME?

Okay. And my response was, you can calculate or you can estimate the basis points. But that really will not help smart investors. Because typically you do not choose between two and a half and thirty and two and twenty. You typically really given what you have on you, then a price taker, or you can negotiate and then you are at least partial price maker. And so the question is, if you're a price taker, do you walk away or not? Or if you're a price maker, you can negotiate and then if you can negotiate, negotiate, negotiate

on what? And from this point of view, two and a half and thirty is not very helpful because the question is, well, two and a half of what? It turns out that whether it's two or two and a half is less important than if it is two and a half or two of the committed capital, of the invested capital, of the managed capital, some combination, and specifically whether it changes over time. For example, all the things equal, I definitely would prefer two and a half of the committed capital that goes into managed capital after year five.

compared to one and a half, forget about two, one and a half of committed capital for 10 plus three years. So I think the base is very important. Now, that is just an example, of course, there are many other things. The same is 30. Now, other things equal, of course I would prefer 20 to 30 as an investor, but in this case I have to ask a question, how can it be that other things equal?

Incentives drive behavior. When I work with large LPs, I always tell them, look, incentives drive behavior and incentives of your incentives drive behavior, but also incentives of fund managers that you invest in. So 20 and 30 create very different incentives. They create very different risk return profile, and there is a selection of fund managers. So that would be my one response to this. So it's very difficult to compare other things equally.

Let's start with incentives. Why is there such different incentives for a manager making 20% carry versus 30% carry? What does carry? Carry is an option. and as with any option, those who have a long position in an option, such as fund managers, would rather prefer high risk.

So that if you have a 20% care, you actually prefer higher risk than many other investors in the world. But if you go from 20% to 30%, you prefer even higher risk. So as a result of this, as an investor, you have to ask yourself a question whether you're okay

with that specific fund manager taking higher risk. Because typically what happens is that what is 30%? Well, 30% results because a manager who was on 20% performed very well. And then that manager says, well, guys, I really delivered returns for you. So now it's going to be maybe 25% or maybe step up to 30%. Okay. But if the manager is the same and the manager delivered great returns on 20, the question is whether this manager will behave exactly the same when you move that manager from 20 to 30 and you have a step up and, uh,

whether the risk profile of that manager will change, which will affect the persistence of returns. So I think the word persistence date is critical. At the end of the day, you invest in successful fund managers on expectation, on belief, or on wish, that they continue to be... The future performance is determined by past performance. The opposite of that disclaimer, right? This is really interesting because this is what LPs believe.

Well, that's what the market very often believes that. future performance is a function of past performance. So let me clarify this, okay, because I think this is one of those, I work with LPs, but also I'm teaching the, one of the classes I teach at Stanford for my MBA students is private equity class, the economics of the private equity industry. And by the way, when I say private equity in our conversation today, I also mean venture capital, okay?

So, and we go very carefully over all possible mistakes or inefficiencies that LPs commit that may affect their returns. So one is the following. You should not think about whether future performance is a function of past performance because you really care about

future net performance. At the end of the year, you're an investor. If the future gross performance is great, but the fund manager takes all the gross and you have zero net, you're not going to be happy. But as a function of gross performance, so that is very important. Let me repeat this,

because I think in my experience with working with many LPs, but also with my students, it's very often unclear. The question is whether your future expected net performance is a function or will depend or how it will depend on the past gross performance, not past net performance. And so this is where our discussion about incentives and about carry comes into play. You said something and I want to play devil's advocate on that,

which is you said 30% carry will incentivize somebody to take more risk. Is that a positive or a negative incentive? That depends. So LPs should think about broadly two things. One is risk criterion profile of a specific manager. So if you were David working for me at 20% carry, okay, and you succeed, and now you increase 30%. Out of each dollar, you lose for me, you're still taking nothing.

It was zero, zero. out of which dollar you make for me, okay, I'm simplifying, you now will take 30 cents as opposed to 20 cents. So this creates dramatic optionality, dramatically higher than for 20 cents on the dollar. And this... What's intuition around that? Why is that dramatically higher?

I guess it's 50% higher. 30% is 50% higher. Actually, what is really interesting is that because it's non-linear, non-linear meaning that, so if you can see my hand, So if you lose money, it's zero. So the fund managers don't lose their own money. I mean, they commit capital, but let's ignore this, okay? But if you take 20% is like this, that's the angle of 20% and that is the angle of 30%.

And that only is amplified by tiered carry where you have certain tiers over certain structures. That even dramatically increases that. Well, tier structure introduces wrinkles on this, on this. But the intuition is the same. That increases the risk-taking. Well, it increases the other things equal predisposition to take risk. Now, it does not mean by itself that risk is, as you said, bad, because it's risk-retion profile.

High-risk can mean better return on the risk-adjusted basis, okay? But, and that is, I think, big difference between prior equity and many other investment spaces, which is investors, fund managers. fund managers, specialize. And as you increase risk... In theory. Oh, I would say it's in practice.

Absolutely. In practice. Do you think the large VC firms are specialized? Well, so many VC firms specialize. Many PF firms specialize. Absolutely. Now, if you take about the giants, they may not specialize,

but they're funds specialize. Absolutely. There's no doubt about this. The team and... And in fact, many success... So if you look at the correlation of specialization of success, those that are very specialization,

other things are more likely to be successful. So that proves out in that data, because a lot of people have this intuition. That's something. That is data definition. What's the research on that? Oh, there's a lot of research. There's a lot of research by my colleagues,

but also I've done this. And I show the specialization to my students every year. We compare the specialization of both for VC for buyouts that if, and that's important for our root discussion, is that persistence tends to disappear, And there's special name for it. It's called style drift. When managers kind of go and do something else.

And going back to risk, this is where I would like LPs to think. If they move from 20 to 30% then that manager is going to increase risk. But the question is whether it also means that there's going to be style drift. Because what does it mean higher risk? Now, in buyouts, it might mean high leverage. But more likely than not, it's actually investing in different kinds of different kinds of portfolio assets underlying portfolio companies. That intuition, why is it if I'm a biotech investor, crypto investor,

or even a AI investor or defense investor, why, if I want to increase my risk, should I go into another sector? What's intuition or not sure whether you should, but that's likely what you're going to do? Because high carry means you like high risk. High risk means that you would like to invest in assets with higher volatility, high exposure. Okay.

Now, what does it mean assets with high volatility? Well, it's different profile of assets. Let's think about the stock market. If I would like to invest in a low volatility assets, I might invest in, let's say, you know, the so-called, at least in the past, dividend kings, electricity utilities, whatever. But if I would like to invest in dramatically high volatility assets,

I will invest maybe in tech companies. Now, the same intuition holds for private assets. Again, there's a, I think it's important, to understand the chain here, the chain of intuitive thought. So if we move from 20 to 30% carry, incentives drive behavior, fund managers have predisposition to be interested in high-risk assets. And the question is, how this high-risk assets will materialize? Will they materialize in different portfolio composition? Will they materialize in different structure of assets? So that depends. But going back to your original question, you asked me, so would investors prefer 30 or 20%?

and carry. If everything else, let's say, stays the same, like management fee, whatever. And there's no right answer for this. And this is, I think, going back to the allocation of capital and private equity and the specific fund manager selection. It depends. But it depends on a helpful way because, in fact,

there are many methods that smart LPs can use to separate those managers that not just deserve 30%, but the net expected return on the risk-adjusted basis is still going going to be high relative to the market, relative to the market expectation, alpha. Higher return without high return. High return. Right. And still could be higher for some managers, but definitely not for all. So let's say you're an endowment and you have the perfect governance structure. You're completely unbounded by investment committee and you're in the tail end of your

career and you just want to say you work for Stanford's endowment. You just want to return the most amount of capital to Stanford on a risk-adjusted basis, and you want to invest in venture capital. What are one or two smart strategies? Well, first of all, a side note, what you're describing is not, might not be the perfect corporate government, but let's double click on that. Okay. So what is the perfect corporate governance? It's just a single-family office investing their own money.

Is that? No, what I mean is perfect governance structure is the structure that is built, again, around understanding that incentives drive behavior. On the one hand, you would like to have the first. flexibility so that decision makers managing money can make decisions that that that maximize risk-adjusted return and allocation on the other hand you would like to have a structure where there is control and where there is an opportunity to to account for the decisions that are made you know the biggest challenge in financial markets especially in

private equity is that you might need to wait for years and years and years before the returns are materialized and before the quality of your decisions become clear so the moment you mentioned at the tail of your career, which I interpret is that, well, you're going to make investments, but in fact, it's the subsequent duration will realize that, okay? Let's assume that you had this angel investor that was completely aligned with the university and had no ego and just wanted to have the best returning portfolio invention. What he or she do? First of all, I think that it overall could be very high-risk reason strategy. I think if you look at historically at venture, venture has returned on the risk return, on the risk adjusted basis,

higher than the market. And there are many, many few spaces, many few spaces in the financial industry that have demonstrated clear persistence and based on the absolute, on relative, on the PME basis, etc. And venture is really one of them. Actually, maybe kind of more or less the only one that persistent to demonstrate that. I asked this very question to Eric Porre, CEO of Atapar, is venture capital the best performing asset class of all time? And he said, no, sports teams, but it's number two. So if you had invested in sports teams over the last 20, 30 years, obviously that's very difficult to access asset.

But joking aside, venture capital appears to have this persistence over, what, 40, 50 years? Yes, at least over 40 years. So, you know, that's actually not a job because it's a very important question. What is an asset class? One can claim that sports teams is an investment. of course niche, but is it an asset class? Now, by the way, some people, including some in Silicon Valley, say, tell me, well, venture is not an asset class because it's relatively small.

It used to be relatively inaccessible, and, you know, there's something into this. Tell me more. Well, let's think about this. So in the stock market, if you believe in a mutual fund manager, well, you just invest in the financial fund manager. Okay, and that's a future fund manager, it takes on more money. in the venture, if you really believe in a specific fund manager, there is no guarantee that that fund manager will take your money.

Almost the opposite. If it's a good fund manager, almost guaranteed that they will not take your money. Well, it depends on who you are. It depends on who you are and the size of the money. So as a result of this, there is not always the equilibrium between supply and demand. And that's a very interesting question by itself,

why that is the case. But as a result of that, it's not the same asset class as, for example, public markets. So I would say some private equity, real estate investments. But to your question about venture, so my first answer would be that it's actually, I think, likely a good decision to invest in venture. So another way, it's a good neighborhood in general. And then if you want to find where to invest in that neighborhood, where would you invest?

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I like rephrasing questions. I'm a little bit maybe too professorial, but when I answer questions of my students, but also LPs that I work with, or fund managers that I work with, I very often replace questions. So you ask me where, I actually would rephrase it as how.

That's more important. Because where suggests to me, like, you know, in robotics or, in, you know, that's data center, et cetera. And that changes very frequently. Whatever I'm, I can tell you right now, but by the time it will be aired or, you know, six weeks down the road,

somebody is going to listen to this, this will change. But the answer to how question does not change, at least as frequently. So first, is that I would think about how you should diversify invention. Because in my experience, this is where I think many LPs make, I would say, strategic mystery.

takes. So on the one hand, you would like to diversify. You don't want, if you're an LP, to invest in a very, very small number of venture funds, however great they are. Because especially in venture, there's a very high degree of volatility, which means among funds, which means that if you invest in a specific fund, you might be very disappointed, even if previously that fund had a great outcome, okay, that fund manager had a great outcome. And that could be nice. It doesn't mean that the manager's bad. Well, it can mean that the manager is no longer great, but it can be also nice. So the noise is where the noise adventure is definitely larger than in many other financial assets.

There's no doubt about that. So as a result of this, you would like to diversify. However, and that is something important. In the stock markets, very often we say, we tell our students in the basic finance classes, you know, you have to diversify as much as possible, okay, like invest in whatever, SMPU 500. And if you look at statistics, you know, passive investment has gained dramatic, including among large institutions, including large LPs, okay?

Well, I think in venture, just diversification to the same extent will not work. So you would like to diversify, but you would like to diversify very meaningfully. So at the end of the day, you need to have a reasonable but limited number of fund manager relationships. Now, how many of that depends on the size of your investor example? But I would say for a very large investor,

they decided to invest, let's say, hundreds of millions of dollars in the venture space, or billions of dollars in the venture space of the course of the years, it would be at least 15 to 25 relationships. And how it depends not only on deciding in which specific manager to invest, in which specific industry or stage to invest, or which specific geography, but the correlation. So the relationship between these fund managers. I think that is critically important.

And in my experience, in my experience, in my experience, this is what many LPs underestimate. So they spend a lot of time thinking about whether to invest in individual managers. So they spent a lot of time with individual managers. They do spend a lot of time on their allocation decisions. We haven't yet mentioned the denominator effect, but they spent quite a bit of time about that, okay, the overall allocation. And also maybe where to invest like geography or whatever, venture to versus private.

They spend much less time, much less effort in, what I believe is very highly productive activity. Thinking about correlation across the venture and more broadly, private equity portfolio. And that's kind of the free lunch and venture. If you could get the same returns with lower correlation, that's what you're looking for. Well, there's almost no free lunch in the world of finance. But yes, it's going to be higher efficient, more efficient decision. So you want low correlation?

You would like to reduce the correlation, absolutely. You would like to reduce the correlation, Absolutely. You would like to reduce the correlation. But again, the way you reduce the correlation in many other markets is just by effectively increasing the number of assets you manage. And in venture, it doesn't work this way. So therefore, you have to think correlation thinking in venture, I would say, is much more strategic than in many other assets

because it's more difficult to implement. Because it is, I would say there's both art and science. also given the access of opportunities you have and I think given also what exact information you observe about all the fund managers. Perhaps a dumb question, but let's say you're in 15 to 20 minutes. There are no dumb questions as I tell my students.

There could be dumb answers though. Let's say you invest in this 15 to 20 manager portfolio that you mentioned this canonical portfolio and you have this larger set of portfolio companies, let's just call it 300 to 400. How would one go about figuring out whether there's correlation between these assets. Is this a tool?

Is this some AI-assisted process? Well, now everything is AI-assisted, so that's not right. So economics is the same. AI is basically helping you with the data processing. So the answer is the following, is that first it depends on the quality of your information. Let's assume that you invest in the manager under the expectations that the manager will not have a style drift,

which means that the manager will continue pursuing the same strategy. Like if the manager was investing, in, you know, series B2C SaaS companies, then the manager will be investing in series B2C SaaS companies with certain modifications in the next fund, okay?

So that allows, in fact, to look at the correlation that this assets class had vis-à-vis the rest of your portfolio, but vis-a-vis also are the fund managers that you invest. And I think that is really important because if you look at,

let's say, adding another manager to your portfolio, and if you look at that manager in isolation, you will, you may conclude that that manager may not be that great, especially maybe then if you have 2.530 or something like this, okay? And looking at isolation, that might be true. But maybe that manager is investing in something that you don't have yet exposure to. So let's say you're investing in the venture,

but you have not had exposure to crypto assets or blockchain assets, let's say. And maybe you didn't because it's a very new asset class you haven't been exposed to, and also maybe because you thought that it's, economics is against you because it's costly to invest in better managers because of high demand. This all might be true, but correlation-wise, it actually, this asset class might be really beneficial, given your portfolio. And again, I think that this is where many, many investors do not pay enough attention. Before we get back to the show, quick invitation for the allocators in our audience. On Thursday, May 14th, I'm gathering an exclusive group of allocators in New York.

New York City for dinner to discuss the evolving landscape of private markets and the DPI crisis. How are savvy allocators navigating the liquidity crunch? If you're an institutional allocator, RIA, or family office, this dinner is for you. Space is limited, so please go to Weisford Capital.com slash events right now to secure your seat at the table. That's W-E-I-S-B-U-R-D, as and David, Capital.com slash events. Before we get back to the show, quick invitation for the allocators in our audience. On Thursday, May 14th, I'm gathering an exclusive group of allocators in New York City for dinner to discuss the evolving landscape of private markets and the DPI crisis. How are savvy allocators navigating the liquidity crunch? If you're an institutional allocator,

RIA, or family office, this dinner is for you. Space is limited, so please go to Weisford Capital.com slash events right now to secure your seat at the table. That's W-E-I-I-S-B-U-R-D, as and David, Capital.com slash events. Before we get back to show, quick invitation for the allocators in our audience. On Thursday, May 14th, I'm gathering an exclusive group of allocators in New York City for dinner to discuss the evolving landscape of private markets and the DPI crisis. How are savvy allocators navigating the liquidity crunch? If you're an institutional allocator, RIA, or family office, this dinner is for you.

Space is limited, so please go to Weisford Capital.com slash events right now to secure your seat at the table. That's W-E-I-S-B-U-R-D as in David, Capital.com slash events. And as many things in life, there's trade-offs. And a lot of these sector funds, for better, for worse, they become sector funds after there's a couple of breakouts, the first couple generations. So, and a lot of times that they're also later stage, they might be a Series A sector fund. How'd you go about the trade-off between Precedency General's funds versus call it Series A specialist funds and talk about maybe earlier stage and late stage in sector versus generalist.

How would you make those tradeoffs? I would approach this question a bit differently. I would look at underlying people who are making decisions. I would say the single most important provision, well maybe I shouldn't say this single most important, but one of the single most important provisions that you have in your LPA is the key person provision in the world of venture, who actually is going to be responsible for managing

those portfolio companies. So if, let's say, consider a hypothetical situation, but I can see this hypothetical situation all the time in Silicon Valley and beyond. And by the way, why do I know about this? Because we've now constructed, with my student who is becoming a professor in his own right, Blake Jackson,

we've now constructed the database of every single venture fund manager and private equity as well, every single investment professional. And we follow them through their career from 1990s till 2020. Where are you guys collaborating from a data perspective? Oh, well, we're collaborating with ourselves. We've manually collected a lot of data, but also we have a lot of,

we have commercial data providers. We've been very grateful for the partnerships with such as institutional investors as Stepstone, for example, and many other providers who prefer to be, who prefer to be anonymous, but we've collected, like, and we know, almost every single fund person. Now, why it's important? Let me give you a hypothetical scenario.

We have, let's say, a great fund manager with a great brand name and great people who are investing in late stage. And then they look around and they say, oh, early stage investment is becoming very interesting in that space. So let's also create series A. Now, we're too busy, and also we don't really understand this very much. So let's maybe hire the team that is going to do Series A. or maybe let's buy out this team from somewhere else.

And they open Series A under their brand. So this is a classical style drift. Usually it's the other way around, right? It's a series A going to the later stage. I see it both ways. Both ways. But it's the same style drift. It's the same idea.

Now, what it really means is that for LPs, the brand name could be relevant. There are some brand names that open the doors, okay? Very few, especially these days. and they change and they turn over, but you should look into underlying people because that specific fund manager was successful because of those specific people in the key person

and maybe some junior people who are rising through the ranks. And now there are different people investing in Series A or there are different people investing in late stage, or there are different people investing in different sector, or there are different people investing in different geography if an American fund decided to go to India. So the question is, Are you as convinced that those new fund managers would be as successful?

So as a result of this, I would say it's not really about a generalist versus specialist. It's how those generalists and specialists came to be. If you have a specialist fund that was very successful, another specialist fund became generalist or became specialist in like several fields, who is making those investments? Are you convinced that those people also know about those investments? in the same way. Sometimes the answer would be yes, but most of the time the answer is actually would be, I'm not sure, or maybe not. Maybe they're not the best in class. Even though I think

LPs are broadly aware of that, I'm not entirely certain that LPs pay too much attention to this. So, for example, when we have less data on venture about this, but when we look at private equity, when private equity, when private...