Why Do LPs Keep Funding Venture Capital Despite Mediocre Returns?
Every few years, someone points out the elephant in the room: venture capital, in aggregate, underperforms. Most funds fail to beat public market equivalents over long horizons. Yet the industry is awash with capital, and Limited Partners (LPs)—university endowments, pension funds, sovereign wealth funds, family offices—keep wiring money.
So, what gives?
As someone put it: "This is much less important than tweeting about AGI, but it is nevertheless amazing to me that the entire venture industry can (in aggregate) lose money for so long and keep getting funded."
Here’s why they do it—and why they’ll likely keep doing it.
1. The Power Law Isn’t Just a Quirk—It’s the Game
Venture capital doesn’t work like traditional investing. Returns follow a power law, meaning:
A handful of companies drive almost all the returns.
If you're an LP and you manage to back funds that invested early in companies like Stripe, OpenAI, Figma, or Airbnb, you can return your entire fund multiple times over.
This creates a mindset where:
- “Missing the next big one” feels riskier than backing 10 average funds.
- It’s not about hitting a batting average—it’s about home runs.
And that mentality drives allocation behavior.
2. Top Funds Are Golden Tickets
There’s a stark performance gap between top-quartile and median funds. Cambridge Associates and others have shown that only the top 5–10% of funds generate consistent outperformance. The rest barely outperform or even underperform public markets.
So why fund anyone but the top 10%?
Because access is scarce. Tier-1 VCs (think Sequoia, Benchmark, Accel, a16z, etc.) often don’t accept new LPs. To get a seat at that table, LPs play a long game:
- Back emerging managers today.
- Build relationships.
- Hope to get invited into top-tier funds when allocations shift.
Optionality trumps immediate ROI.
3. Narrative and Prestige Matter
Allocating to venture gives institutions a seat at the innovation table. Even if the returns don’t beat public markets, being able to say:
- “We backed early AI researchers”
- “We funded climate tech before it was cool”
- “We were early in Web3 (oops)”
…has storytelling and signaling value. In some cases, reputation yield is more valuable than capital yield.
4. Mandates and Portfolio Theory
Many institutional LPs are bound by allocation mandates—for example:
- 20% of the portfolio must be in “alternatives”
- Or a certain percentage must go to illiquid growth assets
Within these constraints, VC is often seen as the sexiest flavor of illiquidity. LPs don’t want to put everything into real estate or hedge funds. VC at least feels innovative.
5. Illiquidity as a Feature, Not a Bug
This one’s counterintuitive. LPs sometimes prefer illiquidity. Why?
Because VC investments aren’t marked to market daily, they can create the illusion of smoother portfolio volatility. While public stocks bounce up and down every day, VC portfolios report only quarterly—and often show a flat line until an exit.
It’s a kind of “mark-to-myth” comfort zone, especially valuable in volatile macro environments.
6. Hope and FOMO
Let’s be real: some of this is driven by hope and fear of missing out.
No LP wants to be the one who said no to OpenAI’s seed round or passed on a now-iconic fund. The next great fund might be raising now, and skipping it could be a career-limiting move.
This creates momentum-based allocation behavior—even when the math doesn’t quite add up.
7. Fee Structures Are Sticky
Most VC funds charge 2% management fees + 20% carry. Even if the fund performs meh, the fund manager still gets paid well. But here’s what’s overlooked:
- These fees also incentivize funds to keep raising.
- LPs get caught in a loop of re-ups to maintain their place in line.
And smaller LPs often accept worse terms just to get access.
8. Lack of Transparency and Herd Behavior
Most LPs don’t have full visibility into how other funds are really performing—especially in the early stages. Much of the “performance data” is self-reported and delayed. This creates a fog of optimism, where everyone assumes others are doing better than they are.
Add to that a natural herd behavior in capital deployment, and you get waves of funding that don’t necessarily align with fundamentals.
9. Politics and Career Risk
Finally, let’s not ignore this: career risk and internal politics shape behavior.
- No one gets fired for backing a known brand.
- But backing an obscure fund that underperforms? That’s on you.
So LPs hedge career risk by sticking with the usual suspects—even if the whole asset class is questionable.
✳️ Finally
LPs fund venture capital despite poor average returns because:
- They’re chasing outliers.
- They want access and optionality.
- They crave narrative prestige.
- They’re boxed in by mandates, illiquidity optics, and peer behavior.
Venture may underperform in aggregate, but it overperforms in ambition—and that’s often enough.
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