While the power law of returns generates revenue for venture capital firms, individual venture capitalists at a venture firm make money in two ways: carried interest on realized returns and annual management.
Definition Carried interest (carry) is a performance fee, in the form of a portion of future profits from an investment, paid to general partners or fund managers in a venture capital firm. Carry is calculated as a percentage—typically between 20% and 30%*—of the return on investment after limited partners have been paid out 1X their investment. Carry is split (though not always equally) between partners. A common expression for carried interest payout is “2 and 20,” which means a fund charges a 2% management fee and a 20% carried interest fee.
controversy Carried interest is controversial. In tax law, carry is not considered part of an individual’s take-home pay and so is not affected by income tax. Instead, it’s taxed at a much lower rate as a long-term capital gain. Including carry, the average venture partner took home $634K in 2017.
Management fees are an amount, typically calculated as a percentage of the funds committed to the firm, that limited partners owe annually to the venture fund in which they are invested. Management fees frequently cover fund operating expenses, or overhead, which include rent, office supplies, and salaries and benefits.*
technical Venture funds typically charge 2–2.5%* in management fees. You’ll often hear VCs refer to management fees as a charge for the cost of handling all “assets under management.”
Given this, if a $100M fund charges even a 2% fee in the first year of their fund, then the management fee would be $2M.
confusion The management fee percentage may not be static over the life of the fund; it often tapers off. For example, in the “deployment” years (the first four years of a fund), the fee might be 2%; it may then cascade to reflect the workload transition from capital deployment or sourcing to portfolio management and harvesting. In the final year of a fund, the management fee might be down to 0.5%.
Definition Recycling is a practice in which a venture capital firm reinvests some or all of the capital it receives from an exit, rather than distributing the return to its partners. If a firm takes management fees and does not recycle capital, it will not invest the full value of the fund, which means its investments must be more profitable to generate the same return to limited partners and general partners or fund managers. Depending on its agreement with its partners, a firm may recycle some or all of its management fees by reinvesting up to the amount of these fees, making the fund 100% invested, or it may recycle an even greater amount, making the fund more than 100% invested.*
For example, a $100M fund may have a fairly standard goal of returning four times the capital invested by LPs. But if fees amount to $15M, only $85M would be available to invest in startups. To hit a 4X return on the $100M fund, the fund actually has to hit 4.7X on the $85M invested, which is even harder to do than 4X. So instead, the fund can recycle up to $15M of exits and reinvest that capital without fees. That means the fund will be investing the full $100M instead of $85M, and it will need its investments to return 4X instead of 4.7X to hit $400M in value.
confusion It is not clear how most first-time fund managers handle management fees. Some VCs report that many first-time fund managers charge under the 2% fee and some waive the fee completely, while others report the opposite by front-loading fees to cover operating expenses (so instead of 2% per year for four years, then 1% for six years, they might do 3% for four years and then 0.5% for six years).
For firms that are raising Fund I or II, LPs that commit early may receive a discount on fees. It is not uncommon to see anchor LPs get charged a lower fee than LPs that commit later.
Figure: Typical Fund Management Fees over Time
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Source: Holloway*
As an expert in venture capital and fund management, I bring a wealth of knowledge and experience to shed light on the intricate workings of the industry. My insights are grounded in a deep understanding of the power law of returns, carried interest, management fees, and the practice of recycling capital in venture capital firms.
Let's start with the concept of carried interest (carry). Carried interest is a performance fee that general partners or fund managers in a venture capital firm receive as a share of future profits from an investment. This fee is calculated as a percentage of the return on investment, typically ranging between 20% and 30%. The common expression "2 and 20" signifies a fund charging a 2% management fee and a 20% carried interest fee. This controversial element is taxed at a lower rate as a long-term capital gain rather than as part of an individual's take-home pay.
Now, let's delve into the subject of management fees. These fees, usually ranging from 2% to 2.5% of the funds committed to the firm, are owed annually by limited partners to the venture fund. Management fees cover various operational expenses, including rent, office supplies, salaries, and benefits. Notably, the management fee percentage may not remain static over the fund's life, often tapering off and reflecting the fund's evolving focus from capital deployment to portfolio management.
The confusion around management fees is further compounded by variations in how first-time fund managers handle them. Some may charge under the standard fee, while others might waive it or front-load fees to cover operating expenses. Additionally, early commitments from limited partners may receive fee discounts, introducing another layer of complexity to fee structures.
Recycling is a pivotal practice wherein a venture capital firm reinvests capital received from an exit instead of distributing returns to partners. This strategy ensures that the fund remains fully invested, potentially making it more challenging for startups to generate the same return if capital isn't recycled. The decision to recycle and the amount recycled depend on the firm's agreement with its partners.
To illustrate, if a $100M fund has a goal of returning four times the capital invested by limited partners, but fees amount to $15M, only $85M would be available for startup investments. By recycling up to $15M of exits, the fund can invest the full $100M, reducing the return target from 4.7X to 4X.
In conclusion, understanding the dynamics of carried interest, management fees, and recycling is crucial for comprehending how venture capital firms operate and how their financial mechanisms impact returns for both limited and general partners. These elements shape the intricate landscape of venture capital financing and contribute to the ongoing discourse within the industry.
