Recycling Management Fees for VC Funds

I spent time explaining to a friend how management fee recycling works for venture capital funds. Funds that recycle management fees can reinvest cash distributed to the fund into new start-ups. The alternative would be to distribute all cash back to their limited partners. For example, let’s say a fund invested $1 million into a start-up and received $1.5 million back after the company was sold. Depending on a variety of factors, a fund that recycles fees could deploy some or all the $1.5 million into a new start-up instead of returning it back to limited partners. If they don’t recycle, the entire $1.5 million would likely go back to limited partners.

Most funds have a ten-year life, meaning the goal is to deploy capital and return profits to limited partners within a ten-year window. And most funds have a management fee. This fee provides cash flow to pay operating expenses of the fund, such as salaries. The management fee is charged yearly, usually as a percentage of capital committed from limited partners. Two percent is what I’ve seen most funds charge, but it can be higher or lower. Two percent charged annually for a decade means that 20% of the capital committed by limited partners won’t be invested in start-ups.

The other venture fund fee is called carried interest. That’s a fancy way of saying profit sharing. The people managing the venture fund (general partners) split any profits generated with the limited partners. Twenty percent carry is what I’ve seen for most funds focused on investing directly into start-ups, but it can be higher or lower. Twenty percent carry means general partners get 20% of any profits earned. It’s important to understand that carry is usually earned after the initial capital is returned to limited partners. If the fund is a $10 fund, the general partners must return all $10 first; then any capital above that is eligible for carry. Said differently, the fund must be returned in its entirety before carry can be earned.

Let’s look at a hypothetical $100 million venture fund with a 10-year life cycle and a 2% management fee:

  • Capital invested in companies: $80 million
  • Capital to manage the fund: $20 million

Most funds aim to generate a 3x return (we’ll assume gross for simplicity) for their investors—$300 million for this hypothetical fund. Let’s run a few scenarios:

  • If this fund doesn’t recycle fees, it must turn $80 million into $300 million. That means the general partners need a return of 3.75x the $80 million they invested into companies to achieve their 3x return target.
  • If this fund recycles fees, they could end up deploying the full $100 million and need to triple the capital invested to achieve their target (3x) $300 million return.
  • It’s possible to recycle to the point where the fund invests more capital into companies than was committed by limited partners. Imagine that the fund recycled enough to invest $115 million into companies. That’s $15 million more than limited partners invested in the fund. To achieve their 3x return target, they need to achieve a return of 2.6x the $115 million capital invested into companies.

From these three scenarios, you can see a range of 3.75x to 2.6x return on invested capital needed to achieve the same $300 million—3x return for a $100 million fund. That’s a big difference.

Venture capital is a power law business where one or two companies can generate a large portion of a fund’s returns. Recycling can allow general partners to place more bets on a single fund.

Fee recycling involves lots of nuances and details that I didn’t get into, but this is an important concept for fund managers (and even founders) to understand.