The Economics of a VC Fund

Of course, it is about the money!

The economics of venture capital funds differ, based on a variety of factors. The most important one being the expertise and track record of the fund manager, based on the number and quality of the deals that have been closed and exited.

It also depends on the overall fee structure of the fund, with factors such as carried interest and catch up, the preferred return of the investors, management fees and other fund-level fees involved, including offsets, and the portfolio company fees paid to the fund manager on a deal-by-deal basis.

The investment investment purpose and structure of the fund, and general market dynamics also play a part to a large extent.

Although the specific vary, there are some basic elements of the economics of a fund common to all VC funds, including:

Investor capital commitments;
Allocations of profits and losses of the fund;
Applicable distributions;
Fees paid to the fund’s investment advisors; and
Expenses of the fund.

Capital Commitments:

An investor participates in a Venture Capital Fund by subscribing for a commitment of capital. In most cases, the commitment is not funded 100% on subscription, but in 3-4 installments called drawdowns, as per the instructions of the fund manager. These instructions are capital calls, and are on an as-needed basis, when the fund is required to make investments, or pay fees and expenses.

An interesting factor to note is that often, the fund manager itself has it’s ‘skin-in-the-game’ by making it’s own capital commitments to the fund. This is a good marketing pitch, and demonstrates better alignment of interests of the fund manager, that manages the fund, and it’s passive investors, and also mitigates the incentives to take larger risks, given that the fund manager’s own monies are also invested.

Back to capital calls. The fund manager can only call-in capital to the extent of what has been committed but not paid in. For instance, if investor A commits US$ 500,000 at the time of subscription, and the fund manager has already drawn down US$ 200,000, it can only issue capital calls of US$ 300,000 to investor A. Usually, this is done in terms of percentages, for instance, 25% tranches, to make the numbers workable across multiple capital commitments.

Close attention is also paid to the provisions of the private placement memorandum of the VC fund where investor obligations to reinvest capital contributions are detailed, and also the extent to which investors recoup their invested capital in ongoing investments before the fund manager receives a share of the profits from exited investments. These are usually detailed in the Carried Interest and Catch-up and Allocations and Distributions.

Reinvesting of Capital Commitments:

The fund’s private placement memorandum (PPM) may permit the VC fund to reinvest capital that is returned to investors. This is usually done by adding the amount of the return on capital to an investor’s remaining commitments.

In most cases, recycling provisions cover the following types of capital returns:

Investments yielding quick returns – for instance, investments realized within one year after the investment is made;
Returns attributable to capital contributions used to satisfy the organisational expenses and other fund expenses; and
Returns obtained on investments during the investment period of the fund.

The VC fund’s PPM provides that these types of capital returns are available for reinvestment by the fund and increase the unfunded commitments of the investors. However, this increase is typically limited, for each investor, to original capital commitments.

Distributions and Allocations:

100 of distributions go to Lps until they have recouped their capital contribution

The venture capital fund is required to make detailed provisions for distributions and allocations. These provisions include allocations on an annual basis of profits and losses realised by the fund each year, the proportion in which the investors share the cash, and in some cases, assets distributed by the fund.

The latter is usually called the ‘distribution waterfall’, where the relative shares of distributions to the investors, on the one hand, and the fund manager, on the other, change as the fund makes distributions to investors, that cause the total amount distributed to exceed pre-agreed minimums.

The allocation provisions and the distribution waterfall are detailed in the PPM of the fund, which requires the fund to track allocations and distributions through capital accounts created for each investor in the fund’s books of accounts. To the extent possible, the allocation provisions (and each investor’s share of taxable income and losses) should reflect the economics of the distribution waterfall.

Distribution Waterfalls:

In a Venture Capital fund, the fund manager manages the committed capital of the fund, for a fixed management fee. The fund manager may also commit some investment to the fund (‘co-investment), usually 1 to 2% of the commitment. When distributing the capital back to the investor, hopefully with an added value, the fund manager allocates this amount based on a waterfall structure previously agreed in the Fund Management Agreement.

A waterfall structure can be thought of as a set of buckets or phases. Each bucket contains its own allocation method. When the bucket is full, the capital “flows” into the next specified bucket. The first buckets are usually entirely allocated to the investors, while buckets further away from the source are more advantageous to the fund manager. This structure is designed to encourage the fund manager to maximize the return of the VC fund.

The layering of the tiers of the waterfall, and the method of distributions among them, is usually a matter of negotiation. There are a wide range of options. Most of them contain these phases:

Return of Capital.
Preferred Return.
Catchup.
Carried Interest.

Here is a common distribution waterfall for Venture Capital funds:

First, to the investors until they have received all of their capital contributions in respect of their investments. Also known as “return of capital”.

Second, to the investors until they have received an allocable percentage of all of the capital contributions in respect of fund expenses, including management fees paid to the fund manager.

Third, to the investors until they have obtained a preferred return on their capital returns in the first and second tranches.

Fourth, a profit participation tranche, to the fund manager until it has received 20% (the usual number, but can be any percentage) of the distributions of profits. Which means, 20% of the amount distributed under the previous tranche, and this one.

This tranche is also known as the “catch-up”.

Fifth, 20% (or any other number as agreed) to the fund manager as its profit participation, and 80% (or any other number as agreed) to the investors. This is “carried interest”.

Let us have a look at these terms in detail.

Return of Capital Contributions and Preferred Return:

The first tranche of a VC fund waterfall usually provides that all capital contributed should be returned to the investor before any other distributions are made. In some cases, this section can also be expanded to include a return of:

The portion of unrelated investments that have been written down.
All unreturned invested capital in previously realized investments.
All unreturned contributed capital.

Following a return of capital contributions, a venture capital fund distribution waterfall next provides a preferred return. This is also known as the hurdle rate, and is calculated again on capital contributions.

The hurdle rate can be any percentage, but typically ranges between 8 and 10%. It is calculated by the simple interest method, or, more typically, by a cumulative compounded rate of return.

The hurdle rate accumulates from the date when the capital contributions are made.

The main purpose of a hurdle rate is to assure investors a minimum target rate of return on their monies, before the fund manager takes a performance fee. It is also subject to a ‘catch-up’ by the fund manager, if aggregate profits on capital contributions exceed this preferred rate of return.

Carried Interest and Catch-up:

The origin of carried interest can be traced to the 15th century, when European ships were crossing over to Asia and the Americas. The captain of the ship would take a share of the profit from the carried goods, usually around 20%, to pay for the transport and the risk of sailing over mostly unchartered seas!

The sponsor of a venture capital fund is entitled to participation in it’s profits, and this is known as carried interest, carry or a success fee. Carry is a set percentage of profits and is usually 20%. In hedge fund parlance, this is also called the 2/20 structure, with 2% representing the management fee and 20% the carry.

The timing and calculation of the carry is set out in the distribution waterfall, and is normally lower in priority to the return of capital contributions and the hurdle rate.

This ‘catch-up’ leg of the distribution continues until the carry to the fund manager equals the negotiated percentage of profits, and the remaining is split 80/20 (investors/fund manager), or any other pre-agreed percentage.

The carry calculations in venture capital funds can be varied, but three methods predominate:

1. American-style carry:

This is a deal-by-deal carry. The fund manager receives carried interest on all profitable deals, regardless of losses made on other deals. As you can see, this wouldn’t be very popular with investors, since they would end up bearing a larger part of the risk, and the fund manager stands to be rewarded regardless of the percentage of deals that are unsuccessful. The American-style carry is usually used in VC funds where it makes sense to isolate profits and losses on a per-investment basis.

2. American-style, with loss carryforward:

Here, the carry is still calculated on a deal-by-deal basis, but after accounting for realised losses on previous deals and write-downs on assets that have not been liquidated. Any losses that are incurred on deals after the distribution of carry to the fund manager, are to be returned at the end of the fund’s term, or other times of distribution during the lifetime of the venture capital fund.

This returned payment is also called a clawback.

The American-style, with loss carryforward is preferred to a straight American carry, since although it allows the fund manager to receive profits on a deal-by-deal basis, it also allows investors to clawback these profits in cases of losses on subsequent deals, thus leading to better risk management from the investor’s point of view. It also maintains the pressure of performance on the fund manager.

3. European-style carry:

This is also known as the back-end loaded carry. Here, investors receive returns on their invested capital, plus full preferred return, before the fund manager receives any carried interest. Hence the profit participation of the fund manager is usually delayed till nearly the end of the lifetime of the fund. There is no need of a clawback clause in this case, since the fund manager does not receive any carry on a deal-by-deal basis.

While investors prefer this style of carry, the drawback for the fund manager is that a majority of the manager’s profits may not be realized for several years after the initial investment.

Clawback:

Fund management agreements provide for clawback mechanisms when it comes to carry distributions to the fund manager.

A clawback is a payment that the fund manager must make to a fund at the end of the term of the fund, or during designated times during the life of a fund. It is triggered if, when calculating the fund’s aggregate returns, the fund manager has received more than it’s share of the fund distributions.

A clawback mechanism is mostly deployed in American-carry style VC fund distributions, since the European carry does not disburse carried interest on a deal-by-deal basis.

Investor Givebacks:

Fund management agreements for venture capital funds also require investors to allocate a portion of their share of distributions to meet fund liabilities and obligations, such as indemnifications in connection with the purchase or sale of investments.

Investor givebacks usually have caps based on the timing of distributions and aggregate amount of distributions.

Fees:

In the UAE, the Fund Manager is usually setup prior to setting up the investment fund. This fund manager can be a company, or a General Partner in a partnership. The fund then signs an investment management agreement with the fund manager, where the fund agrees to pay fees to the manager for the services that the fund manager provides, which includes evaluation of investment opportunities, and arranging the terms of these deals so as to make investments in the target companies.

The fund manager also undertakes the day-to-day activities associated with managing the fund and the service providers for the fund, including the fund administrator, auditors, lawyers etc.

Management Fees:

The fund manager generally receives a management fee for managing the fund. Usually, the management fee is set at 2% per annum on the aggregate amount of capital that is managed by the fund. We have seen this range from 1% to as high as 4-5%, depending on the size of the fund, it’s potential investment portfolio and the profile of the fund manager.

Management fees are charged to the investors of the VC fund on a quarterly or semi-annual basis. Where management fees are charged on committed capital, as opposed to actual capital deployed, the amounts contributed towards management fees reduce an investor’s unfunded commitment.

In some cases, some fund managers may also charge acquisition fees on some investments, especially if the investment in question requires a high level of due diligence and analysis.

Portfolio Company Fees and Management Fee Offset:

Fund managers or their affiliates may perform some additional services for the VC Fund’s portfolio companies. These can include consultancy or advisory services. Most VC Fund managers have resident entrepreneurs who have experience in running and exiting businesses, and so the fund manager may extend this consultancy to the newer startups that they invest in.

VC Fund managers may also receive director’s fees for acting as directors of the fund vehicle.

Investment management agreements usually contain offset mechanisms that require an adjustment to the fund management fee, taking into account the management services and other fees received by the fund manager and it’s affiliates from the fund’s portfolio companies.

In some cases, the fund manager’s affiliates may be service providers and hence provide specialized services to the fund and it’s portfolio companies. In these cases, there is no management fee offset.

All these transactions are expected to be on an arm’s length basis, and at market rates.

Fund Expenses:

The main expenses associated with a venture capital fund, include:

(i.)Organisational expenses: – towards setting up the fund and it’s infrastructure.

(ii.)Operational expenses: – towards ongoing operations of the fund.

(iii.)Management expenses: – payable to the fund manager.

Organisational Expenses :

The investment management agreement of a venture capital fund usually include clauses that require the fund to cover all the costs involved in setting up and licensing the fund vehicle. These expenses mainly include the application and licensing fees paid to the regulator, licensing fees paid to the Registrar for establishing the legal structure of the fund, and service provider and legal costs.

While these expenses are borne by the investors in the fund, from their capital commitments, they are usually capped at 1-2% of the assets under management of the fund. The fund manager would have to bear all expenses in excess of this capped amount.

Operational Expenses:

These include all fees and expenses incurred during the operations of the fund and are paid for by the investors pro-rated with respect to their commitments of capital. Such expenses are not capped, but for larger funds, they may require multi-step authorisations to ensure control.

Typical operational expenses are management and performance fees (payable to the VC fund manager), service provider fees (legal, fund administration, audits, accounting and custodians), printing and distribution, marketing (roadshows and meetings), consultants fees, professional indemnity insurance cover, licensing fees and fees involved in the purchase, holding and disposing of the fund’s portfolio companies.

Management Expenses:

These are different from the management fees, and usually refer to the VC fund manager’s own expenses, such as salaries and overheads. While the fund manager is expected to bear these expenses, there are instances where the VC fund manager may expense monies for the operation of the fund and its investments, such as employee salaries, rent and marketing. These monies are charged back to the fund.