May 23, 2012
Posted by felix
Venture capital, carry and management fee
I recently wrote a reply to a comment on Gründerszene where someone asked how the carry structure works in the VC world. Since this is a core part of a VCs renumeration, I thought this topic deserves a quick blog post.
VC funds and its (general) partners – these are the guys the entrepreneur would interface with – have effectively only three sources of cash inflows:
- the recurring management fee
- returns from portfolio liquidations (trade sales, IPOs, etc.)
- the carried interest or “carry“
Some funds also bill some of their services to the portfolio companies, but this would happen mostly in cases where the funds act more as incubators. So, the above liquidity streams are the most important ones and they are all connected to the absolute fund size.
Let us assume that a €100m fund is raised for a fund lifetime of 10 years. The general partners would then receive an annual management fee which is often 2% of assets under management, in this case €100m x 2% = €2m per annum. This fee is paid by the limited partners, i.e. the actual fund investors who only commit capital, but do not run the fund. This is a steady income stream for the general partners and it is used to pay all operational expenses, such as salaries for the VC employees, office rent and most importantly, investment-related costs. Sometimes the management fee is higher than the standard 2% in the beginning of a fund lifecycle, since most investments occur during the the first couple years and thus, higher costs would be incurred. However, in consequence a lower fee would be expected during the end of the fund lifetime.
We assume the fund does well and returns a 2.5x cash-on-cash multiple on its investments. If the fund had invested all €100m over the fund lifetime the resulting proceeds or returns from liquidiations, trade sales, IPOs, etc. would equal €250m. This is the money the general partners will return to the limited partners, who are the actual fund investors.
Now the carried interest or “carry” comes into play, since the limited partners would not see all of the €250m: to incentivize the general partners, they receive a “bonus” if the reach a minimum return (hurdle rate). This bonus is called a carry or carried interest and it is industry-wide more or less 20% of the profits. In our example the fund did well enough to surpass the hurdle rate and the general partners receive €250m for €100m in investments which means that they generated €250m – €100m = €150m in profits. The resulting carry would be 20% x €150m = €30m – so the general partners would receive a carried interest of €30m for their work (on top of the management fee). A €100m VC fund should be managed by 3-4 general partners, so if they run an equal partnership each GP would take home a hefty €7.5m!