Venture Capital Fund Mechanics - VC Lab (2024)

Those seeking to become limited partners in a venture capital fund may benefit from understanding the basic mechanics of venture capital, before going on to more advanced notions. This includes fund topics such as fees, commitments, carry, returns and structures.

Important to note that these mechanics are often dependent on many factors such as region as well as the individual fund and what is outlined in the Limited Partnership Agreement.

Fund Structure & Management

The structure of a venture capital fund typically involves:

• Limited Partners (LPs) and General Partners (GPs): LPs provide capital, while GPs manage the fund and make investment decisions.
• Fund Life Cycle: The average life cycle of a VC fund, usually spanning 7-10 years, including the phases of capital raising, investment, management, and exit.

Venture capital funds are often structured as closed-end entities. This means that the fund has a predetermined period upon which it will dissolve and returns will be distributed to the LPs. Most VC fund periods are for 10 years as startups take time to mature and yield returns via exits / acquisitions or IPO’s. Usually, there are two years of extensions without fees. In sectors such as DeepTech, the fund duration maybe longer, as these sets of companies take much longer to mature.

On the other hand, evergreen (open) fund structures have no termination date and are more liquid. However, they are very difficult to manage for small to medium funds and are usually adopted by large global multistage firms.

Returns in both structures will be distributed to investors at the discretion of the fund manager and provided a portfolio company has yielded sufficient returns. For closed-end structures, this can also happen before the termination date of the fund. In open-end funds, the manager may choose to hold on to the asset even post IPO.

Capital Commitments

Usually, limited partners will commit a certain amount of capital to the fund. However, important to note that the entire sum is not invested initially. Typically, a fund manager will make a ‘capital call‘ several times throughout the fund’s lifetime; usually, this is between 20%-30%. You may also see that in some funds no single LP makes up more than 10% of the fund.

With this capital, managers will finance a portfolio of startups in exchange for equity. Consequently, though an LP is obligated to meet capital calls upon request by the fund manager, they will still be in possession of the capital up until each call.

Partners of the fund are often expected to commit capital during calls as well. This ensures that there is an alignment of incentives for those managing the fund. Depending on the firm, this commitment on the part of the partners is around 1% of the fund.

Investment Strategies

Key strategies of VC funds include:

• Sector Focus: Many funds specialize in specific sectors like technology, healthcare, or renewable energy.
• Stage Specialization: Some funds invest in startups at particular stages, like seed, early-stage, or growth-stage.
• Geographical Focus: Certain funds invest regionally or globally, depending on their investment thesis.

Capital Allocation & Deployment

The process of capital allocation in VC funds involves:

• Due Diligence: Rigorous evaluation of potential investments.
• Deal Structuring: Negotiating terms and conditions of investments.
• Portfolio Diversification: Spreading investments across various sectors and stages to mitigate risk.

Fund Economics

The economics of VC funds focus on:

• Management Fees: Typically 2% of the fund’s capital, used for operational expenses.
• Carried Interest: Around 20% of the profit, earned by GPs as a performance incentive.
• Hurdle Rate: A minimum rate of return that must be achieved before GPs can claim their carried interest.

Management Fees

Venture capital funds incorporate specific fee structures to manage their operations. These fees are crucial for covering various operational expenses, including fund manager salaries, staff compensations, office rent, and other administrative costs.

• Management Fees: These fees typically range from 1% to 3% annually, varying based on the fund’s fee structure. Over the lifespan of the fund, which often extends to a decade or more, the cumulative management fees can amount to approximately 10-20% of the fund’s capital. In larger funds, managing substantial sums, the total fee percentage may be subject to a cap.
• Fee Structures: Management fees can be consistent, such as a flat rate of 2% per annum throughout the fund’s duration. Alternatively, a cascading fee structure is sometimes employed. This approach starts with higher fees initially, which gradually reduce, averaging out to around 2% over the fund’s lifetime.
• Rationale for Cascading Structure: The cascading fee model is particularly beneficial for new funds. In the early stages, a fund typically requires more capital for initial setup and investment activities. As the fund matures, and its portfolio is established, the need for capital decreases, especially in the latter half of the fund’s lifecycle when follow-on investments become more prevalent than new acquisitions.

Carried Interest

In addition to management fees, venture capital funds also earn through carried interest, which is a share of the profits generated by the fund’s investments.

• Definition: Carried Interest, commonly referred to as “Carry,” is typically set at around 20% of the fund’s profits. This means that the general partners (GPs) receive this percentage as a reward for successful investments and fund management.
• Performance Incentive: Carry serves as a significant performance incentive for the GPs. It aligns their interests with those of the limited partners (LPs) since the GPs only receive this compensation after returning the invested capital and achieving certain agreed-upon performance benchmarks, often known as a “Hurdle Rate.”
• Distribution of Carry: The distribution of carried interest usually occurs after the LPs have received back their initial capital contributions and a predetermined rate of return. This ensures that the interests of the LPs are prioritized.
• Impact on Investment Decisions: The potential to earn carried interest influences the investment decisions of GPs, motivating them to seek out and nurture high-potential investments that can deliver substantial returns.

Hurdle Rate

The Hurdle Rate is an essential aspect of venture capital fund economics, directly impacting the distribution of Carried Interest.

• Definition: A Hurdle Rate is the minimum rate of return that a venture capital fund must achieve before the General Partners (GPs) can start receiving their share of Carried Interest.
• Function: This rate functions as a performance threshold. It ensures that the Limited Partners (LPs) receive an agreed-upon return on their investment before the GPs can benefit from the profit-sharing mechanism of Carried Interest.
• Typical Rates: While the specific Hurdle Rate can vary, it is often set based on market benchmarks or specific agreements between LPs and GPs. It usually aligns with the expected returns that would justify the risks associated with venture capital investments.
• Alignment of Interests: The Hurdle Rate aligns the interests of GPs with those of the LPs. By setting this performance benchmark, LPs are assured that GPs are incentivized to generate substantial returns on investments rather than merely accumulating fees.
• Impact on Fund Performance: The Hurdle Rate is a key factor in determining the overall performance of a venture capital fund. It sets a high standard for fund management, guiding GPs towards pursuing investment opportunities that have the potential to exceed this minimum rate of return.

Returns from VC

Venture capital, as an asset class, embodies high risk with the potential for high returns, presenting a unique landscape for investors and fund managers.

• Risk Factor: It’s a well-acknowledged fact that venture capital involves considerable risk, with over 80% of startups failing. This risk profile is a defining characteristic of the venture capital industry. Something covered at length in our guide ‘Why invest in Venture Capital?‘
• Return Expectations: A return of 3X is often considered a benchmark for success in venture capital funds. However, achieving such returns is challenging, with less than 10% of VC firms reaching this level. Those that do often secure outsized returns, significantly outperforming the market.
• Market Performance: Despite the inherent risks, venture capital has outperformed other asset classes in the past few years. The Pareto Principle, or the 80/20 rule, appears to be in play, where a minority of the funds capture the majority of returns.
• Diverse Return Levels: The expected returns in venture capital vary widely, influenced by factors such as the fund’s stage and sector focus. It’s notable that new fund managers and smaller funds often outperform established managers and larger funds.
• Investment Timeline and Strategy: The returns from VC investments typically materialize over a period of 8 to 12 years. After raising a fund, managers usually spend the first 2-4 years building the portfolio, allocating a certain percentage of the capital for this purpose. The remaining capital is reserved for further investment in the most successful portfolio companies. It is common for VC funds to raise two funds before a clear picture of the initial portfolio’s performance emerges, making the third fund a crucial milestone for new fund managers.

Reserves

As mentioned, VCs will keep a considerable amount of capital to back the fund’s winners. This is because of the inherent power law in VC where a majority of the returns are derived from a handful of companies.

VCs want to keep capital in reserve in order to back their winners and keep the same percentage in ownership. These winners become abundantly clear as the fund matures and VCs usually have pro rata rights to invest in subsequent rounds. Interestingly, there is some debate among VCs about whether it is prudent to invest in new companies, rather than backing companies in flat and down rounds.

Exit Strategies

VC funds aim for profitable exits through:

• Initial Public Offerings (IPOs): Taking portfolio companies public.
• Acquisitions: Selling portfolio companies to larger entities.
• Secondary Sales: Selling shares to other investors or back to the company.

Conclusion

Venture capital fund mechanics are complex but essential for the functioning of this critical investment sector. Understanding these mechanics offers insights into how venture capital drives growth and innovation in various industries.

Apply to VC Lab to Learn more about this and the deeper nuances of VC mechanics

About The Author

Related Posts