How do VC Fund Managers make a living? How do the economics of a VC Fund work?
This is a topic that many have asked me to write about, so if you are not interested on how a fund makes money, you may stop reading now. Otherwise, here is my short and hopefully simple explanation.
There are two ways a Fund makes money: Management Fee and Carried Interest.
The Management Fee is an annual fee that managers charge in order to run and operate the fund. This fee is usually a percentage of the total capital committed in a fund. The Management Fee is used for the day to day operations: pay for office space, salaries, utilities, etc. With this money, the Fund Managers hire a team of analysts, look for investment opportunities, conduct due diligence and finally invest. The idea behind the Management Fee is not for anyone to profit, but for the fund to operate correctly.
The Carried Interest or “carry” is a success fee that Fund Managers’ charge based on the success of the investments. Usually, the carry is given to Fund Managers after they have returned all of the capital invested plus a premium, this premium is called Preferred Return. Once the Fund has returned all of the capital to its investors plus the Preferred Return, then the Fund receives their carry. This carry is typically a percentage of the surplus.
In order to illustrate this in an example, lets assume we raise a $100M fund, where we charge 2% Management Fee and 20% Carried Interest and our Preferred Return is set at 10%. Lets also assume, for the sake of simplicity, that we invest the entire fund in one investment (which is something you should absolutely never do in Venture Capital, I will post about Diversification in a future post) and exit that investment in one year.
First off, we charge Management Fee of 2%, that gives us $2M to operate the fund for the entire year. We have to rent office space, hire people, pay for internet, electricity, water, coffee, you get the point . . . with that money we also have to look for investment opportunities and analyze them to the point where we are ready to invest. Now, we only have $98M to invest because our Fund was of $100M, but we spent $2M on Management Fee. We invest the $98M, and exit in exactly one year, we sell and get $150M. Great investment! We pay our investors their $100M (yes, we also have to pay back the Management Fee), plus $10M of their Preferred Return of 10%. So now we have $40M left. Of those $40M, we pay 80% to our investors and we get 20%, $32M for them and $8M for us.
Summary: $100M fund, Manager charges $2M a year and gets $8M in carried interest. Investor put in $100M gets $142M back.
I would like to make a note that I have simplified the economics of a fund and the technicalities behind these economics. There are many details which I have obviated in order to make this post as simple, easy and comprehensible as possible. If you would like to discuss in more detail, please comment below or contact me via Twitter @adiezbarroso.