What it means
A VC fund is usually set up as a partnership. The investors, called limited partners or LPs, supply the capital, and the managers, called the general partner or GP, find the companies, make the investments and help them grow.
The fund normally has a life of around ten years, with extensions possible. In the early years the managers invest the money, and in the later years they support the companies and sell the holdings, returning cash to the LPs when the companies are sold or listed on a stock exchange.
LPs do not send in all their money at once. They make a commitment, and the fund calls the cash in stages as it needs it for investments and fees, which keeps money working efficiently.
The managers are paid in two main ways. A management fee, often around 2% of committed capital each year, covers the team's costs, and carried interest, often around 20% of the profits, rewards good performance once the investors have been repaid.
The returns are very uneven. A typical fund may have many investments that lose money, some that return roughly what was put in, and a small number that return many times the cost, and those few winners make up most of the profit.
Because the money is locked up for years and the investments cannot easily be sold, LPs are usually institutions such as pension funds, endowments and wealthy individuals. Performance is measured over the whole life of the fund using multiples of invested money and annual return figures, and reported values in the early years are only estimates.
In practice
Real-world examples.
Example
A pension fund commits $50 million to a venture fund over ten years. The fund calls the money in stages as it makes investments. The pension fund receives its first distributions in year six.
Example
A founder raises $5 million for her software start-up from a VC fund in exchange for a stake. The fund also takes a board seat and introduces her to potential customers. The fund hopes to sell its stake when the company is acquired or listed.
Example
A university endowment compares three VC funds. One has a high net multiple but took fifteen years to return the money, while another returned cash faster at a lower multiple. The investment committee weighs both the multiple and the timing.
Formula
Calculation
Net multiple to investors = (Total distributions - Carried interest) / Capital paid in
Carried interest = Carry rate x (Total distributions - Capital paid in)
A VC fund has $100 million of commitments, all paid in. Management fees of 2% a year for ten years total 100 x 0.02 x 10 = $20 million, leaving $80 million invested in companies. The investments are eventually sold for $240 million in total. Profit after returning the $100 million paid in = 240 - 100 = $140 million, and carried interest at 20% = 0.20 x 140 = $28 million. Investors receive 240 - 28 = $212 million, so the net multiple is 212 / 100 = 2.12 times. The gross multiple on the $80 million invested was 240 / 80 = 3.0 times, which shows how fees and carry reduce what investors keep.Case study
Seen in the real world.
This illustrative case follows a fictional fund, Northlight Ventures I, which raised $60 million and invested in 20 early-stage companies. Over the first five years, eight of the companies failed, ten returned small amounts, and two did well.
One of the winners was sold for a price that returned $90 million to the fund, and the other returned $60 million. The two successes together delivered $150 million, more than twice the size of the entire fund, even though 18 of the 20 companies produced little.
After the fund had returned the investors' capital, the managers took their 20% share of profits, and the investors still earned a net multiple of over two times. The fictional story shows the power-law pattern of venture returns, where a few outcomes decide the result.
Watch out
Common mistakes.
- Expecting most investments to succeed. In a typical VC fund many investments lose money, and the fund relies on a few winners.
- Ignoring fees when judging returns. Management fees and carried interest can reduce the investors' return noticeably, so use net figures.
- Judging a young fund by its reported value. Early valuations are estimates, and the true return is known only when the investments are sold.
Questions
People also ask.
What are LPs and GPs?
Limited partners provide the money and have limited liability, while the general partner manages the fund and makes the investment decisions.
What is carried interest?
It is the managers' share of the fund's profits, commonly about 20%, paid after investors have received their capital back.
How long is money locked in?
A VC fund typically lasts around ten years, and investors cannot normally withdraw their money before the fund ends.
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