Why VCs Should Recycle Their Management Fees

I’m an investor in a bunch of VC funds. Some of them recycle their management fees; others don’t. I’ve never really understood why funds don’t recycle their management fees.

Understanding what “recycling management fees” means is a fundamental part of understanding the economics of a venture firm. Here’s how it works.

Let’s assume a $100 million VC fund that charges a 2% management fee and a 20% carry. In the typical case, a fund will get an annual management fee of 2% of “committed capital” (the $100 million) for the “investment period” (usually the first five years, or until a new fund is raised) and then an annual management fee of 2% of “invested capital” (whatever the fund has invested in companies that are still active) over the remaining life of the fund, which is usually 10 years.

Now, there are lots of minor variations on this, but the average “fee load” on a fund over its life is 15%, or $15m paid out over 10 years on the $100m fund.

So – if $15m gets paid out in fees, that only leaves $85m to invest in companies.

That’s where recycling comes in. When a fund has an exit, it can either distribute the money to its investors (the LPs) or it can “recycle it” and invest it in new and existing companies in the fund.

Now, assume that by year three the $100m fund has invested $50m. During this year, it sells a company and gets a realization of $20m. At this point, it would have taken $6m of management fees (2% * 3 years) so it could recycle the $6m (hence, reinvesting it) while distributing $14m to the LPs.

By managing recycling this way, the fund could end up investing the full $100m, instead of just the $85m. The advantage, for all the investors (the VCs and their LPs), is that $100m gets put to work as invested capital, rather than just $85m.

Our view as a firm is that a successful VC fund has a net return of at least 3x to the LPs. That means that if an LP invests $1 in the fund, they get back $3 over time.

Now we get to do the fun math, including the impact of carry on return.

If I’ve only put $85m to work, I have to generate $100m to get to a point where I’ve returned capital, which puts me in a position to get carry. Then for every $100m of additional returns, $20m goes to the VCs and $80m goes to the LPs. To generate an incremental $200m to the LPs, I have to return a total of $250m. So – my $85m needs to generate $350m to get a net 3x return. On a gross basis, my $85m has to generate a 4.1x return to accomplish my “net 3x return to LPs.”

On the other hand, if I recycle my management fee, then I put $100m to work. I’ve reinvested $15m over the life of the fund, so I’ve had to generate this $15m plus the $100m to get to carry and the $250m to get to a net 3x return. In this case, I have to generate a total of $365m (instead of $350m), but I now have $100m at work to do that. In this case, my $100m has to generate a 3.65x return to accomplish my “net 3x return to LPs.”

That’s an 11% difference just by recycling my $15m fee. It’s better for the LPs and better for the VCs.

  • Very insightful post, thanks!

    How do the recycled fees factor in to your “2% of committed capital” calculation? Do management fees get charged on that re-investment as well?

    • Per @davidcowan:disqus comment above, no. You don’t get incremental management fees on the money you are reinvesting.

      • josh franta

        thanks brad i had the same question as dave #1 above. in the way you structure your funds, when does the carry usually come into play? is it when all the committed capital has been paid back? it seems like if the GP has the discretion on distributions, a decision not to re-invest returns (aka what you’re calling recycling) would be a bearish indicator for their fund and prospects. (as shooting for a 2% return is a waste of everybody’s time, they should quit and write bonds instead).

        • Carry dynamics vary by fund. We don’t take carry until we’ve returned 100% of called capital.

  • Adam Hunke

    Great piece on fund economics. It’s an underrepresented aspect of VC. Recycling management after an exit (from the LP’s side) is trades a small guaranteed return for prospective larger returns earned through the reinvestment of the same money. I imagine some would want the cash now to possibly invest elsewhere (public equities, etc) based on fund performance. Is the recycling of management fees set with fund formation documents, or are they the LP’s decision on a case-by-case basis?

    • Generally it’s up to the VC / GP. The documents (LPA) give the VC firm the flexibility to decide what to do.

  • How this plays out on paper vs IRL may be a function of the VC’s own risk profile – some may be willing to reroll the dice, while some may want to make sure they secure their own gains. Not making a value judgment either way.

    • Maybe, but if you aren’t looking at the overall economics of the fund, I’d argue you aren’t doing your job for your LPs. And almost every VC I know believes that with every incremental dollar they put to work they will make more money. See you tonight!

      • Yes! I’m pumped to see all you guys — very gracious of you guys to make the time.

  • davidcowan

    The 2% does NOT get charged on the recycled fees. That’s why some VC funds don’t do it. They’d rather start a new fund with fresh fees.

    • Which would imply that those VCs are playing for fees, rather than returns, which I think is a mistake. And – the magnitude (incremental 2% fee on 15% recycled) is marginal incremental economics, especially when you do the after tax calculation (as I’m sure you know well…) But it’s a good nuance – the other one of course is cash flow, which was too much to cover in this post.

  • Dave

    Great post! I’m missing a step though. Where does the money for the recycle come from? Aren’t the lps getting the $20 million in your $20 million example regardless? How does recycling differ from management fee offsets?

    • It comes from the realization. It’s a completely different issue from management fee offsets.

      • Dave

        Thank you. I’m still missing a bit of a step, sorry for being dense. I’m murky on where the money for the offset comes from.

        Management fees paid in years 1-3 of $6 million. $20 million event in year 4. LPs have rights to the $20 million, less the GPs carry portion (presumably $4 million assuming a 2/20 fee structure and returns above any hurdle rate). Is this saying the LPs only get $14 million, even though they would get $16 million ($20 gross less $4 carry) without the offset?

        I know I’m missing something, sorry.

        • The fund isn’t in a carry position at this point since I’m assuming the $20m realization is the first realization. I should have been explicit about that. In addition, the LPs don’t have the “right” to the $20m – it’s still in the fund and the GPs can either distribute, hold it back for future investments or capital calls, or recycle it. In my example, they are recycling the fees they’ve taken to date ($6m) and distributing the rest ($14m).

          I’m not sure what the word “offset” means in your comment.

          • Dave

            Thank you Brad. That makes sense! Greatly appreciated. I had been assuming you were literally recycling management fee dollars and could not figure out the timing mismatch. Now I think I understand that you are recycling an amount equal to the management fees to date (rather than the management fee itself) to make sure you invest the full amount of the fund and it is the discretion of the GP to make that decision.

            The way you explain it, seems sort of silly not to recycle unless you are playing for fees on a new fund. And VC funds aren’t generally big enough to make people really rich off the fees. Unlike the larger scale buyout funds where the fund sizes increased massively but headcount did not increase commensurately so that one could get really rich on buyout fund management fees….a separate issue though.

            Thanks again for walking me through this.

  • Suzanne King, NEA

    Great post Brad. We have been doing this very effectively for 36 years. To answer some questions below – most firms that do this right recycle underperforming returns/realizations < 1.5X and invest them in new deals (if still in investing period) or follow-ons that should yield 2.5X or better and yes, there are no fees are carry charged on recycled dollars. Decisions are generally made on a case by case basis on whether to recycle a realization or not. Depends on maturity of fund and opportunities to invest at better return. The "invest at better return" is the key component to making this work.

    • Dave

      Suzanne, is NEA recycling all those proceeds or just the management fee portion? You seem to be talking about a broader recycling than I was understanding Brad to be talking about.

      Thanks for weighing in. Very cool to see two great fund groups helping people understand how the VC business works.

      • I think Suzanne / NEA is just recycling fees, but using the decision on which realizations to recycle based on returns. Capital from low returning deals gets recycled; high returning deals doesn’t.

        This will impact IRR but likely won’t impact overall return. In a situation where you have significant fees (as in large funds), managing cash flow will also start to matter a lot – but that’s probably a separate post.

  • ObjectMethodology.com

    You should start signing your posts: “Brad Feld – Musician”

    • Why? I’m like the anti-musician. I can’t sing for shit – if you want an example, take a look at https://www.youtube.com/watch?v=jVoxCijBFXE

      And that’s better than me trying to play an instrument, other than while playing Rock Band.

  • I think the case-by-case decision is important to argue; additional dynamics come into play depending on the relationship with your LPs as well as public markets you’re embedded in. LPs might feel that recycling at high valuations might not be a good idea, while recycling before a market correction is expected might be be received favorably. It’s good to set the expectations with LPs from the beginning regarding fee recycling. But usually at oversubscribed funds the LPs would be more than happy if you put more of their money to work.

    There are some fun tax things to consider if your LPs are tax-exempt organizations (it could increase debt-financed income and thus be taxed as unrelated business taxable income, UBTI, subject to federal income tax). Also, once you’re eligible to get Carry it “raises certain accounting complexities in connection with the fund’s distribution waterfall.” (as PLI aptly puts it)

    • I’m operating under the assumption that any “recycling” will be because the VC thinks they can generate a meaningful return on the incremental dollars invested. If they don’t, then they have a different issue and shouldn’t invest any money.

      Our funds are massively oversubscribed – because we capped the size of the fund (all four of our funds have LP capital of $225m.) We have several LPs who say “we’ll give you whatever you’ll take.” Presumably this will continue as long as we continue to be successful on the investing front. But I don’t think any of them would rather that we take more money from them to have bigger funds, or change our strategy. I recognize this will vary by LP and by VC funds – especially around their strategy – but I still can’t come up with a situation where it would make more sense not to recycle.

      On UBTI – I’m presuming the investments are VC fund investments with the goal of avoiding UBTI. I don’t see how recycling impacts this – can you clarify?

      And – the distribution waterfall is complex, but it’s complex anyway as you true up the pre-carry and post-carry capital accounts. It’s just a messy spreadsheet regardless.

      • hehe, “… whatever you’ll take …”. And agree on the fund size, it would also change culture and processes.

        I am not a lawyer (Jason and you will know more about it), but as far as I understood it the UBTI issue was if one of your LPs — not the VC partnership — is a tax-exempt: if a capital call is debt-financed then any income/return would taxed; if returns of that money are “withheld” instead of distributed then subsequent gains from this new investment could also be seen as debt-financed; it’s a matter of accounting sophistication and reporting standards at the LP and how money flows back into their LP’s pool of committed capital.

        Messy spreadsheet for sure; and not a hard reason not to recycle, probably more an issue with communicating to LPs RE what to expect and if they get how this will work — not everyone has highly sophisticated LPs who fully understand the details and mechanics. Though I believe in the end it’s a matter of trust.

        It does becomes a source of confusion and discussions during Partner (and potentially LP) meetings why the general partner’s interest in assets purchased with reinvested carry will be larger than its capital percentage in the partnership as a whole since the reinvested amounts will include the general partner’s carried interest….

        • UBTI: Yup – I understand UBTI well – I just wasn’t getting your point. You described a pretty rare edge case and one that I think most firms, unless they are having a cash flow issue, wouldn’t run into.

          • can you clarify how the cash flow problem could be an issue RE UBTI in this case (beyond being generally an issue if you have a cash flow problem :))? I am not familiar with that (but had two top university endowment funds LPs in the past who asked the recycling question).

          • You have to have the cash to be able to recycle, which means you have to generate the returns to have the cash. Many funds don’t manage this well because you don’t have to focus on it or pay attention until you get later in the life of the fund.

    • It’s not just a UBTI issue. For tax-paying LP entities, they will owe taxes on the gains that were earned by the fund but not distributed to LPs. In the example Brad gave, they would owe taxes on the gains represented by the whole $20M (I don’t believe he mentioned what the original cost basis was), but would only receive distributions of $14M, so the effective tax rate on the distribution would be much higher. In the example below from NEA, it could be worse, as they seem to be recycling the entire payout, so there would be a tax bill but zero distribution. If they are limiting it to small gains, it won’t be as big of a deal (not that much tax on a 1.5x), but people are not often thrilled to get a tax bill and no cash.

  • I like it – the carry is what the VC should really be there for to begin with.

    There are a lot of different ways you could skin that cat – you could set a hurdle and reinvest anything over the hurdle. If you set a 18% annual return to LPs and another 2% over that as carry. Anything over the total of 20% could be reinvested to elongate the return period. Anything under of course wouldn’t be paid and would need a catch up or clawback. Of course a predefined hurdle presents a lot of other complications, but could be useful if the intention was to build more of an evergreen fund.

  • I’ve always been a big fan of recycling fees – it just makes sense. I only charge my LP’s a one time management fee so it’s not as big of a deal but the amount of money you could otherwise put back to work still makes a difference, especially if you have a small fund like mine.

    Compared to a typical fund manager who draws annual fees, I rather take a short term hit in order to get a bigger long term gain.

  • Cherian Mathew

    Isn’t taking a 2% fee with recycling effectively the same as taking a 1.66% fee without recycling? In both cases you invest $100 and take $20 of fees.

    • Nope. I don’t understand your math at all.

  • Jeff Clavier

    Isn’t it the case that evergreen money is interested in “getting fees in the ground” but FoF seem to be keen on early distributions for the sake of their own fund raising? We have a 100% investment target for the reasons you highlighted, but I have felt slight differences in positioning depending on the source of capital.

    • I haven’t really felt that pressure from our LPs who are FoF investors.

  • MJ Pence

    Fees will always be an issue in the absence of value. Recycling fees seems to be an effort to serve the investors best interest first. As it should be, always.

  • sounds a lot like playing a hand of blackjack for the dealers, instead of just giving them a straight tip.

  • Timo Lehes

    When discussing terms, a seasoned LP (FoF Mgr) ones told me: “Since you’re in VC for the long haul and we (LPs) are measuring you by Net IRR, why would you run a marathon with a backpack when your peers are running without it. The ability to re-invest Mgmt Fees is essential for GPs to maximize returns”

  • Jeremy Zykorie

    Doesn’t this just boil down to “I’d rather reinvest profits” until I can’t? Why not just “recycle” the whole return? If it is at your (fund’s) discretion to do so, and the argument is you can re-invest at another great return, then other then fund timelines (10 years, extensions) to consider, you are basically just choosing the management fees to say I’d rather invest doll. Obviously tax issues, ultimately management fee issues for the fund (now doing a lot of the same work with no fee coming in, etc.)…

    • Depending on the LP agreement, a fund can recycle over 100%. Our standard in each fund is 110% and we’ve increased it in one case to 115%. In a success case, it’s an easy decision for LPs (and the VCs).

  • Eddie Wharton

    Great post. One problem with early stage VC is that it can take a while to see a return: 5-10yrs. If a fund is typically only around for 10 yrs with a few yrs worth of extensions, how can recycled capital go into new investments?

    Is this a case of an early exit in year 4 or 5 and then using the money as follow on capital so that it is only a few years away from exit?

    • If you don’t have exits in the first five years (or whatever your investment period is), then you can only recycle into existing investments. This also has the effect that you describe – you are recycling into companies that should have liquidity in a shorter time frame.