So, What the Heck is Carry?
And How Does It Relate to Management Fees?
It’s no mystery that fund managers of VC megafunds get paid extremely well, similar to their counterparts managing hedge funds or private equity funds. In our last article, we explained that a General Partner (GP) manages and invests the capital they raise from investors called Limited Partners (LPs).
Funds are typically 10–15 years long, and GPs spend the first few years working at finding great startups and investing capital in them. They spend the rest of the life of the fund “harvesting” the profits from startups as they begin to exit (through acquisitions, IPOs, etc.) — or writing off (i.e., forgiving) capital for companies that have failed — and managing the portfolio. This is expected, as some investments just aren’t going to generate any returns while the 1–2 great ones are expected to more than make up for those losses. So, how and what does a GP get paid for this? A GP’s compensation comes from two components: a management fee and carry (also referred to as carried interest). We’ll explain both below and the different ways these fees can be structured.
Management fees
Think of management fees as the money that GPs and their employees need to cover their day-to-day operating expenses and salaries. This should not be where managers get most of their profits from as it is simply meant to “keep the lights on”; fund managers should not think of this as their reward for being good investors (unlike the carry). The management fee is typically a percentage of the fund size in the 1–3% range. Often, this will be 2%, which is where the phrase “2-and-20,” comes from. The “2” refers to the 2% management fee and the “20” refers to the 20% carry (more on that below).
It is important to note that the 2% management fee is charged annually. This is something that tripped me up, because I assumed that for a $100M fund, the total paid in management fees would be 2% of $100M = $2M over the life of the fund. NO! This is a 2% of the fund size that is charged each year. So the total fees for a $100M, 10-yr fund are actually 2% * $100M * 10 yrs = $20M. A good way to remember this is to automatically multiply the management fee by the lifespan of the fund to get the total management fee allocation when making calculations.
That sounds like a pretty big chunk of the fund that never gets invested into companies and a lot of people think it’s pretty crazy (this is a good article that goes into more detail). It does impact the ROI of the fund and means that managers need to have the investable capital ($80M in this case) work harder to get the same returns to LPs. I’ll explain how that works, and how GPs can recycle funds, in the next article.
Variations of fee models
Flat-fee model: This constant 2% on the fund size is called the “flat-fee model.” It’s a constant rate charged every year on the total committed capital (the total amount that was raised from investors).
Step-down model: Some VCs will use the “step-down approach” where they charge that 2%, but only on the money they are actually managing. So, the 2% would be on the committed capital for the first 3–4 years of the fund (the investing period) and on the money actually being managed as companies start generating returns (the harvesting period). How does this work in practice? This article from VentureSouth explains the concept very well, and I’m going to use their example.
This is a $10M, 10-yr fund wherein the GP has been investing for the first 3 years, with investments either paying the fund back or being written off over the next 7 years. The “Base” column above refers to net invested capital, i.e., the capital that is either already in a startup as an investment or hasn’t been invested yet. Think of this as the net value of committed capital that has yet to be paid back to the LPs. In our example of the table above, the “Base” remains at $10M for the first 3 years of the fund. In year 4, a couple of different scenarios may have occurred which reduce this amount by $1M. This could mean that a $1M investment in a startup became $2M, meaning we can now pay $1M of the LPs’ $10M investment back and only need to manage $9M now, or that a $1M investment is lost on a startup that goes bust and needs to be written off (i.e., cannot be salvaged) — so we’re still only managing $9M. Either way, the fee is charged only on the amount of money that is being actively managed each year, rather than committed capital. In the end, the total amount that was paid in fees was only 12.3% of the fund size, rather than a whopping 20%.
Variable rate model: There are also fee structures that charge a variable rate over the life of the fund. For example, they may charge 2% over years 1–4, 1.5% over years 5–6, and 1% over years 7–10 on committed capital. For a $100M fund, this would come out to be $15M in fees, leaving $85M of investable capital.
Carry
The second component of GP compensation is carry, and this is where successful fund managers “make bank.” I mentioned before that this is 20% of the profits of the fund, but let me explain why the carry is more profitable for the GP than management fees. Let’s go with the simple example of a $100M fund with a 2% management fee on committed capital every year. Let’s say the GP is able to generate a 3.5x return on the money invested, meaning that for every dollar invested, $3.50 is generated in returns. Since this GP is only putting $80M to work over the lifespan of the fund, the total proceeds from this fund are $80M * 3.5 = $280M.
The way the payout structure works is that, first and foremost, the LPs will have their original investment returned to them from this pot of proceeds — which makes sense since they are the ones contributing the capital that makes the fund possible. That leaves $180M in the pot, which is the net gain. Of this amount, 20% (the carry) goes to the GP and 80% goes to the LPs. So, the LPs receive $100M (original investment returned) + 80% * $180M = $244M.
The GPs receive $20M (management fees) + 20% * $180M (carry)= $56M.
One ratio that is useful to know is the DPI (distributed to paid-in), which is the return to LPs on their money. This is calculated as (the total money returned to LPs at the end of the fund / total money they invested). In this case, that is $244M / $100M = 2.44x.
Another ratio that is useful to know is called MOC or MOIC (multiple on invested capital). This more accurately reflects how much of the money the GP invested was actually ‘working.’ This is calculated as (total proceeds from the fund / money that was invested by the GP). In this case, that is $280M / $80M = 3.5x.
Sometimes, the carry will be paid out as the fund generates profits. So, if a portfolio company exits in year 5 and yields $25M in proceeds, the fund might pay out the 80/20 carry then, instead of waiting until the end of the fund’s life. However, as this Crowdmatrix article points out, this creates the potential for a GP to collect their 20% carry before the LPs get their money back in full. Instead, we believe it is simplest to have a waterfall model that pays the LPs first before calculating what the GP gets as carry on profits. For example, if this was a $100M fund, ideally you’d want to pay the entire $25M back to LPs and keep paying them back as companies exit until the total proceeds racked up are greater than $100M before paying the GP their carry.
Please comment if you have any questions about any of this. Feel free to DM or tweet @michaelnnelson or @jaswalgauri!
