So, What the Heck is Fund Recycling?

And How It Affects The Gross Multiple (MOIC)

Recapping our last article, we discussed how a 2% flat fee on the fund size can reduce the investable capital a GP has. 2% on a $100M fund over 10 yrs is $20M in fees. Clearly, it’s a big deal if you give someone $100M and they only put $80M of it to work, and this model has been criticized for a while.

You can see how this model becomes lucrative for megafunds. A 2% fee on a $2B fund is a guaranteed income stream of $40M every year. It’s not hard to see why there might not be as much of an incentive to earn carry when you’re already being compensated that much in fees. Some people advocate for removing management fees entirely and perhaps increasing the carry rate to 30% (like in this article by Aidos’ Andrew Vo). We think a good compromise is recycling the management fee (as we touched on in our last article).

What that means is that GPs put back into the fund the money that is taken out as fees. This does not mean they put their fees back into the fund, but that they invest more into the fund to compensate for the fees. But where does this “extra” money to invest come from? Fund recycling. This article by Brad Feld is a fantastic introduction to how recycling management fees means that GPs can afford lower returns on the money invested (the MOIC, explained in our last article) while giving LPs the same return on their investment (the DPI, also explained in the last article). I’m going to use the same example Feld uses here, and then explain a difference in the payout structure that we could see if the management fees were instead recycled.

Let’s say we have a $100M fund that has promised a 3x DPI to LPs. They’re charging a variable management fee of 2% over years 1–4, 1.5% years 5–6 and 1% years 7–10 on committed capital which comes out to be $15M in fees, leaving $85M of investable capital.

Example adapted from Brad Feld’s article

Now, this is a tricky table to understand, mainly because there are a couple of things hidden in there. You’re not alone if you looked at the recycling column and thought “the GPs didn’t take their fees and instead put them into the fund, got what looks like a 1x return on that extra $15M invested (since they got an extra 15M in proceeds from putting another 15M into investable capital) and are getting $53M instead of $50M, which seems like a pretty bad deal considering they appear to have given up $15M in fees.” That’s a conceptual mistake, but I’ll walk through how this works.

As Shawn Broderick, General Partner at SOSV, explained to me, it is really valuable to demonstrate to investors that you are able to invest all their capital. Plus, it is not as though GPs receive the entirety of management fees. He explained that if we (as investors) can be frugal as a fund and not take all the fees possible, it’s great for the fund as it gives us more money to invest. The Feld article puts it well: “think of your management fee as a risk-free, interest-free loan against future carried interest, instead of additional compensation.”

Let me explain how the mechanism of recycling funds in the table above actually works. Just for simplicity, assume a $100M 10-yr fund with fees of $15M. Now go back to the idea that fees are actually loans to be repaid to the fund. Let’s go through this step-by-step:

1. I (the GP) raise $100M from LPs. I take $15M as fees upfront to cover costs over 10 yrs (I know these fees are charged annually, but in this case let’s assume the GP takes them upfront for the sake of simplicity).
2. I then take the remaining $85M and invest it in a few different startups over the life of the fund. For the sake of simplicity, let’s assume by the end of year 9, the $85M invested generates gross proceeds of $350M.
3. Now, I take $15M out of this (dollars that are going to be recycled) and reinvest it in a couple of other startups. That leaves me with $335M in proceeds. This $15M is recycled to offset the fees already taken by the GPs. They could definitely choose to recycle more or less.
4. Essentially, this allows the GP to say to investors that they invested 100% of the fund size, i.e., $85M upfront + $15M taken from gross proceeds = $100M originally contributed by LPs.
5. At the end of 10 years, the $15M I put in these new startups has generated $30M. This translates into a 2x return on incremental dollars (or recycled dollars).
6. The total proceeds are now $335M (from the first few startups) + $30M from the new startups = $365M.
7. Gain on investments = $265M (after $100M returned to LPs).
8. So, the return on incremental dollars invested is not 1x as it looks in the table above, but 2x! If it had been a 1x return on incremental dollars invested (so the money just sits there and is returned), the total proceeds would have been $350M and the return to LPs would then have been 3x. Since LPs would receive $100M (initial funds returned) + 80% * $250M (80% of the profit, calculated after initial funds are returned) = $300M.
9. However, here LPs will receive $100M (initial funds returned) + 80% * $265M = $312M.
10. And the GPs are still getting their management fees. The bonus is that they are now getting a $53M (= 20% * $265M) carry! Not a bad deal after all.

This post by Laura Thompson and Hillary Cook for Sapphire Ventures is probably the best I’ve seen to understand how recycling affects various multiples and has some great tables that explain how return on incremental dollars affects total returns.

Some quick math:

• The distributed proceeds are always calculated as [proceeds from original investments — recycled funds + proceeds from recycled funds].
• The gross proceeds (a metric people sometimes like to use) = [proceeds from original investments + proceeds from recycled funds (this double counts the recycled amount, however)].

There is a difference between distributed proceeds and gross proceeds. Gross proceeds is the amount you receive from investing both with the original funds and recycled funds. But, since recycled funds are removed from the pool of proceeds from the original investments (but included in the amount received from original proceeds), this leads to double counting. The actual money you would have, or the distributed proceeds, is = [gross proceeds — recycled funds].

• Then, the MOIC is simply the [total proceeds / (original funds + recycled funds)].
• From the distributed proceeds, just subtract fund size to get to net gain. Split that into 80/20 to get profit to LPs and carry.
• I would encourage you to try that with those tables and see if you can get the right multiples.

And that’s everything on recycling funds. We hope that was useful! As always, leave us questions in the comments or @michaelnnelson or @jaswalgauri and we will get back to you.