The Venture Capital Fund Structure

Private Equity funds (including Venture Capital funds) are largely structured under a “2 and 20″ business model. This will run through a quick example about how it works from the Limited Parter and General Partner perspective.

• Limited Partner (LP): Invest money in the fund and include: pensions, investment managers, high-net worth individuals, etc.
• General Parter (GP): Select companies for investment and manage the portfolio until exit is realized (IPO, strategic sale, recapitalization)

The 2/20 model says that the GPs receive a 2% management fee on committed capital (in this case, $100m) and 20% of any realized capital gains. The LPs, on the other hand, invest $100m into the fund and receive their initial investment plus 80% of the gains. These percentages can change, but they are fairly standard in the industry.

The management fee is used to keep the lights on and pay salaries (supposedly) and the “carry” or 20% gains is the profit share.

Now, in our example, the fund has a life of 10 years, so the total management fee is 2% times 10 years = $20m. This leaves $80m to invest in companies after fees. For simplicity, we assume 10 investments at $8m each, and mixed outcome on investments (2 winners, 5 even money, and 3 losers).

The table below outline the sample timing and fund IRR. Now, when all is done, the fund has returned a total of $200m in cash, of which $100m is consider capital gains. This gain is then split between the GPs ($20m) and the LPs ($80m).

Granted, this is a simplified example that ignores GP investment in the fund (usually 1%) and the ability to reinvest in follow-on rounds of successful businesses, but it covers the basics.

The model itself encourages big bets on companies that can give the investors the massive returns (e.g. the Apples and Googles). Funds are less interested in companies that will only return a moderate return over 3-5 years. To compensate for the losers, the fund needs to strike it big with a few names to bring home the IRR to investors — they expect in excess of 30-40%.

While this model is generally excepted and does work, there are conflicts, especially when firms raise multiple or overlapping funds. For example, investors may cherry-pick for certain funds/investors or take riskier bets on a fund that is underwater. Also, as the number of funds grow, so does the total management fee, which creates a conflict vs. need to generate excess carry.

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Tags: 2/20, venture capital