Mar 12, 2019

10 min read

Maximizing Fund Distributions

The Secret Sauce to Outperform the Average

The biggest secret in venture capital is that the best investment in a successful fund equals or outperforms the entire rest of the fund combined.
— Peter Thiel

In order to grasp the concept of fund distributions, it is crucial to understand the economic relationship between limited partners (LPs) and the general partner (GP) in venture capital, hedge and private equity funds.

To put it in a nutshell, the GP and its managing partner manage the LPs money, in order to generate a substantial return, whereby the management fees shall pay the operations and the carried interest is the main incentive for the GP.

Having said that, I would like to start with the three most common alternatives on how to distribute cash flows between LPs and the GP in venture capital funds. Before we get to the secret sauce to outperform the average fund in terms of IRRs and ROIs, aside of other valuable soft factors.

In order to simplify and compare all outcomes this exemplary venture capital fund invested USD 10m over a period of 8 years, with a preferred return (hurdle rate) of 8% p.a. and total exit proceeds of USD 30m.

Alternative 1: The Classic 80/20 Split

In this case the fund distributes the cash flows in two steps:

Step 1, all cash flows will be distributed to the LPs, until the cumulative distributions equal their principal amount, plus the 8% p.a. preferred return.

Step 2, thereafter, all cash flows in excess of the distributions made in step 1 are distributed 80% to the LPs and 20% to the GP.

In order to be able to distribute any proceeds beyond the principal amount and the preferred return to the GP, the fund will have to return a minimum of USD 18.5m. As you can see in the chart below, the GP will only receive 7.7% (USD 2.29m) of the exit proceeds, in addition to the management fees.

Alternative 2: The 20% catch-up and 80/20 Split

In this case the fund distributes the cash flows in three steps:

Step 1, all cash flows will be distributed to the LPs, until the cumulative distributions equal their principal amount, plus the 8% p.a. preferred return.

Step 2, the GP receives a full 20% catch-up, equivalent to 20% of the of all the distributions made in the previous step 1.

Step 3, thereafter, all cash flows in excess of the distributions made in step 1 and step 2 are distributed 80% to the LPs and 20% to the GP.

The minimum return of USD 18.5m for a distribution to the GP stays the exact same. Though, in this example the GP gets the real 80/20 split, due to the catch-up in step 2. In this case the GP will receive a total of 20% of all exit proceeds (USD 6m). This scenario is rather unlikely, but still possible.

The 20% catch-up and 80/20 split calculation

Alternative 3: The 20% after Preferred and 80/20 Split

In this case the fund distributes the cash flows in four steps, at the same time it is the most common way to distribute proceeds in a VC fund:

Step 1, all cash flows will be distributed to the LPs, until the cumulative distributions equal their principal amount.

Step 2, all cash flows will be distributed to the LPs, until the LPs have received their 8% p.a. preferred return on the principal amount in step 1.

Step 3, the GP receives a full 20% catch-up, equivalent to 20% of the of all the distributions made in step 2.

Step 4, thereafter, all cash flows in excess of the distributions made in step 1, 2 and step 3 are distributed 80% to the LPs and 20% to the GP.

Here as well, the minimum return of USD 18.5m for a distribution to the GP stays the exact same. Though, in this example the GP only receives a 20% catch-up on the preferred return distributed to the LPs from step 2. In this case the GP will receive a total of 13.3% of all proceeds (USD 4m).

As you may derive yourself, this is the common ground between “the classic 80/20 split” and “the 20% catch-up and 80/20 split”. Furthermore, a VC fund will have to return 3x in order to make it attractive in terms of carried interest, as the GP starts to participate after roughly 1.85x (aside of the management fees).

The 20% after preferred and 80/20 split calculation

The Secret Sauce to Outperform the Average

As a GP you have an intrinsic motivation to maximize fund returns unattached to the distribution mechanism, which you agree upon in the LPA of the fund.

There are various alternatives, which I have seen along the way in my professional career. In short, VCs cannot reliably pick winners all the time, though they can construct portfolios that consistently generate great returns. E.g. Union Square Ventures has an extraordinary unicorn spotting rate.

This is not a lucky coincidence. VCs have to add a secret sauce in order to be able to maximize fund distributions to LPs and the GP. This is rather an ongoing process, which will take time and lots of experience. Lets take a closer look at some ways to get there.

Management Fees and Investment Recycling

The other day I read an interesting article on the impact of management fees and reinvesting realized proceeds on fund performance. To be more specific on total gains, gross and net multiples for LPs and the carried interest for GPs.

To my surprise the impact is more severe than expected. Just by adjusting (lowering) the management fees from 2.5% to 1.5%, assuming both cases are able to generate the same gross returns on their investments, there is a 8.6% increase in net multiple to the LPs.

The implications are fairly clear, when a fund charges higher management fees, the investable capital is diminished. This leads to lower total proceeds and a lower carried interest for the GP, as indicated in the chart below.

To add another thought, some funds reinvest (recycle) realized proceeds into new investments, during the investment period (usually within the first 4 years of the funds lifecycle). While increased management fees reduce the available amount for investment, recycling proceeds have the opposite effect, they increase the investable capital while offsetting a proportion of management fees.

Assuming both cases have the same target net multiple, without recycling realized proceeds the one fund would have to return 4.1x (gross), while the other fund would only need to return 3.65x gross. As long as the recycled capital is deployed into opportunities capable of generating positive results, recycling is an impactful way for GPs to increase net returns.

Power Law Distribution and Outliers

Venture capital returns are distributed according to a power law, with the biggest part of the of returns earned from a fairly small number of actual investments. A larger number of investments will give better odds of investing in an outlier, which can make the difference.

This is a good summary, explaining the power law distribution (copied from The Qualified VC): “If you apply the 80–20 rule to the top 20% of venture capital deals, then 4% of the deals produce 64% of all returns. Apply the 80–20 rule again to the top 4% of deals and you get 0.8% of deals producing 51.2% of all returns. The implication is that 1 in 20 deals may produce 2/3 of all returns and 1 in 100 deals may return more than all other deals combined.”

To give you some examples of outstanding (the 1 in a 100 deal) outliers. Lightspeed Venture Partners invested into Snap USD 485k in a seed round in 2012 and then followed on in future rounds, for a total investment of USD 8.1m, its return on investment is over 250x (at least on paper). Lightspeed Venture Partners holds nearly 82 million shares worth just less than USD 2bn. 1999 Kleiner Perkins Caufield & Byers invested USD 12.5m in Google (10% stake) its hugely profitable fund would have been underwhelming without that outlier.

In short, the data show that venture is an extreme outlier business where a small number of investments drive most of the returns. Therefore, a key question for almost all LPs, especially in early-stage funds, is “what is the chance of an outlier in your fund?”

The answer is driven by two key questions: “How high is the probability of each investment being an outlier” and “what is the total number of investments in the fund”. The chart below is a good indication to grasp the likelihoods.

Successful VCs need at least one outlier to have a well performing fund

Back the Winners

The NY Times ran a story explaining how Andreesen Horowitz made the wrong call on Instagram, even though its USD 250k investment resulted in a $78 million return, which is a whopping 312x multiple on the investment.

The main question here is what Andreesen Horowitz left on the table? They could have returned several hundred of million USD, if they would have “only” invested along maintaining their pro rata share. Or even way beyond that, if they would have decided to back the winner — in this case Instagram.

Putting the numbers into a context, at that point Andreesen Horowitz managed USD 2.7bn, therefore they returned only a fraction of their managed capital with this outlier investment, which they did not back (which is due to other reasons). Keep in mind, for every Instagram, there are literally thousands of failures.

To emphasize the relevance of follow-ons, I aggregated some Pitchbook data on IRRs / TVPIs for American VC Funds (< $250M with Vintage 2005–2017) with a 30% & 50% follow-on rate on their investments. You may judge yourself assessing the numbers.

Fund Innovation

Depending on who you ask, VCs are described both as toxic capital and as the golden ticket to crushing competition to become the next unicorn. In order to get access to the best deals out there VCs are constantly looking to differentiate themselves (this is a great overview of innovative venture capital firms). There are several approaches, which I liked a lot, I summarized some of them below:

Hands-on operational support, VCs are bringing whole teams of startup specialists to the table. They support in areas such as design, marketing, software engineering, business intelligence and sales.

Artificial Intelligence, VCs are not just investing into tech companies, they have started building their own. This leads to a competitive advantage as software-powered VCs for example InReach Ventures’ dealflow software.

Network infused Platforms, platforms shall help entrepreneurs to learn faster than the speed of their own experience. In order to be successful, entrepreneurs have to beat the knowledge curve. Especially on network expansion, business development, talent sourcing, and of course fundraising.

Patient Capital more entrepreneurs are seeking for patient capital, especially in early-stage startups, breaking free from fund cycles. A good example is Draper Esprit. Building a generation-defining company takes 10–15 years, which of course exceeds the lifecycle of a normal fund.

Alignment of interest

One of the best approaches I’ve seen to align interest and killing the moral hazard in the VC industry is what Softbanks Vision Fund is doing. Partners at SoftBank’s USD100bn Vision Fund will share the potential profits from their investments. But they will as well be on the hook when their big bets backfire.

SoftBank has an unusual compensation structure for the fund, which includes a USD 5bn loan to employees. The debt is swapped for equity in the fund and will generate profit when deals make money and losses when they don’t. Furthermore, partners will face a clawback of 20% and above, depending on seniority.

This is what I call meaningful “skin in the game”. But always keep in mind:

“The biggest learning in VC so far: it’s a short memory business. Competitors become partners, founders of bad companies become founders of great companies, and, most difficult for me, which I’m still trying to grock, investor who screws one company can do wonders for others”. — Paul Murphy

Any thoughts or questions? Reach out! Want read more?

The Angel Performance Playbook

Modern Entrepreneurial Fraud

Schrödinger’s Valuation Problem

Cap Table Madness

Venture Capital Fund(amentals)

Equity, debt and the grey zone in-between

KPI <kē pərˈfôrməns ˈindiˌkātər> Hunter

About myself

I am a passionate and hands-on venture capitalist (+6y), entrepreneur (+7y), mentor and angel investor. After 6years of flying over 1.000.000 miles, spending 1.200 hours on airplanes, looking at 1.000 start-up pitches on all continents, I decided to gather some of my thoughts based on this extremely rewarding professional journey at Mountain Partners. Reach out!