This week, I intend to take you through the pipes of a VC fund’s “money pump”. It starts with dollars coming in from our investors, our Limited Partners, LP, to be invested in entrepreneurs’ big ideas. Later, sometimes much later, money comes back to be shared between the LP and us, the General Partners, the GP. And, of course, there are those cases where we loose every penny. We’ll look at how the hits and misses balance and how we (try to) keep track of the streams.
One simple and, I’ll state it outright, simplistic, misleading assumption is the set of win/lose numbers. The theory varies, you’ll see why later. For today, I’ll just say we assume a $200M fund making 20 investments averaging $10M each. Out of these 20 investments, 6 are losers; 8 fall in the “money back” category, roughly returning what we put in, maybe a little more if we had an early exit; 6 are “winners”, returning between 4.5 and 6.5 times our money.
How much money does such a fund makes? What is the rate of return, the equivalent interest rate on the money put at risk by our LP?
With the assumptions above, there is no way to answer the question.
Because we have no idea of timing, of the dates for the investments, for the capital calls (I’ll explain in a moment), the exits (when our companies are sold or go public) and the distributions back to our LP. For the latter flow of money, we also need to know how we split the profits between the LP and us, the GP.
Fortunately, it’s not that opaque and a fairly simple spreadsheet helps.
Let’s start a simple example, without a spreadsheet: You make two $100 investments in years 1 and 3 and get two distributions back, $200 in year 4 and again $200 in year 4.
What is the equivalent interest rate? You don’t need Excel. You could whip out your calculator and start with 10%, a first approximation. You compute the principal + compound interest for each of the investments over time and see if the money has compounded enough to take out $200 in year 4. Yes, of course. But the remainder, invested for one more year, fall short for a $200 distribution in year 5. 10% is too low. Let’s try with a much higher interest rate, 40%. This time it’s too high. With patience you’ll zero on a good enough approximation: 31%.
Now imagine doing for 50, 60 or even 120 movements of money in and out of a fund, using trial and error to find what is called the Internal Rate of Return, IRR, for the whole operation over time.
Excel, the son of VisiCalc and Lotus 1-2-3, has precisely the function we need, called IRR. We give it the investments as negative numbers and the distributions as positive ones and, presto, we get the answer: 31%.
See below where A1:E1 means the range of cells from A1 to E1, with my apologies to the spreadsheet jockeys among our readers:
You see where this is going. Let’s say our fund lasts 10 years, a common assumption, we can open 120 columns for 120 months and track the money going in and out and running an IRR calculation for each month. An arbitrary smaller to get the idea:
Excel can plot a pretty graph of the IRR over time.
That’s it, really.
This model solves the problem of timing mentioned above when discussing the losers/money back/winners assumption: each negative/positive number reflects how much you invest or distribute each month.
In the everyday working of a fund, we make an initial investment and, if things go well, put more money in the start-up company after 18 months or so. More again later, if needed. Some beatific day, we see a positive number because we have an ‘exit’, the company goes public (not these days, probably not for a couple of years…) or is sold to a larger one. This gets us to the topic of splitting profits.
We call the carry for carried interest the percentage of profits we get to keep, say 20%. (Some firms got as high as 35% but those go-go days are gone.) We get 20% of what’s left when the invested capital is repaid along with something called the management fee. Usually pegged at 2%, this is an advance from our LP, money we use to pay expenses, salaries of staff and the GPs draw. The GP don’t get a salary, we get an advance against the fund’s profit to be shared among us, with an percentage also set aside for staff profit sharing. To summarize, we repay the capital our LP gave us to invest on their behalf, we repay the management fee and, when something’s left, our LP get 80% and we share 20%.
You’ve noted the ‘when something’s left’ clause in the previous sentence. This introduces a device called the clawback. To avoid us GP living off the management fee without worrying too much about making money for the LP, fund agreements often have a clawback clause whereby the GP must repay the management fee (or a negotiated portion) when the fund fails to make money.
Lastly, the simplified model skips a nuance. When we start a fund, our LP put up approximately 10% of their total commitment, say $20M for a $200M fund. We start investing and, at various points in time, we make what is knows as capital calls, fractions of 5% of the fund’s size, more or less, so we can make more investments and get our management fee. Those are the negative numbers in the series, not the inputs of money into the companies.
Now, if you want to see a really complicated model… — JLG