Why VCs should recycle management fees

If you're thinking of starting a fund, or have already started a fund but want to attract new LPs, this article is for you.

(Quick reminder that LP = limited partner, or someone who invests in venture capital companies.)

Today is part 2 of 3 in the "attract more LPs" series. And we're covering a critical topic: recycling management fees.

The purpose of this series is to explore the different ways emerging fund managers can set up their fund to be as attractive to LPs as possible. Big thanks to Sam Loui from Sydecar for helping me dig deep into these best practices.

Ok. Recycling management fees! So exciting. Let's dive in.

Quick reminder on how VCs make money

It's typical for fund managers to take 2% of an LP's total investment as a management fee. They call down this 2% every year for 10 years. This allows the company to cover the costs of running the business.

Things like office space, employees, cookies, etc.

This means that if an LP invests $10m into a VC fund, only $8m of that investment will actually be used to invest in startups.

The other fee that VCs charge is carry. Now, I've written about carry before... see my "Beginner's Guide To Carry" for a refresher.

In a nutshell, VCs get 20% of the profit in the event of a liquidation. The other 80% goes back to the LPs. The amount each LP receives depends on the LP's initial investment into the fund.

Ok, recap over. Let's keep it rollin.

Recycling management fees 101

One way a fund manager can make their LP's money stretch farther is to recycle management fees.

Imagine you are a VC and one of your companies shuts down or has an exit. Money is returned to the fund. Rather than taking your 20% and buying a second home, you (fund manager) put that money back into the fund.

You invest the money into additional startups OR write follow-on checks into your most promising companies.

This is referred to as "recycling management fees", and it's a great way to make your fund a more attractive investment opportunity to LPs.

Why? Because it makes an LP's investment stretch further, essentially negating the 2% management fee.

It gives VCs additional shots-on-goal to deliver outsized returns to their investors.

What other funds are doing

Not every fund recycles their management fees.

But in a world where competition for LPs gets steeper by the minute, funds that DO recycle management fees often have a goal... for example, maybe they aim to recycle 100% of their management fees.

So let's say you raised $10m for your Fund I. If you're taking a 2% management fee, that means $200k of your LPs' money is going into your pocket to run the business. The rest is set aside to invest in startups.

If you want to attract new LPs to the fund, you might include in your governing docs that you have a goal to invest the entire $10m into Fund I companies... with $200k coming from the profits you make on your investments.

Some funds go even further and aim to invest 110% of their management fees into the fund. So in this case, that would mean investing not just the full $10m that you raised... but MORE.

$10.1m, to be exact.

Certainly it's a personal cost to you in the short term to take this route. If you opt not to recycle management fees, you would take home a larger check at the end of the year (assuming your companies are returning cash to the fund).

But you also might have a much harder time closing LPs compared to the funds who are prioritizing this strategy.

What's the end goal?

Investing is a business strategy. LPs – although they may love you, your mission, and the companies you back – ultimately invest to make a profit.

By recycling management fees, you have more investable dollars to work with.

Which means, supposing your portfolio companies have a liquidation event (like an acquisition or IPO), you get a bigger return on your investment.

This means your LPs get a higher return on their investment. It also means you make more on carry.

Call that a win-win.