Our long-time good friends and LPs at Greenspring just recently composed a fantastic post entitled Creating GP-LP Alignment: Why Terms Matter. The post specifically went over 3 items: Management Fees, Recycling, and Carried Interest.
Several years ago, I composed a post entitled Why VCs Ought to Recycle Their Management Fees.
From the start of Foundry Group in 2007, we have felt highly about this. We feel that if an LP gives us a $1 to invest, we need to invest at least that $1, not $0.85 (the average cost load over a decade for a normal VC fund is 15%.) Our goal for each fund is really to invest closer to 110%, which suggests if an LP gives us a $1 to invest, we are actually investing $1.10.
The whole post deserves reading, but I specifically liked their area on Recycling which consists of an useful chart showing that recycling means that you only require to create a 3.65 x gross multiple to attain a 3.00 x net several to your LPs, vs. a 4.10 x gross numerous if you dont recycle. The section from their post follows:
Thats worth remembering.
In addition to management costs, the procedure of reinvesting realized proceeds into new investments, or recycling, can likewise meaningfully impact net returns and alignment. While management costs cut into the dollars available for financial investment, recycling can have the opposite result, increasing the investable pool of capital while balancing out a proportion of management charges. To illustrate this point, we revisit our $100 million fund example, and in this case demonstrate how recycling $15 million, equivalent to the funds management cost, favorably impacts the fund.
The fund that picks to recycle charges needs a 3.65 x gross multiple to attain a 3.00 x net multiple, whereas the fund that does not recycle proceeds to offset management fees requires a 4.10 x gross several to accomplish a 3.00 x target net multiple. As long as re-invested capital is prudently deployed into chances capable of producing strong outcomes, recycling is an impactful method for GPs to increase net returns, which eventually benefits financiers and themselves.
Now, envision if you recycled 110%. Your investable capital would be $110m. You now need a 3.45 x gross numerous to achieve a 3.00 x multiple. Plus, as a benefit, you get $56m of bring (vs. $50m of carry in the case where you dont recycle earnings.).
As an outcome, our objective is to produce as much of a return on the dollars invested, and get as numerous dollars invested as we can in each fund. Recycling allows us to do this and brings the gross and net returns better together, lowering the infect the brought interest from revenues on financial investments.
While numerous GPs focus on their gross numbers, in the end the only numbers that actually matter to LPs gradually are the net multiples.
Many fund contracts, consisting of ours, need us to pay back all fees and expenditures prior to taking brought interest. We believe this is another aspect of GP-LP positioning and have actually supported this from our very first fund. As an outcome, if you recycle at least 100%, it is more sensible to consider your management charge as a safe, interest-free loan against future brought interest, instead of extra settlement.
In addition to management charges, the procedure of reinvesting understood proceeds into new financial investments, or recycling, can also meaningfully impact net returns and positioning. While management fees cut into the dollars offered for investment, recycling can have the opposite result, increasing the investable swimming pool of capital while offsetting a proportion of management charges. To highlight this point, we review our $100 million fund example, and in this case show how recycling $15 million, comparable to the funds management charge, positively impacts the fund.
As an outcome, if you recycle at least 100%, it is more realistic to believe of your management cost as a safe, interest-free loan versus future carried interest, rather of additional compensation.