We e k 1 I n t ro d u c t i o n t o

Ve n t u r e C a p i t a l

O V E RV I E W
The study of venture capital involves determining how entrepreneurs
may attract the capital to turn their ideas and technologies into longterm viable businesses.
Typically venture capital is difficult to procure as new venture
possess characteristics, such that calculations made on current
markets are relevant to future markets that the product will be
introduced into that make it extremely difficult to attract financing,
and therefore their financing cannot take place in mainstream
investment markets (stock market, superannuation investments,
direct investment from individuals).
Venture capital investment is referred to as an alternative asset
class.

T R A D I T I O N A L A N D A LT E R N AT I V E A S S E T S
Traditional asset classes include those that we know a lot about,
have existed for a long time and has significant financial institutions
built around their valuation, creation and trade. For example, publicly
traded shares, bonds, foreign exchanges, commodities and real
estate.
Alternative assets have a limited investment history, have clearly
differentiated features from traditional asset classes (eg poor
liquidity), and require specialist skills to manage. These features
make them less common in investment portfolios (eg art, films, notes
and coins, ostriches).

V E N T U R E C A P I TA L A N D P R I VAT E E Q U I T Y
Venture capital and private equity funds are some of the most
common alternative investments available to investors.
Venture capital is a sub-class of private equity, and involves
providing finance for start-up firms that require substantial capital to
expand and cannot usually access it form conventional sources.
Non-venture capital private equity can be used to fund troubled and
distressed firms who have difficulty raising capital to fund a
restructure, or to buyout a large, stable and mature firm which is
underperforming (leveraged buyout).
In general private equity and venture capital funds invest in highrisk, high-return firms. This is due to the uncertainty of the outcome
of the venture, that is, that the firms output can be readily
capitalised upon (ie can be made profitable), brought to market at an
attractive price point, and that the market will remain static (or
rather not move against you).
Private equity investors primarily do not use their own funds in
venture capital investment, rather they establish a venture capital
fund, setup as a partnership, with the venture capitalist(s) being the
general partner(s), who generally contributes 1% of the total funding,
and institutional investors and high net worth individuals who provide
the remaining funding are limited partners.
In the US, where venture capitalism is more prolific, these limited
partners are typically pension funds and university endowments (ie
universities make significant investments in venture capital projects).
In Australia, while universities have reasonable endowments
(accrued revenue from fees and the like), it lags significantly behind
that of US universities, and the actual amount invested in venture
capital is dramatically less.
A typical mid-risk institutional investor will distribute 5% of their
portfolio to private equity, and 20% of that to venture capital. In
Australia, we have very few venture capital funds. This may be a
result of poor performance by venture capital funds in Australia, or
the poor performance may be attributed to the lack of venture
capital funds.
Given Australias private equity performance, we will look at the US
data, and find that the Sharpe ratio of private equity is markedly
above that of debt and the market index (Sharpe ratio of 0.69 for the
private equity pooled average, 0.57 for Government debt, and 0.31

for the S&P 500 Index). If we recall, the Sharpe Ratio is a measure for
calculating risk-adjusted return:

E [ R aRf ]
a

Where:
Ra is asset or portfolio return
Rf is the risk-free or benchmark rate
a is the standard division of the excess return (Ra Rf)
As such, private equity, with its higher Sharpe ratio represents a
good investment. Moreover, private equity pushes out the efficient
frontier and as such, for a portfolio to be efficient, it must contain
some significant proportion of private equity.

P E R S P E C T I V E S O N V E N T U R E C A P I TA L
Primarily this course focuses on how to structure the contributions of
the entrepreneur (human capital), the ultimate investors (financial
capital), and the venture capitalist (intermediary).
Entrepreneurs are generally weary of venture capital, as they want to
minimise the amount of their firm which they give away, and,
moreover, accepting venture capital usually results in a loss of
control in how the firm is run. As a result, venture capital will often be
a last resort source of capital for an entrepreneur.

T H E V E N T U R E C A P I TA L C YC L E
The central issue of venture capital is how to arrange and manage
co-contributions of human and financial capital from separate
parties. Entrepreneurs have many ideas that require substantial
capital to implement, but lack the funds. Usually such
entrepreneurial projects lack tangible assets, expect several years of
negative earnings, and have uncertain prospects. Investors lack
understanding of these projects to provide sufficient funding. Venture
capital funds are one type of solution to the funding problems of
these firms.

Venture capitalist raise funds from investors, invest this capital using
various strategies, and then eventually sells of their stake in the firm
and returns capital to the investors.
These investors are typically pension funds, university endowments
and rich individuals as they are required to contributed significant
capital and have a relationship with the venture capital fund. Top
performing venture capital funds are often very difficult to invest in
for this reason. Venture capitalists raise a fund on a periodic basis
(every 3-5 years), with these funds structures as limited partnerships
and last about 10 years, with initial capital and profit being returned
to investors after this time.
Venture capitalists receive hundreds of proposed investors, after
intense scrutiny a few are selected, with acceptance often
conditional upon approval of a syndication partner (ie a second
venture capital fund, generally utilised to receive additional capital).
Venture capitalists intensely monitor the management of their
investments (often through representation on the board), and
distribute their funds in stages, with funding in the form of preferred
stock with restrictive covenants attached, such as blocking rights or
disproportional voting rights over key decisions, including the sale of
the company or the timing of an IPO, and if the firm. Preference
shares are used so that if the enterprise fails, the shares simulate
debt and allow the venture capitalist first claim to the companys
assets and technology. The contract is also likely to contain downside
protection in the form of antidilution clauses or ratchets. Such
clauses protect against equity dilution if subsequent rounds of
financing at lower values take place. Alternatively, if a company is
doing well, investors enjoy upside provisions, sometimes giving them
the right to put additional money into the venture at a predetermined
price (given the firm is performing well, this would be below market
prices).
Venture capital firms also protect themselves from risk by
coinvesting with other firms. Typically there will be a lead investor
and several followers. It is the exception, not the rule, for one VC to
finance an individual company entirely.
Venture capitalists choose to only hold their stake in the company
during the adolescence period, exiting their position before growth
rates decline. In order for the venture capitalist to exit the
investment, they take the most successful firms (typically 20-35% of
venture-backed firms) public through an IPO. These superstars
account for the bulk of the venture capital fund returns and will often
make tens if not hundreds of times the initial investment, necessary

returns to write-off those firms the venture capitalist invested in

which failed.
Overall there is a 2-6-2 rule, which states that approximately 20% of
investments will be winners, 60% will continue to operate but will
potentially return just enough to justify ongoing monitoring costs,
and 20% will cease to exist (ie they are liquidated in an effort to
recoup the initial investment).

I N F O R M AT I O N A S Y M M E T RY A N D T H E A G E N C Y
PROBLEM
The kind of firms that venture capitalists finance are high risk, which,
theoretically, should be rewarded with high returns. High returns to
investors means that a large ownership fraction of the venture is
transferred to investors. However, the entrepreneurs loss of
ownership creates two key problems, that of an agency problem, and
of information asymmetry.
The agency problem is that the entrepreneur will use the capital you
have provisioned to benefit themselves rather than the business as a
whole (which you are now a part owner of). More specifically, a moral
hazard has been created, which is the tendency to take risks or make
value destroying decisions because the costs that are incurred are
not felt by the risk taking/decision making party. A 1976 paper by
Jensen and Meckling breaks this down. In a 100% owned firm,
consumption of $1 worth of perquisite (a benefit one is entitled to
due to their job) reduces the managers wealth by $1, however, if the
manager owns only 30% of shares, consuming $1 worth of perquisite
only reduces the value of his holding by 30 cents, with this
encouraging perquisite consumption. In addition to this, the
entrepreneur also has less incentive to work to benefit the firm as
they are now only receiving 30% of the firms revenue.
Entrepreneurial firms may be subject to even higher moral hazard
risks because it may be even harder to observe their actions after
financing (particularly if operating a highly complex or scientific
venture which an outsider would have difficulty understanding). This
leads to investors demanding even higher rates of return on their
capital, and makes it harder to attract funding to the firm.
Information asymmetry arises due to a party being unable to
observe/verify a counter partys preferences and abilities prior to
making an agreement, more specifically, the entrepreneur knows

more about their firm than the financer, and as such, knows more
about the risk and return of their projects.
In 1970, Akerlof created a model to demonstrate the effect of
information asymmetry. Under the model there are two types of cars
in the used car market, good cars (worth $6000) and bad cards
(worth $2000). Assuming there are no warranties nor inspections
allowed, buyers may demand a market price reflective of the
average quality of bad and goods cars (ie $4000), however, if this is
the case, sellers with good cars (worth $6000) would withdraw from
the market, leaving only lemons. This is known as adverse selection.
In the real world we would have a continuum of cars with value
ranging from $2000 to $6000. After dropping the price to $4000, and
leaving only those cars worth $2000-$4000 on the market, the
average quality is $3000 so the price must drop to $3000. Then at
$3000 the average quality if $2500 and so the price must drop, and
so this will continue until price is $2000, there is an infinitesimal
number of cars on the market, and thusly the market completely
collapses.
From this we can see that even if entrepreneurs have good projects
and want to maximise shareholder value, information asymmetry
means that good projects suffer heavy discounts. To this end, we
require an intermediary to essentially insure or provide a
warranty (in terms of our analogy, not actual warranty is offered) for
the transaction.
Note that agency problems and adverse selection are two different
problems, they are not also a type of risk per se.

T H E C A P I TA L G A P
The challenge of insufficient capital for young/new firms is known as
the capital gap.
These firms are often initially too small to be financed by the capital
markets (as capital markets have minimum requirements for
revenues and assets), yet require too much capital to be financed by
individual savings, and are too risky to be financed by banks. Even if
the firms could be large enough to be financed by capital markets,
they would still have problems raising equity finance due to
information asymmetry and the perceived agency problem.

Obviously these issues create significant barriers to new innovations

and serious impediments to national economic growth.
If these information problems can be reduced, then financing would
not be such an issue. Retail and institutional investors, and banks
usually do not have the time, resources nor expertise to overcome
these problems (and in many countries banks are not permitted to
hold equity, or a limited in their ownership stake, and even if they
could, laws limiting interest rates banks can charge, and the lack of
hard assets owned by start-ups against which to secure the debt,
mean it would be impossible for a bank to issue a loan with an
interest rate in keeping with the high risk of a start-up); governments
may be able to overcome these problems, however this can lead to
other agency problems such as political agendas and the like. As
such, we require private equity of venture capital funds as
intermediaries to help reduce some of these problems.
Venture capitalists overcome such problems through intense scrutiny
before capital is provided and intense monitoring after capital is
provided. This scrutiny and monitoring may involve screening of
investments, using convertible securities, syndicating and staging
investments and providing oversight and informal coaching to the
firm.
Non-venture capital funding sources include crowd-funding, angel
investors, and incubators/accelerators, which are programs designed
to support successful development of early stage business, providing
infrastructure, mentoring and networking with angels and VCs, and
sometimes provide a small amount of seed capital. Typically venture
capitalists invest in a company which has already begun to
commercialise its innovation: it is comparatively rare for a venture
capitalist to provide capital before this point in the earlier stages of
development, and almost, if not never in the idea stage. Angel
investors by comparison regularly provide capital prior to the
commercialisation point, but still rarely during the idea stage.

We e k 2 - Fu n d Ra i s i n g a n d
Fu n d S t r u c t u re I

S O U RC E S O F E Q U I T Y F I N A N C I N G

F I R S T S TA G E : B O O T S T R A P P I N G
The first stage of financing for a new firm is generally bootstrapping,
which consists of various sources of internal equity, including the
founders own savings, credit cards, personal loans, family members,
tax rebates, second mortgage etc.
Bootstrapping is a good signal to a venture capitalist looking at the
firm, as it shows the founder is personally investment in and
committed to the project.

Approximately 31% of all firms are initially financed through

bootstrapping. The median start-up capital in the US is only around
$10,000.
If a start-up firm chooses to ignore bootstrapping in lieu of external
funds, or moves to external funding too early, the firm may suffer,
as:
There is now greater incentive to spend, expand and
squander;
The firm may be moving too quickly for stable growth, a slower
start is often a safer start, entrepreneurship is particularly
about operating in an unprecedented way, or in an entirely
new industry, where trial-and-error is a vital prerequisite to
expansion;
Outside investors tend to favour the safer, proven methods,
which may not work in a new industry, nor net the highest
returns. As aforementioned, entrepreneurs tend to favour, and
benefit from, trial-and-error;
Outside investors will demand significant firm ownership at
early stages, resulting in little incentive nor wealth creation for
the entrepreneur; and
Venture capitalists are not that patient, and will have a strict
exit deadline (generally 5-10 years after financing).

S E C O N D S TA G E : A N G E L I N V E S T O R S / S E E D
C A P I TA L I S T S
Angel investors, also known as seed capitalists, are professional
investors, investing with their own funds, generally being wealthy
individuals with significant, relevant experience to entrepreneurship
(eg investment bankers, lawyers, retired CEOs, retired engineers).
Angel investors look to reap high initial returns from their early
investment, and returns from their value adding activities (ie from
the intellectual capital and experience they provide to the firm).
Angel investors will also generally prepare the company for venture
capital funding.
Angel investors perform formal screening of proposed firms and are
rather selective, particularly looking to maximise the effectiveness of
their own intellectual capital as they will be more involved in the firm
than a traditional investor. Most angel investors will maintain a
significant amount of additional funds on hand to allow for a firm to

diversify if opportune, as well as provide continuous funding to the

firm in order to avoid dilution of ownership.
Angel investing in the US has almost doubled from 2007 to 2012,
with 270,000 angel investors generating market activity of $23b in
2012. The current acceptance rate is around 10-20% of proposed
deals, with the most prominent industries being healthcare, software
and biotech.
Angel investors will usually invest $50,000 - $100,000, holding the
investment for 12 years on average, with a minimum of seven years
until time of listing/sale. Their portfolio will normally consists of no
more than five firms.

S O U RC E S O F D E B T F I N A N C E
Start-up firms will generally seek debt financing through bank loans:
overdrafts, commitments, term loans and the like. This contributes to
about 30% of total funding.
It is, however, rather difficult for start-ups to acquire debt finance as
banks require stable cash flows, and collateral in the form of tangible
assets, neither of which a start-up has. Moreover, a significant moral
hazard is created as the start-up has an entirely different risk
appetite to the lenders, and unlike equity, debt does not provide
sufficient remuneration for this risk (ie debt has a fixed interest
return).
Just as with equity financing, adverse selection also occurs with debt
financing, with the banks having to set exorbitant interest rates to
make these kind of loans worthwhile, as they do not know the exact
risk of a given start-up (information asymmetry). This high interest
rates will only be tolerated by extremely risky start-up ventures, and
the problem of adverse selection occurs.
The moral hazard and adverse selection problems result in credit
rationing, essentially a debt gap in the same vein as an equity gap.
In the bridge financing round, firms may seek capital from more
exotic debt financing sources:
Mezzanine funds provide debt financing combined with an equity
component, with this debt generally in for the form of unsecured,
long-term and less than senior-rank (ie is paid back after other
unsecured debt in the case of liquidation) debt instruments.

Venture lending provides debt financing with some warrant

component (recalling that a warrant is a security that entitles the
holder to buy the underlying stock of the issuing company at a fixed
price until the expiry date). Venture lending requires the guarantee of
existing venture capitalists and often requires blanket collateral over
all assets. Venture lending typically only provides a small amount of
capital that allows the firm to continue to operate until the next
equity funding round.

O V E RV I E W O F V C F U N D R A I S I N G
The process of fund raising and fund structuring for a venture capital
fund is complex due to the nature of venture capital investing.
Essentially investors in VC funds are concerned in both the moral
hazard and information asymmetry problem between the VC and the
start-up firm, but also the moral hazard and informational asymmetry
problem between the VC and them, the fund investors. While it is
obvious when a traditional fund is underperforming, for example, if
you invest in an Australian mining securities fund, you can measure
its performance against the mining index on the ASX, it is very
difficult to tell if a VC firm is underperforming, as it is completely
justifiable for a fund to make zero return due to the risky nature of
the investments, and hence the moral hazard and informational
asymmetry problem occurs.
In order to help overcome these problems, a VCs remuneration is
heavily tied to the profit of the fund, such that they are incentivised
to ensure fund performance. VCs typically take 20-30% of the total
profit (compared to the at most 5-6% taken by fund managers in
other types of investment funds), despite only contributing a small
initial investment (generally around 1%).
The timing of the profit distributions to the VCs can vary across VC
funds depending on the bargaining power of the VC. Obviously the
VCs will want to receive the profit as soon as possible (given the time
value of money), while limited partners generally require that at least
their initial investment is returned before the carried interest (the
share of the profit the fund is paid, also known as carry, ie the 2030%) is paid.
The relationship between fund investors and VCs affects the entire
venture capital cycle as investors limit the life of VC investments to
ten years, forcing:

 VCs to rush firms to the market, potentially ignoring value

maximisation opportunities that would have taken more time
to develop (eg product revisions);
VCs to focus on a specific end goal;
The dumping of underperforming firms that may have
otherwise been recovered given more time; and
Start-ups to focus on developing a ten year exit strategy (and
the forecasted valuation for such an exit) to pitch to the VCs.

C A P I TA L I N F L O W S
Institutional investors may invest in VC/PE as it they are alternative
asset classes that promise high potential returns as well as offering
diversification opportunities with traditional assets.
From this it can be seen that supply-side demand for VC is largely
dependent of the historical performance of VC funds. VC may also
appear more attractive if capital gains tax is lower than income tax,
as VC returns a single capital gains event rather than a steady
stream of income; or if the public market is performing well, as this is
indicative of potentially improved IPO performance.
Compulsory or incentivised pension contributions should theoretically
increase capital inflow into the venture capital market (however in
Australia with the introduction of superannuation, this wasnt really
the case).
An increase in VC market inflow also occurred in 1979 in the US when
the Prudent Man rule (which stated that retirement funds must be
allocated as a prudent man would, and as such were never invested
in VC) was clarified by the government, and allowed for retirement
funds to diversify into VC.
VC funds may also receive increased funding from the general
partners if those partners have significant amounts of wealth and
can make such investments.
On the demand-side, entrepreneurialism becomes more attractive
(and hence more demand for VC will occur):
During periods of strong economic growth, as a business is
more likely to flourish and have greater returns;
If capital gains tax is lower than income tax, as business
owners accumulate wealth through capital gains rather than
income if they were employed; or

 If the government provides some kind of tax incentive for

starting a business or partaking in research and development.
If we examine the real-world supply and demand factors we see that
supply factor curves are significantly more elastic than demand side.

In terms of attracting capital inflows on the micro level, a newly

established fund is like a start-up firm. The fund will find it incredibly
difficult to raise funds as they need to overcome substantial agency
costs and information asymmetry. A new fund must work to establish
its expertise and network in order to attract investments.
As there is no external market to trade VC fund contributions,
reputation in terms of historical returns, age and size, is critical to
fund raising. Investors in VC are hypersensitive to performance, with
VC funds that hold larger stakes in firms that have recently gone
public able to raise funds with greater probability, and raise larger
funds.
If we look at the statistics of fund performance, it becomes clear as
to why such emphasis is placed on reputation and past performance,
as past performance is a strong indicator of future performance (as
opposed to other types of investment funds which tend to average
out in performance):

Past VC
Fund

Bottom
tercile
Mid tercile

Future VC Fund Performance

Bottom
Mid tercile
Top tercile
tercile
61%
22%
17%
25%

45%

30%

Top tercile

Performanc
e

27%

24%

48%

Consistency in performance has two common explanations. One is

that higher performing VC firms have more skilled VCs and therefore
perform better. The other argument is that a fund that performs well
in its first round (and subsequent rounds) has created a name for
itself, and will receive better deal flow. That is, because of its
reputation, more entrepreneurs, with better ideas will approach the
VC for capital, and the VC is then able to cherry pick the best ones.
Moreover, the longer a VC firm has been operating, the greater its
funds average return, that is, a new, first-time fund has an average
IRR of 2%, while the tenth fund that a VC firm raises has an average
IRR of around 20% (largely because the underperforming VC firms
have been weeded out at this point):

IRR and Fund Sequence Number

25
20
15

IRR

10
5
0

10

11

Sequence Number

These top performing VC firms with high sequence funds have

significant demand and are therefore very difficult to invest in.

THE CHALLENGE OF FIRST TIME FUNDS

Fundraising is particularly challenging for first time funds as investors
are reluctant to invest in an unproven team. The question is of
course, how do you raise a fund without a track record, when to
obtain a track record you need to have a fund?
This challenge may be addressed in several ways:

 Identifying investors who are not purely motivated by returns,

for instance, those investors which wish to see innovation,
research and development in a particular industry or sector,
for example, green energy.
Establishing an alliance with an existing institution as a more
established firm will have greater success if it starts a VC fund,
for example, if you worked for the Commonwealth Bank, you
could suggest that the bank create its own VC fund, which
would have the Commonwealth Bank name and reputation
attached. In some cases, however, the associated institution
may block certain ventures as it may involve a firm that could
possibly compete with them.
Recruit a lead investor or special limited partner, an investor
who has significant clout within the investment community
who certifies the fund. For example, if Warren Buffet was an
investor in your fund, this would improve the attractiveness of
the fund to other investors.
General partners in first time funds often have to invest more than
the minimum 1% in order to cover capital shortages (some times as
much as 5%). Even for non-first time funds, limited partners have
been increasingly demanding that general partners increase their
initial capital outlay to 5%.

P A RT I E S T O V E N T U R E C A P I TA L
Venture capital funds are established by individuals, financial
institutions (banks, IBs and their employees, and other fund
managers), corporations, and governments. Funds must be
established as a partnership, as opposed to a corporation, as a fund
has a finite life, and a corporation must have an infinite life.
General partners (the venture capitalists) are responsible for day-today management of the fund. VCs typically only invest a small
amount of their own capital, as investing any more would expose
them to significant risk (as venture capital is inherently risky) and
may make them too risk adverse in their operation. For first time
funds, VCs may needs to invest slightly more, however it is still only
a relatively small figure.
Limited partners (the investors) are a wide array of individual and
institutional investors, including wealthy families, pension funds,
endowments and wealthy individuals.

Established relationships are necessary to invest in top-flight funds,

whether that is from being an investor in a firms earlier funds, or
that you can show you can add something to the fund by being an
investor. To that end, limited partners will often provide advice or
leads to the general partners. Limited partners must not become
directly involved in the activities of the fund, as they would lose their
limited liability status and become general partners.
Special limited partners (lead investor, see above) typically receive a
portion of the carry, and friends of the fund (successful
entrepreneurs backed by the venture firm and former general
partners) will receive fee discounts or more favourable terms.
Investment advisors or gate keepers provide advisory services to
clients and usually set up funds-of-funds in return for a fee from
investors (typically 1%, but may also include carry). Funds-of-funds
invest as a limited partner in many different VC and private equity
partnerships. Investors may buy into these funds-of-funds as they
allow:
Diversification among many VC funds
Access to funds of which they do not have sufficient clout to
buy into
A minimum investment below that of a typically VC fund, that
is the investment is scaled up by combining it with other
investments (in this case the fund-of-funds may contain a
single VC fund)
Large investments (greater than the size of an entire fund) to
be made, that is the investment is scaled down and spread
among multiple VC funds

S T R U C T U R E O F L I M I T E D P A RT N E R S H I P S
As limited partners cannot be directly involved in the day-to-day
activities of a fund, they rely on a Limited Partnership Agreement
(LPA, the terms under which the partnership was established) in
order to keep the general partners in check. Essentially this
agreement is trying to protect against all the ways the VCs may
expropriate the limited partners investments.
This type of agreement is absolutely essential to VC fund
investments as opposed to other investments such as the stocks, as
VC funds lack the implicit internal controls of these other
investments. For instances, as a shareholder, you have three primary
means of ensuring your investment is protected: if the firm is going

poorly you can sell your stake, which works as both an exit strategy
and a check against the firms board (if everyone sells their shares,
the company will tank); significant stakeholders can hold
extraordinary general meetings if the firm is underperforming, and if
a solid M&A market exists, a consistently poorly performing form will
be taken over and improved. Venture capital investments, however,
have none of these protections.

C A S H F LO W S C H E D U L E
Commitment refers to the maximum amount of capital that an
individual limited partner agrees to invest in a fund. The commitment
generally includes management fees charged by the general partner,
as well as other fund expenses. Rather than immediately providing
this committed capital, and having excess cash waiting to be
invested (and earning minimal interest, in turn depressing the funds
returns), limited partners disperse committed capital in stages, with
each payment referred to as a takedown (also known as drawdown or
capital call).

C O M P E N S AT I O N S T R U C T U R E
The management fee charged by the general partners to the limited
partners typically range from 1.5%-2.5% of committed capital,
depending on the type and size of the fund. This fee is notably larger
than that charged by mutual fund managers, who generally earn less
than 1% of assets under management.
Carried interest is the general partners share in the profits of a
private equity fund. Sometimes a fund is required to return the
capital given to it by the LPs before the GP can share in the profits of
the fund. The GP will then receive 20% of the net profits as carried
interest, although some successful firms receive 25%-30%. This fee
is also known as carry or promote.
As investments are exited, funds are distributed back to LPs, with the
Limited Partnership Agreement specifying how and when these
distributions take place. The timing and form of distribution will also
be defined. This includes clawback provisions, which give LPs the
right to reclaim a portion of carried interest disbursements to a
general partner for early profitable investments if there are
significant losses from later investments in a portfolio.

These issues can become very complex in negotiation of the

partnership agreement.

COMPLEXITY OF PROFIT DISTRIBUTIONS

Profit is the total cash made on the invested capital, for example, if
investors commit $100m and the funds exit proceeds are $200m,
profit will be $100m. This is our first method for calculating profit.
However, we may also consider that profit should be based on initial
investment less fees, for example, if fees paid over the investment
are $25m in this example, then invested capital is $100m$25m=$75m and profit is therefore $125m. This is our second
method.
These calculations of profit only really matter for the distribution of
carry to general partners (the limited partners will receive back
$200m less fees and carry in both cases). The first method is clearly
the more equitable scenario (carry is not being earned on fees
collected), and it is used by 30% of VC funds (typically those that
cant get away with using the second method, such as new funds).
The second method is then used by 70% of VC funds, typically the
more reputable and profitable funds which can get away with this
kind of profit calculation.

T H E T I M I N G O F C A R RY
~20% of funds require the return of committed capital before
collecting carry ($100m from the above example)
~24% of funds require the return of invested or contributed capital
before collecting carry ($75m from the above example)
~48% of funds require the return of a portion of invested capital
before collecting carry
Clearly those funds that have the best reputation can get away with
the third option.
A priority rate or hurdle rate is a preset rate of return that the LPs
must receive before GPs can collect carry (about 45% of funds have
hurdle rates). These usually have a catch-up provision attached

which allows VCs to receive a greater share of profit (up to their true
carry value) once the hurdle rate has been met.
For (a not very realistic) example, consider a $100m fund with carry
of 20% (with committed capital being the basis for profit). There are
priority returns of 8%, and 100% catch up provisions. All committed
capital is drawn on day 1 of the fund and the fund then makes:
Year 1 $108m
The priority rate has not been overcome
$108m to GPs
$0 to LPs
Year 2 - $2m
Priority rate now met, LPs are allowed to catch up, with total
profit now $10m (108+2-100) LPs are owed 20% of profit
which equals $2m
$0 to GPs
$2m to LPs
Year 3 - $10m
LP has completely caught up, so this is now just a standard
split
$8m to GPs
$2m to LPs
For another example, a $100m fund has 20% carried interest, where
profit is based on committed capital. The first exist is $60m and is
based on $50m contributed capital, ie profit is $10m. This $10m is
divided 80/20 between LPs and GPs such that LPs receive total of
58m and GPs get $2m. Now, at the end of the funds life there are no
more exits, and contributed capital is now the full $100m. LPs are
entitled to clawback the $2m carry initially collected by the GPs.