In past articles, we have repeatedly mentioned the outcomes that venture investors seek from their startup deals. Let’s look closer at the rewards for their efforts: Carried interest and Management fees.

How do venture capital funds get paid?

Venture capital funds do not invest out of their own pockets. Instead, they raise most of their capital from third parties represented by limited partners (LPs). The latter include:

• Institutional investors (pension funds, endowments, insurance companies and sovereign wealth funds). They invest a relatively small amount of their own capital (typically up to 10%) in venture capital to diversify their portfolio;
• Private investors. These include high-net-worth individuals (including angels) who invest their money in VC funds for personal gain;
• Corporate investors (CVCs). These are the investment arms of large corporations that invest in startups for strategic advantage and financial gain. Usually have interests related to their core business;
• Others. For example, Funds of Funds, universities, research institutions, and private equity funds may invest in VCs and PE to generate funds and support their innovation and research.

Listed parties invest in VC and PE to generate high returns that exceed the annual growth of the S&P 500 Index, otherwise the purpose of the asset is lost. At the same time, LPs do not participate in the fund’s operational activities and act as passive observers. Therefore, when choosing a fund, limited partners look first and foremost for the trust and competence of the fund’s management.

The General Partner also invests directly in the fund. This is usually between 1% and 5% of the total capital. For example, if the total amount of the fund is $100m, GPs can invest from $1m to $5m.

As a result, the venture fund receives two types of cash compensation for its work (searching for startups, document management, legal support of deals, etc.): Carried interest and Management fee. Fund managers are compensated through these mechanisms, which align their interests with those of the investors. Investment managers play a crucial role in overseeing the fund’s operations and ensuring its success.

Carried Interest

Carried interest, or simply carry, is a portion of a fund’s return paid to the managing partners as a reward for successful investment management. Carry is often taxed as capital gains, which has significant tax implications for general partners. Typically, carry is 20% of the fund’s return after a certain minimum performance level has been achieved. The Tax Cuts and Jobs Act has influenced the treatment of carried interest, particularly in terms of long-term capital gains.

The purpose of the carry is to motivate VC or PE managers to maximise investment returns, as their remuneration is directly linked to the fund’s success. In private equity, carried interest serves as a primary compensation mechanism for fund managers. It also aligns the interests of GPs and LPs, as both parties are interested in high investment outcomes.

The GP may lose the carry if the fund performs poorly. For example, a fund might be expected to generate an annualised return of 10%, but only 7%. Then, under the terms of the investment agreement, the LPs can ‘pull’ some of the carry to make up the shortfall.

But carried interest has its drawbacks. First and foremost is the risk of low returns for the GPs. If the fund does not achieve sufficient metrics, GPs may receive little or no compensation. In addition, carried interest is paid after the exits, which can take at least a couple of years.

Management Fees

A management fee is a charge made by a VC fund for running an investment. This money is used to compensate managers for their time and other expenses, such as administrative costs. In effect, the management fee enables the venture capital fund to carry out its operational activities.

In terms of size, the management fee is typically 2% of the fund’s total assets under management per year. Management fees are typically calculated as a percentage of the fund's assets under management. Thus, in a $100m fund that will exist for 10 years, $20 million will go towards the management fee.

The management fee is paid regardless of the fund’s performance. Hedge funds often charge high management fees, which can be controversial. However, despite the nice figure in the example above, this amount looks like a pittance compared to the carry.

The management fee provides the fund with a stable and predictable income that does not depend on the investment performance. It can be used to cover day-to-day expenses and staff salaries, regardless of returns.

The management fee also removes the all-around financial burden by allowing the fund to focus on strategic objectives without the constant pressure of short-term performance. Mutual funds also charge management fees, which are used for marketing and shareholder services. And because the management fee is a fixed and clearly defined amount, LPs can transparently assess and understand the fund’s expenses.

However, the level of the management fee may not always be sufficient to cover all the fund’s expenses in the event of unexpected changes. In addition, there is a risk that GPs may become disengaged and simply sit on their fees rather than carried interest.

As a result, management fees and carried interest are an important part of the compensation structure in investment funds. They provide income and incentives for GPs and transparency for LPs.

The combination helps to provide a balance between income stability and motivation for high performance. Nevertheless, carried interest is still the main source of income for VCs, so the challenge for any fund is to maximise the number of successful exits.