DISCLAIMER: Things I am not: an accountant, a lawyer, a fiduciary to any reader, or a registered advisor. I’m just a guy writing a newsletter so none of this constitutes any tax, accounting, legal, life, or investment advice.

Following up from last week

I got great feedback in e-mail on last week’s Subscribe Exclusive about fraud. There will be no archive version of that post but if you are a new subscriber and want a copy of last week’s issue just refer two subscribers to the newsletter and I’ll send it to you.

This week we come back to Numbers, for a focus on Accelerated Management Fees in Venture Capital. This is something that is rarely discussed but quite important to understand, particularly for those investing in smaller funds as an LP. Early subscribers may recall in the “Following Up” from Issue #3 I noted that Net TVPI can be negatively impacted by accelerated fees, and I have now updated Issue #2 to reflect that. In that edit to Issue #2 I promised to explain accelerated fee schedules in a future issue — this is that issue!

Numbers
Accelerated Management Fees

Generally funds have a static fee schedule for management fees, the standard fee structure is often considered to be 2/20 — the 2 meaning annual management fees, the 20 indicating 20% carry.

Carry is the carrot at the end of the journey for the fund manager that encourages them to dedicate their all to the fund. It is also the easiest way for VC fund managers to “get rich” as their aarried interest is taxed differently than ordinary income. This means assuming an investor is in a no-state tax state, they take home 17% more for every dollar of carried interest than they would for every dollar of management fee. We’ll cover carry more in depth a later time, including a likely review in to stacked carry structures where the carry % charged increases depending on fund DPI, though others have written about this before.

But the focus of today’s issue is the “2” — the management fee. It’s important to know that the “2” is charged annually, so really the fees for a 10 year fund life are 20/20. 20% comes before the money gets invested, 20% after. When a firm charges standard fees their LPs get 80% of the proceeds that is returned when 80% of their principal is invested. Traditionally funds have charged the management fees in a linear fashion. Meaning 2% per year from years one through ten.*
_{*We’re assuming a ten year lifecycle here to make calculations easy. Actual fund timelines regularly go beyond 10 years at the early stage — we’ll cover fund timing and length in a future issue.}

Linear vs Accelerated

Nowadays though, particularly amongst emerging managers, this math has changed. Nowadays the management fees are often front loaded. This is often called “accelerated”, and is the what this issue is all about, accelerated management fees. The language used to describe this may change but generally when the fee is greater in the beginning and drops later on is what we’re discussing and is what I’m calling an accelerated fee schedule.

Here’s an example of how it works, using a real example provided by a The AGM subscriber who is a GP.

The fund charges 3% management fee during investment period and it drops to 1% after the investment period. Assuming a 10 year fund term we can see that this is effectively 2%.

3 * 5 = 15 (first 5 years management fee %)
1 * 5 = 5 (final 5 years management fee %)
15 + 5 = 20 / 10 ( fund term) = 2 (average management fee %)

So you’re likely asking if the total fee amount is the same, why do it?