The money mechanics

You commit, then the fund calls

When you sign, you commit a total amount. You do not wire it all at once. The fund calls capital as it needs it, usually in several installments over the first three to four years. A capital call notice gives you ten to thirty days to send the money. Missing a call is a serious breach of the LPA, so keep the uncalled portion in something you can access on short notice.

Plan for the calls to come faster than you expect in the first two years and slower afterward.

The management fee

The fund charges an annual fee to cover salaries, legal, accounting and the cost of running the firm. Two percent of committed capital per year is the reference point, often stepping down after the investment period. On a $100,000 commitment, that is roughly $2,000 a year in the early years. Over the life of the fund the fees can total fifteen to twenty percent of what you committed, which means only eighty to eighty-five percent is actually invested in companies. This is normal, and it is why a fund has to return well above what you put in for you to come out ahead.

Carried interest

Carry is the GP’s share of the profits, and it is the main way GPs are paid for good performance. Twenty percent is the reference point. It is charged on profit, not on the whole amount, and it is usually paid only after LPs have received their capital back. Some funds also have a hurdle rate, a minimum return LPs must receive before carry starts. Small early-stage funds often do not, on the theory that the power law makes hurdles meaningless.

The waterfall

When the fund sells a stake and has cash to distribute, the money flows in an order set by the LPA:

1. LPs get their contributed capital back, including the fees they paid.
2. If there is a hurdle, LPs receive that preferred return.
3. Remaining profit is split, typically eighty percent to LPs and twenty percent to the GP.

Some funds distribute after each exit. Some recycle early proceeds into new investments during the investment period, which can be good for returns but delays cash back to you. The LPA says which.

A worked example

Suppose you commit $100,000 to a fund that eventually returns three times its capital after fees. Roughly, you will have paid about $17,000 in management fees, the fund’s investments will have grown enough to return $300,000 of gross value attributable to you, and after twenty percent carry on the $200,000 profit you receive about $260,000 over the fund’s life. Change any assumption and the number moves, so treat this as a shape rather than a promise.

Before you move on

What would you do if a capital call arrived tomorrow? Can you explain why a fund that returns 1.2x gross may return less than 1x to LPs?