Running a Venture Capital Fund

Venture Capital Fund Recycling

Venture capital fund recycling—when GPs reinvest returns from early exits back into the portfolio—increases investable capital and can potentially increase fund returns.
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  • Venture capital fund recycling is when GPs choose to reinvest returns from early exits back into the fund for deployment.
  • Recycling capital can potentially boost returns metrics like TVPI because the effective management fee on invested capital decreases. 
  • However, fund recycling can have downsides—such as potentially lowering TVPI and IRR if the capital is not invested prudently—and opportunity costs to LPs.

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If a VC fund raises $100M and charges a management fee of 1.5% a year for 10 years, how much capital does the fund actually end up investing?

The answer is $85M, as each year, $1.5M is paid out in management fees. Over 10 years, that’s $15M. That means only 85% of the raised capital is invested into the portfolio companies. Only 85% of the raised capital can generate returns for investors.

Fund managers (known as general partners or “GPs”) who want to put more of the raised fund’s capital to work can do so through a process known as “recycling.” This is where GPs reinvest some of the returns from early exits back into the fund for new investments (instead of distributing the returns to the fund’s limited partners or “LPs”). This allows the fund to take a few “extra shots on goal” and can positively impact overall returns.

In this guide, we’ll examine how venture capital fund recycling can potentially boost returns, the mechanics of venture capital recycling provisions, and some crucial considerations when recycling venture capital.

Why Recycle Venture Capital?

There are two main reasons VCs opt for capital recycling:

  • Potentially boost in returns. Provided the investments made by the recycled capital pan out, it can amplify the fund’s return metrics—particularly Total Value to Paid-In capital (TVPI)
  • Provide additional funding to portfolio companies without needing to “top up” capital. When portfolio companies need additional funding, recycling venture capital allows the GPs to provide this funding without needing to resort to things like co-investments, debt, or GP-led secondary transactions.

How Does Venture Capital Recycling Boost Returns?

Let’s use a simple example of a $100M venture fund with a ten-year timeframe and an annual management fee of 1.5%. For simplicity’s sake, we’ll assume that the GPs are able to generate a 4.00x gross multiple (MOIC) on all their investments. This means that if the GPs invest $10M, the fund generated $40M, before all fees, expenses, and carried interest.

Now, let’s compare two scenarios—one where the fund doesn’t recycle any capital, and one where the fund recycles $15M from early exits.

As you can see, the scenario where the fund’s capital is recycled resulted in a significant boost in the fund’s returns. The GP earned 25% more carried interest, while LPs enjoyed a TVPI that was about 16% higher. 

Of course, this is a simplified example where we assume that the recycled capital can be invested to receive the same multiple as the rest of the fund. Such returns (like all VC returns) are not  guaranteed. For instance, should the invested recycled capital generate a MOIC below 1.00x, it will actually drag down the LPs’ TVPI numbers. 

This risk, among others, is one of the critical considerations to evaluate before electing to recycle venture capital. 

Considerations When Venture Funds Recycle Capital

While recycling venture capital can boost returns and align incentives, it’s also important to know that:

Recycling Venture Capital Can Extend the Life of the Fund

If the capital is recycled later in a fund’s life, it’s plausible that it will also extend the fund’s life as those investments will take time to exit. This can negatively impact internal rate of return, which accounts for the time value of money (though it doesn’t impact TVPI or MOIC). It would also mean that LPs receive their distributions later, and that the fund’s DPI (distributions to paid-in capital) metric—which is based on actual distributions to the LPs—could be lower at the end of the original fund life. These lower performance metrics could make it harder for GPs to market any new funds they may be raising. 

Whether Capital is Available to be Recycled is Hard to Predict

The bulk of the recycled capital will likely come from early exits in the fund’s portfolio. This may arise because a portfolio company got a great offer, or the fund decided to sell off its stake on the secondary market. However, these situations are difficult to forecast at the earlier stages of the fund, and therefore make planning difficult.

There Are Tax Consequences to Recycling Venture Capital

When the fund has a liquidity event, LPs that are U.S. residents are generally required to report their share of fund gains on their own tax returns, regardless of whether the proceeds are distributed to them or not. If a fund chooses to recycle a high enough portion of the proceeds from an exit, the LPs will not receive enough cash from the transaction to cover the associated tax bill and would thus need to find the money somewhere else—an unpleasant experience that many LPs would like to avoid.

Not All LPs May be Amenable to Recycle Funds

Because of the aforementioned tax consequences, not all LPs may find venture capital recycling palatable. Some LPs may prefer to receive their distributions earlier, especially if they think they can put the capital to better use. Some LPs may want a limit on recyling (either a cap on the percentage of the fund that can be recycled or a time period after which capital can’t be recyled) to help ensure their capital is not locked up in the fund indefinitely.

Because not all LPs may be amenable to venture capital recycling, it’s essential to document the limits and mechanics of a venture fund’s capital recycling from the beginning. This is done via capital recycling provisions in the fund’s Limited Partnership Agreement (LPA).

Venture Capital Recycling Provisions

To enable capital recycling, GPs often include capital recycling provisions in the LPA. The specifics of such provisions can vary widely, but a sample provision could look like this:

“The General Partner may increase the Partners’ Undrawn Capital Commitments by an amount equal to all or any portion of Distributions received by the Partnership during the Investment Period in respect of a Portfolio Investment prior to the second anniversary of the Partnership’s acquisition of such Portfolio Investment, up to and in proportion to the Capital Contributions of the Partners with respect to such Portfolio Investment, provided that the aggregate amount that may be reused pursuant to this clause will not exceed 25% of Total Commitments..”

A few key points:

  • The recycling mechanism works by increasing the LPs’ undrawn capital commitments. In some cases, this may mean that the GPs have the right to call the capital that has already been distributed to the LPs—provided they meet the other criteria listed above. In other cases, the fund may directly invest the capital received from early exits, without first distributing it to the LPs. Keep in mind that many LPs may not be agreeable to provisions that would allow the GPs to recall distributions for recycling.
  • There is a limit on the maximum amount that can be recycled. In the example provision above, that limit is 25% of the total capital commitments. If the fund size is $100M, the GPs cannot invest more than $125M total.
  • There are conditions attached to the type of capital that can be recycled. In this case, the GPs can only recycle capital obtained from exiting a portfolio investment within two years from the investment date. This can help ensure that GPs do not arbitrarily exit portfolio investments or recycle capital in the last days of the fund’s life. While most venture capital recycling provisions will not have this time limit, they may have other stipulations—such as only allowing recycling during the first five years of the fund’s life.  

Prospective LPs should pay close attention to how any venture capital recycling provisions are structured and ensure they grasp the full implications. Failing to do so could lead to unpleasant surprises—like not receiving a distribution after an early exit.

Venture Capital Recycling: A Powerful Tool If Used Correctly

The ability to recycle venture capital can amplify returns and benefit both GPs and LPs. But it’s not without its potential drawbacks. All parties should  understand the full scope of what venture capital recycling entails and negotiate accordingly.

Authors
Ian Lee
Financial Writer
Kate Bridge
Legal Counsel, AngelList Venture
Micah Sucherman
LP Relations, AngelList Venture
Colt Sauers
GP Relations, AngelList Venture
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