2. VC FUND ECONOMICS
Venture fund economics refers to how capital is raised, invested, and ultimately returned to the investors in a structured manner that encourages responsible management and rewards strong performance.
In simple terms, a venture capital fund collects money from institutional investors and individuals (called Limited Partners), then allocates it across a portfolio of startup or early-growth companies. The manager of the fund charges a management fee to cover operating costs and receives a share of any profits, often referred to as carried interest.
This profit-sharing model is designed to align the interests of the fund managers (General Partners) and the investors, ensuring that all parties benefit when the underlying investments thrive.
2.1
GP Compensation:
How a fund manager gets paid
GPs or fund managers are compensated in two main ways:
Carried Interest and Management Fees.
Carried interest, or carry, is the percentage of a private fund’s investment profits that a fund manager receives as compensation. ​​​​​​
Management fees are the annual charges, typically around 2% of the total money investors commit to the fund, that cover the venture capital managers' operating costs like salaries and office expenses.
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2.2
Portfolio Construction:
How money is deployed
Portfolio construction determines how capital is allocated across various investments to optimize returns while managing overall risk.
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In a venture capital fund, this process typically includes subtracting fees and expenses from the total committed capital, reserving a portion of capital for follow-on investments, and strategically selecting deals that conform to the fund’s target profile.
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2.3
The Waterfall of Distributions:
How and when investors and VCs get paid
The distribution waterfall outlines the order and conditions under which returns flow back to LP investors and GP fund managers. It typically begins with capital returned to investors to recover their initial commitment, followed by a preferred return or hurdle rate, and then the carried interest allocation to GPs.
This step-by-step payout ensures investors recoup their principal first, creating a safeguard against underperforming investments.
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2.4
Performance Metrics
How well did the fund and its investors do?
Performance metrics play a key role in evaluating a venture fund’s success and guiding decisions about future investment strategies. Common measurements such as Internal Rate of Return (IRR), Total Value to Paid-In (TVPI), and Distributed to Paid-In (DPI) reveal how effectively the fund has deployed capital and generated returns.
Accurate performance metrics also inform crucial fund management processes, including determining the optimal time to exit portfolio investments and adjusting risk profiles for subsequent rounds.
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