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Management Fee Recycling

What management fee recycling means, how it works, and common misconceptions.

Management fee recycling is a common practice in venture capital that is often misunderstood by fund managers. Management fee recycling is the practice of recycling, or reinvesting, realized proceeds into new investments. This practice allows fund managers, or general partners (GPs) to maximize the use of its capital and increase returns for its investors.

Why fund managers aim to recycle

Brad Feld covers the incentives and basic math for recycling at Why VCs Should Recycle Their Management Fees; in short, recycling allows fund managers to invest a larger amount of the fund, boosting the total proceeds from the fund. Typically when a fund receives proceeds from an investment, the fund will distribute these proceeds to the fund's investors, or limited partners (LPs), but when a fund is recycling, the fund holds those proceeds, according to the terms outlined in the limited partnership agreement (LPA), and will reinvest them into new and existing companies in the fund. This allows the fund to meaningfully increase the total amount invested and increase total returns.

Why do LPs sometimes not agree to management fee recycling?

Rather than allowing fund managers to recycle proceeds into investments, LPs may prefer to take distributions earlier to see realized proceeds earlier. They also may prefer to use proceeds towards their own investment stratgies, allocating less capital to these managers and handling portfolio allocation on their side.

Standard terms for management fee recycling

Management fee recycling is typically outlined in the LPA between the GP and LPs. The LPA will outline the terms of the recycling, including how the management fees will be used, over what time period recycling can occur, what percentage of management fees can be recycled, and other relevant terms.

Recycling can be worded as a percentage of management fees or as a percentage of total committed capital. As a percentage of management fees, a typical structure would allow the fund manager to recycle up to 100% of the management fees; as a percentage of total committed capital, a typical structure would allow the fund manager to recycle up to 20% of the total committed capital, which would be equivalent to 100% of management fees if management fees represented 20% of the total committed capital.

Common misconceptions about management fee recycling

Why is it called "management fee" recycling when we are recycling proceeds?

Not sure, really, and in some funds recycling is set as a percentage of total committed capital and not management fees.

Does this mean that the management company makes less money?

No. Recycling does not reduce the fees that management companies take, and it does not affect their budgeting or operations. The management company is not giving money back to the fund.

Does this mean that funds only recycle and reinvest when early exits happen?

Not really. Funds may budget for recycling and aim to deploy more capital in earlier periods, knowing they will recycle capital later, and use recycled proceeds to cover capital calls or operating expenses.

How is this different from an evergreen fund?

Evergreen funds also recycle proceeds, but as an open-ended fund they will typically recycle a much higher percentage of original committed capital over the fund's lifetime.

How do you model recycled management fees?

There are several ways to tactically model management fee recycling; in the Foresight venture capital fund models I use an assumption for the percentage of management fees recycled to add recycled management fees to the invested capital, to boost the total invested capital. This invested capital then gets deployed over the investing timeframe, accounting for the budgeted new and follow allocation and deployment timelines. When proceeds come in, they are then recycled back into the cash flows of the fund, according to the investment timeframe and total management fees the fund is allowed to recycle.

A couple important notes on this structure:

  • This does not "wait" to recycle proceeds into new and follow investments for when proceeds are received, this allows the funds to overinvest in earlier periods according to their budget for investments and recycling.
  • This decouples when proceeds are recycled and when the investments are made.
  • Investments made with recycled proceeds are thus treated the same as new and follow investments, with the same expectations on returns and timing for all investments.
  • This helps reduce the fund lifetime, as it allows fund managers to put recycled capital to work earlier in the fund's investment period.
  • Because the metrics are reported using invested capital and recycled proceeds are treated as invested capital, the gross and net metrics automatically adjust for the impact of recycling.
  • Some fund managers prefer to budget for recycled investments separately, with separate investing timeline and returns expectations, and that is a customization I have added when the additional control and detail is deemed necessary by the fund managers.

More on modeling venture funds at How to Model a Venture Capital Fund.