Recycling is a common practice in venture capital that is often misunderstood by fund managers. Management fee recycling and the recycling of investment proceeds are two commonly-used terms that describw the practice of recycling, or reinvesting, realized proceeds into new investments, just based on two different calculation methods. 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.
AngelList has a good primer on recycling at Venture Capital Fund Recycling
Fred Wilson breaks down the opportunity to recycling at Reserves, Recycling, and Returns:
[Recycling] means that for any given fund, we will keep the returns we get on early smaller exits and put them back into the fund. This increases our reserves capacity but it also means that we invest more money in our portfolios than we raised, including the management fee load. If a $200mm fund can actually invest $250mm and gets a 3x on that $250mm, it generates a 3.75x on the $200mm that was invested by limited partners. That has a hugely positive impact on returns.
Why do LPs sometimes not agree to 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 recycling
Recycling is typically outlined in the LPA between the GP and LPs. The LPA will outline the terms of the recycling to specify what can be recycled, how much can be recycled, when in the fund's lifecycle proceeds can be recycled, and what portion of the proceeds can be recycled.
Max amount to recycle and basis of calculation
Recycling is often worded as a percentage of management fees to date 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% or 25% of the total committed capital. Recycling 20% of committed capital would be roughly equivalent to 100% of management fees if management fees represented 20% of the total committed capital.
Note that LPAs may set the number differently; for example, some LPAs may note that recycling is 125% of committed capital (meaning that the total can be 25% higher than the amount of committed capital), or it may say that recycling is 25% of committed capital. Even though the numbers are expressed differently they mean the same thing.
Note that funds are often not able to recycle up to the maximum amount allowed in the LPA based on the other terms related to recycling.
Limit to when in fund lifecycle proceeds can be recycled
LPA terms may limit recycling to the investment period (time period in which new investments are made) or throughout the fund life. Allowing later recycling can allow for recycling to be deployed in follow-ons, so that capital is not deployed into new investments late in the fund life.
Limit in time from initial investment to proceeds event
Terms may specify that only proceeds that come from investments originally made less than N years ago can be recycled. So, for example, the LPA may specify that only proceeds from companies that were originally invested in less than 2 years from initial investment to exit can be recycled. The goal of this is to focus recycling of proceeds from early exits.
Limit to how much of the proceeds can be recycled
LPAs may choose to limit the amount of the proceeds from an exit that can be recycled to (a) the amount originally invested in the company, (b) the amount invested in the company plus the cost basis (allocating expenses to the invested capital, so that it reflects paid in capital related to the investent), or (c) all proceeds from the exit. The main difference is that when the proceeds are limited to the amount invested (and optionally, allocated expenses) then the fund will distribute profits from the investments, whereas is all proceeds from the exit are distributed, then there will be no distributions related to that exit. If present in an LPA, this limits the amount of invested capital that can be recycled.
Limit to what the recycled capital is allowed to be invested in
Many LPAs also have terms that limit recycled capital to only be used to reinvest into new investments, whereas other LPAs may allow recycled capital to also be used for follow on investments. Combined with terms related to the timeframe for recycling, this limits when proceeds can be recycled.
Common misconceptions about recycling
managment fee recycling must be one of the hardest thing for emerging VC managers to understand (based on the amount of emails I get on how to model it)
— taylor (@tdavidson) January 3, 2023
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 always. Many LPAs will specify terms around when and how the proceeds from exits can be reinvested, limiting recyling to early exits within the new investment period. But some LPAs may have more open policies, allowing funds to budget for recycling and aim to deploy more capital in earlier periods, knowing they will recycle capital later, and use recycled proceeds to cover future 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 proceeds?
There are several ways to tactically model recycling; in the Foresight venture capital fund models I use a number of options to allow users to define the recycling policy using the typical options detailed earlier. The models budget for how much capital can be invested, according to the investment timeframe and allocation to new investments, and then figures out how much of the forecasted proceeds per period can be recycled. This recycled capital is added to the total budgeted invested capital to determine the overall invested capital.
Note, invested capital may be greater than committed capital depending on the recycling options selected.
A couple important notes on this structure:
- The timing of deployment and holding period to exit is very important in the Foresight models for determining how much of the proceeds can be recycled.
- Many funds using the options to limit when and how proceeds can be recycled will not be able to hit their target recycling amount, and that is normal.
- The model uses an assumption of 25% of recycling, meaning 25% of recycling + 100% of committed capital = 125% of total committed capital plus recycling. LPAs can vary by how they define the % for recycling, but this is how the model sets the assumption to be used.
- 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.
- 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.