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If you hang around Venture Capital (VC)/Private Equity (PE)/Hedge fund types a lot, you will definitely hear the term 2 and 20 in every other conversation. 2 and 20 is the bread and butter of the industry and this particular business model has endured for decades and seems like it is here to stay. 

These funds, VCs in particular, have supplied the bulk of the capital to the flurry of mega unicorns that have been going public since the pandemic erupted last March 2020. What does 2 and 20 mean? Stay tuned as I unpack the math behind these mystical numbers that underpins an entire industry.

The Queen of Risk Capital

Queen Isabella of Spain arguably was the first Venture Capitalist. She funded the explorer, Christopher Columbus, on his expedition to seek a westward route to Asia, and import the riches back to Spain. In return for the seed capital, she will get a large share of the profits derived from importing the raw materials and other resources found in these new and exotic locales.

In modern days, these risky investors are often incorporated into a company, called Venture Capital, with the aim of investing monies into promising entrepreneurs and startups in return for potential riches once some of these companies have proven themselves. Where do these VC firms get the capital to invest to begin with? Just like an entrepreneur that raised money from other people, VCs also raise OPM (Other People’s Money) in order to get their investment funds off the ground. That said, there are individuals who invest into startups using their own money. They are called Angel investors. That calls for another post. In this post, we will focus on the VC funds.

LPs as Sources of Capital

VC funds raise money from other investors called Limited Partners (LPs). They are called LPs (not to be confused with the vinyl records) because as investors, they are not involved in any decision making done by the investment managers. This is to protect them in case bad things happen with the VC fund and their managers.

Source: OnStartups

The investment managers are called General Partners (GPs). GPs are the ones responsible to raise money, run the funds’ operations, source and invest the money on LPs’ behalf in the hope of generating insane returns for them and the LPs, when it is done and dusted.

There are various types of LPs:

1. Pension funds (KWAP, California Public Employees' Retirement System, Ontario Teachers' Pension Plan) - funds that receive contribution from current employers (government/corporates) to fund their retirees. 
2. Sovereign wealth funds (Temasek, Mubadala, Khazanah Nasional) - these organizations manage the economic reserves of an entire country to generate returns for current and future generations of citizens.
3. University endowments (Harvard, Yale, Williams College) - donations from alumni are invested into various types of assets including venture capital. Proceeds from investments are used to fund university's operations, capital expenditures such as new buildings and/or scholarships.
4. Foundations (Dietrich Foundation, Ford Foundation, Hewlett Foundation) - these non-profits organizations manage the money bequeathed by their benefactors to fund (often expected in perpetuity) charitable givings to causes they identified from the returns generated from their investments.
5. Takaful / Insurance companies (Prudential, MetLife, Nippon Life) - the premiums (or floats) they receive from policy holders are invested to pay for future benefits or claims.
6. Corporates (Intel, Salesforce, PETRONAS) - big companies looking to stay ahead of innovation often invest some monies to VC to ‘scan’ the landscape on new ideas and technologies. 
7. Family offices (Point72, Bezos Expedition, Kuok Group) - mega rich people that set-up a dedicated investment office to manage and grow their wealth.
8. High net worth individuals (HNWIs) - rich folks who are looking to diversify their investments beyond the traditional savings account, money market, mutual funds, stocks and bitcoin. On top of investing into VC funds, they might also become Angel investors and invest into startups themselves.
9. Fund-of-funds (Horsley Bridge, Knightsbridge, Cendana Capital) - similarly structured as VC funds. The fund-of-funds raise OPMs in order to invest into VC funds on behalf of their investors, who otherwise might not have the time or access to VC funds.

Can I Call You for Capital?

A typical VC fund has a ten year life cycle. It may also include two or three additional years to extend its fund life. Within this 10 year period, the fund will focus the first five years of its existence to deploy the capital it raised from LPs. This is called the investment period.

The remaining 5 years is allocated to harvest or monetize the investment made during the prior five years. Although there are cases where startups a VC invests in can be monetized - usually when other companies buy them - earlier.

When you decide to invest $100,000 into a certificate of deposit account, mutual fund or dodgecoin, you have to put the entire amount into the investment vehicle right away.

In the case of VC funds, it works differently. When an LP decides to allocate $10mn into a fund, it doesn’t have to transfer the entire amount to the VC fund. 

The VC will ‘call’ for money to be deposited into its company account as and when it finds a startup to invest during the investment period. Or call for money to pay for the fund’s expenses throughout its 10-year life.

Show Me the Money

Let’s say, there’s a VC called Kembara Ventures that has managed to raise a $100mn fund, with a focus on investing in moonshot startups across the globe (and the moon).

Kembara adopts the standard market fund structure that ‘charges’ 2% management fee and 20% carry interest.   

Assuming that Kembara will charge a 2% management fee throughout the 10-year period, it stands to receive $2mn per year or $20mn throughout its fund life. The fee is used to pay for salary, fund administration (accounting and reporting), events and other related expenses to run the fund.  

Although it seems that the LPs are paying the Kembara team to run the fund for the next 10 years, in reality the fees collected are advanced payments. Kembara needs to pay back the $20mn advance at the end of the fund life i.e. the profit calculation is still based on $100m instead of $100 - $20m of fees. If the VC loses money, then the GPs do not need to pay the loss amount, but it will make life difficult to raise subsequent funds. The GPs may need to find another job.

Carry interest on the other hand, or carry for short, can be labelled as a long term incentive program, deferred bonus or performance bonus. The Kembara GPs will only get to reap this 20% carry if the fund makes a profit on its investments.

In our example, the Kembara team has $80mn ($100mn original fund size - $20mn fees) to invest in moonshot startups within its five-year investment period. Kembara Ventures invested in 10 startups working on quantum computing, fusion energy, space mining and Nyan Cat meme NFTs.  

The total returns from all these 10 startups - including those that flame out - comes out to be $200mn. It is time to tally the books and see how much upside the GPs and LPs stand to gain.

The profit is $100mn ($200mn total returns - $100mn fund size). Remember that Kembara needs to repay the $20mn advance fees to the LPs. The $100mn profit will then be split on a 80:20 ratio. 20% goes to Kembara and the remaining to the LPs. After all is said and done, the Kembara team takes home $20mn (20% x $100mn profit) carry, while the balance $80mn is distributed to the LPs.  

That, ladies and gentlemen, is the business model of a fund in a nutshell.  

Running a VC fund can be financially rewarding, albeit it takes a long time to realize. At the point of investment, you don’t know which startup you invested in will peter out. In 4 years, you might get early indication of your investments progressing on the right trajectory, or not. And you have to wait until year 8,9 or 10 (or longer!) until you can monetize.

If it works out, you do feel like a master of the universe, changing the world, while minting cool Uncle Sams along the way.

Stay cool,

Reez Nordin

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