Recycling in Venture Capital

The topic of recycling in venture capital has come up a lot recently, mainly in talking to GPs who are either (1) thinking about raising a first fund, or (2) raising a second or third fund, while looking to transition to a more institutional LP base.  With a ton of things to worry about, recycling seems to that gets de-prioritized for GPs at this stage – that is a mistake.

Roger Ehrenberg of IA Ventures and Brad Feld of Foundry have both outlined their views on recycling (they like it); my goal here is to succinctly lay out the issue and the math behind it.

The problem – If you have a $100M fund and assume (for simplicity) that you charge a 2% management fee over a 10 year investment period, you end up with $80M to invest in companies, with the remaining $20M going to the management fee.  Thus, even if you deploy that entire $80M, you are only investing 80% of the fund.  VCs are judged on net returns to LPs, so investing only $80M is putting yourself at a disadvantage right out of the gate (on $80M invested, you need to return 1.25x just to return the $100M fund).

The Solution – Recycling.  In the case of an early liquidity event (let’s say a $20M exit), that capital can either be distributed to LPs or recycled back into companies.  S0, if you have a $100M fund, and recycle that early $20M return, you know have $100M to invest into companies out of your $100M fund (the initial $80M plus the recycled $20M).  Taking this a step further, if you are able to recycle $40M in early returns, you could potentially have $120M (original $80M plus $40M in recycling) to invest out of your $100M fund – you’re already $20M “in the money” at cost!  From the funds I’ve seen, 120% is a pretty common recycling ceiling in fund documents.

So why doesn’t everyone do it?  In general, established/successful funds managers know how this works and aim to get over 100% invested, if possible.  The main problem I’ve seen is with funds who scraped together their own capital and an HNWI-heavy LP base for an early fund(s), and who are now hoping to raise from more traditional LPs (e.g. fund of funds and endowments).  Venture capital is a long term game, and institutions with that time horizon prefer to plow early returns back into companies, getting as much out of their fund commitment as possible.  Less experienced GPs and individual investors could potentially be more interested in an early payout, creating a conflict of interest.  While LPs will have different opinions on recycling, GPs who don’t aim to maximize the dollars put to work in companies are doing themselves a disservice and hurting the financial return for both themselves and their LPs.

The Math

To get a 3x net return to LPs on a $100M fund, assuming an annual 2% management fee over 10 years ($20M) and 20% carry ($55M), you need to produce $375M in returns.


So, on a gross basis (at the company level), here is what you have to return at different percent invested levels:


Notice that, without recycling, to generate a 3x net return without recycling (investing $80M), you need a gross return of 4.7x.  Compare that to the scenario where you invest $120M, needing only a 3.1x return.  That is an incredibly large difference, and it is all due to recycling.

Looking at it a different way, assume that you are able to return 4x gross (congrats!) on any amount of deployed capital:


On a gross return basis, each of these scenarios is equal, but comparing the extreme cases of 60% and 120% invested, you get a $192M and $48M swing in payouts for LPs and GPs, respectively.

There are, of course, assumptions above (early liquidity opportunities, recycled dollars being put to work effectively, etc.), but the point remains – recycling benefits both GPs and LPs, and it is critical for fund managers to build an LP base with aligned, long term incentives.