Venture Capital Funds – How Do They work?

Musings of an Intern

19/02/2025

So actually in a Venture Capital Firm you will find that there are many names and companies associated with it. This is because they are split, the management company is the ‘franchise’ employing everyone and paying for every expense. Then there are the Limited Partnership (LP) vehicles that actually contain the investors and the money raised by these Limited Partners (LPs). Then there is also the General Partnership (GP) entities which are the legal entities serving the GPs where often the managing director plays this role.

VCs get money from various places like govt funds, banks, MNCs, rich people, charities and they are subject to a Limited Partnership Agreement (LPA). In this way VCs have a new boss, these LPs. Although lets say they raise 10$ mil, the money is actually with the LPs and they have to do a capital call to get this money to invest from the LPs, if the LPs dont want to provide money, other parties can buy off these LPs and make the contribution. Capital calls do cost money and affect admin fees so sometimes especially with smaller sums and individuals, the money is given directly after a deal sign off.

So VCs make money from management fees of these funds, often between 1.50-2.5% per annum and finance the operation. There is also something called carried interest or carry which is the profit sharing after returning the principal investment to the LPs, often carry can range from 10-30%. There is also a hurdle rate and some LPs will request for up to a 20% hurdle rate which essentially means that the investment will have to give a return of 20% per annum otherwise the GP will not receive any carry. It might look easy but given a 5 year investment fund, the investment will have to reach a 150% profit otherwise hurdle rate will be not hit since the IRR is compounded. Another issue is that since management fee is taken from the principle amount, if the company does not recycle their fees back into the investment sum, then they will have to make the amount based on that. That is where it gets tricky as lets say the management fee accumulates to 10% the company will have to get 200% profits instead due to the smaller pool invested.

There are additional commitments that the GP has to show like co-investing 1% of the fund size alongside the LP, similar to a broker-leverage situation. Cashflow is also very important as they often would prefer to recycle their commitment in order to get back as much returns as possible so they have to be careful otherwise they will be crunched and unable to recycle for investments and pay employees and they will receive less profits and the cycle repeats.