Today's tweet thread is about how LPs (fund investors) make money (or don't) by investing into funds.

When do they send the money to the fund? When do they get money back? What are the fees ppl should be aware of?

thx @zsilvs303 for the topic!

Read on >>

1) First off - what is an LP? A limited partner is an investor in a fund.

@HustleFundVC for example, we have raised money from individuals, families, companies, and fund-of-funds. This is the money we use to invest in startups.

They are our LPs.

2) Next, what is the process to becoming an LP in a fund?

Today almost all US funds (if not all) require LPs to be at least accredited investors in order to invest. ($1m+ in assets or $200k/yr in salary)

A VC fund $10m+ can have 99 LPs max. Under that, 250 LPs is the limit.

3) If you sign the docs to become an LP, unlike invested directly into startups, you usually don't send your full commitment right away.

In most cases, a fund will do capital calls across a few yrs asking you for portions of your commit.

4) For example, @HustleFundVC we do a 3 year capital call period twice a year. So we will ask you for a portion of your investment 6 times.

So if you invest $100, on average, we would ask for $16-17 each time.

5) This is because often most LPs - esp larger ones - don't actually have all the money sitting around in their bank acct right now. Their money is in other assets and over the course of the 3 years they will move their money around to fund their commits.

6) For individuals, sometimes ppl fund their capital commits through yearly bonuses. Some of our LPs are fairly certain they will get EOY bonuses and they use that cash to fund their capital commits instead of selling existing investments.

7) Other VCs who don't invest as frequently as we do may do their capital calls on a deal-by-deal basis. Meaning, they will ask their LPs to send money only when there is a deal.

8) As such, the *surprising thing* to me that I learned when I became a VC is that VCs actually have *very little* cash on hand. Most of it is sitting with their investors.



I'm sure our founders' bank accts have MORE cash than we do at a given time. Isn't that nuts?

9) The capital calls are also used strategically by VCs to display their growth numbers.

Imagine two scenarios:

a) We do a capital call of $100 on Jan 1, 2019. We invest it all in a co on Jan 1, 2020. Company sells on Jan 1, 2021 & returns $200. The IRR is 41%.

b) Now say...

10)

b cont) We do a capital call of $100 on Jan 1, 2020 - *when we NEED the money* to invest in the same co on that date. Company sells on Jan 1, 2021 & returns $200. The IRR is 100%. Same outcome but diff capital call strategy.

That's the power of NOT sitting on cash as a VC.

11) On the flip side, as an LP you need to plan across a few years your cash situation to be able to fund capital calls.

During the stock market crash years, many LPs were not able to make their capital calls. And, funds went belly up. And startups stopped getting funded.

12) Now the fees. If a VC fund is a $10m fund. Not all $10m will necessarily go into funding startups.

Typical VC funds have an ave 2% management fee per year. And a typical lifespan for a VC fund is 10 years. This means that 20% of the fund capital is going towards mgmt fees.

13) So now the fund only has $8m to deploy. In addition, there are legal costs / accounting costs / audit costs / fund admin costs / etc -- all of these are a LOT -- and they come out of the fund.

So, the fund more typically, a $10m fund has $7.5m to deploy.

14) This means that a VC has to do well JUST TO GET TO BREAK EVEN. They need to deploy $7.5m to first get back to $10m -- the breakeven mark.

And then plus a LOT OF upside. Hopefully many multiples over in order to make a lot of money.

15) The good news is that funds often have the ability to recycle capital. This means that if some of the portfolio companies shut down and return the remaining cash or take an exit, the cash coming back to the fund can be used again to invest in startups.

16) For many funds, they are allowed to recycle up to 120% of the fund size -- in the case of a $10m fund, you'd be able to deploy $12m in cash.

This helps get more fire power in getting better multiples.

17) @HustleFundVC we believe in recycling as much as possible, because that's what really enables returns. More money to invest gives you greater returns if you pick well.

We have already started recycling a fair bit of capital from our Fund 1.

18) So as an LP once these exits start happening and cash comes back to the fund, it is usually up to the discretion of the fund manager to decide whether to send out a distribution of cash or whether to recycle that cash.

19) So it's possible you may not see that cash - even if exits happen - for years!

@HustleFundVC we have started distributing some cash to help our LPs cover their taxes from gains created by our fund.

But in general, very strongly believe in recycling.

20) But once recycling stops, then it's a waiting game for the big returners to come back.

As far as funds go, the returns are driven by how large the biggest exits are. And you won't have a sense of that for many years unfortunately.

21) Once those big gains come back, the first 1x (in this case $10m) is distributed to LPs proportionally.

Anything above that is split between the LPs and the fund managers. Typically this split is 80% (LPs) / 20% (fund mgrs).

At established great funds, it could be 70/30.

22) These returns generally don't come back for 10 years or so. So you have to be quite patient as an LP!

And be willing to lose your $$ because many funds don't even return 1x.

On the flipside, @Initialized is having a monster Fund 1. Their multiples will be in the hundreds!

23) There's lots of talk about crowdfunding w/ non-accredited investors. Right now, the SEC doesn't enable crowdfunding of funds with non-accredited investors.

What some funds are doing / thinking about doing is raising $$ through this method for their *management company*.

24) This is not an investment into a fund but into the team that will raise the fund. You will get a % of their earnings if they exceed 1x returns on their funds.

25) Lastly - there is so much innovation happening right now in legal structures and changes w/ the SEC, I'm sure so much will change in how VC funds get raised as soon as this calendar year even.

This is an interesting space to watch.