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SPV (vs VC fund) Economics
A primer on SPVs here.
LPs (investors) in a typical VC fund are usually charged two and twenty or 2/20. The two refers to an annual management fee, and the twenty refers to the carried interest which is usually 20% of the profit, i.e. 20% of the gains made by the fund after the LPs’ principal, or investment, has been distributed back to them.
Management fees cover the fund’s overhead, i.e. salaries, legal fees, etc. The management fees are calculated based on committed capital, i.e. the capital that LPs have committed to the fund. Sometimes though, they’re calculated as a percentage of called capital. If a fund has $50M in total commitments, then a 2% management fee would equate to $1M per year for the lifetime of the fund (usually ~10 years for an early stage fund). $1M per year for 10 years equates to $10M or 20% of the total fund. Some funds will charge a higher management fee during the first few years and then gradually decrease it. But on average, the management fees will typically come out to 20% of the total amount committed to the fund.
Most VC funds will call the committed capital over the course of a few years (capital calls), and the timing of these capital calls in relation to when the capital is deployed by the fund is important. LPs don’t want sleeping money, i.e. money that is not being put to work. Capital calls can occur at various cadences, e.g. quarterly, bi-yearly, etc. At each capital call, LPs will wire a portion of their total commitment to the fund.
SPVs of the type we’re discussing here are different. They have only one capital call or closing, i.e. LPs wire their full commitments to the SPV at once. Whether an SPV charges a management fee or not is up to the Syndicate Lead; many chose not to. However, some Leads charge a one-time management fee, and others will charge an annual management fee. Out of the +100 SPVs that my team has run in the past year or so, our LPs have been subject to a one-time management fee on only three or four deals.
Carried Interest, often referred to simply as carry, is more or less a performance fee, i.e. a percentage of the LPs’ profit, if there is any. The industry standard for early stage VC funds and SPVs is 20%. The GPs of a VC fund or the Syndicate Lead of an SPV will receive their carry after their LPs’ principal investment has been returned. If the carry is 20%, then the GPs/Lead will receive 20% of all gains less the LPs’ principal.
As with VC funds, there are costs associated with establishing and managing an SPV. The costs include SPV formation, preparation of annual statements for LPs, state filing fees, etc. These fees can range from ~$2K on the low end up to tens of thousands on the high end, depending on your SPV service provider and the specifics of your SPV. These costs are sometimes covered by the Lead. But, more commonly, they will be covered by all participating LPs on a pro-rata basis. Often these costs are one-time (at the time of creating the SPV), but each service provider has different cost structures.
Below is a walk-through of SPV economics (not taking fees into consideration)
A Syndicate Lead raises $200K for an SPV. Five years later, the company exits and the value of the SPV is now $1M. It generated a 5x return. First, the LPs get their money back, i.e. their principal. They collectively invested $200K so we’ll deduct $200K from $1M and are now left with $800K. Of the remaining $800K, 20% or $160K, goes to the Lead as carry.
Below is a chart laying out various carry-outcomes for an SPV Lead, assuming a 20% carry. SPV Leads will often commit only a small percentage of the total amount raised by their SPV, often as little as $1K. This can potentially lead to misaligned incentives between Leads and their LPs.
Fund vs SPVs
Two portfolios of identical investments (same amount of capital deployed into the same companies at the same time) can differ significantly if one of the portfolios is a fund portfolio and the other a portfolio of SPVs. Focusing solely on carry (and not taking into account the fact that 20% of the fund will go towards management fees) it becomes clear that there is more upside potential for the Syndicate Lead compared to the fund GP.
This is because of the way that VC funds are structured. A typical VC fund must return at least 1x all the committed capital (including the capital that went towards management fees) before the GPs see any carry. Failed investments in the portfolio must be compensated for by the winners in the portfolio before the fund begins to generate returns.
SPVs work differently. Each SPV is an independent vehicle; its performance is isolated and does not impact the performance of any other SPVs in the portfolio. In other words, the Syndicate Lead receives carry on every SPV that returns at least the LPs’ principal investment in that specific SPV. However, and this is an important distinction, there is generally more risk for an SPV LP than there is for a fund LP as a fund LP will, by nature of the fund, have much more diversified exposure across multiple investments.
SPVs do not need to make up for the losses of the other SPVs managed by the Syndicate Lead, whereas each “win” in a VC fund needs to cover the losses incurred by the fund’s under-performing investments made out of the same fund.
Look at the simplified example below. The chart on the left represents investments made through a fund and the one on the right represents a portfolio of SPVs. Both examples represent the same investments (same amount into the same companies).
Red indicates losses, i.e. investments that are considered write-offs.
Blue indicates performing investments, but the value indicated in blue is still below the threshold at which the LPs’ principal has been returned.
Light green indicates capital returned to LPs in excess of their principal commitment.
Orange indicates carry (20% of the profit).
To make things easy, we’ll assume that all but two investments failed. As you can see on the left, even with two winners in the portfolio, there is no profit from which the GPs earn carry until the winners have collectively returned the LPs’ principal, i.e. 1x the fund (the dashed line).
On the right side however, the losses are not stacked, and each performing SPV only needs to return the principal investment in that SPV before there is profit and therefore carry.
Below is a similar scenario, but using actual numbers. On the left (fund example), you’ll see that 20% of the fund is attributed towards fees, i.e. is not invested. On the right (SPV example), the only relevant fees are the fees that paid the set-up costs of the SPVs that actually returned capital.
To make things easy, the below run-down assumes a fund and an SPV Lead make 40 identical $500K investments. 38 of them return no capital, the other two each return 50x. Because the winners in the fund portfolio must return 1x the entire fund before the GP gets any carry, the SPV lead makes off with almost $5M more in carry than the fund GP (but remember, the SPV lead doesn’t collect any fees during the duration of the investments).
Although the math above makes it appear more favorable to run SPVs compared to investing out of a fund, there are definitely advantages when investing out of a fund vs solely running SPVs. A fund charges management fees which cover salaries, etc. A fund also enables you to move fast - you can wire money to a company immediately, assuming you’ve timed your capital calls well. With SPVs, you must raise capital from your LPs for each new investment. This takes time, and in down-markets, such as right now, this is a lot tougher to do. Investing out of a fund also allows you to get into deals that either don’t have enough “signal” for you to syndicate them (many LPs love signal), or where the founder does not want their deck circulated among LPs.
However, there are some disadvantages in managing a fund vs solely doing SPVs (assuming you’re thoughtful about your portfolio construction). Entry valuation becomes more important, check size (ownership), etc. SPVs allow their Leads to be much more flexible and undisciplined about these criteria as each vehicle is independent of the other SPVs.