Venture Capital puzzles, solved step by step

Rs 20 crore with the catch-up, and about Rs 10.6 crore without it. LPs first get their Rs 100 crore back plus an 8% compounding return, Rs 46.93 crore. The GP then takes the next Rs 11.73 crore until it holds 20% of the profit so far, and the last Rs 41.33 crore is split 80/20. Without the catch-up, only the Rs 53.07 crore above the hurdle is split, and the GP gets 20% of that.

What order does the money flow in?

A distribution waterfallThe agreed order in which a fund pays out cash: which party is paid first, how much, and when the next tier begins. is a queue at a buffet: each tier eats fully before the next is served. Tier one returns the LPs' capital, tier two pays them the hurdle, tier three is the GP's catch-up, and only then does the 80/20 split begin. The hurdle compounds, so after five years it is 1.08 to the power 5 minus 1, about 46.9% of capital, Rs 46.93 crore, not the Rs 40 crore that simple interest would give.

How big is the catch-up, and why does it stop where it does?

The catch-up pays the GP 100% of the next money until the GP holds 20% of all profit paid so far. If the catch-up is c, then c must equal 20% of the hurdle plus c. Solving gives c equal to the hurdle times 0.20 over 0.80, one quarter of Rs 46.93 crore, which is Rs 11.73 crore. At that point LPs hold 80% of profit and the GP holds 20%, so every later rupee split 80/20 keeps those shares fixed.

What is the catch-up worth to the GP here?

Without it, the GP earns 20% only of the Rs 53.07 crore above the hurdle, Rs 10.61 crore. The catch-up nearly doubles the GP's take, from about Rs 10.6 crore to Rs 20 crore, because it gives the GP its share of the hurdle profit back. The limit to say aloud: this is one distribution at year five. Real funds pay out over many years, and the hurdle runs on each rupee's own timing, which changes the numbers but not the order.

Carry is Rs 120 crore, and the fund is 3.0x gross and 2.6x net. The profit is Rs 900 crore less the Rs 300 crore of capital returned, Rs 600 crore. The GP takes 20% of that, Rs 120 crore. LPs receive Rs 780 crore on Rs 300 crore, which is 2.6x, against 3.0x for the portfolio before carry.

What is the carry charged on?

Think of a tutor paid a fifth of whatever a student's marks improve by, not a fifth of the total marks. Carried interest is a share of the profit, so the LPs' own capital comes back to them first and only the gain above it is split. The fund returned Rs 900 crore on Rs 300 crore, so the gain is Rs 600 crore and the GP's 20% is Rs 120 crore. A hurdleA minimum return LPs must receive before the GP earns any carry. This fund has none. would delay the carry but, once caught up, would not change its size at this level of return.

Why is net 2.6x and not 2.4x?

Taking 20% off 3.0x would charge carry on the capital as well as the profit. The gap between gross and net is 20% of the profit multiple, 0.2 x 2.0, which is 0.4 turns, so 3.0x gross becomes 2.6x net. The same logic gives a quick rule: at any gross multiple M with 20% carry and no fees, net is 1 plus 0.8 x (M minus 1). A 2.0x gross fund nets 1.8x; a 5.0x fund nets 4.2x.

What would an LP add?

That fees push net lower still. A typical venture fund also charges an annual management fee on committed capital, often around 2% for the investment period, which reduces both the money invested and the net multiple; confirm the actual terms in the fund's agreement. An LP compares managers on net multiples and net IRR, because that is the only number that reaches its own balance sheet. A GP quoting 3.0x is quoting the portfolio, not the investor's outcome.

About Rs 212.5 per Rs 100 committed, a multiple of 2.125x. Ten years at 1% takes Rs 10 in fees, so Rs 90 reaches the underlying funds. At 2.5x that becomes Rs 225. The profit over the Rs 100 committed is Rs 125, and 10% carry on it is Rs 12.5. The LP keeps Rs 212.5, so the extra layer turns 2.5x into about 2.1x.

Why does the fee cost more than its 10% headline?

Think of buying vegetables through a cousin who takes Rs 10 out of every Rs 100 you give him before he reaches the market. The vendor's prices may be excellent, but you only ever buy Rs 90 worth. Fees come out before the money is invested, so the underlying 2.5x is earned on Rs 90, not on Rs 100. Rs 90 at 2.5x is Rs 225, which is 2.25x of what the LP committed. The 1% a year looks small, but over ten years it is a tenth of the commitment that never works.

Which layer costs the LP more, the fees or the carry?

Split the 0.375x gap between 2.5x and 2.125x. Fees cost 0.25x and carry costs 0.125x, so the fixed fee does twice the damage of the profit share at this return. That ranking flips at higher returns, because carry grows with profit while the fee does not. At 4x underlying, the same structure would cost 0.4x in fees and about 0.26x in carry. The assumption here is that carry is charged on profit over the full commitment, with fees returned first and no hurdle; a structure that charges carry from the first rupee of profit costs more.

What does an LP get for the extra layer?

A fund of funds sells access and diversification: places in funds that are hard to get into, spread across managers and years, with someone else doing the selection and monitoring. The LP should compare the net-of-everything multiple with what it could earn going direct, not compare the fund of funds' fees with zero. The limitation is that this one number hides timing. The fund of funds' fees start on day one, while the underlying funds return money late, so the gap in annual rate terms is wider than the gap in multiples suggests.

Rs 412.5 crore is left to invest, and the portfolio needs about 1.21x gross just to return the Rs 500 crore. Fees are 2% for five years, Rs 50 crore, plus 1.5% for five years, Rs 37.5 crore, a total of Rs 87.5 crore. LPs committed Rs 500 crore, so the Rs 412.5 crore that is invested must grow to Rs 500 crore: 500 over 412.5 is 1.21x before the fund earns a rupee of carry.

Why does a fund need more than 1x just to break even?

If a friend takes Rs 17.5 from every Rs 100 you give him to invest, the Rs 82.5 he does invest has to grow by a fifth just to give you your Rs 100 back. Management fees come out of commitments, so the portfolio is smaller than the money LPs put in, and it must earn the fees back before LPs see any profit. On a Rs 500 crore fund, ten years of fees at these rates take Rs 87.5 crore, 17.5% of the fund.

What multiple does the fund need to deliver a good result to LPs?

Run the same logic to a target. Say LPs want 2x net, Rs 1,000 crore, and the manager takes 20% carry on profit above the Rs 500 crore committed. The LPs' Rs 500 crore of profit is 80% of the total profit, so total profit must be Rs 625 crore and proceeds Rs 1,125 crore. That is 2.73x on the Rs 412.5 crore invested, so a 2x net fund is close to a 2.7x gross portfolio. The gap between gross and net is why LPs ask for both numbers and never compare one manager's gross with another's net.

Where does the clean answer go wrong in practice?

Funds often recycle: they reinvest early exit proceeds up to the amount of fees paid, so invested capital can approach the full Rs 500 crore and the break-even multiple falls towards 1x. The fee terms, the recycling allowance and the carry structure are set in each fund's limited partnership agreement, so confirm them there before using these figures for a real fund. Some funds also charge the later-period fee on invested capital rather than commitments, which lowers total fees.

The 12% deal made Rs 21 crore against Rs 1.5 crore, fourteen times as much. The quick flip shows a 32% IRR because 1.15x in six months annualises to 1.15 squared, about 1.32. But LPs spend rupees, not rates. If the Rs 11.5 crore then sat idle for the remaining nine and a half years, the deal is 1.15x over ten years, an IRR of about 1.4%. The ten-year deal's 3.1x is about 12% a year on the whole Rs 10 crore for the whole time.

How can a 32% IRR make less money than a 12% IRR?

A cab that charges a high rate per minute for a two-minute ride earns less than a modest-rate cab hired for the whole day. IRR is a rate per year while the money is out, so a short deal can post a huge IRR on a tiny rupee profit, and the rate says nothing about how long the capital earned it. On Rs 10 crore the flip made Rs 1.5 crore. The ten-year deal made Rs 21 crore, with a lower rate sustained over twenty times as long.

Why does it matter what the cash does after the exit?

The 32% assumes the Rs 11.5 crore can be put straight back to work at a similar rate. For an LP whose money was committed for ten years, cash returned early earns only what the LP can do with it next, and if that is nothing, the deal's true rate over the commitment is about 1.4%. This is why LPs read IRR beside the money multiple, and why a fund boasting a top-quartile IRR on a 1.3x fund gets hard questions. Some funds also time capital calls with credit lines to shorten the period the money counts as out, which flatters IRR without adding a rupee.

The fair limit: early cash is worth something if the LP really can reinvest it, and the reinvestment rate decides by how much. In the room, say both numbers for every deal, multiple and IRR, and say which one an LP banks.

DPI 0.75x, RVPI 1.75x, TVPI 2.5x. All three divide by the Rs 200 crore paid in. Distributions of Rs 150 crore give a DPI of 0.75x; the Rs 350 crore still held gives an RVPI of 1.75x; the total value of Rs 500 crore gives a TVPI of 2.5x. An LP trusts DPI most, because it is cash already returned. The fund looks like a 2.5x but has not yet given back the money it called.

What does each ratio measure?

A friend who borrowed Rs 2,000, has repaid Rs 1,500 and promises the rest plus Rs 3,500 more from a deal still underway has given you back 0.75 times your money in cash and promised 1.75 times more. DPIDistributions to paid-in capital: cash returned to LPs divided by capital called. counts cash returned, RVPIResidual value to paid-in capital: the portfolio's current marked value divided by capital called. counts value still on paper, and TVPI is the two added together, all divided by the capital called. The fund called Rs 200 crore, so DPI is 150 / 200 = {dpi72:.2f}x, RVPI is 350 / 200 = {rvpi72:.2f}x and TVPI is {tvpi72:.1f}x.

Why does an LP care more about the 0.75x than the 2.5x?

Because the marks can move and the cash cannot. RVPI rests on the fund's own valuation of private companies, often at the last round's price, so 70% of this fund's reported value is an estimate that has not been tested by a sale. If those marks fell 40%, RVPI would drop to 1.05x and TVPI to 1.8x, while DPI would stay at 0.75x. That is why many LPs judge older funds on DPI, and why the phrase 'DPI is the only metric that counts' gets repeated in fundraising conversations.

The fair limit is timing. A young fund naturally has low DPI because its companies have not been sold yet; judging a three-year-old venture fund on DPI alone would punish every fund for being young. Read DPI against the fund's age, and ask how the marks were set, last round, a comparable, or a recent offer, before trusting the RVPI.

Without recycling the fund invests Rs 82.5 crore and needs 3.03x; with full recycling it invests Rs 97.5 crore and needs about 2.72x. Investors want Rs 250 crore back. Without recycling, Rs 82.5 crore must produce all of it. With recycling, Rs 97.5 crore must produce Rs 265 crore, because Rs 15 crore of proceeds was put back to work rather than paid out. Carry is ignored throughout.

Why can a fund not invest all of its commitments?

A family sets aside Rs 1,00,000 for a wedding and the planner's fee is Rs 17,500 of it: only Rs 82,500 buys food and flowers. Management fees are paid out of the same commitments that fund the investments, so a fund that never recycles invests less than its headline size. Rs 17.5 crore could be 2% a year for five years and 1.5% for five more; schedules vary, but the arithmetic is the same. To turn Rs 100 crore into Rs 250 crore for investors, Rs 82.5 crore has to earn 250 / 82.5 = 3.03x.

How does recycling change the multiple, and why is it not 250 over 97.5?

RecyclingReinvesting proceeds from early exits into new companies instead of distributing them, usually capped at about the amount of fees paid. lets the fund put Rs 15 crore of early exit money back into new companies, so invested capital reaches Rs 97.5 crore. But that Rs 15 crore was proceeds the portfolio had already earned and did not pay out, so the portfolio must produce Rs 250 crore for investors plus the Rs 15 crore it recycled. Gross proceeds of 265 on cost of 97.5 is 2.72x: still well below 3.03x, but not the 2.56x a quick division gives.

Say the limit too. Recycling delays money investors would have received early, so it can lift the multiple while lowering the IRR, and it works only if the fund finds good companies for the recycled rupees. It is a tool for getting fees back to work, not free return.

14.9% without the credit line and 18.9% with it, and the multiple is 2.0x either way. IRR measures time as well as money. Without the line, Rs 100 doubles over five years: 2 to the power one fifth, less 1. With it, the investors' Rs 100 is out for four years, and 2 to the power one quarter, less 1, is 18.9%. Nobody made an extra rupee; with 8% interest, investors actually make less.

Why does paying later raise the IRR?

Lend a friend Rs 100 and get Rs 200 back: whether that is a good deal depends on whether it took five years or four. IRR is the yearly rate that turns the money paid in into the money paid out, so shortening the time the money is out raises the IRR even when the rupees are identical. Without a credit line, the investors' Rs 100 grows to Rs 200 over five years, 14.9% a year. With one, the investors pay at year 1 and still receive Rs 200 at year 5: four years, 18.9% a year.

What happens once you count the interest?

The bank is not free. At 8% for one year, the fund calls Rs 108 at year 1 to repay Rs 100 plus interest. The investors now pay more for the same Rs 200, so the multiple falls to 1.85x, yet the IRR is still 16.7%, higher than the 14.9% without the line. Less money, better-looking IRR. That gap is why investors in a fund ask for the multiple and the IRR side by side, and increasingly ask for the IRR with the credit line stripped out.

Why would a fund use a credit line at all?

There are honest reasons: it lets the fund close a deal quickly without waiting ten business days for a capital call, and it smooths many small calls into a few large ones, which investors find easier to manage. The concern is the IRR effect. A fund that ranks high on IRR partly because of the line may have made less money for its investors than one that ranks lower. Say both reasons, then say which number you would compare funds on: the multiple, and the IRR measured from the date the investment was made.