Fund Budgeting and Portfolio Construction for Closed-End Funds — Vector AIS

This blog, by Ashley Christie and based on an original presentation by Vector’s COO Kristina Dayback, dives into the intricacies of fund budgeting and portfolio construction. We explore the essential elements of managing closed-end funds, covering key topics from fund expenses and management fees to recycling strategies and portfolio management philosophies.

This is a general example and does not take into account the specific complexities of individual funds.

Fund Budgeting: Understanding Key Expenses

Effective fund management requires an understanding of the various expenses involved. Fund expenses and management company expenses are two primary categories that every fund manager must plan for over the lifetime of the vehicle. Fund expenses are typically borne by the fund/investors and these expenses are paid directly from the fund’s assets. Management fees, paid by investors as a part of their capital commitment to the fund, are typically a percentage of the committed capital (or invested capital, though generally that strategy is less common in VC and utilized in the latter half of a fund’s life) and are paid to the fund managers. The difference between fund expenses and management company expenses are typically defined by the fund’s governing documents. For Registered Investment Advisers, the allocation of expenses between the fund and the management company are often highly scrutinized by the regulators, and adherence to fund’s governing documents is paramount.

Fund Expenses

Fund expenses are directly related to the operation and administration of the fund itself. It is typical for fund expenses to take up about 20–24% of committed capital. These expenses include, but may not be limited to:

• ‍Audit Fees: Costs associated with the annual audit of the fund’s financial statements.
• ‍Tax Preparation Fees: Expenses for preparing and filing the fund’s tax returns.
• ‍Legal Fees: Costs for legal advice on fund formation, investment transactions, and regulatory compliance.
• ‍Fund Administration Fees: Fees paid to third-party administrators for accounting, financial reporting, and investor communications.
• ‍Due Diligence Expenses: Costs incurred in investigating potential investments.
• ‍Deal-Related Fees: Fees related to sourcing and ongoing maintenance of deals.
• ‍Syndication Costs: Costs incurred to market or sell interest in the fund.
• ‍Valuation Expenses: Costs related to the periodic valuation of the fund’s investments.
• ‍Directors & Officers (D&O) Insurance: Insurance to protect fund managers and directors from potential lawsuits.
• ‍Bank Fees: Charges for banking services, wire transfers, and managing fund accounts.

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Management Company Expenses

Management company expenses are covered by the management fee and relate to the day-to-day operations of the management firm itself. These typically include:

• Salaries and Bonuses: Compensation for staff and executives of the management company.
• Rent and Utilities: Costs for office space and utilities used by the management company.
• Technology and Infrastructure: Expenses for IT systems, software, and other technological needs.
• Professional Services: Fees for external consultants, lawyers, or accountants used for the management company’s operations, not directly attributed to the fund.
• Regulatory Fees: Fees for regulatory filings and ongoing regulatory compliance of the manager.
• Insurance: General business insurance (excluding D&O insurance, which is a fund expense).

Management Fees

Fund managers determine their management fees based on several factors. The size of the fund plays a significant role; smaller funds often look to charge higher management fees to account for the added work and resources required. A strong track record and credibility may allow funds to set higher fees, leveraging their performance history and brand recognition.

The investor base and relationships can also influence fee structures. Funds with robust LP relationships can often negotiate higher fees. Market timing and the economic environment are additional factors that can impact management fee decisions. Furthermore, funds with a more hands-on approach to managing portfolio companies may justify higher management fees.

The most standard management fee rates are between 2–2.5%. Most fund managers adopt a management fee step-down, starting after the investment period.

Management Fee Offsets

There are several mechanisms for management fee offsets. One common strategy is GP cashless contributions, where the GP exchanges their capital commitment to the fund by a management fee offset, rather than paying cash (typically an 80%cashless/20% cash split). This can provide the fund manager a tax advantage by converting ordinary income to long-term capital gains, which are taxed at a lower rate.

Lifetime Projections of Fund Expenses

Understanding and budgeting for the full lifecycle of fund expenses is crucial for effective fund management. Here’s a typical timeline:

• Years 1–5 — Investment Period: During the investment period, the fund actively invests committed capital into new portfolio companies. The majority of capital calls from LPs happen during this time. Expenses are generally highest in year one due to upfront fund formation costs, and management fees are typically at their peak, around 2–2.5% of committed capital annually. Some fund managers may call larger amounts of their management fees in advance, to account for these large upfront costs.
• Year 6 — Deploying and Follow-on Investments: As the investment period ends, no new investments are made. The focus shifts to managing the existing portfolio, making follow-on investments, and preparing companies for exit. Management fees will begin to scale down.
• Years 7–9 — Harvest Mode: This period is focused on realizing returns and exiting portfolio investments through mergers and acquisitions (M&A), initial public offerings (IPOs), and secondary sales. Distributions are made back to LPs as exits occur, and management fees often continue to decrease.
• Year 10 — Fund Dissolution or Extension: By this stage, all remaining portfolio companies must be exited, or the fund may be extended if there are still active companies. Typically, funds have two built-in extension years beyond the initial 10-year term. During these extension years, management fees continue to be charged, although often at a reduced rate. After the two extension years, management fees usually stop completely. Final distributions are made back to LPs as the fund winds down operations. Extension mechanisms allow for the fund’s lifetime to be prolonged beyond the initial 10-year period if necessary. This is typically done through a vote or consent from a specified majority of LPs. The extension period’s duration and terms (e.g., management fees, carry structure) are outlined in the LPA.

Recycling and Reinvesting

Recycling

The specifics of what constitutes recycling, such as the allowable amount or timeframe, will be outlined in the LPA. Recycling provisions enable the GP to redeploy capital (typically 110% -120%) from early exits into new investments without drawing additional commitments from LPs. This practice maximizes deployed capital by putting exit proceeds back to work, compounding potential returns.

Reinvesting

After the investment period ends, remaining proceeds from exits are typically allowed to be reinvested into existing portfolio companies for follow-on rounds, allowing for a “double down” approach. The governing docs will specify what percentage of proceeds can be reinvested, commonly 50%, with the other 50%distributed to LPs.

Benefits and Limitations

Recycling and reinvesting have several benefits. They maximize investment capabilities with limited committed capital and allow for the compounding of returns if exits/proceeds are reinvested effectively. This approach also provides dry powder during the harvest period to support remaining companies and incentivizes GPs to generate early liquidity events.

However, there are limitations. Recycling can’t be relied on in original fund planning and projections because exit timing and amounts are unpredictable. Some LPs prefer distributions rather than heavy recycling, and there is a risk of concentrating too much capital in underperforming companies.

Portfolio Construction Strategies

Laws of Averages

One common philosophy is the laws of averages, where a higher number of investments is made to cast a wider net, increasing the chance of hitting a home run. This approach involves making smaller initial checks and reserving less capital for follow-on rounds.

However, there are risks. Over-diversification can lead to a higher initial workload and the potential to miss outsized winners due to lack of concentration. Proponents argue that unicorns are extremely rare, so maximizing at-bats and not putting all eggs in a few baskets provides a more consistent approach over many funds, even if individual IRRs may be lower. The “more shots on goal” philosophy is common, especially for larger, multi-stage funds that can handle the higher initial portfolio volume. ‍

Reserve and Double Down

The alternative strategy is to concentrate the fund into a smaller portfolio. This involves making larger, more concentrated initial investments while still reserving significant capital (~50–75%) for aggressively doubling or tripling down on the top performers. This data-driven approach allows the fund to capitalize fully on its highest conviction companies. The trade-off is putting more eggs into fewer baskets upfront, so higher conviction bets and strong portfolio management are crucial.

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Portfolio Construction: Key Considerations

When constructing a portfolio there are several things to consider. Variables like fund size, initial check amounts, sector, stage, ownership stakes and more are all part of the process. With proper planning and disciplined strategies, a fund can drive long-term success, balancing risk and opportunity.

However, constructing a portfolio is inherently challenging due to the unpredictability of financial markets, investment outcomes, and macroeconomic factors. The fund’s thesis provides a strategic direction, focusing on specific sectors, stages, or types of investments that align with the fund’s mission. However, the inherent volatility and unforeseen events can complicate decision-making, making it difficult to balance risk and opportunity effectively. This complexity requires a combination of analysis, flexibility, and adaptive strategies to build a high-performing portfolio.

Conclusion

Understanding the nuances of fund budgeting and portfolio construction is crucial for any venture capital or private equity fund manager aiming to achieve outstanding performance. By comprehensively managing fund expenses, setting appropriate management fees, and strategically recycling and reinvesting capital, fund managers can better navigate the complexities of the investment landscape. Moreover, adopting a disciplined approach to portfolio construction, whether through the laws of averages or a reserve and double down strategy, helps in balancing risk and opportunity effectively.

This content is general in nature and is not intended to serve as accounting, legal, or other professional advice. Vector AIS assumes no responsibility for the reader’s reliance on this information. Every VC and PE fund is unique, and it is paramount to adhere to the fund’s governing documents as drafted by experienced legal counsel. Before implementing any of the ideas contained in this publication, readers should consult with a professional advisor to determine whether the ideas apply to their unique circumstances.‍

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Originally published at https://www.vectorais.com.