The Grand Financial Theater of Venture Capital: Anatomy of a Gilded Illusion
Are VC funds really rich? A common illusion hides a far more complex reality. Dive into the financial mechanics of Venture Capital.
A few days ago, over coffee with an aspiring entrepreneur whose eyes sparkled with ambition, I heard this phrase that every General Partner of VC funds will recognize: "These funds are drowning in money, they can afford to spend a bit more." This mirage, this fundamental confusion between AUM and operational liquidity, reminded me of my own rookie illusions. So I wanted us to dig together behind the scenes of this financial play where appearances are often deceiving.
1. The Invisible Architecture of a VC Fund
To understand how a fund works, imagine a baroque building with a double façade. On one side, visible and impressive, the mass of capital under management (the AUM) – these tens or hundreds of millions that fuel founders' dreams. On the other, hidden from view, the economic infrastructure that runs the machine (the management company), a fragile balance of financial clockwork.
A VC fund isn't a monolithic entity but a complex legal constellation:
Venture Capital Firm (SAS in France, LLC in the United States) – A management company
Ventures Capital Fund (SCR, FPCI, Delaware LP) – Investment vehicles
A contractual cascade connecting LPs and GPs – decision-making nervous system
This sophisticated architecture channels capital from institutional and wealthy investors (endowments, pension funds, family offices, corporates, successful entrepreneurs) to promising startups, in a risky alchemy aimed at transforming the lead of ideas into the gold of exits.
2. The Dual Economy: Management Fees and Carried Interest
2.1. Management Fees: The Daily Oxygen
Management fees are the vital fuel of the VC ecosystem – without them, no light in this capitalist cathedral. Like a basal metabolism, they maintain essential functions.
This amount is based on Assets Under Management (AUM) and delivered each year. A standard VC fund will have management fees between 2% and 3% annually, capped between 17% and 20% of total AUM.$
This percentage is generally degressive based on the fund's life.
Investment period (years 1-5): 3-2% annually
Management period (years 6-10): 1-0.5% annually
Extensions (beyond): 0.5% if necessary
These percentages depend on each fund and are intended to ensure LPs have the means for management while incentivizing GPs to raise a new fund. Successive funds cover the management fee gap.
For a €50M fund, these 2% represent an annual envelope of €1M – a sum that, seen through the prism of a high-level investment team, suddenly transforms into a constraint of action rather than a luxury. We'll discuss this more below.
2.2. Carried Interest: The Quest for the Holy Grail
While management fees keep the vessel afloat, carried interest is the constellation that GPs follow, established by LPs to ensure alignment of interests. In other words, it's a distant promise of potential fortune that justifies years of effort and sacrifice.
The fundamental equation is simple: 20% of outperformance beyond the hurdle rate. This is generally 1.8 to 2x the AUM amount, achieved within a timeframe of 7 to 12 years.
This byzantine mechanism transforms managers into true entrepreneurs, aligning their financial destiny with the absolute performance of the portfolio. Ultimately, it's similar to an entrepreneur who develops and sells their company in an M&A – especially since the amounts are quite similar.
3. The Anatomy of Costs: Dissection of a Complex Financial Organism
3.1. Human Infrastructure: First Expense Item
Human capital constitutes the main asset and economic center of gravity of a VC fund. I'll let you discover the average amounts in the industry in 🔗Luis Llorens' excellent paper (right 🔗here and 🔗here).
But this talent pyramid typically consumes 60-75% of available management fees, a proportion reflecting the knowledge-intensive nature of the business.
3.2. The Technological and Informational Ecosystem
The technological arsenal of a VC fund includes sophisticated infrastructure aimed at reducing the informational asymmetry inherent to the business:
Business Intelligence Systems:
PitchBook/CB Insights: €30K-€75K/year depending on team size
Proprietary predictive tools: €15K-€150K (development and maintenance)
Deal-Flow Infrastructure:
Specialized CRMs: Affinity (€7K-€20K/year), Sevanta, DealRoom
Qualification tools: scoring algorithms, monitoring systems
Due Diligence Ecosystem:
Data room platforms: €10K-€25K/year
The digital transformation of VC, far from being a luxury, constitutes a competitive imperative in an ecosystem where quality information represents the decisive advantage for entering the playing field.
3.3. Legal and Regulatory Infrastructure
Like a ship navigating between reefs, a VC fund must negotiate a complex regulatory labyrinth:
Structuring costs:
Initial legal design: €50K-€200K (depending on complexity)
LP documentation (LPA): €30K-€100K (negotiations with investors)
Regulatory registrations: €15K-€40K (AIFMD in Europe, SEC in USA)
Statutory maintenance:
Audit & Compliance: €30K-€80K/year
4. Financial Thermodynamics: Flows, Temporalities, and Entropy
4.1. The J-Curve: Temporal Equation of VC
The financial profile of a VC fund obeys a particular differential equation, materialized by the J-curve – graphical translation of the tension between capital deployment and value harvesting:
Investment phase (t0 to t+5):
Dominant outgoing cash flows (80-100% of committed capital)
Theoretical and volatile RVPI (Remaining Value to Paid-In)
Maximum risk coefficient, minimal visibility
Transformation phase (t+5 to t+7):
Dynamic inflection point (cash-burn vs value creation)
Emergence of first strong signals (leading companies)
Crystallization phase (t+7 to t+10+):
Non-linear acceleration of exits
Distribution cascade to LPs
Exponential materialization of carried potential
This temporal structure explains why the best GPs exhibit strategic patience, a rare characteristic in the contemporary financial universe dominated by the dictatorship of short-termism.
4.2. The Alchemy of Multiples: Quest for Portfolio Alpha
The transformation of lead into gold – perfect metaphor for VC – is mathematically expressed by an equation with multiple interdependent variables:
DPI (Distributions to Paid-In): Absolute performance measure
1x = return of initial capital (nominal break-even)
2.5-3x = high-performing industry standard
5x+ = territory of legendary funds (top 1%)
TVPI (Total Value to Paid-In): Composite measure
TVPI = DPI + RVPI (Residual Value to Paid-In Capital)
Significant temporal dilution (€1 distributed > €1 valued)
Degressive correlation with fund size
IRR (Internal Rate of Return): Temporal dimension
Composite function integrating timing and amplitude, ideal for comparisons between asset classes
Standard objective: 20-25% net to LPs
Inverse correlation with holding duration
Power Law Distribution: Actual statistical distribution
1-3 deals represent 60-80% of total return
Extreme variance coefficient between winners and losers
Non-Gaussian distribution, Bayesian modeling preferred
This quest for absolute alpha justifies the entire economic architecture of VC – a high-wire act where winners-take-all applies to both ends of the investment chain.
5. Case Study: Financial Radiography of a €50M Fund
Let's break down the economic mechanics of a mid-size European fund over its complete life cycle:
Revenue Structure:
AUM: €50M
Management fees: 2% degressive (18% cap)
Years 1-5: €1M/year
Years 6-10: €500K/year (reduced base)
Cumulative total: €7.5M
Cost Structure (Annualized, Active Period):
Human resources: €420K
2 Partners (2 × €120K fully loaded)
2 Associates (2 × €90K fully loaded)
Operational infrastructure: €218K
Premises (150m²): €88K (€586/m²/year)
Technologies and systems: €60K
General and administrative expenses: €70K
Deal-making & Portfolio: €231K
Sourcing and intelligence tools: €81K
External due diligence: €90K
Portfolio support: €60K
Legal & Compliance: €123K
Fiduciary services: €78K
Audit and accounting: €45K
Total annual expenses: €992K
In other words, this structure is just barely profitable with 2% management fees and optimized expenses. Which doesn't leave much room for superfluous spending.
Performance Scenarios and Impact on Carried
Base Case Scenario (3x multiple):
Final fund value: €150M
After hurdle (7%): €25M to LPs priority
Surplus to share between LP and GP: €75M
Carried (20%): €15M
Outperformance Scenario (4x multiple):
Final fund value: €200M
Potential carried: €25M
Underperformance Scenario (1.8x multiple):
Final fund value: €90M
Minimal or no carried
The extreme volatility of carried highlights the entrepreneurial nature of the profession – much closer to the startup founder than the traditional banker in its economic and psychological profile.
In other words, the fund business is a business line where each cost must be hyper-controlled, especially when you're a small fund - which incentivizes all members to seek to unlock carried to really make a difference in their lives.
In other words, it's like an entrepreneur we finance, we don't build our wealth on flows but indeed on stock.
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Great read!