Carried Interest and Management Fee Mechanisms within the Scope of Venture Capital Trusts and Venture Capital Funds

In today’s world, one of the most prominent resourcing ways for companies that do not have the financial strength or are seeking start-up financing is Venture Capital (VC).

Venture Capital is a financing investment tool that helps ventures lack financing or seeking investment financing, to realize their ideas and meet their financial needs. The contribution of VCs to ventures does not only occur as financing, but at the same time VCs may transfer their knowledge and experience. VCs expect high profitability in long-term in return for their contribution and risk of funding.

One of the most important elements to achieve the expectation of high profitability is the management of capital. VC’s may manage the capital within itself or, it is possible to get services from external professional organizations in this regard. The earning of people who provide such an important service in such market equilibrium should be encouraging.

When we look at the global market practice, earning for capital management service occurs in two ways: “carried interest” and “management fee”. After the definitions and implementation of these mechanisms in international law are explained, the concepts “performance fee” and “management fee”, which can be described as reflections of these mechanism in Turkish law, will be examined.

Carried Interest (Carry): Carry mechanism is another essential way for VC, Private Equity (PE) or funds to generate income. The mechanism can be briefly defined as taking a certain amount from the profit. Looking at the historical background, the roots of the carry mechanism go back until an agreement between an investor and a boatman in the 16th century. Pursuant to the agreement, the boatman who transported all goods overseas free of problems, was entitled to receive 20% of the sales price in return for his/her success.

In today’s world, carry mechanism appears similarly. VCs are entitled to a determined fee after exit by selling the shares of the invested ventures or public offering of the invested ventures. The fee is generally determined between 20% and 25% of the profit obtained from the exit. It should be noted that the carry fee is not a mechanism that occurs automatically as a result of the triggering event, but it must be determined by a contract between the parties.

Example: Company A (A) has created a 10 million TL fund through investors and partners. B Portfolio Management Company (B) or B natural person (B) manage this fund. A and B have agreed that they will pay (carry) 20% of the amount calculated as the fund value minus the preinvestment fund value.

As a result of the investments made by A, the total valuation of the invested companies has reached 25 million TL. In the first stage, 10 million TL invested will be repaid to A. Then, the remaining amount, 15 million TL will be distributed between A and B. Under the carry fee agreement, B will be entitled to earn 20% of the remaining amount, in other words 20% of the profit, after the first investment amount is paid back to the investors. Thus B, who manages the fund, will be entitled to a fee of 3 million TL, which is 20% of the 15 million TL, in return for managing the assets in the fund.

In addition to the example: Parties may also set a management fee (usually set as 2.5%) so that B can properly manage assets. In this case, regardless of whether the invested companies make a profit or not, 250 thousand TL of 10 million TL will be allocated to B.

Special Cases in the Carry Mechanism

Hurdle Rate: Sometimes, partners who leave the management of venture capital to managers or management companies, set a threshold called the hurdle rate that triggers the carry mechanism. The determined rate appears in practice as the lowest acceptable rate of return in the evaluation of the fund. The importance of the hurdle rate within the scope of the carry mechanism is that carry mechanism will not be triggered in cases when the profit that comes from the investment does not exceed this rate. This threshold is generally set between 6% and 8% of the fund value.

It would be helpful to proceed from the example given above to be more descriptive. If the payment to be paid to B is conditional on making a profit of 8% of the invested amount, it requires a gain of 800 thousand TL which corresponds to 8% of the investment amount of 10 million TL, to trigger the carry mechanism this time.

In this example, the amount of payment to B will not change in this respect. However, it should be noted that in a hypothetical case where the example differs and the valuation obtained from investments made with a capital of 10 million TL is less than 10 million 800 thousand TL (i.e., the hurdle rate cannot be reached), B will not be entitled to any payment.

Clawback: In cases where the fund invests in more than one company, if the expected return is received from the initial investment but fails to reach the success criteria determined in subsequent investments; there may be an agreement between the manager or the management company and the partners regarding the recovery and reuse (in subsequent investments) of the carry fee obtained from the success in the initial investment. In this manner, clawback means the recovery of the carry payment if the determined success conditions are not met in subsequent investments.

Management Fee: Management fee can be defined as the fee paid for the professional management of assets. In general, the salary, managerial expenses and operating expenses (administrative expenses, legal consultancy fees, accounting fees, etc.) are also included to the content of the said fee. More commonly, the payment date of this fee is determined based on periodic terms (such as daily, monthly, yearly).

In terms of determination of the management fee, parties often use rate of 2% or 2.5% of the assets under management of the enterprise.

Large scale VCs often request this payment, while some VCs intentionally give up demanding it.

Turkish Law Practice

According to the definition on the Capital Markets Board’s (Board) website, a venture company is defined as “companies established or to be established in Turkey in accordance with the capital market legislation, with development potential and in need of resources”. A person, a company, or Venture Capital Trusts (VCT) can make a venture capital investment. Pursuant to Article 3 of the Communiqué on Principles Regarding Venture Capital Trusts (III-48.3) (VCT Communiqué) prepared in accordance with the Capital Markets Law (CML) VCT, is defined as:

“Venture capital trust is a venture capital investment company established or transformed through an amendment to the articles of association, to issue its shares to operate the portfolio consisting of venture capital investments, capital market instruments and other assets and rights to be determined by the Board. It is a capital market institution, which is a joint stock company subject to the registered capital system, which can carry out other activities permitted in this Communiqué, provided that they are within the framework of the activities outlined in Article 48 of the Code.”

As it is clearly understood, the main purpose of VCT is the management of a portfolio. As mentioned in the international practice regarding venture capital, it is also possible to receive consultancy services for the management of this capital in Turkish Law as well. Pursuant to Article 25 of the VCT Communiqué:

“In case there is an article in their article of association, the Board approves and the board of directors have a resolution related, within a scope of an contract to be signed; companies can get a portfolio management service from a portfolio management company and can get consultancy service from specialized companies in matters of selecting and managing venture capital company to be used in matters related to portfolio management services and activities. The principles regarding the portfolio management service are determined within the scope of a contract that includes the minimum elements specified in the Board’s regulations on portfolio management companies.

Within the scope of portfolio management service outsourced, companies may make a payment as performance fee, to be calculated over the difference between the amount that has been obtained during exit and cost of investment to portfolio management companies. Dividends from venture companies and interest income from debt instruments issued by venture companies can also be subject to the performance fee. The performance fee to be paid for the portion of the portfolio consisting of venture capital investments cannot exceed 20% of the amount to be calculated in accordance with this paragraph.”

It has been regulated that VCT can receive services from portfolio management companies or other companies within the scope of investment consultancy in order to receive portfolio management services. In Turkish Law, a ceiling price limitation, which will be calculated as 20% of the profit obtained at the exit, has been stated on the price to be paid for the service, similar to the international practice. The fact that the price to be paid is a matter related to portfolio management and consultancy and that a ceiling price has been determined in parallel with the international practice shows that the performance fee mentioned in this article corresponds to the carry mechanism in practice.

A plausible situation that may come to mind at this point, is the scenario when management or consultancy service is provided by the people working within the body of VCT and the said performance fee is paid to these people. This situation is not clearly regulated in the VCT Communiqué. By legal interpretation techniques, it seems possible to continue management and consultancy activities through internal employees, since this matter is not subject to an explicit permission and does not constitute a prohibited activity in accordance with the legislation. At this point, since there is not any limitation to the price to be paid to the persons who will carry out these activities internally, our opinion is that the ceiling price should still be applied for service externally provided in accordance with the VCT Communiqué. Because outsourcing of a service will be more costly than providing this service internally in accordance with the basic management and economics logic. For this reason, even if the services are provided internally, at least the ceiling price, which is regulated in accordance with Article 25 of the VCT Communiqué and regulated as 20% of the profit obtained during the exit process, must be valid.

Pursuant to article 26 of the VCT Communiqué:

“The sum of the fees paid by the partnerships for all outsourced services, excluding the performance fee, cannot exceed 2.5% of the total assets in the last annual individual financial statement of the company.”

A limitation has been envisaged regarding the services that VCT receives externally with the exception of the service subject to the performance fee. For these expenses, there is a ceiling price to be calculated as 2.5% of the total asset items in the current balance sheet of VCT. At this point, just as in the performance fee, it can be said that the mechanism regulated here corresponds to the concept of management fee in international practice, based on both the content of the services subject to the fee and the similarity of the ceiling price for the services.

Just like a person, company and VCT; Venture Capital Fund (VCF) may also be a subject to venture capital investment. Pursuant to Article 3 of the Communiqué on Principles Regarding Venture Capital Funds (III-52.4) (VCF Communiqué) prepared in accordance with CML, VCF is defined as:

“The Fund is an estate that established, for a period of time with an by law and do not have legal personality, in order to operate the portfolio consisting of the assets and transactions specified in the third paragraph, on the account of the basis of fiduciary ownership, with the money collected from qualified investors in return for participation shares in accordance with the provisions of the Law by the portfolio management companies, venture capital portfolio management companies, real estate and venture capital portfolio management companies that have obtained operating license from the Board.”

It is clearly understood that the VCF is an estate without legal personality and established for the purpose of operating a portfolio. The regulation on performance fees and expenses in the VCF Communiqué is written in more detail than in the VCT Communiqué. In this respect, pursuant to article 24 of the VCF Communiqué:

“All expenses related to the fund are covered from the fund assets. The fund establishment costs and expenses, and the fees arising from the purchase of all kinds of consultancy services related to the creation of the fund’s portfolio shall be covered from the fund portfolio, provided that the said fees and collection principles are included in an investor agreement. The upper limit shall be included in the issuance document, which is calculated as the ratio of all expenses covered by the fund -including the portfolio management- to the total value of the fund. If the performance fee is also desired to be included in this limit, this shall be stated in the fund information documents. Portfolio management fee can be determined as a fixed amount, or as a certain percentage of the fund’s portfolio value, total value or total assets, or the amount of commitment made by investors regarding the purchase of fund shares, and by a method deemed appropriate by the Board.

Provided that there is a provision in the fund information documents, the founder and the portfolio manager (if any) may accrue the performance fee to the fund or to the participation shareholders and collect the fee from the fund or participation shareholders. The procedures and principles regarding the accrual and collection of the performance fee are determined by the decision of the founder’s board of directors before the sale of participation shares. It is necessary to include examples regarding the accrual and collection of performance fees in the said board of directors’ decision.

It has been clarified that a performance fee can be envisaged for management and consultancy services to be received by the VCF. It should be noted that the aforementioned fee mechanisms have received more response from the VCF in our country, parallel with the international practice. In terms of determining the price to be paid for these services, unlike the VCT Communiqué, a price ceiling application is not envisaged in the VCF Communiqué. In this respect, the management expense, consultancy expenses and other expenses may be covered from the fund and a ceiling price for such expenses may be regulated in the issuance document.

In this respect, the venture capital investment method, which is accepted as an effective form of investment throughout the world, has been institutionalized in terms of Turkish Law through VCT and VCF. With the institutionalization of the relevant method, it is desired to regulate the principles and procedures of venture capital investments. Performance fee and management fee concepts have been regulated separately, to correspond to the carry (performans ücreti) and management fee (yönetim ücreti) mechanisms in the world practice in terms of the venture capital market, and a harmonization in the venture capital market has been sought.