Recycling is a loan of the LP's distribution back to the fund, and 1.00x is not its break-even.
Recycled capital helps the limited partners only if what it returns, after carried interest, beats what they would have earned on the distribution they gave up. The break-even gross multiple is ((1 + alternative rate)years − carry) ÷ (1 − carry). On an illustrative $4,000,000 of proceeds recycled for four years in a fund already in carry, with an 8 per cent alternative and 20 per cent carry, the recycled money must return 1.45x, a gross IRR of 9.75 per cent, not the 1.00x that recycling clauses are usually judged against.
Worked in full in Venture Capital by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A recycling provision lets a venture fund reinvest exit proceeds instead of distributing them, usually up to the amount of fees and expenses, so that the whole commitment goes to work. The standard analysis values it as extra profit: recycled capital times the gross multiple minus one, times one minus carry, as worked in how much a recycling provision adds to LP returns. That formula is right on multiples and silent on time. The limited partner who does not receive a distribution today is lending it back to the fund for years, and the question is what the fund must earn on it to make that loan worthwhile.
| Item | Value |
|---|---|
| Fund size | 100,000,000 |
| Exit proceeds recycled instead of distributed | 4,000,000 |
| Holding period of the recycled investments | 4 years |
| LP's return on the distribution if it were paid out | 8% |
| Carried interest, fund past its hurdle and catch-up | 20% |
The 8 per cent stands for whatever the limited partner would do with the cash: a new fund commitment, a public market allocation, or the cost of capital of the institution. It is an assumption, not a market figure. The fund is assumed to be in carry, so every extra dollar of profit is shared 80/20.
Distributed today and invested at 8 per cent for four years: 4,000,000 × 1.084 = 4,000,000 × 1.3605 = 5.44 million
Recycled at a gross multiple M, the fund distributes 4,000,000 × M later, and the profit on it, 4,000,000 × (M − 1), carries 20 per cent:
LP receives = R × M − carry × R × (M − 1) = R × (1 + 0.8 × (M − 1))
1 + 0.8 × (M − 1) = 1.3605
M = (1.3605 − 0.20) ÷ 0.80 = 1.4506x
Gross IRR needed = 1.45061/4 − 1 = 9.75%
Excel: =((1+Alt)^Years-Carry)/(1-Carry) for the multiple and =M^(1/Years)-1 for the rate.
Two pieces make up the 0.45 of a turn above cost. Time accounts for 0.36: the distribution would have grown to 1.36x at 8 per cent anyway. Carry accounts for the remaining 0.09, because the limited partner keeps only 80 cents of each dollar the recycled money makes. A useful rule of thumb follows: the gross IRR the recycled money needs is close to the alternative rate divided by one minus the carry, 8 ÷ 0.8 or about 10 per cent.
| Gross multiple on recycled capital | LP receives | Versus the alternative | GP carry on it |
|---|---|---|---|
| 0.90x | 3.68 | −1.76 | −0.08 |
| 1.00x | 4.00 | −1.44 | 0.00 |
| 1.20x | 4.64 | −0.80 | 0.16 |
| 1.45x | 5.44 | 0.00 | 0.36 |
| 1.80x | 6.56 | 1.12 | 0.64 |
| 2.50x | 8.80 | 3.36 | 1.20 |
At 1.20x the recycled money made a profit, the general partner earned 0.16 million of carry on it, and the limited partner is 0.80 million worse off than if the cash had been paid out. Only from 1.45x does recycling start to pay the investor. At 1.80x it adds 1.12 million over the alternative, measured at year four, against 2.56 million by the undiscounted formula: time takes more than half of the apparent gain. Note also the 0.90x line. While the fund is in carry the general partner shares 20 per cent of a loss on recycled money through lower carry, which is why the limited partner receives 3.68 million rather than 3.60 million.
| Years held | Break-even, with carry | Break-even, no carry | Gross IRR needed |
|---|---|---|---|
| 2 | 1.21x | 1.17x | 9.9% |
| 3 | 1.32x | 1.26x | 9.8% |
| 4 | 1.45x | 1.36x | 9.7% |
| 5 | 1.59x | 1.47x | 9.7% |
| 7 | 1.89x | 1.71x | 9.5% |
| Case | Break-even multiple |
|---|---|
| Alternative 0% (cash sits idle) | 1.00x |
| Alternative 5% | 1.27x |
| Alternative 12% | 1.72x |
| Carry 25% | 1.48x |
| Carry 30% | 1.51x |
The required rate barely moves with the holding period, but the required multiple does: money recycled late in the investment period into a company that takes seven years to exit must return 1.89x. Recycling into follow-ons deserves particular scrutiny, because follow-ons are priced at the next round and in many funds earn less than initial cheques, as worked in whether VC follow-on investments return less.
The common mistake is to treat 1.00x as the break-even, because the undiscounted formula shows a gain at any multiple above cost. That holds only if the limited partner's cash would otherwise earn nothing. The second mistake is to ignore who decides: the general partner chooses whether to recycle, earns carry on any profit, and, if the fund has not yet cleared its hurdle, may gain from a longer runway to reach it. A limited partner reading the clause should ask for the cap, the window, and whether recycled amounts count towards the threshold for carried interest, because each changes the break-even.
The fund's fee schedule and the recycling gap it leaves are worked in the free Venture Capital workbooks.
Only if the recycled money beats the LP's alternative after carry. In the worked case, $4,000,000 recycled for four years must return 1.45x when the LP could earn 8 per cent elsewhere and the fund pays 20 per cent carry. At 1.20x the fund books a profit and the GP earns $0.16 million of carry, but the LP ends $0.80 million behind.
Because the LP keeps only one minus the carry rate of each dollar of profit. Over four years at 8 per cent, time alone requires 1.36x; carry at 20 per cent adds 0.09 of a turn, taking the break-even to 1.45x. At 30 per cent carry the break-even is 1.51x.
Roughly the LP's alternative rate divided by one minus the carry. At 8 per cent and 20 per cent carry that rule gives 10 per cent; the exact figure is 9.9 per cent over two years, 9.75 per cent over four and 9.5 per cent over seven. The required multiple rises much faster with time, to 1.89x over seven years.
This article is one calculation from Venture Capital. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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