Accel Partners VII – VCPE Case Report
Case: Accel Partners VII
Date: Jan. 25, 2022
Managing Partner: Helen Hsu
Partners: Jaden Faunce, Radha Panchap, Isshaa Tusnial
Executive Summary
Regarding Accel’s proposal to raise their carried interest from the industry standard of 20% to 30% for their seventh fund Accel Partners VII, Angel Foundation, the limited partner of Accel’s previous funds, was in the position to decide whether they could justify continuing the investment in the new Accel fund. Considering the incentives that carried interest can bring and Accel’s spectacular past performance, we believe that Accel had a higher chance of outperforming a typical venture capital fund and thus would justify their increase in the carried interest rate.
Background Information
Accel Partners was a successful private equity partnership that had demonstrated superior performance with the net returns to limited partners of over 100% in Accel’s previous two funds– Accel IV and Accel V. Their focus on communications and internet/intranet and recruitment of team members in line management and venture development allowed them to create a shared culture of excellence and achieve a high proportion of successful ventures. Given Accel’s consistent outperformance over typical venture capital funds, investors may hypothesize future success since a venture capital’s past success can bring talented partners and executives to the new venture. With better management, Accel can grow the new venture more efficiently and thus can create more value to return to the investors. To continue retaining and attracting new talents, Accel required higher compensation; this can be achieved by increasing management fees, carried interest, or the size of the fund. Increasing the management fee would notably be expensive. Furthermore, increasing the size of the fund results in diluted returns, while increasing carry is less costly than increasing the management fee, and the compensation structure can lead to increased incentive alignment between Accel and their LPs. In this case, Accel proposed to raise the carried interest from the industry standard of 20% to 30% for its seventh fund Accel VII, which aimed to raise $500 million with a management fee of 2.5%.
Key Assumptions of the Limited Partner Agreements
In private equity partnerships (PEPs), there are general partners (GPs), who manage the fund investments, and limited partners (LPs), who commit capital to the fund but have no power over investment decisions. The GPs are compensated through a management fee that they charge the LPs and a carried interest, or the profit share of the fund. All the investment terms, including the compensation to the GPs and the equity interest, should be presented in the limited partner agreements. To proceed with our calculation and analysis of whether and how Accel could justify a more significant carry, we make some critical assumptions of the limited partner agreements listed below.
Analysis
With the above assumptions of the limited partner agreements, we developed a model to calculate the NPV for the GPs, NPV for the LPs, and the internal rate of return (IRR). Since IRR is one of the key metrics that measure investment performance, investors always look for investments with higher IRR. However, as shown in our sensitivity analysis (Exhibit 1), the increase in carried interest would decrease IRR for the LPs. Therefore, to justify their increase in carried interest, Accel needs to achieve the excess gross return in addition to the average growth rate so that the IRR for the LPs would be at least the same as that of a typical VC fund. For example, in the base case with a growth rate of 25% and a carry of 20%, the IRR for the LPs is 19.25%. If Accel raises carry to 30%, the IRR will decrease to 17.94%. To attain an IRR of 19.25% under the 30% carry, Accel would need to achieve a growth rate of 26.4%, which requires an excess growth rate of 1.4%.
From the different scenarios with different growth rates we tried in the sensitivity analysis (Exhibit 1), we found out that the higher the growth rate, the more excess growth rate Accel needs to achieve to meet the expected IRR. The excess growth rate is a relatively small percentage due to compounding interest – the dollar amount accumulates significantly over time; therefore, Accel is likely to achieve their expected IRR even with such a small excess growth rate. Furthermore, as the GPs work harder to achieve higher IRR for the LPs, the GPs would also earn a higher carried interest and thus benefit from a higher NPV of their compensations. The higher NPV of GPs’ compensations would further incentivize GPs to make better investment decisions that lead to higher returns for both LPs and GPs.
Recommendation and Conclusion
Considering the results of our analysis, we recommend Angel Foundation to continue investing in Accel VII even with a higher carried interest of 30% for three reasons. First, the required excess gross return for the increased carry seems accomplishable for Accel, given its past success in outperforming typical VC funds over a long period. Due to its previous success, Accel’s reputation can help them attract and retain new talents contributing to Accel’s future outperformance. Furthermore, the carried interest can efficiently incentivize the GPs to perform better since part of their compensation comes from the profit share of the fund. Therefore, they would work harder to manage the fund to increase their compensation NPV. Additionally, even if the GPs fail to achieve the desired excess gross return, the IRR wouldn’t decrease significantly since the GPs wouldn’t get the carry until the LPs are paid back with their committed capital. In other words, the cost of carried interest is negligible if GPs fail to grow the fund. Overall, the plausibility of achieving better gross return, the incentives of increasing carried interest, and the low cost of carry suggest that Accel VII is a good investment even with a higher carried interest.