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- 40% Carry?! The Shocking Truth Behind Multi-Layer SPV Fees
40% Carry?! The Shocking Truth Behind Multi-Layer SPV Fees
a newsletter about VC syndicates
Alex Pattis & Zachary Ginsburg
August 21, 2024
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40% Carry?! The Shocking Truth Behind Multi-Layer SPV Fees
There has been a surge in double and triple layer SPVs in Venture Capital. In venture capital, a double layer SPV (Special Purpose Vehicle) refers to a structure where two separate SPVs are used in a tiered arrangement to facilitate investment in a single company.
Here's how it typically works:
The first layer SPV (SPV 1) is created to pool capital from a group of investors. This SPV acts as the primary investment vehicle and invests directly in the target company and is directly on the cap table.
The second layer SPV (SPV 2) is then established, which actually makes the investment in the first layer SPV, creating an intermediary between their investment and the company.
In other words, SPV 2 invests its capital into SPV 1, which in turn invests in the target company.
This double layer structure offers several unique capabilities:
Simplified cap table: From the perspective of the target company, only SPV 1 appears on their cap table, keeping it cleaner and simpler.
Flexibility in investor composition: It allows for different groups of investors to participate at different levels, potentially with varying terms or rights.
Regulatory compliance: It can help navigate regulatory requirements, especially when dealing with international investors or complex legal structures.
Customized terms: It allows for more tailored investment terms for different groups of investors.
Why have we experienced a surge in double and triple layer SPVs?
It’s the only way for many syndicators, VCs and investors to access many of the most in demand startup rounds e.g. xAI, Anthropic, Groq, etc. Most investors couldn’t access xAI directly on cap table, but many investors who could syndicated out part of their allocations, allowing smaller investors (or those that didn’t have access) the opportunity to invest in xAI via a first layer SPV they put together. Some of those investors we’re individuals or institutions investing in the first layer SPV, but many syndicated out part of the first layer SPV’s allocation, creating a second layer SPV in xAI (i.e. the second layer is acquiring interest in the first layer that is acquiring interest in xAI).
It allows first layer SPVs/investors to bypass a company’s secondary approval process, which may be restricting all sales e.g. ABC Ventures is on Company A’s cap table; ABC wants to sell 10% of their position in Company A, but Company A is blocking all secondary transactions, preventing a new investor from buying ABC’s stake. As an alternative, ABC sells the buying SPV as an interest stake, which allows ABC to sell the stake, bypassing the blocking rights of the portfolio company.
Double layer SPVs allow for larger amounts of pooled capital E.g. in a secondary transaction, a seller wants to sell a $10M stake he owns in a business, but can’t find a large enough buyer. A VC, broker or other can put together an SPV to take smaller commitments from a large number of syndicators (e.g. a broker will get $1M commitments from 10 different SPVs to fill the $10M stake it needs to sell).
Unfortunately, double and triple layer SPVs have much larger risks involved that some GPs/LPs may not be aware of. It’s a reason AngelList has actually banned double layer SPVs on their platform as of now. Although there are fund admins like Sydecar that will still support them with certain required documentation.
So what are these risks with double / triple layer SPVs?
Increased Fees:
Each layer of the SPV structure may incur its own set of fees, including management fees, carried interest, and administrative costs. These compounding fees can erode returns, especially in a structure with multiple layers.
For example – the first layer SPV may charge second layer SPVs 10% in management fees and 20% carry. The second layer SPV GP may charge its LPs an additional 20% carry on top of it, meaning the LPs in the second layer SPV are actually paying almost 40% in carry.
Read the fine print around double layer SPVs to make sure you’re not being charged stacked carry and stacked management fees.
Liquidity Constraints:
SPVs often have limited liquidity options, and a double layer structure can exacerbate this issue. Investors may find it challenging to exit their positions or access their capital when needed.
Ultimately when you’re a second layer GP, you are not the manager of the position, the first layer SPV is. So unless you have a side letter or it’s in the contract with the first layer SPV, your rights to sell may actually not be in your hands.
Incorrectly Marketed Terms:
It’s possible that the second layer SPV marketed terms that were incorrect. Because the second layer SPV doesn’t have a relationship with the Company (most often), the second layer GP may have either been given incorrect information or may have had terms that were incorrectly marketed.
As one example - it’s possible the first layer SPV has a term that says if we return up to 3 times the invested capital, we get 20% carry, but if we return more than 3 times the invested capital, our carry increases to 30% on the excess returns. If the second layer SPV GP doesn’t have a lawyer review these contracts to ensure there aren’t terms like this, it’s possible that the second layer LPs (or second layer GPs) have no idea this clause exists and may be paying more in carry than they expect and marketed.
Diluted Control:
Investors in the top-layer SPV may have limited influence over investment decisions made at the lower levels.
This lack of control can be particularly problematic if the underlying investments underperform or if there are disagreements about strategy, such as the note about liquidity constraints.
The company ends up putting together a pay to play round; it is possible the second layer SPV doesn’t have an opportunity to participate because he/she wasn’t notified as they do not have the company relationship.
Reduced Transparency:
Double layer SPVs add an extra layer of complexity, potentially obscuring the underlying investments and making it harder for investors to fully understand and assess their exposure.
Additionally, as the second layer SPV may not have a direct relationship with the company, it is likely that they also will not have any information rights on the business and thus not be given any company updates, making it unclear how the investment is performing.
Difficulty in Due Diligence:
Conducting thorough due diligence becomes more challenging with each additional layer, as investors must assess not only the underlying investments, which becomes already difficult without access to the company, but also the competence and track record of managers at each level. This is extremely difficult to do quite candidly.
Regulatory and Compliance Risks:
Complex SPV structures may face increased scrutiny from regulators, potentially leading to compliance issues or even forced restructuring.
There are other risks involved related to topics we didn’t get into such as tax implications, but these are some of the risks that LPs should be aware of when evaluating double layer SPVs. Given the relatively new nature of double/triple layer SPVs, it is our view that if you choose to participate in these vehicles to only do so with extremely reputable managers.
What’s our view:
Candidly, double and triple layers are some of the most in demand opportunities and the biggest headache and we are all responsible for the rise in this part of the market!
Founders are responsible because they may keep extremely tight cap tables and/or have extremely strict blocking rights for secondary transactions leading for the need for 2nd layer vehicles
First layer VCs are responsible because they are acquiring stakes much larger than their core fund positions with often the sole purpose of putting together SPVs that they are charging 2 and 20 for.
2nd layer SPV GPs are responsible because they are desperate for these allocations and have no choice but to participate in second layers for access
LPs in second layers are responsible because ultimately they are demanding these allocations and are willing to accept whatever terms they can get to participate in these deals
On the one hand, I really want this to stop because it's a mess, but at the same time, incredible opportunities are available because of dual layer structures.
The only way this gets lessened is if founders decide to open up their cap table and/or remove blocking rights on secondary transactions. Without this very intentional change by them (which I don’t expect), the double layer SPV ecosystem will continue to grow. Another alternative is that it actually pays to go public earlier - if we can get better regulation and structure that makes being public more attractive than being private, a lot of these late rounds that are responsible for the dual layer structures may go away as access is now accessible to everyone.
If you enjoyed this article, feel free to view our other posts on investing strategies and rights:
Last Money in is Powered by Sydecar
Sydecar empowers syndicate leads to manage their investments more effectively. Organize, manage, and engage your investor network effortlessly with Sydecar’s management and communication tools. Their platform also automates banking, compliance, contracts, tax, and reporting, freeing up syndicate leads to focus on securing deals and strengthening investor relations. Elevate your syndicate operations with Sydecar.
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