Are Indian VC Funds Moving Beyond The ‘2 And 20’ Fee Model?

More and more venture capital funds (VC funds) in India are moving beyond the tried-and-tested fee models and exploring structures that better suit the Indian context.

The traditional ‘2 and 20’ fee structure — shorthand for the 2% management fee on the corpus and 20% performance fee on profits over a hurdle rate—has dictated how VCs run globally.

However, as the tech startup landscape evolves in India, this model is increasingly being viewed as outdated and misaligned with investor expectations.

Celebrated valuation expert Aswath Damodaran, professor at NYU’s Stern School of Business, explained to Inc42, “There isn’t a single fund manager in the world worth paying 2 and 20—or even 1 and 25—because no active investing approach can consistently deliver returns that justify such high fees. While some fund managers may have winning streaks, the idea that past performance predicts future returns is a fallacy.”

Echoing this sentiment, an ultra-high-net-worth individual (HNI) and a limited partner (LP) in a VC fund added that some fund managers have profited personally, even as their funds have performed poorly, through means like high-water mark clauses, side pockets, and insider trading.

To be clear, most LPs will not publicly talk about these aspects — the venture capital world is all about long-term relationships. But lately there’s a growing call for a review of the fee structure at the very least.

And with more and more Indian VC funds looking to raise from domestic LPs, fund managers often have to give in to these demands.

With the Indian startup ecosystem attracting over $150 Bn in investments in the decade since 2014—and once marquee startups like BYJU’s and Dunzo losing billions in value—it’s high time to rethink the fee structures of fund managers to ensure efficiency and accountability in investment strategies.

Indian VCs In Correction Mode

The year 2023 has served as a wake-up call for Indian VCs. Companies such as BYJU’s and others struggled to justify their valuations and there were a number of corporate governance red flags in large funded startups.

The pooled internal rate of return (PIRR) for Category I AIFs fell to -16.1%, according to CRISIL’s AIF Benchmark Report. The PIRR is a means to understand the returns from a number of concurrent portfolios and fund schemes.

This trend was not isolated to India though. The US also experienced a decline in venture capital activity. According to the National Venture Capital Association, fund managers in the US completed 18% fewer deals in 2023 compared to 2022.

This is largely described as the funding winter, the effects of which still linger.

In India, the compounded annual growth rate (CAGR) of VC funding between 2020 and 2023 was -6% for early-stage investments, +13% for growth stage, and -15% for late-stage funding, as per Inc42’s 2024 Startup Ecosystem Report.

Although there’s been a recovery in 2024, M&A deals remain down, and exits continue to pose a challenge, with the exception of IPOs, which not every company can aspire to.

Despite offering better internal rates of return (IRR) compared to the US in recent years, only a small percentage of these returns—around 15-20%—are actually distributed to investors as DPI (distributions to paid-in capital) after deducting fees.

And therein lies the rub, the majority of the returns remain unrealised for the funds and its LPs, but is reflected in RVPI or residual value to paid-in capital. The RVPI makes up the bulk of the ‘total value to paid-in capital’ which is a key metric to assess fund performance.

This RVPI may or may not eventually convert into returns that land in the hands of a fund’s investors, but the management fee will nevertheless be charged on this amount.

Why The “2 And 20” Fee Model Is Under Scrutiny

As India’s family funds have grown exponentially in recent years, many HNIs and ultra HNIs are reluctant to invest through traditional VC funds due to the high 2% management fee.

Anirudh A Damani, managing partner of Artha Venture Fund, noted, “The traditional ‘2 and 20’ fee model doesn’t fit the Indian context. Indian investors are more concerned with the 2% management fee than the 20% performance fee. In a market where index returns like the NIFTY or BSE Sensex can offer upwards of 15%, fee structures need to adapt.”

Damani further explained that the 2% fee made sense when funds were smaller, around $100 Mn in corpus. However, with fund sizes now exceeding $1 Bn and lasting up to 15 years, management fees have surged. Over time, these fees can eat up 37%-38% of the capital, leaving less than 60% for actual investments. To meet investor expectations of a 5x return, funds would need to generate 9x or more on their invested capital—an increasingly difficult feat.

Globally, there’s growing concern that the “2 and 20” model disproportionately benefits fund managers while leaving LPs with limited returns. Investors are now pushing to change this model.

Localising Indian VC Funds Fee Models 

The key aspects of the Indian startup market—such as risk dynamics, compliance costs, success rates, and exit timelines—differ significantly from those of the U.S. market.

Chirag Shah, president of fundraising & strategy at alternative debt investor BlackSoil, emphasised that fees should be adjusted based on the investment stage. Early stage funds, which face higher risks, should have lower management fees but higher performance fees to incentivise fund managers.

In contrast, growth and late stage, which are considered more stable, justify higher management fees due to their larger corpus needs. However, in this case, fund managers typically have an established track record, so perhaps performance fees can be reduced.

This tailored approach is best suited to align risk, reward, and investor expectation in a still-maturing market like India.

Moreover, sector-specific funds, particularly in areas like deeptech, hardware, and fintech, could potentially adopt differentiated management fee structures to account for unique challenges. These sectors often have longer development cycles, high capital intensity, and regulatory complexities, which delay returns.

Higher management fees can cover the extended timelines and specialised expertise required, while performance fees should reward long-term value creation.

A flexible fee structure ensures that fund manager incentives are aligned with sector-specific risks and expectations, promoting sustainable performance over time, Shah added.

Sanjay Swamy, partner at Bengaluru-based Prime Venture Partners, highlighted that general partners should look at fees as a means of running their businesses efficiently and compliantly.

Fees are necessary to cover team expenses, portfolio support, travel, and minimal marketing costs. He also pointed out that compliance costs in India are particularly high. As fund sizes grow—especially beyond $250 Mn—there may be room for optimisation, but most LPs (limited partners) understand that maximising returns is the ultimate goal.

“For instance, you don’t want a constrained travel budget to result in missing out on a deal or cutting corners on due diligence by not visiting a field office,” Swamy added.

He emphasised that the potential cost of missing an opportunity or overlooking compliance is far higher than any savings from cutting expenses in these areas, which is why more experienced and knowledgeable LPs prioritise diligence over cost-cutting.

Emerging Trends In Fund Management Fees

Most of the biggest VC funds in India including Peak XV Partners (earlier Sequoia), Lightspeed, Z47 (formerly Matrix), Accel India, Stellaris, Nexus and others are said to follow the tried and tested fee structure of ‘2 and 20’. However, in the last few years, some Indian funds have experimented with the lower management fee. .

For example, Artha Venture Fund has implemented a 1% management fee and a 10% hurdle rate for its seed and growth funds, Damani said. Additionally, the firm shares 50% of the carry with its team members to incentivise performance.

This includes not just the investment team but also those in operations, HR, fundraising, investor relations, legal, compliance, accounts, and finance—essentially anyone above the associate level

Artha Venture Fund has implemented a 1% management fee for its seed funds and less than 1% for its growth or winner funds. Additionally, it has set a hard hurdle rate of 10%, ensuring that investors receive the first 10% of returns before the fund participates in the profits, the managing partner added.

One unique feature of Artha Venture Fund’s model is that fees are applied to the net drawdown rather than the full committed capital, which is more common in other funds.

Blacksoil’s Shah pointed out that a “1 and 25” fee structure might be better suited to the Indian startup ecosystem as it encourages fund managers to prioritise performance over fixed income.

In particular, debt-based funds may benefit from a higher management fee and lower performance fee since their structure and risk profile differ from equity-based startups.

The Call For A Fair Fee Structure

But valuation guru Damodaran feels the traditional as well as the ‘1 and 25’ fee structures are flawed. The latter claims to only take 25% of the winnings, it doesn’t account for the potential losses during downturns. Almost all funds will have more losers than winners in their portfolio.

Instead, Damodaran says a balanced approach is warranted. “If investors gain a share of the profits, they should also bear a portion of the losses when the fund underperforms.”

He also proposed a more equitable active investing fee structure, which reflects the costs of active management without disproportionately benefiting fund managers. His argument is that this would result in lower compensation for fund managers, but would better align with the limited value they provide in certain market conditions.

The best LPs are those that understand the importance of the end destination and not necessarily the journey. And when fund structures are aligned to maximise returns for LPs, this also maximises carried interest for GPs, creating something of a win-win.

Edited by Nikhil Subramaniam

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