When PE funds give comp figures to VP+ hires, they talk about the value of the carry assuming the fund has a gross MOIC of 2x, but it appears to me that you actually need more than a 2x on your deals on average to achieve the headline dollar figure - because of management fees (and other expenses charged to the fund).

To that end, can someone confirm how management fees feed into the carried interest calculation?

For example, let's say I have a \$1bn fund, with an American waterfall, 20% carry, 8% preferred return, 2% management fee for the first five years, and let's say a management fee that's equal to 1% of commitments over the last five years.

I believe the 8% preferred return is before management fees and other expenses, so the hurdle rate on your gross investment returns is actually above 8% (I have been told it comes out to being a low teens hurdle after fees but I don't understand the math).

But let's assume you're above the hurdle rate and let's say, with the numbers above, management fees are \$150 million (2% x 1000 x 5+1% x 1000 x 5).

That \$150 million is not incremental to the \$1bn, so really you have \$850 million to invest in the first place.

So which of the following is the actual way carried interest is calculated (assuming you're employed for the entire fund life, no penalties for leaving, etc)?

1. If you get a 2x on actual invested capital, it's \$850 million of gains --> times 20% means \$170 million of carried interest.
2. If you get 2x on the \$1bn fund, that's \$1billion of gains --> minus 150 million of management fees gets you to \$850 million of net gains. --> times 20% means \$170 million of carried interest
3. If you get 2x on the \$1bn fund, that's \$1billion of gains --> you don't net out management fees  --> \$1 billion times 20% means 200 million of carried interest

Number 2, although number 1 can be used when PE firms are showing deal by deal returns (obviously can be misleading). BTW the math winds up with the same result at 2x but breaks down at other returns e.g. 3x

CHItizen

Number 2, although number 1 can be used when PE firms are showing deal by deal returns (obviously can be misleading). BTW the math winds up with the same result at 2x but breaks down at other returns e.g. 3x

Thanks. If that's the case, what percentage of the fund actually gets invested typically vs going to management fees? Let's say it's 2% management fee for the first five years (or until next fund is raised), and 2% on investment cost for another 5 years (so declining in the last five years as assets are sold), I'd guess that means 85% of the fund size is invested.

If Option 2 from my post is the answer, then doesn't that mean you need 2.15x gross MOIC on average for deals to get to the carry figures PE firms give as headline numbers to candidates? ((1150-150)*20%)/1000 = 20%

The convention PE firms give when recruiting and quoting DAW to candidates is something along the lines of "The fund is \$1 billion, if we get a 2.0x, the carry pool is \$200 million (20%*\$1 billion gain). I'll give you 2% of the pool, which is \$4 million and we'll vest it according to xyz schedule."

But if my #2 example above is true, then actually, a \$1 billion fund would actually have only \$140 million of carry (14% rather than 20%) if the deals (before fees) returned a 2x Gross MOIC:

\$1bn fund minus \$150mm of management fees = \$850 million of investable capital. If you double \$850 million of invested capital, that's a 2x gross MOIC on those deals, and there is an \$850 million gain. If the #2 example I gave is correct, then you're saying I have to subtract \$150mm from the \$850 million gain, and then multiply by 20%? It feels like my example 2 would effectively be doubling the impact of the management fees, no? That would mean ((850-150)*20%) = \$140 million, which would indicate 14% is a more honest figure to quote recruits rather than 20% if we're talking a 2.0x gross MOIC. I think example 1 seems to make the most sense to me because it would avoid this double counting - are you sure it's example #2?

Someone please explain to me if I'm wrong here and, if so, where.

Fund docs usually allow for recycling of management fee. This means distributions can be recalled/re-invested up to the amount of the management fee. So the full \$1bn fund is invested in assets.

Gotcha - that makes sense. So let's say you have a \$1 billion fund, you've deployed \$920 million and you've received \$80 million of management fees, there's no room for additional capital calls. But if they monetized investments for at least \$80 million of distributions , you would have room to recycle that cash into a new deal, deeming it recycled mgmt fees

Is that right? I imagine there's a governor at least that you've distributed the amount your recycling so you don't draw more than the fund size

Yes that's right. A typical way the recycling is capped is 110% of commitments.

Whether the recycled funds are used for new deals or follow on in existing deal will come down to the LPA.

You are correct. It's net return to LPs (so net of management fees). So #2 in your example.

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