Gross versus net returns and fee drag

Key takeaways

• Gross returns are measured on the cash flows between the fund and its portfolio investments; net returns are measured on the cash flows between the LPs and the fund.
• Three layers separate them: management fees and fund expenses enlarge paid-in capital without adding value, and carried interest reduces what LPs receive.
• In the base case of this topic, a 2.2x gross MOIC and 17.1% gross IRR become a 1.75x net TVPI and a 12.4% net IRR.
• Fees and expenses are fixed in dollars, so they consume a larger share of the gain as gross performance falls; in the 1.4x case they take 34.1% of the gross gain, against 11.4% in the 2.2x case.
• Carry falls away when a fund misses its hurdle, but the fixed fee drag remains, so the proportional gap between gross and net IRR is largest for weak funds.
• Gross track records are useful for judging deal selection but must never be compared with net benchmarks or with another manager's net figures.

Two returns, two sets of cash flows

Gross returns are computed from the fund's investment cash flows: the dates and amounts the fund paid to acquire or fund each portfolio investment, and the dates and amounts it received back, plus the current value of anything still held. Gross IRR is the IRR of that series. Gross MOIC is total value divided by invested capital. Gross returns can be computed for a single deal, for a group of deals, or for a whole fund's portfolio. They are the right tool for assessing how well a manager selects and manages investments.

Net returns are computed from the LPs' cash flows: every capital contribution the LPs made, for any purpose, and every distribution they received after carried interest, plus the LPs' residual NAV net of accrued carry. Net IRR is the IRR of that series and net TVPI is total value to paid-in. Net returns are the right tool for assessing what an LP actually earned, and they are the basis of most fund benchmarks.

Terminology varies slightly. Some GPs quote a 'gross fund IRR' that includes fund-level cash and expenses but excludes fees and carry. Some quote 'net' returns for a hypothetical LP paying full fees, which will differ from the return an early-close LP with a fee discount actually received. The definitions page of any track record deserves a close reading.

The layers between gross and net

Management fees are the largest fixed cost. They are usually a percentage of commitments during the investment period and of invested capital afterward, and they are paid regardless of performance. Many LPAs require that a share of transaction, monitoring or director fees the GP charges to portfolio companies be offset against the management fee, which reduces the drag.

Fund expenses are the costs the LPA allows the GP to charge to the fund rather than paying from its fee: organizational costs, legal, audit, fund administration, certain deal costs for transactions that did not close, and similar items. They vary widely by fund and deserve scrutiny, because every dollar charged to the fund is a dollar the LPs pay.

Carried interest is the GP's share of profits, typically 20 percent in buyout funds, paid only after the LPs have received their contributions back and, where there is one, a preferred return (hurdle). With a catch-up, the GP then receives a larger share of the next distributions until its cumulative take equals 20 percent of all profits. Other items can widen the gap in particular funds: subscription line interest (covered in the next topic), taxes on blocker structures, and currency effects for an LP whose base currency differs from the fund's.

The model: Fund C

Fund C is a hypothetical $100m fund with a five-year life, simplified so that every cash flow is visible. All flows occur on anniversaries (year 0 to year 5), so the IRRs are periodic annual IRRs. The fund invests its whole portfolio at the start and exits everything at the end, which removes the complications of staggered deals and lets the fee and carry layers stand out.

Management fees are 2 percent of the $100m commitment per year for five years, paid at the start of each year (years 0 to 4). Fund expenses are $0.4m per year on the same dates. Everything else in the $100m commitment, $88m, is invested in portfolio companies at year 0. So LPs contribute $90.4m at year 0 (88 invested, 2.0 fee, 0.4 expenses) and $2.4m in each of years 1 to 4, a total of $100m paid-in.

At year 5 the portfolio is sold for 2.2 times its cost. Proceeds are distributed through a whole-fund waterfall: return of all contributions, then an 8 percent preferred return compounding annually on each contribution from its date, then a 100 percent GP catch-up until the GP has 20 percent of total profits, then an 80/20 split.

Gross returns of Fund C

Gross returns look only at the $88m invested and the $193.6m received. Fees and expenses do not appear, because they were never paid to the portfolio. Carry does not appear, because it is paid out of proceeds after the portfolio has been sold.

Running the waterfall

The waterfall determines how the $193.6m is split. The first tier returns the LPs' $100m of contributions. The second pays the 8 percent preferred return on each contribution for the time it was outstanding. The third gives the GP 100 percent of distributions until it has caught up. The fourth splits the rest 80/20.

The pref is computed contribution by contribution, because each was outstanding for a different length of time. The $90.4m paid at year 0 accrues for five years; the $2.4m paid at year 4 accrues for one.

The bridge from gross to net

With the waterfall done, the net returns follow. Net TVPI is $174.88m over $100m paid-in. Net IRR is the IRR of the LP series: -90.4 at year 0, -2.4 in each of years 1 to 4, and +174.88 at year 5. To attribute the gap, add one layer at a time and recompute the IRR each time: first fees only (as if expenses were zero and no carry was paid), then fees and expenses, then carry.

The order of attribution is a choice. Adding carry first and fees second would assign slightly different amounts to each layer, because the layers interact. The total gap, from gross to net, does not depend on the order. When a manager or consultant presents an attribution, ask what order was used.

Why weaker funds lose a larger share

Now run Fund C again with lower gross performance and identical terms. The fees and expenses are unchanged in dollars, $12m in total, because they depend on commitments, not on results. The carry, by contrast, depends on profit and on clearing the hurdle. So as gross performance falls, carry shrinks and eventually disappears, while fees stay put and become a larger share of a smaller gain.

At 1.4x gross, proceeds are $123.2m. To clear the hurdle, LPs must first receive their $100m plus the $44.507m pref, a total of $144.507m. Proceeds fall $21.3m short of that, so the GP earns no carry and the LPs receive all $123.2m. Net TVPI is 1.23x. The net IRR is 4.5 percent against a gross IRR of 7.0 percent.

In percentage points the gap is smaller than in the base case (2.5 points against 4.7), because no carry is paid. In proportion it is larger: the LPs keep 64.2 percent of the gross IRR rather than 72.4 percent, and 65.9 percent of the gross dollar gain rather than 70.9 percent. At 1.0x gross, with the portfolio merely returning its cost, the LPs lose money on a net basis because the fees and expenses are gone.

What to ask for

A manager's gross track record is valuable diligence material: it shows deal-level skill, and it can be analyzed by sector, deal size and vintage in ways a net fund return cannot. But it has to be translated into an expected net return using the terms of the fund actually being offered, and the translation depends on the level of performance, as the table above shows.

Ask for the net fund-level cash flows for every prior fund, not only summary figures, so the IRRs and multiples can be recomputed. Ask for the gross-to-net bridge by fund, with the attribution order stated. Ask how fees were offset, what expenses were charged to the fund, and whether net figures reflect the full fee rate or a blended rate across LPs with different terms. The ILPA Reporting Template provides a standard format for fee, expense and carried interest disclosure that makes these comparisons easier.