A real estate fund interest bought below its hurdle, run through the whole-fund waterfall it inherits: three zones, and a bid model that gets the carry wrong both ways.
A secondary buyer steps into the seller's place in the waterfall, so it inherits the seller's hurdle balance and any catch-up still owed, not a flat 20 per cent of its own gain. On an illustrative real estate fund interest bought at €30.60m, 85 per cent of a €36.0m NAV, the first €13.38m of value growth is carry-free, because the interest sits below its 8 per cent hurdle. Between 11.11 and 14.98 per cent a year of asset growth, the buyer keeps nothing extra: the GP's catch-up takes every euro.
Worked in full in The Real Estate Secondaries Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Most bid models apply the carry as a haircut on the buyer's projected gain. That is wrong in both directions. Below the hurdle it overstates the carry and makes the bid too low; inside the catch-up zone it understates it, because the GP is being caught up on preferred return that accrued during the seller's years of ownership.
| Input | Value |
|---|---|
| Capital contributed by the seller to date | €40.0m |
| Distributions received by the seller to date | €12.0m |
| Hurdle balance today (contributions at 8%, less distributions) | €39.2m |
| Reported NAV of the interest (no carry accrued) | €36.0m |
| Preferred return, compounding | 8.0% |
| Carried interest, with 100% GP catch-up | 20.0% |
| Price paid | 85.0% of NAV = €30.60m |
| Remaining life, all value realised at the end | 3 years |
| Base case growth in gross asset value of the interest | 7.0% a year |
The hurdle balance is the number to ask for. A capital account statement shows NAV; the hurdle balance comes from the contribution and distribution history compounded at the preferred rate. Here it is €39.2m against a NAV of €36.0m, which is why the GP accrues no carry today.
Step 1: roll the hurdle forward to exit. The buyer must receive this amount before the GP takes anything.
Hurdle at exit = 39.2 × 1.083 = 39.2 × 1.2597 = €49.38m
Step 2: measure the preferred return earned over the fund's life. It is everything the LP position receives, before and after the sale, less what it contributed: 12.0 + 49.38 − 40.0 = €21.38m. Of that, €11.20m had accrued before the buyer arrived.
Step 3: size the catch-up. With a full catch-up the GP takes 100 per cent until it holds 20 per cent of all profit distributed above capital.
Catch-up = pref × carry / (1 − carry) = 21.38 × 0.20 / 0.80 = €5.35m
Catch-up ends at 49.38 + 5.35 = €54.73m
In Excel, with V the gross value of the interest at exit: =IF(V<=Hurdle,V,IF(V<=Hurdle+CatchUp,Hurdle,Hurdle+(V-Hurdle-CatchUp)*0.8)) gives what the buyer receives.
Step 4: read the three zones. Up to €49.38m of gross value, the buyer keeps 100 per cent. From €49.38m to €54.73m it keeps nothing. Above €54.73m it keeps 80 per cent. Measured from today's NAV of €36.0m, the first zone is €13.38m of growth, 37.2 per cent of NAV, and the asset growth needed to fill it is 11.11 per cent a year. The catch-up zone runs to 14.98 per cent a year.
In the base case the interest grows at 7.0 per cent a year to €44.10m, still below the hurdle. The buyer receives all of it: 1.44 times its €30.60m, an IRR of 13.0 per cent. The naive model, which hands 20 per cent of the gain over NAV to the GP, shows €42.48m and 11.6 per cent. It has invented €1.62m of carry the GP will never be paid.
Priced to a 15 per cent IRR, the correct waterfall supports a bid of €29.00m, or 80.5 per cent of NAV. The naive model stops at €27.93m, 77.6 per cent. That is about three points of NAV given up to an assumption about carry, enough to lose a competitive process.
| Asset growth a year | Gross value | GP carry | Buyer receives | Buyer IRR | Naive IRR |
|---|---|---|---|---|---|
| 4% | 40.50 | 0.00 | 40.50 | 9.8% | 9.0% |
| 7% | 44.10 | 0.00 | 44.10 | 13.0% | 11.6% |
| 10% | 47.92 | 0.00 | 47.92 | 16.1% | 14.2% |
| 12% | 50.58 | 1.20 | 49.38 | 17.3% | 15.9% |
| 14% | 53.34 | 3.95 | 49.38 | 17.3% | 17.7% |
| 16% | 56.19 | 5.64 | 50.55 | 18.2% | 19.5% |
| 18% | 59.15 | 6.23 | 52.92 | 20.0% | 21.2% |
The flat line at 12 and 14 per cent is the catch-up. Going from 7 to 14 per cent growth adds €9.23m of gross value and only €5.28m to the buyer: it keeps 57.2 per cent of the upside, not 80. At 16 per cent the GP takes 22.0 per cent of the buyer's gross gain over its price, more than the headline 20, because part of the catch-up is paying for the €11.20m of preferred return accrued before the sale. That slice alone is worth €2.80m of catch-up.
The shape, not the level, is the lesson: below the hurdle the interest is a carry-free asset; inside the catch-up it is a capped one. Where your base case sits decides which of the two you are buying.
The mechanics of the catch-up are set out in how the GP catch-up is actually solved, and the other deductions between headline discount and real discount in what an 18 per cent discount actually buys.
Ask for the hurdle balance, roll it to exit, size the catch-up, and run the buyer's receipts through the three zones. On this interest the first €13.38m of growth is free of carry and the next €5.35m belongs entirely to the GP. The free workbooks for this book include one that converts a continuation vehicle's fee and carried interest into the points of annual return a rolling investor gives up.
Indirectly, yes. The waterfall runs on the original contributions and distributions, so a catch-up pays the GP for preferred return accrued in the seller's years. In the illustrative case €11.20m of the €21.38m preferred return accrued before the sale, and €2.80m of the €5.35m catch-up is attributable to it, paid out of the buyer's proceeds.
Usually net of carry accrued on a hypothetical liquidation at the reporting date, and no more. If the interest is below its hurdle, as here at €36.0m against a €39.2m hurdle balance, accrued carry is zero, and the catch-up of up to €5.35m only appears as values rise. A buyer has to model it, not read it.
Because the growth up to the hurdle is free of carry. On the illustrative interest the hurdle at exit is €49.38m, so value can rise from €36.0m by €13.38m, or 11.11 per cent a year for three years, before the GP takes anything. The buyer keeps 100 per cent of that growth, against 80 per cent after the catch-up.
This article is one calculation from The Real Estate Secondaries Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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