The policy usually says 'fairly'. The fair amount is a calculation, and the gap between policy and practice shows up in the dead-deal log.
Allocate broken-deal expenses in proportion to who would have owned the deal had it closed. If co-investors take 30 per cent of the equity in completed deals and the fund spends 3.0m a year on deals that die, co-investors' fair share is 0.9m a year. A policy that charges all of it to the fund makes the fund's limited partners pay 4.5m of the co-investors' search costs over a five-year investment period.
Worked in full in Operational Due Diligence in Private Equity by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Broken-deal expenses are the legal, diligence and financing costs of transactions that do not complete. They are charged to the fund under most limited partnership agreements. The question operational due diligence asks is narrower: when the manager also runs co-investment alongside the fund, who pays for the deals that would have been co-invested had they closed? The answer is a calculation, and the gap between the policy and the practice is usually visible in the numbers.
| Input | Value |
|---|---|
| Fund commitments | 1,000.0m |
| Broken-deal costs per year | 3.0m |
| Investment period | 5 years |
| Co-investors' share of equity in closed deals | 30% |
| Fund's share of equity in closed deals | 70% |
| Broken costs on deals where co-investment was planned | 2.0m a year |
| Planned co-investment share on those deals | 40% |
There are two defensible methods. Both start from the same principle: a cost incurred pursuing a deal belongs to whoever would have owned the deal.
Method 1, programme share: co-investors' share = broken costs × co-investors' share of closed-deal equity
Method 2, deal by deal: co-investors' share = broken costs on deals with a planned co-investment × the planned share
In Excel, method 2 is a =SUMPRODUCT(C2:C25,D2:D25) over the dead-deal log, cost in
column C and planned co-investment share in column D.
Method 2 is more precise and needs the manager to record the planned syndication on each deal before it dies, which is itself a useful control. Method 1 is a reasonable proxy where that record does not exist. Either is defensible. What is not defensible is zero.
| Policy | Fund pays over 5 years | Co-investors pay | Fund overpays |
|---|---|---|---|
| All broken costs to the fund | 15.0 | 0.0 | 4.5 |
| Method 1, programme share | 10.5 | 4.5 | 0.0 |
| Method 2, deal by deal | 11.0 | 4.0 | 0.0 |
The 4.5m is 45 basis points of commitments. Spread across the fund it looks modest. For a limited partner holding 5 per cent of the fund it is a cost of 0.75m in broken deals, of which 0.225m paid for deals other investors would have owned. That is a transfer from the fund's investors to the co-investors, and often the co-investors include the largest limited partners, the ones best placed to negotiate.
The sharpest version of the problem is the manager's own vehicle. If partners and employees co-invest through a vehicle taking 5 per cent of each deal and that vehicle bears no broken costs, the fund's investors pay 0.15m a year, 0.75m over the period, of the general partner's own search costs. That is a conflict of interest, not a rounding difference, and it is the line an operational due diligence analyst should ask about by name.
| Broken costs a year | 10% co-invest | 20% co-invest | 30% co-invest | 40% co-invest |
|---|---|---|---|---|
| 1.5m | 0.75 | 1.50 | 2.25 | 3.00 |
| 3.0m | 1.50 | 3.00 | 4.50 | 6.00 |
| 4.5m | 2.25 | 4.50 | 6.75 | 9.00 |
The overpayment grows with both inputs and is largest at managers with an active co-investment programme and a busy, competitive deal flow: exactly the managers whose fundraising leans on co-investment access as a selling point.
When a manager does allocate broken costs to co-investors, the common error is the ratio. The co-investors' share of a deal is their equity over total equity, 30 per cent here. Some allocation spreadsheets divide co-investment equity by fund equity instead, 30 ÷ 70, which gives 42.9 per cent and charges co-investors 1.29m a year, or 6.4m over the period. The error runs the other way, but it is the same failure: an allocation key nobody tested against its own definition.
The second mistake is in the review rather than the manager. An analyst who reads a policy saying broken-deal expenses are "allocated fairly among the fund and co-investment vehicles" and stops there has tested nothing. The test is the practice: take the dead-deal log for a year, note which deals had a planned co-investment, and trace where each invoice was booked. Twelve dead deals is usually enough to see whether the policy is applied.
The free workbook for this book at the companion page works this case among three the book's chapters name. For how many expense allocations a review needs to test before it can conclude, see how many expense allocations to test, and for how the rating of findings like this one should work, why refining an ODD rubric makes it weaker.
They should bear their share, though many arrangements leave it with the fund. A fair allocation multiplies broken costs by co-investors' share of equity in completed deals. With 3.0m of dead-deal costs a year and co-investors taking 30 per cent, that is 0.9m a year; leaving it all with the fund costs its limited partners 4.5m over five years.
Divide co-investment equity by total equity in the deal, not by the fund's equity. With 30 per cent co-investment and 70 per cent from the fund, the share is 30 per cent. Dividing 30 by 70 gives 42.9 per cent and, on 3.0m of broken costs a year, overcharges co-investors to 1.29m a year.
The practice, not the policy wording. Take a year of the dead-deal log, mark which deals had a planned co-investment and trace where each invoice was booked. Ask specifically whether the general partner's own co-investment vehicle bears costs: at a 5 per cent share it would otherwise shift 0.15m a year to the fund's investors.
The companion files of Operational Due Diligence in Private Equity work this case from chapters 5 and 9. 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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