The financial highlights note prints an expense ratio, and the number depends on three choices the note rarely states: which costs, which offsets and which denominator.
Divide the fund's costs for the year by its average net assets, then state which costs you counted. On an illustrative fund with average net assets of 250,000, the net management fee and fund expenses give 1.72 per cent, subscription facility interest takes it to 2.00 per cent, and the carried interest accrual to 4.08 per cent. The last figure is the one that reconciles a 12.00 per cent gross return to a 7.92 per cent net return.
Worked in full in How to Read a Private Fund's Financial Statements by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Most private fund financial statements include a financial highlights note with an expense ratio, and investors compare those ratios between funds as if they meant the same thing. They rarely do. The ratio depends on whether the fee is gross or net of offsets, whether interest on the fund's borrowing is in it, whether the carry accrual is in it, and on what it is divided by. All four can be checked from the statement of operations and the statement of changes in net assets.
| Line | Amount |
|---|---|
| Management fee, gross | 4,000 |
| Less fee offsets (transaction and monitoring fees) | −600 |
| Management fee, net | 3,400 |
| Fund expenses: administration, audit, legal | 900 |
| Interest on the subscription facility | 700 |
| Change in accrued carried interest | 5,200 |
| Net assets, opening / closing | 240,000 / 260,000 |
| Commitments | 300,000 |
| Paid-in capital to date | 270,000 |
| Income and gains on investments before costs | 30,000 |
Expense ratio = costs for the year ÷ average net assets
Average net assets = (opening + closing) ÷ 2, or the average of the quarter-end balances where the note gives them
In Excel, build it in layers so that each cost has its own row: =SUM(Fee_net,Expenses)/AVERAGE(NAV_open,NAV_close), then add interest, then carry, each as a cumulative row.
Average net assets are (240,000 + 260,000) ÷ 2 = 250,000. A quarterly average is better when the fund drew or distributed heavily during the year, because a simple average of two dates can sit some way from the capital actually at work.
| Costs included | Costs | Ratio | Increment |
|---|---|---|---|
| Net management fee and fund expenses | 4,300 | 1.72% | 1.72% |
| + subscription facility interest | 5,000 | 2.00% | 0.28% |
| + carried interest accrual | 10,200 | 4.08% | 2.08% |
The management fee net of offsets is 1.36 per cent of average net assets and the fund expenses 0.36 per cent. Interest adds 0.28 points. Carry, at 5,200, is 51 per cent of all the costs on its own. In a good year the incentive allocation is the largest cost the investor bears, and a ratio that excludes it describes the fixed costs only.
The check that the layers are complete is the return. Income and gains before costs were 30,000, a simple return of 12.00 per cent on average net assets. After the 10,200 of costs the investors' result is 19,800, or 7.92 per cent. The difference, 4.08 points, is the full expense ratio. If the gross and net returns in the highlights note differ by more than the ratio printed beside them, a cost is missing from the ratio. In this year the costs took 34 per cent of what the portfolio earned.
| Denominator | Amount | Excluding carry | Including carry |
|---|---|---|---|
| Average net assets | 250,000 | 2.00% | 4.08% |
| Opening net assets | 240,000 | 2.08% | 4.25% |
| Closing net assets | 260,000 | 1.92% | 3.92% |
| Paid-in capital | 270,000 | 1.85% | 3.78% |
| Commitments | 300,000 | 1.67% | 3.40% |
The same year of the same fund produces a total ratio between 3.40 and 4.25 per cent depending only on the denominator, and a ratio excluding carry between 1.67 and 2.08 per cent. A manager reporting on commitments looks 0.68 points cheaper than one reporting on average net assets, without charging a unit less. Early in a fund's life, when little is drawn, the commitment basis flatters even more.
The offsets cut both ways. Before the 600 of offsets the fee and expenses would be 4,900, or 1.96 per cent. The offsets lower the ratio by 0.24 points, but they exist because the manager charged portfolio companies transaction and monitoring fees, a cost the fund bears through the value of its investments, not through the statement of operations.
Two further checks are worth the minutes. First, the denominator in the highlights note is normally the limited partners' average net assets, excluding the general partner's capital, and a fund with a large general partner commitment can show a slightly different ratio on total net assets. Second, organisational costs and placement fees borne by the fund in its first years can appear outside the expense line; if the fund is young, read the notes for them before concluding its costs are low.
The common mistake is to compare a ratio excluding carry for one fund with a ratio including it for another, or to compare across denominators. Both happen because the highlights note often prints a single figure with a one-line description. Rebuild the ratio from the statements for every fund in the comparison, on average net assets, in the three layers above. Then compare the layer you care about: the fixed costs for what the manager charges regardless of results, the total for what the investor actually gave up.
An expense ratio is costs over average net assets, stated with its contents. Here it is 1.72 per cent for fees and expenses, 2.00 with interest and 4.08 with carry, and only the last one closes the gap between gross and net return. The fee calculators in the free workbooks for the book price the management fee on all four bases a fund agreement might use, and the offset recomputation verifies the first line of the ratio before it is divided by anything.
Show it both ways. Under US GAAP financial highlights the ratio is usually presented before and after the incentive allocation. In the illustrative fund carry is 5,200 of 10,200 of total costs, 51 per cent, so a ratio of 2.00 per cent excluding it becomes 4.08 per cent including it. Excluding carry in a strong year hides half the cost.
Because commitments are usually larger than net assets, especially early and late in a fund's life. The same 10,200 of costs is 4.08 per cent of 250,000 of average net assets but 3.40 per cent of 300,000 of commitments. Compare funds only on the same denominator, and prefer average net assets, which is what the investor actually has at work.
They reduce the fee the statement of operations shows, so yes, but the offset is funded by transaction and monitoring fees charged to portfolio companies, which the fund bears indirectly through lower company value. In the illustrative fund 600 of offsets cut the ratio by 0.24 percentage points, from 1.96 to 1.72 per cent before interest.
This article is one calculation from How to Read a Private Fund's Financial Statements. 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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