The fee saving, what carry takes back, the IRR it adds, and the break-even probability at which the option to wait for the final close is worth more.
A first-close discount is worth less than its headline and much less than the option to wait. On an illustrative 50m commitment, 25 basis points off the management fee saves 0.78m of fees, adds 30 basis points of net IRR and is worth 0.556m in present value after the extra carry it generates. That pays for giving up the option to wait for the final close only if there is less than a 6.6 per cent chance that the extra months of information would have changed the decision.
Worked in full in The Private Markets Limited Partner by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
To build momentum, a GP offers investors who commit at the first close a reduced management fee, sometimes for the whole life of the fund, sometimes as a fee holiday. Investors who come in at later closes pay full fees and equalisation interest to the earlier ones, which compensates the first-close investors for having funded calls earlier, as in how equalisation interest is calculated. Equalisation is a fair price for time; the discount is the only real economic incentive, so it is what the LP should value.
| Input | Value |
|---|---|
| Commitment | 50m |
| Management fee, investment period (5 years) | 2.0% of commitments |
| Management fee, after | 1.5% of invested cost |
| First-close discount | 25 bp off both rates |
| Investments | 10.5m in each of years 1 to 4, 42.0m in total |
| Each investment | 2.0x gross after 5 years (14.87% gross IRR) |
| Carry | 20% over an 8% preferred return, full catch-up |
| Discount rate for present values | 8% |
Investment period: 0.25% × 50m = 0.1250m a year for 5 years
After: 0.25% × invested cost, which falls as deals exit: 0.0787m, 0.0525m, 0.0263m
Total = 5.945m of fees at full rates less 5.163m discounted = 0.782m; present value at 8% = 0.641m
Lower fees mean higher profit, and above the preferred return the GP takes 20 per cent of profit. So part of every fee saving comes back to the GP as carry.
| Item | Full fees | First-close discount |
|---|---|---|
| Paid in, investments and fees | 47.945 | 47.163 |
| Carry paid to the GP | 7.211 | 7.368 |
| Distributions to the LP | 76.789 | 76.632 |
| Net TVPI | 1.602 | 1.625 |
| Net IRR | 10.43% | 10.73% |
The discount saves 0.782m of fees but costs 0.157m of extra carry, so the LP keeps 0.626m, or 80 per cent of the saving. In present value the gain is 0.556m. In IRR terms it is 30 basis points, more than the 25 basis point headline because the fee base during the investment period is the full commitment, larger than the capital actually at work.
Committing at the first close means deciding with less information: often before the first deals of the new fund are visible, before the previous fund's latest marks, before other LPs' diligence is finished. Waiting for the final close keeps the option to walk away.
Cost of a wrong commitment = (alternative net multiple − bad-outcome net multiple) × paid in = (1.6 − 1.3) × 47.945 = 14.38m, or 8.39m in present value centred on year 7
Break-even probability = PV of discount / PV of loss avoided = 0.556 / 8.39 = 6.6%
If there is more than a 6.6 per cent chance that waiting would turn up something that makes the LP decline, and so avoid a fund returning 1.3x net rather than its alternative at 1.6x, the option to wait is worth more than the discount. Put differently, take the discount only when you are at least 93.4 per cent sure of the commitment already.
| Discount | PV gain to LP, after carry | Net IRR uplift | Break-even probability |
|---|---|---|---|
| 10 bp | 0.223m | 12 bp | 2.7% |
| 25 bp | 0.556m | 30 bp | 6.6% |
| 50 bp | 1.113m | 61 bp | 13.3% |
Everything scales roughly in proportion. Even a 50 basis point discount, generous by most standards, is only worth taking if the LP's residual doubt is below 13.3 per cent.
The manager selection checklist and the re-up checklist the decision belongs in are among the working documents in the free companion files for this book.
Compute the fees saved, then run them through the waterfall, because lower fees raise profits and the GP takes carry on them. On an illustrative 50m commitment, 25 basis points off a 2.0 and 1.5 per cent fee saves 0.782m, but 0.157m comes back as carry. The LP keeps 0.626m, worth 0.556m in present value, or 30 basis points of net IRR.
Because during the investment period the fee is charged on the full commitment, while only part of it is invested. A 25 basis point cut on 50m of commitments is a larger share of the capital actually at work, so in the worked example net IRR rises from 10.43 to 10.73 per cent, 30 basis points, even after the extra carry.
Compare the discount with the value of the option to walk away. If waiting gives a probability q of avoiding a fund returning 1.3x net instead of an alternative at 1.6x, the loss avoided on 47.945m paid in is 14.38m, or 8.39m in present value. A 25 basis point discount worth 0.556m only wins if q is below 6.6 per cent.
This article is one calculation from The Private Markets Limited Partner. 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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