Trading management fee for carry looks like alignment. In present value it is close to neutral, and the manager bears all the downside.
The lower fee and higher carry pays the manager more only if the fund clears about 1.61x gross. On an illustrative 300 million real estate fund, moving from 1.5 per cent and 20 per cent to 1.25 and 25 gives up 4.69 million of fees for certain; at 1.70x gross it earns 51.28 million against 49.08, but in present value the gain is 0.20 million, and in the 30 per cent of outcomes where no carry is paid the manager is simply 4.69 million poorer.
Worked in full in Raising a Real Estate Fund by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Investors in a first or second real estate fund often push for a lower management fee. The manager's natural counter is to keep total economics by taking more carry: 1.25 and 25, or 1.0 and 30, instead of the 1.5 and 20 pitched in the first deck. It sounds like alignment, because more of the manager's income depends on performance. Whether it is a good trade depends on three things: the return the fund will actually make, when the money arrives, and whether the manager can live without the fee in the years carry is not yet visible.
| Input | Value |
|---|---|
| Commitments | 300 |
| Capital invested in property | 270 |
| Fee basis, years 1 to 4 | Commitments |
| Fee basis, years 5 to 8, share of invested capital | 100%, 75%, 50%, 25% |
| Preferred return, compounding, average years outstanding | 8%, 5 |
| Catch-up | Full, whole-fund waterfall |
| Discount rate for present values; carry paid in year | 10%, 7 |
The pref is applied to all contributions, fees included, over an average of five years outstanding. That shortcut replaces a dated cash flow model and is close enough to compare two term sheets on the same fund.
Fees = rate × 300 × 4 + rate × 270 × (1.00 + 0.75 + 0.50 + 0.25)
Contributions = 270 + fees; Profit = 270 × gross multiple − contributions
Pref amount = contributions × (1.085 − 1)
Carry = 0 if profit ≤ pref; profit − pref in the catch-up band; carry rate × profit once profit ≥ pref ÷ (1 − carry rate)
Excel: =IF(Profit<=Pref,0,MIN(Profit-Pref,Carry*Profit))
| Line | 1.5 and 20 | 1.25 and 25 |
|---|---|---|
| Management fees over the life | 28.12 | 23.44 |
| Contributions, invested plus fees | 298.12 | 293.44 |
| Pref amount at 8 per cent | 139.92 | 137.72 |
| Profit to the fund | 160.88 | 165.56 |
| Gross multiple at which carry starts | 1.622x | 1.597x |
| Carried interest | 20.96 | 27.84 |
| Manager's total, fees plus carry | 49.08 | 51.28 |
| Present value at 10 per cent | 30.76 | 30.96 |
The lower fee also lowers the hurdle slightly: fewer fees are called, so less pref accrues, and carry starts at 1.597x instead of 1.622x. At 1.70x both managers are still in the catch-up band, which completes at 1.752x and 1.767x, so each takes profit less pref rather than a full 20 or 25 per cent of profit.
| Gross multiple | 1.5 and 20 | 1.25 and 25 | Difference | LP net, 1.5 and 20 | LP net, 1.25 and 25 |
|---|---|---|---|---|---|
| 1.30x | 28.12 | 23.44 | -4.69 | 1.177x | 1.196x |
| 1.50x | 28.12 | 23.44 | -4.69 | 1.358x | 1.380x |
| 1.70x | 49.08 | 51.28 | 2.20 | 1.469x | 1.469x |
| 1.90x | 71.10 | 78.33 | 7.23 | 1.577x | 1.561x |
| 2.10x | 81.90 | 91.83 | 9.93 | 1.722x | 1.699x |
The cross-over is at 1.614x gross. Below it the lower fee is a straight loss of 4.69 million; above it the extra five points of carry win, by 9.93 million at 2.10x. At 1.70x both investors net exactly 1.469x, which is 1.08 to the fifth power: in the catch-up band the LPs receive their pref and nothing more, whatever the term sheet. Going further to 1.0 and 30 moves the cross-over only to 1.606x.
Weighting the outcomes 10, 20, 40, 20 and 10 per cent from 1.30x to 2.10x, the expected total is 50.48 million on 1.5 and 20 and 52.39 million on 1.25 and 25. In present value the two are 31.48 and 31.53 million: almost nothing between them. Carry is larger but later and less certain; discounting takes back most of the nominal gain. Carry is paid at all in only 70 per cent of outcomes.
Comparing the two packages at the target return. Every deck targets a multiple comfortably above the cross-over, so the lower fee always looks generous to investors and costless to the manager. The decision should be made on the downside. A manager whose fee only just covers the management company, as in whether a first close covers the management company's costs, cannot afford to lose 4.69 million of certain income in exchange for carry that arrives in year 7, if at all.
The trade also changes who bears risk. On 1.5 and 20, 57 per cent of the manager's income at 1.70x is fees; on 1.25 and 25, 46 per cent. That is the alignment investors are asking for, and it is real. It is also a transfer of business risk to a firm that may not have the balance sheet to carry it.
How fees and carry add up over a full fund is worked in how much a real estate fund manager earns from fees and carry. The raise itself, run on a calendar with the management company's burn, is in the free workbook for this book.
Better in weak outcomes, worse in strong ones. In the illustration LPs net 1.196x instead of 1.177x at 1.30x gross on 1.25 and 25, but 1.699x instead of 1.722x at 2.10x. In the catch-up band both term sheets give LPs exactly their pref, 1.469x at an 8 per cent pref over five years.
Where the extra carry exceeds the fee given up. On the illustrative 300 million fund the lower fee saves investors 4.69 million, and 1.25 and 25 overtakes 1.5 and 20 at a gross multiple of about 1.614x on invested capital. Going to 1.0 and 30 moves the cross-over only to 1.606x.
Because fees arrive every year from year one and carry arrives late, in year 7 in the illustration, and only if the fund clears its hurdle. At 1.70x gross the nominal gain of 2.20 million shrinks to 0.20 million discounted at 10 per cent. Across weighted outcomes the PVs are 31.48 and 31.53 million.
This article is one calculation from Raising a Real Estate Fund. 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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