The fee step-down worked year by year on one agreement, the three readings of the base, and the write-down that gets left in.
After the investment period most private equity funds stop charging the management fee on commitments and charge a lower rate on net invested capital: the cost of investments still held, less permanent write-downs. On a $400m fund that steps down from 2 per cent of commitments to 1.5 per cent of net invested capital, the post-investment-period fees total $13.8m over five years, against $27.0m if the base is read as invested cost never reduced.
Worked in full in The Private Equity Fund Controller Playbook by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The rate change is the part everyone notices. The base is the part that carries the money, and it is defined in one sentence of the agreement that three careful readers can take three ways. A fund controller has to compute the fee from the base exactly as written, every period, and be able to show the limited partners the reconciliation.
| Input | Value |
|---|---|
| Commitments | 400.0 |
| Investment period | 5 years |
| Fee during the investment period, on commitments | 2.0% |
| Fee after the investment period, on net invested capital | 1.5% |
| Capital invested by the end of year 5, at cost | 360.0 |
During the investment period the arithmetic is flat: $400m × 2 per cent = $8.0m a year, $40.0m over five years, whatever the portfolio does.
Net invested capital starts at the cost of everything invested and falls in two ways: by the cost basis of each realisation, and by any write-down the agreement treats as permanent. It does not fall with unrealised markdowns, and it does not rise with markups.
NICt = NICt−1 − cost of investments realised − permanent write-downs
Feet = NICt × 1.5%. In Excel, with the opening base in D2, realised cost in B and write-downs in C:
=D2-B3-C3 for the base, then =D3*0.015 for the fee.
| Year | Cost realised | Write-down | Net invested capital | NAV | Fee on NIC |
|---|---|---|---|---|---|
| 6 | 0.0 | 0.0 | 360.0 | 450.0 | 5.40 |
| 7 | 80.0 | 20.0 | 260.0 | 380.0 | 3.90 |
| 8 | 90.0 | 0.0 | 170.0 | 300.0 | 2.55 |
| 9 | 80.0 | 0.0 | 90.0 | 180.0 | 1.35 |
| 10 | 50.0 | 0.0 | 40.0 | 70.0 | 0.60 |
| Total | 300.0 | 20.0 | 13.80 |
The fee drops from $8.0m in year 5 to $5.40m in year 6, a fall of 32.5 per cent on the day the investment period ends. By year 10 it is $0.60m, 7.5 per cent of the investment-period fee. Over the life of the fund the manager collects $53.8m, or 13.45 per cent of commitments.
Fee bases are drafted as "invested capital", "net invested capital", "acquisition cost of unrealised investments" or, less often, NAV. When the definition is loose, the base is open to argument, and the difference is large.
| Year | Invested cost, never reduced | NAV | Net invested capital |
|---|---|---|---|
| 6 | 5.40 | 6.75 | 5.40 |
| 7 | 5.40 | 5.70 | 3.90 |
| 8 | 5.40 | 4.50 | 2.55 |
| 9 | 5.40 | 2.70 | 1.35 |
| 10 | 5.40 | 1.05 | 0.60 |
| Total | 27.00 | 20.70 | 13.80 |
| Lifetime fee incl. investment period | 67.00 | 60.70 | 53.80 |
| As % of commitments | 16.75% | 15.17% | 13.45% |
Invested cost never reduced charges $13.2m more than net invested capital over five years. NAV charges $6.9m more, and it does so only because this portfolio is marked above cost; in a fund marked below cost the NAV reading would be the cheapest. In year 6 unreduced cost and net invested capital agree to the cent, which is why the error is so often found late: it grows as the portfolio is sold.
The year the investment period ends is the year to test. If year 6 is right and year 7 is wrong, the base is not being reduced for realisations. If it never changes from $5.40m, the administrator is reading "invested capital" as cost never reduced, and the limited partnership agreement should be read again with counsel.
The realisations are hard to miss: there is cash. The $20.0m permanent write-down in year 7 has no cash attached, and it is the line that usually gets left out. Leaving it in the base overcharges $0.30m a year from year 7 onwards, $1.2m in total, 8.7 per cent of the correct post-investment-period fee. Most agreements define what counts as permanent, often a write-down below a percentage of cost or a written-off company; the controller needs that definition in the fee workpaper, not in an email.
Two smaller traps sit next to it. A partial realisation reduces the base by the cost of the part sold, not by the proceeds. And a follow-on investment made after the investment period, if permitted, adds its cost to the base, so the base can rise.
The fee step-down, with all three readings of the base on one agreement, is one of the cases in the free workbook for this case. For offsets of transaction and monitoring fees against the same fee, see how to recompute a private fund's management fee after offsets; for what fees do to the return an investor actually receives, why net IRR is lower than gross IRR.
Only if the write-down is permanent under the agreement's definition. Unrealised markdowns usually leave the base unchanged. In the worked case a $20.0m permanent write-down cuts the base from year 7, and leaving it in overcharges $1.2m over the remaining four years at 1.5 per cent.
It depends on the rate step and on how much has been invested. In the worked case the fee falls from $8.0m on $400m of commitments to $5.40m on $360.0m of net invested capital, a 32.5 per cent drop, and then keeps falling as investments are sold, to $0.60m by year 10.
Not necessarily. On a portfolio marked above cost, NAV is the larger base: $20.7m of fees over five years in the worked case against $13.8m on net invested capital. On a portfolio marked below cost the order reverses. Net invested capital is the basis most agreements use, and it does not reward markups.
Fee step-downs are covered in chapter 7 of The Private Equity Fund Controller Playbook, and the three readings of the base are worked in the free companion files. 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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