The same headline rate on two bases, year by year, and what each does to the management company during the investment period.
A fee on committed capital is charged on the whole fund from the first close; a fee on invested capital is charged only on what has been deployed. On an illustrative 300,000,000 real estate fund at 1.5 per cent, deploying 95 per cent over a four-year investment period, the committed basis earns the manager 18,000,000 in those four years and the invested basis 8,887,500, less than half. To earn the same on invested capital the rate would have to be 3.04 per cent; to match the invested fee on commitments, 0.74 per cent.
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 →
Headline rates on the two bases are therefore not comparable, and a term sheet that offers "1.5 per cent on invested" is a very different proposal from "1.5 per cent on committed". For a first-time manager the basis also decides whether the management company can pay for itself during the years it is buying.
| Input | Value |
|---|---|
| Commitments | 300,000,000 |
| Management fee rate | 1.5% |
| Investment period | 4 years |
| Deployment, years 1 to 4, share of commitments | 20%, 30%, 30%, 15% |
| Total deployed | 285,000,000 |
| Management company cost a year (illustrative) | 2,400,000 |
Capital is deployed evenly through each year, so the fee on invested capital is charged on the average invested balance. After the investment period both bases normally switch to net invested capital, so the difference is confined to these four years.
Fee on committed = commitments × rate
Fee on invested = average invested in the year × rate
Rate on invested that matches = total committed fee ÷ sum of average invested balances
In Excel, with opening invested capital in B5 and deployment in C5, average invested is =B5+C5/2, the invested fee =(B5+C5/2)*1.5%, and the equivalent rate =SUM(CommittedFee)/SUM(AvgInvested).
| Year | Average invested | Fee on committed | Fee on invested | Gap | Committed fee on invested |
|---|---|---|---|---|---|
| 1 | 30,000,000 | 4,500,000 | 450,000 | 4,050,000 | 15.00% |
| 2 | 105,000,000 | 4,500,000 | 1,575,000 | 2,925,000 | 4.29% |
| 3 | 195,000,000 | 4,500,000 | 2,925,000 | 1,575,000 | 2.31% |
| 4 | 262,500,000 | 4,500,000 | 3,937,500 | 562,500 | 1.71% |
| Total | 18,000,000 | 8,887,500 | 9,112,500 | 3.04% |
The last column is the investor's view of the committed basis: the fee divided by the capital actually at work. In year one the investor pays 4,500,000 on 30,000,000 invested, 15.00 per cent. Over the four years the average invested balance is 148,125,000, and the committed fee works out at 3.04 per cent of it. The gap, 9,112,500, is 3.04 per cent of commitments, paid before a single asset has been sold.
On committed capital the fee covers the 2,400,000 management company from day one, with 2,100,000 a year to spare and 8,400,000 over the period. On invested capital it covers the cost only once average invested capital reaches 160,000,000, 53.3 per cent of commitments, which here happens during year three. Before that the manager funds 1,950,000 in year one and 825,000 in year two, 2,775,000 in all. Years three and four then produce a 2,062,500 surplus, but over the four years the invested basis still falls 712,500 short of the cost.
The invested basis aligns the fee with work done and stops a manager being paid for capital it has not found a use for. That is why investors prefer it, and why managers with a short track record are sometimes asked for it. The cost to the manager is the early-year shortfall, which has to come from partners' capital or a larger first close; the arithmetic of that gap is in does a first close cover the management company's costs.
| Pace, years 1 to 4 | On committed | On invested | Gap | Invested rate to match | Committed rate to match |
|---|---|---|---|---|---|
| Fast: 40%, 40%, 15%, 0% | 18,000,000 | 11,812,500 | 6,187,500 | 2.29% | 0.98% |
| Base: 20%, 30%, 30%, 15% | 18,000,000 | 8,887,500 | 9,112,500 | 3.04% | 0.74% |
| Slow: 10%, 20%, 30%, 35% | 18,000,000 | 6,637,500 | 11,362,500 | 4.07% | 0.55% |
The committed fee does not move with the pace; the invested fee does. Slow deployment cuts the invested fee to 36.9 per cent of the committed one, fast deployment raises it to 65.6 per cent. That is the alignment argument in numbers: on invested capital the manager is paid for buying, and on committed capital it is paid for having raised the money.
The mistake is to compare headline rates across bases. A manager offering 1.75 per cent on invested capital looks dearer than one charging 1.5 per cent on commitments; on the base-case pace it collects 10,368,750 over the investment period against 18,000,000, 7,631,250 less. Put both offers on the same footing, total fee over the investment period on your expected deployment, before negotiating the rate. What happens after the investment period, when both bases usually move to net invested capital reduced by realisations, is worked in how the management fee is calculated after the investment period.
At 1.5 per cent on a 300,000,000 fund, the committed basis earns 18,000,000 over a four-year investment period and the invested basis 8,887,500. The equivalent rates are 3.04 per cent on invested and 0.74 per cent on committed. Choose the basis knowing what it does to the management company's first two years, and compare offers on fees in money, not rates. Raising a Real Estate Fund sets out the term sheet term by term and the management company budget with the fee across the fund's life; the free workbook for this case runs the burn against the fee month by month.
Either, as the LPA sets. Closed-end funds commonly charge on commitments during the investment period and on net invested capital after it; some, particularly in real estate, charge on invested capital throughout. On a 300,000,000 fund at 1.5 per cent the choice is worth 9,112,500 over a four-year investment period.
It depends on the pace of deployment. Deploying 20, 30, 30 and 15 per cent over four years, 1.5 per cent on commitments equals 3.04 per cent on average invested capital. Deploying faster it equals 2.29 per cent; deploying slower, 4.07 per cent.
Because the fee then rises only as capital goes to work, so the manager is not paid on money it has not found a use for. In year one here the committed fee is 4,500,000 on 30,000,000 of average invested capital, 15.00 per cent of the capital at work.
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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