Gross to net for a private fund performance page, with a high-water mark, two share classes and the shortcuts that overstate the result.
Under the SEC Marketing Rule, net performance is the return after every fee and expense the investor paid or would have paid: management fee, performance fee and fund expenses, compounded period by period. On an illustrative five-year track record with 7.23 per cent annualised gross, the standard share class nets 4.62 per cent, and that is the figure to show, with equal prominence, beside the gross. The founders class nets 5.34 per cent, but quoting it to investors who would pay standard terms overstates the result by 0.72 points a year.
Worked in full in The Private Fund Compliance Officer by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The fund is a fictional open-ended private credit fund with two share classes, and every figure is illustrative. Gross returns are before all fees and fund expenses. Both classes pay fund expenses of 0.30 per cent of opening NAV. The management fee is charged on opening NAV; the performance fee is charged annually on the NAV above a high-water mark, after management fee and expenses, with no hurdle. New investors are offered only the standard class.
| Year | 1 | 2 | 3 | 4 | 5 |
|---|---|---|---|---|---|
| Gross return | 9.2% | 11.8% | −3.4% | 10.5% | 8.8% |
| Class | Management fee | Performance fee | Fund expenses |
|---|---|---|---|
| Founders (closed) | 1.00% | 10% | 0.30% |
| Standard (offered) | 1.50% | 15% | 0.30% |
Rule 206(4)-1 under the Investment Advisers Act lets an adviser show gross performance only if net performance is shown with at least equal prominence, for the same period and with the same return methodology. Net performance means performance after deducting all fees and expenses a client or investor has paid or would have paid in connection with the adviser's services, performance-based fees included; custodian fees paid to a third party may be left out. A model fee may stand in for actual fees only where the result is no higher than with the actual fee, or where the model fee equals the highest fee charged to the intended audience. The one, five and ten-year periods the rule prescribes apply to portfolios other than private funds; for a private fund the periods must still be fair and balanced, so show the full record and the latest year.
Start at 100. Each year apply the gross return, deduct the management fee and expenses on opening NAV, then the performance fee on any NAV above the high-water mark.
NAVt = NAVt−1 × (1 + grosst) − NAVt−1 × (mgmt + expenses) − perf × max(0, pre-fee NAV − HWM)
Year 1: 100 × 1.092 − 1.500 − 0.300 = 107.400; performance fee 15% × 7.400 = 1.110; NAV 106.290, a net return of 6.29%
Excel, per row: =MAX(0,B2*(1+Gross)-B2*(Mgmt+Exp)-HWM)*Perf for the fee, and the high-water mark carried as =MAX(HWM_prev,NAV)
| Year | Gross | Mgmt fee | Expenses | Perf fee | NAV | Net |
|---|---|---|---|---|---|---|
| 1 | 9.2% | 1.500 | 0.300 | 1.110 | 106.290 | 6.29% |
| 2 | 11.8% | 1.594 | 0.319 | 1.594 | 115.325 | 8.50% |
| 3 | −3.4% | 1.730 | 0.346 | 0.000 | 109.328 | −5.20% |
| 4 | 10.5% | 1.640 | 0.328 | 0.527 | 118.312 | 8.22% |
| 5 | 8.8% | 1.775 | 0.355 | 1.242 | 125.352 | 5.95% |
In year 4 the fund recovers but pays performance fee only on the part above the year 2 high-water mark of 115.325, which is why the fee is 0.527 rather than a full year's 15 per cent of the gain.
Annualised net = (NAV5 / 100)1/5 − 1 = 1.253520.2 − 1 = 4.62%
Gross: 141.786 after five years, 7.23% a year. The fee and expense drag is 2.61 points a year
| Series | Latest year | Three years, a year | Five years, a year | Cumulative |
|---|---|---|---|---|
| Gross | 8.80% | 5.11% | 7.23% | 41.79% |
| Net, standard class | 5.95% | 2.82% | 4.62% | 25.35% |
| Net, founders class | 6.75% | 3.43% | 5.34% | 29.73% |
Every shortcut flatters. On the same gross returns, five-year annualised:
| Treatment | Net a year | Overstatement |
|---|---|---|
| Standard class, all fees and expenses | 4.62% | 0.00 |
| Founders class quoted to new investors | 5.34% | 0.72 |
| Management fee and expenses only, no performance fee | 5.43% | 0.81 |
| All fees, fund expenses left out | 4.88% | 0.26 |
The founders figure is the actual net of a real class, so it looks defensible. It is not the fee the audience would pay. Under the model fee conditions, the figure shown to prospective standard-class investors should be no higher than the standard-class net; the founders class can be shown beside it, labelled, but not in its place. The order of magnitude matters: 0.72 points a year is 4.37 points of cumulative return over five years.
The more serious mistake is not arithmetic but selection: the net series computed on the cheapest class, on a vehicle that does not bear the performance fee, or a period that starts after the loss year. Year 3 alone shows the effect: had it been −8 per cent instead of −3.4, the standard class would net 3.74 per cent a year and a track record starting in year 4 would hide it. The defensible file holds the NAV roll for the class offered, the fee terms it used, the period chosen and why, and the reviewer's sign-off. A further trap is performance fee mechanics: charging the fee on each year's gain without the high-water mark gives 4.46 per cent instead of 4.62, so the documents, not the spreadsheet, must decide the method.
This is a worked illustration, not legal advice. Hypothetical, extracted and predecessor performance carry their own conditions under the rule, and a fund-level credit facility changes the IRR a performance page reports. For the fee mechanics in an evergreen structure, see how an evergreen fund's performance fee is calculated.
The fee and expense figures, the testing sample and a marketing review record for a performance page are in the free companion files for this book.
Yes, under the SEC Marketing Rule, if net performance is shown with at least equal prominence, for the same period and with the same methodology. On the illustrative fund here, a five-year gross return of 7.23 per cent a year must sit beside the 4.62 per cent net of the class being offered, not beside a lower-fee class.
The rule allows a model fee only if the resulting performance is no higher than it would be with the actual fee, or if the model fee equals the highest fee charged to the intended audience. Using the founders class terms of 1.00 per cent and 10 per cent for prospective standard-class investors would show 5.34 per cent instead of 4.62 per cent and meets neither condition.
Yes. The rule's definition of net performance includes performance-based fees. Deducting only the management fee and expenses on the illustrative record here gives 5.43 per cent a year against 4.62 per cent with the performance fee, an overstatement of 0.81 points a year.
This article is one calculation from The Private Fund Compliance Officer. 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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