Investors will ask what your pre-fund deals would have returned on the terms you now offer; the answer is a waterfall run on pooled cash flows, not a deduction from the gross.
Put every realised deal's gross equity cash flows on one timeline, charge the proposed fund's management fee on invested equity as extra contributions, run the distributions through the proposed waterfall, and take the IRR of what the investor pays and receives. On three illustrative deals with a gross IRR of 12.1 per cent, a 1.5 per cent fee and 20 per cent carry over an 8 per cent preferred return give a pro forma net IRR of 9.0 per cent, a gross-to-net spread of 3.1 points.
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 →
A manager raising a first real estate fund usually has a track record of deals done before any fund existed: club deals, separate accounts, or deals done at a previous firm. Investors will ask what those deals would have returned net of the terms now being offered. A gross IRR alone does not answer that, and a rule of thumb does not answer it well. The pro forma net has to be computed on the cash flows.
| Year | Deal A | Deal B | Deal C | Pooled gross |
|---|---|---|---|---|
| 0 | −40.0 | −40.0 | ||
| 1 | 2.4 | −30.0 | −27.6 | |
| 2 | 2.4 | 1.8 | −30.0 | −25.8 |
| 3 | 2.4 | 1.8 | 1.5 | 5.7 |
| 4 | 54.4 | 1.8 | 1.5 | 57.7 |
| 5 | 43.8 | 1.5 | 45.3 | |
| 6 | 37.5 | 37.5 | ||
| Deal gross IRR | 12.3% | 14.1% | 9.4% | 12.1% |
Proposed terms: a management fee of 1.5 per cent a year on invested equity, an 8 per cent compounding preferred return, 20 per cent carried interest with a 100 per cent catch-up, and a whole-fund (European) waterfall. All figures are illustrative.
1. Pool: grosst = sum of every deal's equity flow in period t
2. Feet = fee rate × equity invested during period t, called from investors
3. Waterfall: distributions repay contributions plus 8% compounded, then catch-up to 20% of profit, then 80/20
4. Net IRR = IRR(investor distributionst − contributionst)
In Excel, build the waterfall on rows by period and finish with =IRR(net_row), or =XIRR(net_row, dates) on actual deal dates, which is what an investor's analyst will do.
Equity outstanding is 40 in year 1, 70 in year 2, 100 in years 3 and 4, 60 in year 5 and 30 in year 6. At 1.5 per cent, the fee is 0.60, 1.05, 1.50, 1.50, 0.90 and 0.45: 6.00 in all. Investors contribute 106.00 against 152.8 of gross distributions.
| Year | Contributions | To investors | Carry | Net to investors |
|---|---|---|---|---|
| 0 | 40.00 | 0.00 | 0.00 | −40.00 |
| 1 | 30.60 | 2.40 | 0.00 | −28.20 |
| 2 | 31.05 | 4.20 | 0.00 | −26.85 |
| 3 | 1.50 | 5.70 | 0.00 | 4.20 |
| 4 | 1.50 | 57.70 | 0.00 | 56.20 |
| 5 | 0.90 | 45.30 | 0.00 | 44.40 |
| 6 | 0.45 | 28.14 | 9.36 | 27.69 |
| Total | 106.00 | 143.44 | 9.36 | 37.44 |
The preferred return is not cleared until the last year, so the whole carry falls in year 6, where the catch-up brings it to 9.36: exactly 20 per cent of the 46.8 of profit after fees.
The pro forma net IRR is 9.0 per cent against a gross 12.1 per cent; the net multiple is 1.35x against 1.53x gross. Of the 3.1 points of spread, the fee costs 1.4 (net IRR before carry is 10.7 per cent) and the carry 1.7. That is the figure to put beside the gross track record, with the terms and the method stated underneath it.
| Management fee | Carry 15% | Carry 20% |
|---|---|---|
| 1.0% | 9.8% | 9.4% |
| 1.5% | 9.4% | 9.0% |
| 2.0% | 9.0% | 8.6% |
Each half point of fee costs about 0.4 points of net IRR here, and five points of carry about the same. The waterfall structure matters too. Run deal by deal without a clawback, Deal C never clears its preferred return after fees, so the carry falls to 7.32 and the net IRR rises to 9.2 per cent. Show the waterfall the fund will actually use.
A pro forma net IRR is a full waterfall run on pooled deal cash flows, not a deduction from the gross. Here 12.1 per cent gross becomes 9.0 per cent net, with 1.4 points to fees and 1.7 to carry. The free workbook for this case sits with the other raise documents, and why net IRR is lower than gross walks the same spread from the fund side.
It depends on the terms, the leverage of the returns and the timing of distributions, so compute it rather than assume it. On the illustrative track record, a 1.5 per cent fee and 20 per cent carry over an 8 per cent preferred return take 12.1 per cent gross to 9.0 per cent net, a spread of 3.1 points, of which 1.4 is fees and 1.7 carry.
Use the waterfall the new fund will actually have. On the illustrative deals a whole-fund waterfall pays carry of 9.36 and gives a net IRR of 9.0 per cent; run deal by deal without clawback, the weakest deal never clears its preferred return, carry falls to 7.32 and the net IRR is 9.2 per cent.
Because carry and fees do not scale linearly with IRR: the preferred return defers carry, and fees fall on invested equity over different periods. On the illustrative deals the shortcut gives 8.2 per cent against a computed 9.0 per cent net, and on other cash flows it can err the other way.
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.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: real estate investing, finance and fund management → · All 681 articles →
If this book helped, or didn’t, a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.