Present value of fees and carry under each structure, after the time and cost of raising the fund and the probability that it never closes.
Compare the present value of what each pays the manager, after the time and cost of raising the fund and the chance that the raise fails. On an illustrative 150 million of capital, a commingled fund at 1.5 per cent and 20 per cent carry is worth 10.02 million to the manager against 6.66 million for a separate account at 0.90 per cent on invested equity and 15 per cent, even after a 15-month raise and 1.0 million of set-up costs. The fund stays ahead only while the odds of closing it are above 69.5 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 →
An emerging manager is often offered a separate account, a mandate from one institution to invest its capital alone, while trying to raise a first fund. The account is certain and available now; the fund is larger in economics but distant and uncertain. Both cases have a value, and the question can be answered with three numbers: the fee terms, the time to raise, and the probability of raising at all.
| Input | Commingled fund | Separate account |
|---|---|---|
| Capital | 150.0 committed | 150.0 allocated |
| Management fee | 1.5% on commitments for 3 years, then on invested equity | 0.90% on invested equity |
| Carry or promote over an 8% preferred return | 20% | 15% |
| Starts earning | After a 15-month raise | Now |
| Set-up costs borne by the manager | 1.0 | None |
Invested equity builds over three years and is sold down from year six: 50, 100, 150, 150, 150, 100, 50, 0. Both portfolios return 1.65x over a five-year hold, against a hurdle multiple of 1.4693 at 8 per cent, so the profit above the hurdle is 27.10 million; carry is paid half in year seven and half in year eight. Income is discounted at 10 per cent.
| Line | Fund | Separate account |
|---|---|---|
| Management fees | 13.50 | 6.75 |
| Carry or promote | 5.42 | 4.07 |
| Total | 18.92 | 10.82 |
The account's fees are half the fund's, not 60 per cent as the rate suggests, because they run on invested equity from the first year: 0.45 million in year one against 2.25 for the fund on its commitments. The account's promote is 75 per cent of the fund's carry. Nominally the fund earns 8.11 million more.
PV fund = Σ incomet ÷ 1.10(t + 15/12) − set-up = 11.02 − 1.0 = 10.02
PV account = Σ incomet ÷ 1.10t = 6.66
Excel, yearly income in B2:B9: =NPV(10%,B2:B9)/1.1^(15/12)-1 for the fund
Waiting 15 months multiplies every fund cash flow by 0.8877 and costs 1.39 million of value. The fund still leads by 3.36 million, and the account is worth 66.4 per cent of it. On these terms the raise would have to take 60.8 months before the account caught up on time alone.
Time is not the real risk. Many first funds never reach a first close, and the set-up costs are spent either way. Weighting the fund by its probability of success:
Expected PV fund = p(success) × 11.02 − 1.0
At a 25% chance of failure: 7.27. At 40%: 5.61, below the account's 6.66.
Break-even: p(success) = (6.66 + 1.0) ÷ 11.02 = 69.5%
If the manager believes the fund closes less than 69.5 per cent of the time, the separate account is worth more. That probability is the one number founders are least able to estimate honestly, and it is the one the decision turns on. How the raise converts from names to commitments is worked in how many investors you must contact to raise a fund.
| Months to raise | Fund PV | Account at 0.75% | 0.90% | 1.10% |
|---|---|---|---|---|
| 9 | 10.56 | 4.68 | 3.90 | 2.86 |
| 15 | 10.02 | 4.14 | 3.36 | 2.33 |
| 24 | 9.26 | 3.38 | 2.60 | 1.57 |
| 36 | 8.33 | 2.45 | 1.67 | 0.63 |
The account is worth 5.88, 6.66 and 7.69 million at the three fee rates. A 20 basis point higher account fee is worth about as much as a year's delay in the fund. Negotiating the account's fee basis, on commitments rather than invested equity, would move it further than either.
Comparing fee rates and stopping. 0.90 against 1.5 per cent looks like a 40 per cent discount; on invested equity it is a 50 per cent discount in fees, partly offset by an earlier start and no raise. The reverse mistake is treating the fund as certain. And the two are rarely exclusive: an account run alongside the raise funds the management company, the gap measured in does a first close cover the management company, and builds the record the fund is sold on, provided its terms do not claim the deals the fund will need.
On 150 million the fund is worth 10.02 million to the manager and the separate account 6.66, so the fund wins if it closes at least 69.5 per cent of the time. Put your own odds into that sentence before choosing. Raising a Real Estate Fund works the raise from strategy and track record to first close, and the free workbook for this case runs it on a calendar so the raise time is not a guess.
Usually less than a commingled fund, and often on invested rather than committed capital. In the illustration an account at 0.90 per cent on invested equity pays 6.75 million of fees over eight years on 150 million, half the 13.50 million a fund at 1.5 per cent on commitments for three years earns, not the 60 per cent the rates suggest.
Longer than most raises last, if the fund is certain to close. On the illustrative terms the fund's present value of 10.02 million falls to 8.33 million after a 36-month raise and only matches the account's 6.66 million after 60.8 months. The probability of failure matters far more than the delay.
Often, and it can help: the account's fees, 0.45 million in its first year in the illustration, fund the management company during the raise and build a track record. The risk is a conflict over deal allocation, so the account's terms must say which deals belong to it and which to the fund.
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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