Articles

Should management fees be included in paid-in capital for TVPI?

Net TVPI and IRR computed with and without the fee calls, why the IRR error is so much larger than the multiple's, and when excluding fees is legitimate.

Julian R. Sterling · from Private Markets Performance

Yes. For a net return, paid-in capital is everything the investor wired to the fund, including the capital called to pay management fees and expenses. On an illustrative fund that called 86 for investments and 14 for fees, and distributed 160, TVPI is 1.60x on 100 paid in. Leaving the fee calls out gives 1.86x, and the IRR rises from 11.21 to 14.38 per cent: 317 basis points of return the investor never earned.

Worked in full in Private Markets Performance by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →

The error is common because fee calls often arrive on separate notices, are booked to a different line of the capital account, and are excluded from "invested capital" in the manager's deal-level reporting. All three are legitimate in their own place. The problem starts when a deal-level denominator is carried into a fund-level net return.

The fund

An illustrative fund per 100 committed. Fees of 2 a year for five years, then 1 a year to year 9. Distributions are net of carried interest; the fund is fully realised at year 10.

Year	Investment calls	Fee calls	Distributions	Cumulative paid-in	DPI with fees	DPI without fees
1	25	2	0	27	0.00x	0.00x
2	25	2	0	54	0.00x	0.00x
3	20	2	0	76	0.00x	0.00x
4	10	2	10	88	0.11x	0.12x
5	6	2	20	96	0.31x	0.35x
6	0	1	30	97	0.62x	0.70x
7	0	1	35	98	0.97x	1.10x
8	0	1	30	99	1.26x	1.45x
9	0	1	20	100	1.45x	1.69x
10	0	0	15	100	1.60x	1.86x
Total	86	14	160	100	1.60x	1.86x

The calculation, both ways

With fees in paid-in. Paid-in is 86 + 14 = 100. The investor's net cash flow each year is distributions minus all calls: −27, −27, −22, −2, then 12, 29, 34, 29, 19 and 15.

Without fees in paid-in. Paid-in becomes 86 and the flows lose the fee calls: −25, −25, −20, 0, then 14, 30, 35, 30, 20 and 15.

The overstatement is 0.26x, or 16.3 per cent, on the multiple and 317 basis points on the IRR. The investor made a profit of 60, not 74. The 14 of fees is not a timing difference that washes out: it is money that left the investor's account and never came back.

Why the IRR moves so much

Fee calls are front-loaded. Ten of the 14 are called in the first five years, when the fund has distributed little, and they sit at the most expensive point of the IRR curve: early, negative and compounding. Removing them lifts the early flows and shortens the effective duration of the investor's money, which an IRR rewards heavily. The multiple only sees the 14 once; the IRR sees each unit of fee for as long as it would have been invested.

Netting is not the fix. Some reports keep fees out of paid-in but deduct them from distributions. That restores the profit, 146 on 86, and gives 1.70x, still 0.10x above the true 1.60x, because the denominator remains too small. The only consistent net multiple is total distributions over total calls.

What if: the fee level

Same investments and distributions, three fee schedules (rate in the first five years / thereafter).

Fee	Fee calls	Paid-in	TVPI with fees	TVPI without	Gap	IRR with fees	IRR without	Gap, bp
1.0% / 0.5%	7.0	93.0	1.72x	1.86x	0.14x	12.76%	14.38%	162
1.5% / 0.75%	10.5	96.5	1.66x	1.86x	0.20x	11.98%	14.38%	240
2.0% / 1.0%	14.0	100.0	1.60x	1.86x	0.26x	11.21%	14.38%	317

The return without fees does not move at all, which is the giveaway: a "net" return that is identical whatever the fee schedule is a gross return. Each half point on the first-five-year fee rate, with the later rate scaled in step, is worth roughly 75 to 80 basis points of IRR on this fund. That is the scale of error a limited partner absorbs when comparing a manager that reports properly with one that does not.

When excluding fees is legitimate

Deal-level multiples in a track record are normally computed on invested capital, without fees, because fees are charged at fund level and cannot sensibly be allocated to a single company. That is a gross figure, and labelled as such it is fine. The bridge from that gross figure to the investor's net return has to put the fees back, then the expenses, then the carried interest; the first layer alone is worth 317 basis points here. How carry adds the remaining layer is worked in how much of the IRR reaches the investor.

The common mistake

The common mistake is to build the cash flow series from capital calls for investments and quietly drop the fee notices, often because the fund administrator reports them on a separate schedule. The resulting TVPI and IRR look like net figures, sit in a column headed net, and are 0.26x and 317 basis points too high. Check that paid-in on the performance page reconciles to total contributions on the capital account statement; if it is lower by roughly the fees charged to date, the fees are missing.

Takeaway

Net TVPI and IRR use every call, fee calls included: 1.60x and 11.21 per cent here, not 1.86x and 14.38. Reconcile paid-in to the capital account before trusting either. The cash flow series, its contribution traps and the full gross-to-net bridge are set out in the free workbooks for this book, and the three multiples are defined in how to calculate TVPI, DPI and RVPI.

Questions readers ask

Is paid-in capital the same as invested capital?

No. Paid-in capital is everything the investor has contributed, including fee and expense calls; invested capital is what went into portfolio companies. In the illustrative fund paid-in is 100 and invested capital 86. Net multiples use paid-in, so TVPI is 1.60x; dividing by invested capital gives 1.86x, a gross figure.

How much do management fees reduce a fund's IRR?

On the illustrative fund, a fee of 2 per cent for five years and 1 per cent thereafter costs 317 basis points of IRR, from 14.38 to 11.21 per cent. At 1 and 0.5 per cent the cost is 162 basis points. The effect is large because fees are called early, when the IRR weights cash most heavily.

Can fees be deducted from distributions instead of added to paid-in?

It is not equivalent. Deducting the 14 of fees from 160 of distributions and dividing by 86 of invested capital gives 1.70x, still 0.10x above the true 1.60x, because the denominator stays too small and the timing of the fee payments is lost. Divide total distributions by total calls.

Also on this site

• How do you calculate TVPI, DPI and RVPI for a private fund?Divide by paid-in capital: 791 distributed and 143 of NAV on 564 called give DPI 1.4025x, RVPI 0.2535x and TVPI 1.6560x. Worked case.
• How much of a private fund's reported IRR reaches the investor?A net IRR of 13.2935 per cent became 9.1878 or 6.2571 on the whole commitment. Only 33.3744 per cent of the advertised advantage arrived.
• Why is net IRR lower than gross IRR in private equity?A buyout returning 17.05 per cent gross leaves the investor 12.70 per cent net: 1.90 points go to the management fee and 2.44 points to carry.
• How do exchange rates change a private equity fund's IRR?Convert each flow at its own date's rate: a euro fund earning 14.57% returns 12.71% to a dollar investor after a 10% fall in the euro, not the 13.07% shortcut.
• How much does a NAV markdown cut a private equity fund's IRR?It depends on the fund's age: a 20 per cent markdown takes 9.7 points off a year-4 IRR of 10.1 per cent, 2.6 points at year 7 and 0.5 points at year 10.
• How do you benchmark private equity against an index plus 3%?Run a PME on the index grown at index plus 3 per cent, not the IRR against a CAGR. A fund that misses by 0.08 points on the CAGR beats it with a PME of 1.040.

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