From net to gross in two steps: carry on the way down, fees on the way across. And why dividing the target by 0.8 leaves investors at 2.6x.
A venture fund that spends 20 per cent of its commitments on management fees and takes 20 per cent carried interest must return 4.375x gross on the capital it invests to give its investors 3.0x net. The usual shortcut, 3.0x divided by 0.8 for the carry, gives 3.75x, and a fund that delivers exactly that returns its investors only 2.6x.
Worked in full in Venture Capital by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Investors underwrite venture funds to a net multiple: what they receive divided by what they paid in. Managers report gross multiples on the companies: proceeds divided by cost. The two sit on different denominators, and the bridge between them has two separate deductions. Both are mechanical, so the gross target behind any net ambition can be computed exactly, for a stated set of terms.
| Term | Value |
|---|---|
| Commitments | 100.0 |
| Management fee, years 1 to 5, on commitments | 2.5% |
| Management fee, years 6 to 10, on commitments | 1.5% |
| Total fees over the life | 20.0 |
| Capital invested in companies | 80.0 |
| Carried interest, whole of fund, on profit over commitments | 20% |
| Target net multiple to investors | 3.0x |
Two simplifications are stated rather than hidden. The fund is assumed to call its full commitment, so paid-in capital equals 100. And the carried interest is taken as 20 per cent of all profit: that is exact for a fund with no hurdle, and for a fund with a hurdle and a full catch-up once the catch-up has cleared, which a 3.0x fund over ten years has long since done.
Investors receive proceeds D less carry, and carry is 20 per cent of D less the 100 committed. Set what investors receive equal to the target and solve for D.
D − 0.20 × (D − 100) = 3.0 × 100
D = (3.0 × 100 − 0.20 × 100) ÷ 0.80 = 350.0
Carry: 0.20 × (350.0 − 100) = 50.0. Investors receive 300.0.
In Excel, with the target in B1, commitments in B2 and the carry rate in B3:
=(B1*B2-B3*B2)/(1-B3)
The 350.0 has to come from the 80.0 actually invested, because the other 20.0 went in fees and never reached a company.
Gross multiple on invested capital = 350.0 ÷ 80.0 = 4.375x
On commitments it is 350.0 ÷ 100 = 3.5x. The gross-to-net ratio is 4.375 ÷ 3.0 = 1.458.
Even returning the investors' money takes work. To give back 1.0x, the portfolio must produce 100.0 from 80.0: 1.25x gross, with no carry paid. The book's own fund has its version of this figure: 128,530,000 of investable capital on a 150,000,000 commitment, and 1.1670x to return before the investor is whole.
| Net to investors | Proceeds needed | Carry | Gross on 80 invested | Gross with 20 recycled |
|---|---|---|---|---|
| 1.0x | 100.0 | 0.0 | 1.25x | 1.2x |
| 2.0x | 225.0 | 25.0 | 2.813x | 2.45x |
| 2.5x | 287.5 | 37.5 | 3.594x | 3.075x |
| 3.0x | 350.0 | 50.0 | 4.375x | 3.7x |
| 5.0x | 600.0 | 100.0 | 7.5x | 6.2x |
Recycling changes the denominator. If the fund reinvests 20.0 of early proceeds, so that the full 100 goes into companies, the portfolio must produce 370.0 in total: the 350.0 that investors and the manager need, plus the 20.0 that was put back to work. On 100 invested that is 3.7x, 0.675 of a turn less than without recycling. It does not make the fund any cheaper; it gives the fee money a chance to earn its own return, which is worth it only if the recycled money earns more than the investor could have done with the distribution.
| Fees over the life | Capital invested | Gross needed |
|---|---|---|
| 10.0 | 90.0 | 3.889x |
| 15.0 | 85.0 | 4.118x |
| 20.0 | 80.0 | 4.375x |
| 25.0 | 75.0 | 4.667x |
Each five points of fee load add roughly a quarter of a turn to the gross target. The carry, by contrast, is already in the 350.0 and does not move with the fee.
The common mistake is to gross up the net target for carry only and on the wrong base: 3.0 ÷ 0.8 = 3.75x. Applied to the 80.0 invested, that is 300.0 of proceeds. Carry takes 0.20 × 200.0 = 40.0, and investors receive 260.0, or 2.6x. The shortcut misses that carry is charged on profit over the full commitment, not over invested capital, and that fees have already shrunk the base on which the gross multiple is earned. A manager who presents a 3.75x gross track record as a 3x net strategy has overstated the net result by 0.4 of a turn before any expenses.
Always state the denominator. 4.375x on invested capital, 3.5x on commitments and 3.0x net to investors are the same fund. A multiple quoted without its denominator cannot be compared with anything.
The fee schedule, the investable capital and the carried interest under five conventions are worked on the book's own fund in the free workbooks for this case. What the fees add up to over a fund's life is in how much a 2 per cent management fee costs over a fund's life, and how recycling lets a fund call more than its commitment in can a fund call more than my commitment.
It depends on what the investor needs net. With 20 per cent of commitments in fees and 20 per cent carry, a fund must return 1.25x gross on invested capital just to give investors their money back, 2.813x for 2.0x net, 4.375x for 3.0x net and 7.5x for 5.0x net. These figures are illustrative and exclude fund expenses.
Because two deductions sit between them. Management fees mean only 80 of every 100 committed is invested, and carried interest takes 20 per cent of the profit above the commitment. In the worked case 350 of proceeds on 80 invested is 4.375x gross; after 50 of carry the investors receive 300, or 3.0x on what they paid in.
It lowers the gross multiple needed on invested capital for the same net result, because recycled proceeds put the fee money back to work. In the worked case recycling 20 of early proceeds means 100 is invested, and 3.0x net needs 3.7x gross instead of 4.375x. It only helps if the recycled money earns more than it costs.
Fees, carried interest and time are the subject of chapters 13 to 16 of Venture Capital, worked on the book's own fund in the companion workbooks. 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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