Two and twenty in money, on one commitment, and why the answer depends entirely on the denominator.
Add the three layers in money and divide by the gain before any of them. On an illustrative 600 private equity commitment that earned 518.06 before fees, the management fee took 55.56, carried interest 92.50 and the advisory layer 21.00: 169.06, or 32.63 per cent of the gross gain. The investor kept 349.00. Against the fund's reported net gain of 370.00, the same load is 45.69 per cent.
Worked in full in Alternative Investments by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
"Two and twenty" sounds like 2 per cent a year plus a fifth of the profit. In money it is neither, because the fee base, the carry base and the investor's own costs sit on different denominators. An investor who wants to know what the asset class cost needs one number: the fee load in currency, divided by the gain the underlying investments produced before anyone was paid. Everything below is computed from one illustrative programme, a foundation's ten-year commitment to a buyout fund.
| Input | Value |
|---|---|
| Commitment | 600 |
| Management fee, on commitment for 5 years, then on net invested capital | 1.75% |
| Carried interest, no hurdle | 20% |
| Advisory and administration layer, on the commitment, a year | 0.35% |
| Capital called (fees included) | 564 |
| Distributions | 791 |
| Residual NAV at year 10 | 143 |
| Peak net capital at work (year 4) | 383 |
Management fee: 1.75% × 600 = 10.50 a year for five years = 52.50. Then 1.75% on net capital at work: 154 in year 6 gives 2.6950, 21 in year 7 gives 0.3675, and nothing after. Total 55.56.
Fund net gain: distributions + NAV − calls = 791 + 143 − 564 = 370.00. Fees are inside the calls, so this is already after the management fee and after carry.
Carried interest: 370.00 is 80 per cent of the gain after fees, so carry = 370.00 × 20 / 80 = 92.50, on a pre-carry gain of 462.50.
Gross gain: 462.50 + 55.56 = 518.06, what the companies produced for this commitment before the manager was paid.
Advisory layer: 0.35% × 600 × 10 = 21.00, paid by the investor outside the fund. Kept: 370.00 − 21.00 = 349.00.
Load: 55.56 + 92.50 + 21.00 = 169.06; 169.06 / 518.06 = 32.63%.
In Excel: =(SUM(Fees)+Carry+Advisory)/(SUM(Dist)+NAV-SUM(Calls)+SUM(Fees)+Carry).
| Denominator | Amount | Load as a share |
|---|---|---|
| Gross gain, before all layers | 518.06 | 32.63% |
| Fund net gain, after fee and carry | 370.00 | 45.69% |
| What the investor kept | 349.00 | 48.44% |
| Commitment, per year over ten years | 600 | 2.82% |
| Peak capital at work, per year | 383 | 4.41% |
Carry is the largest layer, 54.71 per cent of the load, management fees 32.87 and the advisory layer 12.42. Of the gross gain, the investor kept 67.37 per cent. Notice that carry is only 17.85 per cent of the gross gain, not 20: it is charged on the gain after management fees, and 20 per cent of the gross gain would have been 103.61. The management fee is heavier than its headline rate suggests while it is charged on the commitment: for five years it took 10.50 a year on 600 while no more than 383 was ever at work, which is 2.74 per cent a year of peak capital, not 1.75. Over the whole programme the full load of 169.06 comes to 4.41 per cent a year of that peak capital.
| Gross gain | Carry | Total load | Investor keeps | Load / gross gain |
|---|---|---|---|---|
| 250.00 | 38.89 | 115.45 | 134.55 | 46.18% |
| 400.00 | 68.89 | 145.45 | 254.55 | 36.36% |
| 518.06 | 92.50 | 169.06 | 349.00 | 32.63% |
| 700.00 | 128.89 | 205.45 | 494.55 | 29.35% |
The share falls as performance rises, because the management fee and the advisory layer are fixed in money: 76.56 that the investor pays before keeping anything, whatever the fund earns. A weak fund is the expensive one in percentage terms. If the fee had been charged on the full commitment for all ten years with no step-down, management fees would have been 105.00 rather than 55.56, carry 82.61, and the load 208.61, or 40.27 per cent of the same gross gain.
With a preferred return and a full catch-up the carry would be unchanged at this level of performance, since the fund clears the hurdle comfortably. A hurdle changes the fee share only for funds near or below it.
Quoting the fee load against the net gain and calling it the share of returns lost. 45.69 per cent sounds like nearly half the profit going to the manager; the share of what the investments produced is 32.63. The opposite mistake is quoting 2 and 20 as if it were 2 per cent a year plus 20 per cent: on this programme the full load was 2.82 per cent a year of the commitment and 4.41 per cent a year of peak capital at work. Both mistakes come from using one layer's denominator for the whole load.
Put every layer in money, then divide by the gain before any of them: here 169.06 of 518.06, or 32.63 per cent, of which carry is the largest part and the fixed fees are what make weak years expensive. The fee load, the smoothing correction and the cost of an early exit are computed for this programme in the free workbook for this case. For the effect of the same fees on the rate rather than the money, see why net IRR is lower than gross IRR.
It depends on performance and the fee base. In the worked case a 1.75 per cent fee with a step-down and 20 per cent carry, plus a 0.35 per cent advisory layer, cost 169.06 on a 600 commitment: 2.82 per cent a year on the commitment, 4.41 per cent on the peak capital at work, and 32.63 per cent of the gross gain.
No. Carry is charged on the gain after management fees. In the worked case carry of 92.50 is 20 per cent of a 462.50 pre-carry gain but only 17.85 per cent of the 518.06 gross gain; 20 per cent of the gross gain would have been 103.61.
Because management fees and advisory costs are fixed in money while carry shrinks. With the same terms, a gross gain of 250.00 loses 46.18 per cent to fees, against 32.63 per cent at 518.06 and 29.35 per cent at 700.00.
This article is one calculation from Alternative Investments. 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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