The top half of a fund's statement of operations is its cost base with a little income netted against it; the return sits in the gains below.
A private equity fund reports a net investment loss because its investment income, interest and dividends, is smaller than its running costs, and its returns arrive as realised and unrealised gains below that line. On the illustrative Harbourgate fund, income of 1,910 against expenses of 5,110 gives a net investment loss of 3,200, minus 1.17 per cent of average net assets, in a year when the fund's net assets grew by 10,750 from operations. The loss is structural, and it says nothing about the portfolio.
Worked in full in How to Read a Private Fund's Financial Statements by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The statement of operations of an investment fund is built in two halves. The top half is income and expenses, ending in net investment income or loss. The bottom half is realised gains, the change in unrealised appreciation and, in many private funds, the carried interest accrual, ending in the net increase or decrease in net assets from operations. A buyout portfolio earns almost nothing in the top half: its companies retain cash or pay it to their lenders. So the top half is the fund's cost base with a little income netted against it, and it will be negative in almost every year of the fund's life.
The figures are those of Harbourgate Partners II, the fictional fund whose reporting pack the book prints, for its fifth year. Amounts are in thousands.
| Line | Amount |
|---|---|
| Interest income | 1,180 |
| Dividend income | 640 |
| Other income | 90 |
| Total investment income | 1,910 |
| Management fee, net of offsets | 3,680 |
| Administration and accounting | 410 |
| Legal and professional | 350 |
| Audit and tax compliance | 265 |
| Interest and financing costs | 210 |
| Other operating expenses | 140 |
| Custody and bank charges | 55 |
| Total operating expenses | 5,110 |
| Net investment loss | (3,200) |
Net investment income (loss) = interest + dividends + other income − operating expenses
NII ratio = net investment income (loss) ÷ average net assets
Average net assets here are the mean of the opening 271,700 and the closing 277,450, so 274,575; a fund with large mid-year flows should use a time-weighted average. In Excel: =(SUM(income)-SUM(expenses))/AVERAGE(B_open,B_close). Funds reporting under US GAAP investment company rules show this ratio, with the expense ratio, in the financial highlights note.
Step 1: income is 1,180 + 640 + 90 = 1,910. Step 2: expenses are 5,110, of which the management fee is 3,680, or 72.02 per cent. Step 3: 1,910 − 5,110 = −3,200. Step 4: −3,200 ÷ 274,575 = −1.17 per cent. On the same base the expense ratio before carry is 1.86 per cent and the income ratio 0.70 per cent.
| Line | Amount |
|---|---|
| Net investment loss | (3,200) |
| Net realised gain on investments | 21,400 |
| Net change in unrealised appreciation | (4,600) |
| Net gain on investments | 16,800 |
| Result before carried interest | 13,600 |
| Carried interest accrual | (2,850) |
| Net increase in net assets from operations | 10,750 |
The net gain on investments of 16,800 covers the net investment loss 5.25 times, and the year's result after carry is 10,750, or 3.92 per cent of average net assets. The net investment loss is not a signal of distress; it is the price of running the structure. Strip out the management fee and the top half is slightly positive, at 480: the portfolio's income covers the administration, audit, legal and financing costs of 1,430 and a little more.
The two lines that do deserve attention are the realised gain of 21,400 and the negative change in unrealised of 4,600. Read together they usually describe one profitable exit seen twice: the gain crystallises on sale and the unrealised appreciation previously booked on the same asset reverses out. How the split works is shown in realised vs unrealised gain on a fund exit.
The sign of net investment income depends almost entirely on what the portfolio pays out. Holding the expenses at 5,110 and average investments at 286,300, the table varies the income yield on investments. Harbourgate's is 0.67 per cent.
| Portfolio | Income yield | Income | Net investment income | NII ratio |
|---|---|---|---|---|
| Pure growth equity, no income | 0.00% | 0 | (5,110) | -1.86% |
| Harbourgate, mostly buyout equity | 0.67% | 1,910 | (3,200) | -1.17% |
| Mixed equity and structured instruments | 3.00% | 8,589 | 3,479 | 1.27% |
| Private credit fund | 6.00% | 17,178 | 12,068 | 4.40% |
| Higher-yield credit fund | 9.00% | 25,767 | 20,657 | 7.52% |
The break-even income yield is 1.78 per cent: below it, a fund with Harbourgate's cost base reports a net investment loss whatever its gains. That is why a credit fund's net investment income is a meaningful measure of its earning power and a buyout fund's is not. For a credit fund, the top half is the return; for a buyout fund, it is the cost.
Net investment income is income less running costs: minus 3,200 here, minus 1.17 per cent of average net assets, and normal for an equity portfolio yielding 0.67 per cent against costs of 1.86 per cent. Read it as the cost of the structure, then read the gains. The free workbook for this case rebuilds the full Harbourgate pack, and the expense side is taken further in how to calculate a private fund's expense ratio.
Net investment income is income less operating expenses and excludes gains. The net increase in net assets from operations adds realised gains, the change in unrealised appreciation and any carry accrual. On the illustrative fund, a net investment loss of 3,200 becomes a net increase of 10,750 after 21,400 of realised gain, minus 4,600 of unrealised and a 2,850 carry accrual.
Not in itself. An equity portfolio pays little income, so the ratio is usually negative. On the illustrative fund it is minus 1.17 per cent, with portfolio income of 0.67 per cent of investments against costs of 1.86 per cent of net assets. For a private credit fund the same ratio would be a warning, because its income is its return.
Its operating expenses divided by its average investments. With 5,110 of expenses and 286,300 of average investments, the illustrative fund needs an income yield of 1.78 per cent. At 3.00 per cent it would report net investment income of 3,479, and at 6.00 per cent, typical of an illustrative credit book, 12,068.
This article is one calculation from How to Read a Private Fund's Financial Statements. 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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