The two partner columns of a fund's statement of changes in net assets move by different proportions in a bad quarter. The carry accrual explains the gap.
Because the general partner's accrued carried interest absorbs part of every fall. While the fund is above its hurdle, a $30m markdown on $300m of investments costs the limited partners only $24m, so their NAV falls 8.57 per cent against a 10 per cent fall in the portfolio. Inside the catch-up zone the LPs lose nothing at all, and once the carry accrual is exhausted they bear every dollar.
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 →
Read a private fund's statement of changes in net assets after a bad quarter and the two partner columns move by different proportions. The limited partners' capital falls by less than the change in unrealised value would suggest, and the general partner's column shows a negative allocation: the reversal of carried interest previously accrued. Nothing has been paid back. The accrual was a liability the fund recognised on paper, and paper liabilities shrink when values fall.
| Item | $m |
|---|---|
| Capital paid in by the LPs, no distributions yet | 200 |
| Preferred return accrued to date | 40 |
| Investments at fair value | 300 |
| Carried interest | 20%, full catch-up |
| Accrued carried interest, hypothetical liquidation | 20.0 |
| Net assets attributable to LPs | 280.0 |
Run the waterfall as if every investment were sold at its fair value today. Profit is $300m − $200m = $100m.
The first $40m of profit is the LPs' preferred return. The catch-up then gives the GP 100 per cent until it holds 20 per cent of all profit: that happens at $40m ÷ (1 − 0.20) = $50m of profit, so the catch-up is $10m. Above $50m of profit, every dollar splits 80/20.
At $100m of profit the GP is fully caught up: accrued carry = 20% × $100m = $20.0m. LP net assets = $300m − $20.0m = $280.0m.
As a spreadsheet function of fair value V: =IF(V-200<=40,0,IF(V-200<=50,V-200-40,0.2*(V-200))).
The structure has three zones, set by fair value: below $240m the LPs have not yet earned their preferred return and there is no carry; between $240m and $250m the GP is catching up; above $250m profit splits 80/20.
Now mark the portfolio down by 10 per cent, to $270m. Profit falls to $70m, still above the $50m at which the catch-up ends, so carry is 20 per cent of $70m, or $14.0m.
Loss on investments: $300m − $270m = $30m.
Reversal of accrued carry: $20.0m − $14.0m = $6.0m, borne by the GP.
Loss to the LPs: $30m − $6.0m = $24.0m. LP net assets fall from $280.0m to $256.0m, which is 8.57 per cent.
In the 80/20 zone the LPs bear 80 per cent of any change in value and the GP 20 per cent. On the statement of changes in net assets, the $30m net change in unrealised depreciation is allocated $24.0m to the limited partners and $6.0m to the general partner.
| Portfolio fall | Fair value | Zone | Accrued carry | LP net assets | LP change |
|---|---|---|---|---|---|
| 0% | 300.0 | 80/20 split | 20.0 | 280.0 | 0.0% |
| 5% | 285.0 | 80/20 split | 17.0 | 268.0 | −4.3% |
| 10% | 270.0 | 80/20 split | 14.0 | 256.0 | −8.6% |
| 15% | 255.0 | 80/20 split | 11.0 | 244.0 | −12.9% |
| 16.7% to 20% | 250.0 to 240.0 | catch-up | 10.0 to 0.0 | 240.0 | −14.3% |
| 25% | 225.0 | below hurdle | 0.0 | 225.0 | −19.6% |
| 30% | 210.0 | below hurdle | 0.0 | 210.0 | −25.0% |
The cushion is not proportional. In the split zone it absorbs a fifth of each loss. Through the catch-up zone it absorbs all of it: the portfolio can fall from $250m to $240m and the LPs' capital does not move. Below $240m the accrual is gone and the LPs take the full fall. A 30 per cent markdown costs them 25.0 per cent, and from there the portfolio has to rise 42.9 per cent to get back to $300m, while the LPs' own NAV needs 33.3 per cent to return to $280.0m, because the carry re-accrues on the way up.
The usual error is to read the LP column as the fund's performance. After a 10 per cent markdown, an investor who sees its capital account down 8.57 per cent may conclude the manager outperformed its own marks. It did not: the difference is the carry accrual reversing, and it reverses on the way up too, so the LPs also capture only 80 per cent of a recovery. The reverse error is to compute carry as a flat 20 per cent of profit. That gives $8.0m of carry at $240m of fair value, when the hypothetical liquidation gives zero, and it hides the zone where the LPs are fully protected. The accrual itself is worked in how to calculate accrued carried interest at quarter end.
Reading test: when the LP column falls by less than the change in unrealised value, find the carry reversal in the GP column. The two must add up to the total change in net assets, here $24.0m and $6.0m to a $30m fall.
An accrued carry is a liability that moves with value. Above the catch-up it cushions a fifth of every loss, inside the catch-up it cushions all of it, and below the hurdle it is gone. The book's fifth worked case prices an accrued carry and shows why it cushions a fall; the free workbook for this case runs the hypothetical liquidation behind it, with the check that tells you whether the catch-up has cleared. The related reading of how a fund's income is allocated between the GP and the LPs uses the same two columns.
It is the reduction of carried interest previously accrued to the general partner when fund values fall. Nothing is repaid in cash; the hypothetical liquidation simply gives less carry. In the worked fund, a fall from $300m to $270m of investments cuts the accrual from $20.0m to $14.0m, a $6.0m reversal allocated to the GP column.
Partly, and only while there is accrual left. Above the catch-up zone it absorbs 20 per cent of each loss; inside the catch-up zone, between $250m and $240m of fair value in the example, it absorbs all of it. Below the $240m hurdle value the accrual is zero and a 30 per cent markdown costs the LPs 25.0 per cent.
Because the preferred return and catch-up make carry non-linear. At $240m of fair value, 20 per cent of the $40m profit suggests $8.0m of carry, but the hypothetical liquidation gives zero, since the LPs have only just earned their preferred return. The flat shortcut overstates the GP column and understates LP net assets.
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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