The gap between a fund's deal return and its investor's return is arithmetic, and every point of it can be traced to a term of the partnership agreement.
Net IRR is lower than gross IRR because the management fee and the carried interest sit between the deal and the investor. On a five-year buyout returning 17.05 per cent gross and 2.20x, a 2.0 per cent fee on committed capital and 20 per cent carry over an 8 per cent preferred return leave the investor 12.70 per cent net and 1.78x. The gap is 4.34 points: 1.90 for the fee and 2.44 for the carry.
Worked in full in The Buyout Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A buyout fund reports two kinds of return, and they measure different things. The gross IRR is the return on the company: money the fund put into the deal against money it took out. The net IRR is the return on the investor's own cash: every contribution it was called for, at the date it was called, against what it actually received after the general partner was paid.
The worked example is Kestrel, a mid-market buyout held for five years and treated, for this purpose, as if it were the whole fund. The fund invested $190.0 million at closing and received $417.4 million at exit: 17.05 per cent and 2.20x. Three terms of the partnership agreement stand between that figure and the subscriber’s account.
| Level | What is deducted | IRR | Multiple |
|---|---|---|---|
| The deal | Nothing | 17.05% | 2.20x |
| Gross to the subscriber | Management fee | 15.14% | 1.98x |
| Net to the subscriber | Fee and carried interest | 12.70% | 1.78x |
| Net with a subscription line | Fee, carry and line interest | 14.39% | 1.69x |
The fee is charged on what the subscriber promised, not on what was invested, and the fee itself is part of the promise. Five years at 2.0 per cent of the commitment must equal the commitment less $190.0 million. The commitment that solves that equation is $211.1 million. The fee is $4.22 million a year, $21.1 million over the hold.
The fee does two things at once. It shrinks the gain and it enlarges the base. The deal earned $227.4 million on $190.0 million. The subscriber, on the same $417.4 million of proceeds, has a profit of $206.3 million on $211.1 million. Run on dated flows, that moves the return from 17.05 per cent to 15.14 per cent, and the multiple from 2.20x to 1.98x.
The preferred return compounds at 8 per cent on each contribution from its own date and comes to $94.8 million. Contributions plus preferred return set the hurdle at $305.9 million. Proceeds of $417.4 million clear it with room, so the full catch-up runs to completion and the carry settles at 20 per cent of the whole $206.3 million profit: $41.3 million. The subscriber’s net proceeds are $376.2 million, and its return is 12.70 per cent and 1.78x.
The total gap is 4.34 points of IRR and 0.42x of multiple: 1.90 points for the fee and 2.44 points for the carry. The carry costs more because it is charged on the profit the leverage produced, while the fee is charged on the commitment. The subscriber keeps $165.1 million of profit out of the $227.4 million the deal earned, 72.6 per cent.
Subtracting the fee rate from the gross IRR does not give the net IRR. A 2.0 per cent fee cost 1.90 points here, and a 20 per cent carry cost 2.44 points. Neither can be read off the rate: both depend on the deal’s multiple, its length and the dates of the calls. The only route to the subscriber’s number is the waterfall itself, run on dated cash flows.
A subscription line lets the fund buy the company with borrowed money and call the capital later. On Kestrel the fund borrows the $190.0 million at 6.50 per cent and calls it 12 months later, with $12.35 million of interest. Nothing changes inside the company. The subscriber’s net IRR rises from 12.70 per cent to 14.39 per cent, 1.69 points, because the same profit is compounded over a shorter time. Its net multiple falls from 1.78x to 1.69x, because it paid the interest and received nothing for it.
The line also moves the hurdle. The largest contribution now arrives a year later, so the preferred return falls from $94.8 million to $78.6 million. The carry falls a little, to $38.8 million, but the general partner reaches its catch-up sooner. The 1.69 points are a change in measurement. The $12.35 million is a change in return.
A deck showing 17.05 per cent and a statement showing 12.70 per cent are not in conflict. They are the same deal seen from the two ends of the fund. The test is whether both figures appear in the same document, with the terms that connect them. Four terms decide the walk, and each belongs in the partnership agreement rather than the summary:
Then rebuild the walk from dated flows, term by term, and see where each point went. The full waterfall, the fee circularity and the line are worked through in The Buyout Investor and its companion workbook.
Gross IRR is the return on the deal: money invested in the company against money taken out, 17.05 per cent on the worked buyout. Net IRR is the return on the investor's own dated contributions after management fees and carried interest, 12.70 per cent on the same deal. The gross figure judges the deal team; the net figure is what the investor earned.
On a buyout returning 2.20x, 20 per cent carry with a full catch-up takes 20 per cent of the whole profit once the 8 per cent hurdle is cleared: $41.3 million of a $206.3 million profit. That cost the investor 2.44 points of IRR, more than the management fee's 1.90 points, because carry is charged on the profit leverage produced.
Yes. Borrowing the $190.0 million at 6.50 per cent and calling it 12 months later raised the investor's net IRR from 12.70 per cent to 14.39 per cent, 1.69 points, with nothing changed inside the company. The net multiple fell from 1.78x to 1.69x, because the investor paid $12.35 million of interest for it.
This article is one calculation from The Buyout Investor. 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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