Chapter 1 of 5 · 10 min

Management fees and fee drag

A $1bn fund never invests $1bn. Why gross and net multiples differ, before carry takes a penny.

By the end of this chapter you can

Calculate lifetime management fees on commitments, then on invested capital
Turn a gross multiple on invested capital into a net multiple on commitments
Find the gross multiple a fund needs for a net target
Show what charging on invested capital from day one saves

The intuition

You give a builder $100,000 to renovate your house, and they charge a management fee out of that same money every month for the whole project. Whatever they spend on the house has to come out of what is left, so the finished kitchen has to be worth a lot more than the bricks for you to come out ahead.

A private equity fund works the same way. The limited partners (LPs) commit the money; the general partner (GP) charges a management fee out of those commitments every year. The deals are done with what remains, but the LPs judge the result against everything they committed.

The key idea

Investable capital = commitments − lifetime fees. Proceeds = investable × gross multiple. Net multiple = proceeds ÷ commitments. The gap between gross and net is the fee drag.

Why it works

The conventions here: a ten-year fund. The fee is charged on the whole commitment during the investment period, then on invested capital, taken as a stated share of commitments, for the rest of the life. Fees come out of the commitments. Carry is left out; it is the next layer (the carry waterfall chapter).
Why commitments first. During the investment period the GP is building a team and finding deals before much capital is at work, and it wants a budget it can count on. LPs accept that, and ask for the base to drop once the buying stops.
Gross is measured on what was invested; net on what was committed. The same proceeds divided by a bigger number give a smaller multiple.
Fees are a fixed share of commitments, whatever the deals return. The drag in turns of multiple is that share times the gross multiple, so a better fund loses more turns to the same fees.
Fee offsets credit any deal or monitoring fees the GP charges portfolio companies against the management fee, so it is not paid twice.

A $1,000M fund; 2% on commitments for 5 years, then 1.5% on invested capital (80% of commitments) for 5 years; 2.5x gross

Investment period: 1,000 × 2% × 5	100
After it: 800 × 1.5% × 5	60
Lifetime fees	160, or 16% of commitments
Invested: 1,000 − 160	840
Proceeds: 840 × 2.5	2,100, so 2.10x net
Gross needed for 2.0x net: 2,000 ÷ 840	2.38x

Charged on invested capital from day one: 800 × 2% × 5 + 60 = 140, saving 20.

The formulas

Fees in the investment period = commitments × fee rate × years

On the whole commitment.

Fees afterwards = invested capital × later rate × remaining years

On what is actually at work.

Investable capital = commitments − lifetime fees

What is left to do deals with.

Net multiple (before carry) = investable × gross multiple ÷ commitments

Proceeds over everything committed.

Gross needed for a net target = target × commitments ÷ investable

Run it backwards.

Worked example

Take the fees out of the commitments, grow what is left at the gross multiple, then divide by the full commitment.

Drawing the numbers…

See it move

Same fund. Change both fee rates, the investment period, how much capital ends up invested and the gross multiple the deals earn.

Drawing the numbers…

Try this

Raise the fee during the investment period. Less is left to invest, the net multiple falls, and switching to invested capital saves more.
Lengthen the investment period. Lifetime fees rise: a year moves from the lower rate on invested capital to the higher rate on the whole commitment.
Raise the gross multiple. The net multiple rises, but the drag in turns grows too, while fees as a share of commitments do not move.
Raise invested capital as a share of commitments. Fees after the investment period rise, and charging on invested capital from day one saves less.

Run it backwards

Same fund, reversed: the LPs want a set net multiple on their commitments. What must the deals earn on the capital actually invested?

Drawing the numbers…

The target fixes the proceeds: target × commitments. Those proceeds must come from the smaller investable pool, so divide by it.

It is why a fund pitching 2x net to LPs has to underwrite its deals at well over 2x, and that is before carry takes its share of the profit.

Traps

Applying the gross multiple to commitments.

The gross multiple is earned only on what was invested, which is commitments less fees.

Charging the whole life's fee on commitments.

The base usually steps down to invested capital after the investment period.

Quoting fees as a percentage and stopping there.

2% a year for ten years is not 2%. Add up the years; lifetime fees are often 12–18% of commitments.

Calling the net multiple before carry the LPs' final return.

Carry comes out of the profit as well. Fees and carry together are the '2 and 20'.

Thinking fee drag is the same in turns for every fund.

The drag in turns is the fee share times the gross multiple, so it grows as the fund does better.

Say it in the interview

The interviewer asks

“How do management fees affect an LP's return?”

Say yours out loud first, then compare.

Check yourself

4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.

Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.

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Drawing your questions…

Remember

Investable = commitments − lifetime fees.
Net multiple = investable × gross ÷ commitments.
Gross needed = net target × commitments ÷ investable.
Fees on commitments early, on invested capital later.