Case 075Fund, LP and portfolio analyticsWarm up

A pension trust puts Rs 100 crore into a deal through a fund charging 2% and 20%, and Rs 100 crore alongside as a no-fee co-investment. The deal returns 2.5x gross in five years. What net multiple does each earn?

The situation

Paramita Pension Trust is an investor in a buyout fund. The fund charges a management fee of 2% a year on the trust's Rs 100 crore commitment for this deal's share, paid at the start of each year, and takes 20% carried interest on the profit after capital and fees are returned. Assume the fund has cleared its hurdle and the carry is charged in full on this deal.

The fund offers the trust a co-investmentA direct stake in a single company the fund is buying, held alongside the fund, usually on no-fee, no-carry or reduced terms. in the same company: another Rs 100 crore, with no fee and no carry. Both stakes are bought on the same day and sold together after 5 years for 2.5x the money invested.

Your task

Work out the net money multiple and IRR the trust earns on each Rs 100 crore, explain the gap, and say what a co-investment programme asks of the trust in return.

Quick check

The deal makes 2.5x gross. What net multiple does the trust earn on the fund stake?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

The fund stake earns about 2.02x net and an IRR of about 15.6%; the co-investment earns the full 2.5x and about 20.1%. On the fund stake the trust pays Rs 10 crore of fees on top of the Rs 100 crore invested and gives up Rs 28 crore of carry, keeping Rs 222 crore on Rs 110 crore paid in. The co-investment keeps all Rs 250 crore on Rs 100 crore. Same company, same exit; the difference is the cost of access.

Step 1Where do fees and carry come out of the fund stake?

From both ends of the multiple. Think of buying the same flat directly or through a broker who charges a yearly retainer and a share of the gain when you sell: the flat appreciates the same, but you pay more in and take less out. Five years of 2% fees adds Rs 10 crore to what the trust pays, so it puts in Rs 110 crore; the profit after returning that is Rs 140 crore, and 20% carry takes Rs 28 crore of it. The trust keeps Rs 222 crore on Rs 110 crore paid in, 2.02x. Half a turn of the gross multiple disappears between the company and the investor.

Same deal, same 2.5x gross: what the trust keeps, Rs croreThrough the fund: 2% fee, 20% carry110Paid inincl. 10 fees250Gross2.5x the 100-28Carry20% of 140222Trust keepsNet 2.02x, IRR 15.6%Co-investment: no fee, no carry100Paid inno fees250Gross2.5x the 1000Carrynone250Trust keepsNet 2.50x, IRR 20.1%
On the same 2.5x deal, the fund stake costs the trust Rs 110 crore including fees and returns Rs 222 crore after Rs 28 crore of carry, 2.02x net, while the co-investment costs Rs 100 crore and returns the full Rs 250 crore, 2.50x, because it carries no fee and no carry.
Rs croreThrough the fundCo-investment
Invested in the company100100
Management fees over 5 years100
Total paid in110100
Gross proceeds at 2.5x250250
Carried interest at 20%(28)0
Net proceeds222250
Profit to the trust112150
Net MOIC and IRR2.02x, 15.6%2.50x, 20.1%
The same Rs 100 crore in the same company earns the trust Rs 112 crore of profit through the fund and Rs 150 crore as a co-investment; across both stakes the trust earns 2.25x on Rs 210 crore paid in.
Step 2Why does the IRR gap look bigger than the multiple gap?

Because fees are paid every year from the start, while the gain arrives only at the end. The fund stake's IRR is about 15.6% against 20.1% for the co-investment, a gap of about 4.5 points a year. That gap is the fee dragThe difference between gross and net returns caused by management fees and carried interest, usually quoted in percentage points a year. on this deal. Notice it is larger than the 2% fee: carry is the bigger part of the drag on a successful deal, and it grows with success, because 20% of a bigger profit is a bigger number.

Step 3If co-investment is so much cheaper, why not do it on every deal?

Because the trust is buying a different thing. The fund stake gives the trust a diversified portfolio picked by the manager; a co-investment is a single company, and the trust must decide, quickly, whether to take it. That needs a team that can review a deal in two or three weeks, a tolerance for concentration, and care about selection: a manager offering co-investment on its largest deals may be offering the ones it cannot fully fund. The usual answer is to run co-investment alongside fund commitments, which is what the trust has done here; across both stakes it earns 2.25x, better than the fund alone. The limitation: this deal returned 2.5x, and a co-investment that loses money loses it without the cushion of other deals in the fund.

Where candidates lose it

The usual loss is taking carry off the gross profit and forgetting the fees, or the reverse. Fees raise what the trust pays in, carry lowers what it gets out, and both must be counted to reach 2.02x.

The second is assuming the co-investment and the fund stake are the same risk. They are the same company here, but a co-investment programme concentrates the trust in a few deals, and its net advantage is only worth having if the deals are chosen with care.

What the interviewer asks next

  • The co-investment charges a 1% fee and 10% carry. What is the net multiple now?
  • How would a 15% preferred return with a full catch-up change the carry on this deal?
  • Why might a manager want to offer co-investment at all?
  • How would you check a manager is not offering its weakest deals as co-investments?

Company names and figures are illustrative.