A private credit fund targets 14% gross, charges 2% a year and takes 20% carry above a 10% hurdle. What does the investor keep, and how does that compare with 8.5% on AAA bonds once illiquidity is priced?

After expected losses and fees the investor keeps about 10.4%, only 1.9 points above AAA bonds. The 14% target less 1.5 points of losses is 12.5%; the 2% fee takes it to 10.5%; carry on the half point above the hurdle costs 0.1. A premium under two points must pay for five years of lock-up and for losses worse than expected, so the case is thin unless the manager's loss record is strong.

Start with what the loans actually earn, not what the brochure shows. A lender's gross yield is before defaults; the investor lives on what is left after losses, then fees, then carry. 14% less an expected 1.5% of losses is 12.5%. The 2% management fee takes that to 10.5%. Carried interestThe share of profits paid to the fund manager, usually only on returns above an agreed minimum, the hurdle. is 20% of the return above the 10% hurdle: 20% of 0.5, or 0.1. The investor keeps 10.4%.

Very, because losses come off before the fee and the fee does not shrink. Every point of extra credit loss is a full point off the investor's return, while the manager's 2% fee is untouched. With no losses, the investor keeps 11.6%. At 3% losses, which a bad credit cycle can produce, gross falls to 11%, the fee leaves 9%, carry is zero and the investor keeps 9.0%, now half a point below AAA bonds that could have been sold at any time.

Think of renting out a flat on a five-year lease you cannot break, against renting it month to month. You would want noticeably more rent for giving up the right to change your mind. An illiquidity premium must pay for the option you surrender, and the expected-loss figure already assumes the manager is as good as he says. On Rs 1 crore over five years, 10.4% grows to about Rs 1.640 crore against Rs 1.504 crore at 8.5%, a gap of about Rs 13.6 lakh, and that is before the tail case where losses run at 3%. A premium of under two points is thin for that trade. It becomes reasonable if the manager can show a long record of losses below 1.5% through a downturn, or if the fee falls.

One more term to check, because it changes the answer. With a full catch-upA clause that gives the manager all returns above the hurdle until the manager has received its full carry share of total profit., the manager takes everything above 10% until it has 20% of all profit. With no losses the investor would then keep 10.0%, not 11.6%. Read the waterfall clause before the brochure.