What Private Markets Funds Really Cost

The documents of a Private Markets fund state a percentage, and most conversations about cost begin and end there. It is the least informative part of the disclosure. What counts is the base it is calculated on, the order in which profit is distributed, and how much of it can be reclaimed.

With an open-ended investment fund, the arithmetic is straightforward. There is an ongoing charge, it is levied on the fund’s assets, and anyone who wants out redeems their units at the next valuation date. With a closed-end vehicle, none of that holds. Capital is drawn down over years, profit is returned in a contractually fixed order, and the term ends not when it suits the investor but when the fund has sold its holdings.

This article explains the four elements that determine the cost question of such a fund, and what to look for in the documents.

The calculation base decides, not the percentage

A fund’s ongoing management charge arises regardless of investment success. It pays for the work that precedes every holding: finding targets, examining them, negotiating, staying involved. That work begins at subscription, not at the first capital call.

That leads to the question that determines the larger part of what a fund actually costs. Is the fee calculated on committed capital, the Commitment, or on capital already invested? During the investment period the first variant is widespread. It means the fee also arises on money still sitting in the investor’s own account, drawn down later through a capital call.

Two funds with an identical percentage can therefore differ markedly in what they actually cost. Comparing two offers means comparing the two sentences underneath the figures, not the two figures.

The order in which profit comes back

The second building block is not a fee but a distribution rule. It sets out who receives how much and when, and it is the reason a single percentage cannot describe what a fund costs.

It usually runs in four stages:

1. Return of the capital paid in. Investors first receive back what they contributed.
2. Minimum return. Beyond that, profit initially goes to the investors alone until the contractually agreed threshold, the Hurdle Rate, is reached.
3. Catch-up. Where the contract provides for such a clause, the General Partner now makes up its share, in full or in part depending on how the clause is drafted, and does so on the entire return, not only on the part above the threshold.
4. Split. The remaining profit is divided according to the agreed ratio. The share of the General Partner is called Carried Interest.

The third stage is the one most often overlooked. Whether a Catch-up clause is present changes the net proceeds of the Limited Partners considerably, and it appears nowhere in the percentage, only in the contract text.

A worked example

Suppose an investor commits one million francs, the fund draws it down in a single drawdown, and after five years it distributes two million. The contract provides for a Hurdle Rate of eight percent per year and a profit share of twenty percent. Every figure in this example is illustrative and is not a market indication; what is agreed contractually differs from fund to fund, and the single drawdown simplifies the arithmetic.

The million is returned first. A minimum return of eight percent, compounded annually over five years, puts the threshold at around 1.47 million. That leaves around 531,000 francs above the threshold.

• Without a Catch-up clause, the General Partner receives twenty percent of those 531,000 francs, so around 106,000.
• With a Catch-up clause that applies in full, it makes up its share on the entire profit of one million, so 200,000. Where it applies only in part, the amount lies in between.

The same distribution, the same two percentages, up to around 94,000 francs of difference for the investor. That is why the contract structure is the real cost question.

What can be reclaimed

A profit share is often paid out after individual successful exits, long before it is settled how the fund closes overall. If the rest runs weaker, the General Partner may end up having received more than the contract grants it.

That is what the Clawback clause is for: it requires repayment. Its weakness lies in the timing, since years can pass between payment and recovery. Whether the money that should come back actually does therefore depends less on the clause itself than on how it is secured, for instance through an escrow account in which part of the profit share is held back until final settlement.

Why early figures say little

Costs arise from the outset, gains in value and exits only later. The interim valuation of a young fund therefore typically sits below the capital paid in before it rises. This curve is called the J-curve.

In practice that means two things. An interim figure in the first years is not a verdict on the fund. And the comparison of two funds of different ages compares primarily their age.

What to look for in the documents

Five points that can be checked before subscribing and that make the difference more often than the level of the fee:

• The calculation base of the ongoing fee, stated separately for the investment period and the time thereafter.
• Catch-up clause: present or not, and whether it applies in full or only in part.
• The security behind the Clawback clause, together with the question of whether the reclaim applies before or after tax.
• Costs at holding level, such as transaction or monitoring fees that arise in the portfolio companies and are not included in the fund fee.
• Offsetting: whether such fees are credited to the fund, and to what extent.

These five points sit in the contractual documents, not in the marketing material. Anyone who cannot find them has found the right question.

Frequently asked questions about the costs of Private Markets funds

What is the Management Fee of a Private Markets fund calculated on?

During the investment period usually on committed capital, afterwards on capital still invested. That part of the disclosure matters more than the percentage itself: if the calculation runs on committed capital, the fee also arises on money the fund has not yet drawn down. Both variants are common, and the offering document states the calculation base.

What is the difference between the Hurdle Rate and Carried Interest?

The Hurdle Rate is the contractually agreed minimum return above which a profit share arises at all. The Carried Interest is that profit share itself. Without exceeding the Hurdle Rate there is no Carried Interest, while the Management Fee continues to arise independently of it.

What does a Catch-up clause mean?

It governs what happens once the Hurdle Rate has been exceeded. Without a Catch-up, the General Partner shares only in the profit above the threshold. With a Catch-up, it makes up its share on the entire return, including the part below the threshold. How quickly that happens depends on how the clause is drafted; it can apply in full or only in part. For the net proceeds of investors the difference is considerable, and it sits in the contract rather than in the percentage.

Can a profit share that has already been paid out be reclaimed?

Yes, if the contract contains a Clawback clause. It applies where the full term shows that the General Partner has received more than was agreed, for instance because an early exit went well and later holdings produced losses. How dependable the clause is depends on how it is secured, not on its presence.

Why do the figures of a young fund look poor?

Because fees and start-up costs arise from the outset while gains in value and exits come later. That curve is called the J-curve. An interim valuation in the first years therefore says little about the final outcome, and a comparison of two funds of different ages says even less.

Context

Private Markets tie up capital over years as a rule, carry the risk of default and of loss in value of the individual holdings, and cannot be sold at short notice. The illiquidity premium is the compensation for exactly that lock-up, not a promise. Whether an investment is worth considering depends on circumstances a text does not know.

What a text can do is explain the cost structure so that the documents become readable. Let’s talk about it.