True NAVs matter

One of the reasons we have decided to target an 8% coupon (actual cash pay) on our fund is because this enforces cash-flow discipline and transparency. It’s very hard to “extend and pretend” during a pandemic that even major banks are not immune to, if you have to make physical payments every quarter. We don’t want to massage the figures and we want our investors to have total transparency and faith in us.

In addition, and perhaps more importantly, we have made our performance fees align with the actual performance of our portfolio (transactions paid back and settled in cash). Why?

The maths of inaccurate pricing is quite sobering for investors. Let’s say you have a “2 and 20” fund that believes its book to be generating 12% gross, and the fund is open ended (investors can come and go). Compounded over, say, 8 years of investment you would have made 82.5% cumulative (or 7.8% p.a.) net of fees.1

But what if you weren’t accounting for the leakage properly? Let’s take the example of a fund accruing 8-10% a year, but then needing to write off or side-pocket 20-30% in one go. Maybe there has been a shock in the portfolio that has forced a full revaluation, or new standards of governance and pricing accuracy have been introduced by an investor or by accounting regulations.

Let’s imagine that the accrued growth rate on the fund’s assets (after bad debts but before fees) is assumed to be 12%, but the true gross return on the fund is 9%. In other words, 3% of the fund each year is unlikely to be recovered but there was no reserving or recognition of this. Not only have you then paid management fees on the inflated NAV, but performance fees have been charged on the higher growth rate. Remember, those fees are real hard cash, paid to the manager periodically. That money has left the fund and is not coming back. Where does this leave the investor?

Rather than having a NAV of 182.5 (for each 100 invested), the true NAV number is 140.2. That means a net return of 4.3% p.a. over the eight years. Suddenly you take a 23% hit on what you thought was your valuation.

But let’s go one step further. For simplicity, let’s say there are four investors in the fund holding 25% each. Now one redeems and is paid 182.5. The true cash value of the whole pot is in fact 561 (140.2 x 4), but 182.5 leaves the pot. The remaining three investors now have 378.5 of value between them, and their true IRR is only 3.27%. Much less exciting than they thought. If another investor redeemed, the remaining two would be left to face the reality of a negative IRR for their eight year investment.

This sobering illustration is just our attempt to explain why accurate pricing and investor alignment is so important for private assets. Small mistakes compound quickly. It is even more important for open-ended funds with private assets that are not marked to market regularly, but where investors can leave at regular intervals.

We’d like to see the market for open ended funds move to properly lagged performance fees – either through fee trusts or hold-back mechanisms. This means performance fees either:

1. go into a trust (where they can be clawed back) and are gradually released to the manager with a long lag. This is a way to ensure that investors who leave early have at least paid their share of the fees.
2. they are simply held in the fund until a reputable independent valuation of the whole book is completed.

1We’re ignoring administrative expenses for now but fees such as audit, directors, legal and recovery costs can add 20-100 bps of overhead, depending on the size of the fund and the specific costs the manager allocates to the fund – not a trivial thing to ask about and understand.