The management fee is charged on the commitments that have closed, not on the target, so the first close funds only part of the firm it is meant to support.
No. A management company costing 200,000 a month, charging a fee of 1.5 per cent, holds a first close of 100,000,000 and collects 125,000 a month against it — 62.5 per cent of the burn. The house loses 75,000 a month from the day the first close completes, and goes on losing it until the second close. The capital that has to close before the fee covers the cost at all is 160,000,000, sixty per cent more than the first close being planned for.
Worked in full in Raising a Real Estate Fund by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A management company with five people and an all-in cost of 2,400,000 a year burns 200,000 a month, funded by the partners until fee income starts. The plan is a first close of 100,000,000 carrying a management fee of 1.5 per cent. That fee is 1,500,000 a year, or 125,000 a month. The two lines do not meet.
| Line | Monthly amount |
|---|---|
| Management company operating cost | 200,000 |
| Management fee collected on the first close | 125,000 |
| Shortfall funded by the partners | 75,000 |
The fee covers 62.5 per cent of the burn. The house is losing 75,000 a month on the day the first close completes, and goes on losing it until the second close. The capital that has to be closed before the fee covers the cost at all is 160,000,000 — sixty per cent more than the first close the plan is built around.
Common practice sets a first close between a quarter and a third of target. Separately, break-even for the house is computed at full fund size: a fee of 1.75 per cent on 121,428,571 covers an annual operating budget of 2,125,000. Both rules are sound. They are tested at different moments, and the gap between those moments is where the cash goes.
Break-even at full fund size says nothing about the year after a first close, because the fee is charged on the commitments that have actually closed. Put the two rules side by side and the target a fund needs, in order that its own first close pays for the firm, is far larger than either rule implies alone.
| Management company | Annual cost | Fee rate, per cent | Target at one quarter | Target at one third |
|---|---|---|---|---|
| Full-staffing house | 2,125,000 | 1.75 | 485,714,286 | 364,285,714 |
| Five-person house | 2,400,000 | 1.5 | 640,000,000 | 480,000,000 |
A worked fund of 300,000,000 with a first close of 100,000,000 sits well below every one of those figures. On the full-staffing house, that first close earns 1,750,000 against 2,125,000 of cost: a deficit of 375,000 a year for as long as the first close is all there is. That deficit is the partner capital a founder is asked to document in operational due diligence, and rarely has.
Fee income does not begin when a commitment is soft-circled. It begins when a committee has sat and the closing has completed, and committees sit quarterly. So the investors do not arrive one by one; they arrive in lumps. On the queue the funnel implies, the first committee approves 37,500,000, which closes in month 7.6, and the second approves 56,250,000, which closes in month 11.3.
Run burn against fee month by month on that calendar and the cumulative requirement on the partners is the following.
| Point in the fund's life | Cumulative partner funding |
|---|---|
| By month twelve | 2,095,312 |
| By month twenty-four | 3,089,062 |
| By month thirty-six | 4,082,812 |
The figure usually quoted as the cost of a delay is not a delay cost. Six months of additional burn at 200,000 is 1,200,000, six months of foregone fee at 125,000 is 750,000, and the combined effect on the partners is 1,950,000. But on the funnel's own conversion rates the commitments that survive are seven and a half at 12,500,000, which is 93,750,000, and the first close never reaches 100,000,000 at any point in the model's horizon. The 1,950,000 is not the price of slipping the plan. It is the price of the plan.
The correction is one line in the model and a large number in the bank. Size partner capital from the first close, not from the target, because the first close is what the fee will be charged on for the twelve months that matter most, and it is what an operational review will test. The rule the review works to is twelve months of cash runway measured from the review date, on the assumption that no further capital is raised.
The answer that survives a review states the deficit rather than concealing it: a deficit of 900,000 a year until the fund reaches 200,000,000, partners subscribed for 1,800,000 of which 1,400,000 is on deposit today, giving eighteen months of runway with no further capital, and here are the accounts and the bank statement. A thin runway is a diligence finding. The arithmetic above is where the thinness comes from, and it is arithmetic rather than misfortune.
Twelve months from the review date, on the assumption that no further capital is raised. The answer that survives states the gap: a deficit of 900,000 a year until the fund reaches 200,000,000, partners subscribed for 1,800,000 of which 1,400,000 is on deposit, giving eighteen months of runway, with the accounts attached.
On an annual operating budget of 2,125,000 and a fee of 1.75 per cent, break-even during the investment period is 121,428,571. Funding a general partner commitment of 2 per cent out of the same fee income raises that to 157,407,407. Whole-life break-even, with a cost base that tapers in the harvest years, is about 150,000,000.
Six months of additional burn at 200,000 a month is 1,200,000. Six months of foregone fee at 125,000 a month is 750,000. The combined effect on the partners' funding requirement is 1,950,000, before the stale track record and the pipeline that has to be refreshed.
This article is one calculation from Raising a Real Estate Fund. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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