Net return

A fund can earn one number and pay its investors a smaller one. The gap is everything the fund spends on itself.

Gross return is measured on the Gross Asset Value — what the portfolio earned before anything is taken out. Net return is measured on the Net Asset Value, after the costs of running the fund have been deducted. The workbook splits net return in two because the incentive fee behaves differently from every other cost: it only exists when the fund does well.

• Net Return (Pre-Incentives) — after fund expenses, costs and management fees, but before the incentive fee.
• Net Return (Post-Incentives) — after all of those and the incentive fee. This is the return the investor experiences.

In a bad year the two net figures are identical, because no incentive fee is earned. In a good year they separate.

Chapter 9 (section 9.3.3) builds the three figures from one fund. Fund ABC raises Rs 50 crore through 5,00,000 units at Rs 1,000 each. It amortises a set-up cost of Rs 1.25 crore over 5 years (Rs 25 lakh a year), spends Rs 30 lakh a year on fund expenses, pays a management fee of 1.5% of gross value plus 18% GST, and pays a 15% incentive fee above a 10% hurdle.

The order of deduction is fixed:

The workbook's results:

In the worst case the NAV never clears the reference hurdle, so no incentive fee is payable and the two net returns are equal.

Three qualifications the workbook adds. Some AIFs compute gross returns before management and incentive fees for a class of large institutional investors that pays a different management fee. Some investors also compute post-expense pre-tax and post-expense post-tax returns. And all of the above is before direct taxes — the net return to investors is finally calculated on the post-tax NAV that is actually distributed.

Net return (single year) = (NAV per unit at year end / NAV per unit at start) - 1

Net return over n years  = (Ending NAV per unit / Beginning NAV per unit)^(1/n) - 1   [CAGR, Box 9.1]

Sunita holds 10,000 units of Fund ABC, bought at Rs 1,000 — Rs 1 crore invested. (Her holding is illustrative; the per-unit NAVs are the workbook's best-case figures.)

Year 1

Of the Rs 16 lakh the portfolio earned on her money, Rs 3,15,320 went on set-up cost, expenses and the management fee, and a further Rs 42,700 on the incentive fee. She keeps Rs 12,41,980.

The fund-level check: NAV pre-incentives is Rs 56,42,34,000; the incentive fee is Rs 21,35,100; so NAV post-incentives is Rs 56,20,98,900, which divided by 5,00,000 units is Rs 1,124.198.

Year 2. Her units are worth Rs 1,257.592 each, Rs 1,25,75,920 in all. The two-year CAGR is (1,257.592 / 1,000)^(1/2) − 1 = 12.14%, against a gross CAGR of 14.02%. About 1.88 percentage points a year separates what the portfolio made from what Sunita kept — before any tax.

Chapter 9 (Fee Structure and Fund Performance), section 9.3.3 defines pre-expense and post-expense returns and works Example 9.5 on Fund ABC; the same NAV series is reused for Gross IRR and Net IRR, for TVPI, DPI and RVPI, and for alpha in Chapter 10. Expect a definition question that asks which deductions sit inside Net Return (Pre-Incentives), and an application question that hands you a GAV, the costs and an incentive fee and asks for the post-incentive return.

• Pre-incentives still deducts the management fee. The only thing it leaves out is the incentive fee. Candidates often treat "pre-incentives" as "before all fees".
• Gross return is on Gross Asset Value; both net returns are on NAV.
• In a year with no incentive fee the two net returns are equal — the worst-case columns in the workbook show exactly this.
• All three figures are pre-tax. The workbook says the net return to investors is finally computed on the post-tax NAV distributed.
• Multi-year figures are CAGRs, not simple averages. Two years of gross value moving from 1,000 to 1,300 is 14.02% a year, not 15%.
• Management fee in the example carries 18% GST — 1.5% × Rs 58 crore × 1.18 = Rs 1,02,66,000. Leaving the GST out overstates the net return.