Carried Interest 2.0
Private Equity Online published an amusing piece last week suggesting an adjustment to the age-old 20% carried interest formula. I had to double check my calendar to see whether it was posted on April Fools’ Day, but alas, it was the day after.
The preamble pointed out that most GPs strongly believe they’re top-quartile performers and that their funds will deliver 3x or 4x cash returns. It goes on to suggest they can’t all be top-quartile funds and that a 3x return is very rare, hence unlikely.
The article then suggested we, as an industry, change the performance fee equation to,
30% carry if the GP achieves above 2x cash, but only a 10% carry for below 2x
This idea plays to the outward confidence of GPs while securing better terms for LPs.
It’s a novel suggestion, but unfortunately for LPs, it would never fly. You see, the LPs are the gamblers in this relationship, not the GPs.
GPs are champions of ratchets, earn-outs, stock options and vendor financing; they’re masters of reducing risk first and maximising return second. That’s their business and they’re unlikely to change course at the behest of the LPs who agreed to the 2/20 terms in the first place. It would go against the grain of the private equity methodology to take on a likely risk for an unlikely return.
With that said, it would sure make for interesting conversation at a GP investor meeting. I think the culture of the LP industry instils fear of confrontation with GPs, when in reality, what do LPs have to fear? A little LP activism would probably do them some good.
I do not think this idea is novel. Many fund these days have something called “hurdle” which means it has to return investors cash + say 6% interest per annum before the fund manager can claim any carried interest. I have also seen proposals with something called “supercarry” which entitles the fund manager a carried interest of 30% if a higher level of interest is achieved. Effectively, these clauses in the fund management contracts simulate the amusing suggestion in PE Online article.
Kaushik Chakravarti
6 Apr 10 at 15:32
Thanks for the note Kaushik.
Don't you think “returning investors cash + 6%” is a ridiculous benchmark? That's what I mean about GPs knowing how to get their way with LPs. Firstly, you'd want to hope they'd “return your cash” before taking a performance fee. And secondly, a 6% return is paltry given the illiquidity and risk of PE. That's the skill of the GP, to make you think that returning your cash is a great privilege. Then once you're wow'd by the fact you get your own money back, they offer, only because they're nice guys, to put a 6% hurdle in place.
The thing about hurdles that most people don't realise, is that they're simply a benchmark to trigger a performance fee on all returns. So, performance fees aren't charge on everything over 6%, they're charged on everything over 0% as long as the 6% is hit. So in addition to paying a 2% management fee, a fund can return only 6% pa over a 10 year investment and for the privilege of 6%, you pay another 20% of the return, so your return isn't even 6% anymore.
Life is great in PE
The Private Equiteer
7 Apr 10 at 01:01
You laugh at the idea of 30% carry based on the returns provided to investors.
But how about 2.5% management fees, 7% preferred return and then 25% carry for the General Partner as standard…and this fund was over subscribed, but that's what happens when you're a new fund in a country where this fancy thing called “Private Equity” means the pension funds have somewhere else to put their cash…
conorcampbell
7 Apr 10 at 02:35
Love the 2.5% management fee.
Interest (mgmt fees) + coupons (pref returns) + upside (carry) = debt risk for equity returns.
The Private Equiteer
7 Apr 10 at 04:59
I agree that GPs find ridiculous ways to capture a disproportionate share of returns (and don't even get me started on cap gains taxes) but the mechanics you suggest above are mostly wrong. First, of all 8% is a more common hurdle than 6% and if a fund has a 20% carry rate with an 8% hurdle, the most common payout structure is:
1. The first 8% profit goes to the LP
2. All of the next 2% goes to the GP
3. Everything above 10% get split 80/20
So if the return are only 8%, the GP gets no carry. If the return 9% the get 1% of the 9% (or an 11% carry). They do no all of a sudden get 20% of the 8% just for hitting it (because the math would then dictate that the net returns are no loner 8%).
Steve Smith
7 Apr 10 at 14:52
Again, like my comment above, the “preferred return” goes to the LP (that is the “hurdle”). There is no PE fund in the world where LPs are giving the first 7% of returns to the GP and then splitting the rest 75/25.
Steve Smith
7 Apr 10 at 14:54
I think you may have misinterpreted my comments. Of course, the 7% goes to the LP.
My point was more related to the fact that the norm for PR is 8% and therefore the LP is “losing” out on the 1%. The comment was more to highlight the increasingly raw deal these LPs were getting from their Fund.
conorcampbell
8 Apr 10 at 00:18
You're right Steve, my mistake.
The Private Equiteer
8 Apr 10 at 05:33
I though it was a preferred 7% out of 25%, not 7+25 = 32% carry. Either way, my mistake. And yes, that would be too audacious even for PE.
The Private Equiteer
8 Apr 10 at 05:41
I thought what was at issue was “penalizing” GP's for UNDER-performance while providing a meaningful incentive to take more risk. There are several funds with premium carry but few, if any, that also penalize the GP for substandard returns (as per the example above) or overly-conservative investments. The PE is right, GP's are experts at mitigating downside risk. As an LP, this is tremendously frustrating as we work with an asset allocation that demands we take MORE risk with our private equity allocation and swing for the fence while “managing” portfolio risk via other asset classes.
Mark
12 Apr 10 at 21:22
Sounds like you're throwing down the gauntlet Mark. It sounds like you're suggesting that “performance” fees should reflect “performance”. Sounds a bit absurd, if you ask me.
Did you ever read my post about how Buffett structured them when he started his fund? Here's the link http://www.theprivateequiteer.com/carried-inter...
He had a 50% carry above a 4% hurdle AND a negative 25% carry below. Now that's confidence in your competence.
The Private Equiteer
14 Apr 10 at 02:56
Yeah, I realize I'm way out there. I'm not a big fan of using the IRR to structure a preference as it causes problems down the road for under-performing funds (though, admittedly, under-performance itself creates proportionately larger issues). Some firms need fairly heroic exits to clear the hurdle, let alone participate in the catch-up and full carry. I prefer MOC. Why not have a 1.15x hurdle, then 15/85 carry below 2x (gross), and 20/80 from 2x to 2.5x and 30/70 for 2.5 and above? It seems like many firms underwrite to 2x, which, net of fees, doesn't get the L.P.'s very much. But, the number “2″ is optically better than “1.anything”. So I can't say I'm surprised. I say take the risks. As a customer, I'd pay $10 for a burger if it tastes like $20
Mark
15 Apr 10 at 03:43
I remember a certain fund (still in activity) where there was no hurdle and direct carry was hit as long as investment came at cost.. Fund was oversubscribed.
Good old pre-2008 times I guess.
HKR
26 Apr 10 at 16:58