Carried interest is a critical component of aligning interests in the private equity fund partnership. It ensures that profits are equitably distributed and creates incentives that motivate managers to achieve the highest returns possible for limited partner (LP) beneficiaries. The Institutional Limited Partners Association (ILPA) was founded with the goal of advancing the interests of LPs by maximising alignment in the private equity industry for the long-term benefit of all its participants. When properly calibrated, carried interest serves as a way to focus on the total fund returns over the long term and diminishes the temptation for GPs to rely on management and other fees as a profit centre.

As such, carried interest has featured prominently in ILPA’s work to establish best practices for structuring the partnership. These best practices, codified in ILPA’s Private Equity Principles, are built around three core elements, each of which reinforces how LPs and GPs can share in the success of the partnership:

  1. Alignment of interest. As a key component of the broader economic model for the fund, carried interest should work to align the interests of LPs by motivating GPs to generate investment profits rather than fee income.
  2. Governance. The opportunity to earn carried interest should be fairly distributed, thereby creating the appropriate incentives among the management team to create lasting value while contributing to the stability of the manager.
  3. Transparency. Investors should be able to easily monitor carried interest accruals and distributions to ensure their investments are functioning as agreed.
    LPs considering new partnerships, or contemplating investments in new funds with existing partners, factor into their risk underwriting the quality of alignment in the partnership, including the structure of the waterfall and how carried interest is accrued and distributed.

The reality is that fund partnership agreements and the economics within them are the product of a bundle of bilateral negotiations, struck within a marketplace shaped by a myriad of factors. The idealised arrangement from an LP perspective — a whole-of-fund waterfall where carry is paid only after all capital and fees have been returned — is not yet standard across the industry globally. Therefore, LPs press for alignment in other ways, such as by ensuring maximum transparency into fees, expenses and carried interest through standardised reporting.

The development of the ILPA Reporting Template has been a significant development in this regard, as it provides LPs with the means for increased visibility into the costs and profits of private equity investments, which will in turn yield valuable insights. As the standard becomes more widely adopted, some LPs are turning their attention to validating the application of the waterfall itself, including fee and expense allocations, by engaging third parties to conduct periodic reviews or by pressing managers to expand the scope of the annual fund audit to include sample testing of fees, expenses and carried interest paid by individual LPs within the fund.

Transparency, validation and the future of private equity

The complexities of the economic model, particularly the incentive structures behind them, are made most real in the translation of the model into accounting practicalities and LP-level reporting. The highly bespoke nature of waterfall provisions present significant challenges for back office professionals, fund administrators and compliance professionals tasked with translating legal language into accounting terms. Inconsistencies in how carried interest is reported to LPs has made validation of these amounts exceedingly difficult.

Surging LP interest in collecting more data on fees, expenses and distributions has been driven by a combination of factors: greater attention to costs in a lower return environment, increased regulator scrutiny and a heightened awareness generally of compliance risks. In particular, compliance examinations of registered investment advisors by the United States Securities and Exchange Commission (SEC) resulted in enforcement actions that heightened investor attention to fee and expense allocations. In response, LPs have expended considerable effort to improve their internal processes for tracking and validating carried interest and fund expenses. These efforts contributed to the development of the ILPA Reporting Template for fees expenses and carried interest, the adoption of which has resulted in significantly increased visibility into fees, expenses and carried interest.

The template provides a more uniform format that offers LPs more granular information, allowing for greater comparability between funds, and on a more predictable interval, thereby alleviating the reporting burden on GPs responding to often bespoke information requests from LPs. Six months after the release of the template, 70 percent of ILPA members were requesting or planning to request the template and 53 percent of GPs were expected to provide the information by 2017 or sooner.

Over the long term, the availability of this more granular data to LPs will be useful in addressing front office needs for transparency and back office needs for standardisation. In practice, implementation of the ILPA reporting standard has already yielded tangible results. For example, in at least one instance, the fact that a fund was currently in a clawback situation was identified through information made available in the ILPA reporting template. The investor was able to remedy the clawback situation and to recommend improvements to the fund’s reporting practices.

Armed with this data, LPs are increasingly attempting to recreate waterfalls in-house, or engaging third parties to assist with in-depth validation processes of sampled funds. These reviews have largely indicated that the majority of funds are in compliance with the distribution provisions in the partnership agreement, but the process of re-running the waterfall can highlight ambiguities in how specific economic terms have been drafted or inconsistencies in their implementation (for instance, the application of offsets to certain fees charged to portfolio companies).

Moreover, investors are incorporating into their due diligence procedures the lessons learned through these compliance reviews. During fund negotiations, LPs increasingly request and receive a hypothetical example of the fund’s carry model, articulating how profits are distributed, in order to guide their internal monitoring processes for each fund
— even of successor funds. Some LPs’ legal counsel also request that the provision includes a text-based illustration, in plain English, of how the waterfall will work in practice. In some cases, investors are even beginning to indicate a preference for external management of GP distributions.

Definitive progress has been made in standardising the presentation of information on carried interest, fees and fund expenses. At the same time, legislators such as the California Assembly are compelling the private equity industry to provide requisite transparency to investors and to the public. Private equity generates unrivalled returns for LP beneficiaries, and the carried interest structure ensures interests are aligned for the benefit of all parties in the fund. Ensuring LPs’ ability to monitor how those profits are distributed will continue to be an intrinsic component of thriving partnerships.

Jennifer Choi is the Institutional Limited Partners Association’s managing director for industry affairs. 

This is an excerpt from The Definitive Guide to Carried Interest (2017), published by Private Equity International, and available for purchase here.