The future of carry

David Snow details the forces arrayed against the sacred 20 percent performance fee.

Sacrilege! The financial plague in which we now find ourselves has instilled doubt in the hearts of some afflicted market participants, causing them even to question the most holy orthodoxy of them all – carried interest.

Carry (the term which grants to the fund manager a disproportionate share of the partnership profits, usually 20 percent) has long been heralded as a powerful aligner of interests. It was the gravitational centre of the alternative investment industry, pulling talent, ideas and trillions of dollars of AUM into its orbit.
It is designed to keep the general partners highly incented toward profit maximization. If the limited partners make money, the general partners make big money. Everybody’s happy.

And indeed when everyone was making money, carried interest (AKA incentive fees; promote) was seldom questioned, except on the tax front.

But right now limited partners are not making money, and what’s more the return outlook for the asset class is not what was previously hoped for. This has cast carried interest in a new light.

Even some Great Men of Wall Street are acknowledging that carried interest, when not properly structured, can have the effect of incenting managers to take on too much risk, especially through the application of leverage. A GP who is insufficiently exposed to downside but has unlimited upside potential will tend to throw caution to the wind, goes this argument.

A recent client memo from Oaktree Capital Management founder Howard Marks makes this very point: “Allowing managers to share in the upside can bring forth best efforts, but it can also encourage risk bearing instead of risk consciousness. Most managers just don’t have enough money to invest in their funds such that loss of it could fully balance their potential fees and upside participation. Instead of alignment, then, incentive compensation must be viewed largely as a ‘heads we win; tails you lose’ arrangement. Clearly, it must be accorded only to the few managers who can be trusted with it.”

Marks argues that carried interest should only be granted to those managers who have shown they can turn in a performance that more than pays for the incentive fees.

Already, traditional carried interest is being seriously challenged in private equity’s younger asset class cousin, infrastructure. For example, new infrastructure offerings from Kohlberg Kravis Roberts and The Blackstone Group include a 10 percent carry and a 15 percent carry, respectively. The main reason for these lower price points is simply that investors expect lower, albeit more consistent, returns from infrastructure investments. (It should be noted that KKR's 10 percent term comes with some fairly GP-friendly unrealised gain payouts, according to a source).

The September issue of sister publication Infrastructure Investor will feature an interview with Mark Weisdorf, head of JPMorgan’s infrastructure group, who among other things argues that a predominant form of infrastructure investment called “brownfield” does not lend itself to carried interest.

Back to private equity: If an LP does not expect this asset class to do much better than a gross performance in the low teens over the next 10 years, will the carry term come under pressure? GPs who hope not may need to produce some mitigating factors, principally in the form of very large and potentially painful GP commitments. In other words, a tough LP might say, you can have 20 percent of the upside if the downside will be deeply felt by all parties.