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The terms, they are a changin'

The European private equity market today is barely recognizable from that of a few years back - and yet terms and conditions, particularly regarding preferred return and carry, are in many cases failing to recognize this. By Ray Maxwell

Please forgive me for abusing a Bob Dylan classic, but the title of this article reflects the fact that terms and conditions that govern private equity funds should be constantly questioned and refined – as befits a dynamic and thoughtful industry. However, there is an unfortunate tendency to accept the status quo and regard terms and conditions as being totally irrevocable.

The private equity industry has grown phenomenally over the past 20 years and terms and conditions that were applicable then are less relevant today. Moreover, funds now range in size from minnows of under €100 million ($120 million) to behemoths that have raised new capital in excess of €6 billion. To have a ?one size that fits all? set of terms and conditions seems manifestly absurd. The motivations that drive an early stage venture capital fund are significantly different to those of a leveraged buyout fund and terms and conditions should reflect these differences.

Before I move on to talk about carried interest, I would like to give some thought to the preferred return, which has become a standard feature of most limited partnership agreements. The rationale for the preferred return was that investors not only received back their capital committed but also received a further accrual, at the riskfree rate, to compensate for the impact of time. The manager would be able to ?catch up?from subsequent distributions equal to 25 percent of the accrual and thereafter all proceeds would be allocated on an 80:20 basis.

When preferred returns were introduced into the UK, the risk-free rate was deemed to be the yield on a gilt with a life expectancy of six to seven years (equivalent to the average life of a ten-year fund). The gilt yield back in the 1980s was 8 percent to 9 percent and that rate has stuck – even though the actual risk-free rate today is significantly lower. At the time it was introduced, the European private equity market was in its infancy and there was precious little history to call upon to evaluate the potential of funds to deliver returns. The assumption was that, as more data points emerged on the performance of funds, the need for the preferred return would become redundant.

There are a number of problems with the preferred return, and they are as follows:

  • ? It is sometimes thought of as being a hurdle rate, but clearly it isn't because a hurdle should be in place throughout the life of the fund. It is the financial equivalent of being half-pregnant.
  • ? The rates used today have little relationship to the present risk-free rates of return.
  • ? There is no standard method of calculating the accrual. Some funds compound quarterly, others annually or may even use an accumulative method. All have different outcomes that could affect investors' returns.
  • ? During the period of the catch up, investors are in effect ?out of the money? for an unknown period, which could be from six months to six years. The investor ends up with a distorted cash flow with periods of plenty interspersed with an indeterminate period of famine.
  • ? By giving investors the first profits, carried interest becomes back end-loaded. Some investors may regard this as being a good thing but it may have a depressing effect on the motivation of the junior members of a GP team.
  • ? If funds have endured a ?rocky? period and will not achieve the preferred return, what incentive is there for them to try to achieve a reasonable outcome?
  • ? The preferred return may distort the manager's behavior early in the life of a fund where, to reduce the impact of the preferred return, investments with a relatively short duration may find favor over those that will generate a higher multiple over a longer period.
  • ? The preferred return works reasonably well for ?one stop?money but makes no sense for venture capital where funding is spread over an attenuated holding period. Under these conditions, the accrual becomes onerous and carried interest is pushed to the outer reaches of the fund's life.
  • Given my comments above, I think we should re-examine the veracity of the preferred return and, with a bit of luck, consign it to the garbage can of history.

    The conventional wisdom is that carried interest encourages general partners to take the appropriate level of risk to maximise investor return. Another way of looking at carried interest is that it is an element of the capital gain forgone by the investor to incentivise the manager to produce stellar outcomes. This may have been the case when funds were modest in size and when the management fee covered the cost of running the management company.

    CARRY INCREASESThe table below gives an example of a €500 million fund with the carried interest percentage rising by 5 percent from a 10 percent base to 25 percent in increments of €100 million, based on performance. In a conventional structure for this €500 million fund, the carried interest assigned to the manager would be €80 million (€400 million x 20 percent). With this structure, the average carried percentage is 17.5 percent against 20 percent and the amount of carried interest assigned to the manager is €70 million. If the fund proved to be outstanding, the carried interest could increase well beyond 25 percent at the margin. Such a structure would more fully align the interests of LPs and GPs. Source: Ray Maxwell, INVESCO

    Capital Returned Additional Carry Carry
    €m Proceeds % €m
    500 0 0 0
    600 100 10 10
    700 100 15 15
    800 100 20 20
    900 100 25 25
    Total 400 17.5 70