Shift in carry models ‘complicating’ fund comparisons

Innovations to the traditional 20 percent profit sharing model between GPs and LPs are making it more difficult for investors to compare fund performance in a like-for-like way, according to a leading private equity lawyer.

A range of new carry models have sprung up that “are material and fundamentally change how profits are shared,” says Eamon Devlin, managing partner at law firm MJ Hudson. And Devlin told Private Funds Management these changes are making it harder for LPs to compare the performance of funds. “Having more complicated economics does make it more complicated for LPs to compare fund to fund with different ways of profits being split. It becomes another variable and is more like comparing apples to oranges than apples to apples.”

Devlin and his colleague Mark Silveira laid out the changes in a recent article, changes which include the following innovations:

Ratcheted carry. This sees the carry level ratcheted up or down according to performance. For example, carry is set at an initial level of 10 percent until the fund returns twice the amount of investors’ called capital, then ratchets up to 20 percent until the fund returns three times investors’ capital, and finally ratchets up to 30 percent for returns above 3x. “This is the most egalitarian change in my view because if managers do less they get smaller a portion of the pie and if they over-perform they get a bigger slice,” says Devlin.

Hybrid carry. This blends whole fund carry, which calculates carry percentages on the fund’s overall returns and deal-by-deal carry which calculates carry on the profits of each deal. Deal-by-deal carry enables a manager to earn profits on strong deals and avoid a carry “penalty” for weaker deals. Hybrid carry includes features to make it behave more like whole fund carry, such as regularly recalculating the carry entitlement, comparing it to actual carry distributions, and recouping any excess carry distributions, and escrowing a portion of carry.

Diverted carry. Used by some European first-time funds this sees deal-by-deal carry distributions diverted to the fund’s investors until they have received amounts equal to the sum of their called capital, preferred return and undrawn capital. The investors do not have to return the diverted carry to the fund, but the manager is allowed to ‘catch up’ on the diverted distributions as and when proceeds come in from exits.

Multi-waterfall carry. Multi-waterfall carry allows investors to choose a return structure that suits them. So Class A investors might pay deal-by-deal carry on returns but get a big discount on management fees, whereas Class B investors pay whole fund carry and charged management fees at the full rate. Alternatively, investors may have to choose among different mixes of hurdle rates, management fees and carry percentages, with more favourable percentages for Class A investors. “The more complicated the waterfall the more likelihood there is of a mistake being made and mistakes are made quite often. First (the profit sharing agreement) has to be put into words by lawyers and then those words have to be translated by accountants,” according to Devlin.

Super carry. This is carry fixed at a higher percentage level than the traditional 20 percent. MJ Hudson says well-known examples of super carry (for some of their funds) include Bain Capital, Accel Partners, Andreessen Horowitz, and Kleiner Perkins Caufield & Byers. “The benefit of super carry is that it increases the likelihood of the team staying together. It is quite sticky glue,” Devlin says.

Performance-based fees. In 2017, Pantheon Ventures introduced a new private equity fund that blends management fees and carried interest into a single performance-based fee. The fund marks its assets to market daily, with the performance fee accruing only on those days when (and by how much) it outperforms a benchmark stock market index, with the fee accrual being reversed on days when the fund underperforms the benchmark.

Devlin says the one innovation not on this list but that he sees coming is a shift in the mission on funds themselves. “I believe all funds will eventually become impact funds. Every fund that’s raising will of course try to earn money for its LPs but it will also have a social goal, for example to create 100,000 jobs and also a 15 percent return. This shift will be driven by youth. If you look at the recent statistics in a Bain report young people want to make money in a responsible way and have a social impact. It’s a generational shift.”