Within private equity there is a holy trinity of terms – carried interest at 20 percent, management fees at 1.5 percent to 2 percent and a preferred return of 8 percent. These terms have become a standard and are applied to virtually all private equity funds no matter their size or purpose and this creates anomalies.
In this three-part series, I examine each part of the trinity and propose solutions.
The accepted view is that carried interest should be 20 percent of capital gains but there is little explanation why this should be so. The earliest reference is in the Bible referring to Joseph’s plan to encourage grain production in ancient Egypt. “Here is seed for you, sow the land. And it will be at the in gatherings that you will give a fifth to Pharaoh and the four parts shall be yours.” (Genesis 47:23-24). In the 12-century ship captains received a fifth of the profits on the cargo they “carried” and closer to today it was the rate adopted by the oil and gas industry as appropriate compensation for “sweat and labor”. Private equity had no hesitation adopting the term without any protest from investors who may not have read all the small print since the general partners of funds only have to contribute a small percentage of committed capital to be enabled to participate in the carried interest. In essence the investors assume the risk and the GP enjoys the return as demonstrated.
Scenario A assumes a fund size of £100 million and the GP contributes 1 percent of the capital. If the fund generates a 2x multiple overall the investors enjoy a 1.8x multiple and the GP a 20x multiple.
Of course, as in Scenario B, if the GP commitment rises to 3 percent the investors enjoy a marginally higher multiple and the GP’s multiple declines but still remains substantial.
The question is the balance between risk and reward and there is an immediate contradiction in that the investors require greater risk to achieve their targeted rates of return while it is not in the best interest of the GP to assume too much risk and thereby jeopardising carried interest.
A further wrinkle is the impact of fund sizes. Over the past 25 years fund sizes have grown substantially and a typical mid-market buy-out fund, which historically would have been in the order of £250 million in size, is now over £1 billion. The impact of the increase in size is that the GP can enjoy a larger quantum carried interest even if the multiple generated is lower. Scenario C below shows a £500 million fund that generates a 1.5x multiple and the GP contributes 1% of the capital. In this instance the GP will enjoy a profit of £45 million and a 10x multiple.
Carried interest is the share of gains given up by investors to GPs as an incentive to produce superior returns and it should not be available for indifferent performance. Standardising carried interest made sense when funds were approximately the same size but now the range is immense and at the top end relatively modest performance still allows GPs to participate in substantial carried interest pools.
To make sure that there is not a tilt in favor of the GP the maximum marginal carried interest rate should be 50 percent and if the GP has reached that point then the investors should be in a state of delirium.
An alternative model, which has some considerable merit, would be to drop the notion of a fixed rate of 20 percent and create a progressive carried interest step function that delivers higher rates of carried interest as additional proceeds are delivered. Scenarios D and E below illustrate the concept based on a £500 million fund with increments set at £100 million. D shows that if the fund produces £500 million of gains the GP would receive £75 million of carried interest, which is equivalent to a rate of 15 percent. E shows that if the GP was able to deliver £1 billion of gains the quantum of carried interest would have increased to £212.5 million equivalent to a carried interest percentage of 21.25 percent.
This model aligns the interests of both GPs and investors as the incentive to delivery high cash on cash returns. To make sure that there is not a tilt in favor of the GP the maximum marginal carried interest rate should be 50 percent and if the GP has reached that point then the investors should be in a state of delirium.
There is an argument that this model ignores the impact of time and that GPs will hold on to investments for as long as possible to maximize the cash on cash multiples. This is unlikely because the opportunity to sell investments is infrequent and moreover, general partners are constantly in the market to raise new funds and they will need to demonstrate performance to their investor base.
Ray Maxwell is the chief executive of priv-ity, which provides strategic investment advice to institutions and to SMEs.