The third part of the trinity is the preferred return, which first saw the light of day in the late 1980s as a mechanism to provide investors with some relatively early liquidity and to create a modest benchmark against which private equity performance could be measured.

Unlike convention equities, private equity is illiquid and that creates significant issues when measuring private equity performance on a time-weighted rate of return basis. It takes time for allocations to be converted into commitments to private equity funds and usually upward of three to four years before those commitments are fully invested. Moreover, investments may take six to seven years before they are realized and in the intervening time those investments are valued on a prudent basis. The result is that private equity appears to be underperforming relative to quoted benchmarks due to a combination of duration and a money rate of return being applied to unspent allocations.

Ray Maxwell

The introduction of a preferred return was aimed to provide investors with some relatively early liquidity and the rate chosen was the “risk free” rate pertaining at the time. The rate was deemed to be the yield on a gilt with similar maturity to the weighted average life of a private equity partnership which was estimated to be around six to seven years and in the late 1980s that rate was around 8 percent. This figure has become a standard feature even though the yield on a 10-year gilt today is only 1.42 percent and equity returns today would struggle to exceed 8 percent.

A consequence of the introduction of the preferred return was that it made general partners aware that time is an exacting mistress and that any delay in achieving exits would make it more difficult to reach the promised land – breaking into the carried interest. Of course, having returned capital and the preferred return to investors the quid pro quo has been that general partners have been granted a “catch-up” and can claim further proceeds until 25 percent of the preferred return is recovered equivalent to a carried interest of 20 percent. This means that investors are in an “out of the money” position for an indeterminate period of time until the catch-up is achieved.

There are, however, a number of other issues with the preferred return.

The rate that has been adopted as standard bears no relationship to current risk free rates or indeed, equity rates.

Should general partners be subject to such time pressure? General partners cannot predict with any certainty when exits will be achieved and indeed, holding periods have increased from four years in the 1990s to over six years now.

It leads to sub-optimal investment decisions at the beginning of the life of a fund because the objective (stated or not) is to eliminate the preferred return accrual as quickly as possible because of the burden of compounding.

It back-end loads carried interest and for younger members of the team, with the immediate expense of growing families, the thought of enjoying carried interest in the distant future is not a great incentive.

What happens if the hurdle rate cannot be achieved? In essence the general partners are running the investments for fee and not capital gain. It could be argued that they have to do their best to be in a position to raise another fund, but since so many investors rely on track record, the general partners may feel that there is little merit in trying to “bust a gut”.

A preferred return works well for “one stop” investment, but makes little sense for venture capital where there are several rounds of funding which may be drawn down in tranches depending on hitting milestones.

The question has to be whether the preferred return has served any useful purpose?  Certainly it gives investors a priority claim to distributions, but the trade-off is the unknown amount of time it takes the general partner to catch up – it could be six months or six years and as mentioned during this period investors are literally “out of the money”.

An argument has been put forward that there should not be a catch-up at all, since the preferred return compensates investors for the loss in the time value of their commitment over a fund’s life. Certainly this would be sensible if the preferred return was set at the current low long-term risk-free rate.

The carried interest structure proposed in part one ignores the internal rate of return as the principle measure of performance, but focuses on the money multiples primarily because private equity is an absolute return class where its objective is to maximize the multiple.  And therein lies a paradox in that the point of maximum IRR is reached well before the point where the money multiple can maximized due to the laws of diminishing marginal returns. The objective is to take time out of the equation since general partners have limited control over the timing of an exit, particularly if the market moves against them.

When private equity was in its infancy 30 years ago more attention was paid to the structure of funds and there was an appreciation that terms and conditions should vary depending on fund size. Today the range of fund sizes is enormous but terms and conditions have become standardized, which favors the behemoths as they do not have to perform well to enjoy large quantum of carried interest as well as enormous fee income.

The holy trinity has to be revisited to determine the terms and conditions that are appropriate for a maturing industry rather than religiously sticking to the terms that were relevant when private equity first saw the light of day in the late 20th century.

Ray Maxwell is the chief executive of priv-ity, which provides strategic investment advice to institutions and to SMEs.

For the first two parts of this series, read The holy trinity of terms: carried interest and The holy trinity of terms: management fees