Alternative Investments. Hossein Kazemi
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for securing the clawback obligation is to place a fixed percentage of the fund manager's carried interest proceeds into an escrow account as a buffer against potential clawback liability.
Clawbacks typically refer to GP clawbacks, or corrective payments to prevent a windfall to the fund manager. However, it is also possible for LPs to receive more than their agreed percentage of carried interest. Consequently, some partnership agreements also address so-called LP clawbacks.
3.5.6 Hard Hurdle Rates
A hurdle rate, or preferred return, specifies that a fund manager cannot receive a share in the distributions until the limited partners have received aggregate distributions equal to the sum of their capital contributions as well as a specified return, known as the hurdle rate. In other words, a hurdle rate specifies a return level that LPs must receive before GPs begin to receive incentive fees. This section details hurdle rates and discusses a hard hurdle rate. A hard hurdle rate limits incentive fees to profits in excess of the hurdle rate.
Consider a $10 million fund with 20 % incentive fees that lasts a single year and earns a $2 million profit. Ignoring a hurdle rate, the fund manager would receive $400,000, which is 20 % of $2 million. But with a hard hurdle rate of 10 %, the fund manager receives the 20 % incentive fees only on profits in excess of the 10 % return, meaning $200,000. The first $1 million of profit goes directly to the limited partners. The fund manager collects an incentive fee only on profits in excess of the $1 million, which is the profit necessary to bring the limited partners' return up to the hurdle rate. Thus, the manager receives an incentive fee of $200,000.
The sequence of cash distributions with a hard hurdle rate is as follows:
■ Capital is returned to the limited partners until their investment has been repaid.
■ Profits are distributed only to the limited partners until the hurdle rate is reached.
■ Additional profits are split such that the fund manager receives an incentive fee only on the profits in excess of the hurdle rate.
3.5.7 Soft Hurdles and a Catch-Up Provision
A soft hurdle rate allows fund managers to earn an incentive fee on all profits, given that the hurdle rate has been achieved. Returning to the example of a one-year $10 million fund with a hurdle rate of 10 % and profits of $2 million, a soft hurdle rate of 10 % allows the fund manager to receive 20 % of the entire $2 million profit, or $400,000. As long as the resulting share to the limited partners allows a return in excess of the hurdle rate, then the hurdle rate can be ignored in terms of computing the incentive fee. The limited partners receive $1.6 million, which is a 16 % return.
The soft hurdle in this case allows the fund manager to receive an incentive fee on the entire profit. A soft hurdle has a catch-up provision that can be viewed as providing the fund manager with a disproportionate share of excess profits until the manager has received the incentive fee on all profits. The sequence of cash distributions with a soft hurdle rate is as follows:
■ Capital is returned to the limited partners until their investment has been repaid.
■ Profits are distributed only to the limited partners until the hurdle rate is reached.
■ Additional profits are split, with a high proportion going to the fund manager until the fund manager receives an incentive fee on all of the profits.
Once the fund manager has been paid an incentive fee on all previous profits, additional profits are split using the incentive fee. This is called a catch-up provision.
Fund A with an initial investment of $20 million liquidates with $24 million cash after one year. The hurdle rate is 15 %, and the incentive fee is 20 %. What is the distribution to the fund manager if the fund uses a hard hurdle? What is the distribution to the fund manager if the fund has a soft hurdle and a 50 % catch-up rate?
The first $20 million is returned to the limited partners in both cases. With a hard hurdle, the limited partners receive the first $3 million of profit, which is 15 % of the $20 million investment. The fund manager receives 20 % of the remaining profit of $1 million, which is $200,000. The limited partners receive 80 % of the remaining $1 million, which is $800,000, for a total profit of $3.8 million. With a soft hurdle, the limited partners receive the first $3 million of profit, which is 15 % of the $20 million investment. To fulfill the catch-up provision, the fund manager receives 50 % of the remaining profit up to the point of being paid 20 % of all profit. In this case, 50 % of all of the remaining profit, or $1 million, is $500,000. Since $500,000 is less than 20 % of the entire $4 million profit, the fund manager is unable to fully catch up. Had the total profits exceeded $5 million, the catch-up of the fund manager would have been completed. With $5 million of profit, the GP would receive 50 % of the profits above $3 million, or $1 million (50 % of the $2 million profit in excess of the profit necessary to meet the hurdle rate for the LPs). The $1 million of catch-up equals 20 % of $5 million. Profits in excess of $5 million would then be split 20 % to the fund manager and 80 % to the limited partners.
3.5.8 Incentive Fee as an Option
Incentive fees are long call options to GPs, who receive the classic payout of a call option: If the assets of the fund rise, they receive an increasing payout, and if the assets of the fund remain constant or fall, they receive no incentive fee. The underlying asset is the fund's net asset value, and the time to expiration of the option is the time until the next incentive fee is calculated, at which time a new option is written for the next incentive fee. In the absence of a hurdle rate, the strike price of the call option is the net asset value of the fund at the start of the period or the end of the last period in which an incentive fee was paid, whichever is greater. The GPs pay for this call option by providing their management expertise.
A hurdle rate may be viewed as increasing the strike price of the incentive fee call option. A hurdle rate increases the amount by which the net asset value of the fund must rise before the fund manager receives an incentive fee. The higher the hurdle rate, the lower the value of the call option.
As a call option, incentive fees provide fund managers with a strong incentive to generate profits. The call option moves in-the-money when the net asset value of a fund rises to the point of providing a return in excess of any hurdle rate. The call option moves out-of-the-money when the net asset value of the fund falls below the point of providing a return in excess of any hurdle rate.
When the option is below or near its strike price, the incentive fees provide the fund manager with an incentive to increase the risk of the fund's assets. The effect of increased risk is to increase the value of the call option. If the risks generate profits, the fund manager can benefit through high incentive fees. If the risks generate losses, the effect on the fund manager is limited to receiving no incentive fee, ignoring clawbacks.
When the incentive fee call option is deep-in-the-money, the fund manager benefits less from an increase in the risk of the underlying assets. The consequences of net asset value changes to the fund manager are more symmetrical when the option is deep-in-the-money, meaning when large incentive fees are likely. Risk aversion may motivate the fund manager to lessen the risk of the underlying assets when the incentive fee option is deep-in-the-money.
It can be argued that the multifaceted incentives generated by the optionlike character of incentive fees are perverse. The LPs prefer fund managers to take risks based on market opportunities and the risk-return preferences of the LPs. However, incentive fees can motivate fund managers to base investment decisions on the resulting risks to their personal finances. In summary, incentive fees can cause decisions involving risk to be based on the degree to which an option is in-the-money, near-the-money, or out-of-the-money.
Review Questions
1. What is the general term denoting compound interest when the interest is not continuously compounded?
2. What