Current models employing customary hurdle rates for sub-$100 million emerging market PE/VC funds create perverse incentives that misalign GP/LP interests.
A senior leader at an emerging market institutional investor told me recently: “When I started managing our private equity portfolio a few years ago, every fund was pitching 2% management fee and 20% carry with an 8% hurdle. I asked people why it was so uniform. Colleagues told me that’s just the way it is and not to question it.”
A Partner at a successful emerging market venture capital fund recently told me: “Don’t waste your time trying to sell an institutional investor on not having a hurdle. Their investment committees just reject everything without a standard hurdle not bothering to consider logic or details presented.”
An investment committee of an institutional investor recently heard our detailed case for tiered carry vs. hurdle. At the end, they said “This is very interesting, thank you. But we always require a hurdle.”
In my role as an emerging market fund manager investing both in operating companies as well as other emerging market fund managers (and their funds), I have had dozens of conversations about fund manager performance compensation over the past years.
I strongly believe the conversation needs to change.
Growth & mid-cap funds invest in companies similar to many listed ones
Most of the institutional fund investors (LPs) investing in emerging market private equity (and venture capital) are investing the bulk of their capital in growth and mid-cap funds of $300m+ and up. For these larger funds, they are rightly concerned about (huge) fees, both for operations (management fees) as well as for performance (profit sharing, aka carry or carried interest). These fund managers (GPs) are generally investing in mature companies which have fairly predictable profit expectations assuming competent investment decisions, support of companies, and exit planning. This class of company is not very different than many listed companies, with the big exception of lack of liquidity increasing the risk. That’s probably the best argument for requiring a hurdle rate (aka preferred return) as a way of motivating GPs to focus on a timely exit.
Sub-$100 million funds invest in early-stage companies with higher return potential but longer hold times
Most sub-$100 million emerging market PE/VC funds are investing in companies at their early-stage or early-growth stage. They have longer initial investment periods; typically, 4 years vs. a later stage VC or PE fund at 2-3 years. Managers are intentionally investing in companies that have higher risk, along with higher return potential. Also, they are expecting to hold these investments longer, often doubling down along the way in order to participate in growing value with reduced risk. Done well, this long-term investment strategy results in 3x or better cash-on-cash returns for the investor with 20-30% net IRRs or more. But in less rosy situations, hurdle rates can incent managers to take decisions that reduce these otherwise excellent return potentials.
Hurdle rates create potential for significant misalignment in interests between GPs & LPs
There are well-known GP/LP misalignment problems with the “carry with hurdle rate” model for PE/VC in general, which are:
- Incentivizes shorter-term view with less risk taking. Every time the GP calls capital, the hurdle clock starts ticking. The GP may then over look some great deals with a higher return potential but a longer hold period due to the hurdle threat. This is not the lens that the LPs should want the GP to be using.
- Incentivizes more risk taking when forecast looks bad. After the investment period, if a GP ever feels like they won’t exceed hurdle rate, they are incentivized to start making more risky investments in order to try and earn some carry. Taken to an extreme, they could be effectively using LP money as gambling money with limited downside for themselves.
- Lower incentive to achieve returns when carry under water. Another logical reaction when no carry seems possible is for the GP to focus efforts elsewhere, looking to do as little as possible to return capital with a modest IRR for LPs, knowing that they have no upside. In such scenarios, they also are incentivized to hold on to assets longer because they are typically paid management fees based on net assets under management.
One can reasonably argue that high quality managers in situations above will continue to do the best they can to provide their LPs with the highest return possible to protect their reputation and hopefully have a case to make for follow-on funds. However, with a substantial percentage of funds in the industry performing poorly (sub-2 MOIC with IRRs under 8%), one simply cannot discount that these misaligned actions have taken and/or will take place.
Tiered carry creates seamless alignment between GPs and LPs
We believe that a better model to compensate GPs to align interests with LPs is to replace a “carry with hurdle” model with a “tiered carry” model. Tiered carry provides a lower amount of profit sharing for GPs when the fund profits are lower and a higher level of profit sharing when profits are higher. For instance, here is an example:
- For fund returns above 1x and up to 1.5x, GP earns 10% carry
- For fund returns above 1.5 and up to 2.0x, GP earns 20% carry
- For fund returns above 2x and up to 2.5x, GP earns 25% carry
- For fund returns above 2.5x, GP earns 30% carry
The ranges of fund returns and carry % can of course be negotiated. And you can also negotiate whether there is catch-up or not.
Tiered Carry vs. Hurdle
Advantages of tiered carry vs. hurdle include:
- Encourages GP to take appropriate risk to seek higher fund returns
- Fully aligns GP & LPs in all scenarios
- Profit sharing level varies with profits, below to above market
- No edge-case bad incentives – GPs always have a reason to try to get more returns
- GP incentivized to invest smartly; is rewarded increasingly
The only “downside” scenario for LPs with the tiered carry is when the fund returns are modest (e.g. below a perceived minimum hurdle level). But with the tiered carry model, this scenario is also much less likely to occur as the GP is incentivized to maximize overall fund returns in almost every scenario.
More GPs and LPs need to have conversations about how to align their interests … and one of the topics should be performance compensation with tiered carry as a serious option on the table for consideration.