{"id":5581,"date":"2020-01-27T00:45:00","date_gmt":"2020-01-27T00:45:00","guid":{"rendered":"https:\/\/www.ewmglobal.com\/site\/?p=5581"},"modified":"2024-07-24T20:14:07","modified_gmt":"2024-07-24T20:14:07","slug":"lifting-the-curtain-on-carried-interest-calculations","status":"publish","type":"post","link":"https:\/\/www.ewmglobal.com\/site\/lifting-the-curtain-on-carried-interest-calculations\/","title":{"rendered":"Lifting the Curtain on Carried Interest Calculations"},"content":{"rendered":"\t\t
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\n\t\t\t\t\t\t\tWritten by Rob Hagmeier\t\t\t\t\t\t<\/h4>\n\t\t\t\t\t<\/a>\n\t\t\t\t\n\t\t\t\t\t\t\t\t\t
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Published: December 2019\/January 2020 Edition of PEI's Private Fund Management Magazine.\u200b<\/p>\n\t\t\t\t\t<\/div>\n\t\t\t\t\n\t\t\t\t\t\t\t<\/div>\n\t\t<\/div>\n\t\t\t\t\t\t<\/div>\n\t\t\t\t<\/div>\n\t\t\t\t\t<\/div>\n\t\t<\/div>\n\t\t\t\t\t<\/div>\n\t\t<\/section>\n\t\t\t\t

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An anniversary date model can secure timely payments \u2013 and need not generate excessive complexity.<\/h5>

Amid the unprecedented growth in private markets and the increasingly competitive environment over the past decade, firms have become experts in finding ways to generate maximum value from their investment strategies. Rewarded based on the ability to identify and deliver optimal returns, carried interest remains the industry\u2019s gold standard employee incentive and shows no sign of losing favor anytime soon.<\/p>

Given the amount of money derived from carried interest, it is not surprising that the mechanics of the calculation have come under scrutiny from LPs seeking transparency into the fees they pay. Today, most limited partnership agreements state the general methodologies behind the carry calculation, leaving only limited room for interpretation from GP finance departments.<\/p>

One area often left ambiguous is the compounding model used in determining the preferred return hurdle. When it comes to this calculation, a significant portion of firms choose simplicity over optimization. In doing so, they run the risk of inflating preferred returns, delaying carry payments to deal team members, and even lowering total carry payouts. To explore how these inefficiencies arise, we\u2019ll compare two commonly used European waterfall models and measure the impact of their different preferred return interpretations on a hypothetical fund.<\/p>\t\t\t\t\t\t\t\t<\/div>\n\t\t\t\t<\/div>\n\t\t\t\t\t<\/div>\n\t\t<\/div>\n\t\t\t\t\t<\/div>\n\t\t<\/section>\n\t\t\t\t

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The easy option \u2013 fixed date compounding<\/h5>

In an effort to simplify the preferred return calculation, many firms compound all their fund\u2019s outstanding capital on a fixed calendar date each year. Maintaining a fixed date waterfall model tends to reduce complexity compared to other approaches, but the simplicity comes at a cost.<\/p>

A fixed date approach means that few (if any) of the capital calls accrue preferred re- turn for a full 12-month period before the accrued amounts compound and begin accruing interest of their own. Not only does early compounding always result in a higher hurdle compared to more precise methods, it also results in a larger true hurdle than the rate stated in the LPA.<\/p>\t\t\t\t\t\t\t\t<\/div>\n\t\t\t\t<\/div>\n\t\t\t\t\t<\/div>\n\t\t<\/div>\n\t\t\t\t\t<\/div>\n\t\t<\/section>\n\t\t\t\t

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The fixed date model\u2019s impact on marginally profitable funds (ie, funds that liquidate with an IRR close to the hurdle rate) can be significant. Keeping the hurdle low in an under-performing fund may prove the difference between partners receiving a small amount of carry or none at all. Fixed date compounding is particularly damaging in these scenarios. Funds with substantial returns also feel the impact of sub-optimal compounding, albeit to a lesser extent than their low-IRR counterparts. Funds capable of repaying the preferred return and satisfying the GP catch-up will be brought into equilibrium (eg, 80 percent LP, 20 percent GP) and will not see an impact to their final carried interest numbers, but the partners in those funds may still feel the impact in the form of time-value loss. A larger hurdle re- quires larger realizations before being paid down, which means partners are often paid on their carry later in the fund\u2019s life.<\/p>\t\t\t\t\t\t\t\t<\/div>\n\t\t\t\t<\/div>\n\t\t\t\t\t<\/div>\n\t\t<\/div>\n\t\t\t\t\t<\/div>\n\t\t<\/section>\n\t\t\t\t

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A worthwhile alternative? Anniversary date compounding<\/h5>

Firms looking to keep their hurdle low may opt for an anniversary date model. This calculates separate preferred return accruals for each capital call and compounds them on their respective anniversary dates. This model introduces two main complexities:<\/p>