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Hurdle? What Hurdle?

Like many terms, the preferred return has become something of a standard in limited partnership agreements. But has it actually served any useful purpose, asks Invesco Asset Management's Ray Maxwell?

The hurdle or, more precisely, the preferred return has become a standard limited partnership term. Yet in many ways it is more confusing than useful.

It first saw the light of day during the mid to late 1980s when the private equity industry was still in its infancy. The rationale for its introduction was to ensure that general partners could not be compensated for indifferent performance. It was also meant to ensure that investors had a distribution priority equivalent to their commitment, plus the ‘risk-free’ rate of return. The risk-free rate was deemed to be the yield on a Treasury with similar maturity to the weighted average life of a private equity partnership. This was perceived to be around six to seven years. Over the past few years the preferred return has been set at somewhere between six per cent and eight per cent –pretty much those adopted a decade ago when interest rates were significantly higher.

An attraction of the preferred return was that it made general partners aware that time is an exacting mistress. Any delay in achieving exits would make it more difficult to reach the promised land, ie breaking into carried interest. Of course, having returned capital and the preferred return to investors the general partner has claim to future distributions until 25 per cent of the preferred return is recovered, assuming a carried interest of 20 per cent. This is frequently referred to as a ‘catch-up’. Thereafter, distributions are shared between general and limited partners in the proportion agreed in the legal documentation.

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

1. There does not appear to be a standard methodology to calculate the preferred return. There is a wide range of methodologies, from simple interest compounded annually to compounding on a quarterly basis.
2. There is no standard catch-up mechanism. Some partnerships have a 100 per cent catch-up, others 50:50, and others 80:20.
3. In the case of the 100 per cent catch-up, the problem is that limited partners are effectively out of the money until the general partner has made a full recovery and nobody can predict how long that will take. In essence, the preferred return heavily distorts the limited partners’ cash flow.
4. If the preferred return is set too high or the general partner performs poorly, the situation may arise where the general partner may never reach the ‘promised land’ and therefore, the incentive becomes meaningless. If it is set too low it is becomes a minor irrelevance.
5. After the preferred return has been reached the partnerships are no longer subject to any performance measurement. This is why the preferred return cannot be regarded as being a hurdle. A hurdle should remain effective throughout a partnership’s life.
6. The preferred return mechanism works reasonable well for later stage activities such as expansion capital and buy-outs in which there is usually only one round of finance. But it is ineffective for early-stage venture, where there are multiple rounds of funding, many of which are subject to milestone payments.

The question has to be whether preferred returns have served any useful purpose? Certainly the term 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. 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. On the other hand, from the general partner’s standpoint, the issue would be the length of time it would take to participate in the carried interest. It could try the patience of a saint.

A further observation is that it is extremely difficult to predict when investments can be sold or listed. The dilemma that many general partners face is whether it is better to realise an investment over a short period of time and try to optimise the IRR or hold on for longer and try to optimise the multiple. With the clock ticking away remorselessly, the tendency would be to take early realisations until the preferred return had been met.

An alternative model, which has some considerable merit, would be to move away entirely from the preferred return. The idea would be to create a model based on variable percentages of carried interest, starting at a low base of five per cent and rising incrementally to, say, 30 per cent or 40 per cent as more investments are realised. The table below demonstrates the concept based on a £500m fund with £50m increments. With gains of £200m generated , the resultant average level of carried interest would be 12.5 per cent. In essence, the greater the multiple the higher the carried interest would be. This should align the interests of both general and limited partners.

In conclusion, although the preferred return is now an accepted standard term, I believe that it has passed its sell-by date. Private equity terms are not ‘writ in stone’ and there is no reason why new approaches should not be considered. In today’s climate, carried interest has to be earned – not given away.

Ray Maxwell is managing director, private equity, INVESCO Asset Management.

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