Do waterfall provisions lead to conflicts of interest?

Provisions in private equity and real estate fund agreements that allow GPs to 'catch up' on profits after they hit an agreed hurdle rate create a potential conflict of interest between investors and managers, according to a new research study by secondaries adviser Landmark Partners. Because the size of the GP's return goes up substantially during the period immediately after hitting the hurdle rate, managers are financially incentivised to push through exits to lock in returns – even if holding onto investments for a longer period might generate a better return for LPs over the life of the fund.

To illustrate this point, the authors of the paper (Barry Griffiths, Landmark's director of quantitative research, and David Robinson, Professor of Finance at Duke University's Fuqua School of Business) have constructed a returns scenario for a fund with a standard 2/ 20/ 1 arrangement (i.e. 2 percent management fee, 20 percent carried interest, and 1 percent GP commitment). Once LPs have received their preferred return of 8 percent, the GPs then gets 100 percent of distributions until they have caught up with 20 percent of all profits to date, after which profits are split 80/ 20 between LP and GP.

The model shows that in the period immediately after the hurdle rate is hit, the GP's return goes up rapidly: for instance, during the period in which the gross IRR of the underlying deals goes from 10 percent to 13 percent, the GP's 'total value to paid in' goes from 1.4x his original investment to more than 8x. For LPs, however, the return profile during this period barely changes.

What this means, according to Landmark, is that the GP is heavily incentivised to get through that catch-up period and into carry – whereas LPs are not. What's more, the GP loses out to a much greater extent, relatively speaking, if the fund holds onto its investments too long and ends up not making as much money as expected from an exit. As a result, the GP is incentivised to bring exits forward to lock in returns – even if holding onto them might result in a better return over time.

“We’re into the harvest phase for most boom era funds, but not many of them are in the catch-up,” says Griffiths. “As firms get into the range of 8-9 percent cash-on-cash IRR, there’s a tremendous impetus to get money out – although if they decide to realise assets then, the overall upside might not be as much. So there's a tension between what the LPs want, which is a high return over their whole portfolio, and what the GPs want. And there's also a tension within the GP firm between what individual partners want — which is often to get their share of the carry in cash — and what the franchise needs, which is usually to have both a high teens IRR and a good multiple.”

Landmark argues that this has a clear impact in practice: according to its data, total distributions to LPs are almost three times as high in the period after the threshold as in the period before the threshold.

The firm did point out that its analysis comes with a few caveats: notably that different funds will set up their hurdle rates and catch-up provisions in different ways. Another important point to note, it added, was that its data did not necessarily show that economic value was lost as a result of this incentive to being exits forward; in fact, the funds studied all generated returns of about 20 percent in excess of returns from public markets over a similar period.

For a copy of the report, please contact one of its authors: Ian Charles or Barry Griffiths