Friday Letter Carry 2.0

It’s time to tether carried interest to GP confidence. 

Individuals have an amazing capacity to believe they are special.

A gambler believes that otherwise unfavourable odds will make an exception in his case. On Wall Street, traders and stock pickers will unceasingly believe they can beat the index in the long term, despite evidence to the contrary.

In private equity and private equity real estate, general partners always believe their next fund will be above average. In the top quartile, even. They believe this because they are special, unlike the last GP you took a meeting with.

One very astute private equity endowment manager (who asked to remain nameless) has come up with a new formula for carried interest that was inspired by the endless parade of GPs who claimed they were above average.

The following formula is just as applicable to private equity real estate as it is to its cousin asset class, private equity.

Our LP says he has been struck by the number of GPs who enter his office and, in response to the question, “So how good are you?” say they are aiming to return 3x, 4x LP capital commitments. The endowment manager finds that interesting, because returns of that magnitude would place the managers in the Pantheon of the GP Gods. Even a 2x return over a reasonable amount of time would be highly, highly satisfying to most LPs, including this endowment manager.

After some meditation on this phenomenon, our LP source has come up with a unique partnership term he thinks GPs should find highly interesting – any return over 2x and the carried interest rate is 30 percent. Anything under 2x and you get 10 percent. Since most GPs are (outwardly) confident that they will return to LPs two times their money, it’s an offer to which they should have a hard time saying no.

The endowment manager wants to make one thing very clear: he’s happy to pay 30 percent carry if the returns are good enough. “If I get 2x net to me, I win,” he says.

As for the GPs, this reengineered carry term is a way to guarantee that “the good guys get paid more than the bad guys”, he says.

This LP also doesn’t mind deal-by-deal carry under the new structure. A clawback from the GP based on a lower 10 percent carry level would be less painful than the current practice. In fact a more likely clawback scenario would be from the LP. A fund may very well start out by paying interim carry at a 10 percent rate but then end its life moving up to the 30 percent rate once it becomes clear that the performance is above 2x. At that point the LP gets a clawback notice – a happy event for both parties.

Of the many heated discussions between LPs and GPs taking place today, the third rail of carried interest is seldom touched. Most people believe that 20 percent carried interested is sacred. For the most part, people agree that an outsized incentive for GPs to generate profit strongly favours LPs and GPs alike.

Instead, the terms that LPs are most in a lather about are those that blunt the power of carried interest. For example, management and transaction fees that serve as a source of GP wealth generation in their own rights can have the effect of turning carry into the icing on the cake, as opposed to the whole cake.

Most seasoned limited partners find laughable the idea of a fund offering to cut its carry below market rates. What kind of a weak GP team would do that, they ask, and why would I want to invest with them?

In fact, while no GP worth his salt will go below market terms on carry, we have seen evidence that market terms for carry can shift when the perception of the asset class shifts. In the relatively immature infrastructure investment market, for example, a number of firms that launched fundraisings with private equity-style carry terms have cut this down to 10 percent. These lowered carry rates precisely reflected investor assumptions that infrastructure assets will generate lower returns than what is expected in private equity and private equity real estate.

Will return expectations therefore drop, and with them carried interest rates? Yes and no. Many funds will deliver weak returns, but a small handful will deliver spectacular returns. But this has always been the case. Our unnamed LP’s idea for “carry 2.0” is an elegant evolution that recognises this disparity, and will appeal to the only kind of GPs you want to back – the confident kind.