Alternative Investments Compensation Structures

Partnership Structures

Partnerships in alternative investments typically consist of a General Partner (GP) and some Limited Partners (LPs). In this arrangement, the GP is the fund manager while the LPs are the accredited investors. The engagement of the partners is based on the legal framework of the fund. LPs usually assume the investment risks while the GP manages the business and bears unlimited liability given any unfavorable eventuality. The GP can manage multiple funds.

Ideally, the number of LPs is limited in a given fund. LPs perform passive roles and are not part of the fund management. Therefore, the GP makes all decisions and runs the fund.

A limited partnership agreement (LPA) governs the relationship between the GP and the LPs. The LPA is a legal document that defines the rules of the partnership and institutes the structure guides for the entire fund’s operations. The structure of LPAs varies from one fund to another.

In addition to LPAs, there are side letters, which are the agreements between the GP and a particular number of LPs formed outside an LPA. Side letters may include favored fee structures and/or requirements of notice in litigation, insolvency, and related issues.

Examples of alternative investments include private-public partnerships in infrastructure and joint ventures in real estate.

Compensation Structures

Compensation structures in alternative investments include management fees, performance (incentive) fees, and hurdle rates.

Management Fee

In private equity, management fees are based on the committed capital and not the invested capital. This decreases the GPs’ tendency to deploy the committed capital to earn a higher return quickly. Moreover, this feature forces GPs to be selective when investing committed capital. In hedge funds, the management fee is based on assets under management (AUM).

Performance or Incentive Fee and Hurdle Rate

The performance fee is earned only after the fund achieves a return known as a hurdle rate. The hurdle rate is the lowest rate of return that the GP must exceed to earn a performance fee. Performance fees are meant to reward GPs for enhanced performance.

In private equity, if the hurdle rate is calculated based on annual returns in excess of the hurdle rate, it is termed as the hard hurdle rate. On the other hand, if the hurdle rate is based on the annual gross return in excess of the hurdle rate, it is termed as the soft hurdle rate.

Other Fees

In private equity, consulting and monitoring fees may apply to the underlying company.

Common Investment Clauses, Provisions, and Contingencies

Catch-up Clause

A catch-up clause is intended to make the manager whole so that their incentive fee is based on the total return and not exclusively on the return in excess of the preferred return. For instance, if a GP earns a performance fee of 20%, a catch-up clause stipulates that the GP receives all of the distributions above the hurdle rate until they receive 20% of the profits earned. Then every amount above that is split 80/20 between the LPs and GP.

For example, consider a fund that has earned a 15% IRR, and a performance fee of 20% and a hurdle rate of 9% are applicable. Assuming that the catch-up clause is included in the agreement, LPs would take the 9% profit (hurdle rate) in its entirety, and then the GP would receive 1.2% [= 20% × 6%]. Given that the catch-up clause applies, the remaining 4.8% [= 6% – 1.2%] is split between the LPs and the GP in 80/20 proportion. Therefore, the total earned by LPs is 12.84% [= 9% + 80% (4.8%)] and total earned by a GP is 2.16% [1.2% + 20% (4.8%)].

Intuitively, if the catch-up clause was absent, the LPs would still take the 9% profit, and the remaining 6% would be split in 80/20 proportion between LPs and the GP. In this case, the GP would receive only 1.2%.

High-water Mark

A high-water mark is the highest value, net of fees, that a fund has reached in its history. It indicates the highest cumulative return used to calculate an incentive fee. A high-water mark clause stipulates that a GP must recover the decrease in funds value from the high-water mark prior to charging a performance fee on new profits earned.

Normally, in most alternative investments, a high watermark is carried over to the new calendar year. However, in hedge funds, investors cannot claw back incentives earned in the previous calendar year if losses are experienced in the current year.

High-water marks apply differently to different investors given their time of investing. For instance, an investor who invests at the lowest point of the fund will benefit when it improves. On the other, an investor who invests when the funds improve will have to wait until what was lost is earned to be entitled to the pay.

Waterfall Clause

The waterfall clause is a distribution technique that defines the order in which distributions are made to LPs and GPs. Normally, GPs get a higher proportion of profit to motivate them to make more profit. There are two major forms: Deal by deal (also called American) and whole of fund (also called European).

In deal-by-deal (also called American) waterfall, performance fees are accumulated on per deal methods. This makes the GP receive payments before LPs get their rates of return (hurdle rate) on the fund and initial investments.

In whole-of-fund waterfall, the GP does not receive any profit until LPs are paid their hurdle rate and initial investments. 

Clearly, the deal-by-deal waterfall is more profitable to the GP and the whole-of-fund waterfall is more beneficial to LPs.

Clawback Clause

A clawback clause gives LPs the right to recover the performance fees from the GP. For instance, if a GP pays itself an incentive fee on profit not yet fully earned, the clawback clause allows an investor to claw back past incentive fee accrual and payments. Clawback is usually applicable when the GP closes successful deals early and incurs losses after some time within the life of a fund.

Question               

Which of the following most likely indicates the highest cumulative return used to calculate an incentive fee?

1. Waterfall.
2. Clawback.
3. High-water mark.

Solution

The correct answer is C.

A high-water mark is the highest value net of fees that a fund has reached in its history. It indicates the highest cumulative return used to calculate an incentive fee.

A is incorrect. A waterfall represents the distribution technique that defines how distributions are made to LPs and GPs.

B is incorrect. A clawback requires the general partner to return any funds allocated as incentive fees until the limited partners have got back their initial investment and a percentage of the total profit.