Investment and Compensation Structures in Alternative Investments  

Different alternative investments, especially hedge and private equity funds, have a partnership structure with a general partner (GP) and 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 investment risks while the GP manages the business and bears unlimited liability in case of any unfavorable eventuality. It’s equally noteworthy that the GP can manage multiple funds.

The general partner is paid a management fee based on committed capital or the assets under their management. Besides, they earn an incentive fee based on actual profits.

Ideally, the number of LPs is limited in a given fund. LPs perform passive roles and are not part of fund management. It’s the GP that 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 spells out the rules of a 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 potential additional reporting due to an LP’s unique circumstances, such as tax requirements, first right of refusal, notice requirement in case of litigation, and related issues. In addition, they contain the most favored nation clauses. For instance, this includes an agreement that if a particular  LP pays lower fees, this will be offered to them.

Compensation Structures

Compensation structures reward the general partners for improved performance through performance and management fees.

The management fee normally ranges between 1% and 2% of assets under management/committed funds, i.e., the funds the limited partners have invested/committed to the fund.

In addition, funds have a performance fee, also called an incentive fee or carried interest. It is based on excess returns. The partnership agreement may also specify the hurdle rate.  A 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 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 referred to as the soft hurdle rate.

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 the distributions above the hurdle rate until they receive 20% of the profits earned. Every amount above that is then split 80/20 between the LPs and GP.

For example, consider a fund that has earned a 15% IRR, a performance fee of 20%, and a hurdle rate of 9% is applicable. Assuming that the catch-up clause is included in the agreement, LPs would take the 9% profit (hurdle rate), 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 an 80/20 proportion. Therefore, the total amount LPs earn is 12.84% [= 9% + 80% (4.8%)], and the total amount a GP earns is 2.16% [1.2% + 20% (4.8%)].

Intuitively, in the absence of the catch-up clause, the LPs would still take the 9% profit, and the remaining 6% would be split between LPs and the GP at an 80/20 distribution rate. In this case, the GP would only receive 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,  a high watermark is carried forward to the new calendar year in most alternative investments. 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 mark application varies from investor to investor, given their investment timing.   For instance, an investor who invests at the fund’s lowest point will benefit when it improves. On the other hand, to qualify for payment, an investor who invests when the fund improves will have to wait until it recovers any previous losses.

Waterfall Clause 

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

In the deal-by-deal waterfall structure, 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 the whole-of-fund waterfall structure, 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,  while 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, this happens if a GP pays itself an incentive fee on profit not yet fully earned. Note that 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?

A. Waterfall clause.

B. Clawback clause.

C. 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 clause/structure 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 returned their initial investment and a percentage of the total profit.