Investment Ownership and Compensation Structures used in Alternative Investments

Alternative investment structures are complex due to the illiquidity, complexity, and long-term nature of these investments. These structures are designed to bridge potential gaps between manager and investor interests. They explicitly address the roles and responsibilities of both parties to mitigate these gaps. These roles are designed to ensure that both parties’ interests are aligned and that the investment structure functions effectively. For instance:

• Managers might stipulate that investors are obligated to make future capital contributions. For example, in a private equity fund, the fund manager may call for additional capital from investors for new investment opportunities.
• Investors may put restrictions on manager investment selection to avoid conflicts of interest or hostile takeovers, among other investment criteria. For instance, an investor in a hedge fund may stipulate that the fund manager cannot invest in specific industries or companies.

Moreover, alternative investment structures tailor the distribution of returns between managers and investors to better align their incentives. For instance, performance-based compensation structures are designed to encourage managers to maximize returns in the best interest of investors. They can include:

• Minimum return requirements for investors: This ensures that the investors receive a certain level of return before the manager can receive their performance fee. For example, a hedge fund may have a hurdle rate of 8%, meaning it needs to earn at least 8% before the manager can receive their performance fee.
• Delayed payouts: This is a mechanism to ensure that the manager is focused on long-term performance. The manager’s performance fee may be held in escrow and paid out over several years.
• The ability to reclaim incentive compensation in the event of poor fund performance: This is known as a clawback provision. If the fund performs poorly in subsequent years, the investors can reclaim some of the manager’s performance fee.

Ownership Structures

Alternative investment vehicles frequently adopt partnership structures to optimize flexibility in their investment arrangements, allocate business-related risks and returns, and delineate specific responsibilities between investors and managers. Specifically, we shall look into limited partnerships.

Limited Partnerships (LP)

Limited partnerships involve at least one general partner (GP) with theoretically unlimited liability who is responsible for managing the fund. Limited partners (LPs) are investors who own a fractional interest in the partnership based on their initial investment and the terms set out in the partnership agreements.

LPs play passive roles and are not involved with the management of the fund. The operations and decisions of the fund are controlled only by the GP. For example, in a private equity fund, the GP might be the private equity firm, while the LPs could be pension funds, endowments, or wealthy individuals. However, note that co-investment rights grant limited partners (LPs) the opportunity to make supplementary direct investments in the portfolio companies.

A limited number of LPs hold fractional interest in the fund. LP investors must generally meet specific minimum regulatory net worth, institutional, or other requirements to be considered accredited investors and, as such, are able to access these investments, which are less regulated compared to general public offerings.

Limited Partnership Agreement (LPA)

A limited partnership agreement (LPA) establishes the terms of an LP. Important components of an LPA encompass the allocation of profits and losses, managerial duties and obligations (including investment criteria and limitations), as well as provisions governing the transfer, withdrawal, and dissolution of the agreement.

For example, the LPA might specify that profits are distributed 80% to the LPs and 20% to the GP after the return of the initial investment.

Side Letters

Occasionally, modifications to LP terms are implemented to cater to the distinct legal, regulatory, or reporting demands of a particular investor. In such cases, a supplemental document known as a side letter is issued between a GP and one or more LPs with terms that override or modify the original LPA terms. The terms might include:

• increased investor ability to transfer investments to a successor
• first right of refusal and other similar clauses,
• ability to forgo a contractual capital contribution, 
• ability to receive additional investment reporting. 
• “most favored nation” clause, which guarantees that any more advantageous or supplementary terms negotiated externally to the LPA with other investors will likewise be applicable to a specific LP.

Specialized Structures

Different specialized structures are commonly adopted for other alternative investments. For instance,

• Infrastructure investors often engage in public-private partnerships, which involve agreements between the public and private sectors to fund, construct, and manage public infrastructure. Infrastructure projects frequently incorporate a special purpose entity tasked with securing borrowed and ownership capital for developing and operating a particular long-term asset.
• Investors in real estate or natural resource funds are typically categorized as unitholders within a master limited partnership (MLP). An MLP shares similarities with a limited partnership but tends to offer greater liquidity and is frequently publicly traded. As an illustration, an MLP might be utilized for investments in oil and gas pipelines.
• Additional forms of liquid investments in alternative assets include real estate investment trusts (REITs), commodity funds, and various exchange-traded funds (ETFs).

Compensation Structures

In the world of alternative investments, there often exists an asymmetry of information between the general partner (GP), who possesses specialized knowledge and control, and the limited partners (LPs). This imbalance necessitates the creation of more complex compensation structures to align the incentives of both parties. For instance, consider a venture capital firm (GP) and its investors (LPs). The firm has in-depth knowledge about the startups it invests in, while the investors rely on the firm’s expertise to make profitable decisions.

Management and Performance Fee

Unlike funds that own public equity or debt securities, which charge management fees as a fixed percentage of assets under management (AUM), alternative investment funds usually combine a higher management fee (often 1%–2% of AUM) with a performance fee (also known as an incentive fee or carried interest) based on a percentage of periodic fund returns.

Hedge funds and REITs usually assess a management fee based on assets under management. In contrast, private equity funds often apply this fee to committed capital, which encompasses the entire sum that limited partners (LPs) have pledged to support future investments.

The management fee is typically based on committed capital, not invested capital. This reduces the incentive for GPs to allocate the committed capital as quickly as possible, allowing them to be selective about deploying capital into investment opportunities. Furthermore, given the significant impact of the general partner (GP) on the asset’s value, it would be unsuitable to calculate management fees based on the value of assets under management.

For example, a hedge fund might charge a 2% management fee and a 20% performance fee. This means that for every $100 million in assets, the fund would charge $2 million in management fees. If the fund generates a return of $20 million, it would also charge $4 million (20% of $20 million) as a performance fee.

Performance Fees and Hurdle Rates

Performance fees in alternative investments are mechanisms to reward fund managers for achieving returns above a specified baseline. This baseline is often termed the ‘hurdle rate‘. The introduction of a hurdle rate ensures that managers are incentivized to outperform a minimum benchmark, aligning their interests with those of the investors.

There are two primary types of hurdle rates:

1. Hard Hurdle Rate

In this arrangement, the manager earns fees only on the portion of returns that exceed the hurdle rate. For instance, with an 8% hard hurdle rate, if the fund achieves a 10% return, the manager is compensated based on the 2% excess return.

2. Soft Hurdle Rate

Under a soft hurdle rate, the manager earns fees on the entire return once the hurdle is surpassed. Using the same example, if a fund with an 8% soft hurdle rate achieves a 10% return, the manager is compensated based on the full 10%.

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%.

Calculating the GP’s Rate of Return

Ignoring management fees and assuming a single period fund rate of return of \(r\), the GP’s rate of return (\( r_{GP} \)) with a hard hurdle rate is calculated as:

\[ r_{GP} = \max[0, p(r – r_h)] \]

Where:

• \( r_{GP} \) = GP’s rate of return
• \( p \) = Performance fee as a percentage of total return
• \( r \) = Fund’s rate of return for a period
• \( r_h \) = Hard hurdle rate

If there’s a catch-up clause, the calculation changes to:

\[ r_{GP} = \max[0, r_{cu} + p(r – r_h – r_{cu})] \]

Where \( r_{cu} \) is the return rate, after which the GP starts to ‘catch up’ on performance fees.

Example: Calculating GP’s Return

Let’s consider a fund with a 20% GP performance fee and an 8% hurdle rate. Suppose the fund achieves a 12% return for a period.

Without a catch-up clause (Hard Hurdle):

The GP would earn fees on the 4% excess return (12% – 8%). Thus, \( r_{GP} \) would be \( 20\% \times 4\% = 0.8\% \).

With a catch-up clause:

In this case, the catch-up return (\( r_{cu} \)) is 0.8%. For the 12% fund return, the GP will earn on the full 0.8% catch-up return plus 20% of the excess return (12% – 8% – 0.8%). Thus, \( r_{GP} \) would be:

$$\begin{align}r_{GP} &= \max[0, r_{cu} + p(r – r_h – r_{cu})]\\ &= \max[0, 0.8\% + 20\%(12\%- 8\%- 0.8\%)]\\&=1.44\%\end{align}$$

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.

Usually,  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.

Clawback Provision

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.

Waterfall structure

Alternative investments frequently employ a waterfall structure to establish the allocation of cash flows to general partners (GPs) and limited partners (LPs). There are two types of waterfalls: deal-by-deal (or American) waterfalls and whole-of-fund (or European) waterfalls.

• Deal-by-Deal (American) Waterfalls: Here, GPs can earn performance fees on individual deals, even before LPs have fully recouped their investments and earned their predefined returns. Clearly, this is beneficial to GPs.
• Whole-of-Fund (European) Waterfalls: LPs are prioritized. GPs only start earning profits once LPs have fully recouped their initial investments and the hurdle rate is achieved for the entire fund.

These structures are designed to ensure that the distribution of profits is fair, and that GPs are incentivized to deliver consistent, long-term returns to their LPs.

Question 

A private equity fund has $500 million in committed capital. The fund charges a 2% management fee and a 20% performance fee with a hard hurdle rate of 8%. In a given year, the fund generates a return of $50 million. How much would the fund most likely charge in total fees for that year?

1. $10 million
2. $12 million
3. $14 million

The correct answer is B.

The total fees charged by the private equity fund consist of two components: the management fee and the performance fee.

Management Fee:

The management fee is calculated as a percentage of the committed capital. In this case, it is 2% of $500 million.

$$ \text{Management Fee} = 2\% \times \$500 \text{ million} = \$10 \text{ million} $$

Performance Fee:

The performance fee is calculated as a percentage of the returns above the hurdle rate. The hurdle rate is 8% of the committed capital, which amounts to:

$$ \text{Hurdle Rate} = 8\% \times \$500 \text{ million} = \$40 \text{ million} $$

Since the fund generated a return of $50 million, the returns above the hurdle rate are:

$$ \text{Returns above Hurdle Rate} = \$50 \text{ million} – \$40 \text{ million} = \$10 \text{ million} $$

Therefore, the performance fee is 20% of $10 million:

$$ \text{Performance Fee} = 20\% \times \$10 \text{ million} = \$2 \text{ million} $$

Total Fees:

The total fees charged by the fund for that year would be the sum of the management fee and the performance fee:

$$\begin{align}\text{Total Fees} &= \text{Management Fee} + \text{Performance Fee}\\& = \$10 \text{ million} + \$2 \text{ million}\\ &= \$12 \text{ million} \end{align}$$

Therefore, the correct answer is B) $12 million in total fees, with the hurdle rate not affecting the calculation as the returns exceeded the hurdle rate.

The hurdle rate affects this calculation by determining the portion of the returns that are subject to the performance fee. In this case, since the returns exceeded the hurdle rate, the performance fee is calculated based on the returns above the hurdle rate. If the returns had not exceeded the hurdle rate, there would be no performance fee, and the total fees would be equal to the management fee alone.