Private Market Fund Performance

Private investment firms, such as venture capital and private equity firms, play a crucial role in the financial ecosystem. They provide capital to businesses that are not publicly traded, often in exchange for equity. These firms are typically managed by General Partners (GPs) who make investment decisions and manage the portfolio companies. The investors in these funds, known as Limited Partners (LPs), are typically institutional investors, high-net-worth individuals, and family offices.

One of the key challenges in private markets is the lack of transparency and information asymmetry. Unlike public markets, where information is readily available and prices are determined by the market, private markets are characterized by illiquid investments, long holding periods, and limited publicly available information. This creates a challenge for LPs to independently assess and benchmark the performance of GPs. To overcome this, private investment firms charge a combination of fees, including management fees and performance-based incentive fees, also known as carried interest. These fees serve to align the interests of GPs and LPs and incentivize successful GPs.

For instance, consider a private equity firm that specializes in investing in technology startups. The firm charges a 2% management fee on the total committed capital and a 20% carried interest on the profits. The management fee covers the operational costs of the firm, while the carried interest aligns the interests of the GPs and LPs by incentivizing the GPs to generate high returns.

Management Fees

Management fees are typically charged as a percentage of the total committed capital, which includes both drawn and undrawn portions of the capital. Once the capital is fully deployed, the fees are levied on the amount of committed capital minus the cumulative cost basis of investments exited and written off during the fund’s life. In certain instances, GPs may receive additional transaction fees for providing advisory services for transactions such as mergers, acquisitions, or Initial Public Offerings (IPOs) that benefit the fund. These fees may be shared with LPs, and if such fee-sharing agreements are in place, they are generally deducted from management fees.

The use of committed capital, rather than invested capital, as the calculation basis for management fees serves two main purposes. Firstly, it compensates GPs for the significant upfront cost of due diligence and other responsibilities prior to capital deployment. Secondly, it reduces the incentive to deploy capital as quickly as possible in less attractive investments simply to generate fees. Furthermore, the use of the cost basis reduces the potential conflict of interest associated with fund valuations, as GPs may otherwise have an incentive to inflate values over the life of a private investment to generate higher management fees.

Example: Management Fees Calculation for ArborTech VC Fund

ArborTech VC, a venture capital fund based in Germany, engages in an equity commitment of EUR 15 million from Greenwood, a German pension scheme. This example outlines the fund’s equity drawdowns, investment write-offs, exits, and the corresponding management fees over an eight-year lifecycle.

• Equity drawdowns are made evenly over the first three years from Greenwood.
• Investments are written off with a cost basis of 15% and 5% of committed capital in Years 4 and 5, respectively.
• Successful exits are made with cost bases of 30%, 20%, and 30% of committed capital in Years 6, 7, and 8, respectively.

Calculation

The management fee structure is 2% per annum on the committed capital during the first five years and 2% per annum on the invested capital for the last three years.

The calculation involves determining the annual management fees based on the specified percentages of committed and then invested capital. The write-offs and exits alter the invested capital base, affecting the fees in the later years.

$$ \begin{array}{l|c|c|c|c|c|c|c|c}
\textbf{Year} & \bf 1 & \bf 2 & \bf 3 & \bf 4 & \bf 5 & \bf 6 & \bf 7 & 8 \\ \hline
{\text{Drawdowns} \\ \text{(EUR million)} } & 5.0 & 5.0 & 5.0 & 0 & 0 & 0 & 0 & 0 \\ \hline
{\text{Write-offs} \\ \text{(EUR million)} } & 0 & 0 & 0 & 2.25 & 0.75 & 0 & 0 & 0 \\ \hline
\text{Exits (EUR million)} & 0 & 0 & 0 & 0 & 0 & 4.5 & 3.0 & 4.5 \\ \hline
{\text{Committed capital} \\ \text{minus exits and} \\ \text{write-offs} \\ \text{(EUR million)}} & 15.0 & 15.0 & 15.0 & 12.25 & 12.0 & 7.5 & 4.5 & 0 \\ \hline
{\text{Management Fee} \\ \text{(EUR million)}} & 0.3 & 0.3 & 0.3 & 0.27 & 0.255 & 0.15 & 0.09 & 0.0
\end{array} $$

For Years 1 through 3, the invested capital increases as funds are drawn down. By the end of Year 3, the total drawn down is EUR 15 million, which matches the committed capital. Starting from Year 4, the invested capital begins to decrease due to write-offs. After the EUR 2.25 million write-off (15% of EUR 15 million) in Year 4, the remaining invested capital is EUR 12.75 million. After the EUR 0.75 million write-off (5% of EUR 15 million) in Year 5, it further reduces to EUR 12 million. There are no additional write-offs in Years 6-8 but investors start to exit, so the invested capital starts to decrease.

Carried Interest

Carried interest is a performance-based incentive fee that aligns the interests of GPs and LPs. It is typically applied to investment returns above a hurdle rate, or a predetermined minimum target rate of return per period. GPs usually receive a 15%–20% share of returns above the hurdle. Limited partner agreements sometimes specify this threshold as being a hard hurdle rate, which means the GP earns incentive fees only on annual returns that exceed the hurdle rate.

The GP rate of return (r) is given by the formula:

$$r_{GP} = max[0, p(r – r_h)]$$

Where:

• \(r_{GP}\) is the GP’s performance fee
• \(r_{cu}\) is the catch-up return
• \(p\) is the GP performance fee percentage of total return
• \(r\) is the one-period fund rate of return
• \(r_h\) is the hard hurdle rate

While some alternative investment fund general partners charge performance fees annually, common practice in private market funds is to defer payment of carried interest until 100% of committed capital has been returned to limited partners through distributions or in some cases until the end of the fund’s term.

Soft Hurdle Rate and Catch-up Clause

A soft hurdle rate is a return threshold above which the entire return is subject to an incentive fee once the hurdle is exceeded. Soft hurdle arrangements benefit GPs by ensuring their performance compensation “catches up” once a hurdle threshold is exceeded. Under a so-called catch-up clause, once the hurdle is exceeded, the GP often earns 100% of distributions (or a catch-up return of r) until total return reaches a share of p for the GP and (1 – p) for the LP. Remaining distributions are split on the same basis.

The GP’s performance fee (r) from Equation 1 with a catch-up clause is given by the formula:

$$r_{GP} = max[0, r_{cu} + p(r − r_{h} − r_{cu})]$$

The incorporation of a soft hurdle rate may result in a higher carried interest amount earned by a private fund general partner even in the case of a lower carried interest rate. The use of a soft hurdle rate, instead of a hard hurdle rate, makes the carried interest rate a reasonable approximation of the GP’s ultimate share of total fund returns if the hurdle is cleared.

Example: Highland Equity Ventures

Highland Equity Ventures, a GP in a USD 250 million venture capital fund focused on technology startups, traditionally employs a performance-based incentive structure to align its interests with those of its LPs. The fund’s terms include a provision for carried interest to be paid to Highland at the conclusion of the fund’s lifecycle, typically 12 years. Highland receives 25% of the fund’s returns exceeding a hard hurdle rate of 7% per annum without compounding. Throughout the lifespan of the fund, the total return amounts to USD 325 million, on top of the initial USD 250 million capital investment.

Given recent shifts in the venture capital landscape, Highland Equity Ventures is re-evaluating its incentive structure. Rather than continuing with a 7% hard hurdle rate coupled with a 25% carried interest, Highland is contemplating adopting a softer approach. The new terms under consideration would set a soft hurdle rate at 6% and reduce the carried interest rate to 15%, but introduce a catch-up mechanism. This adjustment aims to better balance the risk-reward ratio for both Highland and its LPs, encouraging more aggressive pursuit of high-return investments while ensuring LPs’ capital is prioritized.

compare the proposed new carried interest policy with the original carried interest approach using a hard hurdle rate

The fund’s initial capital is USD 250 million, and it generates USD 325 million in returns over a 12-year life, totaling USD 575 million in fund value at the end. Net Return is found to be USD 75 million.

Annual Hurdle Amount = Initial Investment \(\times\) 7% = USD 17.5 million. Cumulative Hurdle Over 12 Years = Annual Hurdle Amount \(\times\) 12 = USD 210 million (Since the fund does not exceed this, the hurdle is not met for additional calculations).

Additional Fees in Limited Partnerships

General partners (GPs) may receive additional fee payments from firms they control. These fees are often rebated, but sometimes restrictions or complications reduce the rebated amount. Management service agreements may allow GPs to claim a wide range of discretionary expenses. In some cases, they may also allow GPs to withhold fees to lenders, such as arrangement fees. GPs’ fee arrangements with suppliers to portfolio companies can lead to potential conflicts of interest.

Liquidity Risk and Opportunity Cost

Investors must consider the liquidity risk associated with future capital calls of uncertain size and timing when investing in private market funds. Investors may incur an opportunity cost by holding committed capital in relatively liquid assets with return below that of private markets with higher correlation with public markets.

Benchmarking and Diversification

The ability to benchmark and adequately diversify private market portfolios is an important consideration for limited partners (LPs). While public equity fund investors have many investible index-based alternatives, private market LPs face several barriers in matching the aggregate reported returns for a particular private asset class. The need to hold liquid investments for committed capital that is not yet deployed creates a drag on returns. An investor’s ability to diversify across specific GPs is limited, and a high dispersion of realized returns often exists between the top and bottom quartiles of performance for private asset classes. Due to the illiquidity of private investments and limited secondary markets, vintage year diversification is difficult to achieve for investors seeking to increase private market allocations.

Practice Questions

Question 1: In private fund management, General Partners (GPs) often have more control over illiquid investments, which are typically in unlisted assets. This lack of public information creates an information asymmetry, making it difficult for Limited Partners (LPs) to independently assess and benchmark the performance of private market GPs. Private investment firms aim to bridge this information gap and align the interests of GPs and LPs by charging a combination of fees. What is the primary purpose of the management fees and performance-based incentive fees, also known as carried interest, charged by private investment firms?

1. To cover the costs of underperforming investments
2. To incentivize and reward successful GPs
3. To compensate for the lack of publicly available information

Answer: Choice B is correct.

The primary purpose of the management fees and performance-based incentive fees, also known as carried interest, charged by private investment firms is to incentivize and reward successful General Partners (GPs). Management fees are typically a fixed percentage of the fund’s assets under management and are used to cover the operational costs of the fund, including salaries, research, and office expenses. On the other hand, carried interest is a performance-based incentive fee that is designed to align the interests of the GPs with those of the Limited Partners (LPs). It is typically a percentage of the fund’s profits and is only paid out if the fund achieves a certain level of performance. This structure incentivizes the GPs to maximize the fund’s performance, as their compensation is directly tied to the fund’s success. It also rewards successful GPs for their skill and effort in managing the fund’s investments.

Choice A is incorrect. While management fees may be used to cover the costs of underperforming investments, this is not their primary purpose. The primary purpose of management fees is to cover the operational costs of the fund, while the primary purpose of carried interest is to incentivize and reward successful GPs.

Choice C is incorrect. While the lack of publicly available information about private market investments can create an information asymmetry between GPs and LPs, the fees charged by private investment firms are not primarily intended to compensate for this. Instead, they are designed to cover the costs of managing the fund and to incentivize and reward successful GPs.

Question 2: The nature of illiquid investments held by private fund General Partners (GPs) often results in long holding periods. This prevents Limited Partners (LPs) from selling partnerships of underperforming managers without incurring significant bid-offer costs in the secondary market. Given this scenario, what is the primary challenge faced by LPs in the private fund management sector?

1. High management fees and performance-based incentive fees
2. Difficulty in independently assessing and benchmarking the performance of private market GPs
3. High bid-offer costs in the secondary market

Answer: Choice B is correct.

The primary challenge faced by Limited Partners (LPs) in the private fund management sector is the difficulty in independently assessing and benchmarking the performance of private market General Partners (GPs). Due to the illiquid nature of the investments held by GPs, it often results in long holding periods. This makes it difficult for LPs to evaluate the performance of the GPs and compare it with other GPs or market benchmarks. The lack of transparency and standardized reporting in private markets further exacerbates this challenge. LPs need to rely on the information provided by the GPs, which may not always be complete or accurate. This makes it difficult for LPs to make informed investment decisions and monitor the performance of their investments. Therefore, the ability to independently assess and benchmark the performance of GPs is a critical challenge faced by LPs in the private fund management sector.

Choice A is incorrect. While high management fees and performance-based incentive fees are a concern for LPs, they are not the primary challenge in this scenario. These fees are a part of the cost of investing in private funds and are typically known upfront. They do not prevent LPs from assessing the performance of GPs or selling their partnerships in the secondary market.

Choice C is incorrect. High bid-offer costs in the secondary market are a result of the illiquid nature of the investments held by GPs, but they are not the primary challenge faced by LPs. These costs can deter LPs from selling their partnerships, but they do not prevent LPs from assessing the performance of GPs or making informed investment decisions.

Glossary

• General Partners (GPs): The individuals or firms that manage a private investment fund.
• Limited Partners (LPs): The investors in a private investment fund.
• Management Fees: Fees charged by GPs to cover the operational costs of the fund.
• Carried Interest: A performance-based incentive fee that aligns the interests of GPs and LPs.
• Hurdle Rate: A predetermined minimum target rate of return per period.
• Soft Hurdle Rate: A return threshold above which the entire return is subject to an incentive fee once the hurdle is exceeded.
• Catch-up Clause: A clause that allows the GP to earn 100% of distributions once the hurdle is exceeded until total return reaches a certain share.

Private Markets Pathway Volume 1: Learning Module 2: General Partner and Investor Perspectives and the Investment Process; LOS 2(b): Discuss how private investment firms align their interests with those of the investors and calculate, interpret, and discuss private market fund performance from an investor perspective, including management fees and carried interest