Why is it that most buyout funds, many growth equity funds and few venture capital funds have an 8% preferred return hurdle? Why should there be a difference among the different strategies?
What is a preferred return hurdle?
A preferred return hurdle is a component of the fund manager’s carried interest.
To read more, please click on the "Read More" link below and to the right.
What is a preferred return hurdle?
A preferred return hurdle is a component of the fund manager’s carried interest.
To read more, please click on the "Read More" link below and to the right.
Simply stated, carried interest is the profit share that a fund manager (the “GP”) receives when the fund does well, and is usually 20% of the profits from the fund. Using a very basic example, let’s say a $100 million fund returns a total of $170 million over its 10-year life. Of the $170 million, $70 million is profit and $100 million is a return of LP capital. The GP would receive 20% of this $70 million in profit, or $14 million, and the investors in the fund (limited partners or “LPs”) would receive $56 million of these profits, in addition to the return of their original $100 million investment. An important note is that the GP’s carry does not consider the time value of money – the GP’s carry is solely based on the cash-on-cash return of the fund. For more on carry, please see my post “LP Corner: Fund Terms - Carried Interest Overview.”
A preferred return hurdle is layered on top of the GP’s carry, and injects a time value of money consideration. A preferred return hurdle basically says that the LPs receive a certain minimum annualized return before the GP can receive carry. An 8% preferred return hurdle means that the LPs must receive an annualized 8% return on their capital before the GP receives its carry. Using our very basic example, an 8% annual return on a $100 million fund means that the LPs must receive $8 million per year before the GP can receive carry. So, after 10 years, the LPs must receive $80 million in returns (above the $100 million original investment) before the GP can receive carry. As our fund only returned $70 million in profit, the GP is not entitled to carry. If, on the other hand, the fund returned $200 million ($100 million of profit and $100 return of LP capital), then the GP would be entitled to carry. For more on preferred return hurdle, please see my post “LP Corner: Fund Terms – Preferred Return Hurdle and GP Catchup.”
The key take-aways are (1) GPs who have carry with no preferred return hurdle are motivated solely by a multiple of invested capital, and (2) GPs who have carry with a preferred return hurdle are motivated both by a multiple of invested capital and the time value of money.
Why does this matter? A few reasons, but primary among them is that most LPs use IRR either as the primary metric or as one of the primary metrics to evaluate the performance of their overall investment program and their private equity investment program.
Most institutional LPs evaluate their fund investments using IRR
In my experience, most institutional LPs evaluate their private equity programs (and their fund investments) based on an annualized rate of return, or IRR. For example, Yale Endowment’s 2017 Endowment Update Report (obtained here: http://investments.yale.edu/endowment-update) focuses on percentage return. CalSTRS measures its private equity portfolio performance based on a rate of return (a dollar-averaged internal rate of return, see https://www.calstrs.com/private-equity-portfolio-performance). CalPERS evaluates their private equity program on both IRR and investment multiple (see https://www.calpers.ca.gov/page/investments/asset-classes/private-equity/pep-fund-performance). I have discussed IRR in a couple of posts: LP Corner: Fund Performance Metrics - Internal Rate of Return (IRR) Part One and LP Corner: Fund Perormance Metrics - Internal Rate of Return - Part Two. I don’t believe any one metric (IRR, multiples, PME) fully captures return, an so I analyze fund performance using a combination of metrics: IRR, multiples (especially DPI) and PME.
Since most institutional LPs use IRR as the primary, or a primary, return metric, private equity funds should be structured to have IRR be a primary metric to reward GPs with carry. Most buyout funds have a preferred return hurdle, so that’s good. Many growth equity funds also have a preferred return hurdle. However, most venture capital funds do not have a preferred return hurdle. Why?
Venture Capital Funds Have Long Lives.
Early-stage venture capital firms invest in companies that are truly starting up. It can take 5 to 10 years (or longer in some cases) for these companies to mature to the point that they go public or are sold.
The NVCA Yearbook for 2015 contained a chart based on data from Adams Street Partners (based on 2010 analysis of dissolved funds) showing that the median life span of an IT fund in their analysis was over 14 years, and that 10% of funds in their analysis had life spans that were 19 years or longer. I believe that this is only stretching out longer. I have served on Limited Partner Advisory Committees for funds that were close to 20 years old!
Because of the long hold times (which longer for early stage venture capital than for buyout or growth equity), GPs of venture capital firms, especially ones with whole-fund carry, may have to wait a very long time to ever see carry. If a preferred return hurdle is added to the carry, it would stretch even longer the period before the GP can receive carry. This is the main argument why venture capital funds do not have a preferred return hurdle.
Alignment of Interests
Another issue is alignment of interests between the GP and the LPs. As a venture capital fund ages and reaches the end of its initial 10 year term, GPs that don’t have a preferred return hurdle don’t need to consider time value of money. What this means is that if the fund has a number of portfolio companies that are growing slowly, the GP may be motivated (by the prospect of carry) to let the companies continue on for a period of time to see what happens (oh, and possibly continue to charge a management fee). This creates a misalignment of interest between the GP and the LPs.
If that same GP had a preferred return hurdle, the GP would have to weigh selling now vs letting the company continue on for a period of time. The GP would have to consider the time value of money, which better aligns the interests of the GP and the LPs.
Summary
The arguments for an 8% preferred return hurdle for VC funds:
Arguments against:
A preferred return hurdle is layered on top of the GP’s carry, and injects a time value of money consideration. A preferred return hurdle basically says that the LPs receive a certain minimum annualized return before the GP can receive carry. An 8% preferred return hurdle means that the LPs must receive an annualized 8% return on their capital before the GP receives its carry. Using our very basic example, an 8% annual return on a $100 million fund means that the LPs must receive $8 million per year before the GP can receive carry. So, after 10 years, the LPs must receive $80 million in returns (above the $100 million original investment) before the GP can receive carry. As our fund only returned $70 million in profit, the GP is not entitled to carry. If, on the other hand, the fund returned $200 million ($100 million of profit and $100 return of LP capital), then the GP would be entitled to carry. For more on preferred return hurdle, please see my post “LP Corner: Fund Terms – Preferred Return Hurdle and GP Catchup.”
The key take-aways are (1) GPs who have carry with no preferred return hurdle are motivated solely by a multiple of invested capital, and (2) GPs who have carry with a preferred return hurdle are motivated both by a multiple of invested capital and the time value of money.
Why does this matter? A few reasons, but primary among them is that most LPs use IRR either as the primary metric or as one of the primary metrics to evaluate the performance of their overall investment program and their private equity investment program.
Most institutional LPs evaluate their fund investments using IRR
In my experience, most institutional LPs evaluate their private equity programs (and their fund investments) based on an annualized rate of return, or IRR. For example, Yale Endowment’s 2017 Endowment Update Report (obtained here: http://investments.yale.edu/endowment-update) focuses on percentage return. CalSTRS measures its private equity portfolio performance based on a rate of return (a dollar-averaged internal rate of return, see https://www.calstrs.com/private-equity-portfolio-performance). CalPERS evaluates their private equity program on both IRR and investment multiple (see https://www.calpers.ca.gov/page/investments/asset-classes/private-equity/pep-fund-performance). I have discussed IRR in a couple of posts: LP Corner: Fund Performance Metrics - Internal Rate of Return (IRR) Part One and LP Corner: Fund Perormance Metrics - Internal Rate of Return - Part Two. I don’t believe any one metric (IRR, multiples, PME) fully captures return, an so I analyze fund performance using a combination of metrics: IRR, multiples (especially DPI) and PME.
Since most institutional LPs use IRR as the primary, or a primary, return metric, private equity funds should be structured to have IRR be a primary metric to reward GPs with carry. Most buyout funds have a preferred return hurdle, so that’s good. Many growth equity funds also have a preferred return hurdle. However, most venture capital funds do not have a preferred return hurdle. Why?
Venture Capital Funds Have Long Lives.
Early-stage venture capital firms invest in companies that are truly starting up. It can take 5 to 10 years (or longer in some cases) for these companies to mature to the point that they go public or are sold.
The NVCA Yearbook for 2015 contained a chart based on data from Adams Street Partners (based on 2010 analysis of dissolved funds) showing that the median life span of an IT fund in their analysis was over 14 years, and that 10% of funds in their analysis had life spans that were 19 years or longer. I believe that this is only stretching out longer. I have served on Limited Partner Advisory Committees for funds that were close to 20 years old!
Because of the long hold times (which longer for early stage venture capital than for buyout or growth equity), GPs of venture capital firms, especially ones with whole-fund carry, may have to wait a very long time to ever see carry. If a preferred return hurdle is added to the carry, it would stretch even longer the period before the GP can receive carry. This is the main argument why venture capital funds do not have a preferred return hurdle.
Alignment of Interests
Another issue is alignment of interests between the GP and the LPs. As a venture capital fund ages and reaches the end of its initial 10 year term, GPs that don’t have a preferred return hurdle don’t need to consider time value of money. What this means is that if the fund has a number of portfolio companies that are growing slowly, the GP may be motivated (by the prospect of carry) to let the companies continue on for a period of time to see what happens (oh, and possibly continue to charge a management fee). This creates a misalignment of interest between the GP and the LPs.
If that same GP had a preferred return hurdle, the GP would have to weigh selling now vs letting the company continue on for a period of time. The GP would have to consider the time value of money, which better aligns the interests of the GP and the LPs.
Summary
The arguments for an 8% preferred return hurdle for VC funds:
- Better alignment of interests. Because IRR is one of the main metrics to evaluate venture capital funds, having a preferred return hurdle better aligns LP-GP interests.
- It will make VCs focus more on the time value of money.
- It might lead to shorter venture capital fund life spans.
Arguments against:
- It would delay carry being paid to VCs (especially for funds with whole-fund carry)
- Most buyout funds have a preferred return hurdle, so why not venture capital funds?
