was allowed to grow with positive returns and decline with negative returns until the end of the measurement period, with no cash withdrawals or additional contributions. The rate that equates the initial value with the accumulated value is the time-weighted average return, and it is somewhat near the arithmetic average annual return (in this case, 10 % per year). The idea is that a single sum of money invested at the start of the first year and allowed to remain in the fund until the end of the last year would accumulate to the same value as if it had been invested at a fixed return of 9.5 % per year, ignoring rounding.
But in practice, investors often contribute additional cash (i.e., make additional investments) or withdraw cash (e.g., liquidate part of the investment or receive cash distributions) during the time period under analysis. Their average returns depend on whether the amount of money invested was highest during the high-performing periods or during the low-performing periods. Dollar-weighted returns adjust the average annual performance for the amount of cash invested each year. In the case of the hedge fund, an investor who had much more cash in the fund in the early years than in the later years would earn more than an investor whose money was primarily invested in the last three years, when the fund generated 0 % returns.
Dollar-weighted returns can be computed for each investor using investors' cash flows into and out of the hedge fund. The total cash flows into and out of the fund for all investors can be used as an indication of the performance of an average investor. The dollar-weighted return that individual investors experience depends on their cash contributions and withdrawals.
When the timing of the aggregated cash flows for the entire hedge fund is taken into account, the bulk of the hedge fund's assets earned a 0 % return in years 4, 5, and 6. The example shows that only the first $100 million earned the great rates of return of the first three years. The $400 million that flowed into the hedge fund in years 4 and 5 earned a 0 % return. When the timing of the aggregated cash flows is taken into account, the dollar-weighted return (solving for the IRR with cash flows reinvested) is only 4.3 %. The IRR is found in this case with CF0 = –100, CF1 = 0, CF2 = 0, CF3 = –200, CF4 = –200, CF5 = 0, and CF6 = +572.8; that is, CF6 is found as: [(100 × 1.2 × 1.2 × 1.2) + 200 + 200].
Investment managers are best evaluated on time-weighted returns, as these managers should not be held accountable for the cash flow decisions of their investors. Investors should evaluate their own investment results using dollar-weighted returns based on the cash flows from their particular investment pattern.
3.5 Distribution of Cash Waterfall
Limited partnerships, including private equity funds and hedge funds, have provisions for the allocation of cash inflows between general partners (GPs) and limited partners (LPs). Provisions related to the distribution waterfall are often the most complex parts of the limited partnership agreement. The waterfall is a provision of the limited partnership agreement that specifies how distributions from a fund will be split and how the payouts will be prioritized. Specifically, the waterfall details what amount must be distributed to the LPs before the fund manager or GPs can take a share from the fund's profits.
One important reason LPs need to understand the distribution waterfall is because of its impact on managerial incentives and, consequently, on the behavioral drivers of the fund's performance. Familiarizing themselves with the design of the waterfall's terms and conditions is one of the few opportunities LPs have to anticipate and manage risk. The waterfall's design always produces effects (sometimes unintended ones) as it drives the motivation and attitude, sense of responsibility, accountability, and priorities of fund managers.
3.5.1 Terminology of Waterfalls
The distribution of cash waterfalls has specialized terminology, and the terminology tends to differ between private equity and hedge funds. This section introduces most of the major terminology that is used in the remaining sections.
Cash inflows to a fund in excess of the costs of investment and the expenses of the fund represent the waterfall that is distributed to GPs and LPs. Excess revenue above expenses is referred to as cash flow or profit. In calculating profit, management fees are deducted, but any fees that are based on profitability are not deducted. (Management fees are usually deducted from the fund, regardless of profitability.)
Carried interest is synonymous with an incentive fee or a performance-based fee and is the portion of the profit paid to the GPs as compensation for their services, above and beyond management fees. Carried interest is typically up to 20 % of the profits of the fund and becomes payable once the LPs have achieved repayment of their original investment in the fund, plus any hurdle rate.
A hurdle rate specifies a return level that LPs must receive before GPs begin to receive incentive fees. When a fund has a hurdle rate, the first priority of cash profits is to distribute profits to the LPs until they have received a rate of return equal to the hurdle rate. Thus, the hurdle rate is the return threshold that a fund must return to the fund's investors, in addition to the repayment of their initial commitment, before the fund manager becomes entitled to incentive fees. The term preferred return is often used synonymously with hurdle rate – a return level that LPs must receive before GPs begin to receive incentive fees.
A catch-up provision permits the fund manager to receive a large share of profits once the hurdle rate of return has been achieved and passed. A catch-up provision gives the fund manager a chance to earn incentive fees on all profits, not just the profits in excess of the hurdle rate. A catch-up provision contains a catch-up rate, which is the percentage of the profits used to catch up the incentive fee once the hurdle is met. A full catch-up rate is 100 %. To be effective, the catch-up rate must exceed the rate of carried interest.
Vesting is the process of granting full ownership of conferred rights, such as incentive fees. Rights that have not yet been vested may not be sold or traded by the recipient and may be subject to forfeiture. Vesting is a driver of incentives. Vesting can be pro rata over the investment period, over the entire term of the fund, or somewhere in between, such as on an annual basis.
A clawback clause, clawback provision, or clawback option is designed to return incentive fees to LPs when early profits are followed by subsequent losses. A clawback provision requires the GP to return cash to the LPs to the extent that the GP has received more than the agreed profit split. A GP clawback option ensures that if a fund experiences strong performance early in its life and weaker performance at the end, the LPs get back any incentive fees until their capital contributions, expenses, and any preferred return promised in the partnership agreement have been paid.
3.5.2 The Compensation Scheme
A key element of the managerial compensation structure is the nature of the incentives that align interests between fund managers and their investors. Investors and fund managers have an agency relationship in which investors are the principals and fund managers are their agents. The compensation scheme is the set of provisions and procedures governing management fees, general partner investment in the fund, carried-interest allocations, vesting, and distribution. As with all agency relationships, compensation schemes should be designed to align the interests of the principals (the LPs) and the agents (the GPs) to the extent that the alignment is cost-effective. It is generally cost-ineffective to try to maximize the alignment of GP and LP interests. For example, requiring huge investments into the partnership by general partners might initially appear to be an effective method of aligning LP and GP interests. However, GPs with a large proportion of their wealth invested in a single fund may manage the fund in an overly risk-averse manner.
The partnership agreement provisions, as well as other terms and conditions, such as investment limitations,
