withdrawals, indemnification, and the handling of conflicts of interest, tend to look quite similar across fund agreements. Surprisingly, fund terms have been relatively stable across the market cycles. The explanation for this phenomenon is that both fund managers and their investors have sufficient negotiation power to reject terms sought by the other side that differ substantially from terms widely used in the market, but not so much leverage as to move the market in one direction or the other.
Management fees are regular fees that are paid from the fund to the fund managers based on the size of the fund rather than the profitability of the fund. The purpose of management fees is to cover the basic costs of running and administering the fund. These costs are mainly the salaries of investment managers and back-office personnel; expenses related to the development of investments; travel and entertainment expenses; and office expenses, such as rent, furnishings, utilities, and supplies. Management fees are nearly always calculated as a percentage of the net asset value of the fund, typically between 1 % and 2.5 % depending on fund size, but may taper off after the investment period or when a successor fund is formed. Although the management fee's general calculation is relatively simple and fairly objective, there are controversies surrounding the finer details.
The general partners' investment in the fund is the amount of capital they contribute to the fund's pool of capital. GPs typically invest a significant amount of capital in their funds, usually at least 1 % of total fund capital, which is treated the same way as the capital contributed by limited partners. There are a number of reasons for this. For example, the GPs contribute a meaningful amount of capital to ensure their status as a partner of the fund for income tax reasons. More important, however, is that they contribute substantial personal wealth to the fund to help align the interests of fund managers and their investors. For all of the calculation examples that follow, the GPs' own investment in the fund is not being considered, because it has the same payoff as that of the limited partners. In other words, in this volume, the computations of the amount of cash being distributed to GPs ignore their ownership interest, since that ownership interest receives cash in the same manner as the LPs.
3.5.3 Incentive-Based Fees
Incentive-based or performance-based fees are a critical part of the compensation structure. Carried interest, as discussed earlier, is an incentive-based fee distributed from a fund to the fund's manager. The term carried interest tends to be used in private equity and real estate; the term incentive fee is more often used in hedge funds. Management fees are paid regardless of the fund's performance and therefore fail to provide a powerful incentive to produce exceptional investment results. Excessive and quasi-guaranteed management fees stimulate tentative and risk-averse behavior, such as following the herd. Consequently, the carried interest, meaning the percentage of the profit paid to fund managers, is the most powerful incentive to align interests and create value. The most common carried-interest split is 80 %/20 % (a.k.a. 80/20), which gives the fund manager a 20 % share in the fund's net profits and is essential to attracting talented and motivated managers. These fees are asymmetric, as a fund manager shares in the gains of the investors, but does not compensate investors for any portion of their losses. (Note that the following examples ignore management fees for the sake of simplicity.)
Fund A at the end of its term has risen to a total net asset value (NAV) of $300 million from its initial size of $200 million. Assuming no hurdle rate and an 80 %/20 % carried-interest split, the general partner is entitled to receive carried interest equal to how much?
The answer is $20 million. The answer is found by multiplying the GP's share (20 %) by the total profit ($100 million). The total profit is found as the difference in the NAVs. The NAVs are calculated after adding revenues and deducting expenses.
Fund B terminates and ultimately returns $132 million to its limited partners, and the total initial size of the fund was $100 million. Assuming a carried-interest rate of 20 %, the general partner is entitled to receive carried interest equal to how much?
The answer is $8 million. Note that if $32 million is the profit only to the LP, the total profit of the fund was higher. The answer is found by solving the following equations: LP profit = 0.8 × total profit; so $32 million = 0.8 × total profit; therefore, total profit = $40 million. The second equation is GP carried interest = 0.2 × total profit; therefore, carried interest = $8 million.
3.5.4 Aggregating Profits and Losses
In the case of multiple projects within private equity funds, two approaches are used for determining profits and distributing incentive fees. Carried interest can be fund-as-a-whole carried interest, which is carried interest based on aggregated profits and losses across all the investments, or can be structured as deal-by-deal carried interest. Deal-by-deal carried interest is when incentive fees are awarded separately based on the performance of each individual investment.
Consider a fund that makes two investments, A and B, of $10 million each. Investment A is successful and generates a $10 million profit, whereas Investment B is a complete write-off (a total loss). Assume that the fund managers are allowed to take 20 % of profits as carried interest. How much carried interest will they receive if profits are calculated on a fund-as-a-whole (aggregated) basis, and how much will they receive if profits are calculated on a deal-by-deal (individual transaction) basis?
On the fund-as-a-whole basis, the fund broke even, so no incentive fees will be distributed. On the deal-by-deal basis, Investment A earned $10 million, so $2 million in carried interest will be distributed to the managers.
Participating in every investment's profit, or deal-by-deal carried interest, can be problematic because the general partner can make profits on successful investments while having little exposure to unsuccessful transactions. As the limited partners take the bulk of the capital risk, this approach significantly weakens the alignment of interests. A fund-as-a-whole carried-interest approach protects the interests of the LPs but may be less effective in attracting talented managers. The fund-as-a-whole scheme may entail the risk of frustrating the fund managers, as their rewards may be deferred for years until all deals can be aggregated. Carried-interest distribution is typically one of the most intensively negotiated topics. The amount of the payment is often not as much of an issue as the timing of the payment. In practice, carried-interest schemes include elements of both approaches in order to circumvent their respective limitations.
3.5.5 Clawbacks and Alternating Profits and Losses
Clawbacks are relevant to funds that calculate carried interest on a fund-as-a-whole basis. The idea of typical clawback provisions is that incentive fees distributed to managers are returned when a firm experiences losses after profits so that the total incentive fees paid, ignoring the time value of money, are equal to the incentive fees that would be due if all profits and losses had occurred simultaneously. Funds experience early profits and late losses in two primary instances. In private equity funds, it is possible that a few of the projects in which the fund has invested may successfully terminate and generate large cash inflows and profits to the fund. Other projects may fail at a later date, thereby generating large losses or write-offs. An important issue when a fund experiences large gains early in its life, followed by subsequent losses, is whether incentive fees paid on the early profits will be returned to the LPs.
Another instance in which losses follow profits is more common in the hedge fund industry, where market conditions or managerial decision-making can cause strategies to be highly
