Content area
Full Text
An important part of the incentive structure of private investment funds is the choice between a hard hurdle with no catch-up and a higher soft hurdle, above which the general partner quickly catches up to a carried interest equaling 20% of all profits. Some limited partners hold strong opinions about this topic; Swensen [2009] calls soft hurdles a "marketing scheme," whereas Douvas [2006] describes the catch-up's associated high hurdle rate as necessary to prevent overpaying general partners. Because each structure has offsetting benefits relative to the other, proponents of both sides can cite discrete scenarios where their view is superior.
This article seeks to inform discussion and evaluation of hurdle structures. The first section uses historical returns of real estate opportunity funds to estimate carried interest paid under typical hard and soft hurdles, concluding that a lower hard hurdle reduces carried interest by 12% to 16% versus a higher soft hurdle. The second section describes scenarios in which each structure can produce misalignments, although the hard hurdle comports better with agency theory. The article concludes with criteria that may drive a limited partner's decision regarding whether to accept the catch-up's incremental cost.
VALUE OF THE CATCH-UP TERM
Literature Review
Metrick and Yasuda [2010] use an optionpricing approach to conclude "[t]he effect of a hurdle return on expected revenue is greatly affected by the existence of a catch-up clause." Specifically, removing the catch-up reduces the present value of carried interest by between 9% and 23% . Their study is based on data from "one of the largest private equity investors in the world."
Conner (2005) ascribes a far smaller value to the catch-up, less than 1% of carried interest. However, this result stems from very specific cash flow patterns; a long investment period and rapid return of capital, followed by a seven- to fourteen-year holding period long after the preferred return has been repaid in full. Metrick 's and Yasuda's [2010] cash flow assumptions are more typical for real estate private equity funds. This is particularly true of their mean five-year holding period, which more closely matches opportunity funds' average holding period of two to five years (see Appendix A).
Data
As shown in the table in Exhibit 1, 1 obtained vintage-year opportunity fund mean...