Level 1 CFA® Exam:
Partnership Structures, Compensation Structures & Investment Clauses
Just like any company, private equity funds and hedge funds have their ownership structure and specific terms of functioning. For funds, the most common form of ownership is a limited partnership.
In a limited partnership, there are 2 types of partners:
- limited partners (LP) who only provide capital and don’t play any active role in managing the investments. Their liability is limited to the amount of their investment in the fund.
- general partners (GP) who are responsible with all their assets for all liabilities of the partnership and actively manage the investments.
How an alternative investment fund functions is determined by specific terms. We can find these terms in the fund prospectus or a limited partnership agreement (LPA). They are a result of negotiations between the partners of the fund. The terms can be divided into 2 categories:
- compensation structure terms, and
- investment clauses and provisions terms.
Before discussing the compensation structures, let’s discuss the difference between committed capital and paid-in capital (aka. invested capital).
Committed capital is the amount of money that investors agreed to contribute to the private equity fund. Paid-in capital (aka. invested capital) refers to the funds actually paid by investors in the fund until a given moment in time.
Compensation structures include:
- management fees for general partners who manage the fund's assets. These fees usually amount to 1-2% of the committed capital in the case of private equity funds or assets under management in the case of hedge funds.
- performance fee (aka. incentive fee or carried interest) that relates to the general partner’s share of profits. Typically it amounts to 20% of the fund’s profit after management fees (if the hurdle rate is met).
- hurdle rate is the rate of return that a fund must achieve before general partners receive their performance fee. It is usually equal to 8%. We distinguish between soft hurdle rate and hard hurdle rate.
Examples of investment clauses and provisions include:
- catch-up clause according to which first the LPs receive the hurdle rate, then the GP receives the performance fee, so that the profit received by the LPs (hurdle rate) and the GP (performance fee) is in the proportion specified in the limited partnership agreement (e.g. 80/20). Then, any extra profit above this threshold (= LPs’ hurdle rate + GP’s performance fee) is split between the LPs and GP according to the proportion specified in the LPA. So, as a result of the catch-up clause, if the profit substantially exceeds the hurdle rate, the full amount of profit is always split according to the proportion specified in the limited partnership agreement (e.g. 80/20). Without a catch-up clause, the LPs receive the hurdle rate and then all the profit above the hurdle rate is split according to the proportion specified in the LPA. So, a catch-up clause is advantageous to the GP and no catch-up clause is advantageous to the LPs.
- high-water mark which is a parameter specifying that the incentive fee is not calculated for profits covering losses from previous periods.
- clawback which refers to the provision limiting the remuneration of a GP. The GP has to return the performance fee if in subsequent periods the fund's net asset value decreases.
- distribution waterfall which is a mechanism that defines the rules under which the investment profit is paid to the GP and LPs. There are two methods used: 1) deal-by-deal method (aka. American waterfall) according to which the performance fee is collected for each deal separately and may be unfavorable for the LPs when e.g. the first investment is profitable and the second one is not, 2) whole-of-fund method (aka. European waterfall) where performance fee is paid to the GP after the LPs receive their total initial investment plus hurdle rate.
| hurdle rate = 8%; profit split = 80/20 | ||
|---|---|---|
| Profit | Catch-up Clause | No Catch-up Clause |
| 6% | LP = 6% | LP = 6% |
| GP = 0% | GP = 0% | |
| 8% | LP = 8% | LP = 8% |
| GP = 0% | GP = 0% | |
| 9% | LP = 8% | LP = 8% + 80% x 1% = 8.8% |
| GP = 1% | GP = 20% x 1% = 0.2% | |
| 10% | LP = 8% | LP = 8% + 80% x 2% = 9.6% |
| GP = 2% | GP = 20% x 2% = 0.4% | |
| 13% | LP = 8% + 80% x 3% = 10.4% | LP = 8% + 80% x 5% = 12% |
| GP = 2% + 20% x 3% = 2.6% | GP = 20% x 5% = 1% | |
| 20% | LP = 8% + 80% x 10% = 16% | LP = 8% + 80% x 12% = 17.6% |
| GP = 2% + 20% x 10% = 4% | GP = 20% x 12% = 2.4% | |
The committed capital of AE Fund is EUR 80 million. The performance fee has been set at 20%.
At the beginning of Year 1, the fund invests EUR 50 million (Investment 1) with a net profit of EUR 20 million which is realized at the end of Year 1.
What’s more, let’s assume that the same fund made another investment (Investment 2) in the amount of EUR 30 million at the beginning of Year 2. This investment incurs a loss of EUR 5 million at the end of Year 2.
What will be the GP’s carried interest and LPs’ profit for each year according to the American waterfall and European waterfall? Assume that the hurdle rate was met, there is no management fee, and a catch-up clause and clawback provision are included.
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Level 1 CFA Exam Takeaways: Partnership Structures, Compensation Structures & Investment Clauses
star content check off when done- In a limited partnership, there are 2 types of partners: limited partners (LP) & general partners (GP).
- Limited partners (LP) provide capital and don’t play any active role in managing the investments. Their liability is limited to the amount of their investment in the fund.
- General partners (GP) are responsible with all their assets for all liabilities of the partnership and actively manage the investments.
- Committed capital is the amount of money that investors agreed to contribute to the private equity fund.
- Paid-in capital (aka. invested capital) refers to the funds actually paid by investors in the fund until a given moment in time.
- General partners receive management fees for managing the fund's assets.
- Performance fee (aka. incentive fee or carried interest) is the general partner’s share of profits.
- Hurdle rate is the rate of return that a fund must achieve before general partners receive their performance fee.
- A catch-up clause is advantageous to the GP and no catch-up clause is advantageous to the LPs.
- High-water mark is a parameter specifying that the incentive fee is not calculated for profits covering losses from previous periods.
- Distribution waterfall is a mechanism that defines the rules under which the investment profit is paid to the GP and LPs.