Investors Are Overpaying for Bad PE Funds – A Note On Carried Interest In Private Equity


A Note On Carried Interest In Private Equity

Ludovic Phalippou

University of Oxford – Said Business School; University of Oxford – Oxford-Man Institute of Quantitative Finance

August 6, 2015

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Investors in private equity funds make payments for fund management fees and for fund investments; they receive capital which comes from the sale of these investments and that capital is net of carried interest. The carried interest is non-zero if the fund has returned sufficient capital back to the investor (and is zero otherwise). The calculation of the carried interest is complex and investors usually do not track the total amount of carried interest accrued. This means that investors cannot have a historical and comprehensive perspective on carried interest. However, because carried interest is paid only if performance is good, it is commonly thought that tracking carried interest does not matter anyway. Yet, because this fee is non-linear and investors have a portfolio of funds, significant carried interest can be paid even when the private equity portfolio has shown poor performance. This means that tracking carried interest is economically useful. Data from three large US pension funds is used to illustrate. Statistics are remarkably similar across these investors. Estimated carried interest is about $5 billion, which represents about 13% of capital invested, 19% of overall profit and 38% of profits above a standard benchmark (8% per annum over four year). Given past performance, past carried interest paid does not appear to be a major issue. Yet, the conclusion depends on the benchmark used, the estimated absolute amount of carried interest is significant, and if future performance differs from past performance, the way carried interest is currently computed could be problematic for investors going forward.

A Note On Carried Interest In Private Equity – Introduction

Investors usually do not verify whether carried interest is computed correctly or not. They have to rely on the fund auditors. In fact, investors often do not even track the total amount of carried interest paid in each fund. The carried interest is already deducted from the payments they receive. To track it they would need to obtain and collate the information from each of the fund managers every quarter or year. Pensions funds often hold over one hundred funds. CalPERS for example is currently invested in 274 private equity funds. Collating such a large amount of data is therefore not trivial and costly. In addition, CalPERS has recently reported that a minority of GPs are not willing to provide this piece of information.

Importantly, we need to not only track carried interest paid, but also the latent carried interest. Latent carry is less often (if at all) provided by GPs. Table 1 shows Blackstone’s fee decomposition as shown in its annual report. We see that in 2014 Blackstone carried interest is about $2 billion. The total carried interest for 2012 and 2013 was about $1 billion. Most interestingly, we see that there is about as much carried interest received as carried interest accrued/latent. This latent carried interest is the carried interest that will have to be paid when currently held investments get exited.

Let us continue with CalPERS as an illustrative example. The funds they invested into from 1991 to 2008 have called $42 billion and returned as much capital. But these funds currently hold investments which they value at about $23 billion in total. When these $23 billion will be realized (at which point the amount distributed can be higher or lower; $23 billion is what funds currently expect) then carried interest will be paid. Hence if an investor says: as of today my private equity program got me 1.6 times the capital invested, as in CalPERS case, then one should bear in mind that part of this return is not realized yet and there is therefore a latent/accrued fee due on this amount. It is therefore important to account for it. It is an expense to come. Notice that this is private equity specific. For hedge funds, carried interest is paid on latent returns. In fact, hedge fund carried interest fees is principally based on changes in Net Asset Values.

Because carried interest is paid only if performance is good, it is commonly thought that tracking carried interest is not important: in a way, the more carry has been paid the better for the investor. However, and importantly, because the fee is non-linear (i.e. paid only when performance is above a certain hurdle and zero otherwise) and investors have a portfolio of funds, significant carried interest can be paid even when the private equity portfolio has shown poor performance. Take an investor who invested equally into two funds. Fund A returns 10% before carried interest charges while Fund B returns -18%. Carried interest of about 2% would be paid on fund A, nothing on fund B. This investor would have an average return after carried interest of -5% and have paid a total of 2% in carried interest. Hence, at a portfolio level, knowing how much has been paid in carried interest is economically relevant and informative. The relationship between carry and performance at a portfolio level is not mechanically positive.

Private Equity

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