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November 18th, 2018

Alignment a Great Deal

Alignment a great deal to geometry teachers, but meant even more to private equity investors. As private equity partnerships evolved over the past four decades, the recurring motif was one of alignment of interests between the general partners and the limited partners. Early structured attempts to create the alignment were rooted in requiring both parties to invest some capital in the Fund. As experience and wisdom grew, the adverse selection structure of “20% of the winners / 1% of the losers” to the GP began to be replaced by collective guilt accounting which shared 20% of the net gains with the GP. Management fees, which had been added to the LP’s capital commitment, were bundled into the capital commitment. A few years later, those fees were added to the repayment waterfall. Preferred return appeared in this time period as an alignment performance hurdle the general partners were required to exceed to earn their carried interest.

Ironically, as the LP universe has grown significantly larger and has formed an industry association, it has been silent as federal laws have been passed to create large rifts in alignment and while financing techniques have done the same. Tax law changes in December 2017 changed the holding period from one year to three years to qualify the general partners’ carried interest for capital gains tax treatment. All taxable limited partners qualify for capital gains treatment after one year. A two year gap in tax treatment between the GP and the LP is as unaligned as their investments have ever been for exit decisions in private equity, yet no investors were seen lobbying against this change as the law was being debated. Undoubtedly, as private equity is not a sympathetic party in the press, no ten foot poles were being sought by investors to touch this issue. The fiduciary duty to protect client investments might have given cause to limited partners to flag this issue to Congress. Since the tax rate for ordinary income is nearly twice the capital gains rate, the financial incentives for GP and LP were rent asunder by the tax changes. We have tried to buy companies in 2018 where the GP demurred as tax policy has altered their holding period. LP’s are now taking the risk of longer holds and having to sell in the next recession due to these changes. Subsequent equity financing rounds by the Fund and by co-investors exacerbate this problem as a new three year clock starts on these finances.

The other interesting alignment change is in the application of the preferred return. The original notion of the “pref” was to compel the GP to make investments above a minimum level to earn their incentive, the carried interest. Failure to reach the preferred IRR meant no carry was paid to the GP. Now through the magic of the credit line, borrowing at a cost of 3%, Fund returns on investment portfolios that do not exceed the “pref” can be moved from below the preferred level to above it simply by borrowing against the credit worthiness of a Fund’s LP base and deferring capital calls. A performance of 7% on portfolio investments can be turned into a 10% Fund return, above the standard 8% preferred return, and qualify for carried interest by using fund level leverage. This is precisely the result the “pref” was meant to avoid and a misalignment that was not anticipated. In the above example, ignoring interest cost, the effect of leverage at the Fund level by beating the preferred return is to leave the investors with less cash than the preferred return intended. Normally, if the investments in a Fund earned 7%, or $100MM in profit, the entire $100MM would be distributed to investors based on capital contribution if 8% is the applicable preferred return rate. However, if leverage pushes a portfolio level return of 7% into a Fund level return of 10% and creates a carried interest of 20% of the gain, permitting the General Partner to receive $20MM of the gain while $80 MM is distributed to investors. The carry was not earned by investing acumen, but by using the LP investors’ credit rating to borrow cheaply, a benefit for which the Investors are not compensated but are instead charged $20MM.

I’m Rob Morris and I approved this blog.

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