Don’t count your chickens (Carried Interest) before they hatch

I meet many investment professionals who tell me they received as part of their offer package a significant amount (pick your number based on seniority) in carried interest. When asked how that’s calculated, they begin mumbling various methodologies but often it ends up at a similar place — their firms are assuming that (i) the funds achieve a 2.0x Return, (ii) vests over a period of time and (iii) the number they suggested to me was undiscounted. So let’s break down each of these — I’ll emphasize that this is MY way of thinking about carried interest, and this is NOT the only way

(i) How many firms even make 2.0x Return: I’ll illustrate how difficult this is driven by (a) fees and (b) expenses

I’ll pick Blackstone since I have significant regard for the institution that they’ve built

You’ll notice that only four Blackstone vehicles for their Corporate Private Equity portfolio cleared that threshold (as on 03/31/2020) and that the aggregate MOIC is closer to 1.7x, recognizing several elements: much of this portfolio likely is young, and has not had time to season and / or compound

So how about your friendly neighborhood PE fund? My sense is that the MOIC number is even lower. Why?

The typical PE fund only deploys 80% — 85% of the vehicle (likely closer to the lower end of the range) as the remainder is utilized to pay fees and expenses

Remember, someone is paying your salary, that’s part of the management fee which for many fund managers is 2% annually on committed capital for the first 4–5 years of the fund

There is also maintenance fees (NO — we haven’t even gotten to transaction fees) associated with running a fund (these are the major buckets) including (i) fund formation, (ii) ongoing legal, (iii) audit, (iv) tax preparation and (v) fund administration. These can range from 0.5% — 1.0% annually on committed capital. So over the commitment period (5 years), this could potentially be an incremental 5% of the fund

This 15% of the vehicle that was expended on fees / expenses — are effectively a 0.0x return towards your carried interest

So you now only have 85% of your fund (you could recycle — but let’s save that for another day) to actually deploy — let’s say you do a 2.0x on those transactions

2.0x multiplied by 85% of your fund = 1.7x MOIC

Another item that I might add is if you’re a credit investor, carried interest isn’t terribly valuable for two reasons as (i) the MOIC on credit vehicles tend to be 1.2x — 1.3x as you don’t remain outstanding for a terribly long time (weighted average life of a second lien is 2.5 years) and (ii) if you conclude your investments in the fund and can’t defer your carried interest prior to three years (you’ll receive all of it as ordinary income vs. long-term capital gains)

(ii) Vesting: That money isn’t yours until you’re through the vesting period and some firms even have the ability to take it back from you

So now the final component is the vest — often this is based on your investment period. Should your investment period end early, this vests earlier which would be great for you (the investment professional)

I would think about this as earned pro rata annually based on your vest schedule (e.g., if your is time vested over four years, then I would divide the carry over four)

Remember your 4th year of carry, however, is vastly more valuable than your 1st year - it’s significantly closer to the day you actually receive the carry. Also, the thing about this carry construct is often meant to mimic your time to your next promotion — if they don’t view you as being worthy of a promotion and are seeking to raise the next generation, why not let you go in your 4th year and given the unvested carry to someone younger and likely cheaper?

(iii) Time Value of Money: In Finance 101, we are thought, money today is more valuable than money over time, so why are we not implementing a PV factor when we think about value?

I’ll be brief here but the main delta here is if your fund has an American waterfall vs. a European waterfall

If you have an American waterfall, you get paid the moment you have a windfall on that transaction while in the European waterfall you have to wait until the fund returns all investor capital and a preferred return. The danger with American waterfalls is that if the fund fails to clear the preferred return (at the end of the life of the fund), all the carried interest paid out would need to be paid back to investors (i.e., you’ll need to refund the carried interest you received)

The typical fund pays out carry between years 5–7 during the harvest period — American waterfalls pay off significantly earlier then European waterfalls

The note of caution I would encourage the reader is that if you’re in an American waterfall, please do NOT spend that carry (I have friends who have experienced clawbacks, and it is NOT pretty)

Now let’s discuss an example, Personnel C — he’s a relatively senior guy and is told he’s going to make $10mm of carried interest.

(i) MOIC: We would reduce this $10mm to reflect 1.7x (or pick your number based on your firm’s track record) vs. 2.0x so that number is likely closer to $7.0mm Undiscounted ($10mm x ([1.7x — 1.0x] / [2.0x — 1.0x]))

(ii) Vest: I would for this exercise, just pro rate your carried interest over the investment period (so let’s say 4 years) for value of $1.75mm ($7.0mm / 4 years)

(iii) Time Value of Money: Now I would utilize a simple NPV at pick your discount rate, I’ll utilize 8% on a stream of cash flows which are $0 annually for 6 years and pays $1.75mm annually ($7.0mm / 4 years) for Years 7–10

Given the above — the value of each year’s of carried interest is $0.92mm, $0.99mm, $1.06mm and $1.15mm from Year 1 to 4, respectively. C could be a rich guy (in a decade — someone to stay close to)!

I’ll now add two twists:

(i) Are you sure your firm has a full 20% carry? Or has that been reduced to attract certain investors? Large investors often get fee discounts to secure their commitments

If you’re a first time fund, I would expect that carry percentage to be closer to 15%

(ii) Are you sure your fund is going to make carry? Many Natural Resources funds are unlikely to make carry given the macro backdrop of the sector they’re invested in

I would review your firm’s track record and reflect (and be intellectually honest). Have we demonstrated the ability to achieve / generate these returns amidst today’s market?

To analyze this, I would seek to understand your firm’s Gross to Net return splits — even firms like Apollo (see above) have significant delta’s between the two. If your firm is in the 10% — 12% gross category, I’m sorry — I’m not sure if you’re going to be seeing carry any time soon (if any). Depending on the size of your firm, you could utilize CalPERs database to find some performance information

Taking a big step back - Most firms would prefer to pay you in carried interest (and if you’re long-term greedy, you should want to receive that too) as the market places a lower value on that stream of value. See the quote below from Apollo’s 2019 Investor Day

“A big part of our margin expansion story has been managing comp as you can see on this slide. The top half looks at our total comp ratio, which combines FRE and incentive; and then the bottom half looks at our incentive comp versus our FRE. And you can see here, those lines have diverged, and that’s been purposeful. Incentive earnings get a lower multiple, but they’re valued by employees. So we’ve leaned into that. And we’ve let that margin, that comp ratio increase over time. FRE earnings are highly valuable. And we’ve been able to use an increase in incentive comp to buy down our FRE comp.”