Friday Letter: The sermon on the mount

When Moses brought down the stone tablets from the mountain to deliver the Ten Commandments, he could only have guessed at the durability of the rules.  

Three millennia later, the Decalogue is still going strong.

It is, however, a less well-known fact that Moses took a third tablet to share with investors, which laid out the standard terms for private equity funds. Thou shalt pay a management fee of two percent; thou shalt not covet the manager’s 20 percent carried interest and thou shalt enjoy a preferred return of eight percent.

There are small variations on the theme of “two and 20”, and one or two outriders such as Bain Capital’s 30 percent carry scheme, which have been the exceptions that prove the rule.

But should the terms be writ in stone? Not according to Ray Maxwell, a private equity veteran and founder of boutique advisory firm Priv-Ity. In his keynote speech at Private Equity International’s European Private Equity COOs and CFO’s Forum, Maxwell challenged the status quo.

Maxwell said that in the past, management fees were justified to cover the cost of the manager’s activity but then they transmogrified into profit centres in their own right. As a result, the manager’s economic focus has shifted away from generating carried interest, which in turn has influenced the amount of risk they assume in their investment decision-making. Why risk the farm (or the house in the Alps, the Bentley and the Gulfstream) on a tricky deal, while the money is rolling in? Just raise a bigger fund instead and try not to lose any of it.

Worse still, the benign fundraising climate also means that managers are raising funds more often, leading, Maxwell said, to “unwarranted fee stacking”. On top of that go the notorious transaction fees, which also help feather a well-appointed nest.

Maxwell’s critique is time worn and has tended to carry little weight with general partners who say that nobody forces investors to part with their money. Why should investors worry about how much they are paying if the returns are stellar? And anyway, management fees are just an advance on the carry. As the fund starts to return capital, so the management fee is paid back.

But Maxwell came to the conference armed with solutions that a room full of industry executives found harder to dismiss. He made a case for dropping the hurdle, or preferred return to investors, which is typically set at around eight percent (Eurazeo’s new fund has a hurdle of seven percent).

Maxwell argued it was an anachronism, a throwback to the days when eight percent represented the money investors could earn elsewhere. He said the risk-free rate of return is in fact lower, as are long-term equity returns. The hurdle can also distort the return profile of a fund as managers look for early wins to pay back the accrual. And the catch-up period, i.e. the time between clearing the hurdle and paying out profits, is often an unknown.

Maxwell’s solution is to move to a progressive carried interest structure. Under his proposal, carry starts accumulating as soon as the fund registers a capital gain. As the capital gain grows, so does the carried interest. So in the case of a €100 million fund, the first €50 million of capital gain attracts a carried interest of 10 percent. The next €50 million pays a return of 15 percent and so on until it hits a cap of 25 percent.

All told, Maxwell’s model delivers an accumulative carry of 17.5 percent. Its inventor urged the audience not to focus on the numbers but to look instead at the smoother delivery of profits for manager and investor alike. It would also shift the emphasis back towards carry as a reward for performance rather than management fees.

Instead of muttering mute dissent, a number of managers in the audience said they would look at the impact that Maxwell’s model would have had on the performance of their historic funds.

It may not even need a burning bush and the Voice of God, before managers adopt Maxwell’s plans. His speech came in the same week it emerged that Berkshire Partners, a US buyout firm, was raising its carried interest from 20 to 25 percent for its latest fund. The inertia of standardisation that has held back terms and conditions appears to be easing. Managers and partners are starting to work harder to find more appropriate structures.

Praise be.