20 September 2023 - Public market equivalent (PME) benchmarking - sometimes called Index Comparison Method (ICM) - is not in and of itself a new or novel concept, but there has been a recent emerging trend - largely driven by institutional Limited Partners (LPs) - to directly tie General Partner (GP) compensation to PME benchmarks.
This trend has almost certainly been exacerbated in the current environment of rising interest rates, calling into question the efficacy of a compensation structure based on a static Preferred Return that is non-reactive to broader market conditions.
Because all investment products have a rate of return which is measured against what you can get risk-free from holding your money in cash, as rates rise, that risk-free return increases. That is fine for some asset classes, but when you have a static, pre-determined rate of return (as you do with private markets funds) it creates potential challenges for compensation structures.
Anecdotal evidence among managers is that fundraising across private markets is therefore tougher at the moment, with rising interest rates causing challenges for traditional, static compensation structures.
Direct Alpha Waterfalls
Efforts to instigate PME benchmarking as an input to GP compensation have thus far been generally focused around the “Direct Alpha” PME methodology.
In the Direct Alpha model, which is the primary PME method currently used to determine GP compensation, fund contributions and distributions are discounted based on the daily rates of a representative public market index, in order to calculate a “discount rate” IRR.
This IRR is then compared to the true IRR of the fund, in order to calculate a version of the fund’s Alpha performance over the representative index. Carried Interest is charged on the Alpha value, with the “non-Alpha” profits being allocated to the LP as a modified form of Preferred Return in excess of the LP’s capital contributions.
The carried interest allocated to the GP is thus directly tied to the performance of the index underlying the Direct Alpha calculation.
Challenges facing Direct Alpha PME Benchmarking
While Direct Alpha PME benchmarking is certainly useful in terms of comparing fund performance across a portfolio of alternative investment products, linking carried interest to public market performance is in many ways antithetical to the PE investment thesis, in which the long-term, illiquid nature of PE investments is largely agnostic to short-term public market performance.
While Direct Alpha does attempt to account for the irregular timing of a PE fund’s capital inflows and outflows, the nature of the calculation itself is subject to the influence of short-term market swings.
It also makes capital forecasting and carried interest projections difficult and uncertain, as those projections tend to be based on investment-level liquidation multiples and IRRs, without the associated variable of future public market performance.
Although still not seeing widespread adoption, the increasing focus around Direct Alpha waterfall structures merits further consideration.
Catching Up to Alpha
A possible solution would be the incorporation of a dynamic Direct Alpha calculation into the GP Catch-Up component of the fund’s waterfall calculation (in contrast to existing Direct Alpha waterfalls, which tend not to include a Catch-Up provision).
The GP Catch-Up component of a traditional waterfall involves a static allocation of profits to the General Partner in the form of carried interest, in order to compensate the GP for the static Preferred Return allocated to the LP.
In line with the potential waterfall calculation methodology suggested for dynamic Direct Alpha, after the LP has recouped their capital contributions and been allocated a Preferred Return, remaining profits would be split between the LP and the GP until such time as the GP has been allocated profits equal to a static carried interest.
The ratio at which profits would be allocated between the LP and GP in the Catch-Up tier would be a dynamic ratio, calculated based on the delta between the Direct Alpha IRR and the Preferred Return IRR. As the delta between Direct Alpha and Preferred Return increases, the allocation of profits to the LP in the Catch-Up tier would increase proportionately, ensuring a priority allocation to the LP until they have been “caught up” to the PME value, while at the same time ensuring an allocation to the GP once the Preferred Return threshold has been hit.
Assuming sufficient positive performance, the LP will be “caught up” to the Direct Alpha IRR, while ensuring that the GP has been allocated profits equal to their negotiated carried interest percentage. This proposed methodology would have the dual benefit of compensating the LP for the opportunity cost of contributing into a closed-end structure, while allocating the GP a static and forecastable allocation of carried interest (again, assuming sufficient positive performance.)
While it remains to be seen whether Direct Alpha PME-based waterfall structures will gain a foothold in the industry, the GP Catch-Up mechanism provides a framework for the alignment of both LP and GP interests, while still allowing for the inclusion of public market performance in private market compensation.