Articles

When the promote stops clearing: the hurdle as a binary threshold

Carried interest is not proportional to performance near the hurdle. It is a step function, and $2m of headroom is what stands between a promote and none.

Julian R. Sterling · from Private Equity Real Estate

A ten-investment fund clears its catch-up by exactly $2 million. Take the winners from 1.8x to 1.7x — a 4.8 percent fall in proceeds — and the promote does not get smaller. It stops.

Worked in full in Private Equity Real Estate by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →

Carried interest is usually described as though it were proportional: the fund does well, the general partner earns more; the fund does less well, the general partner earns less. Over most of the range that is true. Near the hurdle it is not true at all. The hurdle is a threshold, and a threshold has one side and another side.

The fund

A $500M value-add fund makes ten investments of $50M each. Seven return 1.8x and three return 0.7x.

Outcome	Count	Invested	Multiple	Proceeds
Winners	7	$350M	1.8x	$630M
Losers	3	$150M	0.7x	$105M
Fund	10	$500M	1.47x	$735M

Total profit is $235M. Run it through the waterfall — capital back, preferred return, catch-up — and the catch-up clears by $2 million. The general partner earns its full promote, with $2M to spare on a $500M fund. Four-tenths of one percent of committed capital.

Now move the winners

Nothing about the fund changes except the exit multiple on the seven investments that worked.

Winners at	Winner proceeds	Loser proceeds	Total	Profit	Fund multiple
1.9x	$665.0M	$105M	$770.0M	$270.0M	1.54x
1.8x	$630.0M	$105M	$735.0M	$235.0M	1.47x
1.75x	$612.5M	$105M	$717.5M	$217.5M	1.44x
1.7x	$595.0M	$105M	$700.0M	$200.0M	1.40x
1.6x	$560.0M	$105M	$665.0M	$165.0M	1.33x

At 1.7x the catch-up no longer clears. Compare the two rows:

Measure	Change from 1.8x to 1.7x
Proceeds	−4.8%
Profit	−14.9%
Fund multiple	1.47x to 1.40x
General partner's promote	−100%

A five percent move in exit values, on seven assets out of ten, in a fund still returning 1.4x. In any performance discussion this is a good fund with a slightly worse year. In the waterfall it is the difference between a full promote and none.

Why the leverage is this violent

Three effects compound at the hurdle.

Profit is geared to proceeds

Capital is a fixed subtraction. A 4.8 percent fall in proceeds is a 14.9 percent fall in profit, because the $500M of capital comes out first and does not shrink with performance. On a 1.4x fund, every percentage point off proceeds costs roughly three points of profit.

The preferred return does not shrink either

The preferred return is calculated on capital and time, not on performance. It is the same number in a good year and a bad one. So the whole of the reduction in profit lands on the tiers below it — which is where the general partner's economics are.

The catch-up is all or nothing

The catch-up tier either has enough left in it to clear or it does not. There is no partial state in which the general partner receives a proportionally smaller catch-up. Below the threshold, the general partner's share of profit is zero and the limited partners take everything.

What to do with this

For a general partner: know the headroom. Not the fund's projected multiple, but the distance in dollars between projected proceeds and the point at which the catch-up stops clearing. On the fund above that distance is $2M against $735M of proceeds — and it should be on the same page as the projection, because it is the number that determines whether the promote exists.

For a limited partner underwriting a manager's track record: a fund that just cleared its hurdle and a fund that just missed it look almost identical on gross performance and completely different on net. Ask which side of the threshold each prior fund landed on, and by how much. A manager whose promotes have all cleared by a hair has been lucky as well as good, and the two are worth telling apart.

For anyone modelling it: derive each tier from the one above rather than asserting the residual. The whole point of the sheet is to be able to move one exit multiple and watch the promote disappear — which a model with the residual typed in will never show you.

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