Alternative Investments

IRR and MOIC are two popular performance metrics, especially within “alternative” investment asset classes such as real estate, private equity, and venture capital (where time-weighted returns are essentially meaningless). Both IRR and MOIC are important metrics, but neither should be used in isolation when comparing a fund’s performance; investors should always evaluate both within the context of the other (as well as expenses, since MOIC and IRR are often quoted on a gross basis).

IRR

IRR Definition

IRR stands for Internal Rate of Return. IRR is the discount rate one would need to use so that the net present value (NPV) of all future cash flows is zero. In other words, one would look at all the contributions into and distributions from an investment and then find the rate that discounts the sum to zero. IRR is not a perfect way to calculate returns, but it is one of the better metrics for many real estate, private equity, and venture capital assets (among others). IRR can be quoted on a gross or net of fees basis.

IRR Formula

Mathematically, IRR is variable than enables the sum of the NPV of cashflows to equal zero. The bad news is that the equation below is the formula used to derive IRR. The good news is that many calculators, Microsoft Excel, and Google Sheets can calculate IRR.

IRR Example & IRR Calculation

The IRR calculation is complex, but a calculator can do it relatively quickly. If I’m in rush or want to get a ballpark estimate, I’ll simply google “IRR calculator.” Microsoft Excel and Google Sheets also have IRR (if periodic cashflows) and XIRR (if non-periodic cashflows) functions.

Using an online calculator, Excel, or Sheets, we can input the below hypothetical cash flows and determine that the IRR is 42%.

Initial Investment	$100,000
Year 1 Cash Flow	$125,000
Year 2 Cash Flow	$10,000
Year 3 Cash Flow (final distribution)	$20,000
IRR	42%

IRR: Pros & Cons

Pros of IRR

• One the primary reasons that IRR is the default performance reporting metric for alternative investments is that it accounts for varying amounts of capital. Many alternative investments are funded over time and distributions are also made over time.
• IRR accounts for the time value of money, unlike MOIC which does not account for time at all.
• IRR is very sensitive to several factors that (within a fund context) encourage managers to only call capital when it is needed and to return capital to investors relatively quickly. As we will see later, this can also be a negative.

Cons of IRR

Despite the above pros, IRR is not necessarily sufficient to evaluate investment performance for a few reasons.

• As illustrated in our example and mentioned in the “pros” section above, IRR is sensitive to early cash flows and small (often inconsequential) distributions early on can elevate IRR for years.
• IRR calculations begin when capital is put to work. However, it does not account for the opportunity cost of uncalled capital. Uncalled capital is often generating low(er) returns since it needs to be relatively liquid.
• On the flip side, IRR does not account for the time after capital is returned to investors. In the above example, capital was returned relatively quickly (which could be a pro or con for the investor, depending on their opportunity set available).
• Lastly, IRR’s are based on cash flows and cash flows can be changed without impacting performance. In other words, IRR can be influenced (or manipulated) relatively easily.
  • Subscription lines: Funds have increasingly used “subscription lines” to defer calling investor capital. The leverage allows funds to buy assets and generate returns early on. The funds can then distribute more capital back to investors earlier. Sounds great, except the leverage has a cost and is simply in lieu of called capital (rather than in addition to). This inflates the IRR while often reducing economic returns (due to interest and administrative expenses).
  • Leverage & Dividend Recaps: Assume an investor buys a building for $10 million and it generates $2 million of cash flow in the first year. The IRR would be 20%. However, if the investor decides to borrow 90% of the buildings value and pocket the proceeds, the investor has now taken $11 million out of the investment ($2 million of cash flow and $9 million of cash out refinance proceeds). The IRR jumps from 20% to 200% without any difference in economic returns (the investor may actually be worse off, since they now have to pay interest on the loan).
• Performance fees (carry, promote, incentive, etc.) are often based on IRR, even though it is not necessarily representative of actual dollar returns.
• Similar to MOIC, IRR is simply an estimate at any point before all all returns have been realized.
• Since MOIC is generally quoted on a gross basis, gross IRRs can vary wildly from net IRRs. Investors should calculate net IRRs if needed.

MOIC

MOIC Definition

MOIC stands for Multiple On Invested Capital. It expresses returns as a multiple of investment. MOIC is typically quoted on a gross basis (so before expenses such as fees are deducted and taken into account).

MOIC Formula

MOIC Example

Let’s use the above numbers (from our IRR example above) to calculate MOIC. The initial investment is $100,000. The asset generates total proceeds of $155,000 through its life. In this case the MOIC is 1.55x.

MOIC Calculation

In the above example, we get 1.55x by adding $125,000 from Year 1, $10,000 from Year 2, and $20,000 from Year 3 and dividing by $100,000.

MOIC: Pros & Cons

Pros of MOIC

• MOIC is relatively easy to calculate (even in your head) and easily understood intuitively. Thus, a main benefit of MOIC is that conveys the actual dollar return (gross of fees, generally).
  • In the above IRR example, the IRR is 42%. So a prospective investor may mistakenly extrapolate that the next (similar) investment will grow to approximately 286,000 over three years (assuming a 42% return compounded annually). However, the investment only grew to $155,000 over three years.

Cons of MOIC

• One of the downsides of MOIC is that it does not account for time value of money. MOICs can grow quite large by just holding assets for a long time, so MOIC must be evaluated within the context of time.
  • As an example, is a 3x MOIC or a 4x MOIC better? Nobody can say unless they know what the time periods are. If the 3x MOIC was generated in two years and the 4x MOIC over 8 years, I’d say that the 3x investment was the better one.

• Another weakness of MOIC is that it does not account for varying amounts of capital. It is quite easy to understand if capital is all invested at once. But what if capital is called/invested over time?
  • For instance, assume 10% of capital is invested in Year 1 and doubles in value. An additional 10% of capital is invested in Year 2 and then the asset value doubles again. Then 80% of capital is invested in Year 3 and there are no distributions or change in value through Year 5. The MOIC after five years is 1.6x. Is this good or bad return? The returns were great the first two years and terrible during the last three years (when the majority of capital was invested).
• Similar to IRR, MOIC is simply an estimate at any point before all capital has been returned to investors.
• MOIC is generally quoted on a gross basis. Investors should account for fees and expenses in these cases.
• MOIC is often a performance metric for individual fund assets, which can differ quite a bit from fund-level performance. For fund-level performance, investors may want to consider using TVPI rather than MOIC.

MOIC vs IRR

Similarities

MOIC and IRR are different but do have some similarities:

• Are preferable to time-weighted return (TWR) in many scenarios.
• Widely used in the (alternative) investment industry.

Differences

As readers can glean from the above, there are some important differences between MOIC and IRR:

• IRR represents the time value of money, but MOIC represents the multiple of money.
• IRR is relatively sensitive to inputs (and easier to engineer/manipulate); it is more difficult to do this with MOIC.
• IRRs are generally higher early in an investment’s life; MOIC is generally higher later in an investment’s life.
• MOIC is generally quoted on a gross basis, while IRR is quoted on a gross or net basis.

Using MOIC and IRR Together

Both MOIC and IRR have strengths and weaknesses, but neither should be used in isolation. Unfortunately, many investment managers and funds often advertise IRR or MOIC but not both. Investors wanting to understand performance should be evaluating both MOIC and IRR within the context of expenses and other factors such as leverage, pacing, etc.

IRR MOIC Table

One resource that may be helpful is the below IRR MOIC table, which models the relationship between IRRs, multiples (such as MOIC), and hold time. Of course, each investment is unique with caveats and there is no standard MOIC to IRR formula or calculator (since the inputs can vary quite a bit especially for IRR). In the absence of a IRR to MOIC conversion formula, the below MOIC IRR table is a great resource (although it may or may not hold in each case depending on an investment’s details).

As an investor, one of the first things I do when evaluating a fund’s pitch or performance is to ensure that I have IRR and MOIC data as well as an understanding of the size/pacing of capital calls and distributions. If this information is not provided initially, I will ask for it and most managers can provide it relatively quickly. But I will not make an investment without looking at and understanding both IRR and MOIC.

IRR and TVPI are two popular performance metrics, especially within “alternative” investment asset classes such as real estate, private equity, and venture capital (where time-weighted returns are essentially meaningless). Both IRR and TVPI are important metrics, but neither should be used in isolation when comparing a fund’s performance; investors should always evaluate both within the context of the other.

IRR

IRR Definition

IRR stands for Internal Rate of Return. IRR is the discount rate one would need to use so that the net present value (NPV) of all future cash flows is zero. In other words, one would look at all the contributions into and distributions from an investment and then find the rate that discounts the sum to zero. IRR is not a perfect way to calculate returns, but it is one of the better metrics for many real estate, private equity, and venture capital funds (among others). IRR can be quoted on a gross or net of fees basis.

IRR Formula

Mathematically, IRR is variable than enables the sum of the NPV of cashflows to equal zero. The bad news is that the equation below is the formula used to derive IRR. The good news is that many calculators, Microsoft Excel, and Google Sheets can calculate IRR.

IRR Example & IRR Calculation

The IRR calculation is complex, but a calculator can do it relatively quickly. If I’m in rush or want to get a ballpark estimate, I’ll simply google “IRR calculator.” Microsoft Excel and Google Sheets also have IRR (if periodic cashflows) and XIRR (if non-periodic cashflows) functions.

Using an online calculator, Excel, or Sheets, we can input the below hypothetical cash flows and determine that the IRR is 42%.

Initial Investment	$100,000
Year 1 Cash Flow	$125,000
Year 2 Cash Flow	$10,000
Year 3 Cash Flow (final distribution)	$20,000
IRR	42%

IRR: Pros & Cons

Pros of IRR

• One the primary reasons that IRR is the default performance reporting metric for alternative investments is that it accounts for varying amounts of capital. Many alternative investments are funded over time and distributions are also made over time.
• IRR accounts for the time value of money, unlike TVPI which does not account for time at all.
• IRR is very sensitive to several factors that (within a fund context) encourage managers to only call capital when it is needed and to return capital to investors relatively quickly. As we will see later, this can also be a negative.

Cons of IRR

Despite the above pros, IRR is not necessarily sufficient to evaluate investment performance for a few reasons.

• As illustrated in our example and mentioned in the “pros” section above, IRR is sensitive to early cash flows and small (often inconsequential) distributions early on can elevate IRR for years.
• IRR calculations begin when capital is put to work. However, it does not account for the opportunity cost of uncalled capital. Uncalled capital is often generating low(er) returns since it needs to be relatively liquid.
• On the flip side, IRR does not account for the time after capital is returned to investors. In the above example, capital was returned relatively quickly (which could be a pro or con for the investor, depending on their opportunity set available).
• Lastly, IRR’s are based on cash flows and cash flows can be changed without impacting performance. In other words, IRR can be influenced (or manipulated) relatively easily.
  • Subscription lines: Funds have increasingly used “subscription lines” to defer calling investor capital. The leverage allows funds to buy assets and generate returns early on. The funds can then distribute more capital back to investors earlier. Sounds great, except the leverage has a cost and is simply in lieu of called capital (rather than in addition to). This inflates the IRR while often reducing economic returns (due to interest and administrative expenses).
  • Leverage & Dividend Recaps: Assume an investor buys a building for $10 million and it generates $2 million of cash flow in the first year. The IRR would be 20%. However, if the investor decides to borrow 90% of the buildings value and pocket the proceeds, the investor has now taken $11 million out of the investment ($2 million of cash flow and $9 million of cash out refinance proceeds). The IRR jumps from 20% to 200% without any difference in economic returns (the investor may actually be worse off, since they now have to pay interest on the loan).
• Performance fees (carry, promote, incentive, etc.) are often based on IRR, even though it is not necessarily representative of actual dollar returns.
• Similar to TVPI, IRR is simply an estimate at any point before all capital has been returned to investors.

TVPI

TVPI Definition

TVPI stands for Total Value to Paid In. It expressed return as a multiple of “paid-in capital.” Paid-in capital is the money that an investor invests in a fund (regardless of how much is actually invested by the fund), so TVPI is often used to measure the performance of fund investments. TVPI can be quoted on a gross or net of fees basis.

TVPI Formula

TVPI Example

Let’s use the above numbers (from our IRR example above) to calculate TVPI. The initial investment is $100,000. The investor receives a total of $155,000 through the life of the investment. In this case the TVPI is 1.55x.

TVPI Calculation

In the above example, we get 1.55x by adding $125,000 from Year 1, $10,000 from Year 2, and $20,000 from Year 3 and dividing by $100,000.

TVPI: Pros & Cons

Pros of TVPI

• TVPI is relatively easy to calculate (even in your head) and easily understood intuitively. Thus, a main benefit of TVPI is that conveys the actual dollar return to investors.
  • In the above IRR example, the IRR is 42%. So a prospective investor may mistakenly extrapolate that their next investment would grow to approximately 286,000 over three years (assuming a 42% return compounded annually). However, the investment only grew to $155,000 over three years.

Cons of TVPI

• One of the downsides of TVPI is that it does not account for time value of money. TVPIs can grow quite large by just holding assets for a long time, so TVPI must be evaluated within the context of time.
  • As an example, is a 2xTVPI or a 5x TVPI better? Nobody can say unless they know what the time periods are. If the 2x TVPI was generated in one year and the 5x TVPI over 12 years, I’d say that the 2x investment was the better one.

• Another weakness of TVPI is that it does not account for varying amounts of capital. It is quite easy to understand if capital is all invested at once. But what if capital is called/invested over time?
  • For instance, assume 10% of capital is called in Year 1 and doubles. An additional 10% of capital is called in Year 2 and then the fund value doubles again. Then 80% of capital is called in Year 3 and there are no distributions or change in value through Year 5. The TVPI after five years is 1.6x. Is this good or bad return? The returns were great the first two years and terrible during the last three years (when the majority of capital was invested).
• Similar to IRR, TVPI is simply an estimate at any point before all capital has been returned to investors.

TVPI vs IRR

Similarities

TVPI and IRR are different but do have some similarities:

• Quoted on a gross or net basis (read more about gross vs net IRR).
• Are preferable to time-weighted return (TWR) in many scenarios.
• Widely used in the (alternative) investment industry.

Differences

As readers can glean from the above, there are some important differences between TVPI and IRR:

• IRR represents the time value of money, but TVPI represents the multiple of money.
• IRR is relatively sensitive to inputs (and easier to engineer/manipulate); it is more difficult to do this with TVPI.
• IRRs are generally higher early in an investment’s life; TVPI is generally higher later in an investment’s life.

Using TVPI and IRR Together

Both TVPI and IRR have strengths and weaknesses, but neither should be used in isolation. Unfortunately, many investment managers and funds only advertise IRR or TVPI but not both. Investors wanting to understand performance should be evaluating both TVPI, IRR, and other factors such as leverage, pacing, etc.

One resource that may be helpful is the below table, which models the relationship between IRRs, multiples (such as TVPI), and hold time. Of course, each investment is unique with caveats, so this table may or may not hold in each case but I find it is a good general resource.

As an investor, one of the first things I do when evaluating a fund is to ensure that I have IRR and TVPI data as well as an understanding of the size/pacing of capital calls and distributions. If this information is not provided initially, I will ask for it and most managers can provide it relatively quickly. But I will not make an investment without looking at and understanding both IRR and TVPI.

MOIC and TVPI are two popular performance metrics, especially within “alternative” investment asset classes such as real estate, private equity, and venture capital. Both are relatively easy to calculate and provide the context needed to understand performance beyond internal rates of return (or IRR, which is the default reporting metric for many private investments.

However, TVPI and MOIC are not the same. Continue reading to learn how to differentiate between TVPI vs MOIC.

MOIC

MOIC Definition

MOIC stands for Multiple On Invested Capital. It expresses returns as a multiple of investment. MOIC is typically quoted on a gross basis (so before expenses such as fees are deducted and taken into account).

MOIC Formula

Mathematically, MOIC is expressed as an investment’s value (both realized and unrealized) divided by the amount invested.

MOIC Example

Let’s assume an investor purchases a building for $10 million. Over the next few years, the investor receives $2 million of distributions and the building appreciates in value to $13 million. In this case, the total realized value is $2 million and the total unrealized value is $13 million. The total cost was $10 million. So the MOIC would be 1.5x.

MOIC Calculation

In the above example, we get 1.5x by adding $2 million and $13 million and then dividing by $10 million.

TVPI

TVPI Definition

TVPI stands for Total Value to Paid In. It expressed return as a multiple of “paid-in capital.” Paid-in capital is the money that an investor invests (regardless of how much is actually invested), so TVPI is often used to measure the performance of fund investments. TVPI can be quoted on a gross or net of fees basis.

TVPI Formula

TVPI Example

Let’s assume an investor buys into a fund that buys the above building. The investor contributes $11 million. $1 million dollars goes towards fund expenses and fees. The investor receives $1.5 million of distributions and expects to receive $12.5 million from the sale of the building (after all expenses and fees are paid). In this case, the TVPI is 1.27x.

TVPI Calculation

In the above example, we get 1.27x by adding $1.5 million and $12.5 million and then dividing by $11 million.

TVPI vs MOIC: Differences

Although MOIC and TVPI appear quite similar, the main differences between the two are:

• MOIC is generally:
  • Quoted on a gross basis
  • Applicable to an investment
• TVPI is generally:
  • Quoted on a gross or net basis
  • Applicable to an investor

Despite the differences, both metrics are helpful to use when evaluating IRR. Read our posts on MOIC vs IRR or TVPI vs IRR to learn more.

The Importance of MOIC and TVPI

MOIC and TVPI occupy an important place in investing in that they are widely-used multiple-based metrics. The other common metric in private market investing is internal rate of return (IRR). Both multiple-based and IRR-based returns have strengths and weaknesses, but neither should be used in isolation. Investors wanting to understand performance should be evaluating both multiples and IRRs.

Unfortunately, many investment managers and funds only advertise IRRs (and sometimes only gross IRRs!). At best, its an non-intuitive metric that does not paint a full picture by itself. At worst, it is used to obscure low investment returns on a multiple basis. Both MOIC and TVPI are valuable tools for investors evaluating investments.

An important consideration when investing in private equity is the preferred return, which is not a standardized term and has many variations. At the highest level, private equity investors should understand what the preferred return is as well as how its calculated, what the catch-up is (if any) and whether there are claw back provisions. Additionally, investors should evaluate whether the preferred return is simple, compounded, cumulative, and so on.

Performance fees are also known as carry, carried interest, performance allocations, incentive allocations, or incentive fees (among other terms) and I’ll be using them interchangeably. Private equity funds are typically long-term closed-end vehicles, so the below information and examples are more conceptual than anything else. They are examples of private equity preferred returns and investors are encouraged to carefully read the legal documents of any prospective investment.

Preferred Returns: Pure vs Catch-Ups

Pure Preferred Return

Pure preferred return is also known as a “true preferred return” or a “hard preferred return” (similar to a “hard hurdle” in hedge fund lingo, although use the term in a private equity context too). A pure preferred return means that the manager only collects a fee on the performance above the preferred return. This arrangement is more investor-friendly than the alternative of a “preferred return with catch-up.” Below is a detailed example of a private equity pure preferred return:

In the above example, the manager charges a 20% performance fee above an 8% preferred return. Since the fund returned 10%, the performance fee is .4% (20% multiplied by 2%).

Preferred Return with Catch-Up

A preferred return with catch-up means that the manager collects fees back to the first dollar of performance (the manager “catches up”), assuming that gross performance exceeds the preferred return. This arrangement is more manager-friendly than a pure preferred return. Below is a detailed example of a private equity preferred return with catch up:

In the above example with catch-up, the manager also charges a 20% performance fee above an 8% preferred return. However, the fee is applied on all returns (assuming fund performance exceeds the preferred return). So the performance fee is 2% (20% multiplied by 10%).

100% Catch-up

Once performance hits 7%, all additional returns accrue to the manager until gross performance surpasses 8.24% (because 7% is 85% of 8.24%). In other words, investors receive the returns from 0% to 7% and the manager receives returns from 7% to 8.24%. Returns of 8.25% and beyond are split 85%/15% between the investors and manager.

50/50 Catch-up

A 50/50 catch-up is a common catch-up structure, although it could be 60/40, 75/25, or any other combination.

Let’s look at an example of a private equity preferred return with a 50/50 catch-up. A private equity fund fund has 20% performance fee above a 10% preferred return with a 50/50 catch-up provision. In this case, the investors would receive all of the returns up to 10%. Additional returns would be split 50/50 until gross returns hit 12.5%. At 12.5%, the manager would be fully caught-up since they would receive 50% of the returns from 10% to 12.5% or 1.25% (which is 10% of 12.5%). Returns above 12.5% would be split 90/10 between the investors and manager.

Catch-Up Modifications and Limitations

Some funds have a structure where the manager earns carried interest back to the first dollar of performance (assuming that gross performance exceeds the preferred return), but the performance fee is reduced if it would cause net returns to be lower than the preferred return. Below is a detailed example of this modified structure private equity waterfall structure.

This structure allows managers to retain the upside, while somewhat protecting investors.

Tiered Preferred Returns

Similar to how a catch-up allows managers to have more upside than a pure performance return, a tiered preferred return allows managers to capture even more upside as performance increases.

Here’s an example of a private equity fund with tiered performance fees. The performance fee may be 20% over an 8% preferred return, 30% over a 12% preferred return, and so on. The performance fee can be structured to only apply to returns above the preferred return or to go back to the first dollar of returns. So an investor may pay a 20% performance fee up to 12% and a 30% performance fee on returns above 12%. Or they might pay 30% on all returns if the performance is above 12%. The fees at different tiers can also be limited so as to not push returns below the tier that they are being charged fees for.

Some investors believe that tiered preferred returns in private equity improve the alignment of interests between managers and investors, while others believe that it incentivizes risky behavior.

Simple, Compounding, and Resetting

Regardless of whether a private equity fund has a pure preferred return or a catch-up, it is important to note how the preferred return rate is quoted and how it works.

Simple Preferred Returns

Some private equity preferred returns are quoted as a simple rate, which is generally not a great arrangement for investors. Consider the example in the below table where a fund may have a preferred return of a 7%. In this case, the fund will be entitled to its performance fee as long as it returns at least 7% on invested capital. So if the fund starts with $10 million and returns are 10% in Year 1, the manager gets the performance fee. However, if the fund returns 6.5% in Year 2, the manager still gets the performance fee. This is because the $715,000 (calculated as 6.5% x $11 million) that it earned in Year 2 is more than 7% of invested capital (of $10 million).

This model is obviously favorable to managers, although it may make sense for certain open-ended vehicles (and may not matter for some closed-end vehicles).

Compounded Preferred Returns

Some private equity preferred returns are quoted as an annually compounded rate. If the preferred return is 6%, then the fund must return at least 12.36% over a 2-year period (since a 6% return compounded for 2 years is 12.36%), 19.1% over a 3-year period (since a 6% return compounded for 3 years is 19.1%), and so on.

Non-cumulative Preferred Returns

The advent of evergreen and open-ended private equity has resulted in some preferred returns that are “non-cumulative” and reset periodically. In other words, the preferred return will reset regardless of the prior periods performance.

This is obviously manager-friendly (and unfavorable to investors). Consider a fund with an 8% preferred return that that loses 20% in Year 1 and gains 10% in Year 2. No performance fee would have been charged in Year 1, but it would have been charged in Year 2 (since the Year 2 performance exceeded the preferred the return). Investors would be down 12% and yet still have to pay a performance fee! This example is detailed in the table below.

High Water Marks

A high water mark (or high-water mark or high watermark) has primarily been used by hedge funds historically, but it is becoming more common in private equity due to the wave of evergreen offerings with non-cumulative performance fees.

A high water mark is a mechanism to address the downsides of a non-cumulative preferred return. Furthermore, it ensures that a performance fee will not be charged until cumulative performance is positive. Returning to the previous example, a high water mark would prevent the manager from collecting performance fee in Year 2 (even though the preferred return resets in the new year) because the cumulative performance is still negative. However, once the cumulative performance exceeds the 0%, then the manager would be entitled to the performance fee.

It is easy to think of other examples where a high water mark would protect investors. A common risk would be paying the performance fee twice on the same performance. In the chart below, we assume a fund returns 10% in Year 1 and -20% in Year 2 and then 30% in Year 3. The investment would have gone from 100,000 to 110,000 in Year 1 and again in Year 3 and investors would not want to pay for that twice. A high water mark ensures that they only pay a performance fee on the gains from 110,000 to 114,400 in Year 3.

Private Equity Waterfall Structures

I’ll probably write another post on this, but there are two main types of “waterfalls” or ordering of distributions.

European Waterfall

Under a European waterfall structure, investors typically receive their return of capital and preferred return before the manager begins receiving its fee carried interest catch-up. Given that many private equity funds are 10 year funds (plus extensions), managers may be waiting a very long time before receiving any carry from the waterfall.

American Waterfall

Under an American waterfall, the manager is allowed to receive advances of its carried interest catch-up on a “deal-by-deal” basis. Essentially, this allows the manager to receive some compensation earlier. Proponents of this structure argue that it allows managers to think longer-term and not sell assets prematurely in order to generate income for themselves.

Clawback Provisions

Clawback provisions are important for investors to have under an American waterfall structure. It provides a mechanism for investors to receive some compensation from the manager if the deal-by-deal carried interest fees that are advanced are ultimately more than what the manager is entitled to (once the fund is fully wound down and the actual fees known). Unfortunately for investors, clawbacks are generally net of taxes since managers argue that they cannot refund what they paid to the IRS. So investors may receive a fraction of what was overpaid to the manager.

Conclusion

Ultimately, performance fees, preferred returns, and high water marks are designed to align the interests of private equity managers and investors. The structure of these terms varies from fund to fund, depending on factors like manager size, asset class, and so on. There is no “best” set of terms, but investors should ask whether the terms create alignment in a variety of good and bad scenarios. This is also true when investing in real estate, hedge funds, and many other alternative investments beyond private equity.

Further Reading

The above primarily relates to private equity and vehicles with a “private equity structure”. However, a very similar set of concepts can be found in hedge fund hurdles, hurdle rates, and high water marks.

A hedge fund’s hurdle rate is an important consideration when investing in hedge funds, especially since it has many variations. At the highest level, investors should understand what a hedge fund hurdle is, whether it is a hard hurdle, soft hurdle, or blended. Additionally, investors should evaluate whether the hedge fund hurdle rate is compounding or non-compounding as well as the existence and structuring of a high water mark mechanism.

Performance fees are also known as carry, carried interest, performance allocation, incentive allocations, or incentive fees (among other terms) and I’ll be using these term interchangeably. It is important to note that fees and hurdles can be assessed monthly, quarterly, annually, or longer. The below information and examples are just examples and investors are encouraged to carefully read the legal documents of any prospective investment.

Hedge Fund Hurdles

Hard Hurdle

A hard hurdle means that the manager only collects a fee on the performance above the hurdle rate. This arrangement is more investor-friendly than a soft hurdle. Below is a detailed exampled of a hedge fund with a hard hurdle:

In the above example, the manager charges a 20% performance fee above an 8% hurdle. Since the fund returned 10%, the performance fee is .4% (20% multiplied by 2%).

Soft Hurdle

A soft hurdle means that the manager collects fees back to the first dollar of performance, assuming that gross performance exceeds the hurdle rate. This arrangement is more manager-friendly than a hard hurdle. Below is a detailed example of a hedge fund with a soft hurdle:

In the above example of a soft hurdle, the manager also charges a 20% performance fee above an 8% hurdle. However, the fee is applied on all returns (assuming fund performance exceeds the hurdle rate). So the performance fee is 2% (20% multiplied by 10%).

Blended Hurdle

A blended hurdle is similar to a soft hurdle in that a manager can collect fees back to the first dollar of performance (assuming that gross performance exceeds the hurdle rate). However, the performance fee is reduced if it would cause net returns to be lower than the hurdle rate. Below is a detailed example of a hedge fund with a blended hurdle.

Blended hurdles allow the manager to capture upside, while somewhat protecting investors.

Graduated Hurdle Rates

Similar to how a hedge fund with a blended hurdle allows a manager to have more upside than a hard hurdle, a graduated hurdle allows a manager to capture even more upside as performance increases.

Consider the following example of a hedge fund with a graduated hurdle. The performance fee may be 20% over an 8% hurdle, 30% over a 12% hurdle, and so on. Again, the hurdle can be structured to only apply to returns above the hurdle or to go back to the first dollar of returns. So an investor may pay a 20% performance fee up to 12% and a 30% performance fee on returns above 12%. Or they might pay 30% on all returns if the performance is above 12%.

Some investors believe graduated here fund hurdle rates improve the alignment of interests between managers and investors, while others believe that it incentivizes reckless risk taking.

Hedge Fund Hurdle Rate: Compounding vs Non-Compounding

Regardless of whether a fund has a hard hurdle or a soft hurdle, it is important to note whether the hedge fund hurdle rate is compounding or non-compounding. If it is non-compounding, investors should determine whether the performance fee is subject to a high water mark (see below).

Compounding

A compounding hurdle rate means that the hurdle rate compounds over time. Here is an example of a hedge fund with a compounding hurdle rate. If the hurdle rate is 6%, then the fund must return at least 12.36% over a 2 year period (since a 6% return compounded for 2 years is 12.36%). A hurdle rate could also be a benchmark index like the S&P 500 or a benchmark plus a spread (such as 3-month T-bills plus 200 basis points). Using these types of benchmarks could result in a negative hurdle rate, so the hurdle rate often has a floor of 0%.

Non-Compounding

If the hurdle rate is non-compounding, then it resets periodically. In other words, the hurdle rate will reset regardless of the prior periods performance. This is obviously manager-friendly (and unfavorable to investors).

Consider this example of a hedge fund with a non-compounding 8% hurdle rate that loses 20% in Year 1 and gains 10% in Year 2. No performance fee would have been charged in Year 1, but it would have been charged in Year 2 (since the Year 2 performance exceeded the hurdle rate). Investors would be down 12% and yet still have to pay a performance fee! This example is detailed in the table below.

High Water Marks

A high water mark (or high-water mark or high watermark) is a tool frequently used to address the problems with non-compounding hurdle rates. A high water mark simply ensures that a performance fee cannot be charged until cumulative performance is positive.

Continuing from the previous example, below is an example of how a high water mark would prevent the manager from collecting performance fee in Year 2 (even though the hurdle rate is non-cumulative) because the cumulative performance is still negative. However, if the cumulative performance exceeded 0%, then the manager would be entitled to the performance fee.

It is easy to think of other examples where a high water mark would protect investors. A common risk would be paying the performance fee twice on the same performance.

In the table below, we see an example of how a high water mark protects investors from paying fees on the same performance twice. Assume a fund returns 10% in Year 1 and -20% in Year 2 and then 30% in Year 3. The investment would have gone from 100,000 to 110,000 in Year 1 and again in Year 3 and investors would not want to pay for that twice. A high water mark ensures that they only pay a performance fee on the gains from 110,000 to 114,400 in Year 3.

Problems with High Water Marks

High water marks are a mechanism to protect investors. However, it can backfire in cases where managers severely underperform. If a fund is loses 50% from its high water mark, then the fund must return 100% to get back to even and qualify for performance fees again. Some managers may be de-motivated by this and decide to shut the fund down rather than continue without the near-term prospect of performance fees. Of course, if the manager launches a new fund, they can begin collecting performance fees immediately on any positive performance. There was a high profile example of this recently when the “meme stock” craze crushed Melvin Capital. First the hedge fund manager floated the idea of modifying the hurdle rate and high water mark, before ultimately deciding to shut down and reopen. This example highlights why hedge funds are infamous for playing a game where “heads I win, tails you lose.”

Conclusion

Ultimately, hedge fund hurdle rates, performance fees, and high water marks are designed to align the interests of managers and investors. The structure of these terms varies from fund to fund, depending on factors like manager size, asset class, and so on. There is no “best” set of terms, but investors should ask whether the terms create alignment in a variety of good and bad scenarios. This is also true when investing in real estate, private equity, and many other alternative investments beyond hedge funds.

Further Reading

The above primarily relates to hedge funds and vehicles structured similarly to hedge funds. However, a very similar set of concepts can be found in private equity preferred returns, catch-ups, and waterfalls.