Private Equity: Preferred Returns, Catch-Ups, and Waterfalls

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.

Hedge Fund Hurdle Rate (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.

Evergreen Private Equity Funds

Evergreen private equity funds offer investors many benefits.

There is a growing number of open-ended evergreen private equity funds. The overwhelming majority of private equity funds are closed-end vehicles with finite lives. Private equity evergreen funds are a new development that offer investors a different set of tradeoffs than traditional private equity funds. I view this development as part of the larger democratization of alternative investments and we can find new evergreen vehicles in private equity, credit, venture, real estate and so on. A reminder that these are simply examples as this site does NOT provide investment recommendations.

Challenges of Drawdown Funds

Perhaps the biggest difference between evergreen private equity funds and traditional private equity funds is the structure. Traditionally, private equity funds have been “drawdown funds.” Funds with this “private equity structure” have a “drawdown” where they call capital over time (rather than calling 100% of committed capital immediately). So an investor who commits $1 million may only invest $100,000 in year one, $300,000 in year two, and so on. A similar dynamic occurs when these types of funds wind down, distributing say 6% of the fund in year seven, 18% in year eight, 34% in year nine, and so on. So investors slowly invest capital and slowly receive it back.

The above dynamics present several challenges to the investor:

  1. The pace of capital calls is unknown and investors must be ready to fund capital calls with only a week’s or two’s notice (generally). Therefore, investors with uncalled commitments need to maintain sufficient liquidity. Whether that liquidity comes in the form of lower-returning liquid assets or a credit line, there is often either an opportunity or explicit cost for this liquidity.
  2. Oftentimes, investor commitments are not fully called. A fund may only call 60% of commitments or 95% of commitments or some other number.
  3. Given the closed-end structure of private equity funds and the capital call and distribution activity, PE investors usually develop a “recommitment strategy” where expected distributions from older funds are earmarked for expected capital calls from newer funds.
  4. Given the above three challenges, investors cannot easily project how much they will have invested at any point in time. Consequently, many investors practice an “overcommitment strategy” in which they commit more capital than they have. This mitigates the risk of cash drag from uncalled commitments and inefficient cash flow management. However, overcommitting requires careful planning to ensure the investor does not default on a capital call.

The above challenges are routinely addressed by institutional investors, but can be problematic for individual investors.

Performance Reporting

Traditional PE: Fund performance is typically quoted as an internal rate of return (IRR). There is a famous saying that “you can’t eat IRR,” which is a way of saying that IRR is an academic metric that may not accurately measure the economic return to investors. Investors should always evaluate both IRR and “multiple of invested capital” (MOIC also called “total value to paid-in capital” or TVPI). I cannot count the number of times I’ve seen pitchdecks with eye-popping IRRs before learning that the multiples are disappointing. Understanding, negotiating, calculating, and verifying private equity waterfalls can be a job unto itself.

Evergreen PE: Rather than IRRs, performance is reported in time-weighted returns (like publicly-traded funds). Low returns are more difficult to obscure through financial engineering.

Opportunity Costs

Traditional PE: Fund performance calculations are based on the capital that is called, which may or may not be a material amount. The opportunity cost of uncalled capital is not included in a fund’s returns. As an example, consider an investor who wants to keep sufficient liquidity for expected capital calls. The investor decides to hold $100,000 of uncalled capital in bonds earning 4% rather than an illiquid investment yielding 10%. At the portfolio level, there is an opportunity cost of 6%, which is not reflected in a fund’s performance reporting. This is why many investors practice the aforementioned overcommitment strategy.

Evergreen PE: Capital is invested immediately and return-generation begins immediately. Investors know how much they are investing and when.

Liquidity

Traditional PE: Many private equity funds have a 10-year life, plus optional extensions. So many private equity investors don’t get their last dollar out until 10-15 years have passed. 

Evergreen PE: Evergreen funds are often open-ended, which means that the funds accept capital on an ongoing basis. Additionally, many have liquidity features that provide investors the option to tender or redeem their investment on a periodic basis.

Investment Minimums & Investor Qualifications

Traditional PE: Many private equity funds require investors to be a qualified client or a qualified purchaser. Minimum ticket sizes generally start at $250,000, but can be $20M+. Thus, it is difficult for many individual investors to diversify within private equity unless they have a few million dollars (on the low end).

Evergreen PE: Since many evergreen vehicles are designed to alleviate the challenges of traditional PE for individual investors, the minimums and qualifications are generally lower.

Portfolio Management

Traditional PE: Many private equity sponsors launch a new fund (also called a vintage) every 1-3 years. So an investor may commit to Fund I and have their capital called over a number of years. Once the majority of capital is called, the sponsor launched Fund II. Again, capital is called over a number of years for Fund II. The investor then commits to Fund III just as Fund I begins to distribute capital back to the investor. This is perfect because the investor can use the Fund I distributions to cover the Fund III capital calls. This example is overly simplistic, but it illustrates that allocations to a manager often remain relatively constant even if there is a lot of committing, contributing, and distributing going on. 

Evergreen PE: Rather than distribute all proceeds to investors, an evergreen private equity fund can reinvest a portion of the proceeds that it receives. So investors can make a single investment and upsize or redeem as needed, rather than embarking on a recommitment strategy of continually recycling capital into subsequent vintages.

‘40 Act Funds

There are an increasing number of evergreen private equity vehicles that are registered with the SEC under the 1940 Investment Company Act. The funds are often referred to as ’40 Act funds or registered funds. The ’40 Act structure often provides additional investor protections and efficiencies.

Tax Reporting: ’40 Act vehicles tax reporting is typically via a 1099, which is much simpler than a K-1. While this may marginally increase fund expenses (and possibly limit tax benefits), it often reduces individuals’ tax prep complexity and costs.

Minimums: Many ’40 Act vehicles have investor requirements that are even lower than accredited investor requirements.

Diversification: While some ’40 Act fund sponsors view registered funds as a distribution channel and/or stuff their evergreen vehicles with their own assets, an increasing number of funds contain assets of other managers.

Traditional Private Equity vs Evergreen Private Equity

I believe there is room for both types of vehicles. Traditional private equity has many benefits for institutional investors (and even some individual investors). However, permanent capital vehicles in the form of evergreen fund structures alleviate many of the challenges that private equity investors face. Based on the rapid growth of evergreen vehicles, it seems that individual investors (without teams of investment professionals) find these funds attractive.

Accredited Investor vs Qualified Client vs Qualified Purchaser

Private market investing typically requires investors to qualify as an Accredited Investor, a Qualified Client, or a Qualified Purchaser. These terms and related criteria are designed to protect investors, although some argue that they also limit investor opportunity.

Publicly-traded assets and investment vehicles register with the Securities and Exchange Commission (SEC), while private investment vehicles are exempt from registration if they follow certain rules. The idea being that the SEC will allow funds to not register if they limit their offerings to those who have the financial ability to tolerate risk and/or the sophistication to understand the risks. Different exemptions are available, but each exemption has rules about what types of investors a fund can accept. Some funds can only accept accredited investors, some can accept qualified clients, and some can accept qualified purchasers.

Accredited Investor

One of the prerequisites to private market investing is to be an “accredited investor,” as many private investment vehicles require investors to be accredited (even if there are additional requirements to be a qualified client or qualified purchaser). Both people and entities can be accredited investors.

Benefits of being an accredited investor

The primary benefit to being an accredited investor is that the investment universe is the opportunity to invest in private investments. Non-accredited investors are generally limited to publicly-traded assets and funds that have been registered with the SEC. Below are some examples of why it is beneficial to be accredited:

  • Nearly all private investment vehicles are “Reg D” offerings, which require investors to be accredited.
  • Many real estate funds rely on the 3(c)(5)(C) exemption, which requires investors to be accredited.
  • The accredited investor standard is viewed as a default investor qualification in many contexts and may be used to restrict access to additional products and services.

How do people qualify as accredited investors?

Individuals can qualify as an accredited investor with their income OR with their net worth.

Based on income

To qualify as an accredited investors based on income, an investor must have:

  • earned at least $200,000 in each of the prior two years and have a reasonable expectation of the same for the current year, OR
  • earned at least $300,000 jointly with their spouse (or a “spousal equivalent”) in each of the prior two years and have a reasonable expectation of the same for the current year.

Based on net worth

To qualify as an accredited investor based on net worth, an investor must have a net worth of at least $1 million. The equity and debt in a primary residence must be excluded from the net worth calculation (unless the debt exceeds value of the home, in which case ).

Other ways

There are some less common ways for individuals to qualify as an accredited investor as well:

  • Hold, in good standing, any of the following securities licensing designations: Series 7, Series 65, or Series 82.
  • Be a “knowledgeable employee” of the fund (or affiliate) in which the investor is investing.
  • Be a client of a family office.

How do entities qualify as an accredited investor?

Investors who want to invest through an entity (such as a trust or business) are subject to a different set of criteria:

  • The entity must own at least $5 million of investments, OR
  • All owners of the entity must be accredited investors.
  • Certain types of financial firms are also accredited investors.

It is important to note that there is no way for entities to qualify based on revenue or income. It is also important to note that the accredited investor rules may apply to different types of entities differently, although those differences are outside the scope of this particular post.

The accredited investor definition can be found here and a summary from the SEC can be found here.

Qualified Client

Qualified clients are a step up from accredited investors in terms of net worth.

Benefits of being a Qualified Client

The main benefit to being a qualified client is that the investment universe is even larger than for accredited investors. Many private equity, private debt, venture capital, and hedge funds cannot rely on the same registration exemptions that real estate funds do, so they often rely on the 3(c)1 exemption. However, these 3(c)1 funds can only accept qualified clients, so investors who wish to allocate beyond real estate generally need to be qualified clients. Yet, even many real estate funds rely on the 3(c)1 exemption, so being a qualified client really opens up the opportunity set.

3(c)1 funds are allowed to charge a performance allocation (also known as a performance fee or incentive fee). Since many private equity funds and hedge funds charge performance fees (above a hurdle rate), many are organized as 3(c)1 funds (or 3(c)7 funds if they are larger, generally).

Definition of Qualified Client

A Qualified Client is:

  • A person or entity that owns at least $2.2 million of investments (the definition of investments excludes residences). Assets owned jointly with a spouse can be counted.
  • A person or entity who invest at least $1.1 million with the adviser. In other words, if someone has a net worth of $1.5 million, they are not a qualified client. But if they invest $1 million in a single fund, then they are a qualified client.
  • A Qualified Purchaser.
  • Certain “knowledgeable employees” of the fund and/or it’s affiliates.

Funds that require investors to be qualified clients usually require the investor to be accredited too. The definition of a qualified client can be found here and (similar to the treatment of accredited investors) the application of qualified client criteria to certain types of entities often varies from fund to fund.

Qualified Purchaser

Qualified purchaser is the highest qualification of these three common investor qualifications.

Benefits of being a Qualified Purchaser

There are several benefits to being a Qualified Purchaser, most of which relate to being allowed to invest in 3(c)7 funds.

  • While many funds rely on the 3(c)1 exemption, the downside is that they are only allowed to have 99 investors. So many funds decide to rely on the 3(c)7 exemption instead, which allows the fund to have 499 investors. However, only qualified purchasers are allowed to invest in 3(c)7 funds. Thus, the investment universe for qualified purchasers is larger than for qualified clients or accredited investors
  • Some sponsors launch parallel funds, meaning that they manage one 3(c)1 fund and one 3(c)7 fund that both invest in the same strategy. If the 3(c)1 has used up its 99 investor slots, qualified purchasers can still invest in the 3(c)7 fund (which has 499 investors slots).
  • Many funds have a cap of 25% on ERISA-protected accounts, meaning that less than 25% of the fund can be from accounts such as 401k’s, SEP IRAs, etc. If there are parallel funds and one fund has reached its ERISA cap, a qualified investor may be able to invest in the second parallel fund.

3(c)7 funds are also allowed to charge a performance allocation (also known as a performance fee or incentive fee). Since many hedge funds and private equity funds charge performance fees (usually above a preferred return), many are organized as 3(c)7 funds (or 3(c)1 funds if they are smaller, generally).

Definition of Qualified Purchaser

A Qualified Purchaser is:

  • A person or family-owned entity that owns at least $5 million of investments (the definition of investments excludes residences). Assets owned jointly with a spouse can be counted.
  • An entity where all of the “equity owners” are Qualified Purchasers.
  • An individual or entity that invests at least $25 million on a discretionary basis (either for themselves or on behalf of other Qualified Purchasers).
  • Certain “knowledgeable employees” of the fund and/or it’s affiliates.

Funds that require investors to be qualified purchasers usually require the investor to be accredited too. The definition of a qualified client can be found here and (similar to the treatment of accredited investors and qualified clients) the application of qualified purchaser criteria to certain types of entities often varies from fund to fund.

Concluding Thoughts

In my experience, the accredited investor qualification is the best known among individual investors, while qualified client and qualified purchaser terms are not as widely known. Investors should understand which criteria they meet in order to better understand the investments that they are allowed to invest in.

Alternative Investments Definition

At a recent conference, I was reminded that definitions in the “alternative investment” space can be ambiguous and sponsors/managers are more than willing to slap the “alternative” label on nearly any investment product for marketing purposes.

One of the most helpful lessons I learned about “alternative” investments was that there is no such thing as an “alternative” asset. Every investable asset is either equity or debt. Let’s look at some common assets:

  • Stocks = equity in a company
  • Bonds = debt owed by a company
  • Real Estate = equity in a land or building
  • Mortgages = debt owed by a real estate owner
  • Commodities = equity in a physical asset

*Derivatives could technically be classified as a third category, but they will “derive” their value from equity or debt and can behave like either depending on the structure.

So the most important thing to know about alternative investments is that there’s no such thing. “Alternative” describes an asset’s place in a classification system, but not an inherent attribute. Hybrid assets, structured products, hedge funds, private equities, infrastructure, and so on can all be disaggregated into equity and debt.

So before investing in an “alternative” investment, throw out the alternative moniker and understand what exactly the investment is and how it will behave. This simplified framework has been invaluable to me and I hope it is for you too!