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The Dilemma of Minimum Threshold Requirements

Recently, several well-known and publicly held private equity firms released their fourth quarter 2013 earnings. This self-imposed requirement at many private equity funds, however, creates an under the surface effect on earnings results—minimum threshold requirements. A significant source of profit for many private equity firms are the performance fees the general partners earn on the funds they create and operate, while the limited partners (investors in the fund) receive profits throughout the entire life of the fund. These performance fees, referred to as “carried interest,” typically amount to 20% of the profits received from investments made by the fund. ((Andrew Metrick & Ayako Yasuda, The Economics of Private Equity, 23 The Rev. of Fin. Stud. 2303, 2311 (June 2010).))  However, for the majority of firms, these hefty fees can only be paid out to the firm’s general partners after the investment fund reaches a minimum return threshold requirement, commonly referred to as a “hurdle rate.” ((Id.))  For most funds, the hurdle rate is set at around 8-9% of the total value of the fund. ((David A. Weisbach, The Taxation of Carried Interests in Private Equity, 94 Va. L. Rev. 715, 722 (2008).))  This may keep earnings down initially, but once the fund reaches its hurdle rate, many firms also employ “catch-up” clauses that entitle the general partners to all further profits of the fund until the divide between the limited partners and general partners returns to an 80%/20% ratio. ((Brian Cheffins & John Armour, The Eclipse of Private Equity 33 Del. J. Corp. L. 1, 10 (2008).))  For firms that do not employ a catch-up clause in addition to their hurdle rate, general partners still receive the same amount of profits from the fund, but receive them at a much slower rate. ((Metrick, supra note 1, at 2312.))

These fee arrangements can have significant effects on firm earnings reports. Two of the largest and best-known private equity firms, Blackstone Group and Apollo Global Management, had their fourth quarter 2013 earnings reports at least partially affected by minimum threshold requirements. Back in December 2005, prior to the financial crisis, Blackstone Group created the largest private equity fund in the world, Blackstone Capital Partners V (“BCP V”), which was initially so successful that the firm created a related subsidiary fund, Blackstone Capital Partners V-AC (“BCP V-AC”), to raise additional capital for investments. ((William Alden, For Blackstone, a Pot of Gold Remains Out of Reach, N.Y. Times DealBook (Jan. 30, 2014, 5:07 PM),  The success of the fund faltered, however, as soon as the recession hit and profits fell. ((Id.))  While the fund has continued to pay out to limited partner investors, Blackstone set a threshold requirement of 8% of invested capital, compounded annually, on the fund before the firm could begin receiving carried interest payments. ((Id.))  Furthermore, BCP V-AC was not allowed to pay carried interest either until it made up for the shortfall of the larger BCP V fund. ((Id.))  Currently, BCP V is still 4% short of the threshold requirement required and analysts do not expect the fund to reach the threshold until late this year or early next year, despite huge profits on investments such as Hilton Worldwide Holdings, which owns Hilton Hotels, and SeaWorld. ((Id.))  In the meantime, the Blackstone Group and its earnings reports are isolated from what will eventually be a major payday for the firm.

Carried interest payments and payments on catch-up clauses in previous years can also affect the analysis of the current year’s earnings report. Apollo Global Management, another well-known private equity firm, saw fourth quarter 2013 profits fall 45% from the previous year. ((William Alden, Apollo Profit Fell 36% in Fourth Quarter, N.Y. Times DealBook (Feb. 7, 2014, 8:48 AM),  The numbers, however, are misleading. In the fourth quarter of 2012, Apollo’s profits spiked as the catch-up provision in one of its investment funds was triggered when the fund reached its minimum threshold for investment performance. ((Id.))  These types of fluctuations are the norm for private equity firms that set minimum threshold requirements for their funds, and the industry as a whole is decidedly one of long-term returns, rather than yearly results.

Some of the top private equity firms on Wall Street, however, are beginning to change the way they think about their investments in what one commentator stated was “short-term thinking about a long-term business.” ((Jeffrey Goldfarb, The Standouts of Private Equity, N.Y. Times DealBook (Nov. 8, 2013, 2:03 PM),  Under the typical private equity model, the investment horizon can be up to ten years, which means significant returns can be years away and not very steady. ((Id.))  The Blackstone Group, Apollo Global Management, the Carlyle Group, and Kohlberg Kravis Roberts have all recently begun to turn to alternative investment strategies that increase yearly returns to their investors. ((Id.))  Perhaps this is partly because stock analysts have focused more on the steady income that fund management fees provide for the firm than the potentially hefty profits that carried interest can provide. ((Id.))  Whether or not this focus is misguided is debatable. Some estimate that firms generate two-thirds of their income from management fees, with just one-third from carried interest. ((Weisbach, supra note 3, at 723.))  Others place the more significant emphasis on carried interest. ((Cheffins, supra note 4.))  It is clear, however, that the focus of stock analysts is the steadier sources of income that these firms can produce.

As private equity firms continue to turn to the public for investment in their funds, the dilemma of how to analyze future cash flows and appropriately reflect them in yearly earnings remains a challenge. The farther into the future a stream of income, the more difficult it becomes to estimate its present value. Furthermore, the success of an investment, that is, the profits to be earned, may not be ascertainable for a number of years; all while billions of dollars of capital have already been dispersed. Self-imposed minimum threshold requirements only add another level of complexity to the challenge of estimating future cash flows, delaying profits that have already been obtained from being distributed to the firm and providing a somewhat inaccurate picture of a firm’s earnings.

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Ethan Anderson

Vol. 3 Associate Editor
University of Michigan JD Candidate, 2015 Northeastern University BS in Economics, 2012

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