September 30, 2024
Marketing Director
Keeping track of the fees associated with fund management, partnership expenses, and carried interest imposed by general partners can prove to be a complex task, primarily due to inconsistent reporting practices, time intensive work to keep track of all the relevant Limited Partnership Agreements (LPA) terms, and a pervasive lack of transparency in the industry. In addition, misinterpreted terms from LPAs can lead to inaccuracies, overpayments, and discrepancies with fund returns.
At qashqade we regularly discover discrepancies with terms in LPAs as part of our validation service. Here are some real-world examples with their potential effect on a hypothetical investment.
Many funds use the so-called strict compounding method for preferred return calculation. It works as follows: throughout the year simple interest is calculated on the outstanding capital, and at year end the accumulated interest is added to the outstanding capital. Next year the simple interest is calculated on this new bigger balance.
We have frequently discovered examples where the accumulated interest is overlooked or considered wrongly and not added or only partially added at year end, which results in a lower preferred return, which in turn can hurt the investors.
The chart shows the potential effect on a USD $100m fund within 4 years.
Hybrid waterfalls have a unique way of treating fund-level expenses in the distribution waterfall calculations. They let in only a portion of the expenses to the waterfall at each of the distributions.
Typically, this portion is not calculated the same way over the fund’s lifetime. During the investment period they let in a portion that is realized investments divided by commitment, and thereafter a portion that is realized investments divided by all investments.
We have seen multiple examples when at the end of the investment period there was a failure to switch to the new calculation logic… which is to the detriment of the investors: they get back less capital and less preferred return than what they would be entitled to.
The chart shows the potential effect on a USD $100m fund within 4 years.
We have discovered instances of a hurdle step of 6% continuous compounding in the LPA, which means that any contribution to the fund involves calculating the 6%, but in the GP model it considered 6% IRR hurdle. This is often due to ambiguity of language in the LPA which talks of internal return in one place and compounded interest in another.
What is the issue? As soon as the distributions to contributions reach the 6% internal rate of return, calculating pref often is stopped, even if further contributions are made in the future.
In continuous compounding, it doesn’t matter what the internal rate of return is, every time there is a new contribution, 6% is calculated continuously.
The chart shows the potential effect on a USD $1m fund over 4 years.
Limited Partners (LPs) need better transparency and management oversight on all their LPAs with their respective GPs so fees can be validated, and misinterpreted terms and inaccuracies do not go unchecked. Even minor deviations can result in significant discrepancies when compounded over the life of a fund. qashqade offer a tech-enabled solution to help LPs validate their LPs and ensure they get the deal they signed up for.
To learn more, download this useful white paper: LPA Validation - trust but verify
