This content is from: Portfolio

Don’t Get Carried Away

Where does "2 and 20" and the carried interest compensation arrangement actually come from? The bottom of the ocean! Read on...

I’ve come to the conclusion that generic conversations with pensions or sovereign funds about private equity, venture capital or hedge funds will inevitably elicit some choice expletives about fees and costs. It seems to be the pervasive nature of “2 and 20” in these asset classes that roils even the most seemly investors. Why? Because the one size fits all nature of this arrangement is widely perceived to enrich asset-gathering managers without providing incentives to generate outsize returns.

Anyway, this is a story that’s undoubtedly familiar to anyone reading this post. However, what readers may not know about is the actual origin of 2 and 20; where the “carried interest” forms of compensation actually come from. I suggest this may be the case because, until this morning, I didn’t know.

Indeed, I was having a conversation with a big pension fund when the individual on the phone (predictably) bemoaned the PE fee structure and remarked that it was ludicrous that LPs accepted a fee structure that was used to incentivize ship captains hundreds of years ago.

Say what now? Cue the Google machine.

Apparently, the notion of “carried interest” can be traced back almost 500 years to a time when a ship’s captain was given 20% of whatever he or she physically “carried” back to the private investors. Huh. Interesting, right? Here are some more details:

“In the 16th and 17th centuries, when European traders were traveling to the New World and the Far East, voyages were funded by private investors, each of whom took a share of the risk and a share of the profits in proportion to his or her investment. By custom, the captain of the ship took 20% of the cargo. That rule still applies: private equity firms generally take a carried interest of 20 percent of the capital gain made by the funds under management.”

As such, the captain was compensated for putting his or her life on the line in dangerous environments. And it was the extremely risky nature of these voyages that led private investors to give captains a massive (borderline outrageous) incentive to do _whatever it took_ to get the ship's cargo back to the private investors. This incentive was so great, in fact, that some suggest that it was partially responsible for captains “going down with the ship”. After all, if you personally owned 20% of the ship's cargo, you might also do everything in your power to get the ship to safety... even if it cost you your life. How’s that for an alignment of interests!?

Anyway, in sleuthing around the interwebs for more info on “carry”, I came across a lovely quote from the head of PE at Oxford’s endowment that I think is particularly appropriate here:

“There’s no longer an alignment of interest... You are no longer just paying the captain to sail on a ship. You pay the captain to live quite a different lifestyle... The resources and expenses investing through limited partnership structures is a pain in the backside... It is as if you make it deliberately hard for us, you make it hard to get in, the tedious fundraising process, the fight for allocations, the pain of partnership documents, the fees. And not just the headline figure, all the tricks we have to look out for such as transaction fees, monitoring fees, fees for paying the fees for your software licenses, fees for visiting limited partners. Come on guys, pay your own bills.”

Amen!

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