Private equity firms can better align their interests with those of investors by using their relationship to portfolio companies as a model, according to research from the University of Oxford.
In its current form, so-called carried interest does not align incentives for general and limited partners because of the way returns and losses on investments are structured, Ludovic Phalippou, a professor of financial economics at the University of Oxford, wrote in a paper last month. Carried interest is a share of profits from an investment that is paid to the general partner as compensation.
The managers of a company purchased by a private equity firm typically have more of their personal wealth tied up in the deal, according to the paper. While their equity interest in the company is small compared to the total investment in the buyout, they have more at stake.
“If the management plan does not bear fruit, the first party to lose, and to lose dearly, is management,” Phalippou wrote in the paper. On the flip side, management earns a proportionally larger payout than the general partner, or private equity firm.
"At first sight, the contract between GP and LPs resembles the contract between GP and management,” he wrote in the paper.
General partners tend to put at least some of their own capital into the investments they make on behalf of limited partners, the paper said. And, like the portfolio companies, the gains are taxed at a capital gains rate, Phalippou wrote.
However, in a relationship between general partners and limited partners, the losses from an investment are the same while the general partners earn a higher rate of return, according to the paper.
Phalippou said general partners and limited partners can better align their interests while continuing to receive the most beneficial tax treatment. For example, private equity firms could take a first-loss under the carried interest agreement and reduce the catch-up rate in their contracts with investors, according to the paper.
The way the catch-up rates typically work is that after an investor receives their preferred return, the general partner receives between 80 percent and 100 percent of all distributions until they hit a 25 percent return, according to the research. Reducing the catch-up rate from 100 percent to 55.5 percent would help ensure that the interests between LPs and GPs are in line, Phalippou wrote in the paper.
“Within this agreement, many firms can preserve the tax benefits,” Phalippou said in a phone interview. “You’re doing it with management, why can’t you do it with the LPs?"