10.1.

12: Temporary Investments and Rate of Return

'Bogies'
In the course of events, the investor partnership will draw down cash from the investors in anticipation of
investments being made. Such funds are invested for a return in liquid fixed-income instruments, creating
income to the partnership.
[1]
Investors often demand that such income not be included in the profits in
which the GPGP enjoys a carried interest on the theory that the GPGP is not being paid 20% of profits to
run a money market fund. Hence, income from "idle funds" is sometimes segregated and allocated entirely
to the investors. Moreover, that thinking-that investors are paid to do something special-occasionally
manifests itself in an allocation scheme, which ties the GPGP's share of profits to profits in excess of some
target, or "bogey." The notion is that anyone can earn a rate of return on capital that does no more than
equal some index: the composite yield on Treasury securities, for example. The managers should be
compensated if the profits from the fund exceed that index. The thought is conceptually sound, but
experience teaches that the drafting issues are subtle.
[2]
Presumably the share of profits allocable to the
GPGP will increase as the record of performance exceeds the index. To the extent performance is tracked
in accordance with realized profits and unrealized appreciation, questions arise not only as to valuation of
the illiquid securities in the fund but also on the appropriate periods during which such appreciation should
be deemed to have occurred for purposes of comparing indexes. The problems are exacerbated if phantom
capital accounts are being maintained to account for partners admitted and withdrawing in midstream; the
draftsman of the allocation provisions has to juggle at least three moving targets-realized profits and
losses, unrealized appreciation or depreciation, and the target return or "hurdle rate."
One way to cut through some drafting formalities is to eschew the carried interest in whole or in part and
cause the investor partnership (or the investors directly) to lend the managers, nonrecourse in whole or in
part, the sums necessary for them to buy directly 20% of the stock offered for sale in each portfolio
opportunity. The interest rate on the loaned funds becomes, in effect, a form of hurdle rate, albeit on an
investment-by-investment basis.
[1]
If entities subject to ERISA own more than 20% of the aggregate profits interests, idle funds should be
invested in commercial paper so as to ensure compliance with Department of Labor Interpretative Bulletins
governing the status of venture funds in which ERISA entities are substantial players. See 10.11.2.
[2]
"Generally, the investors who have first hand experience with hurdle rates are most vehemently
opposed to them." 1993 Terms at 35. Another potential glitch in the hurdle rate provisions has been
covered - the distinction between a preferential return, which gives the limited partners a permanent
advantage, and one designed only to insure that ultimate profit allocations total the agreed ratio, say
80/20.
Page 1 of 2 10.1.12: Temporary Investments and Rate of Return 'Bogies' - Ency...
VC Experts, Inc., Expertise and Opportunity in Private Equity and Venture Capital

Copyright 2000 - 2009 VC Experts, Inc. All Rights Reserved.
Privacy Policy | Terms Of Use | Site Map | Contact Us
Website developed and powered by Rare Ideas, LLC.
Disclaimer: Literature and other private equity and venture capital-related materials publicly available on this website are provided
by VC Experts, Inc., and are for general informational and educational purposes only. VC Experts provides content and services that
are not legal services. An attorney-client relationship does not exist in connection with the non-legal services VC Experts provides.
Page 2 of 2 10.1.12: Temporary Investments and Rate of Return 'Bogies' - Ency...