Brazil: Catch-Up As A New Way Of Alignment Of Interests In The Brazilian Private Equity Funds

Last Updated: 4 November 2015
Article by Daniel Kalansky and Rafael Sanchez

In the private equity funds, the compensation of the manager is usually made through the management fee and the carried interest. The first consists of a fixed value, calculated based on a percentage over the committed capital or the net worth of the fund, according to whether the fund is in the investment or the divestiture period, serving for the manager to cover his costs with a dedicated team to the fund and its general expenses of functioning. Currently, for the private equity funds raised with Brazilian institutional investors, the average has been 1.7% per year.

The carried interest consists in the participation of the manager in the profits of the fund, being paid to him a percentage of the proceeds of the fund (usually 20%) that exceeds the capital invested by investors plus a multiple defined upon the constitution of the fund – the preferred return/ hurdle rate. This is the minimum return to be achieved by the investors before the carried interest can be paid to the manager, varying, nowadays, around IPCA increased by 10% to 11% per year.

The manager's compensation is a key point for the alignment of interests among managers and investors, since investors do not want to pay large management fees to their managers, in order to avoid leaving them only comfortable with their compensation. Thus, the carried interest emerges as the main tool to align the interests of the parties, for it links the gains of the manager to those of the investors. There is consensus among investors that most of the manager's compensation should come from the carried interest. However, the carried interest shall only be paid after the return to the investor of invested capital and the preferred return, being, therefore, the preferred return the main challenge for the manager to reach his target.

The increase in amounts charged with respect to the preferred return can possibly misalign the interests of investors and managers. The solution to this problem can be found in the North American market itself: the catch-up clause.

Catch-up clauses allow the manager to receive compensation on the values paid to the investors as preferred return, operating the distribution of the proceeds of the fund as follows: (i) first the capital invested is returned to the investors, (ii) then, the preferred return is paid, (iii) next, it is paid to the manager the catch-up, a compensation incident upon the amounts paid with respect to the preferred return, generally, in the same proportion of the carried interest; and (iv) at last, the other proceeds of the fund are distributed, between investors and the manager, in the same proportion agreed for the carried interest. This way, the manager would have a compensation based on all the profits generated by the funds and not only on what exceeds the preferred return.

As an example, suppose an investment fund has a committed capital of R$100,000,000.00, carried interest of 20%, preferred return of 15% per year and has already invested all of its capital. Let us consider that after 5 years, such fund has completed all of its divestment in the amount of R$200,000,000.00. With the catch-up clause, the distribution of capital between investors and managers would be the following: (i) R$100.000.000,00 would be destined as return on invested capital; (ii) after the return of the invested capital, the remaining amount would be destined to the payment of the preferred return, which, considering the percentage of 15% per year on the invested capital, after 5 years, would be R$75,000,000.00; (iii) once paid the preferred return, it would be destined the catch-up to the manager, which, considering the referred compensation on the values paid with respect to the preferred return, R$75,000,000.00, representing 80% of the profit to the investors, the manager would be entitled to R$18,750,000,00 (the 20%, equivalent to the same proportion of the carried interest adopted); and (iv) finally, the amount left (R$6,250,000.00), would be distributed among the investors, in the proportion of 80% (R$5,000,000.00), and to the manager, in the proportion of 20% (R$1,250,000.00).

In the example above, the manager would receive R$ 20,000,000.00 with respect to the compensation, with carried interest and catch-up, while the investors would receive R$80,000,000.00 (besides, obviously, the amount of the capital invested). In a scenario like the one above, if there were no catch-up clause, as it occurs in most of the Brazilian funds, the manager would only receive R$5,000,000.00 and the investors R$95,000,000.00 (besides the invested capital).

The catch-up can still be adjusted to the Brazilian reality, excluding its application on the portion of the index referring to the IPCA, which would only be calculated over the amounts exceeding the IPCA, not paying to the manager return on what was paid as monetary adjustment. Although the concept of catch-up is still new in Brazil and faces resistance from most of the institutional investors, there is no doubt that it consists of a very efficient mechanism to align interests, motivating the manager and ensuring the investors receive, firstly, the so much desired preferred return.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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