The Missing Preferred Return
Fleischer, Victor, Journal of Corporation Law
Managers of buyout funds usually offer investors an 8% preferred return on their investment before they take a share of any additional profits. Venture capitalists (VCs), on the other hand, offer no preferred return. Instead, VCs take their cut from the first dollar of nominal profits. They offer investors no feature to account for investors' cost of capital, nor do they index their compensation to an industry benchmark. This disparity between venture capital funds and other private equity funds is especially striking because the contracts that determine fund organization and compensation are otherwise very similar. This Article examines the mystery of this missing preferred return.
The missing preferred return is puzzling because it suggests that VCs may receive "pay without performance."1 VCs receive incentive compensation even if their funds do poorly when compared to other venture funds, and even when compared to less risky investments that investors could have made. This gap between pay and performance might even suggest that agency costs in venture capital are a more stubborn problem than previously thought. In the public equities market, regulators strive to protect small investors. Many laws and regulations, such as the one million dollar limit on the deducibility of executive pay that is not linked to performance,2 are designed to protect investors who may not be able to effectively constrain management from extracting rents.3 In private equity, however, the regulatory landscape reflects the conventional wisdom that sophisticated investors can look out for themselves.4 The missing preferred return poses a challenge to this view. Are fund managers camouflaging the true value of their compensation? If not, then why would sophisticated investors pay fund managers for mediocre work? Unlike the children of Lake Wobegon, not every venture fund is above average.5
Take the University of California Retirement System (UCRS), a prominent institutional investor. More than one in ten venture funds in which the UCRS invested has missed the common hurdle rate of 8%, and nearly one in five would have received less compensation if the hurdle rate mechanism were used.6 Using a preferred return would seem to make a difference. By leaving out a preferred return term, VC fund agreements reward mediocrity. This arrangement hardly seems efficient, let alone fair to retirees worried about their pension plan assets. Are VCs using compensation design to sneakily extract rents from their investors, as CEOs are said to do?
This agency costs story starts to feel a little thin, however, when one considers the presence of the preferred return in buyout funds. Investors routinely demand a preferred return in buyout funds. These very same investors then accept its absence in venture capital. With billions of dollars in fees at stake, the missing preferred return cannot be the product of greedy managers sneaking one past sleepy investors. No one is being hoodwinked here. Something else must be going on.
The secretive pay practices of the private equity world are worth investigating. Private equity fund managers, recently dubbed "Capitalism's New Kings" by The Economist magazine, draw hefty management fees from investors and cash in on even greater amounts by taking a share of the profits of their funds.7 This share of the profits is known as the "carry" or "carried interest." In contrast to the considerable research on CEO pay, private equity compensation practices are largely unexplored in the legal literature. Stock options are praised or scorned, but few know enough about the carried interest to even have an opinion. This Article uses the mystery of the missing preferred return to take the first hard look at the compensation of private equity fund managers.
I argue in this Article that the peculiar workings of the tax law, combined with institutional differences between venture capital and buyout funds, best explain the missing preferred return. …