By Elizabeth K. Lewis, Business Assurance & Advisory Services Manager | Real Estate & Construction Industry Team
As an investor in the current market, an 8% return sounds too good to be true. However many private investment vehicles, including real estate funds, are producing the promised returns and then some. But how exactly is the “return” measured?
Preferred return or the “hurdle rate” defines the threshold return that the limited partners must receive before the general partner (or manager) is entitled to carried interest. The method of calculation is defined within the entity agreements and may include compounding at specified times. The below methods are used most commonly to calculate preferred returns:
- Internal rate of return (IRR) – The IRR typically is calculated using Excel where a residual value is used to produce the target IRR. Although timing is considered for the final calculation, a year of payments resulting in an 8% IRR is not equivalent to a year of payments where the investor is caught up to (and does not exceed) 8% return at all times throughout the year. In addition, impacts of compounding are more complicated to apply. Investment companies that have limited lives should present IRR since inception as a component of the financial highlight footnote (regardless of how preferred return is defined).
- Total return – Using total return as a threshold results in a consistent return throughout the year. This method allows calculation at any interim period of the amount due to reach the specified return. Therefore, distributions made in excess of the threshold at an interim period can be applied to the subsequent step per the operating agreement distribution provisions. Tracking payments and allocations is a bit more cumbersome. Investment companies that do not have limited lives should present total return as a component of the financial highlight footnote (regardless of how preferred return is defined).
So why does it matter?
The liability to pay preferred returns is not contractually set, and it only should be recorded in the financial statements once all contingencies are met. However, it is common practice to disclose the amount.
More importantly – the preferred return, as the “hurdle rate”, must be calculated first before determining the amount of carried interest due (if any). Calculated incorrectly, the differences to investors and the manager over a long hold can be substantial. Additionally, Investment Company guidance from the AICPA states (summarized):
“The cumulative unrealized gains (including carried interest) should be reflected in the ending equity balances of each class of investor as if the investment company had realized all assets and settled all liabilities at the fair values reported in the financial statements, and allocated gains and distributed the net assets to each investor at the reporting date consistent with the provisions of the governing documents.”
As the amount of carry to be recognized is based on the preferred return threshold, understanding the definition and calculation process of the returns is imperative to ensure properly stated financial statements and transparency to investors.
Elizabeth is part of the Business Assurance & Advisory Services group at Keiter. Her client base consists primarily of private equity and real estate funds and also includes contractors and non-profits. Elizabeth specializes in auditing non-registered investment funds and possesses a comprehensive understanding of fund accounting and auditing services. She is also a member of the Firm’s Real Estate and Construction Industry Team. Read more of Elizabeth’s insights on our blog.
- AICPA Technical Questions & Answers section 6910.29
- AICPA Investment Company Guide (Chapter 7)
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.