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| Strategic Investment Funds
Financial alignment of interest is commonly embedded in the structure of a limited partnership or equivalent structure through two levers: 1. Profit sharing. The manager is compensated by a management fee,35 which is not tied to performance, and a share in the profits (or carried interest) of the fund beyond a hurdle rate.36 2. Contribution of capital. The manager is often required to contribute capital (usually about 1 percent) to the fund, thus establishing skin in the game for the manager. There are limitations to such alignment of interests, however, as discussed in box 4.5. When the public sponsor has no ownership interest in the management entity of a SIF, oversight responsibilities are also met via a limited partnership advisory committee or similar structure. This advisory committee represents the owners’ interests in the SIF and is usually populated by the public sponsor and other key investors. The advisory committee has a more hands-off relationship to the management of the SIF than a board of directors does because the public sponsor and other investors have no ownership interest in the management entity.37 The committee structure instead collapses the ownership interests in the SIF with the oversight responsibility of the board of directors. The SIF advisory committee provides oversight, serves as a sounding board on strategic matters, weighs in on conflicts, and provides waivers for investment or risk thresholds and other restrictions laid out in the limited partnership agreement, and other key matters.
Management The third tier of a SIF’s governance structure focuses on the management of the fund, driven primarily by whether the manager is in-house or dedicated BOX 4.5
Limitations to aligning financial interests in a limited partnership model or equivalent structure Despite using such financial levers to align interests, the public sponsor cannot fully eliminate the principal-agent problem. For instance, although carried interest helps to provide an incentive by allowing the fund manager to participate in profits, it does not eliminate the possibility that the manager may take excessive risk because, in the downside scenario, the manager may forgo a share in profits but does not give up management fees (Magnuson 2018). The hurdle rate seeks to partially correct this misalignment at a portfolio level by not permitting the manager to participate in a share of profits until capital plus an agreed rate of return (usually 8 percent) has been remitted to the investors.
However, if the profit-sharing arrangement is not a sufficient motivator for the manager, the public sponsor and other investors may also bear the risk that capital is not fully deployed or is deployed in suboptimal investments. A key risk is that the fund manager may perceive the possibility of never seeing carried interest, so it is important to keep track of fund life and establish an attractive profit-sharing arrangement. The public sponsor and other investors must therefore pay keen attention to the profile of the manager hired, to ensure that the manager is unlikely to be complacent about its own track record or to focus only on fixed management fees.
Source: World Bank, including interviews with International Finance Corporation (IFC) Private Equity Funds and IFC SME Ventures teams.
