- Carried Interest As Compensation: Demystifying a Complex Topic
Carried Interest As Compensation: Demystifying a Complex Topic
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juin 18, 2024
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This report was co-produced with Dartmouth Partners/Catalyst Partners and EWM Advisory. The views expressed herein are those of the author and do not necessarily represent the views of FTI Consulting, Inc. or its other professionals
For recruiters, HR professionals, and compensation experts in the world of alternative investment managers, few issues are as much thought about — and as little discussed, at least in public — as the use of carried interest (“carry”) in employee compensation packages.
Carried interest is a share of profits from private equity, venture capital, and hedge funds that is used as a compensation incentive. As it is considered a return on investment, it is mostly taxed as a capital gain (subject to the carried interest rate of 28%), usually at a lower rate than employment income (the highest marginal rate being 45%).
Offering carried interest can be a powerful incentive for current and potential employees. But it’s an issue that is often complicated and comes with a host of legal and tax implications that need to be addressed. The fact that it is so shrouded in secrecy can make it hard to explain to employees who might be eligible, and difficult for alternative asset managers to benchmark themselves against their peers and competitors.
In an attempt to demystify the topic, FTI Consulting’s Employment Tax and Reward team, together with Dartmouth Partners/Catalyst Partners recruiting agency and compensation specialists EWM Advisory, gathered finance, HR, and reward professionals from more than 20 leading and mid-market asset management firms in late April 2024 for a rare exchange of views on carried interest schemes. Most notably, it was clear from the discussion that whilst there is little differentiation between approaches taken towards cash compensation (both salary and bonuses), carried interest plans are highly varied and uniquely tailored to each firm and its business model — which helps explain both the complexity and the secrecy in discussing such a topic.
Here we focus on the key dimensions of carried interest and co-investment that emerged from the discussion. The range of views on these dimensions underscores just how diverse the usage is.
Deciding Who Is Eligible
In most cases, founders, partners, deal teams, and heads of corporate functions are the main recipients of carry. However, in some firms the distribution of carry is much wider and deeper, extending to operations and sustainability teams, corporate team members above a certain grade, and even more junior deal team members. This particularly the case where there is a desire to demonstrate appreciation for a broader contribution to a deal, or to compensate in circumstances where team members are not quite ready for promotion.
The decision process around who was eligible to participate in carry also differed among firms, with some attendees noting that deal team leaders ultimately determine who can participate and the value of carry awards received.
The Rise of “Phantom” Carry
About half of the firms said they use some form of “phantom” carried interest plans. These are essentially cash bonus arrangements that track the performance of the underlying fund with any returns taxable as employment income, rather than capital gains, as would generally be the case for typical carry plans. Whilst attendees continued to recognise the importance of tax savings in structuring carry plans, the increase in popularity of phantom awards in part demonstrates the need for greater flexibility in awarding carry throughout the life of the fund and demonstrates a move away from awarding carry purely because of potential tax savings alone.
Whilst most firms generally aim for one carried interest incentive scheme, many are open to adding phantom awards in cases when carried interest is already valuable and may be too expensive to acquire.
Equally, firms also noted that phantom carry plans are a useful tool to align the interests of investors and the deal team where local tax rules can mean that structuring carried interest arrangements is costly, complex and time consuming; this is in comparison to the overall size of the employee population and where the cost of arduously structuring carry for favourable tax rates outweighs the potential benefits in tax savings.
It was also noted that phantom schemes can be attractive to more junior employees where carry may not be meaningful enough to warrant the upfront cost of acquiring.
However, even phantom schemes don’t provide the certainty of receiving cash compensation that may be more meaningful for junior employees, who have immediate financial needs like managing mortgages, moving house, or funding school fees.
The Challenge of Educating Employees
The apparent lack of employee knowledge in understanding the principles of carried interest and the concurring need for employee education on both the potential value of carried interest and potential tax implications of carried awards was also widely discussed. Participating firms were almost unanimous in saying that their employees, other than finance teams, did not fully understand the potential value of carried interest or how it operates. Many noted that there was a general hesitancy among the senior team to share information (whether in the form of investment models or the underlying legal documents). Some noted that the hesitancy to share such information came from concern that details of these arrangements could potentially spread beyond the firm (for example, through leavers), thereby potentially negatively affecting the perception of the firm in the market.
Ultimately, there was consensus that employee education programmes can help, and some alternative asset managers spoke about the benefit gained from facilitating annual road shows for employees. Such programmes are not without drawbacks, however, with some participants noting a reluctance to share forecasted carry values given the anticipated difficulty that could arise in managing employee expectations.
Establishing the Value of Carried Interest
Approaches to valuation can differ substantially between firms, ranging from a “light touch” view (and therefore a riskier approach from a tax perspective) to a more arduous assessment of the upfront value of carry awards. Generally, participating employees in the UK always pay at least the unrestricted Market Value (“UMV”)1 to acquire carried interest to ensure that they fall within the general terms of the Memorandum of Understanding (“MoU”)2 and that any carry payments received by participants would be taxable based on the underlying nature of returns.
Interestingly, one firm noted an increased reluctance amongst eligible employees paying UMV to acquire their carry, with employees questioning that should there be a change in the UK government – as is currently anticipated – the Labour Party would reform the perceived carried interest ‘loophole’ and therefore remove any of the tax advantages gained by paying upfront to acquire carry.3
Calling it a ‘loophole’ seems somewhat misleading, given that the statutory backing for carried interest is to be taxed at 28%.4 Even so, the Labour Party have expressed their intention to reform the carry rules. The shape that such a reform may take remains unclear, and while having expressed their intention to support the Financial Services sector, it seems unlikely that a Labour government would go so far as to remove the potential tax savings available to carry plans in their entirety. Nevertheless, whilst some employees may be expressing concern around the potential forthcoming changes to the carry regime, it appears that most alternative asset managers are not yet scenario planning for a change in government, as was widely seen in the run-up to the 2019 election.
Communicating Value Without Raising Expectations
Communicating the value of carried interest remains a delicate issue. Some communicate the value (both current and forecasted) to employees annually, and others do so twice a year, particularly at the start of the life of the fund where the value may fluctuate the most. Such communications are typically heavily caveated, to help manage employee expectations and to reaffirm that valuations do not necessarily hold true on divestment of assets.
Helping Employees With Tax Implications
Given the complexity of limited partnership agreements (“LPAs”), several firms said they provide ongoing help and support with employee tax reporting. There were several reasons for providing support to employees, including ensuring that a consistent approach was taken between positions adopted in respect of fund reporting, and individual employee reporting to mitigate the risk of any potential enquiry from HMRC. Demonstrating their keenness for consistency between reporting approaches adopted, some firms line up specific advisors to help employees with the preparation of tax returns. Other firms share ‘tax packs’ to set out the distributions received by employees and the nature of such returns (e.g., whether capital or income); the contributions made by employees on acquiring their carry; and a summary of total cash compensation received throughout the tax year.
Dealing With Leavers
In the world of carried interest schemes, employees who leave tend to fall into one of two categories: “bad” leavers and “good” leavers, with the distinction between the categorisation of leavers also varying considerably between firms.
‘Bad leavers’ are generally those who quit to join a competitor (or leave for cause) and are therefore likely to forfeit some or, in some cases, all of their vested and unvested carry. Interestingly, however, there was a reluctance amongst firms to define what counts as a ‘competitor’ for the purposes of determining whether an individual is a bad leaver, with most leaving it to the discretion of the head of the deal team.
The approach towards ‘good leavers’ also varied, with the definition of what counted as a 'good leaver’ being equally vague. Most firms assess the circumstances under which an employee leaves on a case by case basis, making it difficult for existing employees to understand the potential implications should they find themselves resigning to join another alternative asset manager.
Approaches to Co-Investment
In addition to carried interest, most firms will also expect key individuals to make a co-investment into their funds. Co-investment arrangements differ widely from firm to firm. In some, for example, there is a mandatory amount that the deal team must co-invest, calculated on an aggregate basis. In these firms it is often up to the lead deal executive to determine how much each of the deal team are required to co-invest. Some make this determination by reference to previous carry payments received, or by looking at total cash compensation previously received. In those cases where carry payments are used to determine co-investment, there is a risk that carry becomes less meaningful to more junior employees who view the link between carry and co-invest negatively.
Most firms at the roundtable offer the opportunity for employees to co-invest on a voluntary basis. These firms noted that such schemes generally have a high uptake amongst eligible employees. Employee participation in such schemes is generally on a non-fee basis, and in some cases, firms facilitate leverage arrangements to enable employees to participate if needed. Eligibility for employees to voluntarily co-invest varies among firms, with some setting a minimum tenure ranging between 6 months and 2 years, and others allowing all employees above a certain grade to co-invest, subject to any local regulatory requirements.
Carried interest remains a topic shrouded in secrecy. While all carried interest compensation plans are different, many of them face similar issues when governing such plans. An open discussion of the challenges and benefits seen amongst alternative asset managers is ultimately helpful in setting a market approach that also allows employees to understand the value of carry.
Authors: Lewin Higgins-Green, Ellie Avni, Dominic Elias, Lucy Bills
Footnotes:
1: Unrestructured Market Value (“UMV”) is the value of shares immediately after a chargeable event and under the presumption that there are no restrictions.
2: Memorandum of Understanding (“MoU”) is a statement of intent between two parties, indicating an intended common line of action. It often starts as the starting point to negotiations.
3: Link
4: Link
Date
juin 18, 2024
Contacts
Managing Director, Head of EMEA Employment Tax & Reward
Senior Director