Incentive and retention frameworks quietly shaping stability

Incentive and retention frameworks play a decisive role in shaping decision making, risk appetite and cultural alignment. When structured and executed effectively, they support long term value creation by aligning individual outcomes with organizational objectives. When they are poorly governed or constrained by administrative limitations, they can encourage short-term thinking and elevate operational risk.

History offers repeated reminders of how closely compensation structures are linked to institutional resilience. Rewards have evolved in response to market instability in the form of deferral plans introduced after the financial crisis to the growing use of mandatory and voluntary deferred compensation plans. Understanding how incentive and retention frameworks shape outcomes over time remains fundamental to any discussion of financial stability and responsible growth.

When a private equity firm establishes a continuation fund, the spotlight often lands on pricing, process, and investor dynamics. But lurking in the background is a technical – and often more contentious – issue on how to handle sponsor economics, particularly carried interest and employee co-investment.

These incentive mechanisms, essential to alignment in the legacy fund, don’t disappear when assets are rolled into a new vehicle. In fact, their complexity typically increases. How they are addressed can materially impact not just fairness and optics, but actual team motivation and retention. 

Maintaining Alignment

The core principle is simple: alignment between sponsors and LPs must be preserved. But applying that principle isn’t always straightforward. In some cases, maintaining alignment may mean diverging from how things were done in the legacy fund.

Carried Interest: Fairness, Timing, & Risk

But under a European waterfall, carry is locked until the entire fund meets its hurdle. That creates friction. If an asset is sold into the continuation vehicle before that hurdle is met, no carry is paid, raising questions about fairness to the deal team.

Clawback is another key concern. In cases where interim carry is distributed before final outcomes are known, clawback risk emerges – and must be carefully modeled, negotiated, and managed. 

Then there’s the issue of vesting in the new vehicle. Carry earned in the continuation fund generally merits a fresh vesting schedule, reflecting its own horizon. However, legacy fund vesting status shouldn’t be ignored.

Employee Co-Investments: Balancing Buy-In with Burden

In today’s competitive business landscape, many companies are revisiting their compensation strategies to better align employee interests with organizational success. One approach gaining traction is the allocation of carried interest to junior staff. This practice offers several benefits but also presents notable challenges.

Industry Trend

Junior candidates are increasingly seeking carry participation, a trend influenced by compensation practices at larger firms. To remain competitive in attracting talent from these larger organizations, boutique firms are facing pressure to expand carry eligibility, consequently impacting their overall allocation strategies. This shift underscores a growing acknowledgment of the significant contributions that early-stage employees make to a company’s growth and success.

The Challenges

1. Cost and Administrative Burden: Participants typically bear the cost of initial and ongoing investment commitments, including fees related to legal, tax, and financial advice to manage their interests. Additionally, participants must navigate the timing of carried interest payouts, which can be uncertain and contingent on the performance of the underlying assets, requiring careful financial planning.

2. Lack of Understanding: Junior staff may not fully appreciate the value of carry allocations, particularly if they are unfamiliar with the concept. This lack of understanding can result in an under appreciation of the benefits, thereby undermining the intended impact of the carry program.

3. Preference for Immediate Rewards: Many employees, especially those in the early stages of their careers, may favour immediate rewards over long-term incentives. The deferred nature of carry allocations may not resonate as strongly with junior staff, who may be more inclined toward immediate cash bonuses.

4. High Turnover: Junior staff typically exhibit higher job mobility compared to more senior employees. This high turnover rate can reduce the effectiveness of carry allocations, as the benefits may not be fully realized if employees depart before their equity or profit-sharing stakes fully vest.

The Potential Benefits

1. Talent Acquisition: Offering carry allocations can significantly enhance a company’s appeal to high-caliber junior candidates. In a competitive labor market, the prospect of having a stake in ongoing deals serves as a powerful incentive for talented individuals seeking both financial rewards and career growth opportunities.

2. Performance Alignment: Carried interest allocation aligns the interests of junior staff with the company’s success by offering a direct financial incentive linked to the company’s performance. This structure encourages junior employees to contribute more effectively, fostering a stronger commitment to the company’s long-term success compared to those who are not financially tied to the firm’s performance.

3. Reduction in Turnover: A well-structured carry allocation plan can significantly boost job satisfaction and a long term outlook for junior employees. The prospect of future financial rewards tied to long-term company performance helps reduce turnover by encouraging employees to stay with the company longer, to reap the benefits of their profit-sharing stakes.

The allocation of carry to junior employees can be considered problematic, as this group often lacks a full understanding or appreciation of the program, and may perceive its cost and administrative burden as significant. Implementing a phantom plan or offering larger bonuses offers a practical alternative, especially considering the fact that junior employees generally favour immediate cash bonuses over long-term incentives. However, companies that effectively address these challenges and clearly communicate the value of carry allocations are likely to experience substantial gains in employee engagement and organizational success.

While there is a growing push to include analysts and associates in carry allocations, the prevailing view is that Vice Presidents (VPs) should be the minimum level eligible for carry, with exceptions made for high-performing associates or analysts. As firms expand their allocation policies, advancements in compensation management technology are helping to manage the complexities associated with carry allocation.

The information presented in this article is based on discussions and findings from a round table event hosted by EWM Global on July 10^th, 2024. The views expressed herein do not necessarily represent the official views or opinions of EWM Global. EWM Global is not in the business of providing tax, legal or accounting advice, and we recommend seeking Counsel to address your specific circumstances.

Approaches to Allocation

Allocation Process

The allocation of carried interest within private equity and investment firms is largely dictated by the firm’s overall strategy, investment time horizon, and the proportion of carry retained by the “House” account. There was an agreement among participating firms that the allocation process typically commences at the top of the organization with the head of the business unit and cascades down the hierarchy, aligning with the roles and available market data associated with each level. Investment team members primarily receive carry, derived from a team pool, while support functions typically do not. On the rare occasion that supporting roles receive carry, there is a split in approach regarding whether this allocation comes from the House or the Team pool. However, allocating from the House share has the advantage of maintaining a clear distinction between investment and non-investment roles.

Junior Staff Involvement

There is a push to include analysts and associates in carry allocations, but the general consensus is that Vice Presidents (VPs) should be the minimum level to receive carry, with exceptions for high-performing associates or analysts. It was noted that larger firms are more likely to include associates in carry than boutique firms.

The notion of allocating carry to junior employees was viewed as problematic, due to the fact that this group often do not fully understand or appreciate the program, and view its cost and administrative burden as significant. Junior employees tend to prefer immediate cash bonuses over long-term incentives. Implementing a phantom plan or offering larger bonuses was discussed as a practical alternative. High turnover among junior staff further complicates administration, making senior associates better candidates for carry awards due to their higher likelihood of remaining with the firm.

However, junior candidates are increasingly expecting carry participation, influenced by practices at larger firms, which is reshaping industry norms. To attract talent from these larger organizations, boutique firms are under pressure to broaden carry eligibility, impacting their overall allocation policies.

Including Risk, HR, and Finance in Carry Allocation

Including individuals in control functions such as Risk, HR, and Finance in carry allocations can lead to conflicts of interest, as their objectivity and impartiality may be compromised by fund performance incentives. While boutique firms outlined that they may involve these roles in carry to enhance competitiveness and attractiveness, representatives from larger firms noted that they often face stricter regulations and greater scrutiny, limiting their ability to do so.

The Rising Popularity of Phantom Carry

Phantom or shadow carry replicates the benefits of actual carried interest without transferring ownership or equity stakes. It uses notional accounts to share profits based on fund performance and defers taxable income until distributions are made. This approach offers a flexible and administratively simpler alternative to direct carry, aligning incentives without the complexities of equity transfers.

While tax savings are important in carry plans, the rise of phantom awards underscores the need for flexibility throughout a fund’s life. Firms often start with direct carry schemes but increasingly adopt phantom awards when direct carry is too costly or complex. Phantom schemes are particularly appealing to junior employees, who may find the upfront cost of direct carry prohibitive. Firms are recognizing that the ability to adapt carry awards is as crucial as tax benefits.

Phantom carry is especially common in jurisdictions with complex capital gains tax treatment or in larger organizations with global operations. The diverse characterizations of carried interest across regions complicate the administration of global direct carry plans, leading larger firms to adopt phantom carry more frequently than boutique firms, sometimes structuring entire strategies around it.

Dominic Elias, Chief Advisory Officer at EWM Advisory commented: “Structuring for optimal tax treatment in the country of each participant can entail a significant amount of time and cost, and the end result is still highly varied across participants in different locations. For this reason, many firms will choose to structure their operations to optimize tax benefits for the country where the majority of the participants reside and only adjust for others when required to do so for regulatory reasons. Many will opt for a phantom plan to take advantage of the significant management and administrative benefits”.

Handling of ‘In-the-Money’ Awards

Allocating carried interest points promptly is crucial to avoid the tax consequences associated with points that have amassed value prior to allocation, sometimes referred to as ‘built-in-gains’. Once an investment surpasses the predefined hurdle rate, any awards of  ‘in the money’ carry are typically taxed as ordinary income rather than capital gains, leading to significant potential tax burdens for recipients.

Two strategies are being deployed by firms to minimize the tax consequences of ‘in-the-money’ awards, while ensuring compliance and maximizing the economic value of carry allocations:

A) Redistribution Of Forfeited Points

Pro Rata Reallocation

In this approach, forfeited points are redistributed to remaining participants on a pro rata basis, ensuring that each active participant’s relative proportion of ownership remains unchanged. The proportionality of the points must remain consistent with the original allocation to retain the desired tax treatment.

Removal of Forfeited Points from the Point Pool

Alternatively, forfeited points may be permanently removed from the overall point pool. Under this method, while the total number of points decreases, each active participant’s relative proportion remains the same. This ensures that the relative ownership among participants is preserved despite the reduction in the total number of available points.

B) Notching

Notching adjusts points to a new cost basis, which can be complex to manage. This strategy ensures that the future value of an award is taxed at a lower capital gains rate. The ‘in-the-money’ amount can either be retained within the organization for bonuses or distributed to employees as taxable income.

One strategy discussed was to hold a reserve at the outset, ensuring that points are then allocated before they are “in the money.” If this is not feasible, one of the aforementioned methods must be utilized. If the notch is excessively high or administratively burdensome, the remaining carry points can be managed as phantom carry, a commonly practiced approach.

The Dynamics of Buying Out Carry for New Hires

In public companies, it is relatively straightforward to assess the compensation that candidates are forfeiting when they join a new firm. This transparency of equity awards allows for more accurate adjustments to compensation packages. In contrast, the private market often lacks clear information on the carry that candidates are relinquishing, making it challenging to identify and verify these amounts.

Generally, buying out carried interest was not reported to be a common practice among participating firms. Instead, it seems to be preferable to replace the forfeited carry with alternative forms of compensation. This can include offering new carry allocations, providing equity, or introducing other incentives that align with the firm’s goals. By doing so, firms can create a competitive compensation package that recognizes the value of the candidate’s forfeited interests while ensuring alignment with the new organization’s incentive structures.

If managing carried interest plans is central to your role, we encourage you to sign up for future EWM Global round table events by clicking here.

The election of the Labour Party has introduced new dynamics to the fiscal landscape, particularly concerning the tax treatment of carried interest. While the Labour manifesto lacked detail, there is growing concern about its implications for private equity fund managers and the broader investment and asset management industry in the UK.

Carried interest has long been a cornerstone of private equity and hedge fund compensation, designed to align fund managers’ interests with those of investors by rewarding them for superior performance. However, its favorable tax treatment, which enables it to be taxed at the lower capital gains rate rather than as ordinary income, has become contentious. The UK is not unique in offering favorable tax treatment for carried interest, similar regimes exist in the US and much of Europe.

In a classic fund structure, the fund manager is typically entitled to 20% of the investment profits, but only after investors have recouped their initial investment plus a preferred return, commonly set at about 8%. This performance-based compensation, known as carried interest, is then distributed among the team members to promote retention and incentivize strong performance.

Labour’s Tax Overhaul

The Labour Party has identified reforming the taxation of carried interest as one of its signature tax policies. Rachel Reeves, now Chancellor of the Exchequer, has signalled a shift that could provoke significant backlash from the private equity industry. Reeves stated “Private equity is the only industry where performance-related pay is treated as capital gains. Labour will close this loophole”. The proposed changes aim to raise between £400 million and £500 million.

Currently, carried interest benefits from capital gains tax rates, which critics argue do not reflect the economic reality of the earnings. Reeves suggests that carried interest should instead be classified as a performance-related bonus and taxed in the same category as income. This reclassification could result in effective tax rates rising as high as 53% on carried interest, a drastic shift from the current capital gains taxation rate of 28% in the UK.

It remains uncertain whether a blanket employment income tax rate will be applied, or if an adjusted capital gains tax on carried interest will be introduced. The issue has sparked polarized debate, with proponents of the reform viewing it as a move toward greater tax equity. In contrast, opponents contend that it could undermine the UK’s appeal as a hub for investment management, potentially diminishing its attractiveness as a domicile for private equity and hedge funds.

A Shift in Administration Approach

Firms may respond by adopting phantom-based carry, which allocates notional shares reflecting the performance of real equity interests without conferring ownership. Unlike direct carried interest, phantom carry is taxed as ordinary income upon payment. This approach can be particularly advantageous in a higher tax environment, where there is lower or no tax advantage of implementing a direct carry structure, as it offers flexibility in compensation structures and simplifies administration.

Dominic Elias, Chief Advisory Officer at EWM Global, remarked, “A significant drawback of a direct carry plan is the requirement, for tax efficiency, to allocate the carried interest in the fund’s early stages. In contrast, phantom plans offer notable advantages by enabling more precise targeting of awards to those contributing the most over time. Many Private Equity firms are already leveraging phantom plans, and we anticipate this trend will grow if the taxation of carry changes as expected.” 

By deferring taxable events until the phantom carry is disbursed, firms can strategically align tax liabilities with recipients’ tax planning needs. The ease of administration and the ability to defer taxes make phantom carry an appealing alternative under stricter tax regimes, enabling firms to maintain similar economic incentives without the complexities of direct equity participation.

The Conflict in Regulatory Strategy

The proposed changes to carried interest taxation seem to contradict recent regulatory shifts, such as the removal of the banking bonus cap under the previous Conservative government. The removal of the cap, which had previously limited the banker’s bonuses to 100 per cent of their salary, was intended to make the UK more competitive globally by attracting top talent to its financial sector. In a positive move for the UK financial services industry, Reeves has stated that the Labour government “does not have any intention of bringing that back” and emphasized her commitment to supporting a thriving financial services sector in the UK.

In contrast, the planned reform of carried interest could discourage investment professionals and firms from operating in the UK, creating a conflict in regulatory strategy. While one set of policies aims to boost the UK’s appeal to financial professionals, the other may inadvertently undermine it.

The future of carried interest taxation in the UK remains uncertain, but it is likely to shift toward higher tax rates. Whether this will result in the full equalization of carried interest with income tax or the establishment of a different rate of capital gains tax on carried interest payments, remains to be seen. As the new government outlines its fiscal policies within the Chancellor’s autumn budget, the private equity market will closely monitor the developments to understand and mitigate the impacts on their operations and overall compensation strategies. Should changes be implemented, investment professionals will be particularly focused on the regulatory changes to existing undistributed carry awards.