This article appeared in the December 2017 print edition of PEI’s Private Fund Management Magazine.
As managers expand their fund franchises and grow their deal teams, often with uniquely structured vehicles, the administration of carried interest plans can become increasingly complex.
EWM Global’s chief executive officer, Wolfgang Schroter, and chief marketing officer, Tom Pittman, explain how managing carry plans in-house can become challenging and potentially risky for GPs.
How do GPs typically manage the administration of carried interest?
Wolfgang Schroter: Typically carried interest plans are administered in-house on Excel spreadsheets. Some PE firms use their fund administrators or related law firms to support carried interest plan administration. Even in these cases Excel-based “systems” seem to be the norm. When a fund manager has one or two funds and maybe five to ten people on the deal team this approach may seem the most straightforward. In our experience, however, those one or two spreadsheets quickly turn into 20 or 30 as managers launch new funds and make changes to carry plans as executives join and leave the firm over time.
This creates significant key man risk as the person who built the spreadsheet is often the only one who understands how the formulas work and who can interpret the transactions entered. When the key person leaves, that knowledge leaves with them. An Excel-based approach does not meet today’s audit standards nor does it meet today’s transparency requirements.
How demanding is it for HR and finance teams to administer carry plans?
Tom Pittman: Private equity firms like to create bespoke structures comprised of several legal entities, including on and offshore vehicles. For firms with multiple funds and numerous executives involved at different levels in a variety of vehicles, managing how these entities ultimately pay out to individual executives can be complex to track and administer. It can become a full-time job for multiple resources, in some cases entire teams, across HR and finance.
What is the risk of failure if carry plans are administered in-house?
Wolfgang Schroter: The risk is high. Regardless of whether a firm is big or small and whether it has individuals fully or partially dedicated to carry plan administration, the risk of key people leaving remains and commonly used Excel-based “system” solutions will always be error prone and set to fail over time. In our opinion only a third party vendor can mitigate the key man risk by maintaining the knowledge within a broader team of highly skilled experts and through proper documentation. Accurate record-keeping can only be achieved via a robust IT system built specifically to handle carried interest plan administration.
Which problems can arise from relying on Excel-based solutions?
Tom Pittman: Eliminating the potential for mistakes is critical. When an executive leaves the plan and forfeits their points, tracking the underlying value and making sure those points are properly assigned—either back to the GP, existing executives or a new executive—is an example of the complexity.
Funds could be generating millions of dollars of carry payments to executives. If one of those payments is off by just a fraction it could result in a multi-million dollar mistake. Keeping track of any type of payment advanced to a participant is challenging to address on a spreadsheet. This could, for example, be a tax distribution that happens before realization or an actual advance on a portion of carry, which needs to be accounted for later.
How do individuals monitor their carry plans?
Tom Pittman: In our experience, executives receive a (hard copy) capital account statement on an annual basis. Some firms use a document aggregator or an in-house portal, where executives—if they have time to hunt for it—could find all of their carry plan documents, including a copy of the LPA and previous years’ tax forms. In some cases there is neither document cataloguing nor a library where executives can access information at a later date. Very often it falls on the individual to make copies.
How transparent is the administration of in-house carry plans?
Wolfgang Schroter: As mentioned before, we believe that in-house carry plan administration is typically not sufficiently transparent to the deal team and to management. Often, when we speak to potential clients they say that the deal team knows exactly what their carry is worth because they know what the underlying portfolio companies are worth. Roughly speaking this may be true, but carry points are not only issued to deal teams in which case executives may not always be fully aware of the inner workings of every fund and every deal. Speaking to deal teams directly, it seems there is often a lack of transparency with regard to the impact of events such as reallocation and dilution on the individual carry point allocation as well as a lack of understanding how and when realizations and withholdings were treated.
When a manager is about to launch a fund, what pitfalls should they avoid when setting up a carry plan?
Tom Pittman: In many cases, firms don’t think through the eventualities before the plan is actually launched. What happens in a forfeiture scenario or when someone leaves or is hired; what happens to the money kept in reserve when hold-back comes into play; how will the winner-loser mechanism work in an American (deal-by-deal) waterfall scenario? Managers need to define these terms, not just for administrative purposes, but also to communicate these terms to carry recipients to inform them of what will happen in specific scenarios. You’d be surprised how many firms don’t do that.
At the time of realization, which challenges can arise?
Tom Pittman: Ensuring managers net any previous advances or expenses against payments is one of the first challenges. As long as the GP is keeping track of that, when the realization happens they will automatically account for any previous advances or expenses that have been paid out. Those could be unique to each participant.
A further challenge is to manage the actual distribution. In most cases, carry is paid directly to a participant’s bank account, rather than through payroll. The manager needs to ensure that they have the accurate employee bank account information on file. An administrative error can present a real challenge, especially if the firm manages multiple distributions a year.
Taxation adds to the complexity. Typically a firm prepares data to give to its tax advisor to generate a preliminary and final K-1. They must do that for the firm and individual participants and make sure that participants receive their K1s in a timely and secure way.
You’ve described the difficulty of managing carry plans in-house. What is the alternative?
Wolfgang Schroter: The alternative is to use a third-party vendor with a robust, non Excel-based, IT system solution. As mentioned before, only a specialized vendor with highly skilled resources can reduce the key man risk by maintaining the knowledge within its team and through proper documentation. Accurate record keeping can only be achieved via a robust IT system built specifically to handle carried interest plan administration.
Tom Pittman: A system should accurately allocate a range of interests, retain a full audit trail of every transaction, manage tax and plan documentation, and capture participant bank account information for every type of carry vehicle. Accounts should be updated on a periodic basis and when it’s time to make a payment, the GP should be able to approve exactly how much executives should receive netted out automatically against previous expenses before this is communicated to executives. All relevant communication should be logged in their online message center.
Wolfgang Schroter: As a fintech company, EWM Global’s cloud-based system was specifically built in response to client demand to address carried interest plan administration challenges and is used today by some of the largest private equity firms in the world. EWM Global is the alternative to in-house administration.