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.