This executive reward option can motivate fund managers and encourage long-term growth, say Chris Lebâcle, Technical Manager of Carried Interest, and Shane Hugill, Head of Executive Compensation Services, Intertrust Group
Carried interest finds itself in the spotlight after being targeted for tax changes by the UK’s main opposition party, Labour.
It is an executive incentive plan used by private equity and real estate fund managers (the fund managers) to reward executives and employees within internal funds teams (the carried interest members) with a share of investment profits.
The shadow chancellor, Rachel Reeves, announced last month that up to £440m a year could be raised by taxing carried interest – or carry – as income rather than gains.
Under current rules, carry is taxed at the capital gains rate of 28%, rather than the higher income tax rate of 45%. Labour’s proposal – which would treat carry as a management fee, not a capital gain – forms part of its wider tax and spending review.
For many in fund management, human resources and executive compensation, however, the system offers several benefits.
Carry is paid to carried interest members as a reward for long-term investment growth, based on a fund’s success. As a direct incentive, it therefore encourages those members to maintain focus on how their funds perform.
So, crucially it benefits not only those who receive it, but also institutional investors, such as major pension funds (and their beneficiaries) that often invest in the funds.
How does carried interest work?
Most funds have strict performance criteria that must be met before carried interest is paid. Regulations also cover how long the investment must be held before carried interest members can potentially benefit from capital gains tax rates rather than income tax.
In the US, this only happens after funds have been held for three years, with a similar rule in the UK.
The tax treatment of carried interest is under continual scrutiny, so it is important for fund managers to make sure their structures are appropriate for the regulations in place. These ever-developing regulations limit scope for malpractice as fund managers must ensure detailed and accurate records are maintained and appropriate reporting completed.
The amounts that carried interest members can receive depend on the fund’s specific arrangements. Only top slice returns on fund performance bring potential for carried interest, and an Internal Rate of Return (“IRR”) or hurdle rate must be met before any carried interest becomes payable, ensuring the focus is on strong performance.
The total carried interest sum is split at a predetermined ratio between participants. So while the total carried interest plan may bring a 20% return, an individual’s holding may be as little as 1%.
For example, for a £1bn fund with a hurdle rate of 10%, only investment profits over £100m would be subject to carried interest. If the fund returned £101m, then £1m would be attributable to carry.
But carried interest members do not necessary benefit directly as that £1m profit must be shared with other third-party investors. If the carried interest vehicle has a 20% holding, the return of carried interest will be 20% of £1m, that is £200,000. This is then apportioned to the carried interest members so a member holding 1% of carry, will get £2,000. So the actual returns on carried interest are not as inflated as some think.
Over a fund’s typical ten to twelve-year life cycle, the first three to five years generally focus on investment and growth. Only after this can the fund consider divesting and reaping the profits of those investments. Carry can only be paid after that – often after a longer period, with five to seven years a typical timeframe.
This gives carried interest members an incentive to invest personally in the fund – and hold it for the medium to long term. Carried interest members usually target long-term growth because a successful track record helps them attract new investors for subsequent funds. The fund’s assets are also usually sold to another fund, again making sustainable growth important.
Carried interest directly links reward with sustainable growth
There is usually no automatic pay-out in carried interest plans. Because they are connected to the success of specific funds that carried interest members work on, the members have an incentive to make a return that clears the hurdle rate agreed at the outset. This gives both carried interest members and investors a clear view of goals and rewards.
The timeframe of carried interest schemes can also help ensure sustainable growth, encouraging long-term commitment and discouraging asset stripping. While this is sometimes a concern, it is not something we have actually seen happen.
Working with a partner to manage a carried interest plan
Carry plans are complex and administering them in-house can be a challenge, particularly in the face of complex and changing regulations. Working with an expert partner, such as Intertrust Group, can offer the necessary support.
Such a partnership gives fund managers efficient access to accurate data as their teams evolve. It also ensures they can manage ever-changing tax, regulatory and reporting requirements to ensure a plan is compliant and doesn’t expose the fund to financial or reputational risk.
Carried interest may be subject to continuing scrutiny and challenge, but it is a well-established, legal form of compensation and for many fund managers, part of a well-rounded remuneration package.
A robust offering of carried interest is an important part of executive compensation plans and ultimately should benefit institutional investors.