A major factor in some parts of the remuneration chessboard has been the performance fees private equity and venture capital funds charge, and what that means for the earnings of managers. When fees are in the spotlight, what has changed to "carried interest" over the past decade?
The following article has been written by Nigel Mills of MM&K, an advisor firm which assists companies to design and implement remuneration strategies. The article examines carried interest in private equity and similar investment enties. Carried interest is a share of any profits that the general partners of private equity and hedge funds receive as compensation regardless of whether they contribute any initial funds.
This is also part of our continued commentary on executive remuneration and governance topics. The editors are pleased to share these views; we welcome reactions. Email firstname.lastname@example.org or email@example.com. The usual editorial disclaimers apply.
Many will have read about the extraordinary level of activity that we are seeing in both the private equity and venture capital industry in the UK over recent months. According to reliable statistics, the global value of deals carried out by private equity firms is set to surpass $1 trillion for the first time this year. Investors in PE funds continue to put money into this asset class, leaving the global industry sitting on circa $3.3 trillion of uninvested cash (or “dry powder” as it is commonly referred to). In the UK alone, it is reported that 517 deals have already been completed this calendar year with an aggregate deal value of £51.6 billion ($70.9 billion), making 2021 already the highest deal value size in the last seven years, with four months still to go.
Not only has deal activity reached unprecedented levels, so have new entrants into the market both in terms of new investors and new fund managers.
It is interesting to hear that Nest, one of the UK’s largest workplace pension schemes, has announced a £1.5 billion private equity investment strategy in what is being hailed as the biggest move by a UK defined contribution pension fund into the asset class.
Last month, the Prime Minister Boris Johnson and his Chancellor Rishi Sunak issued a call to action to UK Pension funds to put more of their cash into long-term investments such as private equity and infrastructure.
DC pension funds have until now steered clear of private equity, partly because the performance fees that PE fund managers charge would put them at risk of breaching the 0.75 per cent charge cap on retirement savers’ fees. But earlier this year, the government loosened the annual charge cap making it easier for DC pension funds to accept the performance fees that are commonplace in the asset class.
It is interesting to observe that through all this activity and growth in private equity as an asset class, the one thing that seems to have remained pretty constant throughout is the size and structure of the performance fees that PE and VC fund managers are charging to their investors, their LPs, whether they be pension funds, university endowments, family offices or sovereign wealth funds.
The standard performance fee (or carry) that is charged by a direct investing private equity or venture capital fund manager on the funds that it manages in this asset class remains at 20 per cent, as it was right at the outset of the private equity industry forty or so years ago. What does this mean? In summary, what it means is that once a fund has returned all its invested capital, plus a hurdle rate of return (typically per cent per annum), to the investors in it, then 20 per cent of all the proceeds received by the fund after that point go to the fund manager, and actually slightly more than that if there is a catch-up mechanism.
A quick example illustrates the point. If an independently-owned PE fund manager raised and invested a £500 million fund and this fund generated a net return of two times money, the gain on that fund would be £500 million. Out of this “net profit” that has been generated, and assuming the hurdle IRR has been met – which one would expect that it would be given the 2 x money multiple achieved – the performance fee would be calculated at £100m (20 per cent of the £500 million).
In most funds, the performance fee is shared out among the partners and the other senior investment professionals of the fund management entity. In this way, it is in effect their long-term incentive to maximise the returns to their investors. In this guise it is typically referred to as a carried interest plan. While the way in which the carry is calculated has not really changed in forty years, the way in which it is shared out has changed, particularly over the last ten years.
Looking back at our Private Equity Survey results over the last ten years, it is apparent that the way in which these performance fees have been shared out among the team has shifted quite a bit.
In our 2010 UK and Europe Private Equity survey, 75 per cent of the "carry" typically went to the partners in the firm. In the US, this figure was 79 per cent. In our 2015 Surveys, 68 per cent of the carry went to the partners in UK/European houses, whereas in the US this figure had fallen to 76 per cent.
In our most recent surveys (2020) the percentage share of the carry going to the partners in European/UK houses had fallen to 61 per cent, whilst in the US this figure had fallen to 69 per cent. In terms of carry allocations, these are really quite sizeable shifts downwards for the partner level incumbents.
We believe that there are three main reasons for this:
1. Private equity firms have grown much larger over the years and the ratio of non-partner investment professionals to partners has increased quite a bit. In other words, there are relatively more non-partner investment manager mouths to feed through the carry plan than there were ten years ago.
2. The partners in these firms have recognised over time the importance of incentivising and rewarding their more junior talent, in particular the talent which is going to become the next generation of partners in the firm. Accordingly, they are needing to award greater amounts of carry to their investment directors and vice presidents to keep them happy and motivated and feeling that they are really wanted in the business. It is the most important retention tool that these firms have for these investment professionals.
3. There has been a small shift towards awarding more carry to the senior back-office functions. This has been partly in reflection of the fact that more and more PE investment firms are now bringing in chief operating officers and dedicated chief finance officers and heads of IR, whereas in older times these functions were often carried out by one or two of the senior investment partners themselves. There has though also been a recognition that these roles are extremely important and valuable in these firms and they deserve an allocation of carry in their own right. In fact, in order to recruit and retain the best talent in these roles, carry needs to be offered to them. The statistics show that more of these roles are being awarded carry than they were ten years ago.
If you would like further information or have any questions about the design of carried interest plans or the issues raised in connection with them in this article, please contact Nigel Mills.
MM&K is a leading independent advisor and assists companies to design and implement remuneration strategies, which support their values, culture and business plans. We operate across a wide range of sectors and have particular strengths in oil and gas, investment management (including private equity, venture capital and hedge funds), retail, media and construction.
MM&K is able to provide global remuneration advice as part of its membership of the Global Executive Compensation and Governance Network GECN. MM&K is a member of the Remuneration Consultants Group and has signed up to its code of conduct.