Clearing the hurdle

Where carry is scarce, listed private equity funds could take inspiration from a public company compensation method to pay their partners.

With distributions scarce, and carry a distant dream for all too many, private equity firms need to get creative in how they compensate their employees, particularly the junior ones. Managers of listed funds might be able to take inspiration from a new type of public company share that has become popular in the UK: the hurdle share.

Hurdle shares are a class of equity that sits at, or near to, the top of the liquidity waterfall. Similar to growth shares in US companies, they entitle the holder to a fixed percentage of any proceeds from an exit in excess of some threshold, which is usually set at or above the company’s valuation at the time of issue.

“They are largely a reaction to the drop-off in values that became particularly acute last October,” says  David Mardle, UK head of venture capital at law firm Taylor Wessing. “They’ve started to become more prevalent as people start to work out what they’re going to do in this new world where valuations have drifted downward.”

Typically, management at portfolio companies is incentivised with shares of common equity. But in a world where valuations have dropped across the board, many portfolio companies are facing a situation where their likely exit value is going to be close to or at the liquidation preference, Mardle says. The effect of that is that the common shares won’t see a significant yield when the company is sold.

One solution might be to simply give management more senior shares, but those would incur an immediate tax penalty. Hurdle shares, on the other hand, aren’t taxed until the point of exit, when the hurdle has been cleared. Gains are also taxed at the capital gains rate rather than the personal income rate, as a cash bonus would be.

Hurdle shares aren’t just applicable to portfolio companies – at least one listed investment fund in the UK uses a similar structure to compensate its managers, Mardle says. The fund’s investment professionals have options over shares in the fund, and if the fund’s share price clears a hurdle – in this case the amount that the managers have promised to return to investors – the hurdle share pays out proportionately to the increase in value.

Of course, share prices for many listed private equity funds have sunk under their net asset values, which would defeat the purpose of the hurdle share. But with a new study by the European listed funds industry group LPEQ reporting that 53 percent of investors in such funds want to increase their exposure to the asset class over the next year, hurdle share schemes may yet become a viable option.