There is a reason that carry and co-investment by executives go together from an employer’s and a limited partner’s perspective. Co-investment, in which a private equity’s firm’s executives make a capital commitment alongside its investors, is the insurance plan that kicks in when carry fails. Given the binary outcomes associated with most carry plans, co-investment is the perfect foil to ensure that investment teams and LPs remain aligned.
For the alignment to bite, the amounts must be meaningful. Co-investment will rarely equate to the value in play in a carry program, but it doesn’t need to. Once the carry plan is below the hurdle, its value becomes zero. The co-investment now only needs to be meaningful in relation to the other components of the investment team member’s compensation to keep them motivated and focused.
No matter the personal financial situation of the investment team member, there is a percentage of annual compensation that will be painful for him or her to lose. For more senior team members, that may be 50-100 percent of total compensation (excluding carry). But for more junior team members it could be as low as 10-20 percent.
Cashflow will work in a similar way so that the more senior members of the team will have more cash readily available to meet co-investment needs. However, LPs today will require a significant amount of co-investment from at least the ‘key persons’ and often the broader team – up to 1-2 percent of the fund size in some cases. One way to achieve this is to ask the more junior team members to invest what they can and the senior people to pick up the slack. However, this invariably results in a very uneven distribution of co-investment across the team. After a few years of pay increases and promotions, that co-investment can be meaningless to the more junior team members.
For this reason, firms will do what they can to try to facilitate co-investment, often by reducing or (permanently or temporarily) removing bonus deferrals. Deferral with vesting can be a useful way to help retain employees and align them with the firm (if the deferral is directed into a vehicle linked to the firm’s performance). Removing these deferrals eases the cashflow burden on the employee (at least temporarily) and hopefully helps them to meet the co-investment requirement. However, this is at the expense of a retention device and aligning the employee with the firm.
A happy medium might be to direct an employee’s deferral into their own fund and to apply vesting to the co-invested amounts that would otherwise have been deferred into shares or cash. However, the amounts would have to be taxed prior to being invested, and if there was a forfeiture it would be difficult to reclaim the tax. A loan structure may be a feasible replacement but the administrative burden and difficulty of communicating vesting status to employees makes deferred co-investment with vesting one of the least preferred alternatives.
Arguably the most powerful way to facilitate co-investment is to provide leverage. This is most commonly offered on a ratio of up to 3:1 of the out-of-pocket commitment (ie, the team member invests $100 and the firm or third-party lender puts in another $300). This has the effect of enabling the junior people to invest more so that the investment is spread more evenly across the team.
Leverage provides a kicker to the incentive provided by co-investment. If the fund or product return drops below the hurdle, it is ‘disappointing’. If your out-of-pocket investment has declined in value it is more than disappointing. But if your out-of-pocket investment is now worthless and any further depreciation of the asset will result in a payment from you to the ‘bank’, it will definitely focus the mind.