Junior-level shakeout

Retaining junior talent may take some creative compensation structuring for firms whose funds will struggle to collect carry. The result may be a leaner industry but with greater promise.

An unprecedented amount of capital flowing to private equity firms during 2005 to 2007 meant recruitment efforts went into overdrive. But many of the junior-level professionals brought on during the boom have yet to see their first dollar from carried interest – and in some cases, they may not see it at all.

Even some top quartile funds raised pre-credit crisis will struggle to generate carried interest based on current IRRs, according to recent research from Oxford finance professor Tim Jenkinson. That, coupled with LPs’ increasing disdain for deal-by-deal carry distribution, makes the private equity industry less attractive in the short term for junior professionals and could cause a staff retention problem.

If there’s no carried interest to divide, firms will have to find other ways to compensate and retain talent. One way this can be done is by senior partners setting aside a small tranche of carried interest from newer vehicles raised, calculated on a deal-by-deal basis, and preserved for junior partners, points out one London-based funds lawyer. Co-investment schemes too, where junior managers invest with limited liability alongside the fund, can also motivate promising GPs.

But firms – particularly those planning to reduce fund sizes going forward – may also use the scarcity of carry from pre-crisis vintages as a means of weeding out underperforming executives. “Firms cutting back often divide carried interest awards to advantage the junior staff they want to keep and disadvantage those they’re encouraging to leave,” says Graham Elton, a private equity specialist at consultancy group Bain & Company.

The end result should be a leaner industry more aligned with investor interests. For it will mean the most talented junior staffers prepared to make a long-term commitment to the asset class will be those motivated and cultivated to become the industry’s next generation of leaders.