This article is sponsored by PFA Solutions.
What challenges do CFOs and heads of finance currently face when it comes to managing compensation, carried interest and waterfalls?
We carried out a small survey at the beginning of the year showing the main challenge CFOs and heads of finance are facing, and the top result was the increasing complexity of allocations and incentive plans.
This was a survey of finance leaders within our own customer base at a roundtable we hosted in New York, and it highlighted that this is a challenge for firms of all sizes. The point is that complexity doesn’t just come with size, it’s a fact of life for emerging and new firms as well.
We had Mark Feirman of Cross Rapids Capital on our webcast series in May, and he said:
“Employee compensation is obviously very important in our business. Trying to align compensation with people’s efforts is a top priority of our leadership. But trying to match that with a carry program that isn’t overly complex, that’s going to cause crazy tax issues and a lot of operational pain when people coming and going is hard work.”
Fundraises, complex waterfall calculations with bespoke terms, and new individuals coming on board with different requirements add complexity. The wider macroeconomic environment is also playing a role. Interest rate changes mean firms are belt-tightening in the face of more expensive financings and a slowdown in transactions. The US Securities and Exchange Commission’s efforts to improve transparency and disclosure have been welcomed by institutional investors, but the regulator will increasingly step in to make sure that greater clarity is available when it comes to incentive plans.
“Fundraises, complex waterfall calculations with bespoke terms, and new individuals coming on board with different requirements add complexity”
The rising interest rate also has a specific potential impact on incentive arrangements for those funds that offer carry but that also require a mandatory co-investment. Many funds want that additional skin in the game, but often those capital requirements are made by using loans or borrowings from the firm itself. These interest rate increases do therefore affect employees that have an investment in carry and have that co-investment obligation.
What additional complexities are emerging in allocation schemes?
Many CFOs and finance heads are finding that their spreadsheets do not scale over time. The growing volume of responsibilities in allocation schemes, including one-off exceptions, reporting requirements, unique vesting schedules and new leavers and joiners at successful funds has led to increasing calls for software solutions.
The number one concern revealed by our survey was the complexity of incentive plans. The number two item was reporting requirements. We are seeing more clients reaching out to us for support because as funds get larger and onboard more people, the challenges become more acute.
Often, the biggest issue is exceptions. There is always an exception with every firm and every arrangement. You may also have to deal with performance-based vesting. In the venture capital community, for example, vesting can sometimes be accelerated based on the performance of the underlying deal that the individual has invested in, which the finance team will also need to track.
How can technology solutions help increase the automation and efficiency of compensation in PE firms?
Let’s look at scaling. Most of our clients outgrow the Microsoft Excel workbooks they have created so having a centralized system with up-to-date information on terms and processes can help.
Technology solutions also help to address the issue of key person risk. The worry is that the one person who lives and breathes the data and who understands how all the allocations work leaves. That risk is significantly reduced with an automated system.
The other real benefit of introducing an automated technology solution is efficiency. We see clients with deal-by-deal allocations of carry where a fund could have 30-50 different investments, and they are trying to manage allocations at the deal level or sometimes even at the investment tranche level. Our system helps to automate so much of the nuance involved in managing these allocations, which speeds processes up and brings real cost savings.
Firms can also see what carry that is available to be allocated more easily with an automated system. This is especially helpful when it comes to hiring new people, which usually involves working through all of the existing allocations to figure out what can be pulled from where, and how. If this report was part of an automated process, you could immediately see what carry is available for a given investment in a fund and you can streamline that onboarding process.
How else can digitalization support lean operating teams?
Feedback from our clients shows that it is really all about automating a core facet of compensation and being able to provide transparency back to employees and investors. The forecasting capability is also valuable when you take the current macroeconomic picture into account. With dealflow being down, firms want to be able to forecast what new grants of carry is going to be worth, so helping firms accurately communicate the potential impact to partners of the firm and the employees who receive carry is invaluable.
“Interest rate changes mean firms are belt-tightening in the face of more expensive financings and a slowdown in transactions”
As well as helping clients to calculate their allocations, we are also advising them on how to use these tools to help in areas beyond everyday operations. For example, the visibility that firms can get when they forecast for the first time provides valuable insights for business leaders, and they can continually re-forecast where necessary to look at how potential changes will impact carry allocations over the longer term.
There is also an increased trend among our clients for total compensation reporting, which allows people to see not only their base pay, their bonus and their carry, but also their comprehensive benefits package. We have helped a segment of our clients get to the point where they can produce that kind of statement, and it is very useful in the current context of a challenging employment market.
Finally, more than 300,000 accountants have left their roles in the US since 2020, according to data from the American Institute of Certified Public Accountants. We are also seeing fewer college graduates signing up to join the profession, compounding the problem. This talent shortage enhances the pressures on already-lean operating teams, so automated solutions which can help to drive efficiency and increase the productivity of those professionals are going to be in high demand.
Are there benefits for employees and investors in bringing more transparency into these processes?
There is an ongoing war for talent in the private funds industry. Everyone is looking to lure the best graduates from the top universities or to pull people from other firms that have the experience they need. The added transparency piece that comes with automation allows firms to communicate with every individual employee about what exactly is on the table when talking about total compensation packages. Being able to show what equity allocations are worth today and how they are likely to change over time adds weight to that conversation.
Isabel Chirase at Drive Capital was also on our webcast at the end of last year and she said that automation allowed her firm to “create a new level of transparency for team members.” She added: “Historically, it was just kind of PDF statements that we were distributing. Now employees can look at their vesting schedules, they can understand where they sit relative to the fund. This has been one of my first big pushes in breaking down barriers and getting more alignment in the organization.”
From an investor standpoint, LPs want to see exactly how carry is being allocated, how it is being accrued over time and how well those systems are working. The capabilities that we provide for our clients, to be able to show deal-by-deal and tranche-by-tranche what is being paid, can help. Technology allows firms to show LPs that they are paying fees in accordance with their LPAs.
Finally, a lot of the big institutional investors are now crafting bespoke arrangements where it could be that they are paying lower fees because they are going to co-invest alongside the firm on a deal, and then this dynamic becomes even more interesting. The typical ‘two-and-20’ carry model may not apply when you have some investors ‘riding shotgun’ with the fund on specific deals. This has implications for calculating both carry and management fees.
Richard Change is co-founder and managing partner at of PFA Solutions