Shifting pay

Private equity firms are facing a number of stress points right now: the very likely possibility of increased regulation, diminishing carry and sometimes reduced management fees for new funds, and the evolution of some of the bigger private equity firms into diversified asset managers. Each of these points has had an impact on how, and how much, private equity firms today are thinking about compensation.

“Some of our clients have done some right-sizing, they’ve proactively cut their ranks,” said Bob Braddick, the global leader of the private equity practice of HR consulting firm Mercer. “We’ve also seen people depart to start their own shops. So there’s quite a bit of churn, which we didn’t see in the good days when people were more settled in.”

There’s quite a bit of churn, which we didn’t see in the good days when people were more settled in. Bob Braddick

Those firms that have to cut pay handle the issue in a number of ways, said Gregg Passin, a principal at Mercer. Some cut pay across the board, for all levels and all parts of the business, which fosters a sense of egalitarianism. Some firms decide where to cut pay based on performance – a targeted approach that ensures that the best people are retained. And at some firms, the senior people take a disproportionate share of the cuts, in order to keep the junior talent – who may feel the pinch of less carry more acutely – from moving onto greener pastures.

It’s worth noting though, that for the moment there aren’t too many places for disgruntled private equity executives to go.

 “Outside of private equity, even though the Wall Street financial services firms have had tremendous years and paid up for it, they really haven’t started hiring to the degree that would reverse the downsizing that they did in 2008 and 2009,” Passin said. “So there is still not a particularly strong pull from other places for these core professionals. So even though there is not a lot on the table right now, there’s also the question of, where are people going to go?”

In recent years, bigger private equity firms have started adding new lines of business. Some firms have set up operational arms that work on improving operational efficiency and productivity at portfolio companies, such as KKR’s Six Sigma. Others, like Apollo, have begun underwriting their own portfolio company IPOs. And many more firms have built up their back offices, adding finance, human resources, investor relations and legal teams. 

Initially, many firms have the impulse to give these new professionals a piece of the carry, as a way of aligning their interests to those of the funds, and simply because that’s how private equity professionals have always been paid. 

But this leads to an undesirable dilution of the carry, and it may not be a sensible approach from a business perspective. Is it appropriate for the most senior person in the investor relations team to earn carry, even though the investor relations function doesn’t necessarily impact the success of the portfolio? And maybe the operations team actually deserves a larger portion of the carry, because improving the operations of portfolio companies is becoming a more powerful driver of returns than financial engineering these days.

As a point of reference, some firms are looking at how certain professionals would be compensated for their work outside of private equity, such as the general counsel or the HR director, Passin said. Often, a salary plus a bonus tied to performance goals makes more sense than a piece of the carry, and private equity managers are adjusting their compensation models accordingly.

Some of these trends were set in motion before the credit crunch, but the crisis has certainly accelerated them, Braddick and Passin said. The crisis may have the effect of permanently altering the way people in private equity are paid.

“Before, there was an all-for-one and one-for-all ethic at many of these firms. That’s being called into question both because of the economic environment and the pressure points on the private equity model itself,” Braddick said.