A ‘waterfall’ of approval

It was possible, maybe even probable, that EU regulators would have failed to appreciate the risk controls built within private equity compensation practices when drafting remuneration rules. 

However, regulators appear to be doing the right thing and making an exception for managers who adopt a “fund-as-a whole carried interest” waterfall model.

Unlike hedge funds which distribute bonuses (or carry) on an interim basis, some private equity managers only get paid after they pay back their investors all committed capital, plus a preferred return. This waterfall compensation model is much more prevalent in European funds; most funds in the US collect carry upon exiting a deal. 

Under the waterfall structure GPs are paid based on the performance of the total fund, which inherently aligns their interests with investors. Add to this some other routine practices of private equity – heavy negotiations around carried interest payments and management fees; firms that typically take stakes in their own funds – and you have an industry in which the interests of GPs and LPs are strongly aligned.

Luckily, the European Securities and Markets Authority (ESMA) recognised this alignment of interests in its draft pay rules submitted in late June as part of its mission to fine-tune core provisions of the Alternative Investment Fund Managers directive agreed by politicians in late 2010. 

In what appears to be a carve out for private equity funds, ESMA said funds adopting a waterfall model would satisfy a number of the rules’ objectives so long as the compensation was subject to a claw back mechanism until liquidation of the fund. Since the large majority of European-based funds already employ a back-ended carry model – it will instead be those funds which follow the more US-centric deal-by-deal carry model that face a greater compliance test. 

However, not all in the draft remuneration rules is likely to be welcomed by the industry. As we reported, questions still swirl around how carried interest should be reported (as a contingent interest in the fund or only at the point actual payments are received). 

Consequently the industry should continue airing their concerns as final rules are considered. ESMA will take feedback on its rules until 27 September, with the goal of adopting final guidelines before the end of the year. 

One can only hope their appreciation for the uniqueness of the private equity model spills into other areas of AIFM rulemaking. 

(By the way, for a more exhaustive review of AIFM remuneration rulemaking and its potential impacts on GP pay, be sure to check out our Private Equity Compensations and Incentives handbook, available now by clicking HERE.)