Carry through the ranks

Succession planning has been discussed more in the past few years than ever before.  It is a mandatory dialogue among investors and managers in any private equity firm and is as relevant to emerging managers as it is to seasoned teams.  Many firms ignore the issue until the firm’s leaders have grey hair and are of ‘that certain age’ where retirement is looming.  It may not be at the forefront of the private equity firm leader’s mind, but it is in the investor’s mind.  And if retirement is not a manager’s focus, then certainly at least retention of the next generation should be.  If the senior managers hitting ‘that certain age’ – whatever that might be – do not move on, how will there be room at the top for the next generation? 

This article explores some of the strategies and tactics related specifically to carried interest that private fund managers may wish to consider for retention and succession purposes.

VESTING OF CARRIED INTEREST

A manager’s rights to carry are the proverbial carrot that keeps private equity firm managers aligned with investors in their focus on maximizing returns. Vesting into carry is commonly recognized as a key retention tool and is typically done as ‘reverse vesting’ where the person receives 100 percent of the interest up front, the interest is subject to forfeiture and the forfeiture risk is removed over the vesting period. US taxable managers receiving interests subject to vesting should consider making an election under Section 83(b) of the US Internal Revenue Code to have the entire interest included in income in the year of grant rather than taxed at each milestone when there is a lapse of forfeiture risk. Doing so will generally allow the manager to avoid phantom income. 

Julia Corelli

The periods over which carried interest forfeiture restrictions lapse vary dramatically among private equity firms. This is where the rubber meets the road when designing a retention strategy for key managers. There is almost always a time vesting component to the program, but other components may look to capital deployment and performance reviews, among other things.  The following four examples demonstrate considerations that can be influential:

Example 1. Firm A decided a basic time vesting program over five years would be appropriate, but was worried what would happen after five years given that the fund life was ten years plus up to three extension periods.  Firm A decided to vest 80 percent over the five years, and require that a manager had to be there to receive the other 20 percent.  Firm A also decided that:

• it had a stable firm and did not consider it necessary to hold back the 20 percent or any other unvested portion from distributions of carried interest that occurred before full vesting;

• all vested and unvested carry would be forfeited in a termination for cause, which it defined without reference to performance;

• the firm founders would not be terminable without cause and would have the authority to require other managers to leave without cause; managers terminated without cause would receive one year of accelerated vesting;

• managers who died or became disabled would also receive a year of accelerated vesting;

• it would clawback a year of vesting if the manager resigned before five years of service with the private equity firm; and

• if the individual resigned to go to a competing firm, or hired away employees from the firm or any portfolio company, then all carry would be forfeited at that time; if the manager resigned after five years, the manager would keep his/her 80 percent vested share.

Example 2. Firm B decided on a more complicated vesting approach and vested 30 percent of the interest on a time basis over four years, 30 percent  on the basis of performance reviews over six years (that is, a discretionary annual vesting of 5 percent per year), 30 percent on the basis of the managed fund’s success in deploying capital during the investment period (based on a 75 percent targeted amount invested, committed or reserved at the end of the investment period) and 10 percent upon dissolution of the fund.  Firm B also decided that:

• it would hold back any distributions that related to unvested carry, holdbacks would be released at vesting dates and forfeited if the manager left for any reason other than death or disability;

• in a death or disability situation after six years of service, the manager would be fully vested and all held back monies would be distributed to the decedent manager’s estate or to the disabled manager (or his/her legal representative);

• if the death or disability occurred before six years of service, then the manager (or his estate) became vested in 50 percent of the portion that otherwise was unvested at the time of his/her death or disability; and

• all managers could be terminated with cause (which included performance-based cause after notice and substantial opportunity for reform) upon a 67 percent vote or without cause upon an 80 percent vote; if terminated for cause, all carry would be forfeited and if terminated without cause, the terminated manager kept his/her vested piece with no accelerated vesting.

Example 3. Firm C decided on a time-based vesting scheme with equal amounts vesting per quarter over the investment period , which was the later of four years from the fund’s final closing, but not more than six years after the initial closing, or five years from the initial closing.  The number of quarters prior to end of the investment period would therefore be at least 20 (if the final close was less than one year after the initial close) but could be as many as 24 (if the final closing was two years or more after the initial closing). They vested 10 percent on the initial closing date and decided 80 percent would vest quarterly over the remainder of the investment period. For the vesting during the fundraising period, they assumed that there would be 20 quarters and if the final closing did not occur in a year (at which point an additional 16 percent would have vested, for a total of 26 percent), then vesting would be suspended and the remaining 64 percent would vest in equal quarterly amounts over the period from the final close to the end of the investment period. The final 10 percent would vest at time of distribution.  Firm C also decided that:

• in a death or disability event, a manager (or his/her estate) would accelerate the greater of 50 percent of the unvested portion of the interest or 25 percent (but would never vest in more than 100 percent);

• all managers could be terminated with or without cause upon an 80 percent vote; the terminated manager would forfeit all vested and unvested carry in a termination for cause; the same result would apply if he/she resigned and solicited or hired employees of the firm or C-level executives of portfolio companies; 

• there would be no accelerated vesting if the manager were terminated without cause, but there also was no impact on vested interests if the manager went to work for a competing organization.

Example 4.  Firm D used a stepped scheme vesting 15 percent on the initial close of the fund, an additional 40 percent at the end of the investment period and 10 percent per year at the end of years six through nine, and the last 5 percent at dissolution. Firm D decided to:

• accelerate a proportionate amount of the initial 40 percent upon death or disability during the investment period and a fixed 20 percent  upon death or disability after the investment period;

• impose full forfeiture on a termination for cause at any time; and

• provide no acceleration upon a termination without cause (but had a cash severance policy).

As the four examples above demonstrate, vesting schemes vary considerably. The specific design must be tailored to the concerns and areas of focus of the particular firm. Firm C, for example, wanted to drive managers to complete the fundraising as quickly as possible and Firm D was more interested in consistency (that is, retention) through the investment period than after. 
Stability in the management ranks was a top priority in each scheme and all of the firms emphasized long-term retention.  In each case, the manager had to be with the firm for the fund’s entire life in order to receive the full carry the manager was awarded. 

SLICING THE CARRY PIE

Carry as a retention tool is very common among the founders and their top lieutenants, but how deeply should it be shared with those below the first level lieutenant?  At first blush, this would seem to be a desirable incentive for those people to also stay with the firm, but this particular feature of carried interest dispersion has a number of considerations which may drive different outcomes as described below:

• The more junior the person is, the more likely they are to change jobs, raising the risk that vested carry is owned outside the firm’s employees. To mitigate this risk, many would subject lower down employees to full forfeiture if they resign before a full vesting period and a longer initial vesting period (and certainly no up-front vesting) so that they would not be entitled to much if terminated early on, whether with or without cause.

• Should more junior employees see what founders, first lieutenants or other employees receive? If not, the resulting closed compensation system can create office dynamics that may not be desirable.  An open compensation system has still other impacts on office dynamics and any compensation system, once opened, can never be closed. The more junior employees may need to receive their share of the carry through a separate employee ownership vehicle that is entitled to a pool of carry dollars, increasing costs of administration, but decreasing transparency and increasing control.

• Should forfeitures revert back to the founders and first lieutenants as opposed to other more junior employees? If one founder is diluted by the employee grant, while first lieutenants were not, firms will usually want to reallocate forfeitures first to restore the founder’s interest to the extent of the dilution.

• If it is desirable for a larger portion to vest on a discretionary basis based on performance, the founders and first lieutenants should consider whether the same retention and incentive objectives could be accomplished with a well-designed bonus pool. 

Julia Corelli is a Philadelphia-based partner with law firm Pepper Hamilton and vice chair of the firm’s executive committee. She also co-chairs the firm’s commercial department and its fund services group.