Reinventing incentives

“Bankers set for record bonuses on back of Goldman Sachs profits” – The Times, October 2009

“JPMorgan heralds return to bumper bonuses” – The Daily Telegraph, October 2009

“Hedge funds show the way on bonuses” – Financial Times, September 2009

With an industry that has long been credited with hiring superior talent to buy, run and sell companies, it is headlines like the above which are starting to make some senior private equity firm partners think about how they attract, retain and motivate the best in-house talent. The pressure on returns, and the fact that superior returns are driven largely by the decisions made by the investment team, means that GPs are required to focus heavily on their own teams.

Historically, it was simple: reward the team with a piece of the carried interest. This incentivisation tool worked extremely well over the past decade when funds have been generating super returns over a short time horizon. As a result, private equity was able to attract some of the best talent, which previously ended up in other sectors such as investment banking or hedge funds.

The economic events of the past 12 to 24 months, and the response of the market and regulators, have changed the landscape for private equity. The timeframe of carry has been pushed out and in some cases pushed underwater. So how have some houses addressed this issue?

Simon Hamilton

Firstly, this is not a new problem and if you look around other industries the solutions start to become apparent, if maybe somewhat disguised. For instance, in listed corporates the concept of “zero price” vesting share options are common. Some GPs have used this concept to create their own “share scheme”, where the GP buys a secondary interest in their own fund from a distressed LP and allocates this interest to key members of their team. In essence, this low water marks a new incentivisation programme well before carry kicks in. For example, if a fund has a current book value of 0.7x investment cost and a GP buys this at a 50 percent discount, by the time the carry hurdle is reached – normally around 1.4x – the team has already received a 4x return.

Of course, funds need to consider the conflict issue of their other LPs. However, if the motivation is to align and motivate the whole team to work out the current fund and assets then most LPs accept the positive impact that this will have on their own investment.

Yet, while additional co-investment is interesting to more junior team members, the biggest growth area Investec has seen in relation to retention strategies are changes being implemented to the ownership of the actual management company. This is partly due to the influence and control more junior partners want over the strategy, but in some cases more partners are taking the opportunity to retire. Investec has been involved with a few funds in assisting them to structure deals to allow new partners to come in, existing partners to retire and in some cases the management team to buy out a non-core shareholder.

As private equity adjusts to the changing market of debt and regulation it would be foolish to forget that the only asset a house has is its people.

Simon Hamilton is a partner at  Investec Private Equity Partner and Fund Finance, a team dedicated to working with general partners in providing specialist debt facilities.