CORPORATE LAW AND PRACTICE Course Handbook Series Number B-2186 Sixteenth Annual Private Equity Forum Chair Yukako Kawata To order this book, call (800) 260-4PLI or fax us at (800) 321-0093. Ask our Customer Service Department for PLI Order Number 57117, Dept. BAV5. Practising Law Institute 1177 Avenue of the Americas New York, New York 10036
26 Private Equity s Pixie Dust: Carried Interest Arrangements Amanda N. Persaud Wachtell, Lipton, Rosen & Katz This publication is for informational purposes only and should not be relied on as a source of legal advice. Ms. Persaud would like to thank Andrew D. Kenny and Sherri D. Reiss at Wachtell, Lipton, Rosen and Katz for their invaluable contributions. Wachtell, Lipton, Rosen & Katz 2015. All rights reserved. If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written. 341
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For many private equity sponsors, the most lucrative payouts and thus the main financial attraction to owners and employees come in the form of carried interest. As a result, sponsors find themselves regularly confronting the question of how to share carried interest across the firm. Whether an employee is an investment professional or an operations professional, the expectation and market practice is for carried interest to comprise part of the compensation package. Regardless of initial splits, exceptional performers will expect their share of carried interest to go up when a sponsor succeeds, and sponsors likewise may want to reallocate carried interest to these valuable employees. Balancing the need for continuity with a flexible approach that allows the sponsor to revisit carry splits when new hires and promotions are made is paramount to retaining and incentivizing the sponsor s talent pool. This article provides an overview of various considerations that come into play when sharing carried interest in particular, allocation approaches, classes of recipients, structuring carry rights, changes to carry splits over the life of a fund and vesting. (This article will not address tax aspects of carried interest.) A sponsor s ultimate goal is to create a flexible system, preferably early in its business cycle, so that the sharing of carried interest among owners and employees adjusts smoothly, predictably and equitably as the business matures. APPROACHES TO SHARING CARRIED INTEREST Historically, as part of the 2 and 20 model, general partners, which are typically separate entities under common control with a sponsor s management company, received 20% of the distributed net profits generated by a particular pooled investment fund after the return of the initial investment and an additional preferred return (of 8%, for example) to the private fund s limited partners ( carried interest or carry ). Nowadays, bowing to investors demands, it is not unusual to see sponsors agreeing to carried interest of less than 20%. Regardless of the percentage, sponsors frequently receive a sizable portion of the overall distributions of a successful fund to allocate internally. Private equity sponsors take diverse approaches in deciding who shares in carried interest. Often, sponsors are launched by one or more employees of another asset management or financial services firm, and the culture of the former organization, together with the contributions of the founding members, may influence how carried interest is initially allocated (for example, a preference for an even split). In some cases, carry may be shared with a third party, such as a seed investor who 3 343
receives carry as part of its financial arrangement with the sponsor. As these sponsors mature, other factors, such as new hires and promotions, particularly of investment professionals, take on greater importance in determining how to split carried interest. Most sponsors ultimately arrive at an allocation approach that makes full use of carried interest as a powerful performance incentive and personnel retention tool. Making performance and seniority primary considerations in allocating carry creates an alignment of interests. Even if not fully memorialized, an implicit understanding has developed in the industry that these considerations should be determinative of an investment professional s share of the carry pool. RECIPIENT CLASSES As personnel generally have similar expectations across a common level of seniority, carry is usually allocated by seniority. At the top are founders, who may have extensive deal networks, both on the sourcing and execution sides of the business, be responsible for investor relationships and serve as chairpersons, CEOs or other high-level strategy professionals. They tend to take a sizeable portion of carried interest relative to others in the firm, and in the case of sponsors with multiple founders who are still actively involved in the business, this can amount, in the aggregate, to 60% - 80% of carried interest. Senior investment professionals i.e., those who actively source and manage portfolio companies (including sitting on their boards), are referred to as partners in the business, typically have an ownership interest in the management company and have more than a decade of investing experience tend to take the next largest share of the carried interest pool. Other investment professionals, such as vice presidents and associates, who assist in sourcing and managing deals, generally receive smaller shares of carried interest. Today, many private equity sponsors also set aside carried interest for operations professionals, such as the general counsel, chief operating officer and chief financial officer. As sponsors have become more regulated and fund raising more involved, it has become more common for the head of investor relations, the chief compliance officer and other key operations professionals to also receive a share of carried interest. 4 344
STRUCTURING THE RIGHT TO CARRIED INTEREST Sponsor personnel who share in carried interest tend to be admitted as limited partners (or members, depending on the form of legal entity) in the general partner or other entity receiving carried interest from the fund. 2 They are then entitled to a share of carried interest when this entity makes a distribution to its owners. While most employees generally have a passive interest with limited consent rights in the general partner entity, founders (and sometimes other owners of the management company) typically also have robust consent and management rights. Rights could include a certain percentage of owners consenting to dilution of carried interest after crossing a threshold amount and consenting to change of control events. Careful drafting of the general partner s governing agreement is crucial to providing a sponsor with maximum flexibility in allocating carried interest over the course of its business cycle. Failure to provide flexibility at the outset can result in unexpected complications, particularly when a carry recipient departs the sponsor or when the allocation of carried interest is being altered. For example, if automatic removal is not built into the governing documents, then when an investment professional s employment is terminated, depending on the circumstances giving rise to the termination, such individual may continue to receive carried interest and may remain in the general partner, albeit with passive rights or none at all. 3 At a number of private equity sponsors, an employee s share of carried interest is documented in a side agreement admitting the employee to the general partner entity that is not shared with other carry recipients. Such admission agreements are particularly helpful when structuring one-off arrangements with key new hires who bring unique skills to the sponsor. While these agreements allow for discrete confidential negotiations, the general partner s governing agreement continues to memorialize salient governance, removal and funding terms. Despite the use of confidential 2. Under the Investment Advisers Act of 1940, as amended (the Advisers Act ), while the general partner may not need to separately register as an investment adviser, its employees and persons acting on its behalf are persons associated with the registered sponsor, and as such the sponsor would need to subject such persons to its compliance program and disclose any relevant disciplinary matters of such associated persons on its Form ADV. 3. Consideration should be given to whether the departure of a key employee or owner of the management company requires amendment to Form ADV disclosures, triggers an assignment under the Advisers Act requiring consent by the fund(s), or triggers a fund s governing document s key man provision. 5 345
admission agreements, sponsors generally recognize the importance of fostering a collaborative culture, which in practice means employees of the same title or those who meet certain performance metrics tend to receive the same percentage of carried interest and are subject to the same dilution and vesting terms. Sponsors will often establish special vehicles to more effectively manage how carried interest is shared by operations, administrative and non-senior investment personnel. The carry vehicle will typically be a direct or indirect limited partner (or member) of the general partner, without governance rights and employees will be granted interests in the carry vehicle. This serves as an efficient way to include a larger number of employees in the carried interest pool, as it allows for uniform terms to apply to relatively small stakes, avoids the administrative burden of having dozens of limited partners in the general partner and facilitates more efficient admissions and removals of carry recipients. REASSESSING CARRIED INTEREST SPLITS Sponsors typically allocate carried interest for a particular private equity fund upfront before investments are made. Besides tax advantages, settling carry splits early helps to temper contentiousness and prevents distractions from the real work of investing. The downside is that, given the long lifespan of a typical fund, an upfront allocation that works initially may become outdated over the life of the fund as some employees excel, others falter, and the fund s ultimate success is revealed. This downside can be mitigated somewhat through adjustments to compensation (e.g., tracking interests or a higher annual bonus), which serves as a reminder that carried interest is but one part albeit a potentially substantial part of overall compensation. The reassessment process varies among private equity sponsors. Smaller sponsors may prefer less formality, particularly if there are frequent open channels for ongoing dialogue with senior management. Larger sponsors with more employees are more likely to require formal reassessments to provide objectivity and fairness in the review process. Periodic reviews during the life of a fund may prove useful because they provide multiple opportunities to differentiate among investment professionals based on performance. However, besides potential tax inefficiencies, interim adjustments to carry splits based on periodic reviews may create the risk of increased gamesmanship or detrimental short-term thinking. No matter the pros and cons of periodic reviews, sponsors should provide proper procedures to change carried interest splits during the life 6 346
of a fund and, indeed, during the life of a sponsor. Such changes may become inevitable as new employees are hired and others get promoted or leave. Moreover, private equity sponsors that are further along in their business cycles may be faced with reassessing the founders share of carried interest in yet-to-be-formed successive funds as expectations by key employees for increases in future carried interest are brought to the fore. In such cases, assisting founders and key employees in reaching consensus is important to the business s long-term success. Awarding carry points to existing personnel or new hires means a dilution of other recipients carried interest. A common approach to addressing such changes is for founders and senior investment professionals to participate pro rata in some or all of the pool of personnel subject to increases or dilutions in carried interest when a carry recipient is promoted or leaves or a new hire is made. Another approach is to solely designate founders to participate in dilutions or increases. However, unless founders receive a substantial share of carried interest, sponsors will usually find this impractical. A less common approach is for all carry recipients, no matter how small their stakes, to participate in increases or dilutions. For employees with very small stakes, however, the general approach is to leave such percentages fixed, as founders and senior investment professionals are typically considered to be better positioned to bear adjustments. Usually, dilutions will be subject to a floor, below which some form of consent is required, whether by founders solely or by founders and other owners of the management company. RETENTION INCENTIVES: VESTING, FORFEITURE AND CLAWBACK Vesting is a valuable tool for ensuring continued alignment of interests between the sponsor, its personnel and a fund s outside investors. Sponsors generally seek longer vesting periods in order to ensure continuity of management, promote retention and preserve institutional knowledge. Similarly, a fund s limited partners prefer longer vesting periods to ensure that sponsor personnel are properly incentivized to achieve longterm success. As a result, the most common approach is deal-by-deal or tranche-by-tranche vesting. In such systems, the vesting clock will start on the date a particular investment is made, and will vest in fixed installments over time (for example, 20% a year for four years, with the final 20% vesting upon a fund s exit from that particular investment). The same schedule is typically applied to all employees, regardless of rank. Another approach is fixed vesting over a period of years based on a 7 347
fund s closing date. Fund-based vesting as opposed to deal-by-deal vesting is more typical where carry is shared primarily among founders and other key owners of the sponsor. This approach has the potential to create entrenchment when applied to other employees and, if not structured properly, could result in departing individuals retaining substantial carried interest even though they are no longer employed by the sponsor. When a carry recipient voluntarily leaves a sponsor (or is terminated without cause), unvested carried interest is typically forfeited, and thus returned to the remaining carry recipients who participate in the dilution/ increase pool. This provides an obvious retention incentive, as substantial portions of potential wealth may be locked up in unvested portions of carried interest at any given time. If a carry recipient dies or becomes disabled, all unvested carry may vest immediately, or the unvested portion may be forfeited, or a middle approach may be used for example, sponsors may award an additional period of vesting, with the (unvested) remainder being forfeited. If a carry recipient is terminated for cause, by contrast, sponsors typically require such person to forfeit all vested and unvested carried interest. The threat of losing all carried interest via cause removal acts as a strong deterrent for misbehavior, but also means that the definition of cause in the employee s contract and/or the general partner s governing agreement requires careful drafting. Typical cause events include fraud, willful misconduct, securities law violations, gross negligence and behaviors that cause reputational harm to the sponsor. Certain post-employment covenants are also typically incorporated into the cause definition such that a breach of a post-employment non-compete or non-solicit of the sponsor s investors will also trigger a forfeiture of carried interest. In this way, a sponsor can customize protective arrangements that put greater portions of employees carried interest at risk, over longer periods, with respect to those actions that are most concerning to the sponsor. Finally, there is the issue of clawbacks of carried interest. Unless a fund s limited partnership agreement requires some portion of carried interest to be escrowed, many sponsors immediately distribute all carried interest upon receipt. If a fund is initially successful, this may mean that recipients get substantial carried interest payments early in a fund s life. If a fund s later investments are not as successful, or a fund has to bear extraordinary pass-through liabilities (e.g., from indemnity obligations), the limited partners of the fund may be entitled to claw back carried interest previously received by the general partner. To ensure that all carry recipients bear their share of the clawback obligation, irrespective of whether they are still employed by the sponsor, robust powers and 8 348
remedies in the general partner s governing agreement and employment agreements are essential to retrieve distributed amounts if a clawback is ever triggered. CONCLUSION Done properly, sharing of the carried interest pie can create a unique alignment of interests among a private equity sponsor, its owners, employees and outside investors, serving as a powerful retention and incentive mechanism, especially when vesting and termination triggers are properly incorporated. While the right sharing of the carried interest pie will remain fluid over the life of a sponsor, a considered approach at the outset will pay dividends in the long run. Thus, thoughtful drafting of employment contracts and the general partner s governing agreements is necessary from the outset to manage expectations of carry recipients and minimize unintended consequences when unexpected events occur. 9 349
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