Alternative asset management compensation
- Structuring and design
- The annual administration and event cycle
- Escrow and clawback provisions
- Accounting and reporting
Combining best practice and expertise across alternative investment funds and employee incentives industries.
Carried interest is an incentive and compensation arrangement provided to alternative asset fund managers to align their interests with the fund’s investors. Given it represents such a significant element of compensation, one would assume that carry arrangements receive the same care as other corporate and employee incentive schemes, however, this is often not the case.
Carry arrangements are either managed in-house or by third party fund administrators. Often, in-house solutions can prove to drain resources and create increased risks for fund managers. Outsourcing has therefore become a more popular bolt-on service.
As carry arrangements expand in scope and complexity and come under ever increasing scrutiny from regulators and tax authorities, alternative asset fund managers are understandably turning to corporate and employee incentive specialists to support these important requirements. The advantages of this approach are compelling.
In an international, returns-driven context, the domicile of alternative investment funds will always be determined on facts. International advisors are ethically bound to act with integrity, in the best interests of their clients.
Putting aside the various tax-related considerations given to the fund structuring process, by leveraging the extensive understanding of alternative investment funds across multiple regions, we are able to shift the focus of the industry to a more product-led, jurisdiction agnostic and collaborative approach. This is likely the most effective approach in delivering best in class services to alternative investment funds.
When it comes to the design and structure of the carried interest schemes, there is added complexity when it comes to alternative investment deals and the waterfall modelling which is often applied to these structures. The multiple variables outlined in the owner’s agreement can mean each waterfall structure varies, however, working with trusted advisors and service providers can draw on their understandings of the common components in relation to methods of return and provisions for the investors and sponsors. The importance of structuring the carried interest arrangements to align with the interests of the investors, managers and sponsors is paramount in designing the incentive mechanism.
Sanne has seen the benefits of working with managers on their carried interest waterfall before the launch of a fund to ensure that this meets their expectation. This approach avoids potential issues arising further down the line when distribution payments are made.
An appropriately structured fund distribution waterfall can assist in driving the motivation of managers and investors to executing and achieving the fund’s investment strategy. Putting aside the considerations of the common features of a carried interest scheme, an ever more important aspect to the structuring process is the mechanism and timing of distributions for the managers.
In order to attract and retain the best management team, managers look to different ways in which any profits can lead to liquidity events for their team before the end of the fund. The ‘deal by deal’ model, albeit with applicable claw back provisions, as opposed to a ‘whole of fund’ approach caters for this scenario.
Sanne is seeing firms exploring variations of either model in order to address and achieve the different goals of the managers, reflecting such terms within the limited partnership agreement.
Investors and managers should carefully consider the structure of the carry scheme and consult with their administrators to leverage the broad experience and local knowledge where possible.
The tax efficiency of carried interest, particularly relevant in the UK, is dependent on a few characteristics of the arrangement to ensure it complies with the regulatory requirements imposed by local tax authorities.
Despite the Disguised Investment Management Fees (DIMF) rules having applied since April 2015, they are still often overlooked during the structure and design stage, therefore, posing a potentially significant risk to the fund managers. Over time a fund structure can become more complex, with the establishment of offshore entities/trusts as well as co-investment and mandatory remuneration deferral structures in line with regulatory requirements. It is worth noting that these structures can raise a number of other tax issues, not least with regard to disguised remuneration, and it is important to understand whether and how the DIMF rules and other provisions apply by liaising closely with advisors and service providers to establish how such matters will be assessed and co-ordinated. Design and documentation can be maintained by an administrator like Sanne to ensure they are made available to the authorities on request.
Annual administration and event cycle: Allocations, forfeitures, vestings
Due to the very nature of alternative investment funds, the average period of each fund being between ten to twelve years, the carried interest vehicles can place an exponential strain on the administrator over the lifetime of a series of investments.
As carry plans can be complex, it can create additional burden on the firm when juggling against their core strategic objectives. Sanne can assist by providing administrative assistance and guidance throughout the lifecycle of the scheme(s). Throughout the design and launch of a carried interest scheme, administrators like Sanne can build a clear understanding of the objectives.
Implementation and communication programmes should be clear and delivered in a timely fashion. Administration is an outsourcing specialism and removes the risk and costs associated with managing and processing data in relation to complex arrangements.
Sanne takes a unique approach by appointing specialists across a wide range of corporate and fund structures and combining their expertise to provide a flexible and scalable service. As a result, our teams have a high level of technical knowledge across all aspects of alternative investment funds, applying their broad experience to handle any queries and provide the necessary guidance where applicable. Record-keeping is at the core of everything, and whilst it might not seem particularly onerous, it is vital that the data is accurate and up-to-date. Administrators will often utilise the efficiencies brought by bespoke systems and software, designed to maintain data records and facilitate regulatory reporting. Overlaying this with an intuitive and intelligent portal, such as Sanne’s customised and industry recognised web portal application, enhances participant engagement and processing efficiencies for reporting and capturing instructions.
Sanne has delivered significant cost efficiencies for firms when transitioning from managing complex and onerous administrative tasks via manual process on spreadsheets, to a well-established and digitised service delivery framework. Tasks include carried interest specific processes for allocations, capital contributions, distributions, valuation reports and management information. This ensures the vehicle is properly operated under the required framework and all documentation is maintained and audited in a transparent and compliant manner.
The accuracy of the data administered by a third-party allows reports and management information to be created in customised formats and made available via a portal.
Comprehensive functionality offered through the software simplifies and automates administration of allocations, vestings, calculations, terminations and communications.
Distributions: Escrow and clawback provisions
The order of priority and timing of distributions made to limited and general partners are set out in the limited partnership agreement. Distributions may be made in the form of cash or securities, with securities typically taking the form of listed equity as a result of an IPO. Distributions can be a particularly sensitive element to the administration of carried interest, especially given the heightened emotive aspect of receiving significant components of an individual’s compensation. There are benefits in considering the use of a third-party escrow services provider, such as Sanne, due to the independence and confidentiality it brings when distributing payments. Escrow payments ensure that there is a third-party to regulate the effective and timely completion of the distributions to the beneficiaries, minimising the risks in a convenient and confidential manner.
Depending on the design and structure of the scheme, distributions will be calculated on an aggregate cumulative or whole basis, offsetting realised losses against previously realised gains. As a result, later losses can eliminate earlier gains so that, on a fund as a whole basis, the overall return for investors may fall below the hurdle rate and earlier carried interest distributions prove to have been overpayments.
Most funds therefore impose a clawback provision on the carried interest vehicle that requires the repayment of any excess carried interest it receives. This obligation is often supported by Sanne’s escrow services, retaining a portion of the general partner’s carried interest for distribution at a later date.
Reclaiming any overdistribution can be challenging in practice, especially if previous payments have been invested or spent. Many investors demand escrow and “claw-back” arrangements so early over-payments can be returned if the fund underperforms as a whole. Occasionally, we find that limited partnership agreements include interim clawback provisions thereby adopting periodic measurements of distributions throughout the life of the fund.
The obligation to meet clawback payments sits with the firm’s senior partners and an escrow account can mitigate any risk in managing those guarantees.
Accounting and reporting
In addition to the periodic financial, tax and regulatory reporting required for the fund, alternative asset management firms use different accounting approaches for carry. Some account for carry on an accrual basis or use the cash basis to record carry as it is paid and received. Others use option valuation techniques to determine carry at the beginning of a new investment.
It is fundamental to set the legal structure, design, process and procedures, and rules of engagement as effective and efficient as possible. Key stakeholders and third parties will need to be involved at early stages to understand their roles, responsibilities and obligations. Given the emphasis on the fiduciary duties of all parties over the course of the lifecycle of a fund and carried interest vehicle, any framework and governance must be sufficiently robust to ensure a compliant yet flexible management process.
Shervin Binesh, Director of Corporate Services, Sanne Group