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A practical guide for general partners, limited partners and portfolio-company management PRIVATE EQUITY COMPENSATION AND INCENTIVES

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  • A practical guide for general partners, limited partners and portfolio-company management


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    Published in April 2012 byPEISecond FloorSycamore HouseSycamore StreetLondon EC1Y 0SGUnited Kingdom

    Telephone: +44 (0)20 7566

    © 2012 PEI

    ISBN 978-1-908-783-06-6

    This publication is not included in the CLA Licence so you must not copy any portion of it without the permission of the publisher.

    All rights reserved. No parts of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means including electronic, mechanical, photocopy, recording or otherwise, without written permission of the publisher.

    The views and opinions expressed in the book are solely those of the authors and need not reflect those of their employing institutions.

    Although every reasonable effort has been made to ensure the accuracy of this publication, the publisher accepts no responsibility for any errors or omissions within this publication or for any expense or other loss alleged to have arisen in any way in connection with a reader’s use of this publication.

    PEI editor: Anthony O’ConnorProduction editor: William Walshe

    Printed in the UK by: Hobbs the Printers (

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    Figures and tables ix

    Introduction xi

    Section I: Interviews on compensation trends 1

    Q&A: A placement agent’s expert view on the fundraising cycle’s dynamics 3With each cycle in private equity-style fundraising new concepts emerge and long-standing negotiation points rise and fall. Alan Pardee of Mercury Capital Advisors tells PEI’s Anthony O’Connor what compensation and incentives issues limited partners are expected to focus on in the coming years

    Q&A: An Asia Pacific limited partner’s view of compensation and incentive terms 11The choices limited partners face in Asia Pacific private equity are complex, challenging and evolving fast. Wen Tan of Squadron Capital talks to PEI’s Anthony O’Connor about how investors are working to develop a true alignment of interest with region’s general partners

    Q&A: The diversity of infrastructure strategies and how this shapes compensation and incentives 19As infrastructure continues to mature into a fully fledged institutional investment strategy in its own right, Richard Anthony of Evercore Partners advises that new and experienced fund managers should carefully consider infrastructure fund terms, avoiding the temptation to simply mimic those seen in private equity

    Section II: In-depth chapters 25

    Crafting carried interest provisions in the limited partnership agreement 27By Marc Biamonte, James Board, Matthew Judd and Morri Weinberg, Ropes & GrayIntroduction 27 Carried interest fundamentals 27





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    Common carry models 29The devil’s in the detail – drafting points to consider 30Which carry structure is best? 35Conclusion 36

    A review good-leaver/bad-leaver provisions and joiners issues 39By Kate Simpson and Nigel van Zyl, Proskauer Rose LLPIntroduction 39Investor focus 40Carried interest 40Co-investment 45Clawback and escrow 46After-tax basis 48Settlement arrangement with leavers 48Conclusion 50Checklists 51

    Allocation of carried interest 51Leaver arrangements 51Ongoing record-keeping 51

    Management fee versus priority profit share 53By Mariya Stefanova, PE Accounting InsightsGeneral principles and future trends 53Management fee versus priority profit share 54What is the rationale for the priority profit share? 55Management fee/PPS calculation 55Management fee calculation – an example 57Accounting treatment 61Summary 64

    Carried interest – a fund accountant’s perspective 67By Mariya Stefanova, PE Accounting InsightsCarried interest: substance and legal form 67Why is it called carried interest? 67UK and US tax aspects of carried interest 68Carry participants 69Types of carried interest models 69Carried interest modelling – useful advice 75Definition of a waterfall 76Clawback provisions 76Accounting treatment for carried interest 77Summary 83

    Trends in key economic terms in the Asia Pacific region 85By Matt Feldmann and Ryan McCarthy, Clifford Chance LLPIntroduction 85Management fees 86





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    General partner revenues 88Carried interest 89Employee incentive arrangements 90Summary 91

    The impact of Europe’s AIFM Directive on private equity compensation 93By Solomon Wifa, O’Melveny & Myers LLPIntroduction 93Definition of remuneration 94Remuneration policies and principles 95Remuneration guidelines and governance 96Disclosure requirements 96Impact on private equity 97

    Co-investment: Its crucial role in alignment of interests and incentivisation 99By Shawn D’Aguiar, SJ Berwin LLPIntroduction 99Benefit for limited partners 99Benefit for the general partner and its team 100Benefit for the portfolio company 100Amount of co-investment 101Approaches to structuring and contributing the general partner’s commitment 102Conclusion 105

    Management participation model – common/preferred participation 107By Michael J. Album, Trevor J. Chaplick and Donna L. Yip, Proskauer Rose LLPNarrative to the model 107

    How US private equity compensates management through the investment lifecycle 113By Steve Rimmer & Aaron Sanandres, PwCIntroduction 113Pre-signing compensation due diligence 113Executive ‘buy-in’ on prospective compensation 115Sizing of long-term equity incentive awards 117Vesting conditions 117Issues arising during investment period 118Treatment of management equity at exit 121Conclusion 121

    Portfolio-company management incentives 125By Marc Hodak, Hodak Value AdvisorsThe (sometimes hidden) power of incentives 125Incentives and control 126






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    Why equity is not enough 126Target variable compensation: the first step in incentive-plan design 126Subjective measures for bonus distribution 129Target-setting 130Plan leverage 131Management versus board’s role in establishing incentive plans 133

    Legal aspects in managing portfolio-company senior management 135By Scott Price, Kirkland & Ellis, LLPIntroduction 135The goal of legal arrangements 135The concept of ‘fairness’ 136Material provisions of legal documents 137Severance 139Restrictive covenants 141Dispute-resolution provisions 142Exiting the relationship 142Conclusion 144

    How to attract and retain talent 147By Simon Buirski and Simon Francis, LancorIntroduction 147Mitigating risk 148How to position ‘reward’ 150Careers not just jobs 151Incentivising executives to perform 152Operating partners 154

    Trends in real estate compensation 157By Roy J. Schneiderman, Bard Consulting LLC and Amy H. Wells, Cox, Castle & Nicholson, LLPIntroduction 157Strategies and structures 157Fees 159Other sources of compensation 166

    Setting management incentives in a venture-backed context 169By Stuart Chapman, DFJ EspritIntroduction 169Bonuses work best in packages 170The real cost of options 170Time is an overarching consideration 171Good leaver/bad leaver provisions 171





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    Section III: Compensation data 173

    The 2011 Private Equity Compensation Survey 175Private Equity InternationalIntroduction 175Respondent profiles 176Key job functions compared 177Pay scale within specific job functions 179Carried interest 182Other compensation methods 182

    About PEI 183


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    Figure 5.1: Diagram illustrating where, in a typical fund structure, executives may receive compensation and incentives 42

    Figure 10.1: LPs’ views on areas of fund terms where alignment of interests can be improved and where improvement has been witnessed in the past six months 101

    Figure 13.1: Bonus plan leverage 132

    Figure 13.2: Conventional bonus plan 133

    Figure 18.1: Average total compensation in 2010-2011 176

    Figure 18.2: Average base salary in 2010-2011 177

    Figure 18.3: Average performance-related bonus in 2010 178

    Figure 18.4: Average projected 2011 bonus 179

    Figure 18.5: CFO compensation in 2010-2011 – total cash figures 179

    Figure 18.6: COO compensation 2010-2011 – total cash figures 180

    Figure 18.7: Senior GP compensation in 2010-2011 – total cash figures 180

    Figure 18.8: Controller compensation 2010-2011 – total cash figures 180

    Figure 18.9: Fund accountant compensation 2010-2011 – total cash figures 181

    Figure 18.10: Senior accountant fund operations compensation 2010-2011 – total cash figures 181

    Table 7.1: Simple whole-of-fund calculation 72

    Table 11.1: MBO mathematical analysis: management participation model – common/preferred participation approach (Capitalisation table) 109

    Table 11.1: MBO mathematical analysis: management participation model – common/preferred participation approach ( Option plans) 110

    Table 11.1: MBO mathematical analysis: management participation model – common/preferred participation approach (Management pre-tax disposition scenarios) 111

    Table 16.1: Distribution of management fees charged during the investment period 165

    Figures and tables



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    The dynamics driving incentives and compensation in private equity and other private investment classes follow the inevitable pendulum swing of interests which understandably rocks in favour of certain individuals and entities at different stages of the economic cycle. As these asset classes continue to mature and practitioners become better at engaging, communicating and negotiating with each other, new levels of sophisticated compensation and incentives terms become best practice.

    Without well-conceived and expertly structured incentives, there is likely to be little in the way of attractive compensation for practitioners in private equity, private equity real estate and infrastructure. However, arriving at an optimum level of aligned interests and suitable levels of remuneration and profit-sharing can create a whole series of challenges which need to be provided for with increasing levels of business, legal and technical skills.

    Private Equity Compensation and Incentives is designed to provide all practitioners in private equity, private equity real estate and infrastructure in all regions with a contemporary expert resource written by leading professionals, who spend their working lives at the cutting edge of compensation and incentives.

    As well as understanding the theory behind incentives and compensation models, general partnerships that apply the best models and structures send clear signs to the wider market of being successfully organised and well managed. The more prepared general partners are, the more they are able to maintain a steady capital flow from and to their limited partners and can also manage the best performance from their portfolio companies.

    This brand new publication presents expert guidance on how to structure and implement the most appropriate models and best practices across private equity, real estate and infrastructure at the general partnership (management company), limited partnership and portfolio-company levels.

    Expert lawyers, consultants and advisers candidly share their detailed understanding and in-depth know-how and why-so of the minutiae of compensation and incentives models, terms and best practices. Readers can therefore learn how to achieve the best solutions and outcomes and get the insider view on how to avoid the common pitfalls unprepared practitioners commonly make. A selection of these includes: common mistakes at the fundraising stage; ineffectively managing the share of carried interest at


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    the general partnership level; presenting limited partners with untenable terms; and not understanding how to make to best hires to run portfolio companies and create value. As you’ll see from the table of contents on the following pages these topics and many more are addressed.

    This expert guide should be used in the spirit of how it was conceived: to provide guidance and consultancy and to allow you not only to benchmark but also to sense-check how you approach these very complex topics and how the improvements can be made to your business.

    The various interviews and chapters in this publication have been compiled to take you on a journey and to build up your own expert understanding of how to achieve the best outcomes and solutions for your business, whether you represent a limited partner, a general partner or a professional advisory or consultancy company.

    Anthony O’ConnorPrivate Equity International

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    1 Q&A: A placement agent’s expert view on the fundraising cycle’s dynamics

    PEI: How are limited partners in private equity-style funds generally positioning themselves to invest in the evolving fundraising markets?

    Alan Pardee: As limited partners have re-engaged with investing in private equity-style funds there has been a lot of scrutiny of the existing relationships with general partners in terms of their firms and funds. Re-ups were never automatic but they are receiving the greatest level of scrutiny they have had for some time. Investors are evaluating each firm that they have a relationship with to determine whether that relationship should still stand as it relates to the next fund going forward. At the same time, limited partners are assessing funds which are in the market that are new to them to make determinations about which one they should partner with going forward. Compensation ties in very tightly with that analysis.

    How have the experiences in the wake of the global financial crisis shaped the backdrop of limited partner negotiations in fund terms?

    AP: In North America, the limited partners involved in closely shaping the ILPA guidelines since they were first issued in 2009 have continued this work by going out into the market to negotiate actively with their general partners. Many limited partners expressed concerns that there should be a very close alignment between the general partner and limited partners with respect to how fees and incentive compensation are handled. In

    With each cycle in private equity-style fundraising new concepts emerge and long-standing negotiation points rise and fall. Alan Pardee of Mercury Capital Advisors tells PEI’s Anthony O’Connor what compensation and incentives issues limited partners are expected to focus on in the coming years

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    5 A review good-leaver/bad-leaver provisions and joiners issuesBy Kate Simpson and Nigel van Zyl, Proskauer Rose LLP

    The reality of every business is that changes in personnel will occur. For private equity managers, the legally distinct but interconnected vehicles that make up fund structures and the common use of limited liability partnerships (LLP) as management vehicles create some issues specific to fund managers. These include allocation and vesting of carried interest, fund-level impact of departures (for example, key-man events and change-of-control provisions) and stapled co-investment rights.

    Although this chapter does not seek to deal in detail with situations where executives have employment rights (it is generally assumed they will be LLP members), it is important to be aware that anti-discrimination will nonetheless apply.

    A private equity manager’s position with regard to personnel issues is also an area of focus for investors that want to assure alignment of interests between the executives and investors. As such the make-up of the management team and allocation of carried interest and co-investment are increasingly relevant, as evidenced by investor due diligence and greater focus on key-man and change-of-control provisions in fund documents. In addition, investors will often want to understand carried interest allocations among the team and vesting arrangements to ensure the right members of the team are properly incentivised to work towards the success of the fund. In addition, common provisions in fund documents that provide investors with protection, such as escrow arrangements, clawbacks and guarantees will impact on the internal arrangements.


    This chapter discusses:

    How fund investors undertake detailed due diligence on funds and management zvehicles about how leavers and joiners are accounted for.

    The precise detail of how different types of leavers and joiners will influence the zway carried interest is structured and shared at the manager level.

    The importance of understanding how escrow, clawback and guarantee zarrangements, how they impact at the manager level and the fund level.

    All relevant issues and aspects of a leaver’s settlement agreement to ensure that zthe private equity house is sufficiently protected.

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    Chapter 5: Private Equity Compensation and Incentives

    Accordingly, it is important that private equity managers incorporate procedures into the their funds and management vehicles to deal with personnel issues such as leavers, joiners and promotions and to deal with the arrangements negotiated with investors in the fund, such as clawbacks and escrows. While it is not possible to cater for every situation, a well-thought- through infrastructure will generally allow managers the flexibility to cope with a wide variety of personnel changes. As such, when putting fund and management structures in place, managers should seek, so far as they are able, to future-proof the documentation and to create structures and processes that are adaptable and durable.

    Investors, when undertaking due diligence on a fund, will spend time focusing on how compensation and incentive arrangements are structured in the management vehicle. This will include how the carried interest in the fund will be allocated between the executives, how the management vehicle is owned, how profits in the management vehicle are shared between executives and who is participating in the executive co-investment arrangements in or alongside the fund and how this is funded. The key focus for investors is to ensure proper incentivisation of the management team and an alignment of interests between the investors and the executives.

    A manager, when dealing with leavers, should also bear in mind that departure may impact on certain provisions that have been agreed with investors during negotiation, such as key-man suspension events, key-man notification provisions and change-of-control provisions at the manager level.

    Most fund documents include provisions that require a specified group of executives to devote substantially all their business time to the affairs of the relevant fund. These provisions will typically also require that investors are notified of any relevant departure which sometimes extends to departure of the wider investment team. It is, therefore, important that the manager carefully considers how a leaver’s exit is managed in order to ensure that these provisions are not triggered. In addition, it is becoming more common for fund documents to contain provisions requiring that the manager be substantially owned by its executives. To the extent that a leaver has a significant ownership share, the manager will need to consider what arrangements are put in place to deal with the departed executive’s interest in the manager in order to ensure that there is not an inadvertent breach of any relevant provisions. A breach of a change-of-control provision may give the investors the right to either suspend the investment activity of the fund or possibly remove the manager.

    In determining how the carried interest in a fund will be held, a manager should take into account the tax position of the carried interest holders, as well as the overall structure and nature of the fund and the nature of its investments and returns. Most private equity funds seek to produce capital gains and, as such, for UK and other carried interest holders, for whom capital gains are taxed at lower rates than income, vehicles which are tax-transparent tend to be popular structures, with limited partnerships being the most commonly used vehicles. Some executives may, having taken their own professional

    Investor focus

    Carried interest

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    7 Carried interest – a fund accountant’s perspective By Mariya Stefanova, PE Accounting Insights

    Carried interest or carry in private equity jargon is, in substance, a performance fee – a reward for good performance. In layman’s terms it is similar to a bonus payable to the carried interest partner (CIP) for doing a good job, which means that carried interest is conditional on performance. If the general partner’s/manager’s performance, that is, the returns it generates for limited partners in the fund it manages hits certain targets (the hurdle), the CIP is entitled to receive (often subject to some limitations called clawback provisions) a bonus or performance fee called carried interest, which is in simplified terms usually a certain share (usually 20 percent) of the profits. Since it is performance-related, carried interest is designed to incentivise the carried interest holders; therefore it could be regarded as an incentive mechanism. In terms of legal form, in many jurisdictions, carried interest is commonly structured as an ownership share with the relevant legal and tax implications as explained below.

    Based on my experience of teaching fund accountants, many people interestingly do not know why the concept is called carried interest. With reference to its etymology, many incorrectly associate the word ‘interest’ with bank interest (I have no idea why) rather than interest in a fund or limited partnership. Asking fund accountants about the meaning and origin of the word ‘carried’ usually results in stony silence in the training room.

    As a brief explanation, there is a parallel to be drawn between carried interest and a highly geared investment return for the CIP. The CIP injects a very small percentage

    Carried interest: substance and

    legal form

    Why is it called carried interest?

    This chapter discusses:

    UK and US tax aspects of carried interest in private equity. z

    The nuanced differences between different carried interest models. z

    The accounting treatment of different models underspecific frameworks. z

    How to prepare fro the impact of regulation change in the asset class. z

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    Chapter 7: Private Equity Compensation and Incentives

    of the initial capital of the fund, often referred to as ‘skin in the game’, but receives a disproportionately high return on its tiny investment – the rest of its investment/interest in the fund is carried, in a way, by the limited partners (LP).

    The prevailing question is whether this tiny investment is really an investment from the CIP’s perspective and whether carried interest can be regarded as an equity return on realisation. I do not claim to have the definitive answer, but I would say that we can probably view it in this way.

    Without claiming to be tax expert, I think it is worth mentioning some tax aspects because taxation of carried interest, in the UK as well as in the US, is generally derived from the premise discussed above – namely that the CIP, whether the founder partner (FP) in the UK or the general partner (GP) in the US, has an interest (mostly carried by the LPs) in the partnership and the carried interest is a return on that investment in the fund. Therefore, part of the profits the CIP is allocated will be capital gains and will be taxed on the basis of capital-gains tax (CGT) and not income tax. If the manager/CIP were raising invoices for carried interest payments, this approach would be viewed by the tax authorities as a performance fee and, accordingly, income tax would be the appropriate form of taxation.

    In the UK, in addition to the benefit in the tax treatment of carried interest mentioned above, there is an added benefit of base-cost shift (BCS). BCS is an extension of the reallocation of profits from the LPs to the CIP/FP (to be explained in detail later in the chapter) that is derived from the concept that if the interest in the partnership of the CIP/FP is carried by the LPs, later when profits/gains are to be distributed to LPs, a certain proportion (usually 20 percent), corresponding to the CIP’s carried interest in the partnership, should be shifted or reallocated from the LPs to the CIP/FP. Not only are the profits and the fund’s assets shifted or reallocated, but also a similar proportion of the tax-deductible base cost associated with those assets, which further reduces the effective rate of the CGT on carried interest.

    With reference to tax treatments, they have been agreed (including carried interest and the priority profit share (PPS)) between the British Private Equity and Venture Capital Association (BVCA) and the UK’s HM Revenue & Customs (Inland Revenue at that time) in two memorandums of understanding, dated May 1987 and July 2003, respectively. However, any potential future challenges to the present agreements are likely to be politically motivated as evidenced by the ongoing situation in the US, as of early 2012, which is described in more detail in the following paragraphs.

    The US Internal Revenue Service (IRS) accepts (at least currently) that carry is a ‘profit interest’, that is, a profit share and not remuneration. This, however, may change with the American Jobs Act of 2011 (a job-creation plan featuring tax reliefs to stimulate jobs, funded by tax increases), unveiled on September 8, 2011, which includes proposals to tax carry as ordinary income. The issue about carried interest taxation has been publicly debated for a number of years in the US.

    UK and US tax aspects of carried


    In the UK: base-cost shift

    The US experience

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    8 Trends in key economic terms in the Asia Pacific regionBy Matt Feldmann and Ryan McCarthy, Clifford Chance LLP

    As in the US and Europe, general partners of private equity funds investing in the Asia Pacific region have traditionally enjoyed superior bargaining power in negotiations with investors seeking higher returns than would be available with traditional investments. However, over the past five years, investors in the Asia Pacific region as elsewhere have been increasingly pushing for – and obtained – more favourable investment terms. This is partially a result of a more difficult global fundraising environment as well as increased transparency and coordination among institutional investors in the region.

    In the course of negotiations with general partners, it has become commonplace for investors’ legal counsel to refer to the ‘post-Lehman period’ or otherwise cite the economic downturn that began in the West in 2008 in support of a decidedly pro-investor shift in what are considered ‘market’ terms in the funds industry.

    Undoubtedly, fund sponsors from all regions have had to work harder to find capital, particularly in North America and Europe. While funds in the Asia Pacific region have certainly been impacted, the effects of the global economic slowdown on fund terms in the region have been somewhat mitigated by the fact that investors in the West have increasingly looked to the Asia Pacific region as a source of growth and hence higher returns, and have targeted funds with a focus on the region.

    In addition, new private equity investors continue to surface in the Asia Pacific region, where the emergence of new high-net-worth investors has outpaced the West in recent years.


    This chapter discusses:

    How investor scrutiny and negotiations are reducing the level of management zfees and requiring more manager costs to be attributed to these fees.

    Investors are carefully examining miscellaneous revenues received by the general zpartner of the fund and revenues in connection with other funds.

    With more focus on investor-friendly waterfalls, whole-fund waterfalls are more zcommon than deal-by-deal structures in the region.

    Why investors are looking more closely at general partner compensation and zcalling for general partners to implement carried interest sharing programmes.

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    Chapter 8: Private Equity Compensation and Incentives

    While investors in the Asia Pacific region are certainly perceived to be in a stronger negotiating position than they were five years ago, the extent to which this shift is the result of global economic developments, as opposed to other driving factors, is unclear. Increased organisation among limited partners and improved transparency with respect to fund terms, resulting from the increasing role of investor organisations such as the Institutional Limited Partner Association (ILPA) and the publication of its widely read private equity principles, have arguably affected negotiations between general partners and investors at least as much, if not more, than recent economic events. Such efforts to increase investor cooperation and knowledge of the market might have an even stronger effect in the Asia Pacific region than in the West, as private equity is less developed than in more mature markets, and hence more amenable to change.

    With these driving factors in mind, this chapter discusses recent trends in key economic terms found in fund documents in the region. While other fund terms of a more legal nature (for example, no-fault divorce, key person, transfers, co-investment rights, advisory committee involvement, reporting, excuse rights, and limited partner consent rights) are not discussed, it should be noted that these terms have also been the subject of some movement in recent years, possibly even to a greater extent than key economic terms.

    Not surprisingly, one of the first topics discussed with general partners is often the management fee, as this has a direct impact on the bottom line for both parties. As in the West, private equity funds in the Asia Pacific region have traditionally charged a 2 percent management fee. Investors have generally viewed the management fee as part of the general partner’s overall compensation package. Since management fees are fixed, a general partner could be certain that its business would have a quantifiable income stream, irrespective of the performance of the fund’s investments. In good times, this model was generally accepted and only the largest investors would receive discounts from the standard 2 percent fee. Investors did not seem bothered that the general partner might receive management fees in excess of its overhead expenses.

    In recent years, however, some investors in the Asia Pacific region have begun to see things differently after having witnessed general partners make a profit through the management fee even as the fund’s portfolio suffered major losses. Instead of viewing the management fee as part of the compensation package received by the general partner, investors began emphasising that management fees should be based on reasonable operating expenses and reasonable salaries. Investors are more likely to take the position that the purpose of the management fee is not to guarantee the general partner’s overall profitability, but instead to provide the general partner with adequate cash flow to ensure that its overhead expenses are paid while it manages the fund. As a result, while a 2 percent management fee continues to be most common in Asia, funds in the region are more likely than before to offer lower management fees of 1.75 percent, down to as low as 1.25 percent.

    However, discounts are granted more often than not through rebates to anchor and other key investors rather than to all limited partners. In Australia, fees below 2 percent are often the starting point.

    Management fees

    The standard 2 percent

    management fee

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    9 The impact of Europe’s Alternative Investment Fund Managers Directive on private equity compensationBy Solomon Wifa, O’Melveny & Myers LLP

    This chapter provides an overview of the scope and impact of the Alternative Investment Fund Managers Directive (AIFMD) on private equity compensation and discusses some of the practical implications of the directive’s requirements on private equity firms. The AIFMD was published in the Official Journal of the European Union (EU) on July 1, 2011 and entered into force on July 21, 2011 with the aim of providing a harmonised regulatory framework across the EU for alternative investment fund managers. Implementation of the directive into the national laws of EU member states has to be completed by July 22, 2013. The scope of the directive is broad and, with a few exceptions, covers the management and administration of all “collective investment undertakings” which are not subject to the UCITS Directive.1 These include investment trusts, hedge funds, private equity funds, commodity funds, real estate funds and infrastructure funds.

    AIFMD is primarily focused on the regulation of the alternative investment fund manager rather than the alternative investment fund itself and it does not restrict underlying investment activities in the same way as the UCITS Directive. The extent to which AIFMD impacts on the fund will depend on, among other considerations, where the fund manager is established, where the funds managed by the fund manager are authorised

    1 UCITS (Undertakings for Collective Investment in Transferable Securities) are investment funds that have been established in accordance with UCITS Directive (adopted in 1985). Once registered in one EU country, a UCITS fund can be freely marketed across the EU. Managing over €5 trillion in assets UCITS have proven to be successful and are widely used by European households. UCITS are also regularly sold to investors outside the EU where they are highly valued due to the high level of investor protection they embody.


    This chapter discusses:

    The remuneration aspects of the AIFMD paid by fund managers and directly by zthe fund entity including carried interest payments.

    The principles set out in Appendix II of the AIFMD relating to remuneration policies, zbalanced remuneration, payments to staff and performance-related payments.

    The role ESMA will play in providing guidelines on best practices relating to fund zmanagers’ remuneration policies.

    Any private equity executive engaged in making investment decisions in the funds zthey manage will be subject to rigorous and complex rules and regulations.

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    16 Trends in real estate compensationBy Roy J. Schneiderman, Bard Consulting LLC and Amy H. Wells, Cox, Castle & Nicholson, LLP

    Private equity deal structures in general, and manager compensation in particular, have been impacted in the aftermath of the financial crisis that began in 2007. Real estate equity investment vehicles have not been immune from this change. This chapter reviews current manager or general partner compensation trends for various investment strategies and vehicles in the real estate equity arena.

    In terms of structure and governance, real estate investment vehicles look very different from the structures and governance that existed pre-Lehman. In terms of manager compensation, for the most part, the impact has not been seen in dramatically different or new compensation structures, but rather has manifested itself in the same structures but with terms generally more in favour of the limited partner investors.

    This chapter will focus on some of the more important trends in compensation for real estate investment vehicles.

    There are three or four major investment approaches or strategies in real estate private equity. In this chapter we will use the traditional tripartite approach and combine core-plus with core as there is not a dramatic distinction between core and core-plus compensation structures. However, there is a substantial differentiation in compensation structure among the other three real estate investment styles. Brief descriptions of each style and some compensation themes are described below.


    Strategies and structures

    Real estate investment


    This chapter discusses:

    The main investment strategies and vehicles in real estate private equity and zcompares how compensation differs for each.

    The range of standard incentive fees and increasingly non-standard incentive zfees in the asset class, describing how they tend to be calculated.

    How management fees are applied in real estate private equity and how feature zin different investment vehicles and at various stage of the investment cycle.

    Ancillary fees earned by real estate managers to supplement their income, zranging from development fees to charges applied to asset sales.

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    Chapter 16: Private Equity Compensation and Incentives

    The core investment strategy is the least risky of the strategies. It involves acquisition and management of existing buildings that a) are fully or near-fully leased; b) do not require substantial short-term capital improvement dollars; and c) are conservatively leveraged. Befitting this strategy’s relative lack of risk, core compensation structures are more orientated towards cash flow than capital appreciation. And core investment structures generally have the least focus on incentive-based compensation. In today’s market, core investments are typically targeting leveraged returns, before manager fees, in the range of 8 percent to 12 percent. The recent Management Fees & Terms 2011 study by the Pension Real Estate Association (PREA) indicated an average target before fee return of 11.2 percent.

    The value-added approach is the next highest on the risk spectrum. The strategy involves a) acquiring existing buildings which, in most cases, are generating some operating cash flow; and b) spending capital to improve the asset in some manner, and thereby either increasing lease revenues or reducing operating costs. Often value-added properties have higher-than-market-rate vacancy, lower-than-market rents and/or require substantial capital improvement dollars to spruce up interiors and fix antiquated operating systems. Examples of value-added investments are a) improving the occupancy and tenant mix at a retail mall; b) systematically renovating apartment units; or c) improving the common areas of an office building and introducing ‘green’ building systems. Value-added investments combine the routine management elements of a core investment with the capital appreciation elements of an opportunistic investment (discussed below) and thus their compensation structures, like their risk profile, slot in between the other two strategies. Currently value-added investments are typically targeting leveraged returns, before manager fee, in the range of 12 percent to 18 percent, with an average as reported by the PREA study of 17.2 percent.

    The opportunistic strategy has the highest risk. Either there is no current income or the current income is at substantial risk due to high leverage or market conditions. These investments include land without perfected development rights, ground-up development, substantial renovation and repositioning, highly leveraged investments, investment in emerging markets and other high-risk approaches. Opportunistic investments are generally focused on capital appreciation and thus have the highest emphasis on incentive compensation. Opportunistic investment vehicles are typically targeting leveraged returns, before manager fee, in excess of 18 percent, with the PREA study average being 20.6 percent.

    Real estate private equity has a wide variety of investment structures, and compensation structures can differ substantially depending on the investment vehicle structure. The more common structures are briefly summarised below. It is also important to note that there is a tendency for certain investment strategies to be found in certain investment structures. However there are many exceptions to this generalisation to be found in the marketplace.

    Open-ended funds are typically large, multi-investor funds. The size of an open-ended fund varies, but is often in the billions of dollars and typically includes a manager co-




    Real estate investment


    Open-ended funds

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    17 Setting management incentives in a venture-backed contextBy Stuart Chapman, DFJ Esprit

    Management, management, management is the cliché often used by venture capitalists to describe the three most important factors of an investment’s success. This chapter aims to describe some of the tools available to retain and incentivise management teams in venture companies.

    A senior role within a major corporate will usually bring with it a large salary, the potential for sizeable cash bonuses, exhaustive benefits including pension and health insurance, plus a modest capital or stock plan. It may also bring with it centralised decision-making, corporate politics and unfulfilled ambitions. Whatever the reason that motivates the senior executive to leave the relative low-risk environment of the corporate world to join the high-risk roller coaster that is venture, the potential rewards, both financial and personal, need to be significant.

    Incentive packages are designed to reward executives for the roles they perform and a share of the potential value that they create. The difference between role and value is very important and often not understood by management or investors. Reward for the role that the executive plays within the company is the monthly salary, benefits and potential bonuses he receives.

    Bonuses offer the executive with ability to earn further monies for outperformance against a set of agreed objectives. Unlike in a large corporate, executives’ objectives within a venture-backed company can be directly linked to those efforts that drive shareholder


    This chapter discusses:

    Bonuses need to be time-based and limited to help facilitate the company’s zstrategy.

    Capital schemes are generally the most appealing to executives but also attract ztax authority scrutiny.

    For investors creating an option pool, it is important to remember the capital- zdilution issue.

    Clear vesting details and good-leaver / bad-leaver provisions need precise zconsideration.

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    18 The 2011 Private Equity Compensation SurveyPrivate Equity International

    Private Equity International’s 2011 annual compensation survey was set against a backdrop of greater public and political scrutiny of the how executives in the asset class are compensated and how this money is taxed in the US. As private equity practitioners were being surveyed in the two-month window to January 2012, it was becoming clear that the former Bain Capital executive Mitt Romney was heading towards securing the Republican Party nomination in the 2012 Presidential Election against President Obama.

    Despite private equity executive total remuneration being scrutinised by media organisations and political groups across the US and around the world as election fever builds, this greater focus on a quintessentially private asset class did not dent interest among the 96 respondents who shared their earnings data, albeit on an anonymous and confidential basis.

    PEI commissioned US-based compensation and data consultancy firm J. Thelander Consulting to run The 2011 Private Equity Compensation Survey, which examines earnings a year in review. Throughout December 2011 and January 2012, a diverse range of US-based professionals, including chief financial officers (CFO), chief operations officers (COO) and investment and operations professionals were asked to complete an online questionnaire. All attendees at PEI’s CFO & COO Forum in New York on January 19 and 20, 2012 were also invited to participate. They were asked, among other things, to provide figures for their base salary and performance-related bonus in 2010-2011, the


    This section presents the results of Private Equity International’s latest annual compensation survey. It provides a useful barometer of how professionals working in a variety of job functions across private equity, including CFOs, COOs and other job titles, were remunerated in 2010-2011, allowing professionals to benchmark against the industry averages.

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    Section x: Private Equity Compensation and Incentives

    bonus they expected to receive for performance in 2011 as well as if they have a share of the carried interest pie.

    Industry experts working across a wide variety of private equity firms responded to the survey, ranging from small, boutique venture capital firms though to large-cap international buyout firms.

    The findings are a revealing insight into compensation in today’s private equity industry and an essential resource for anyone who wants to benchmark their compensation against what the wider industry is being paid. For private equity firms, the results provide a useful indication of how to cost human capital and how to fairly compensate employees.

    Representatives from buyout firms accounted for just over 30 percent of all respondents, private equity growth firms made up nearly 20 percent of replies and venture capital firm employees accounted just over 33 percent. A total of 51 respondents work for private equity firms managing less than $1 billion of assets under management whereas 21 work for firms managing assets totalling between $1 billion and $2 billion.

    A range of firms headquartered in different cities and regions are represented in the survey: New York (20.2 percent); Northern California (19.1 percent); Boston (18.1percent); Mid-Atlantic (10 percent); and Mid-West (8.5 percent)-

    Respondent profiles

    Figure 18.1: Average total compensation in 2010 – 2011

    Senior GP



    General counsel

    Post-MBA analyst/associate


    Fund accountant

    Senior fund accountant operations

    Junior accountant

    200 400 600 800 1,000 1,200 1,400$ 000

    Source: Private Equity International/J. Thelander Consulting

    Private Equity Compensation and Incentives - front matterPrivate Equity Compensation and Incentives - sample contentCompensation p3.pdfCompensation p.28Compensation p55 & 56Compensation p73 & 74Compensation p81Compensation p 135 and 136Compensation p147Compensation p.153 and 154