Benefits And Challenges Of Using Carried Interest In a Family Office

In recent years, Family Offices worldwide found themselves struggling to retain their key employees. Family Office professionals often come from the benchmarked environments of financial or professional services, hence they are accustomed to a consistent and comparable compensation structure. In order to retain these professionals, Family Offices must compensate them to or above the market standard. This has prompted many Family Offices to replicate the compensation structure of investment firms in an attempt to retain their key investment employees and stay competitive in the talent race.

Carried interest, also known as “Carry”, is a common way to compensate investment professionals in the Private Equity sector. It is now gradually increasing in popularity as a reward and retention incentive in the Family Office world. We believe it is essential for Family Offices to familiarise themselves with remuneration practices that are common in the Private Equity sector and thereby adopt some of these for their in-house professionals. With that in mind, we have created the “Carried Interest 101” report that delves into Carried Interest and explains how it may benefit your Family Office. This is a snippet of the report discussing the benefits and challenges of using Carried Interest in a Family Office.

Benefits of using Carried Interest in a Family Office

Drawing from the data we collected for our Global Family Office Compensation benchmarking report created in collaboration with KPMG Private Enterprise, we found that while 60% of Family Offices offer discretionary bonuses to their staff, only 23% of the Family Office professionals receive a Long-Term Incentive Plan (LTIP). Among that, the most common form of LTIP offered to Family Office professionals is Carried Interest. We believe that Carried Interest as an LTIP is highly effective in retaining investment professionals in a Family Office environment.

Carried Interest operates in line with the life of the investment fund and its retention effect is particularly pronounced in the Family Office space. Family Offices value longevity. With longevity in mind, Family Offices tend to invest in asset classes like Venture Capital, Real Estate, and Private Equity that often require many years to increase in value or exit. In contrast to Private Equity firms and institutional investors, Family Offices have a longer time horizon. While the time horizon depends on the life cycle of the Family Office, generally, Family Offices seek to hold their investments for 15 + years and are known to have the luxury of “patient capital”, capital they choose to deploy whenever they deem appropriate. Consequently, they would expect their investment employees to be loyal and stay for a relatively long period of time. Carried Interest is therefore gaining popularity as an ideal measure in the Family Office space to retain and attract key investment employees, specifically those with a Private Equity background.

Carried Interest also offers several other advantages. As it is performance-based, the amount of carry a Family Office receives is linked to the increase in the value of assets, making it an effective way to incentivise their employees to generate a favourable return. The presence of a Carried Interest structure is also vital in aligning the interests of the Family Offices with the investors. With a hurdle rate in place, the Family Office will not receive carry unless the investments generate sufficient profits, meaning that they have a financial stake in the performance of the portfolio which encourages them to be diligent and prudent in their investment decisions.

The challenges of implementing Carried Interest within a Family Office

The main challenge faced by Family Offices when it comes to implementing Carried Interest lies in the investment time horizon and the structure of the Family Office. Compared to Private Equity firms, Family Offices tend to have longer investment time horizons. Many Family Offices sometimes even view these as a generational wealth creating activity and do not want to consider an exit for decades in pursuit of real value. This presents a challenge in terms of motivating investment professionals until there are realised gains. As carry is only applicable upon exit and achieving the hurdle rate, this may never even materialise. This unpredictability poses the potential risk of disincentivising employees and can potentially lead to a conflict of interest, especially if they have come from a traditional Private Equity firm.

The other less talked about challenge within a Family Office is the structure of the team and how they are rewarded. Carried Interests are generally paid to investment staff of the Family Office, often those at the executive level, including the CEO or CIO of the Family Office. However, if the Family Office has a practice of sharing carry among its key investment professionals, this can lead to dissent. A Family Office typically has a whole-fund approach to measuring performance. A whole-fund based approach to rewarding the wider team may mean a manager looking at a specific sector of investments that does well is rewarded alongside a manager whose sector does not do so well. Essentially rewarding non-performance and creating internal dissent.

Concluding Notes

Overall, Carried Interest is a great measure to attract, incentivise and retain investment professionals in a Family Office. The potential of attractive financial rewards is appealing to high-calibre professionals and will be able to attract professionals from institutional firms. The performance-based structure will also effectively align the interests of investment professionals. Ensuring the alignment of interest can foster a focus on sustainable growth and risk management, contributing to the longevity of the Family Office. It is important to note that the use of Carried Interest should be implemented in accordance with relevant laws, regulations, and best practices. In regard to that, we recommend using in-house legal and financial professionals to ensure compliance and alignment with the Family Office’s purposes and goals.

However, we would caveat this to say that this could only work if the Family Office behaves similarly to a typical Private Equity fund, for example, those that have visible exit time horizons that are similar to a Private Equity fund and a fair employee reward structure based on either a deal-by-deal or a whole-fund approach.

As for traditional Family Offices that have a longer exit timeframe, we recommend adopting the phantom equity model instead of Carried Interest to compensate their investment employees. Phantom equity, sometimes known as synthetic equity or shadow equity, mimics the benefits of owning equity in a company without actually granting the employees ownership. Employees are entitled to financial benefits associated with the ownership and can benefit from the appreciation in the value of the Family Office’s investments over time. As it often comes with a vesting period during which the individual must remain with the Family Office to receive the benefits, it effectively encourages long-term commitment.

You can access the full “Carried Interest 101” report via our website if you are interested in knowing more.

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