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Vested interests

If the hiring market picks up, more funds may want to consider annual vesting provisions to reward better-performing employees and to hold on to senior executives.

Although the use of annual vesting provisions at hedge and private equity funds remain relatively rare, more GPs are looking at whether they are a better way to marry performance and compensation.

Jason Glover, partner at Clifford Chance, gave an example of annual vesting: if carry is divided into 10,000 points, with 1,000 points issued at first closing and then 1,000 points issued on each anniversary until the carry is fully issued (this is a simplification, as often the points allocation is non-linear). By issuing on each anniversary rather than issuing all points up front – the alternative method which is most common in the industry – one is much more able to allocate the carry to those who have done more work and generated deal flow.

“One of the dilemmas is that most carry structure allocations are made up front, so frankly the executive can come along, get that carry and potentially coast unless the private equity house is prepared to get rid of them, and in effect that person is going to get the carry irrespective of what they generate in terms of deal flow, opportunities etc.,” Glover said. “People are looking to recent times and saying maybe rewarding people with their carry allocation up front, without any reference to performance on the fund for which they are getting the carry, doesn’t make a lot of sense.”

Glover said that linking performance with carry allocation also ensures that executives are incentivised to do the deals that are going to generate significant exit proceeds as well. He said such a system typically works better for funds that are going to have an investment period of more than four years, rather than distressed debt-type funds that are investing over 12 to18 months.

Jeff Berman, partner at Clifford Chance, also said that such provisions are a way to keep fund teams intact and executives, especially senior ones, from running off to competitors. 

“Where you see it most is in institutionally sponsored funds, because they are really keen on the whole retention issue and are sensitive to competitors,” he said. “It’s definitely the senior people who the institutions are more interested in making subject to vesting provisions, because they are more marketable and more valuable.”

However, while Glover said he is getting more questions about annual vesting provisions from clients, certain tax considerations mean that annual vesting won’t work for everyone. 

“For instance, in the UK for employees, if you were to issue carry that has some value, then in effect anytime that that employee receives that instrument with value then there is tax to pay on the value,” he said. “However, while the tax is clearly a problem, for many institutions the question is ‘do we think that commercially this offers a more attractive route for compensation because it is rewarding people for actual performance?’ The general view is that it is a better way.”

Another aspect that may be holding back more funds from utilising annual vesting provisions is that the employment market for the time being is not as deep as it was a few years ago, and thus there is less of a threat of people leaving. However, there is also a flipside to that situation, which funds who are looking at adopting annual vesting should consider. “It may be easier for an employer to impose vesting and forfeiture provisions now without risking losing their employees,” Berman said.