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.
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.
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.
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