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Goodbye yellow brick road: new compensation issues facing private equity managers

Profit distributions may have plummeted since the US private equity market dived in 2001, but professional remuneration has so far continued to rise, says Howard Rosenblum of Testa, Hurwitz & Thibeault. Here he explores what he believes to be the future for management fees, performance accountability and clawbacks.

During the Fall of 2002, The Private Equity Analyst and Holt Private Equity published a detailed survey of compensation results and practices at over 180 private equity firms. In many respects, the survey results were
not all that surprising. In the recent past, salaries in the private equity industry have increased at significant rates, and senior investment professionals at these firms remain among the highest compensated profession-als
in the U.S. While profits distributions (carried interest) all but disappeared in 2001, base salary and bonus compensation in the industry continued to rise. The results further highlighted the disparity in compensation
paid to managers at larger firms ($1 billion or more under management) compared to their counterparts at smaller firms ($300 million or less).

While the results of the survey provide interesting insights on what has happened in the industry over the past several years, it is now critical to think about the trends that will emerge in the compensation area over the next several years.

Impact of Reduced Management Fees. The past year has witnessed a number of firms cutting their management fees or even cutting their overall fund size (thus indirectly lowering their fee levels). New funds in
formation are facing intense pressure from limited partners (who may have thought current management fees were excessive) to lower management fee levels. For existing funds that deferred, or even abandoned, new fund-raising, anticipated income from additional management fees will not be forthcoming. The net result throughout the industry will be fewer available management fee dollars, which, in turn, will likely result in reduced levels of current compensation.

Attention to Clawbacks. For those managers who are facing “clawback” obligations to return excess carried interest distributions from earlier funds, management fee dollars may need to be utilized to address these obligations. In some cases, future management fees are being “traded” for forgiveness of clawback liabilities. Other managers are reserving a portion of their management fees in order to “pre-fund” potential clawback liabilities. This focus on addressing clawback liabili-ties will also result in fewer dollars available for current compensation.

Focus on Performance. As fee dollars become scarce, managers will be more prone to adjust salary, bonus and even carry based upon perfor-mance. Compensation will reflect greater shifts on a year-to-year basis,
and will put greater focus on near-term results.

Succession Planning. Within an environment of potentially shrinking current compensation, existing fund managers will also need to develop strategies to groom and incentivize the next generation of general
partners. This task is made even more difficult with the limited ability to utilize the “carrot” of near-term carried interest distributions. Senior managers will need to find a way to allow junior members to share in the
firm's economic benefits as greater responsibilities are handed over. During the late 1990s, decisions regarding compensation within the private equity industry seemed relatively easy. In the current economic
environment, fund managers will have to spend significant time develop-ing compensation structures and strategies in light of a future that may very well provide fewer dollars.

This article is reproduced with permission of Testa, Hurwitz & Thibeault, LLP.  For more information about Testa, Hurwitz & Thibeault, LLP, please contact www.tht.com

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