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The best things come to those who wait …14/06/2006. Source: SJ Berwin. Josyane Gold 
 Carried interest - the management team’s share of fund profits - is a critical factor in motivating private equity executives, says SJ Berwin, and suggests that carried interest arrangements for European funds may be shifting a little in favour of managers
The deal on carried interest has not changed significantly for several years, but SJ Berwin’s analysis of recent trends in fund terms - unveiled at a seminar this week - suggests that carried interest arrangements for European funds may be shifting a little in favour of managers.
“How much?” is not really in issue - only a very few exceptional management teams achieve a profit share in excess of the market standard 20% - but “how soon?” seems to be increasingly up for negotiation.
For European funds, entrenched investor expectations mean that carried interest is usually calculated on a “fund-as-a-whole” basis - so that the management team receives 20% of the aggregate profits on the entire portfolio - often with a “full escrow” arrangement.
That means that carry is only paid to executives once there is no possibility that the under-performance of later investments would require a “clawback” of carried interest to restore an overall 20% profit share. As a result, private equity executives must often wait for several years before reaping the fruits of their labours.
This is in sharp contrast to the US deal-by-deal model, where carried interest is payable by reference to the performance of each separate investment, subject to losses on realised investments having been recouped and a clawback in the event that subsequent investments under-perform.
This model puts hard cash in the hands of executives much sooner than the fund-as-a-whole model, although there is a risk that they might have to pay some of it back.
Psychologists say that deferred gratification - the ability to wait for the things you want - is critical to life success. Investment executives in Europe have, for many years, embodied this trait. But some managers are finding that that the lengthy wait before carried interest payments begin to hit bank accounts is making it difficult for them to attract, and keep, the best talent, particularly at junior levels.
Investors have indicated that they have a degree of sympathy with managers on this issue, understanding the need for management teams to remain motivated - after all, a highly incentivised management team should lead to a highly performing fund.
Our analysis suggests that some managers are, therefore, beginning to challenge the status quo. A small number of European managers (especially those raising larger funds) have persuaded investors to accept the deal-by-deal carried interest structure familiar to their US counterparts. And even where there is no wish to challenge the standard fund-as-a-whole approach, some managers are pressing for less restrictive escrow arrangements, arguing that it is simply inefficient to have significant amounts of cash sitting in an escrow account for extended periods.
It is not yet clear whether these developments mark the beginning of a long term trend. At present, the manager-friendly fund raising climate may be emboldening GPs in negotiations, and much could depend on how long this continues.
But the seeds of change may have been sown.
Josyane Gold
SJ Berwin is a pan-European law firm with a particular focus on private equity. It has offices in London, Frankfurt, Munich, Berlin, Madrid, Paris and Brussels. If you would like further information on our services to the private equity industry please contact Simon Witney in our London office 020 7533 2222 or visit our website at www.sjberwin.com.
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