Carried interest - still fit for purpose?

The recent changes to the taxation of carried interest in the UK (see our summary here) have prompted many asset managers to consider the future of reward for fund executives.? It’s not just the rate at which carry will be taxed which is of note – there are various practical implications to consider under the new regime going forward.?

For example, current and new funds will have to monitor investment holding periods to determine whether the Income Based Carried Interest Rules are applicable (if appliable, carried interest should be subject to a higher rate of tax at max. 47% compared to 34.075%). Further, the government is considering introducing a minimum co-investment requirement and minimum holding period for carried interest holders for carried interest to be subject to tax at 34.075%. Even the mainstream increases to NIC and CGT rates more generally are worthy of factoring into the mix.?

There is a lot of uncertainty between now and when the new legislation will be released (expected to be later this year).? But uncertainty creates opportunity.? Or at the very least a time frame in which to ponder what the best answer might look like.? So, if the tax regime for carried interest becomes more onerous (be it via a higher tax rate or complexity of application), do we think that it will continue to be used in the same way??

Better the devil you know

At risk of stating the obvious, carried interest is the mechanism whereby the manager of a fund is paid a performance fee if the fund outperforms a pre agreed hurdle. For a team whose business is setting up a fund, raising capital, deploying the capital on value accreting assets, selling such assets at profit and distributing the proceeds to the fund investors, it is a happy alignment of interest on outcome, timing, quantum and participant. ?It also has the not inconsiderable advantage of there being developed practice around it – meaning that the industry knows what is viewed as the norm, and consequently, what is outside of the norm.

Put simply, tax is but one advantageous feature. And a (partial) loss of tax efficiency doesn’t eradicate the reality of what made it a sensible reward currency for the industry in the first place.? For example:

1. Quantum – we see examples of “super carry”, and “carry lite” – but generally everyone knows how much carry is available – there is an industry norm. Arguing for more, increasing limits, creating kickers and the like is just not a good use of time. Carry has taken the quantum debate in absolute terms off the table – there is very little noise about it.
2. Metrics – same again. There are many variations out there and the data is fascinating in terms of how these stack up between the investing focus of different types of entity. But in broad terms, the basis on which carry pays out has some clear parameters and parallels. There is no news here.
3. Time frame – funds have a life. Hence we have a real time-frame, not a made up one.
4. Recipients – there are no rules here. But many fund management entities employ small numbers of people (or are smaller units in larger entities). Who gets what is driven by practice (and data) of course. But allocations in a small team tend to have a transparency and clarity that a large programme cannot.

So, perhaps there is no news here?

But nothing stands still…

Change begets change.? The shifting tax treatment of carry will certainly change how it is used.? And this change will create further change in the sector.?

The reason for this is threefold.?

First, there has been a convergence of practice between the fund sector and elsewhere. For example, base pay is pitched at a level most reward practitioners would recognise as being meaningful. It increases on a not dissimilar basis to that which we see in other sectors.

Benefits look similar between sectors – permanent health insurance, private medical, life cover and pension all are used on a widespread basis. Nothing very surprising is happening here.

Annual bonus usage does look a little different. We do see greater variability in quantum, and certainly greater discretion applied in determining outcomes. But arguably, these are features of reward we often find in a smaller organisation – where trust and discretion often go hand in hand. In short, whether this is a fund management trait, or a scale of entity trait is a moot point.

So, the real difference lies in the long-term incentive piece of the jigsaw. And if this were to become a little more corporate in nature, it would simply represent the direction of travel the industry has been on for some time.

Secondly, the world has got much better at working out what works.? And a reward currency with a 7–10-year horizon is unlikely to be the most effective instrument to deploy other than for a very small number of the most senior players.? The concept of carry being cascaded deeper within an organisation is likely to disappear.? Necessitating its replacement with something more efficient and effective.

Finally (and most importantly), senior roles within the industry are not homogenous.? The role of someone in the Investor Relations team bears no relation to an Investment Director.? And Investment Team roles look very different to (say) a CFO or Legal Counsel position.? What the change in taxation of carry will ultimately lead to, is much greater differentiation in how people are paid within a firm.? With carry, profit share, equity (or partnership interests) in the platform and GP Commit all being used in different ways, to different populations and in different amounts.

The fund management industry has a range of reward currencies available to it.? And carried interest is but one.? The smart move will be to deploy your currencies where they are best aligned with the role.? It might mean that individuals who work primarily for the platform will have equity.? And individuals working in one fund only will have a heavy bias to carry to in the specific fund in which they work.? Some roles are focused across the funds and the platform – which would suggest a blended use of carry and equity would be appropriate.? And so on.

Is the future bright?

There is a lot of academic research and practical experience that tells us that reward in isolation cannot achieve change. If we apply this logic to carried interest, we can happily conclude that very little of the success of the fund management sector can be attributed solely to its reward programmes.? But conversely, we can always find firms who have failed because they got reward wrong.?

So, as practice develops, and tax rates change, the use of carry will change also.? But the changes will be positive – designed to better target value to those fulfilling the requirements of the role.?? The higher tax rate will, in effect, have been offset by a more targeted response. I'm not saying that the higher tax rate is a good thing (i'm happy that tax rate decisions are owned by someone else and my view on them is neither here nor there...). But I can see that the change in use of carry necessitated by tax rate changes will be positive in nature in terms of impact. There's my January positive spin for you.