Successful private capital firms long ago ditched their spreadsheets and moved to digital tools for accounting and other middle-office tasks as part of a larger trend toward improving efficiencies, controls and operational transparency. But there’s one function desperately in need of the same modernization: compensation.
Private markets are eclipsing public markets, and the trend shows no indication of letting up. Alternative assets under management are primed to exceed $17 trillion by 2025 — a compound annual growth rate of 9.8% that far surpasses both global GDP and inflation, according to research firm Preqin.
With that growth has come increasing operational maturity and a focus on talent as a top strategic priority in firms of all sizes.
It’s not hard to see why. In alternative investments, success is driven far more by human intelligence, judgment, relationships and reputation than by algorithms. When your second-most important asset walks out the door (physical or virtual) every day, attracting and keeping that talent in-house is paramount.
Between salary, bonus, vesting, carried interest and management-company ownership, it can be nearly impossible for employees to know where they stand financially.
It’s no myth that many investment bankers at the analyst/associate level dream of going buy-side — the romantic fantasy of acceding to “master of the universe” status has long been supplanted by a less romantic, data-driven mindset drawn to the meritocratic culture (and highly accretive compensation model) of private capital.
But when it comes to attracting and holding on to the best and brightest, there’s no such thing as a slam dunk. While a talented young associate may make the lateral move to your firm with an eye on total compensation growth over time, there is zero guarantee that they will stay put until they reach the magical threshold of earning carried interest — typically, not until years four, five or six. From a retention point of view, those early years are the most vulnerable (a factor further intensified by today’s Great Resignation trend).
There’s a way to win the loyalty of the people who hold your future success in their hands. Offer them compensation transparency — 360-degree visibility into the issues that matter most to them as they chart their career — into everything from salaries, benefits, bonuses, carried-interest allocations, co-investments, past distributions and forecasting (or dollars-at-work).
Hidden costs and hidden risks
While private capital’s compensation system rewards longevity, it carries a hidden cost: complexity and opacity on top of the “predictable unpredictability” that is a hallmark of the industry.
It’s hard for an employee to know what they have, what they will have, what they might have or to understand the rights and obligations of both joiners and leavers. And in a clawback situation, where employees could be forced to pay back previously received carried interest, additional complexities and tax consequences can ensue for all.
The SEC has taken note. Commissioner Allison Herren Lee recently described employees with equity as investors “with much at stake,” who are nonetheless unable to determine the “full financial consequences of leaving their jobs” — essentially an “investment decision that must be made in the dark.”
This development is only one element of a larger story: the commission’s growing oversight of private funds, from proposed changes to its Form PF disclosure-of-material-events rules to a 341-page document of proposals focused on increased transparency at private funds.
Four steps to a talent advantage
The last few years have seen massive improvements in data power, automation and transparency — factors that are increasingly important to the kinds of investors firms want to attract. They also support the speed and scale required to compete in today’s private markets.
Most companies have already digitized fund administration functions like investor relations and accounting. But that digital revolution has often failed to reach the complex and sensitive field of compensation, where inefficiencies, limitations and the potential for errors abound.
That’s a huge missed opportunity. Why shouldn’t employees, who have as much (or more) skin in the game as limited partners, be entitled to the same benefits of transparency — access to legal documents, advanced reporting, sophisticated portals, scenario planning, “push-button analytics” and more? The advantages and efficiencies cut both ways.
Spreadsheets have simply outlasted their utility. Cloud-based software tools not only provide vastly improved functionality, they also offer efficiencies, analytical insights and a single point of truth. When it comes to the war for talent, that can help win something even more important: the confidence that often leads to long-term loyalty.
Here are four key principles to follow as you transition to automated carried interest and compensation systems:
Show them the money
Between salary, bonus, vesting, carried-interest, co-investment, and management-company ownership, it can be nearly impossible for employees to know exactly where they stand financially.
Simple, aggregated compensation reporting can bring them the transparency they need. Bonus points if you can add forecasting and projected earnings.
Give them the power of the portal
COVID-19 forced every company’s hand in creating interactive digital systems for communication with their employees. That gives you a head start when it comes to sharing compensation data. Limited partners already enjoy online portals for accessing portfolio information and analytics. Your people deserve the same level of enhanced, interactive reporting.
Use firmwide analytics to ensure fairness and clarity
With fundraising at all-time highs and new funds being launched regularly, carried-interest awards must be constantly restructured and recalculated to ensure fairness and timeliness of information. That’s the kind of clarity both employees and management need, especially when there is so much flux in the market.
Remember: It’s a transition not a revolution
When introducing an important reform in a sensitive area, it’s best to proceed in stages. Start by laying a foundation and migrating your allocations, vesting schedules and carried-interest reporting. Then add the portal, forecasting and co-investment tracking to reach total compensation transparency for your people.
More than ever before, talent is hard to win today and even harder to retain. With technology advancing in leaps and bounds along with growing regulatory scrutiny, you need to nail down and future-proof your administrative functions wherever you can.