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Ropes & Gray attorneys provide timely analysis on legal developments, court decisions and changes in legislation and regulations.
Deb Lussier: Hi, everyone—I’m Deb Lussier. Welcome to our podcast, A Word for Our Sponsors, where we talk with private equity insiders about the issues that matter most to them. Today, I’m joined by my partner, Yoni Levy. Yoni, welcome to the podcast.
Yoni Levy: Thanks, Deb—glad to join you.
Deb Lussier: Yoni, what’s on tap for today’s episode?
Yoni Levy: Today, we’re going to talk about compensation schemes at private equity firms. Historically, private equity firms and other alternative asset managers have taken a very professional and critical approach to employment and compensation decisions at their portfolio companies, but decisions about compensating personnel at the asset manager itself—be they investment professionals or operating partners—have tended to be made on a more ad hoc, less data-driven basis. In this episode, we will explore the contours of a good compensation plan and the pitfalls to avoid. To help us navigate the discussion, we’re joined today by Jonathan Goldstein, the regional managing partner for the Americas in the private equity practice of Heidrick & Struggles. Hi, Jonathan.
Jonathan Goldstein: Hi—thank you very much for including me on this.
Yoni Levy: We’re thrilled to have you. Let’s just jump right in. As you know, an asset manager, as an employer, has a whole host of levers it can pull on to incentivize and attract employees: carried interest, benefits, salary, and so on. In your experience, what are the most important factors for an asset manager to consider for attracting and retaining key personnel?
Jonathan Goldstein: While compensation certainly is important, without a good compensation program you’re not going to recruit anybody. Candidates look at compensation as the last thing that would attract them to a platform. What candidates look for initially is a great strategy, a strong track record, the ability to grow in their career, and for a great culture. If you think about it, in jobs like this people are spending more time at their firms than they are with their spouses or with their family. These are long-term propositions—you only start to make the economic returns that you’re hoping to make after a decade, so all these other things have to be in place. If those things are in place, usually compensation works out. But to get specifically to your question about compensation, there are markets for the various different sizes of funds that firms are investing out of. When you’re looking to recruit somebody, you don’t want to either overpay for somebody or underpay. What we find works best is you bring somebody in at the same compensation package as others are at the level that they are. If we’re working with a client and they find somebody who is twice as expensive, you can’t recruit that person, or the candidate has to understand that this is the package that everybody else makes. By the same token, if you find somebody who’s making half that amount, I tell my clients, “You can’t pay them a discount, because all of this stuff eventually comes out.” And if you have a firm where there are wide bands—individual deals around how folks are paid—then that just destroys the culture.
Yoni Levy: As we think about the package to put together, let’s say, for the first time a sponsor is hiring into a specific role, how would you think about setting the pay scale for salary relative to giving more points of carry to someone and the tweaks you could make around a vesting schedule? How important are those when you’re going out to seek new talent?
Jonathan Goldstein: Usually, the vesting has already been determined in the fund documents, and so, I’ve actually never seen a private equity firm able to change vesting. Now, there are caveats around that. When somebody is brought into a firm, and they’re coming from another private equity firm, sometimes folks are given carry in an older fund, as well as the carry they might be given in a new fund going forward. The studies we’ve done, where each year we get somewhere between 500 and 800 respondents, 80% of the vesting is usually between five years to eight years. Sometimes, it’s straight-line, sometimes, it might be weighted a little bit more back-ended, but that’s where the bulk of the market is. I would argue that five years is probably too fast, given the duration of a lot of these funds. Somewhere between six and seven years, six to eight years, is probably the right number, although, we’ve seen firms that have vesting over fewer years and firms that are vesting longer. The issue with having vesting that’s too long or too back-ended, you’ll lose candidates. They’ll just say, “I could be here for two years. I can do a couple of deals, and then you’ll fire me, I’ll leave, or for whatever reason, and I’ll walk away with nothing.”
Yoni Levy: To some degree, piggybacking off of your concept that the compensation package ties into culture, do you have a view on whole-fund vesting versus deal-by-deal vesting for a candidate, and potentially, giving carry in respect of products or deals that the candidate might not actually be working on directly?
Jonathan Goldstein: I’ve seen all sorts of different types of vesting programs. The good thing about fund vesting carry, is that everybody’s on the same side of the table and everybody is working hard across a whole portfolio so that everybody wins. Usually, firms that do it right will allocate 85% or 90% of the carry and leave 10% to 15% of the carry aside—if they have to hire somebody or they want to reward somebody along the way, they can do that. Now, where that sometimes can break down over time is if you have certain teams or certain individuals that are outperforming and certain teams or individuals that are underperforming, populated almost entirely by A-type personalities, it can cause resentment and dysfunction. By the same token, if you have deal-by-deal carry or if you have yearly carry, on the one hand, that certainly rewards the high performers, but it also can cause two things. It can cause an atmosphere that’s extraordinarily competitive internally. There are firms that do this, which shall remain unnamed, that are good hunting grounds for me and my team because I know everybody’s unhappy because it’s so internally competitive. The other element is that it can, at times, encourage people to do bad deals because you get rewarded for getting a deal closed, and so, there’s some perverse incentives. Now, there are certain firms out there I know that have this type of model and it works. I feel it works at these firms because they’re smaller and the managing partners of these firms spend a lot of time managing their business, managing their people, they know what everybody’s doing, they’re working as hard, if not harder than, everybody else, and there’s an esprit de corps at the firm. If you are a managing partner or a managing partner group at a private equity firm, and you have a model like this and you don’t want to spend a lot of time managing people, then I assure you that you’ll have problems internally. But if you’re willing to get involved and explain why you gave this person seven points and this person two points, and they see that you’re active, then it can work, but it takes a lot more management, which is something that is frankly in short supply at a lot of these firms.
Deb Lussier: Do you have a sense of where in the structure of a PE firm carry is typically granted on a title basis, and where there may be some other shadow bonus plan or other mechanism to get them something that looks like a return but is not, an interest in the general partner where they’d be entitled to carried interest?
Jonathan Goldstein: I should caveat the answer with the statement that the work that we do starts at the VP level and above. I would say that probably 100% of VPs and above do get carry (or close to 100%—maybe it’s 99%). Sometimes, you see it at the senior associate level—rarely do you see it at the associate level. What I have seen at some firms, if an associate or a senior associate has done a particularly good job or maybe has sourced the deal, they will be given an extra large bonus check at the end of the year. But all of these things are more unilateral decisions—they’re not in any contracts or employment agreements—and are episodic.
Yoni Levy: Deb mentioned the concept that we occasionally do, what she called “shadow carry,” where you’re not given an actual interest in the partnership, but you’re given a right to distributions that tracks what you would have as carry. That comes with tax consequences of the carry getting generally capital gains treatment, assuming that it otherwise meets the capital gains requirements where shadow carry does not, and so, you pay ordinary tax rates. Is that something that you see candidates think about or consider, or is that too nuanced for them to worry about?
Jonathan Goldstein: No, it’s absolutely not too nuanced. When I’m working with clients that don’t pay out carry and it’s treated as ordinary income, that’s the first thing that candidates pick up on—we’re talking about a significant amount that’s lost through taxes. But we see the negotiations going down to such picayune items as re-lo: “Are you going to pay me re-lo pre-tax or post-tax?” In this space, everybody’s extraordinarily sophisticated, everybody knows exactly what’s going on, and so, when they come to these negotiations—at least my experience is—for the most part, they know all the right questions to ask.
Yoni Levy: Interesting. How do you think about from both the perspective of an operating partner and an investment partner, the opportunity to co-invest within the fund or alongside the fund—both as an opportunity, and, I’ll say, simultaneously, as mandatory, culturally mandatory, or mandatory if you don’t want to be penalized by being excluded from some future investment opportunity, and balancing folks wanting opportunity versus not wanting to be obligated?
Jonathan Goldstein: Most firms need the folks coming in to write a check for their GP commit. I don’t think I’ve ever found any pressure from my clients to write a check that’s larger than the GP commit—so, their pro rata portion. But also, I find that almost all of my clients are happy and pleased if you want to write a larger check because it does show more commitment to the fund. You find folks who have grown up at a firm—they started as a VP, then a principal, and now they’re a partner—and fund sizes have gotten larger, their commitment check has gotten larger, but they might not have had many realizations on the prior funds. So, they’re actually cash poor because they’re writing a larger check and the commitment size is growing faster than their cash is growing—I don’t want to say that they’re upside down, but it hurts them more in their pocket. Now, as you know, there are banks that will provide loans for that. In some cases, the managing partners themselves will come out-of-pocket and write that check.
Deb Lussier: You mentioned subsequent funds being larger in size, and it made me think about some sponsors wanting to express the grant of carry not as points or percentages, but as dollars-at-work to take into account increased fund sizes. Have you seen a trend towards dollars-at-work or do you have any views or observations on that?
Jonathan Goldstein: I don’t know if there’s a trend one way or the other. I had a situation with a well-known private equity firm that has done very well over the years, and we were recruiting a partner over from one firm to this firm. The private equity firm came back and said, “This is what I’ll do: I’ll adjust it a little bit in terms of actual dollars, or we could keep it at this percentage. But if we raise a larger fund, then you get all that upside.” The candidate, being a private equity guy, and analyzing the situation, took the percentage. He ended up getting way more carry than he would have gotten if he stayed at his other firm, and a lot more carry than the private equity fund expected to pay him. And, to this firm’s credit, the managing partner called me up and said, “We didn’t expect to give Bob this amount”—his name’s not really Bob—“but that’s what I agreed upon, so that’s what I’m going to do.” Thankfully, they honored it, to their credit, and for me, that’s become one of the best stories I can tell about this client when I’m recruiting for this client. There’s always a fear that somebody will re-trade or not honor their verbal commitment, and in the end, I feel doing the right thing just pays incredible dividends.
Yoni Levy: I would say that that’s consistent with my many conversations with clients and investment professionals at clients: that faith in the management of the firm, both in terms of the direction of the firm—and this gets to your culture point, too—but also, faith that you can trust whomever the managing partner is, is a big deal and goes a long way towards retention.
Jonathan Goldstein: You’re absolutely right. We’re working with a firm right now which has a number of different private equity strategies, and they brought in a new person to manage all of these strategies. The new person came in and re-cut everybody’s deal in one of the strategies. That strategy no longer exists at the firm because two of the key men left, and that strategy is now gone. They had a strategy, they had money raised, and now they’ve got nothing because they went in and re-cut the deal. I see this all the time, where it’s short-sighted and penny-wise, pound-foolish.
Yoni Levy: You mentioned a bit about growing and managers that have multiple funds, and they’re complex. What do you think is the biggest challenge facing a manager that’s in growth mode, and trying to raise a much bigger fund than its previous funds?
Jonathan Goldstein: Yes, there are a lot of challenges. I think from an execution standpoint, the challenge is if you’re writing larger checks, looking at larger companies, it’s a new network and a different world—it’s different bankers, different intermediaries, different types of management teams, and now, you’re competing against different firms. Depending on where you are on that spectrum, you probably have to bring on new people, and that can always change cultures. You have to manage the people who are there. You have to learn new skills. You want to raise a larger next fund because you get more management fees. And you can also provide a path, a career, for your non-partners. But there’s a certain point at which that dynamic and the timing doesn’t match up. So, you’ve gotten larger, and then, you find you have a bulge at the principal level—you have 15 principals, but only space for three partners in the next go-around. Half of those principals have to find a new job or stick around for another five years. Well, they’re not going to stick around.
Yoni Levy: I think that’s right. I think in a lot of cases, investors will be wise to that, and you’ll have to demonstrate to investors that you think you can execute on the mandate from the broader fund. “Can we convince investors that these new personnel are just as dependable as the old guard?” Especially, like you said, most of these firms are pretty tightly held at the highest levels, and that’s why we have these key person provisions. I think it also is a sign to why it’s easier probably to grow more organically and slower, where people are naturally taking on bigger and bigger roles over time and becoming more investor-facing and the like, than it is to try to just, all at once, jump to a new level with a bigger team, acquiring outside help and hired guns for everything. I think one of the mistakes that we see, and we try to advise clients to avoid, is not thinking sufficiently about succession planning in advance, and the role that compensation of others will play in succession planning. There also needs to be some thought given to not establishing permanent compensation for the founders, or thinking about the impact that permanent compensation for the founders will have on the ability for the institution to exist after they’re gone. I imagine that’s something you talk to your clients about also, thinking about, “How are you setting up a compensation arrangement that will allow for succession in smooth order?”
Jonathan Goldstein: I’ve partnered with our consulting arm to have these conversations, but it’s a relatively new thing. Private equity, if you think about it, it’s 30 years old in a professional sense or formal sense. And so, there are a lot of firms where the managing partners are at an age where, if they’re not thinking about leaving, they’re certainly scaling back how much they’re doing day to day and they’re getting pressure from the partners underneath them to step back, and it’s really hard to do. There are so many firms out there where the managing partners do not want to step back and it creates such tension throughout the firm, but it’s something some more forward-thinking, more progressive firms are thinking about, but probably not enough. I think a lot of it depends on what the founders of the firm really want their legacy to be. I’ve seen any number of firms where the founders just want to extract as much as they can from the firm and don’t care if the firm dies on the vine after they’re gone or withers away while they’re still there, rather than handing over the reins and potentially growing a larger firm, and potentially actually even being more lucrative to them in the long run, having a smaller piece of the bigger pie, but it’s hard to do.
Yoni Levy: Right, which are cultural points that sponsors can have. I think having a fantastic track record is, of course, great, and going to attract good talent. But, beyond that, the ability to highlight that “we have a founder who really cares about the success of the firm long-term. Here’s how he or she is setting up all of the people behind them to be successful, as well” is going to play very well with potential investment personnel.
I want to pivot for a moment. Most of the conversation has focused around investment professionals and hiring them, but operating partners play an increasingly large role at private equity firms. How do you see managers finding the best operating partners? And, in a broad sense, what is the operating partner compensation market like?
Jonathan Goldstein: I often get asked, “What is the best operating partner model?” And my answer is somewhat tongue-in-cheek: “It’s in some ways almost irrelevant as long as everybody, all of the investment professionals, agree upon it.” So, if you have investment professionals who view the operating partner as a negative, then it doesn’t matter what model you have. But from the model that you have, you start to think about what type of person you’re looking for. Generally, private equity firms pull out of three buckets, three verticals: one, you’re recruiting somebody who’s already in the role; two, you’re recruiting somebody who comes out of consulting; and three, you’re recruiting somebody who comes out of a relevant portfolio company—a relevant company that’s private equity-backed in one or more of the sectors that the private equity firm is investing in.
If you go back over 10 years, operating partners used to be very senior, retired or near-retirement, and they would sit on boards, but it was a part-time role, very advisory. What’s changed is that it’s certainly not part-time for most of these roles. They’re now at all levels—you can bring in operating executives as associates, VPs or partners in some cases. And the role is, in some ways, harder than the investment professional role, in that the operating executives are usually on the road—they can be on the road three to five days a week at the portfolio companies. If they’re in the office, they’re probably not doing something right. Private equity firms in the past would hire, a lot of times, senior consultants. They’ve stopped doing that. Maybe at the VP level, sometimes at the principal level, certainly at the associate level, they’ll hire folks right out of consulting, but what they’ve found is at the very senior level they don’t have the implementation or execution skills that are necessary. Usually, at the senior level, the partner level, or the MD level, they’re looking for somebody who can sit alongside the C-level executives, and say, “I’ve been there, I’ve done that, and this is where I’ve done it,” and so can be a mentor in that respect. Although now, that said, private equity firms do like to see them having a little bit of consulting experience. The ideal profile is somebody who started out in consulting, then maybe worked at an academy company, and then worked at a private equity-backed portfolio company so they have the private equity experience and maybe they’re in an operating role already. The last jump is into an operating role, and those candidates are usually more expensive because they’ve got carry, and they have embedded carry. And so, private equity firms, more often than not, given the choice of pulling somebody out of a portfolio company will pull somebody out of a portfolio company because it’s less expensive.
To your question about how much they’re paid: There are firms that pay operating executives at the same level in the same way that the investment professionals are paid. If you’re a VP investment professional, you’re a VP operating executive—you’re paid exactly the same. That’s the minority. I would say my rough rule of thumb is that the equation is N-minus-1. So, if you’re an MD operating professional, you’re paid like a principal, an investment professional principal, and then you can go from there. In many ways, there’s much more variability in the operating partner role because you don’t have a cast of thousands, but on the operating partner side, you can have that variability where it’s harder to do with investment professionals where it has to be more systematic. So, I would say, a lot of times, it’s a triangulation: “What did this person make? Where is this person coming from? What’s their level?” Sometimes, you can pay less, or sometimes, if a person’s a superstar and they’re raising the profile of your firm, they will pay up for that, and maybe even pay in excess of what a partner will make if they’re really bringing something to the table that is outsized. But, more often than not, it’s N-minus-1—at least that’s been our experience.
Yoni Levy: That makes sense, and it’s consistent with what we’ve seen, as well, especially the part about variability. “Operating partner”—and there are varying other terms used by different firms to refer to the same concept—actually is a spectrum of roles that vary from just being an external consultant to being really something a lot closer to an employee of the manager in terms of how much time you’re dedicating to the role, and, naturally, the compensation, I would think, scales with that. We’ve seen operating partners who even want the opportunity to get the same benefits—even if they’re in more of a consulting role, to find a way to get the same benefits as an employee, in terms of health care and the like. Whereas the tension from the other side, I’ll say, is that many of our clients have arrangements with the funds where the funds pick up the cost of operating partners, and the more and more the operating partners look like employees of the manager who are doing what the managers’ employees should be doing, the less defensible that position becomes that it makes sense to be charging them because these are really external operating professionals who are there to improve the operations of portfolio companies on a case-by-case basis. A lot of times, the compensation of the operating partners might be pushed down to the individual portfolio companies, which, depending on the operating partner role, can make sense if the operating partner is really focused on one or two or three portfolio companies, rather than across a portfolio. But there’s a bit of a tension there to, like you said, triangulate the right payment arrangement based on their seniority and the value they bring, and then, also, keeping in mind the impact it has on the fund’s economics and on perceptions by investors.
Jonathan Goldstein: That’s right. What can the fund afford, and what can it do? In the LP/GP agreement, it might not be allowed to pay out of the fund. So, to your point, I’ve seen firms where they’re getting paid everything out of the fund. I’ve seen firms where they’ve set up consulting arms, where it’s entirely paid by management fees from their portfolio companies. And I’ve seen hybrids, where it’s a little bit of here, a little bit of there.
Yoni Levy: There really are pros and cons to each. I think people sometimes think “hybrid” means it will be the “easiest because you have the best of both worlds,” but sometimes, that means you have to track their time and find some way to be allocating their time—sometimes to the portfolio company, sometimes to the fund, sometimes between portfolio companies. So, a detailed discussion should be had before setting up any of these arrangements about what you’re trying to accomplish and where you’re trying to put the cost, because there can be pitfalls to each of the approaches.
Jonathan Goldstein: Absolutely—couldn’t agree more.
Yoni Levy: Great—let’s end on a point of agreement. Thank you.
Deb Lussier: Yes—thanks so much, Jonathan, for joining. This was a really wonderful conversation and, I think, will be really useful for our listeners.
Jonathan Goldstein: Thank you very much for having me on. It’s been a real pleasure.
Deb Lussier: I’d also like to thank our audience for joining us today. For more information on the topics that we discussed, please visit our website at ropesgray.com. Of course, if we can help you navigate any of the topics that we discussed, don’t hesitate to get in touch with us. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple and Spotify. Thanks again for joining us.