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Benefits And Challenges Of Using Carried Interest In a Family Office

by Janessa Lee

In recent years, Family Offices worldwide have been facing a challenge in retaining their key employees. The professionals working in Family Offices often come from financial or professional service backgrounds and are accustomed to a consistent and comparable compensation structure. To retain these professionals, Family Offices must compensate them at or above market standards. Many Family Offices have now started replicating the compensation structure of investment firms in an attempt to retain their key investment employees and stay competitive in the talent race. One such compensation structure gaining popularity is Carried Interest.

Carried Interest, also known as “Carry,” is a common way to compensate investment professionals in the Private Equity sector. It is now gradually increasing in popularity as a reward and retention incentive in the Family Office world. To familiarize Family Offices with this remuneration practice, a “Carried Interest 101” report has been created to delve into Carried Interest and explain how it may benefit Family Offices.

The report highlights several benefits of using Carried Interest in a Family Office. One of the key benefits is its effectiveness in retaining investment professionals in a Family Office environment. Carried Interest operates in line with the life of the investment fund and its retention effect is particularly pronounced in the Family Office space. Family Offices value longevity and tend to invest in assets classes like Venture Capital, Real Estate, and Private Equity, which often require many years to increase in value or exit. Carried Interest, therefore, becomes an ideal measure to retain and attract key investment employees in a Family Office, specifically those with a Private Equity background.

In addition to retention, Carried Interest offers several other advantages. As it is performance-based, the amount of carry a Family Office receives is linked to the increase in the value of assets, making it an effective way to incentivize employees to generate a favorable return. Furthermore, the presence of a Carried Interest structure aligns the interests of Family Offices with those of the investors. With a hurdle rate in place, the Family Office will not receive carry unless the investments generate sufficient profits, creating a financial stake in the performance of the portfolio and encouraging diligence and prudence in investment decisions.

Despite these benefits, there are challenges in implementing Carried Interest within a Family Office. One challenge lies in the longer investment time horizons typically seen in Family Offices compared to Private Equity firms. Family Offices often view their investments as generational wealth creating activities and may not consider an exit for decades. This presents a challenge in motivating investment professionals until there are realized gains, as Carried Interest is only applicable upon exit and achieving the hurdle rate. The unpredictability of realizing gains may potentially disincentivize employees and create a conflict of interest, especially if they have a background in traditional Private Equity firms.

Another challenge within a Family Office is the structure of the team and how they are rewarded. Carried Interests are generally paid to investment staff of the Family Office, often those at the executive level. However, if a Family Office follows a practice of sharing carry among key investment professionals, this can lead to dissent. A whole-fund based approach to rewarding the wider team may mean rewarding non-performance and creating internal dissent.

In conclusion, Carried Interest is an effective measure to attract, incentivize, and retain investment professionals in a Family Office. It aligns the interests of professionals with the performance of the portfolio and contributes to the longevity of the Family Office. It is important, however, to implement Carried Interest in accordance with relevant laws, regulations, and best practices. Traditional Family Offices with longer exit timeframes may consider adopting the phantom equity model to compensate their investment employees. Overall, the use of Carried Interest or phantom equity should align with the specific goals and purposes of the Family Office.

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