Navigating carried interest planning can be challenging, but having a better understanding of different structure models may provide some additional clarity to your firm. Listen to Paul Patrow and Esther Chiang, partners at Paul Hastings as they discuss different carried interest planning structures and answer questions about the models.
Ryan Burger 00:02
Hi, everyone. Welcome to our series. We are gracious to have Esther Chang and Paul Petro from Paul Hastings. They’re both partners and attorneys who specialize in the fund space. They have a lot of experience structuring carried interest, co-investment programs, as well as other projects with private capital firms. So let them both introduce themselves, and we’ll go through a series of questions. There’s also a Q&A at the bottom of the screen. So feel free to ask questions. Esther and Paul will certainly do their best to answer. If not, we can certainly have follow-up sessions to talk through some of your questions and things that you all type in the Q&A.
Esther Chiang 00:49
Hi, everyone. I’m Esther Chiang. I am an investment funds and private capital partner at Paul Hastings based in New York.
Paul Patrow 01:00
Hi. I’m Paul Patrow. I am in the task group of Paul Hastings. But I primarily focus on representative sponsors, obviously at the GP level, as well with respect to carry for various types of private funds.
Ryan Burger 01:16
Great. Thanks, Esther. Thanks. Thanks, Paul. I think we’ll just get things kicked off and see if you could provide some trends that you’re seeing right now specifically related to carried interest plans. What are you seeing with your clients?
Esther Chiang 01:34
As a corporate finance lawyer, what I have seen is, at least in the United States, the big-picture trend of many managers either expanding their business lines or smaller managers joining forces with larger fund sponsors. We see many sponsors who have to start managing increasingly complex carry plans to fit their underlying different business lines, whether it’s like housing, private equity funds, carry, private credit bank carry under one roof or accommodating, for instance, open-ended or hybrid-sale funds versus closed, traditional closed-ended style funds. So I think that the big picture trend is that, in addition to the traditional fund as a whole, carry, and also maybe deal-by-deal carry are some additional tools that every sponsor of scale seems to need in their toolboxes in terms of accommodating carry to meet their retention and incentive goals. Some of them, I have personally seen, our being used more, for instance – they are certainly not new, but probably used more in the toolbox we would say would be jump ball carry, for instance, and also phantom carry plans. Perhaps Paul can walk us through a little bit more about those at a technical level.
Paul Patrow 03:26
I agree. What you’re seeing is probably more combining different types of carry arrangements along with the traditional carry. Obviously, the old deal-by-deal approach isn’t new. Some sponsors have used that historically. The thing to keep in mind, obviously, with deal-by-deal, as always, or if you’re thinking about moving to deal-by-deal, is there’s a lot. It may sound easy in theory to, say “You’re working on XYZ deals, you get carry out of those deals.” The trick. and where real, granular tracking needs to be done if you’re considering moving in that direction or expanding, let’s say, deal-by-deal carry, is to be able to effectively deal with the fund as a whole economics as it flows up to the GP. The GP’s carry, we’re assuming, has a lot of complexities that can certainly arise where, for example, early winners use the proceeds to pay off, let’s say, the preferred return hurdle with respect to the GPS carry that it’s taking from the fun.
So you’ve got a lot of complexities both in the legal documentation, typically through a series of notional accounts to try to unwind the fund-level carry waterfall. Then, on the back end, as far as dealing with the accounting and reporting to generating accurate reports to the partners – that’s obviously significant complexity. Jump ball is, I would say, essentially discretionary deal-by-deal carry. Essentially the founder is reserving a pool of carry and saying, “I’m not going to allocate this either on a fund-as-a-whole or deal-by-deal. I reserve the discretion to make distributions in any given year or carry comes up to certain people based on whatever metrics this sponsor deems appropriate to reward people – you worked on XYZ, your performance overall, you particularly worked on this on this transaction.”
The final thing, obviously, with phantom is that, from a tax perspective, it really is just a bonus point. It’s not carry, right? It is simply a formula bonus that is pegged to the returns. It’s not as attractive from a purely tax perspective, because it’s W2 guaranteed payment income. That’s compensatory income. But the uses that I see of that are twofold. One, with true carry, as a lot of people know, particularly funds, private equity or venture funds that may have flow-through investments, if you are getting a share of the applicable carry and the potential capital gains tax reporting along with that, you are also getting federal and state-level tax reporting and tax-filing requirements, and, participation, composite returns, withholding, direct flight, income tax returns. There’s a myriad of complexity. A lot of times what people will grant the traditional deal-by-deal carry to the more senior principals. Then, if they have a broader pool of more junior people that they want to incentivize but aren’t getting a huge portion of the carry, the rate difference may simply not be that significant and the ability to avoid all of the complexity, particularly state-level types of reporting, is often attractive.
The second prong we may see phantom carry would be non-US principals. A lot of times, particularly if you’re in a fund that might be doing flow-through investments if a non-US principal has a direct interest, they are becoming a non-US taxpayer and filing tax returns and trying to deal with claiming foreign tax credits. A lot of people don’t want to be brought into the US tax system. One of the other key uses you might see would be a back-to-back type arrangement, a sub-advisory type arrangement where a portion of the carry is paid over to, say, UK-based or wherever-based management company based on a formula of what the person would have earned and how they held real carry. Then it’s just paid on a compensatory basis out of the non-US entity.
Esther Chiang 08:52
I want to mention that, for phantom carry, there is one thing that we need to be careful about which is relating to 409A deferred compensation, right?
Paul Patrow 09:06
Yes. That’s a critical point. It is a bonus point. It’s not an equity interest. It’s a bonus plan for tax. One of the key complexities is, when you set that up, you need to make sure you’re working with your exec comp advisors to make sure that you’re not triggering the 409A penalty excise tax. Where it really comes into play is the foreign aid tax is based on impermissible deferred compensation arrangements and generally to comply with 409A. If you have a compensation arrangement that can be paid out over a span of years, you’d have it paid within some fixed timeframes. The problem is, that simply saying, “Well, we’re going to make payments whenever carry is distributed.” is not a permissible fixed timeframe under the foreign aid rules. The real key takeaway for 409A is generally only going to apply if a person has a vested right, meaning that they are vesting into the right to that bonus payment. If, on the other hand, the arrangement is for the people who are not participating in this phantom plan, if they don’t have a vested right, i.e., if they cease to perform services at any time before the payment is made, IF they lose that right, then takes you pretty simply out of 409A rules.
But if you are trying to construct a plan where they do have a vested right similar to what carry recipients have, then we’ve certainly seen people try to work around it. There are ways people can structure that, but it’s complicated and does not tend to mirror exactly the payment streams and the timing of the payment streams when carry is paid.
Ryan Burger 11:19
On the topic of payments for employees, we at PFA have seen more clients asking us about the PTE tax [pass-through entity tax] and being able to pay the employees’ state income tax through the GP entity to bypass some of the home state income caps for the interest on their mortgages. Can you just talk through PTE tax for us if you’re seeing the same thing? Or can you talk through some of the dynamics of what firms are doing here?
Paul Patrow 11:58
PTE tax, as people are probably aware, was part of the 2017 tax reform legislation. Deducting state income tax payments on your federal turn was significantly limited, essentially a $10,000 limit. The reaction of the states was to pass legislation instead saying, “I’m going to have a flow-through vehicle pay a state income tax at that level, and therefore less income is allocated up to the owners of that vehicle.” That’s typically called the PTE tax regime. When it first came out, it appeared to deal with operating businesses. So the obvious candidate for that in a fund space was the management fee. People getting net fee income could potentially make a, make PTE tax channel election and get them the ability to net the state tax payment out at the management company level and then get a de facto federal credit or a deduction for that.
What we’ve seen over the years is more states have expanded. Again, this is on a state-by-state basis. The key thing is you’ve got to look at your profile, what state are you in, and what states are your carry recipients and management fee recipients in on top of the accounts, specifically on the ground. More states expanded that and accounting firms have certainly taken the position that some of the state legislations are broad enough to also apply carry to it. You need to have the ability to track that in real-time, as to what the election is, what the amount of the credit is going to be, and quickly produce that, because different states have pretty quick timeframes after the end of the year to elect into the PTAP regime for that year – because you’re going to have to disseminate that out to the individual accounts for all of the principals. They’re all their tax return preparers.
Ryan Burger 14:37
I think in New York, it’s late September.
Paul Patrow 14:45
We’ve talked taxes with PFA a lot and having the ability to track that in real-time, as opposed to trying to scramble after the fact, is important and a huge benefit for principals.
Ryan Burger 15:05
Thanks, Paul. We did get a question on how carry waivers play into a jump ball carry system.
Paul Patrow 15:17
Carry waiver is a feature at the fund level. Let’s say you have a two-year hold asset. Let’s keep it simple. A fund investment corp has a two-year holding period. There’s an attractive sale event, obviously, from the GP’s perspective under the 2017 tax reform. During that two-year hold period, any income allocations that the GP is going to get will be subjected to essentially ordinary rate income tax as opposed to capital gain on that realization because the fund did not hold the asset for at least three years. So what the GP will do at the fund level is to say, “Instead of giving me my proceeds and giving me the income allocation associated with those proceeds, I’m going to waive my right to any of these proceeds. I’m going to try to recoup that amount over future income increases at the fund that then produce carry.” You typically pay the portfolio on a mark-to-market basis. At the time of your waiver, the GP is betting that there is going be future appreciation above the current mark-to-market value. Then the GP has the right then to say the first dollars of that new creative value is going to be distributed to me but also, importantly, allocated to me, such that they’re hoping to recoup obviously, from three-year-plus hold period assets or qualified dividend income as well.
It highlights the mechanical complexity in the deal-by-deal world. Let’s say you are a principal that has jump ball or deal-by-deal carry. There’s no cash, right? No cash has come up from that asset. But it’s effectively being used to pay down the preferred and also give additional enhanced distributions to the LPs on the fund waterfall. That’s where all of those notional mechanics at the GP level are going to have to kick in and credit that person to say, “Okay, you would have received X but received nothing because we made the decision to waive that cash.” Now, let’s say you didn’t participate in deal two or deal three. Nonetheless, because of the notional bookkeeping you have to have at the GP level, you’re going to be able to get distributions for deal two and deal three even though the individual deal one actually didn’t have an economic interest on the deal by deal grant.
Esther Chiang 18:23
Yes, I agree. I think that is similar to the variation of the deal-by-deal carry when the underlying fund waterfall is either modified deal by deal or European.
Ryan Burger 18:45
That’s helpful. Thanks, Esther. Thanks. Thanks, Paul. On our side, we’re seeing more companies that have fund-level carry come to us and want to track the hurdles in the system. We see a trend on our side. I’m wondering if you all are also seeing a trend with your firms on structuring the legal component related to the hurdles for late joiners and then catch-up provisions. Sometimes we see the hurdle without a catch-up. Sometimes we see it with the catch-up. We’d love your thoughts from a legal and tax perspective. Or if you’re seeing an uptick from your client base to figure out how best to structure the documents when new joiners come into a fund that has an actual carry value.
Esther Chiang 19:52
Paul?
Paul Patrow 19:54
Sure. You’re right. What you’re describing is critical. There’s a critical tax issue that’s motivating this because, if you are a late joiner into the GP and you end the fund at the time that the person joins the fund is “in the money” on a valuation basis on the carry – like you’ve had appreciation in the fair value of the fund’s investments over the preferred return hurdle at the fund level. What is the right tax result? If you simply just grant someone a portion of that embedded value would be a capital shift to that person and treated essentially as a compensatory payment. That’s a bad answer. Because it’s ordinary income for that person. Plus, it’s like phantom income. It’s income at the time that they join. Typically, what people do is, they will impose one of two things. One is either, “We’re going to pay the carry value today, and you only get to participate above that.” That’s one option.
From a trend perspective, it’s certainly been around for a while, particularly with really late joiners, people who join relatively quickly to the final close of a fund. I generally see the economic deal and say, “Well, you joined, but you know, we haven’t realized anything. We’re still deploying capital as much as possible, we are going to give you the economics as if you had started here on day one. So to avoid the tax result I just described – people call it catch-up or turbocharged carry – people can call it different words. But the idea is actually, essentially, the same things I described in the carry waiver context where that person on day one has no right to receive any dollars of carry, but future allocations of income on the carry are prioritized and allocated to that person to “catch them up” to where they would have been had they started at the fund at the beginning. If there’s sufficient future appreciation in the assets, then there’s sufficient catch-up, and they and their economics are identical to a person that started in the beginning. The risk is that, if there isn’t sufficient future appreciation in the assets, then they don’t catch up. They don’t get that business deal. To work from a tax perspective, they have to be willing to undertake that risk. Where it doesn’t maybe work, or where there are challenges is when you’re bringing someone in year four, year five. You’re through your investment period. Maybe you’ve written up a lot of assets or realized a lot of assets. That’s where it becomes a harder discussion to say, “Well, maybe there just isn’t enough kind of future appreciation for this person to get comfortable that they’re going to be able to catch up.”
Esther Chiang 23:27
I would say that most of it is often documented in the grant letter. Because of the hurdle, you need to have the valuation of what is on the ground in the money and their communication. Maybe I can quickly tie this into one of the questions. Their communication to the employees often requires some illustration or explanation.
Are there any resources for poor reporting centers for employees? I don’t think that I’m aware of that. There’s usually a difficulty or translating what’s in the legal documentation, which is usually the GP or carry vehicles operating agreement, and what’s in the grant letter to the dollar amount. Some people will use dollar amounts at work as a way of communicating. I hope that one day there’s a reporting center – maybe created by PFA – but not today. More than once I had to create a memo or user guide to translate to the employees so that it’s clear to them what happens.
I believe another participant asked the question about what’s the best practice on different requirements around vesting to carry. I think that this is mainly a commercial issue. But usually, I will say, the treatment of carry should be clearly documented. What is the rule of thumb should be clearly documented in the operating agreement of the carry vehicle, a typical commercial arrangement, or at least how people think about it. From the sponsors’ perspective, because I typically represent sponsors, it’s reciprocal to who gets diluted. Whatever is left over when an employee leaves goes back to who gets originally diluted. Translated into real English, it’s the founders and whatever third-party minority owners there might be, because they are usually considered as diluted, meaning the hypothetical, or the assumption, we start with is that they own 100 percent of the carry right as a house. Then they decide whatever is presented. They’ll give it to the LPs, and they often get diluted between the owners. So oftentimes, not all the time, but oftentimes, the rule is that our best carry goes back to whoever gets diluted in a reciprocal way.
Ryan Burger 27:08
Looks like some more questions are coming in here. Do you see carry at work or carry dollars at work being the most common valuation tool to communicate current value to participants? Or do you see calculation? What this is getting at is, is it a multiplier effect, like a 2X multiplier? Or is it actually stamping the fair market value to provide a current valuation back to the employees so they could see how much their carry is worth?
Esther Chiang 27:50
I’ve seen both. From a legal perspective, it’s important that those who show the employees the carry dollar amount of work concept, because, when it comes down to everything, most of the time, the document will say its percentage. Because there are things that could happen at the fund level. The dollars at work concept is not necessarily super accurate all the time. If there are challenges relating to, in my mind, for instance, how much money is actually drawn down, reinvestment and recycling, and even the use of leverage and so on, I think that it’s good to communicate as conceptual. But there’s a real challenge of baking those illustrations into real legal terms. I’ve been certainly asked more than once to use them in the actual legal documents instead of the percentages, but I’m not sure that that approach has been adopted on a wide-scale basis, given the difficulties I mentioned.
Ryan Burger 29:33
I would agree. I think we’re seeing all different methods in terms of the reporting. The further you get along in the fund, the less accurate the multiplier effect works. If a firm can calculate what’s accrued plus a factor of unvested, that would be the most accurate.
I see a lot of people still on the webcast so we could do one more question. Esther, you talked about the documents and setting things up if a firm were starting a new fund and they wanted to get all of their ducks in a row or even if they’re changing their carry programs and they’re moving on and they’re going from deal-by-deal to fund or fund to deal-by-deal. Are there any words of wisdom that you have for a firm that’s making changes or starting up from a carry plan perspective?
Esther Chiang 30:35
We are actually helping some clients do exactly that right now. If the firm operates multiple business lines with different carry plans, it might be good to find the time to sit down and revisit the templates used and try to find a template on a standardized basis. So that is more easily deployable going forward. The other thing, quickly, from a legal perspective I will say is that because a lot of provisions might be in those documents, such as restrictive covenants, for instance, could be greatly impacted by state law or tax aspects. So it might be good to revisit those documents from the templates from time to time, just to make sure that they remain up to date.
Ryan Burger 31:38
Thank you. Thank you, Esther. Thank you, Paul. Thanks to everyone who joined. If you have any questions please feel free to reach out to me.
