Tackling next-generation compensation

With most managers employing European waterfalls, the challenge has been to retain younger employees while getting investor buy-in.

European waterfalls: favored by investors since the financial crisis

Even for an industry heavyweight that has just raised one of the largest-ever private real estate funds, incentivizing and retaining mid-level employees is still a key consideration.

Brookfield Asset Management, which captured $15 billion for Brookfield Strategic Real Estate Partners III in late January, plans to award performance-based compensation from the vehicle to investment professionals at the vice-president level and above, subject to a five-year vesting period, according to a September memorandum from private markets firm StepStoneGroup.

“This mixed carried interest program, which includes incentives based on fund performance and options on Brookfield’s stock is consistent across the firm’s verticals and keeps mid-level investment professionals motivated by the performance of the fund,” Steve Novick, partner at StepStone Real Estate, wrote in the memorandum.

In contrast to competitors like Blackstone and KKR, which use a deal-by-deal American carried interest waterfall, Brookfield employs a back-ended European structure and consequently has adopted a hybrid carried interest program for all three BSREP funds.

The Toronto-based alternative asset manager is not alone in thinking about retention of mid-level employees. For example, PERE understands that Starwood Capital Group, which also has a European waterfall, allows high-performing investment professionals at the VP level and above to participate in the firm’s co-investment carry.

Following the global financial crisis, many US-based general partners switched from having an American waterfall to a European structure at the behest of investors, which wanted to ensure they would be able to protect their capital after seeing poor returns and some investments wiped out, according to Alan Pardee, co-founder and managing partner of New York-based global capital raising and investment advisory firm Mercury Capital.

Doug Weill, co-founder and co-managing partner of real estate advisory firm Hodes Weill & Associates, estimates approximately 90 percent of real estate managers globally have a European waterfall today. “The shift from American to European waterfalls has made it very challenging for managers to pay their teams on a more regular basis when the carry is back-ended, and this is more pronounced for smaller managers and/or managers with one fund series,” the firm said in a January report.

“Most mid-sized firms are challenged with how to incentivize and retain the next generation of individuals,” Weill says. “They want carry to reward investment performance and to be valuable to the individual, which can be a challenge when payment is so long dated – often out seven or eight years.”

One solution has been to offer deal-by-deal payouts that are subject to certain provisions including reserves and portfolio valuation tests, with some managers personally guaranteeing the clawback. The payouts are coupled with a vesting program for carry, where the majority of the carry typically vests over a three- to five-year period, with a certain percentage withheld until the portfolio is fully liquidated.

“While very logical to have a deal-by-deal payout, it can be a challenge to convince investors otherwise”

Doug Weill

“What that does for the individual is even though the carry may be long dated, they know that if in one or two or three years, for whatever reason, they want to leave the firm, at least they own a portion of the carry,” Weill says. In some cases, the interim carry payout also only goes to non-principals, with the owners and partners deferring their share of the carry until liquidation.

When it comes to raising the retention issue with investors, however, Weill says “managers are making that argument and it’s typically falling on deaf ears.” Consequently, only a handful of his firm’s placement clients offer modified deal-by-deal promotes to their younger professionals: “While very logical to have a deal-by-deal payout, it can be a challenge to convince investors otherwise. It’s a highly competitive market and many managers, especially boutique managers, don’t want to give an investor an easy reason to say no to their fund offering.”

However, Steven Cowins, head of funds at law firm Greenberg Traurig, says that while investors typically favor back-ended promote, many have recognized the importance of incentivizing and retaining junior and mid-level team members. “Intelligent investors will look at the stability of the platform and the fact that a good manager should have talent running through the whole platform, not just at the senior end,” he says.

Jennifer Choi, managing director of industry affairs at the Institutional Limited Partners Association, says the situation is more nuanced: “It really comes down to the nature of the manager’s relationship with the LP, and the specific circumstances for that firm, particularly if it is earlier in its development. LPs recognize that today’s market for talent is competitive and do consider whether there may be business risk related to not properly incentivizing more junior members of the team.”

With deal-by-deal promotes, some considerations include how the clawback works when distributions are made to junior members of the team. Adding to the complexity is increased use of subscription lines, which if used aggressively can accelerate a fund’s performance past its hurdle, the threshold on which compensation would be based, she says.

“On a case-by-case basis, LPs may take into account the circumstances of the manager, but the majority of LPs would like to see the whole of fund waterfall become the industry standard globally,” says Choi.