DAVID DOREY OF BEDELL FUND SERVICES GUERNSEY DISCUSSES THE IMPORTANCE OF STRUCTURING CARRIED INTEREST IN FUND MANAGEMENT HOUSES TO ALIGN THEIR INTEREST WITH THE LONG-TERM INTEREST OF INVESTORS.
Carried interest represents a key incentive to fund managers that aligns their interests with the long-term interests of fund investors. Until the advent of the megabuyout funds, carried interest was the primary component in wealth generation for fund managers with the potential to eclipse earnings from management fees and, unlike management fees, has historically been viewed as generating a capital gain rather than income. As a consequence carried interest is viewed as a vital component, not only in the establishment of fund structures, but as an important tool in the recruitment and retention of key staff in fund management houses.
Carried interest is a share of the gain on investments in a fund (be it on a deal-by-deal or, more usually, a whole-fund basis) and can be earned directly by the general partner of a fund or more frequently a dedicated carried interest vehicle that is set up separately from the general partner. These carried interest structures may take a variety of legal forms, although the use of limited partnerships as carried interest vehicles has been extensive in many European funds.
Carried interest in general, and particularly its treatment as a capital gain, has created a groundswell of negative public opinion across the EU and the US. Furthermore, its tax treatment is inconsistent within the EU and US. Given the importance of carried interest to fund managers and the variability of its tax treatment, effective carried interest structures should be established to ensure that tax transparency is maintained and that tax leakage is minimised.
The nature of the carried interest structure and its use should be determined as part of the fund establishment process. Managers may wish to incentivise a diverse group of individuals, each of whom may be in different jurisdictions or subject to differing fiscal regimes. Additionally they may also wish to hold the carried interest in a variety of tax efficient personal structures ranging from private trusts through corporate entities to EBTs. The final carried interest structure will need to be flexible to accommodate these fiscal and investor variations.
It is also imperative that fund managers not only consider the current requirements but maintain enough flexibility in the structure to ensure that future legislative and fiscal changes can be accommodated. Indeed another area for consideration is that of adding and removing key staff from the structure throughout its life. The removal of members of the structure is straightforward but the addition of new members is an area for caution, in particular personal taxation issues such as benefit in kind may affect how and when new members may be admitted. Bedell Group has worked with a variety of legal and tax advisers in establishing carried interest structures and is well placed in assisting fund managers seeking to establish fund and carried interest structures offshore.
Carried interest structures and funds are often bundled together and either dealt with in-house by the fund manager or placed with a dedicated third-party fund administrator. While this may satisfy the manager’s needs, it is not always necessarily in the best interests of the carried interest vehicle and its own investors. For example, the service approach adopted by many fund administrators is based on the needs of a fund and is dominated by volume and system-driven processes in relation to calls, distributions and investor accounting. Carried interest structures are more like private wealth management structures and are often complex with an investor or partner base whose requirements are bespoke, where individual actions by administrators can have significant, and often detrimental, effects on the partners, particularly where blind processes are followed. While a carried interest structure may be required to adapt during its life to accommodate the changing needs of its members, fund administration, by necessity, requires complex checks and balances and cannot always accommodate fast paced highly variable structures. Given the sensitivity of carried interest structures it is, perhaps, advisable that the administration and operation of such structures is entrusted with administrators able to leverage their knowledge of the fund industry. At the same time, an in-depth understanding of the private wealth aspects of carried interest and an appreciation of the impact that their actions may have on the structures administered i s required.
Managers who look after their own structures may also want to consider the confidential nature of their carried interest structures. The award of carried interest within a business is always commercially sensitive and may have a significant effect on the smooth operations of a manager. A manager’s core business is to manage its funds, not to provide administration services to carried interest structures. Given these sensibilities, even where managers administer their own funds, it may be in their interest to place the running of their carried interest structures with third-party specialists, therefore minimising any confidentiality risks as well as allowing their staff to focus on core business.
As carried interest structures can be established in a variety of forms and jurisdictions there are no hard and fast rules as to where they need to be administered. Fund structures, both onshore and offshore, may have carried interest structures established in their operating jurisdiction or in other jurisdictions. Indeed, as tax regimes worldwide change and adapt, it is more likely that a ‘simple’ Scottish limited partnership carried interest structure will be replaced by a number of different vehicles ranging from other limited partnerships to Guernsey companies to Delaware LLCs, and all manner of vehicles in other jurisdictions in between. These all operate in parallel to the benefit of the manager’s key staff and are tailored to the requirements of their tax domicile. Complex carried interest structures of this sort can still be administered by a single administrator; for example in Guernsey such structures would be expected to fall outside of the regulatory regime governing investment funds, and with the appropriate attention at the outset can be structured to ensure that they do not fall within any other regulatory regime governing fiduciary business.