Many companies experimenting with ways to provide a competitive incentive package to their key employees are focusing on what are called private equity co-investment plans. While this trend remains new, it may represent a significant new source of private equity investment capital. Equally important, companies using private equity in this way acquire a potentially powerful means of attracting and retaining top-quality talent. In addition to the usual incentive package of salary, bonus, stock options and so forth, a company can offer its key employees the chance to participate in a private equity fund, often on a highly leveraged basis. The result is that a previously unavailable asset class can now be added to employees' portfolios.
Certainly investment banks, fund management organizations and other financial services firms have long allowed – and in some cases required – their key people to invest in the individual funds they create. However, the practice I am describing is different. In this case, a company creates the private equity co-investing fund specifically as an incentive vehicle. For the purposes of this article, I will call this practice private equity co-investing.
Co-investing funds typically have a 5 to 12 year duration. And they can be organized in a number of ways. Generally they fall into three categories: funds investing directly in private equity investments ('buyout'); funds investing in other funds ('fund of funds'); or a combination of the two. Organisations may choose to carve out a slice of their existing and future private equity portfolio portfolio to have the fund invest on a parallel basis.
Private equity co-investing has existed in some form for years. It began to grow in popularity during the '90s when investment banks increasingly became involved in private equity.
This was the height of the tech IPO boom, you will recall. It was also a time when executive search firms threatened to lure away the banks' top talent to Internet start-ups. The incentive these executive search firms offered, was lucrative stock options in their client company's forthcoming IPO.
To stem the flow of talented defections, investment banks created special private equity funds. The advantage to the key employees who took part in the program was clear. Instead of participating in the success of a single company as a stock option plan enabled them to do, key employees enrolled in a private equity co-investment program that potentially could profit from a diversified group of companies within the fund. 'In the late 1990s, co-investing expanded significantly among banks. It almost became a standard component of compensation packages for top talent. At first, such plans normally were restricted to key employees. But by the next decade, participation gradually broadened.
In the aftermath of the market crash, private equity funds offer participating employees distinct advantages as capital appreciation vehicles. Chief among them is diversification into previously unavailable asset classes. With markets depressed and unpredictable, company stock options have arguably become a less attractive perk. Companies are often forced to offer greater numbers of shares to match the monetary value of pre-crash plans. Naturally, this tends to further dilute share values. The resulting pressures from shareholder and regulatory groups to reign in stock options along with adverse media publicity may further dampen the enthusiasm for stock options.
Meanwhile, firms still face the dire need of retaining quality individuals in order to weather the downturn. Yet they, and the key employees they hope to retain, are acutely aware that the company's stock price might decline further in the near term, significantly diminishing the value of stock options as incentives. So here again, a private equity co-investment fund provides an alternative to provide an opportunity to earn a return higher than generally available from public securities with commensurate risk.
Because private equity co-investment is a relatively new phenomenon, there is scant public information about the number and size of funds that currently exist as well as the number of companies that have launched a program. At the firm I represent, DML Fund Services Group ('DML'), a third-party administrator to private equity funds and their investors, our own knowledge comes from clients and colleagues whose funds we administer.
From this vantage point, our experience suggests that private equity co-investment funds are closed-end. That is, they become closed off to participants once subscription commitment targets have been met. Commitment amounts are called from employees periodically to fund investments and expenses. This, of course, means employee participants won't face additional, unanticipated capital calls during the funds' lifetime. At the same time, their own invested capital is amplified by the potential leverage their employer may provide.
We have also found that financial institutions remain the predominant users of private equity co-investment to date. The obvious reason for this is that financial firms and their top employees already possess a thorough knowledge of private equity investment. Creating a private equity co-investment program allows them to further leverage this in-house expertise.
Interest in private equity co-investment continues to grow outside the financial services sector. At DML, we know of at least two non-financial Fortune 50 companies that have recently launched co-investment programs.
How exactly does a company go about setting up a private equity co-investment program? The following example draws upon DML's experiences with companies that have done just that. For the purposes of this example, please assume that the fund is being created by a financial services firm with considerable experience in private equity investment. As a first step, once top management makes the decision to create a co-investment program, the company's human resources department, with input from its legal department and key executives, may assess the desires of its top employees as to the type of private equity investments they seek.
Here, we've found that the type of investing strategies run the gamut of what is currently found in private equity investing as a whole. That is, investments focused on venture, buyout, and distressed opportunities as well as private investments in public companies, are among the possibilities. In addition, funds can be focused on the same geographic regions where private equity has been used effectively in the past, including: North America, Europe, Asia, Latin America and the world's other opportunistic regions.
Regardless of their investment plan, private equity co-investment funds – like traditional private equity funds – typically are organized as limited partnerships, with the employees serving as limited partners and the company serving as general partner. The task of managing the fund usually is relegated to senior members of the financial firm's investment banking group. They can also be assisted by outside advisors and administrative professionals.
Important questions to be answered during the pre-launch stage include: eligibility, the company-provided leverage, fees and expenses, the vesting period, carried interest charges, if any, and so forth.
Eligibility brings up important regulatory questions. For example, in the U.S., because of their structure as unregistered securities, private equity co-investment plans have normally been confined to senior employees. This is principally because investors must be accredited under SEC Regulation D, which stipulates that participants must have a net worth of over $1m, for example. With many larger corporations these limitations still permit a sizeable participation. We administer one program, for example, that has several thousand employees in it that qualify. Mechanisms exist that may allow participation to be broadened to other employees within a company. As research at the Foster Center notes, 'Loans or grants from companies would allow some individuals to achieve qualification status' ('Co-Investing in Corporate Venture Funds,' Yale D. Tauber and R. Michael Holt, WorldatWord, 2001). These avenues should, of course, be explored with great care to insure the fund remains compliant.
The leverage (including any interest thereon) loaned by the employer must be repaid in total before the employee can receive a return on their cash subscription. Subject to the vesting criteria of the employer and whether there is a carried interest participation by the employer, the full economic benefit from the realization of the investments once the leverage is repaid belongs to the employee. Leverage can significantly impact the employees investment return(s). We have seen the leverage ratio's range from 1:1 to 4:1.
* Carried Interest
A determination needs to be made by the employer whether they will receive a carried interest. The carried interest represents an allocation of profits to the employer after the leverage is repaid based upon a prescribed formula.
* Fees and Expenses
A determination must be made as to who will bear the costs of organizing and administering the fund. We generally find the fund paying the direct expenses of the program.
* Vesting Period
It is important for the company to specify the circumstances under which employees may be removed from the plan. Common reasons include being terminated for cause, for example, or for disclosing proprietary information, joining the competition and soliciting the firm's employees or customers. Depending upon when the 'harmful act' took place and the circumstance of the act will determine the economic consequence.
Still other important questions in the pre-launch stage concern when and how employees will make their contributions. Since cash calls may occur throughout the life of the fund, employees may be required to maintain a minimum balance in an escrow account to meet them. Alternately, participants might be asked to furnish their entire contribution when they join the plan. We know of situations where the equity and leverage are contributed in tandem and also situations where the equity is contributed first, followed by the leverage component.
Companies use recourse and/or non-recourse loans to leverage the equity investment being made by employees. In the case of recourse loans, the employee is responsible for repayment of principal and interest irrespective of the investment returns. With non-recourse loans, the company assumes that responsibility.
Depending upon how it is organized, leverage can give employees a strong inducement to remain with a company. For example, a requirement to repay a loan upon leaving the company amounts to a kind of poison pill for executive search firms, according to Forbes magazine. Repaying the loan, which might amount to hundreds of thousands or even millions of dollars, would make hiring away the executive too expensive for competing firms. As one compensation specialist reportedly told Forbes magazine: 'That is the handcuff.'
In some cases, employees that are bought out of funds prior to harvesting may receive capital appreciation resulting from their principal, but not the leverage. Other possible options would allow them to remain in the fund.
The Forbes magazine article advised executives negotiating the terms of a private equity co-investment plan to insist that such loans be forgiven in the event of firing without cause or – say – if they are dismissed because the company has been acquired or merged. The Forbes article also advised executives to demand the option to exit the fund at a time of their own choosing, so they aren't forced to sell during a downturn. And finally, executives may insist that they be granted access to reports on the funds' progress, even if they are no longer with the firm.
Despite these restrictions, we have found that executives are especially pleased to participate in private equity co-investment plans. Leverage is a valuable inducement, as well as the reduced capital commitment amounts required to participate in a private equity fund as compared to the traditional private equity funds which have excluded all but the most-wealthy individuals from participating. Transparency is also a major advantage. Since participants are already a part of the company, they can monitor performance much more closely than they could with a typical investment.
Risk factors for employees
Before investing employees need to consider the following:
* If the investment returns prove insufficient to reimburse the employer for the leverage, such employee will lose his or her entire cash subscription. In addition, employees could lose more than their subscription if the employer provides recourse financing.
* Termination of employment may limit the economic participation in the investments.
* The return of capital and the realisation of gains (if any) occur only upon the disposition of an investment. An investment may not be sold for a number of years after it is made. It is unlikely that there will be a public market for most of the investments held by the Fund.
* An employee of the Fund will not be permitted to transfer his or her interest without the consent of the Employer. The transferability interests will be subject to certain restrictions contained in the partnership agreement and will be affected by restrictions imposed under applicable securities or other laws.
In time, it's our belief that major companies worldwide will embrace private equity co-investment plans as a competitive necessity. Before that occurs, several things must happen, however.
Companies must also be prepared to face what is a potential conflict of interest with private equity co-investment funds. Shareholders, for example, may protest if key executives of the company derive a large portion of their overall incentive package from ownership stakes in other companies – that is, companies the fund has invested in, some of which might even prove to be competitors.
Companies must also carefully manage investments so that their co-investment obligations don't impinge on other short-term cash needs. And they must educate eligible employees on the risks and rewards of private equity investment. Equally important, the funds must be organized and scrupulously managed in a way that meets all state and federal legal requirements. High among the issues that must be considered are whether or not the fund will need to be registered with the SEC and how realizations are to be treated for tax purposes.
And finally, companies with operations throughout the world will face the greatest challenges of all. They must take great pains to optimize and domicile the fund so that it provides the most efficient tax treatment for all its employees, wherever they might be located.
Doing that, while achieving adequate liquidity and avoiding potential conflicts of interest will naturally require that such funds be astutely managed, with large amounts of oversight provided by the company's legal and human resources staff.
Thankfully, firms considering private equity co-investment can rely on skilled outsourcing services from consultants, legal counsel, as well as full-service private equity-fund administration firms.
I am confident such challenges will be resolved. And that is because the use of private equity as an incentive vehicle represents a win-win situation for all concerned. The companies' profit by retaining the talent they need to thrive, participants have the potential to profit from a new asset class, particularly when equity markets and other investment venues face uncertain times, and lastly, an expanded list of deserving businesses will benefit from the ever-increasing amounts of private equity funding these programs will make available.
Norman Leben is a managing director with DML Fund Services Group, a Bisys Company (www.dml.net), a leading provider of accounting, tax, and administrative services to private equity firms and investors worldwide.