How to give employees skin in the game

Employee co-investment programmes can be an attractive offering for fund managers, but setting them up means overcoming various obstacles, writes Nathalie Sadler of law firm Dechert.

Nathalie Sadler, Dechert

Employee co-investment is an increasingly important tool for private fund managers. While setting up an effective employee co-investment programme requires forward planning and resources, with careful thought it will reap dividends for both manager and participants. This article provides an overview of the reasons to implement an employee co-investment structure, as well as common features and issues associated with creating and running such a programme.

Employee co-investment can be seen in many guises – from a select number of individuals investing directly into the main fund through to a separate employee co-investment fund offered across the firm’s international footprint. Alternatively, some firms use ‘phantom’ programmes, which are effectively bonus or profit-sharing schemes linked to fund performance with no actual investment in the underlying private fund. Employee co-investment can also form part of the ‘GP commitment’ to the fund, although this is not always the case.

The focus of this article is on separate employee co-investment funds, which generally allow a wider population of employees to participate and allow for a range of attractive and/or operationally helpful features to be incorporated into the programme.

There are many reasons why a firm may wish to implement, refresh or widen the ability for employees to participate in the manager’s private funds. Firstly, it can be an important tool from a recruitment and retention perspective: it can act as a differentiator when comparing job opportunities and encourages employees to be emotionally and economically invested in the firm’s success.

“Some investors actively encourage employee co-investment if they know it is a possibility”

Also, effective leaver terms may mean that an employee thinks twice before handing in their notice. Similarly, the opportunity to invest will form part of the employee’s reward package and can be particularly valuable given that, despite a recent focus on ‘retailisation’ in the industry, private fund strategies are not usually available to retail investors and the employee is unlikely to access such an opportunity elsewhere.

More generally, co-investment can assist in a sense of democratisation within a firm because it is not just the most senior individuals that are given the opportunity to invest.
The existence of these schemes can also be attractive to third-party investors in the private fund – it shows ‘skin in the game’ across a wider cross section of the firm, demonstrating an alignment of interests. Some investors actively encourage employee co-investment if they know it is a possibility and can sometimes request co-investment alongside their separately managed accounts.

One key point to determine at the offset is whether employee co-investment will be offered in respect of a single private fund (replicating the programme every time an eligible private fund is offered) or whether a single co-investment fund will offer exposure to a mix of strategies run by the manager. The latter can be a good way to ensure alignment across the firm, as well as offer a more diversified investment. It also reduces the administrative burden associated with replicating multiple co-investment vehicles, although it is possible (and often efficient) to launch a programme that allows exposure to single private funds through a single employee co-investment fund entity.

Funding issues

How employees’ investments will be funded and the charging of fees and expenses are also potential differentiators when launching a programme. Employees may invest their own money or through a form of salary sacrifice/bonus pool. In addition, offering leverage is likely to be attractive to employees, although a lender will need to be found and this generally increases the complexity of the programme.

Similarly, many firms offer fee or carried interest waivers on employee investment at the level of the private fund. In some instances, charging performance-based fees to employee investors can cause regulatory issues so care should be taken. In addition, firms will need to consider whether other costs (such as establishing and operating the co-investment programme and underlying funds) will be borne by employees or whether there will be some form of ‘subsidy’ from the house.

Another key decision is the scope of employees who will be offered the programme. In many instances this will be determined by the employees’ local regulatory requirements as different jurisdictions have different approaches to investor eligibility. However, as a commercial matter, managers may wish to determine a threshold level of seniority/role or compensation within the firm, at which point an employee becomes eligible to invest. Also, firms will need to consider whether they will allow personal investment vehicles or parties who are not technically employees (such as spouses/partners, retirees or consultants) to participate.

Extending investment beyond the employee could cause regulatory issues. For example, in mainland Europe and the UK, it is likely that an employee co-investment structure would rely on an exemption from the Alternative Investment Fund Managers Directive on the basis that the employee co-investment fund was an ‘employee participation scheme’. While clear guidance on what constitutes an ‘employee participation scheme’ is sparse, a prudent approach would be to assume that the further removed a party is from the employment relationship, the less likely the exemption is to apply.

Firms will also need to have a view on a number of operational issues before launching an employee co-investment programme. Typically, these would include matters such as the treatment of joiners and leavers, the consequences if an employee fails to fund their investment, as well as more practical matters, such as whether employees will be able to fund in their home currency.

An effective employee co-investment programme will aim to ensure that the employee structure itself does not impose an additional layer of taxation on fund returns and, to the extent possible, that it delivers the most efficient tax outcome available (while balancing the tax position of different jurisdictions). Similar to regulatory issues, steps may be taken to limit the scheme’s availability or create additional investment vehicles if there are jurisdiction-specific tax concerns.

Launching or expanding an employee co-investment programme is worth serious consideration. Once a programme has been launched and factors such as those outlined above have been worked through, it is likely to be a long-term asset for both the manager and participants alike.

Rising to the regulatory challenge

Regulatory factors can affect the scope of an employee co-investment programme

The most significant point to consider is the regulatory position regarding offering the scheme in each jurisdiction in which participating employees reside. Both the US and Europe have statutory regimes that allow for employee participation programmes, although in many other jurisdictions the offering needs to be brought within general securities offering regimes or tolerated exemptions. These may restrict the offering generally or the scope of employees who are eligible to invest in that jurisdiction.

While offering a programme in some jurisdictions may require careful consideration, the challenge is not insurmountable. However, managers will sometimes take a view on their employee footprint (and perhaps the seniority of employees in certain locations) and take steps such as excluding certain jurisdictions from the programme, imposing eligibility criteria to cater for regulatory issues or creating additional vehicles to deal with local requirements. Regulatory factors may also affect how the availability of the programme is communicated to employees.

Nathalie Sadler is a partner in the London office of law firm Dechert