Seventy-three percent of private equity professionals with 10 to 15 years of experience reported having carried interest as part of their compensation package this year compared to only 64% in 2010, according to a report recently released by PrivateEquityCompensation.com.
"One thing that will not change in the industry is that carried interest can make all the difference for a private equity professional," said David Kochanek, publisher of PrivateEquityCompensation.com. "If you have deal-by-deal carry, a private equity executive could receive checks years after departing the fund. That's an attractive feature when evaluating career path options."
The private equity fund industry has tripled in size in recent years with some $3 trillion in global assets. The 2,600 private equity firms in the U.S in 2012 were invested in 15,300 companies, according to Private Equity Growth Capital Council, the industry’s trade organization.
Although carried interest is typically 20% of a private equity fund’s profits that managers and partners receive on top of their management fees, shares in the management company and severance benefits also come into play when a partner leaves depending on whether it’s a good or bad termination.
“When a senior person departs, he or she is entitled to a broad array of rights under the agreement and it may not make sense to adhere to what was previously negotiated because it could do damage to the private equity firm,” said Shukie Grossman, partner at the law firm Weil, Gotshal & Manges and co-head of Weil's private funds group in the U.S.
Originating out of the U.K. private equity industry, the terms “good leaver” and “bad leaver” describes a partner who, when departing, is subject to a buyout depending on terms of termination. A buyout is the purchase of the general partner’s interest as well as the shares in the management company and the carried interest available to members.
Bad leavers are partners who are fired for cause after indictment or conviction or because they are departing to work for a competing firm.
“If the value of the leaver’s shares in the management company and their participation in carried interest is not clear, it can lead to expensive litigation and that hurts the funds returns when partners are not playing as a team and arguing with each other,” said Joseph Bartlett, who is of counsel at Sullivan & Worcester, a law firm based in New York.
Carried interest can be granted up front, annually or on a deal-by-deal basis. Ideally, the manner in which carried interest is granted is negotiated at the start of an executive's job at a private equity firm to avoid a dispute down the road.
"To the extent that an executive owns an interest in the management company, murky issues emerge when there are no clear-cut buyout mechanisms set forth in the governing agreement of the management company," Grossman said. “You often don't want someone who is no longer affiliated with the firm to have an ownership interest because what comes with that is the right to continued economics and to review records."
If documented properly, owners of interest in private equity firms who leave on good terms can expect a fair market buyout for their carried interest interests while bad leavers may receive no more than book value, which can translate into little or nothing.
"Every situation is different but, to the extent that the agreements are unclear, it's usually in the best interest of the firm to pay something to get the bad leaver out of the way but negotiating a buyout with a bad leaver can be complicated and contentious," said Grossman.