Another Argument For Back-ended Carry Distributions?

Buyout firms chafe at the notion they could trip up another financial crisis. No matter. They now find themselves battling proposed rules limiting incentive-based compensation rooted in the premise that they could. The rules may also give limited partners a stronger argument for back-ended carry distributions.

It’s yet more fallout from the Dodd-Frank Wall Street Reform and Consumer Protection Act, enacted last summer, which requires buyout shops with more than $150 million in assets under management to register as investment advisers with the Securities and Exchange Commission. (Although the SEC has indicated it may extend the July 21 deadline to register, industry observers say it is unlikely that grass-roots efforts will succeed to repeal the requirement altogether.)

From the perspective of your run-of-the-mill buyout shop, the prospect of registering—necessitating the appointment of a compliance officer and the development of a compliance program—is viewed as burden enough. But Dodd-Frank has the SEC and other agencies piling ever more rules on their backs. This week the Private Equity Growth Capital Council weighed in with comments on one of the latest proposed rules, which would put limits on incentive-based compensation at covered financial institutions. Buyout shops with $1 billion more in assets—a good portion of the market—would likely have to comply. (Those with $50 billion or more in assets face additional restrictions.)

Section 956 of Dodd-Frank directs the SEC and other agencies to forbid overly generous incentive-based payment plans that encourage people to take inappropriate risks that could lead to significant financial losses. Firms covered by the rule would have to disclose enough about their incentive-based payment plans for regulators to judge their danger.

In their joint rulemaking, published this spring, the agencies said that “supervision and regulation of incentive compensation … can play an important role in helping ensure that incentive compensation practices at covered financial institutions do not threaten their safety and soundness, are not excessive, or do not lead to material financial loss.” Among the main components of the proposed rule are the following:

• Incentive-based compensation would be defined “to mean any variable compensation [cash or non-cash] that serves as an incentive for performance,” but it would exclude “dividends paid and appreciation realized on stock or other equity instruments that are owned outright [not subject to vesting or deferral] by a covered person.”

• The SEC and other agencies would have to consider several factors in determining whether incentive-based compensation is excessive, including a person’s compensation history, the financial condition of the firm and compensation practices at comparable firms.

• Regulators would have to prohibit incentive-based compensation plans that could lead to inappropriate risk-taking and “material” financial losses to a firm. Any plan would be required, for instance, to balance risk and financial reward, such as by deferring payment of a bonus tied to an investment until after most losses can be accounted for. It would also have to be “supported by strong corporate governance,” with incentive-based pay plans overseen by a board of directors or one of its committees.

What would this mean for buyout shops? Given how open to interpretation the proposed rules are, it’s impossible to say to any at level of detail. However, LPs might take the view that, under guidance from the rules, carried interest should not be paid to general partners until they’ve gotten all of their contributions back—to guard against buyout pros taking profits on individual transactions before all fund losses are fully known. LPs might also have a stronger argument against buyout pros keeping fees paid by companies, or a portion of fees, simply for doing deals. Of course, buyout pros could point to a myriad of checks inherent in their financial terms that protect LPs from excessive risk-taking, including their having their own money at risk in funds, escrow accounts, interim true-ups, and GP clawbacks.

In its letter to the SEC dated May 31, the PEGCC, which counts 35 buyout and growth-equity firms as members, argued that neither of the two main forms of performance-based compensation received by buyout pros—annual bonuses and carried interest—should be covered by the new rules. Here’s a few reasons why, according to the letter:

• Buyout firms, by the nature of their structure and the kinds of investments they make, don’t present systemic risks to the U.S. financial system.

• The compensation plans of buyout shops don’t encourage excessive risk-taking, in part because both management fees and carried interest are negotiated by “sophisticated third-party investors.”

• Management fees are based on a percentage of committed capital and therefore are “structurally prevented from becoming distorted by risk-taking activities.”

• Carried interest is paid only from profits of successful transactions, while a clawback typically protects investors from overpayments; for these and other reasons carry is “structured to pay out in such a way that it does not encourage excessive risk-taking behavior.”

David M. Toll is editor-in-charge of Buyouts Magazine. Follow him @davidmtoll. Follow @buyouts.