Beyond bonuses: incentivizing tomorrow’s family office executive

Reward and retention strategies for family office executives have often been limited to salaries and bonuses. However, families seeking to retain and incentivize their executives better should also consider various other options to craft the most appropriate package for the right candidates.

Flexibility is key to customizing remuneration packages that not only reward executives for good results, but further incentivize them, precisely reflecting executives’ particular needs and desires. Existing family executives can help families create the most appropriate remuneration package by exploring the different options and presenting them to principals in early discussions before meeting potential candidates. 

Below, we outline three different ways in which families can financially reward executives to align their interests more closely:

Carried interest

Popular in the fund management business, carried interest is a reward and retention arrangement that pays an executive a specific percentage of net gain in investment returns in the family portfolio(s) above a hurdle rate or cost of capital. For example, if a net return of 14% is achieved and the hurdle rate is 11%, the manager is entitled to a share of the gain in excess of 11%.

A carried interest arrangement is most often struck with the Chief Investment Officer (CIO) and Chief Executive Officer (CEO) of a family office with active assets of over US$500 million. In large investment organizations, other team members may also receive some payment. The percentage of carry may vary from a modest 1-2% to a high of 10-20%.

More common than carried interest arrangements are structures that create a ‘pool’ from which the executive and select staff can benefit from long-term returns, subject to their staying in their roles and achieving favorable investment returns. Such pools may be modest in size and provide a payout only after the return of capital and an acceptable pre-tax rate of return on capital – typically 10-20% – are achieved.

The benefit of having some form of carry arrangement is the incentive that it creates for the executive to remain in his or her position over the full investment horizon. Venture capital, real estate, and private equity investments often require many years to increase in value and to achieve an exit from. Executives eligible for carry payments will be more incentivized to remain with the family office if continued employment is a condition of participation and to deliver the desired level of risk-adjusted returns.

However, carry arrangements should only be applied to actively managed assets where the acumen of the executive has a direct bearing upon the sourcing, management, and returns of the investment. 

Co-investments

A less complicated and increasingly popular method of rewarding key executives is to provide a carve-out of shares or ownership interest in real estate ventures, private equity, and venture capital investments that allow the executive to make a personal investment. 

Indeed, some families actually require the CIO or CEO to participate in the investments selected by the executive for the family in the belief that ‘what is good for the goose is good for the gander’. This can be onerous, however, as even a modest $50,000 co-investment may represent a disproportionately large amount of the executive’s net worth compared to the amount of net worth that the family is risking on the investment. 

More common is a case-by-case approach to co-investments with some pre-defined rules. These may include:

• Considering co-investment only if the family’s desired dollar level of exposure can be satisfied first
• An absence of conflicts with the interests of the family, particularly around the timing of liquidity and/or exits
• The timing and the amount of the executive’s investment being deemed by the family to be appropriate relative to the executive’s net worth

Where co-investment opportunities exist, the amounts put up by the executive are typically 1-2% of the notional total investment amount or up to $200,000 annually, depending upon the net worth of the executive. 

The amounts should allow tag-along benefits negotiated on behalf of the family. For example, follow-along rights, which allows shareholders to participate in further issuances of the stock, and anti-dilution rights, which protect against equity dilution. Anti-dilution provides added protection, whereas follow along only gives the holder the right to invest.

Long-term compensation

Long-term compensation plans in family offices typically consist of deferred cash or stock payouts that vest over a typical period of three to five years. The vesting element provides a retention incentive, as well as a reward for objectives achieved. 

Stock may be in the form of real or synthetic equity in the family investment vehicle, or in shares of the underlying companies held by the family. The amounts awarded may be determined annually, or accumulate over a multi-year period based upon portfolio or investment company performance. Awards may occur on an annual basis, so as to achieve rolling vesting that fosters long-term retention.

The principal advantage of long-term compensation strategies is they can achieve multiple needs and objectives for both family and executives. They reward performance, can be goal/objective-oriented, incentivize executive behavior, and promote long-term retention.

Families who wish to attract and retain top family office executive talent need to establish a process that helps to align both parties’ interests and seeks to improve outcomes for all. An increasing number of family offices are trying to achieve this via customized compensation deals that combine various remuneration arrangements.