Financial Services in Focus: Carried interest: Key employment considerations

Carried interest is a common financial incentive for individual investment fund managers (Fund Managers). The Fund management team will generally be employees of an entity separate from the Fund (for example, the Fund’s investment advisory or management entity) and will receive an annual salary for providing investment advisory services to the Fund. In addition to this, senior Fund Manager employees will commonly be granted carried interest rights.

Carried interest (or carry) provides the Fund management team a right to share in the profits of the Fund. Carry is generally structured as allocating to the Fund Managers a share in the Fund’s profits, once investors have received back an amount equal to their original investment, plus an additional return on their investment (known as the hurdle). Carry is popular with investors because it incentivises the Fund Managers to ensure the Fund is a success, thereby creating greater alignment between the carry holders and investors.

There are four key employment aspects to consider where carried interest is awarded to Fund Managers.

Carry vs employment income

Fund Managers who are employees of the Sponsor, are usually employed by an entity separate from the Fund (such as the Fund’s investment advisory or management entity) and it is through that entity that they receive their annual salary and any other employee benefits. However, where a Fund Manager is granted carried interest, a different set up is used and in European Funds, the Fund Manager generally becomes a limited partner of the Carry Limited Partnership. It is by virtue of this limited partner status that they are entitled to any interest in the Carry Limited Partnership and their carry rights are governed by the limited partnership agreement of the Carry Limited Partnership.

As mentioned, in European established Funds, the Carry Limited Partnership will generally be a newly established limited partnership, which itself is a limited partner into the main Fund limited partnership.  By contrast, in US established Funds, the typical set-up is that general partner of the Fund will be a limited partnership, and the carry will flow through the general partner, and the carry holders will be admitted as limited partners of the general partner.  In this Article, we have assumed that the Fund in question is a European established Fund and therefore the Fund Managers will be holding their carried interest rights through a Carry Limited Partnership.

For carry holders, the limited partner status is separate and distinct from their employment status and it is important this distinction is maintained, predominantly for tax reasons. The Fund managers are generally considered to be holding their carry rights, a separate security, as an investment in the Carry Limited Partnership. Accordingly, carry consisting of a capital gain, including a share buyback, will be taxed at capital gains tax rates for carry (up to 28%), whereas dividends and interest income returns are taxed in the hands of the Fund managers at higher rates (up to 39.35% and 45% respectively).  By contrast, salary paid by the employer would always be subject to tax at the higher employment tax rates (up to 45% plus national insurance contributions).

Protecting the relevant parties in the group

In most Fund structures, there are other entities, limited partnerships and legal persons in addition to the entity which employs the Fund Managers. Therefore, it is important to ensure that key employer protections in the employment contract are not limited to the business and the interests of the employing entity alone. Definitions of Group, Business, Confidential Information, Clients, Prospective Clients and Restricted Business should all be reviewed to ensure they are wide enough to cover the information, business and contacts the Fund Manager will be involved with as part of their role as an employee. This should not be confused with their status as a limited partner and/or as a beneficiary of carried interest as there will be different legitimate interests and information rights and flows.

Post-termination restrictive covenants

The Fund Managers who are awarded carry can present a real risk to the business when they depart. Post-termination restrictive covenants are, therefore, likely to be a key requirement. Both the carry documentation and the employment contract are likely to contain such restrictions and it is important to have separate restrictions to recognise the difference status of the Fund Manager in each arrangement.

Equally, the reasonableness and enforceability of such restrictions will differ depending on such status. When a court is scrutinising the reasonableness of a restrictive covenant, they will treat employees and limited partners as having different bargaining powers. Yet, this can be undermined where the carry documentation links back to the employment documentation or relationship. For example, where a compulsory transfer of rights in the Carry Limited Partnership is triggered by the Fund Manager ceasing to be employed by the employing entity. An alternative to help mitigate this risk would be to grant the Carry Limited Partnership with an arbitrary right to require compulsory transfer at any time instead.

Whilst the restrictive covenants in the employment contract will be subject a stricter enforceability test, it is still beneficial to have these. Well-drafted covenants, even though they may be narrower and shorter, can provide useful back-up protection where the restrictions in the carry documentation are subject to challenge.

Caution should be taken when drafting the restrictive covenants and the related definitions in both the carry documentation and the employment contract as often the real business risk, clients and confidential information is in respect of the Fund and not the Carry Limited Partnership or the employing entity.

Termination of employment

A Fund Manager will often view the carry as part of their overall package despite the distinct arrangements and status. Inevitably, this filters into settlement negotiations on termination of their employment. However, any settlement agreement is normally entered into by the employing entity who would not have the authority or power to enforce any terms regarding carry on the Carry Limited Partnership. Care should be taken to ensure that any terms regarding carry are kept distinct from the settlement agreement and where required, entered into between the Fund Manager and the Carry Limited Partnership instead.

Practical Tips

The following practical tips can help to address the employment aspects above:

  • Ensure communications to Fund Managers regarding carry do not refer to them as employees.
  • Ensure any communications and documentation regarding carry are sent on behalf of the Carry Limited Partnership and not the employing entity.
  • Avoid cross-referencing the employment relationship and/or employment contract with the employing entity in the carry documentation and communications and vice versa.
  • Ensure the definitions in both documents reflect the Fund structure to ensure the confidential information, client and prospective client contacts and business are sufficiently protected.
  • Keep restrictive covenants in the carry documentation distinct from those in the employment contract so to as to ensure the following differences are maintained to mitigate the associated tax and employment risks:
    • status (e.g. employee vs limited partner);
    • the legitimate interests being protected;
    • the entity who would enforce the covenants (e.g. employer vs Carry Limited Partnership); and
    • the event triggering the commencement of the covenants.
  • Avoid aligning the restrictive covenants in the different documents as the enforceability will vary due to the status of the Fund Manager.
  • Keep any settlement terms regarding carry separate from any relating to the termination of employment.
  • Avoid the employing entity entering into contractual commitments with the Fund Manager regarding their carried interest on the termination of their employment.

You can access DLA Piper’s multi-jurisdictional guide to Carried Interest here.

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