LP of the future: tying pay to performance

Staying competitive on remuneration will take some creative thinking.

Future LPs will incorporate performance-based incentives into their investment professionals’ compensation packages.

Data from the latest Coller Capital Global Private Equity Barometer show LPs whose remuneration is tied to private equity performance are almost three times more likely to deliver annual returns in excess of 16 percent than their peers.

Corporate pension funds and banks or asset managers are the most likely to include an element of performance-based compensation, at 80 percent and 77 percent respectively, according to the report. Just 41 percent of public or other pension funds or insurance companies do the same.

A GP-like compensation package has worked well for Ontario Municipal Employees’ Retirement System, which almost exclusively makes direct PE investments.

“OMERS wanted to build a direct-drive private equity business, and we understood that if we wanted to do that, we would have to be competitive” with GPs on compensation, says the pension’s global head of private equity Mark Redman, adding that compensation at the pension “tends to be more analogous to mid-market players” rather than the amounts on offer at large-cap and multi-strategy managers.

“To attract and retain top talent, you have to be sufficiently competitive that people feel fairly compensated.”

Mirja Lehmler-Brown, managing director in the private equity funds investment team at Hayfin, highlights the necessity of “alignment in a positive sense” to produce the best outcomes. But she stresses the need for that alignment to go beyond the individual.

“You do need to structure remuneration levels to incentivise teams, not just individuals, to perform together.”

Edi Truell, co-founder of private equity firm Disruptive Capital and a key figure behind the UK’s public pension consolidation, sees low salaries as a significant impediment to UK pensions’ success in private equity. Low pay deters the best investment professionals, and in his view is to blame for the lukewarm relationship between most of the country’s public pensions and the private equity industry.

“You have to be lucky to get a bunch of experienced people pro bono,” Truell told Private Equity International in April. “You’ve got to be prepared to pay proper money to attract the talent to take on private asset managers on equal terms.”

But performance-based remuneration is not without challenges. For starters, how do you structure an annual compensation scheme to take into account J-curves and other issues specific to long-term asset classes? It can also sway investment decisions – and not necessarily for the better.

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“It could cause some decisions to be made that could enhance performance, [such as] if you’re an LP compensated on short-term performance, wouldn’t you want to invest in private equity firms that aggressively use subscription lines of credit, because that mitigates against the J-curve and in some cases it enhances the performance,” says David Fann, president and chief executive at TorreyCove.

This underscores the need for alignment to be pursued “mindfully”, as Lehmler-Brown says. Working at an LP requires fundamentally different mindset to working at a GP.

“It can’t be only money-driven.”