Long Term Incentives in European Private Debt: Is Carried Interest the Most Effective Form of Team Retention?

Introduction

• Team retention issues raise questions around the efficacy of long term incentives.
• Managers must consider how best to compensate and incentivise their teams.

In mid-March 2024, twenty-two of the most senior members of Barings’ Direct Lending team simultaneously left to Nomura-backed Corinthia Global Management. Although Barings has retained its portfolio and worked to rebuild its team, the long-term effects on fundraising and enterprise value remain uncertain. Nevertheless, when the senior leadership from a manager with over $50bn AUM in Direct Lending are able and willing to leave en-masse, it highlights the need for closer attention to how managers incentivise their teams.

Over the last year, we have completed a thorough quantitative analysis of the levels of carry allocated across the industry and the varying approaches to carry systems between managers. While this report provided a lot of insight into the level of allocations that Investment Professionals across these teams receive, it also raised several additional questions. As this piece will explore, the future of long-term incentives in this space is uncertain, leaving room for debate about the efficacy of carry systems and the best approaches to retention.

With a growing universe of managers all vying for both top talent and a limited number of high quality deals for their funds, it is important for investment teams to be aware of how appealing other manager’s incentives are. As potential evolutions in systems develop, the managers will also need to take care to ensure they offer competitive schedules and payments in relation to their competition in order to attract and retain top talent.

What Is An Effective Long Term Incentive?

• The motivations of the manager and the employees in regards to long term incentives can conflict.

Ultimately, we must consider the efficacy of long term incentives from two, often competing perspectives.

The manager’s primary motivations in structuring their incentives are team retention and business growth with a view to maximise profits. They need to minimise turnover to sustain business operations and fundraising growth. However, they equally look to increase profits by limiting the fees allocated to employees.

In contrast, investment professionals prioritise maximising payouts and shortening return timelines but may accept longer waits if the potential rewards are substantial.

There will always be tension between these perspectives. The investment team want to secure larger payments. However, the manager seeks to maximise net profits from generated fees which is reduced in the short term by larger carry allocations. Additionally, the investment team would look to shorten the timeline on payouts where the manager wants to retain enough of a deferred element for them to feel “locked in”. Ultimately, an effective long-term incentive must balance satisfying the investment team’s motivation enough to ensure retention with maintaining deferred timelines that promote extended commitment and protect the manager’s profit share.

Where Carry Succeeds

• Carry has an established history in Private Equity.
• It offers substantial payouts with significant deferral acting as a theoretically strong motivation for retention.
• Carry scales with the size of funds allowing exposure to long-term GP growth.

Our research shows that currently, 59% of European Private Debt managers provide their teams with fund level carry. As already proven concept within Private Equity strategies, it is easy to see why it was mirrored within Direct Lending. Seen in isolation, closed funds with long timelines naturally struggle to provide for high cash compensation. While this is not universally true at scale, the annual management fees cannot necessarily provide high cash compensations. For managers without other revenue-generating strategies to support investment team compensation, a payout in relation to final fund liquidation is the easiest way to provide significant rewards. Providing the investment team a structured share of the final carry taken by the manager allows for candidates to be promised a tangible upside to their counterparts in other strategies.

At face value, traditional carry is very effective as a motivator for retention. The estimated final value is usually considerable and multi-year vesting periods mixed with the long timeline on distributions provides a potentially life-changing reward for long term loyalty. In our recruitment experience, it is challenging for candidates to consider a move when there are potential considerable liabilities in their name if they remain with their current employer.

Additionally, carry is a straightforward long-term incentive for managers to justify. Since the GP’s ability to collect incentive fees and distribute carry directly reflects the team’s investment performance, this structure appears merit based. It is simple to argue that the outcome of carry is a direct result of the strong or poor performance of the investment team and the compensation, or lack thereof, is justified.

Particularly with the current higher base rates, many are confident about the outlook of their carry pools. With static hurdle rates set before the rise in interest rates and recently closed funds not raising on primarily raising them, the high rates should theoretically make passing the hurdle rate and increasing the realised incentive fees for current vintages more reliable. In an environment in which one is confident in distributions, the huge payouts at the end of funds are an effective retention tool.

Moreover, as AUM grows, carry payouts in Private Debt strategies benefit from economies of scale. Although increased AUM usually leads to some team expansion, it seldom grows at the same pace, reducing the dilution of carry pools. As a result, having a set portion of the carry pools of steadily scaling funds opens the door to increasingly large potential payouts. If an individual stays at a manager over several fund raises, each larger than the other, they can expect the liquidation of the earliest funds in the short term while being provided progressively larger allocations for each new fund raise. Ultimately, carry systems are designed to reward loyalty and retention by aligning long-term value creation with team compensation.

The Core Problems

• The timeline to distributions can be too long for team members to wait for if they are considering a move.
• Carry payouts can be unreliable with problematic assets significantly reducing or preventing carry payments.
• There can be conflicting motivations between team members desire to maximise performance for distributions and GP’s aim to maximise deployment and larger fund raises.

With further interrogation, however, traditional carried interest has several flaws as a form of long-term incentive. These can broadly be broken down into Timeline Challenges, Reliability Issues, and Motivation Misalignment.

Timeline Challenges

As a simple retention tool to incentivise investment teams, traditional carry can struggle in the same place it succeeds: the long waits for payouts. While they can lock candidates in for up to a decade, there is a potential for the distributions to be too far away for team members to meaningfully wait for them, particularly if it is their first allocation.

Traditional carry in European Private Debt overwhelmingly follows the “European Waterfall Style”. The GP only realising carry once the overall fund hurdle rate is hit leaves a long timeline for distributions.

Where fund life cycles are, for example, four year investment periods and four year harvesting periods, the team is then waiting at least eight years for enough assets to realise to pass the hurdle rate if everything goes according to plan. Most funds will have additional extension periods for both phases thus often increasing the timeline by another two years. Even assuming payments are guaranteed, the timeline is a substantial wait. While long term deferral is desirable as a retention tool, this delay is long enough that we do not see candidates being overly dissuaded from leaving after their first allocation.

Reliability Issues

Furthermore, the previous section assumed that performance and successful realisation was guaranteed. In practice, carry payouts are not always reliable. Given the relative youth of the European Private Debt market, most funds have yet to complete their life cycles. According to our research of the eight major funds which are old enough to be expected to have paid distributions, (even after both normal and extension period timelines), only half of them have paid any substantial carry.

Unlike in Private Equity, where one asset can outperform substantially and return the initial investment several times over, Private Debt lacks the potential upside to reliably make up for underperforming assets. All it takes is a small number of assets to underperform or default for the fund’s hurdle rate to be missed thus causing no carry to be generated. There is thus a reliability issue. With a limited universe of good credits in European and growing number of Direct Lenders, portfolios cannot all be fully healthy. Moreover, if single assets can be the between successful or unsuccessful generating carry even strong portfolios have the risk of unforeseen circumstances effecting a single company and threatening distributions. Several major Direct Lending managers have equitized positions in their portfolio over recent years. Even with the best investment decisions, with a sizeable enough portfolio problematic assets are inevitable. With underperforming assets or owned companies, at best the timeline is extended by an uncertain amount and at worst the assets cannot be turned around and no carry distributions are paid.

Motivation Misalignment

Finally, carry at its core demonstrates a mismatch of motivations between the manager and its employee. The investment team is incentivized to maximize fund performance, a goal that aligns with the manager’s interests at face value. However, the GP’s core motivations often diverge.

Because carry does not heavily influence LP investment decisions, it is of lesser importance to the GP’s profit generation. The team’s incentives derive from the carry pool based on a 10-15% fee on returns (assuming the hurdle rate is met), whereas the GP’s profit comes primarily from the more predictable 1-2% annual management fees. The manager does, of course, have to use a portion of this to cover the team’s annual cash compensation but other than this the team has no claim on the capital generated from those fees.

As previously mentioned, most managers are focused on business growth with the end goal to maximise profits. Especially as managers and their boards get larger and more well established, the emphasis can shift more towards avoiding underperformance than achieving significant overperformance. It has been demonstrated that more revenue can be raised through putting significant money to work and raising the next fund rather than waiting to only invest in the highest performing deals. As a result, they are not as motivated to pursue overperformance but instead to deploy quickly and substantially. The core of carry thus incentivises the team to achieve a metric which is not the manager’s ultimate concern.

Can These Problems Be Fixed With Carry?

• American Waterfall Style carry can improve the timeline and reliability but is unlikely to become commonplace in traditional funds.
• Carried interest systems struggle to fix the motivational misalignment.

While this piece will discuss potential alternatives to carried interest, it is worth exploring whether carry systems themselves could be adapted to address current challenges.

While differing motivations between managers and investment teams are inherent to carry, alternative forms could shorten timelines and improve payout reliability. One example is the American Waterfall Style, which distributes carry on a deal-by-deal basis. Although currently adopted by a minority of European managers, this style offers potential advantages. This approach provides more frequent payouts, allowing investment teams to access cash earlier in the fund’s lifecycle, rather than waiting for full liquidations. Despite its benefits for investment teams, this structure remains unpopular with LPs, who prefer systems that ensure they recover most of their returns before the GP claims incentive fees.

In the future, this approach may gain greater viability. The rise of evergreen funds, designed to attract a broader investor base, could drive greater adoption of the American Waterfall Style. In open-ended funds, applying the traditional European style is less feasible, making the American style a more justifiable choice. Theoretically, if these vehicles continue to become more common, we will see a growth of this carry style which may be a draw for investment teams looking to secure shorter term payouts.

Ultimately, however, without a majority shift to evergreen fund structures it is unlikely that the American Waterfall Style will become common given its implications for LPs. While evergreen structures are developing, they may not even generate carry, as will be discussed later, and closed-ended funds remain a longstanding norm that is unlikely to shift dramatically.

Fundamentally, formulaic carry systems cannot resolve the issue of mismatched motivations. Nor can they address challenges around timelines and reliability without significant changes in market structures or persuading LPs to accept less favourable terms for closed-ended funds.

The Evolution of Manager’s Vehicles

• The increased size of SMAs may lead to further use of American Style or even synthetic forms of carry.
• Synthetic carry can provide an effective alternative to traditional formulaic carry for both SMAs and overall strategies.
• Vehicles are being raised without incentive fees that may lead to changes in how teams are incentivised.

As managers grow, their vehicles are becoming more complex. With a variety of vintages, SMAs, and other strategies, what people refer to as “carry” is not always simple fund level formulaic allocations. With more vehicles and subsequently more flexible approaches to carry itself we have already seen competitive systems of long term incentive that overlap with traditional carry becoming more common.

SMAs

Firstly, managers are raising more SMAs. The majority of managers that make use of SMAs alongside traditional funds provide some form of carry allocation on them. Additionally, there is far greater flexibility towards how their allocations and distributions are provided.

SMAs appeal to larger LPs because they allow customization across mandates, return structures, and fee negotiations. As a result, particularly among larger managers, SMAs are likely to continue to be a substantial factor in newer strategies. Additionally, splitting allocations among multiple smaller vehicles reduces the risk of a few assets depleting a large carry pool. However, in an asset class that benefits significantly from scale, these SMAs will only exist alongside larger funds with more lucrative upsides.

Large managers with diverse vehicles can implement broader “synthetic” SMA carry styles. Along with traditional European and American style carry, these substantial managers can effectively pool the carry distributions for SMAs. This allows managers to provide annual returns to investment teams based on realized SMA incentive fees, ensuring regular payments and more reliable distributions through a diverse range of vehicles.

This approach benefits significantly from economies of scale. Smaller managers are unlikely to have a number of vehicles that justify pooling carry distributions when they can simply provide formulaic carry in individual accounts nor are their returns likely to be as regular. We can already see a divide here between larger and smaller managers and, with the majority of fundraising increasingly going towards a small group of managers, this is likely to increase.

If mega-funds continue to grow and monopolise the upper mid and large cap market with progressively larger AUMs, it is clear that some managers will have far more vehicles and thus much more regular and reliable distributions in a way that their lower market focused peers could not necessarily provide.

Broader Synthetic Carry

SMAs are not the only area for synthetic carry. There is a trend for larger managers to synthetically pool their wider vehicles. Currently, 19% of managers implement some form of overall synthetic carry. While this can cover exclusively Private Debt strategies, they regularly provide some carry exposure to other strategies. Managers such as KKR or Partners Group annually allocate carry across all their strategies. In a similar way to pooled SMAs, this provides an improved timeline to distributions as they can follow the varied payout schedules of a range of fund raised at different times and with different life cycles. Additionally, aside from simply speeding up payouts, exposure to different strategies can be attractive to Private Debt team members who can benefit from the higher potential upside of strategies.

In contrast to SMA carry, synthetically pooling flagship funds and larger vehicles allows for the timeline and reliability of payments to be solved while still providing large distributions which smaller SMAs are not always able to do.

For the managers themselves, avoiding formulaic incentive fee percentages offers greater control over distributions. They can ensure the team members get paid regularly but they can also take steps to limit the potential for outsized carry payments. This system strikes a balance by improving the timeline and reliability of payouts, addressing team concerns about regular payments. At the same time, it retains enough of a deferred component to keep investment professionals engaged and reduce turnover.

Furthermore, it helps managers promote teams within growing multi-strategy platforms. For most of these managers, Private Debt is not the sole vertical, and they are looking to develop new strategies. Building and compensating new teams, particularly for strategies with closed end funds, is traditionally challenging as returns are limited until the end of their fund life-cycles. With synthetic carry systems that cross between a manager’s strategies, these newer teams can still be well compensated while they work towards building their own investments and performance. This means that a synthetic carry approach can provide a scaling ability to a platform to launch new stable teams.

While the portion of the market that relies on large synthetic carry systems is fairly small, it is easy to see how this can evolve to be more common. It would be difficult for most established funds to announce to their teams that the next large flagship vehicle would not provide any traditional carry. However, as previously discussed SMA carry can be pooled synthetically. With several managers increasing the number of vehicles that feed into these pools it can act as a proof of concept leading to more varied and larger vehicles and maybe one day even more flagship funds being part of the synthetic carry pools.

As an alternative approach to carry, however, it is challenging to see how smaller managers would provide this type of synthetic carry. Where a manager has a single or very few strategies and a limited number of vehicles, there are less benefits to a synthetic carry system. Without the scale and number of vehicles, it is not possible to have the synthetic payouts be reliable or follow a shorter timeline. It instead returns to sharing the same issues as traditional formulaic carry in which distributions are dependent on the completion of key fund life-cycles.

Despite its advantages and likely future adoption, synthetic carry could contribute to a bifurcation in incentive styles, as smaller managers may lack the resources to adopt this approach. Thus, if synthetic carry is deemed to be a stronger form of incentive, especially in its ability to scale with manager sizes, it could lead to a further widening of overall compensation levels and reliability between the bigger and smaller ends of the market.

The Future of Incentive Fees

Despite being the source of carry and a part of practically all Private Debt fund structures, incentive fees are not guaranteed to be a part of all future funds. Notably, both KKR and Carlyle have announced upcoming evergreen funds that will collect no carry whatsoever. This naturally begs the question of how investment teams would be incentivised.

Unlike previously discussed evergreen funds which charged incentive fees, if no-carry vehicles sought to provide any form of carry-payments they would rely on some form of pooled synthetic system that comes out of management fees in line with performance based on the employee at work. While it is not to say that these no-incentive fee funds will become commonplace, the competition for LPs in an already reasonably saturated market could lead more managers to go this way to attract investors. Without resorting to a synthetic carry system in these examples, the manager would have to forgo any form of carry and instead consider alternative form of long term incentive.

Equity

• The provision of equity can be a measure to realign motivations between the manager and team.
• Equity provides indirect exposure to management fees and provides strong alignment with AUM growth.
• Unlisted equity can lead to much larger payouts, however, managers may be less willing to provide it.

The possible evolutions we have discussed around carry systems improve the timeline and reliability of long term payouts but they largely fail to realign the motivations between managers and their teams. This raises an important question: is there a long-term incentive that effectively aligns these motivations? The answer lies in the provision of equity, which is increasingly common, albeit in smaller amounts, alongside carry in many private debt strategies.

Equity effectively realigns these motivations. While both LPs and GPs place less emphasis on overperformance, investment teams are most impacted when hurdle rates are either partially met without full catch-up or entirely missed, resulting in no incentive fees. In an AUM-focused strategy, where managers are motivated by raising larger funds and driving business growth, equity aligns the team with these goals.

Carry rewards are tied to fund performance but only indirectly align with AUM-focused goals. While strong performance can aid future fundraising, overperformance is not a requirement. Moreover, as more managers concentrate on large-cap transactions, where products become commoditized and potential upsides stabilize, carry’s alignment with business growth motivations diminishes.

Does it then make sense to directly incentivise the team for the end goal of the GP? Very few managers forgo carry entirely and replace it with equity although some, such as Apollo or Tikehau, only provide shares as a long term incentive. Many managers give some equity alongside carry but this is usually at a far smaller level than it would have to be if carry systems were to be replaced.

Providing that larger funds continue to be raised, gaining equity provides direct and reliable returns against the prospect of waiting to see if the hurdle rate is hit for incentive fees to be taken. Equity allows teams to directly benefit from management fees, which are often more substantial than incentive fees. This improves payout reliability and reduces dependence on meeting specific incentive fee thresholds. Where these fees are taken, the manager’s value will further increase which continues to incentivise the team by performance while also providing compensation in accordance to manager growth.

For listed companies, equity is a much simpler incentive. While it still provides potential fluctuations in value and ability to profit in term of long term manager growth, it is also fairly liquid outside of a vesting period. As a result, it acts much more similarly to an additional bonus that manager can provide without increasing cash compensation.

Additionally, this improves the timelines against traditional carry. Listed equity allocations can be provided annually alongside bonuses instead of exclusively at fund closes and can follow a determined deferral structure while still provide team members with long term incentives dependent on retention but offers a predictable schedule.

Where we see more substantial swings in potential upside is in unlisted equity. We currently see many managers looking for a sale or IPO. In these scenarios, investment teams with significant equity are highly motivated and substantially rewarded by a sale. For unlisted equity to be effective, however, there must be a timeline towards a sale or IPO or any equity or options would have no liquidation event.

Both situations still motivate the team to work towards strong performance to generate higher incentive fee returns, help raise larger future funds which they will have exposure to the management fees through the equity, and in the case of unlisted companies to help justify a potential buyout or IPO at the highest enterprise value possible.

Moreover, equity allocations can scale far more easily with seniority. Instead of being allocated an amount of carry equal to one’s current corporate title and receiving it in 8+ years after potentially several promotions, allocation can be adjusted in accordance to the individual’s seniority, personal performance, and overall fund/manager performance. This has the opportunity to provide an attractive ability for long term incentives to more closely follow progression and more control from the manager over the levels they give out.

While it undeniably realigns the interest between the manager and the investment team, one could argue that an alternative system such as the previously discussed synthetic carry solves the issues of timeline and reliability to a similar extent as equity does. Other than the less tangible issue of motivations, what additional benefits does equity bring? One of equity’s key advantages is accessibility. As mentioned previously, a synthetic carry system requires managers to be of significant size, typically with multiple strategies, to facilitate regular, substantial, and reliable allocations. In contrast, equity can be made available to smaller managers. Obviously, if it is too small there may be a smaller value in the equity, however, with growth there is a higher potential to generate outsized returns, and it far easier for managers outside of the mega funds to provide equity than a system like synthetic carry.

However, the dilution of equity is a mitigating factor preventing some from providing significant equity. Particularly in an unlisted company, it is potentially difficult for the current equity holders who have taken on risk to justify giving away their valuable equity to members of the team. The value proposition, however, is that if the provision of equity results in a more effective method of retaining a high quality team, then the value of the retained equity may end up being more than the smaller portion given away.

Conclusion

To conclude, while carry remains a logical and established incentive system, it is not without significant flaws. Carry serves as a seemingly effective retention tool, leveraging substantially delayed distributions and offering potentially life-changing payouts to investment teams contingent on strong performance. There is no evidence to suggest that carry will disappear. It is ingrained from its tenure in Private Equity and on paper it is a logical system. If the fund performs well everyone is extremely well compensated and if it does not then their carry is in jeopardy.

However, as the realities of Private Debt funds become more apparent, shifts in incentive structures are likely. It is open to debate how successful Private Debt funds continue to be but if we are already seeing delays, equitized portfolio companies, and threats of missed hurdle rates in what has been a growing universe of managers we will surely see more funds which invested during the lower rate environment come to their conclusion without paying attractive distributions. While vintages that invested with lower fixed hurdle rates in the current high interest rate conditions may not struggle realising carry, future vintages with higher hurdle rates or following rates cuts may be likely to struggle once again.

Ultimately, we can’t know how exactly these systems will evolve but it is clear to see that managers will vary and experiment with forms of long term incentives. Investment professionals must closely monitor how their carry and long-term incentives compare to industry standards. Similarly, managers must carefully design incentive structures to retain top talent and guard against competitors offering faster or more reliable payouts.

In an environment shaken by the team exodus at Barings, there will be far more scrutiny going towards how long term incentives function and how successful retention is within the market. In the coming years, we will watch as the rest of the early entrants to European Private Debt reach the end of their fund life cycles as carried interest continues to be stress tested. This will likely dictate if traditional carry continues to become the established primary incentive of the space or if the struggle for top talent forces evolution to alternative systems.