This executive reward option can motivate fund managers and encourage long-term growth, for example Chris Lebâcle, technical director of interest, and Shane Hugill, Head of Executive Compensation Services, Intertrust Group
Deferred interest is in the spotlight after being the target of tax changes by the UK’s main opposition party, Labor.
This is an executive incentive plan used by private equity and real estate fund managers (fund managers) to reward executives and employees within internal fund teams (members holding funds). ‘interest) with a share of the investment profits.
Fictional Chancellor Rachel Reeves announced last month that up to £ 440million a year could be raised by taxing deferred – or deferred – interest as income rather than earnings.
Under current rules, carry is taxed at the 28% capital gains rate, rather than the higher tax rate of 45%. The Labor Party’s proposal – which would treat the deferral as a management fee, not a capital gain – is part of its broader review of taxes and spending.
However, for many players in fund management, human resources and executive compensation, the system offers several advantages.
The carry is paid to members with deferred interest as a reward for the growth of long-term investments, based on the success of a fund. As a direct incentive, it therefore encourages these members to stay focused on the performance of their funds.
So, crucially, it benefits not only those who receive it, but also institutional investors, such as large pension funds (and their beneficiaries) who often invest in the funds.
How does the interest work?
Most funds have strict performance criteria that must be met before any deferred interest is paid. The regulations also cover how long the investment must be held before deferred interest members can potentially benefit from capital gains tax rates rather than income tax.
In the US, this only happens after the funds have been held for three years, with a similar rule in the UK.
The tax treatment of deferred interest is under continuous review, so it is important for fund managers to ensure that their structures are in line with applicable regulations. These ever-changing regulations limit the scope of malpractice, as fund managers must ensure that detailed and accurate records are kept and that proper reports are completed.
The amounts that interest-bearing members may receive depend on the specific provisions of the fund. Only the best returns on fund performance offer the potential for deferred interest, and an internal rate of return (“IRR”) or minimum rate of return must be achieved before any deferred interest becomes payable, ensuring that the focus be on solid performance.
The total sum of the deferred interest is distributed according to a predetermined ratio among the participants. So while the deferred total interest plan can provide a 20% return, an individual’s participation can be as low as 1%.
For example, for a £ 1bn fund with a 10% cut-off rate, only investment profits over £ 100m would be subject to deferred interest. If the fund brought in £ 101million, then £ 1million would be attributable to the carry.
But deferred interest members don’t necessarily benefit directly as this £ 1million profit has to be shared with other third party investors. If the deferred interest vehicle has a 20% interest, the return on deferred interest will be 20% of £ 1 million, or £ 200,000. This is then distributed among the members with deferred interest, so that a member with 1% of the deferral will get £ 2,000. So the actual deferred interest returns are not as inflated as some people think.
During the typical ten to twelve year fund lifecycle, the first three to five years are typically focused on investing and growing. It is only after this that the fund can consider divesting itself and reaping the benefits of these investments. Porterage can only be paid for after that – often after a longer period, with a typical delay of five to seven years.
This provides an incentive for deferred interest members to invest in the fund personally – and hold it for the medium to long term. Interest-bearing members typically target long-term growth, as a successful balance sheet helps them attract new investors for subsequent funds. The fund’s assets are also usually sold to another fund, again making sustainable growth important.
Deferred interest directly links the reward to sustainable growth
There is generally no automatic payment in deferred interest plans. Because they are tied to the success of specific funds that interested members have worked on, members are incentivized to make a return that erases the initially agreed limit rate. This gives both interested members and investors a clear view of the goals and rewards.
The timing of deferred interest regimes can also help ensure sustainable growth, by encouraging long-term commitment and discouraging asset stripping. While this is sometimes a concern, it’s not something we’ve actually seen happen.
Work with a partner to manage a deferred interest plan
Transportation plans are complex and administering them internally can be a challenge, especially in the face of complex and changing regulations. Working with an expert partner, such as Intertrust Group, can provide the necessary support.
Such a partnership gives fund managers efficient access to precise data as their teams evolve. It also ensures that they can manage the ever-changing tax, regulatory and reporting requirements to ensure that a plan is compliant and does not expose the fund to financial or reputational risk.
Deferred interest may be the subject of ongoing review and challenge, but it is a well-established legal form of compensation and for many fund managers it is part of a set of well-balanced compensation.
A solid supply of deferred interest is an important part of executive compensation plans and should ultimately benefit institutional investors.
Why Intertrust Group?
Intertrust Group has expertise in managing a wide variety of deferred interest and other deferral plans.
We use state of the art technology to ensure that your deferred interest plan is set up and managed appropriately, keeping data confidential where necessary, as we understand the importance of these plans containing details of the employee compensation agreements.
We work closely with the internal human resources departments and lawyers to draft all the documents necessary for the implementation of deferred interest plans, organize the allocation of deferred interest, as well as the transfer for any departure event. .
We help businesses and executives manage and track deferred interest plans by also performing regular reviews with fund teams to ensure records are kept up to date and accurate.
Contact our team for more information