In this edition of Alt Insider: Business Intelligence, we revisit the topic of human capital and the impact of the active regulatory environment on human capital policies and compensation. In 2023, we saw regulatory action, inconsistent fund performance, volatile markets, elevated interest rates, low unemployment, and a softened yet hot labor market. These factors are expected to result in varied compensation and human capital policies across the alternative funds industry. In this edition of Business Intelligence we will not only break down the differences in policies based on performance but also highlight the discrepancies in how individuals are being paid by firm type. Lastly, we will discuss the continued lag of infrastructure of private managers compared to public managers, proving itself even concerning human capital initiatives.

The How, The What and Other Headlines Going Into Year-End

Given the continued competition for talent and pressure from investors, alternative asset managers are continuing to institutionalize processes and double down on paying for performance. Many managers have formalized philosophies that include fair and equitable compensation along with incentives aligned to individual, team and firm performance. Policies and procedures related to compensation provide a multitude of benefits including improved performance, increased retention, and enhanced appeal to investors. Finally, a recent push by many investors to see skin-in-the-game from, not only senior professionals, but also mid-level professionals has accelerated these changes.

Base Salaries
Historically, base salaries were not a major focal point in compensation conversations. However, over the past few years, given record inflation and heightened regulation around the disclosure of salary ranges in job postings, salaries have become a bigger part of discussions. Notably, according to Eisenhandler &Co., across alternatives, salary increases going into 2024 are likely to be at 5% for private funds managers. Further to this point, according to data gathered by Eisenhandler & Co., hedge funds have recently increased their salary caps to between $250K and $275K. Moreover, illiquid managers like alternative credit real estate and private equity, tend to have higher base salaries given their differing compensation philosophies and bend towards stability compared to hedge funds. Alternative credit and real estate base caps range between $300K to $375K and private equity skews even higher in the $400K to $500K range, significantly higher than hedge fund peers.

Restrictive Covenants
Considering the recent proposals prohibiting non-competes in the US, many firms have spent 2023 auditing restrictive covenants holistically, including non-competes. While non-competes are currently in legal limbo, recent proposals have led many firms to re-examine their own restrictive covenants including non-competes, garden leave, notice periods, and non-solicit agreements. Despite reassessment of policies, non-competes continue to range from thirty days to twelve months depending on level of seniority and role. On occasion, systematic and quantitative hedge funds continue to enforce non-compete periods of eighteen to twenty-four months to safeguard intellectual property. While many firms continue to leverage non-competes, it is worth noting, given the recent scrutiny, one could speculate managers will extend notice periods as a substitute for non-compete periods.

Equity
As firms plan for year end, succession and awarding the next generation of talent is an important component to be considered. Recently, both Schulte Roth & Zabel (SRZ) and Eisenhandler & Co. have seen a slow increase in interest from privately held alternative asset managers in establishing arrangements, to provide employees with opportunities to share in the future appreciation of their firms as ongoing concerns as opposed to investments in particular funds. To ensure a successful transition, the promotional criteria for each job level needs to be easily understood, well communicated, and most importantly, transparent. The path to partner for top-performers and the highest potential employees should revolve around building trust. Many firms plan to recognize, reward, and retain the next generation with phantom and/or real equity. These arrangements range from actual equity interests, typically in the form of profits interests, to so-called “phantom” arrangements in which participants may become entitled to cash bonuses in respect of annual profits and/or a payment upon the sale of the manager.  In many cases, the design of the arrangement is dictated by which employees the manager wants to include in as participants.

Additionally, while some managers have an initial intent to include all employees in equity opportunities, due to the complexity of the arrangements as well as tax and securities law issues, according to SRZ, most firms are restricting awards of profits interests to a limited, small group of key employees while other employees only participate in phantom arrangements. Finally, the framework will differ by firm, a key to the success of this type of program is ensuring employees and investors understand the award criteria for both forms of equity. If managers get this transition to the next generation right, the firm stands a much higher chance of successful succession. 

Carried Interest Programs
As a result of the market turmoil since the pandemic, many alternative asset managers have started launching new funds that deviate from their core strategy. Alternative asset managers that began more like hedge funds (predominantly liquid funds) have launched private equity and credit products (more illiquid strategies) leading to the challenge of allocating carried interest. The launching of these new vehicles necessitates the understanding of carried interest, the mechanics of which involve a radically different mentality around wealth accumulation because of the longer-term nature of the distributions. As firms navigate implementation of new compensation practices in the form of carried interest (e.g., eligibility, allocations, vesting, forfeiture, etc.), it is key to put significant thought into how these policies could impact fund and firm goals as well as the holistic firm culture.

Projected Compensation Forecasts
It is important to emphasize, we are still in the early innings of the 2023 compensation season and these forecasts are subject to change depending on performance.

• Base salaries: As mentioned above, base salaries are likely to increase by 5%.
• Senior Non-Investment Professionals (NIPs) across alternatives, at firms having challenging years, the bonus/incentives of senior NIPs are likely to be negatively impacted.
• Bonus pool projections for a select group of strategies:
  • Private equity: flattish for mid-market PE firms, up 5% for large multi-product managers. Carry distributions may be less than once expected.
  • Alternative credit: inconclusive, dependent on asset class, direct lending bonus pools likely to be up given outperformance and attraction from investors. 
  • Real estate: inconclusive, dependent on type of strategy however, many managers are challenged given the macroeconomic environment.
  • Hedge funds: dependent on performance, status of high watermark and AUM. Small to mid-size managers bonus pools flat to down. Larger multi-strategy firms are likely to be flat to up.
• Re-assessment based on the current challenging macroeconomic market and shift to an environment that favors employers vs employees.  It is key to assess headcount ahead of 2024 and consider areas of growth, holes in the organization and areas of excess capacity.
• Important for firms to focus on the most critical talent and ensure these individuals are rewarded and feel recognized.

The Bottom Line: To attract and retain talent it is important to highlight the total employee value proposition and each firm’s attributes as the compensation philosophy and structure is unique to each firm.

The above was gathered in collaboration with Eisenhandler & Co. LLP during September 2023.

“Pause and Re-Examine” – 2023 Regulatory Agenda Consequences on Human Capital Management

2023 has been a year of regulatory change in the private funds industry, including developments related to employment law. While much of the regulatory change has been slow to be adopted, proposed change has led many alternatives managers to reexamine current policies, especially related to Diversity, Equity & Inclusion (DEI), salary transparency and restrictive covenants.

DEI Initiatives
In June, the US Supreme Court released its long-awaited decision related to affirmative action in college admissions. In summary, the “Students for Fair Admissions (SFFA) v. Harvard” decision ruled the use of race is prohibited in university admission. While this decision does not cover private employers and related diversity programs, since this decision was released many private employers, specifically, fund managers began auditing their DEI programs for legal compliance. Several lawsuits have been filed following SFFA v. Harvard, alleging that employer DEI programs discriminate against white males. Early expectations indicate most managers will continue DEI programs, but ensure that race, gender or any other legally protected characteristic is not a factor in employment decisions.  

Restrictive Covenants
In January the US Federal Trade Commission proposed a ban on non-competes across all industries and roles. This led a few states, like New York to pass a non-compete ban (note the NY bill has not yet been signed by the Governor thus not in effect). This action by the federal government also led employers to begin re-examining practices with respect to restrictive covenants. It is worth noting that while the laws vary by state, similar to salary transparency statutes, there is a clear trend developing which places limitations on the use of non-competes.  

While the regulatory environment continues to evolve, as managers head into 2024, it will be important to continue to evolve human capital policies to adhere to new guidelines.

The above was written in collaboration with Schulte Roth & Zabel LLP.

MUFG Investor Services’ Alt Insider: Business Intelligence newsletter, curated insights by our Business Consulting team designed to bring you the latest news and trends in the alternative investment industry.