Getting a Slice of the Action: Employee Co-Investment in Private Funds

Employee co-investment is an increasingly important tool for private fund managers. Implementing, refreshing or widening an employee co-investment scheme can generate a lot of interest, excitement and alignment within a firm, help drive strategic change within an organization and build alignment with external investors.

Reasons to widen employee co-investment

• Reward: a valuable component of employee reward package, as it allows employees to access (and perhaps leverage) strategies not usually available to ‘retail’ investors.
• Retention: employees do not just ‘feel’ invested in the firm, they are invested in the firm!
• Recruiting: offering a compelling employee co-invest program can give a competitive edge in recruiting.
• Community: Increases the sense of democratization within a firm (it is not just the most senior employees who get to invest).
• Alignment: Attractive to fund investors, as it demonstrates alignment with the business and a sense of shared ownership in the strategies offered. Employee co-investment can also form part of the ‘GP commitment’ to the fund, although this is not always the case.

Broadly, employee co-investment can be structured in three forms:

1. Direct investment into the main fund.  This is generally used where only a few (senior) employees are investing, not least given the financial barriers to entry to investing directly into a private fund, and potential complications around having individual employees and institutional investors commingled in the same structure
2. Separate employee co-investment fund, formed to invest in or alongside the main fund.  This is often a more appropriate structure, especially where larger numbers of employees are concerned, and as such is the focus of this note.
3. Phantom program (also referred to as synthetic or shadow program). These are effectively bonus or profit sharing programs linked to fund performance, and are briefly discussed at the end of this note.

Whilst there are a number of regulatory, tax and operational points (many of which are jurisdiction-dependent) to work through in creating employee co-investment structures, these can generally be overcome.  In this article we will discuss some common themes and big picture considerations in setting up and running these programs.

Initial Decisions

There are a number of initial strategic decisions to make when a manager decides to create an employee co-investment fund:

Will the vehicle be investing into only one or multiple strategies? If broad exposure to the manager’s business is required, the employee co-investment fund could invest in (or alongside) multiple strategies offered by the manager. This can be a good way to help align employees across the whole firm as well as offer them a more diversified investment. It also lends itself well to employees whose role supports multiple different strategies within the organization. Alternatively, if exposure is only required on a fund-by-fund basis, a manager can either form near-identical employee co-investment funds for each underlying fund or set up an overarching co-investment vehicle. The latter could have separate classes or sub-funds, each with different employee investor populations and formed to invest in (or alongside) a separate underlying fund. Replicating a single vehicle for each fund can be a simple solution but can result in an administrative burden given the number of vehicles that could be formed over time. In contrast, the option of using a multiple class or sub-fund structure reduces the administration to one vehicle.

Will the co-investment fund invest as a feeder fund into the main fund, or will it co-invest alongside the main fund? The answer to this question will be influenced by the existing fund structures and whether they are set up for feeders or parallel investment. Also, if employees in the United States are involved, there are regulatory issues related to the entity having been formed for the purpose that will likely have a bearing on this question (see below).

How widely will the co-investment fund be offered? Ultimately, this may be dictated by the employees’ local regulatory requirements as different jurisdictions have different approaches to investor eligibility. However, as a commercial matter, managers may wish to determine a threshold level of seniority/role or compensation within the firm, at which point an employee becomes eligible to invest. Also, firms will need to consider whether they will allow personal investment vehicles, parties who are not technically employees (such as spouses/partners, retirees or consultants), family members or family investment vehicles/trusts to participate. Extending investment beyond the employee themselves could cause regulatory issues in certain jurisdictions, which would need to be considered as part of the structuring process. For example, in Europe and the United Kingdom, it is likely that an employee co-investment structure would rely on an exemption from the Alternative Investment Fund Managers Directive (“AIFMD”) on the basis that the employee co-investment fund was an ‘employee participation scheme’. Whilst clear guidance on what constitutes an ‘employee participation scheme’ is sparse across European Union member states, a prudent approach would be to assume that the further removed a party is from the employment relationship, the less likely the exemption is to apply. Considerations relevant to the jurisdiction of the fund also need to be considered. For example, if the employee co-investment fund were structured in the Cayman Islands, it may rely upon an exemption from the Cayman private funds regime on the basis that the investment derives from ‘proprietary money’; but this exemption may not be available if participation in the scheme is extended too far beyond the employment relationship such that the money ceases to be considered ‘proprietary’.

Structure of employee vehicle. The location and legal form of the employee vehicle are likely to be driven by a number of factors, including the location of the eligible employees and the relative number of these populations, the fund jurisdictions that the manager is currently working with, and the nature of the investments. Employees concentrated in one location will make a domestic fund structure a prime contender, if a suitable structure is available. Managers wishing to create a truly global offering may wish to opt for an offshore location, such as the Cayman Islands, or may anticipate sufficient uptake that parallel funds might be considered to cater for, say, employees based in the United States and Europe. Jurisdictions that allow legal segregation between sub-funds or ‘sleeves’ of the same vehicle can offer managers more flexibility in terms of offering different strategies or leverage options. As with more vanilla private funds, the tax treatment of the employee co-investment fund in the relevant employee jurisdictions is also likely to inform the structure.

Will the vehicle be leveraged? The manager will also want to consider if leverage will be applied to the employees’ investments. Some managers provide leverage internally, whilst others look to a third-party lender. This raises questions around default, guarantees, set offs and so forth and can present tax issues in certain jurisdictions. Similarly, some managers will only offer a levered option whilst others will offer multiple levels of leverage (potentially offering a higher level of gearing to more senior employees). Increasing the leverage options will likely increase the complexity of the structure as well as increase the chance of needing to use separate investment classes or potentially different sub-funds or other legal entities.

Economic terms. The manager will need to consider if fee or carried interest waivers will be offered on employee investment. In some instances charging performance-based fees to the employee investors could cause issues under the U.S. Investment Advisers Act of 1940, so care should be taken if the vehicle will bear carried interest or other performance fees and is also offered to U.S. employees. In addition, the manager will need to consider whether other costs (such as the costs of establishing and operating the co-investment program as well as the underlying funds) will be borne by employees, or whether there will be some form of ‘subsidy’ from the house.

Offering the Employee Scheme

There are a number of regulatory points to consider with respect to employee co-investment structures. First and foremost, it is important to understand the regulatory position regarding offering employee schemes in each jurisdiction in which participating employees reside. Regulation was cited as the most common perceived barrier to widening an employee co-investment program in a vote of approximately 80 private fund in-house counsels at the most recent Dechert Private Funds Legal Retreat. However, the following overview of certain key geographic considerations demonstrates that regulatory issues are certainly not insurmountable.

Europe-based Employees

In the United Kingdom and Europe, it is possible to structure an employee co-investment fund so as to be exempted from the AIFMD on the basis of the fund being an ‘employee participation scheme’, but, as discussed above, this is not a ‘given’ and specific advice and structural considerations will be necessary, as the position is ill-defined in many European jurisdictions.

In addition, in Europe and the United Kingdom, legislation regarding selling products to ‘retail’ investors is capable of biting on employee schemes. That means that a key information document (“KID”) including certain prescribed information might be required. The requirement derives from the Packaged Retail and Insurance-Based Investment Products Regulation, which requires that a KID be produced before a packaged retail and insurance-based investment product (“PRIIP”) is made available to retail investors. As with the AIFMD exemption, whilst there is some scope for different approaches, in practice many managers categorize their employee schemes as PRIIPs. There is an alternative to producing a KID where the manager is able to ‘opt up’ an employee to ‘professional investor’ status. This is a prescribed process, requiring the manager (which must be regulated in the relevant European Union Member State and/or the United Kingdom, as applicable) to undertake an assessment of the expertise, experience and knowledge of the investor. However, this route is generally only possible for smaller schemes that are only offered to more senior employees.

U.S.-based Employees

There are a number of considerations for offering to U.S. employees. For example, if the employee co-investment fund is offered pursuant to rule 506 of Regulation D under Section 4(a)(2) of the U.S. Securities Act of 1933 (the “Securities Act”), the employees must be ‘accredited investors’ (although up to 35 non-accredited investors may be permitted to participate). Additional eligibility criteria may also arise out of the fact that the employee co-investment fund will generally rely on an exceptions from the definition of “investment company” under the U.S. Investment Company Act of 1940 (the "1940 Act"). In this way, the fund may need to monitor to see if the employees are “qualified purchasers” or “knowledgeable employees” (if the employee co-investment fund is seeking to be treated as a Section 3(c)(7) fund). Whilst the qualified purchaser test looks to a certain threshold of assets,¹ the “knowledgeable employee” test needs to be applied to each employee’s role, which can be laborious for the manager (and can also significantly reduce the pool of eligible employees). Another approach would be to seek to treat the fund as a Section 3(c)(1) fund: this doesn’t apply the qualified purchaser or knowledgeable employee test, but requires that the fund’s outstanding securities (other than short-term paper) to be beneficially owned by not more than 100 persons, which could significantly limit a program that would otherwise be broadly offered. Another alternative approach to the foregoing would be to seek to be exempt from most provisions of the 1940 Act by applying to the U.S. Securities and Exchange Commission to be treated as an employees’ securities company. A key advantage of this approach is that the employee co-investment fund would have no numerical limitation on the number of investors. The trade-off is an ongoing compliance burden associated with this.

Employees Based Elsewhere

A lot of jurisdictions do not have particular statutory regimes for employee participation programs, as are found in the U.S. and Europe, which means the offering needs to be brought within general securities offering regimes or tolerated exemptions. The position varies widely from country to country, and it is recommended that managers seek advice specific to their structure and employee footprint prior to formally offering their program.

Dealing With a Global Workforce

When working with a manager on rolling out a global program, Dechert’s approach is to assess the number and seniority of potentially eligible employees in each jurisdiction and to apply our prior experience of each jurisdiction to help the manager navigate eligibility, regulatory and tax issues.  All inputs can then be consolidated to allow the manager to take an informed decision, weighing the risks and commercial benefits, on a number of issues, such as:

• whether the scheme will be open to employees in all jurisdictions, or whether some will need to be excluded;
• eligibility criteria for investors in the scheme, and whether these will be the same globally or differ from country to country;
• whether employees in certain jurisdictions will need to invest through different vehicles in order to accommodate local requirements, or whether all can invest through the same vehicle;
• whether the subscription terms available will be the same globally or differ from jurisdiction to jurisdiction; and
• how the employee scheme can and will be promoted or ‘marketed’ to employees.

Tax Issues

Clearly, the manager and employees will be concerned to ensure that the employee structure itself does not impose an additional layer of taxation on fund returns and, to the extent possible, that it delivers the most efficient tax outcome available (for example, capital gains versus income treatment). As with regulation, the tax position can vary significantly from country to country. There are two gating questions for managers to consider. First, how much will the manager seek to understand the position in each jurisdiction prior to structuring the scheme and offering it to employees; second, will the manager entertain possibly offering different vehicles in order to optimize the tax position for different employees? Different managers pursue different approaches. Some will vary their approach based on the number (and, perhaps, seniority) of employees in particular jurisdictions. Others will adopt a ‘take it or leave it’ approach.

Advisory Structure

If the structure is a simple feeder set-up, it may be that a manager/adviser does not need to be appointed, which can ease some of the compliance burden in creating such a structure. However, even if no adviser is appointed, it is possible for regulatory activities to be inadvertently undertaken by the manager on or behalf of the fund, and operating guidelines should be established to ensure that regulated activities are not unwittingly undertaken. More complex employee scheme structures are likely to require an investment manager/adviser, in which case an appropriate entity within the group will need to be identified.

Impact on Underlying Fund(s)

For employee schemes that will invest directly into an underlying fund sponsored by the manager (as opposed to side by side with the fund), it is also crucial to ensure that the scheme meets any applicable eligibility criteria and will not have any adverse impact on the underlying fund. For example, to the extent that the employee co-investment fund is deemed to be formed for the purpose of investing in the underlying fund (which is likely if the employee fund only focuses on one underlying fund), the underlying fund will look through to the participants in the employee fund in terms of its own compliance with U.S. securities laws.

In addition, managers will often want employee scheme funds to form part of the GP commitment. In this regard, the employee scheme may need to co-exist with other vehicles included in this calculation, for example, founder family office vehicles, carried interest/co-investment vehicles, etc.

All of the above will need to be accommodated within existing disclosures at the level of the underlying funds (unless it is practical to amend these) and planned future funds.

Operational Issues

Especially where a closed-ended employee co-investment fund structure is used, there are a number of operational points to consider when dealing with an employee population that will change over time as employees come and go:

New joiners. Issues to consider include how new joiners will be treated. There are a number of options here. First, the manager could hold a pool of interests for new employees pending them being hired and passing their probation periods. This requires some administration though, as well as consideration of tax issues regarding the holding and subsequent allocation of the ‘pool’. Another option is to adopt a cut-off point where no new employees may join a scheme (in relation to an existing fund) and will have to wait for a successor vintage (or, potentially, a secondary transfer in the event of a departure) in order to invest. The least formal route would be an internal expectation that senior individuals who have taken a large stake in the employee co-investment fund would transfer a portion of their interest to significant new joiners. However, this approach could present issues in the United States, where investors have to represent that they are purchasing their interests for investment purposes and not with a view to resale.

Leavers. The treatment of leavers will also need to be drafted into the documents, including the relative treatment of ‘good’ leavers (e.g., those leaving for reasons such as retirement, disability, death etc.) versus ‘bad’ leavers (e.g., those leaving for a competitor). Given employees will have typically invested their own money in the structure, it is more difficult to argue that draconian measures should be applied, although an appropriate adjustment to value or compulsory transfer might be appropriate in certain situations (for example, ‘for cause’ termination). There will also be other practical and commercial questions where a leaver has left the firm to a competitor but retains an interest in the employee co-investment fund, for example, the level of reporting they should receive and whether this reveals any commercially sensitive information. Managers will also need to consider how, if the employee co-investment fund has made an illiquid investment in an underlying fund, the leavers’ stake will be funded and who an appropriate transferee might be.

Drawdowns and defaults. Another area for consideration is the drawdown schedule (assuming the entire investment is not required upfront). Broadly there are two options – drawdowns could be aligned to draw down requests from the underlying fund, or a drawdown schedule could be pre-agreed in the employee co-investment fund documents. If the latter approach is used, managers sometimes align payments to the bonus year to assist employees in funding their commitments. Consideration also needs to be given of how defaults will be managed. For example, how much grace period will employees get; how much administrative support will employees be given to manage drawdowns and avoid default; what will the consequences of default be and how will the funding gap be bridged in this event?

Other common operational questions:

• Will employees fund the employee co-investment fund through their own money, through an in-house or third-party loan facility or through a form of salary sacrifice/bonus pool? The latter two can be very effective, but raise employment law and tax issues that need to be considered on a jurisdiction-by-jurisdiction basis.
• Will employees be able to invest in their local currency?
• Will a third-party administrator be appointed and, if so, will they be involved in the verification of the subscription documentation? Many managers elect to use electronic subscription documentation for employee funds in order to simplify the process for all concerned, although both the subscription documents and the accompanying tax forms will still require checking before admission to the partnership.
• What standard of AML and customer due diligence will be required of the employee participants?

Phantom Schemes

Synthetic award programs deliver a cash return to participants based on a notional investment in the underlying fund(s) or strategies rather than an equity investment in a purpose-built employee co-investment fund.

There are a number of advantages of these structures, including the fact that, since they are implemented by contract, there is no need to create and operate a specific vehicle. There is also flexibility in being able to tailor the offering for specific circumstances or jurisdictions (although generally managers try to keep their programs relatively consistent, both for operational ease and also employee perception reasons). Phantom programs should also result in relatively a simple tax treatment in most jurisdictions, generally with no taxation until payment; albeit most likely at inefficient marginal income tax rates.

This is one of the biggest downsides to a phantom scheme: participants (and their employers) may ultimately pay more tax (and/or social security) on their returns than they would if they were invested via the fund structures. In addition, as the participants do not have an equitable investment in the underlying fund (directly or indirectly), this may diminish the sense of ownership and alignment among employees. Further, it will not count toward the GP commitment, and may be problematic in the context of European Union or United Kingdom remuneration rules. From the house perspective, phantom arrangements can also present challenges in terms of how best to hedge against the employer’s liability under the contractual arrangements (for example, whether the employer needs to make a corresponding actual investment in the underlying fund).

Conclusion

An effective employee co-investment programme can be an extremely valuable tool in attracting and retaining talent and building alignment both within a team or organization and with external investors. Whilst setting up such a program requires some forward planning and resources, with careful thought it will reap dividends for both the manager and participants.

Footnotes

1. i.e., (1) any natural person who owns not less than US$5 million of “investments.” This includes an individual and his or her spouse, if they hold the investments jointly; (2) a family office with not less than US$5 million in investments; or (3) any trust that was not formed for the purpose, as to which, the trustees and each settlor or other person who has contributed assets to the trust, is a qualified purchaser.