Do not muzzle an ox while it is treading out the grain.Deuteronomy 25:4
Where no oxen are, the trough is clean; but increase comes by the strength of an ox.Proverbs 14:4
Several months ago, we had a series of posts entitled “We Only Good Deals is Not An Investment Strategy” which looked at the challenges families face when choosing to engage in direct private equity deals. Over the course of the 5 parts of the series, we explored family identity, deal competition, sourcing of investment opportunities, valuation, and knowing when to exit. We considered carefully the importance of the team that you choose to execute your direct investment strategy. Yet as one friend was kind enough to point out, one aspect that was left undiscussed was the challenge of compensation.
This is an important subject that could easily occupy a much longer piece. We went Old Testament with our opening quotes to highlight that this question of how to manage a resource that compounds value is a timeless one. Rather than dive into an extreme level of detail here today, I would like to offer instead a framework for thinking about compensation.
First, good people (honest, loyal) with real investment skill are rare.
As such, they are difficult to find and very, very expensive. Check out the Forge Community’s 2019 Family Office Executive Compensation Survey – Chief Investment Officer base comp is easily $500,000 or more, plus annual incentive targets of 100% of base, plus long-term incentives. For team members making direct investments (i.e. buying whole companies), Hedrick and Struggles, a recruiting firm, publishes an annual survey of private equity compensation.
If you think you are getting a good deal on someone, you are likely compromising on values, skill or tenure. Some families are comfortable betting on younger talent that is earlier in their career – but recognizing that there is tuition that all rookies must pay as they learn valuable lessons. A great investor will generate returns that more than compensate for the initial learnings in the long run.
Second, how the compensation is structured will make a massive impact on the results received.
Let’s highlight a few dynamics.
It is common for most private investment vehicle to pay a carry to the investor. This is a percentage of the profits that are allocated to the person making the decision as a way to align interests. Family offices offer a compelling long-term platform with long-term committed capital and limited need to raise additional funds to an investment professional. These features are attractive, but additionally families should be prepared to consider carry as table stakes to allow recruitment of senior professionals, as well as retention of the junior members of the team who are looking for career mobility.
Alignment of interest is critical. Finding a way for the investor to have real ‘skin in the game’ is of vital importance, lest the incentive be present to swing for the fences since there is no real personal downside risk from failure. Deployment horizon is important as well. If the time pressure is too great, investors will be tempted to put capital to work, even if sub-optimal. If the time pressure is too little, they may not be active enough.
Balancing the tension between doing a direct deal vs. investing with another manager is a key tension to manage. Sometimes, the best investment is not to acquire a business, but instead to invest with a world-class third-party manager who has a cyclically advantageous time to deploy capital. Determining whether or not that choice hurts the family office team’s compensation potential is critical to understand.
Other sources of income. Within a private equity firm are a host of additional tools that are utilized to drive personal profits. For example, funds will use lines of credit to manage how long an investors capital is deployed, thereby boosting the returns used to calculated carried interest. Some funds charge board fees or consulting fees to portfolio companies – benefits that generally accrue to the investment firm, not the investors. Some or all of these may or may not be relevant to the family office – but better to consider at the outset.
Finally, time horizon is a challenge and an opportunity.
Private equity funds are typically 7 – 10 years in duration. Most fund managers begin raising the next fund before the prior fund is completely deployed / harvested. For family’s, this time horizon complicates knowing when to set the calculation data for incentive compensation. As well, it could take a significant amount of time to determine if the team hired are geniuses or knuckleheads.
As we have written often, the long-time horizon is the great investing advantage of a family office vs. other investors in the capital markets. Recruiting and retaining the right team can dramatically increase the size of the family’s wealth over time. The Sid and Robert Bass family offices in Texas are tremendous example of that. Both offices have a who’s who of investors – Richard Rainwater, Eddie Lampert and others who came through their platform. The market for investment talent is fierce and not to be under-estimated. Family offices who are unfamiliar with this dynamic can easily be shocked by the dollar figures required to be a serious player.