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A version of this article first appeared in CNBC’s Inside Wealth newsletter with Robert Frank, a weekly guide for high-net-worth investors and consumers. Sign up To receive future editions delivered directly to your inbox.
Family offices are increasingly offering lucrative equity and trading profits to employees amid an intensifying war for talent, a top family office lawyer says.
As family offices surge in size and number and compete more directly with private equity firms and venture funds for top employees, they are optimizing their compensation plans. In addition to salary and bonuses, many companies now offer equity and various forms of profit sharing to provide employees with more room for advancement and incentives.
Patrick McCurry, a partner at McDermott Will & Emery LLP in Chicago who works with single-family offices, said family offices must adapt to a more competitive recruiting environment.
“It’s a war for talent,” McCurry said. “Family offices are competing with each other for talent and with traditional private equity, hedge funds and venture capital.”
Family offices, the private investment arm of a single family, are also turning to profit sharing to better align employee and family incentives.
“It helps keep everyone rowing in the same direction,” McCurry said.
In an article in the latest issue of UBS Family Office Quarterly, McCurry said there are three common ways single-family offices pay their employees through transactions and equity plans.
1. Profit interest
Profit equity gives employees a share of the proceeds from a deal or package of deals. So, if a family office buys a private company for $10 million and sells it for $15 million, employees may receive a share of the $5 million profit (such as 5% or 6%), or a profit above the target or “barrier.” If there is no profit, employees do not get their share. “Basically, unless there’s growth, they’re not going to participate,” McCurry said.
They also save money on taxes. Because profits are capital gains, employees typically pay long-term capital gains rates (which can be up to 20%) rather than ordinary income (which can be up to 37%).
2. Co-investment
Co-investing allows employees or groups to put their own money into investments, effectively investing in the deal alongside the family. Typically, families lend a portion of their money to employees to invest, called leveraged co-investments. Therefore, an employee could invest $100,000, borrow $200,000 from the family, and receive $300,000 in shares.
If the deal isn’t profitable, the employee loses their investment and may have to repay part of the loan. Family office owners like co-investing because it encourages employees to make less risky transactions. They often combine co-investment with profit sharing, creating benefits and potential downsides for employees.
“By co-investing, you have some headwinds, so you may get fewer high-risk ‘moonshot’ deals,” McCurry said.
3. Virtual Equity
If family offices are too complex, with dozens of trusts, partnerships and funds, to issue profit shares or co-invest, they can sometimes offer virtual equity — a basket of assets or nominal shares in a fund or company that track performance without actual ownership.
Shadow equity can be like a tax-deferred 401(k) plan. But ultimately it’s typically taxed at ordinary income rates, so it may be less attractive to employees.
“It’s not common, but it’s mostly for simplicity’s sake,” McCurry said.
Because family offices serve a single family, they have more flexibility than many firms in designing compensation plans. However, McCurry said family offices looking to compete for talent need to start offering more forms of equity.
“There’s a crowd effect,” he said. “The more family offices start offering this service, the more employees will expect it. You don’t want to be an outsider when everyone across the street is offering this service.”
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