Family offices & incentives: how to recruit, reward and retain employees

A long-term incentive plan (LTIP) is a plan designed to incentivise employees over the long-term. Senior employees joining family offices from banking, private equity or corporate backgrounds will often be coming from an environment where LTIPs form a substantial part of their overall pay package (and, as such, may therefore be something that they expect to receive). Typically awards under an LTIP take the form of free shares or options (rather than cash) and usually the incentive only pays out if a performance condition is achieved over a certain period (usually three years).

Implementing an LTIP

An LTIP can directly shape employees' behaviour and expectations, particularly through the use of performance conditions. Attention should therefore be given to the specific aims and values of the family office. For instance, the aims of a family office may go beyond profit and growth to include sustainability and philanthropy as well. An LTIP can then be designed so that employees are genuinely motivated to achieve such goals. That said, it is important to avoid setting goals which may create tension between the employee and the family. For example, if the LTIP is tied to the realisation of assets which the family office intends to hold indefinitely, the LTIP will not achieve the intended motivational effect.

Thought should also be given to where the LTIP sits within the corporate structure of the family office. Given the wide variety of assets often held by a family office (including assets that relate solely to the family), it may not be appropriate for the LTIP to be implemented within the same corporate entities as those holding such assets. Instead, it may be better that the LTIP operates at the subsidiary level so that: (i) employees associated with specific assets are appropriately incentivised; and (ii) family assets are ring-fenced from the LTIP.

In addition, consideration should be given to how the family office can deliver value to employees in the absence of a traditional liquidity or exit event. For instance, it may be appropriate to set up an employee benefit trust (EBT) arrangement. An EBT is an independent discretionary trust established for the benefit of employees. It can be used to create an internal market so that employees can sell their shares to the EBT. An EBT will ultimately need to be funded, so the family office will need to consider the sources of cash funding available to satisfy awards. An independent valuation may also be required to determine the value of shares held.

Carried interest

The LTIP can be structured so that awards take the form of carried interest. This structure may be particularly suited to investment professionals. Typically, these awards are granted for low or nil upfront cost and are linked to the increase in value of assets under management over time. With these awards, the LTIP operates in line with the life of the investment fund. If and when investors receive a return over a specified level, employees receive a percentage share in any return. However, family offices should consider the term of their investments before offering this type of award. If there is a particularly long-term horizon from the family office's perspective, these types of awards can conflict with the interests of employees who want to realise value as soon as possible. 

Phantom options give the participant a right to receive cash benefits that relate to the value of real shares. This type of arrangement can have several advantages. Firstly, it is quite straightforward to establish and administer, as no actual shares are being awarded. It also offers a significant degree of flexibility. For instance, if the family office wishes to exclude certain factors which would ordinarily impact the market value of a share, such as certain investments which relate solely to the family itself, it can choose to do so.

As mentioned above, family offices may struggle to deliver value to employees in the absence of a traditional liquidity or exit event. Phantom options can reduce this pressure as they can be designed to deliver value at set milestones. As such, phantom options can be a strong short-to-medium incentive, as it is clear to employees when value will be received.

However, the compensation provided for phantom options, whether paid in cash or other assets, will ordinarily be subject (in the UK) to income tax and national insurance contributions. Accordingly, it is not usually the most tax-efficient structure.

Growth shares are a special class of share structured such that participants only benefit from the growth in value of the family office above a certain threshold or "hurdle." This can be an attractive structure in aligning the interests of the family office with those of the participants so that everyone is working towards the same goal.  

Implementing a growth share arrangement

A new growth share class is usually created at the family office level or a different level within the family office corporate structure. The growth shares specify a growth hurdle that must be achieved, usually relating to the financial performance of the family office or a specific investment. The participant then benefits from growth in the value of the share above that hurdle. The growth shares typically have limited rights. For instance, the shares typically have no voting rights or the right to receive dividends. As mentioned above for an LTIP, an EBT can be implemented to help deliver liquidity in the absence of any other type of exit event.

Growth share arrangements can offer favourable tax treatment, particularly for UK-based employees. Participants must purchase the growth shares for their full market value. However, as the participants will only share in the future value, the market value of the growth share (and therefore its price) is normally relatively low. On disposal of the shares, capital gains tax (CGT) is payable in the UK. The CGT rate is currently 20% whereas the income tax "Higher" and "Additional" rates are currently 40% and 45% respectively.