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A version of this article first appeared on CNBC's Inside Wealth with Robert Frank, a weekly guide for high-net-worth investors and consumers. Register to receive future issues directly to your inbox.
Family offices are increasingly offering lucrative equity shares and transaction profits to their staff amid a growing battle for talent, according to a leading family office lawyer.
As family offices grow in size and number and compete more directly with private equity firms and hedge funds for senior staff, they are sweetening their compensation plans. Along with salaries and bonuses, many now offer equity stakes and various forms of profit sharing to give employees more perks and incentives.
Patrick McCurry, a Chicago-based partner at McDermott Will & Emery LLP who works with single-family offices, said family offices are having to adapt to a more competitive hiring landscape.
“There's a war for talent,” McCurry said. “Family offices are competing for talent against each other and against traditional private equity, hedge funds and venture capital.”
Family offices, the private investment arms of single-family homes, are also shifting to profit-sharing as a way to better align staff incentives with the family.
“It helps everyone row in the same direction,” McCurry said.
In an article published in the latest UBS Family Office Quarterly, McCurry said there are three common ways single-family offices pay their staff with business and equity plans.
1. Interest on profits
A profit share gives an employee a portion of the profits in a transaction or set of transactions. So, if the family office buys a private company for $10 million and sells it for $15 million, the employee can get a share (say 5% or 6%) of the $5 million profits, or of profits above a target or “goal.” If there are no profits, the employee gets no share. “They basically don’t participate unless there’s growth,” McCurry said.
They also save on taxes. Because the profit is a capital gain, the employee typically pays the long-term capital gains rate (which is as high as 20%) rather than the ordinary income rate, which can be as high as 37%.
2. Co-invest
A co-investment allows an employee or group to put their own money into an investment, investing in a business alongside family. Often, the family will lend a portion of the money to the employee for the investment, which is known as a leveraged co-investment. So, an employee can invest $100,000, borrow another $200,000 from family, and get a $300,000 stake.
If the deals don't turn a profit, the employee loses his or her investment and may have to repay part of the loan. Family office owners like co-investments because they encourage employees to take on less risky deals. They often combine co-investments with profit sharing to create both advantages and potential disadvantages for staff.
“With joint ventures you get a disadvantage, so you might get fewer 'moonshot' deals that would be high risk,” McCurry said.
3. Phantom heritage
If a family office is too complicated, with dozens of trusts, partnerships and funds making it difficult to issue profit shares or co-invest, they can sometimes offer phantom equity — notional shares in a basket of assets or a fund or company that track performance without actual ownership.
Phantom money can be like a 401(k) plan that is tax-deferred but is ultimately typically taxed at ordinary income rates, so it may be less attractive to the employee.
“It's not that common, but it's mainly used for simplicity,” McCurry said.
Because they serve a single family, family offices have more flexibility than many companies in designing compensation plans. However, McCurry said family offices that want to compete for talent need to start offering more forms of equity ownership.
“There's a mass effect,” he said. “The more family offices start offering it, the more employees will expect it. You don't want to be the only one offering it down the street.”
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