Thom Young has spent the better part of the past 13 years trying to better align the financial interests of investment managers and asset owners.
The former hedge fund manager and consultant is now president at FARCapital, which helps investment managers implement fund alignment rights — an options structure to use in lieu of annual incentive fees.
“I’m trying to get to a level playing field where everyone is aligned,” Young said in an interview. “The manager can earn even more money for long-term performance. The LPs get the skin in the game, and everyone is better off for long-term performance.”
The problem: Finding a manager and an allocator to take a chance on this new structure. Young and his team have faced several obstacles so far, including an IRS ruling process interrupted by a government shut down and a last-minute pullout from a public pension fund. But they have now found a willing manager: a new investment firm founded by ex-Invesco employees.
First, though, a primer on fund alignment rights. In a typical fund structure, managers pull carry — or incentive fees — out on an annual basis, selling assets in the process. That money is distributed to employees and taxed. For managers who hold assets for less than three years, which is the case for many active investors, this capital is taxed at ordinary rates.
A fund alignment right — or FAR — structure operates differently.
Rather than managers pulling carry out of a fund each year, they have the option to buy authorized but unissued shares at an agreed-upon price based on their net asset value. Those options sit in the fund, pre-tax, and fluctuate in value based on fund performance until the manager is ready to withdraw capital. This ties the incentive fees to the fund’s longer-term performance, according to Young.
When that capital is withdrawn, the managers owe taxes at the same ordinary rates that most managers would typically pay. This would also be the case for any private equity firms that use the FAR structure. Private equity firms typically pay lower taxes based on the long-term capital gains rate, but by using the FAR structure, they would be able to run continuation or evergreen funds without raising more capital, according to Young.
The structure is flexible and can include provisions for the flat split of profits, hurdles, pay for alpha only, holdbacks, or clawbacks, he added. And the reporting looks similar for limited partners, according to Des Johnson, chief executive officer of Centaur Fund Services’ U.S. division. Centaur acts as a fund administrator for FARCapital.
“The investors themselves get the same reporting,” Johnson said by phone. “They’re still getting statements, they can still request further details, and they still get gross and net returns. They’re getting transparency with fund liability.” He added that any time a manager decides to withdraw capital, Centaur alerts investors.
The origins of the FAR structure can be traced back to 2009, when the passage of a new tax law — 457a — barred hedge funds from holding assets offshore, instead ensuring that they paid taxes annually.
At the time, Young was working as president at Optcapital, an incentive compensation firm that is now FARCapital’s parent company. Young’s team had specialized in administering deferred compensation for hedge fund managers — work that was upended by the new tax rules.
As he pored over the law, he realized that there was a way for investment managers to still defer their taxes by holding their incentive compensation as options — and it was something that could also benefit investors, because the managers would remain invested, riding the highs and lows of their own funds.
“It says that U.S. managers can no longer leave their fees pre-tax offshore,” Young said. “You have to recognize them in the year you earn them unless you take a fair market option on shares in your own fund.”
Managers that Young spoke to were interested, but their legal teams, ever cautious, needed more clarity than was provided in 457a. So Young set out to get a private letter ruling on the law — a document that would clarify the provisions and show whether Young’s interpretation was correct.
“George Bostick at the U.S. Treasury said the law passed, can’t you read it?” Young recalled. “But the lawyers, being properly conservative, said they needed guidance from the IRS.”
So Young and his team, along with Bostick, attorneys, and allocators from the Utah Retirement System and Intel pension plan, joined a conference call to confer over the rule. Just as the Treasury was poised to issue a general ruling, the first of many hurdles for FAR Capital hit: The U.S. government shut down, delaying the process. It took a year and a half before the guidance was finally issued.
“The ruling was a pretty important step to providing some proof of concept to the structure and that was pretty key to addressing a lot of GP concerns,” Young said.
The next step for Young and his team: finding a manager and an allocator to agree to use the structure. There were several false starts, including an attempt by the San Francisco Employees’ Retirement System.
One of the pension fund’s managing directors was David Francl, who came to SFERS in 2016 from Intel. Francl had been one of the allocators on that conference call with Young’s team.
“Having been in the industry for a considerable period of time, one of the things that troubled me about the dynamics between GPs and LPs was that fee structures were often very GP-oriented,” Francl said by phone. “It was challenging to come up with a GP/LP fee structure that provided a high degree of alignment.”
Francl was sold on the FAR structure, despite the hard work that would be involved in setting up.
“Fund alignment rights are not a one-size fits all structure,” he said. “It requires a lot of thought, careful negotiations, and technical considerations around the structuring.”
Francl and his team found a GP willing to put use fund alignment rights — but at the last minute, the deal fell through. SFERS ultimately did not move forward with the investment, citing business stability concerns, rather than issues with the FAR structure.
Now, more than a decade after Young first envisioned the use of fund alignment rights, his work may finally be coming to fruition.
Tectonic Investors — an investment management firm founded last year by former Invesco chief investment officer Jeffrey Everett and portfolio manager Bert van der Walt — is set to be the first real user of the FAR structure. The firm’s investment themes include energy transition, the circular economy, mobility, and infrastructure — each with a long-time horizon. It’s that long horizon that made FARs make sense for the firm, according to Everett.
“We said look, if we’re going to invest our money in the biggest opportunities, we need a structure and ideally an alignment that’s different,” Everett said. “FARS enables us to not only capture the opportunities in a tax-efficient way but also to align ourselves with investors.”
Investors have responded well to the pitch, according to Everett. “It’s the same thing Tim Cook is doing with his Apple options,” he said.
Young, for his part, is excited that Tectonic has decided to implement the structure — and eager for others to do the same.
“I’m so passionate about this because it’s a way pensions, endowments, and foundations can be aligned and stay aligned with managers,” Young said.
