Senior executives hired by the exceptionally affluent to run their family offices are principally compensated in one of two ways: as employees or participants. Surveys of single-family office senior executives conducted between 2004 and 2014 clearly illustrate the often dramatic differences in compensation between these two arrangements. The surveys also clarify the responsibilities of the respective executive positions and the often diverse ways the arrangements are structured.
In Figure 1, we have a simplified comparison of the employee and participant compensation arrangements.
A base salary plus a discretionary bonus is the norm under the employee structure. If there’s a deferred compensation plan in place, it’s an incentive to do a good job. As the compensation is a function of the family’s perceptions of the senior executive, there are rarely any clawback provisions.
Participants, in contrast, are compensated on specific performance outcomes. The performance can be tied to the single-family office or specific investments. The base salary is increasingly set up as an advance against performance or as a forgivable non-recourse loan. The bonus—which is typically how the bulk of the compensation is delivered and closely modeled on the way professional investors, portfolio managers and investment bankers are remunerated—is formulaic and structured around the nature of the investments in question. Deferred compensation arrangements with clawback provisions are usually included to mitigate the family’s risk.
The Nature Of Participating
The overriding criteria that must be met for senior executives to be eligible for participatory compensation arrangements are that their results must be clearly and objectively measured. This doesn’t negate or minimize the important additional responsibilities of the senior executive. However, if fuzzy criteria—things that are not easily measured or that are subject to the personal opinions or assessments of others—are added to the mix, it’s rarely possible to determine their monetary value in advance. Critical to the overall success of a participatory compensation arrangement is impartiality and specificity.
Since single-family offices are bespoke financial and lifestyle firms, there are usually idiosyncratic gauges and yardsticks tied to very specific scenarios. Nevertheless, there are several, often interrelated, sets of results upon which participatory compensation is based.
The most common are:
Investment Results. Investment management is the primary way senior executives are compensated as participants. Benchmarks, hurdle rates, success fees and time lines have to be decided. It’s not uncommon to have different criteria based on asset classes. However, by adjusting for asset classes, the monitoring can become exceedingly complicated, which can skew the motivations of senior executives. It can be easier and more efficient to devise an overarching and inclusive methodology that allows for detailed exceptions.
There are many variants when establishing compensation based on investment management responsibilities and results, many of which are predicated on the investment style, objectives and comfort levels of the wealthy family. For instance, directly investing in companies and real estate is increasingly common among single-family offices, and participant SFO executives involved in these deals are usually vested in their equity over time with traditional change-of-control provisions.
Tax Mitigation. Identifiable mitigation of taxes is a function of the money saved by the wealthy family that would have otherwise been paid to the government. Rarely are estate tax mitigation strategies included in this approach due to ongoing changes in the tax code and the time frames associated with multigenerational wealth transfer and estate settlement. Instead, when applied, it’s more often used for income-tax strategies.
When this approach is used, the compensation is often escrowed or otherwise deferred to account for the possibility of changes due to IRS audits. Many of these strategies deal with asset transfers, charitable giving and transnational matters.
Overall SFO Performance. The overall performance of the single-family office most often ends up being a blend of the other approaches, coupled with a variety of subjective factors. The more these subjective factors determine compensation, the less purely participatory this approach becomes. In practice, this approach works best when one or more of the other approaches are employed and the senior executive’s other responsibilities are well defined. Less than acceptable results for these other responsibilities results in a systematic decrease in the senior executive’s compensation. In these cases, the base salary is generally set higher to offset the additional obligations.
In nearly all participatory compensation arrangements, a percentage of the payout is deferred. This more tightly aligns the senior executives with the wealthy family. Concurrently, the wealthy family can enact clawbacks—typically from funds that are being deferred—if the longer-term investment performance fails to meet preset conditions.
The Participatory Compensation Arrangement
For participatory compensation arrangements to work efficaciously, they have to be well designed and implemented. The following is the process we’ve employed to develop participatory compensation arrangements in single-family offices. There is a series of steps that the parties must take to create the compensation package:
Step #1: Determine the parameters. It’s very useful to begin by establishing the constraints acceptable to all parties. Comparative compensation—while fraught with limitations—is a useful starting point, provided reasonable comparisons can be made. At the same time, it’s essential to determine where it makes the most sense for both sides to have senior executives participating.
Step #2: Structure the compensation package. Once there is general agreement on the parameters, the parties can focus on various implementation strategies.
Certain partnerships, for example, have proved very viable in that they can be established to compensate senior executives when hurdles are met, while also used for clawbacks. Private placement life insurance in deferred compensation plans is becoming more common.
Step #3: Establish a contingency plan. If something unfortunate happens to the family decision-makers or to the SFO executive and there is no contingency plan, the office can cease to function and previous arrangements can be forgotten or overlooked, so it’s important to have a plan in place to protect all parties in the case of unexpected disasters.
There are two components to a well-conceptualized contingency plan. One is a game plan detailing how responsibilities and roles are transitioned. The other component is a financial plan, often including trust or corporate structures, sometimes in conjunction with life insurance, sinking funds or equity. Whatever the approach, it’s advantageous to tie it in tightly with any participatory compensation arrangement.
Step #4: Refine the compensation package. Even when everyone happily agrees with the compensation package, it often needs to be modified to reflect changes in circumstances—such as market conditions or changes in laws and regulations—that nobody can control.
Conclusion
While it’s possible to make a nice living as an employee executive of a single-family office, it’s possible to become quite wealthy as a participant executive. In most cases, it is a function of the individual’s ability to deliver substantial results—usually exceptional investment performance relative to a peer group and an agreed upon benchmark—for the family.
The best participatory compensation arrangements are always negotiations aiming for balance; all parties involved must see significant upside potential while limiting the risks.
