Infrastructure funds have risen to prominence recently at a time when the entire financial services sector has attracted a great deal of scrutiny from investors. Perhaps this is not surprising as concerns about other types of financial products perceived to carry more risk seem to have fueled some of the interest in infrastructure. With the ability to generate stable cash flows over the long-term and the competitive barriers to entry that infrastructure provides, this investor interest is only likely to grow, particularly if such vehicles are perceived to be a safer bet during an economic downturn. However, it is also important to note that despite their shared characteristics, infrastructure funds are evolving: already the market is seeing an increasingly differentiated asset class with an evergrowing number of funds exhibiting diverse risk-reward profiles. This puts pressure on the compensation structures within infrastructure funds and makes the challenge of incentivising talent appropriately even harder to get right.

Compensation across financial services has been placed under the lens recently, and with a renewed concern in ensuring that pay packages are logically aligned to investor interests, many firms across the sector have revisited the design of their incentive structures. The potential implications for infrastructure funds are serious since even for firms that have been at the forefront of the trend, compensation has not been similarly innovative, with the preference simply for incentive structures that have been used in other contexts (for example, substantial cash bonuses and carried interest plans). The consequence is that infrastructure funds may not be getting the most from their compensation structures as these structures may not be optimally geared to drive fund performance.

This Perspective summarises Mercer’s views on how infrastructure funds might best design effective compensation arrangements. In brief, Mercer advocates a holistic approach that is underpinned by a thorough assessment of fund objectives and a set of guiding remuneration principles from which to design incentive structures. While it requires more engagement than simply setting compensation according to current market pay practices, it is the best way to ensure that compensation structures help drive fund performance over the long haul, and for new funds it can also be a big selling point to investors.

In this issue, answers to:

• How can infrastructure funds drive their objectives through effective compensation design?

• What guiding principles should shape compensation design at infrastructure funds?

• What is an appropriate balance of short-term and long-term incentives for fund managers?

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Mercer’s approach

Mercer believes a good test of the effectiveness of an infrastructure fund’s compensation structure is the extent to which it can be said to deliver on some basic guiding remuneration principles, the most important of which are:

Alignment of interests

With more and more competition for infrastructure placing an upward pressure on asset prices, and the rising cost of debt making it difficult to secure favorable deal terms, infrastructure funds are facing challenges that have made some question their sustainability over the longer term. This criticism has tended to focus on the features of some funds that may not be in the best long-term interests of investors, including: distributions out of capital, high debt levels and aggressive debt financing, and the decoupling of management fees from cash flows. Given these potential pitfalls, the right incentive structures, by helping encourage the right managerial behaviours, can help align the interests of fund managers with the interests of investors.

Risk-reward alignment

Infrastructure is not a uniform asset class and, therefore, risk and return characteristics vary. Similarly, the risk-reward profiles of infrastructure funds vary according to the assets in which they are invested.

It is Mercer’s view that the risk-reward profile of an infrastructure fund should shape the design of fund manager compensation. In this way, the potential rewards both to investors and fund managers can be aligned with the risk profiles of the investments.

No rewards for failure

While all infrastructure funds are different – no one compensation structure will fit all – most share similar characteristics, including the need to drive short-term results (such as securing favourable financing terms and paying down debt) and long-term results (such as delivering predictable cash flows). Rewards, therefore, should relate to all of these objectives. Of course, the need to deliver on these objectives is also matched by the need to motivate and retain key talent. Certainly, the talent necessary to manage infrastructure funds often is scarce and where available, it is likely to compare itself against the well-paid financial services industry in which it works. These considerations, however, can be reflected in the compensation of fund managers without breeding a culture that tacitly accepts “reward for failure.”

Developing a compensation framework

While new funds should resist the urge to move away from compensation structures that already may be working in some ways, they also need to assess how current structures might be improved upon and enhanced by new features in order to ensure that compensation design actually aligns with investor interests and drives fund objectives going forward. It is Mercer’s view that some popular types of incentives – deferred annual bonus plans, long-term performance cash plans and long-term performance share plans – do not work well in the infrastructure fund context while other incentives such as short-term cash bonuses only get a fund part of the way. Rather, a logical, well-balanced compensation framework for infrastructure funds might look as follows:

Base salaries and annual bonuses

These short-term elements can be funded from the management fees paid by investors to the fund management but, to ensure against any payment for failure, annual bonuses should always be paid to fund managers based on performance against key criteria such as fund raising and packaging infrastructure assets. Competitive positioning of these elements should reflect the risk-reward profile of the infrastructure fund in question. On the one hand, higher base salaries and cash bonuses are in line with the risk profiles of more stable assets in which cash streams are more assured over the short-term. On the other hand, lower base salaries and cash bonuses, with more pay at risk over the long-term, are in line with the profiles of high risk-high reward funds.

Long-term co-investment opportunity

A long-term co-investment opportunity would ask fund managers to invest their own capital in the fund pari passu with other investors, thereby providing strong alignment of the interests of fund managers and others investors. Not surprisingly, the co-investment and match should reflect the risk profiles of the funds, with lower matches (for example, 1:1) for low risk-low reward funds and higher matches for high risk-high reward funds (for example, 5:1). In total, co-investment might comprise approximately 3 percent – 4 percent of the overall fund.

Carried interest plan

Carried interest plans are the longer-term incentives likely to be of the most interest to fund managers. For that reason, a sensible carried interest plan should be based on time horizons in line with ambitious fund objectives and should enable fund managers to realise significant long-term wealth opportunities only if they deliver results to investors. Therefore, the magnitude of the carry might also be aligned with the returns suggested by the fund’s risk-reward profile.

Fund management would need to assess how much of the overall carry should go to the fund managers. The advantage of carry plans, of course, is that the timing of carry payments is tied to the long-term objectives of the funds and, thus, complements the short-term timing of other pay vehicles.

As the point at which the carry kicks in will vary with the risk-reward profile of the infrastructure fund, with lower risk-reward funds potentially taking longer to deliver a carry to their fund managers in line with the returns to investors, this mix of short-term and long-term compensation becomes very important. Ensuring that the other components of compensation are in line with the timescales of the carry, yet still significant enough to ensure talent retention and motivation, is one of the most critical challenges for funds in compensating managers.

Pensions and benefits

Pensions and benefits, like other elements of the remuneration package, can be structured to align with the risk-reward profiles of the funds. For example, where possible, employer pension contributions might be varied in line with the risk-reward profiles of the funds, that is, higher contributions for low-risk funds and lower contributions for high-risk funds. Benefit levels also might be structured in this way, with more comprehensive benefits in lower-risk funds and more basic benefits in higher-risk funds.

Putting the pieces together

The strength of a framework such as the one detailed in this Perspective (and illustrated below) is that it is robust and flexible enough to be able to create congruence between fund objectives and compensation structures, ensuring appropriate mixes of fixed and variable pay both in the short-term and long-term.

Of course, the reality is that most funds do not fall so neatly within one of the above categories but may fall somewhere else along the spectrum. The challenge for those infrastructure funds then is to assess their risk-reward profile accurately and align awards accordingly, to do so in a way that also serves investor interests and to put in place safeguards to prevent any reward for failure. Considering the potential benefits in terms of driving fund performance, not to mention the attractiveness of such an approach to potential investors, a well-considered compensation structure for an infrastructure fund is not really a luxury but a must.