Investors Worried About Wealth Inequality Should Focus on Fund Manager Compensation

(Illustration by iStock/z_wei)

Since Bill McGlashan, the cofounder of a prominent social and environmental impact investing fund, TPG Rise, was charged in the recent college admissions bribery scandal, people in the impact investing community have faced another fierce round of questions about their relationships with economic inequality, power, and privilege.

Joining broader criticism of philanthropy and impact investing from Anand Giridharadas, Rob Reich, Edgar Villanueva, and others, the news cast a scathing spotlight on the specific issue of inequality. While the accusations against McGlashan may have nothing to do with the Rise investment strategy, they do raise questions about his compensation, particularly in comparison with an average employee or customer of a company in Rise's portfolio. Why are fund managers paid so lavishly relative to other stakeholders?

With annual executive compensation at some of the largest private equity firms—including those launching impact funds—hovering around or even exceeding $100 million, those of us in the impact and environmental, social, and governance (ESG) investing communities need to recognize that paying such incredible amounts may be exacerbating the very problems we seek to solve. Unless we do more to address this glaring cause of income and wealth inequality in our own backyard, we may not only worsen social inequities and instability, but also compromise the financial performance of our own investments.

Wealth and income inequality have been discussed widely in the media and highlighted at the most recent United Nations Principles for Responsible Investment (UN PRI) conference, the Global Impact Investing Network (GIIN) forum, and the annual gathering of the World Economic Forum. The United Nations Sustainable Development Goals (SDGs) also spotlight the issue, particularly through the objectives involving poverty, decent work and economic growth, and inequality. Investors are increasingly aware that economic inequality is a systemic risk that destabilizes markets. Even Ray Dalio, who leads the prominent hedge fund, Bridgewater, has declared income inequality as a national emergency in the United States. 

While there is growing concern, particularly among ESG investors, that executive-to-average-worker compensation ratios are contributing to income inequality, there is little attention on fund manager compensation. As an example of the scope of the problem within the private equity industry, take a hypothetical multibillion-dollar impact or ESG fund similar to the aforementioned TPG Rise. It may invest in products and services for the underserved. It might work with the companies in its portfolio to get them to pay a living wage. It could help employees grow their wealth by distributing some equity to them, as the firm KKR has been doing with several companies in its industrials portfolio. Or maybe it establishes profit-sharing programs. 

But let's say this fund is also charging a standard 2 percent management fee to its investors and collecting the typical 20 percent of profits from portfolio companies, commonly known as carried interest. Such a compensation structure means the wealth of the fund manager will grow exponentially faster than the wealth of the portfolio companies' workers or beneficiaries, exacerbating wealth inequality.

Shouldn't workers be more fairly compensated for the value that they create? Wouldn't it be better to share wealth at the start of the financial cycle by paying workers more, putting them in a place of power rather than a state of dependency that relies primarily on redistribution through philanthropy, impact investing, or taxes? Why wait until the end, when a few people who have been grossly overcompensated decide to share their riches with the underserved through philanthropic activities that could also perpetuate the systemic injustices that created the problems in the first place?

If asset owners indeed care about economic inequality, the reduction of systemic market risk, higher returns, and strong impact or ESG strategies, then there is an opportunity to create a new type of private equity fund that more fairly rewards everyone. Such a fund would seek positive impacts not only through the companies in which it invests, but also through how it is run. It would adhere to ESG criteria, support the SDGs, and help address systemic causes that perpetuate out-of-control economic inequality. We can create it by following five guidelines:

1. Evaluate the whole picture. We must consider aspects of investing that are not typically seen to fall within the purview of ESG and impact objectives. This includes fund manager compensation levels and the metrics used to evaluate the investment team. It also ropes in commercial aspects of investing, such as weighing valuation methodologies that encourage short-term thinking—internal rate of return (IRR) being one—against those that push long-term thinking, such as multiple on invested capital (MOIC).
2. Improve compensation ratios. We need to narrow the pay disparities between fund managers, non-executive members of a fund's team, portfolio company leaders, middle managers, and workers. The profits of portfolio companies taken as carried interest could be shared with workers in portfolio companies. Employee stock ownership plans (ESOPs) could be expanded. This is not a call for a redistribution of wealth, nor an argument against it. This is about fairly compensating people based on the value they actually create. And there is substantial data showing better financial performance by companies that pay and treat their workers better—an improvement that could mean higher investor returns.
3. Examine fund managers’ fees. For public and union pension funds, for example, high management fees cut into beneficiaries’ returns. What about reducing the fees once a fund reaches a certain size? There could also be efforts to avoid excessiveness in routine business costs, such as hotel rooms, meals, and administrative charges to asset owners beyond the annual management fee. With the support of organizations such as the Institutional Limited Partners Association (ILPA), many asset owners are already proposing such solutions to their fund managers. 
4. Collaborate. In the spirit of "nothing about us without us," other stakeholders in addition to asset owners and fund managers should help design this type of fund. Unions, labor advocates, civil society, field-building organizations, companies, foundations, and academics should also have a say. Doing so will help ensure everyone understands other stakeholders’ needs and perspectives from the start, creating a more equitable fund structure in the end with stronger potential for success. 
5. Consider multi-stakeholder governance models. Funds and their portfolio companies should consider structuring themselves fully or partially like benefit corporations, models with worker ownership, steward ownership firms, or hybrids of them. Doing so will help maintain the integrity of diverse input throughout the life of the investments, as highlighted in the previous point. However, including only workers in such multi-stakeholder governance models is inadvisable because worker interests may then be prioritized over other stakeholders, such as local communities and customers, which could lead to negative consequences. For instance, employee shareholders may be incentivized to maximize their own near-term returns through sales and profitability at the expense of the environment, as some believe was the case in the Volkswagen emissions scandal.

My firm, Development Capital Strategies, along with several partners, is launching the Predistribution Initiative to develop fund structures that follow these guidelines while producing competitive returns for asset owners. Fund managers, asset owners, unions, labor advocates, field-building organizations, civil society, academics, lawyers, and accountants will all be able to offer valuable input into this effort. The work will contribute to the growing field of important initiatives focused on alternative funds, holding companies, and deal structures that enhance impact, such as those of GIIN, Transform Finance Investor Network, and Rutgers University's School of Management and Labor Relations.

Adjusting the mainstream private equity model will be an important step towards achieving ESG and impact-investing goals. However, the changes must be clear and simple so they can be easily adopted by the market at large. If prototypes of these funds produce competitive returns for asset owners as expected, they may be adopted more widely, unleashing the systemic changes that we desperately need in the face of rampant economic inequality.

Support SSIR’s coverage of cross-sector solutions to global challenges. 
Help us further the reach of innovative ideas. Donate today.