How can state-owned fund investors obtain carried interest?
At the beginning of this month, the Shanghai State-owned Assets Supervision and Administration Commission issued the "Guiding Opinions on Further Promoting the High-quality Development of Private Equity Investment Funds of Enterprises under the Supervision of the SASAC". Article 13 specifically addresses the reform of the incentive mechanism: Support the management teams of state-owned funds to obtain returns through follow-on investments and Carry distributions.
This opinion should be the first time in the country to write about how to distribute money in a municipal-level document, and its significance is self-evident.
In the past five years, state-owned funds have experienced explosive growth. Local governments have set up guidance funds, industrial investment funds, and S funds one after another, with management scales often starting from billions or even tens of billions. However, there is still no clear answer in many places on how the people in charge of the money should be compensated.
As is well known, the private equity investment industry is essentially a business of people. Without an efficient incentive system, it is difficult to cultivate excellent investment teams. However, implementing the incentive mechanism in the state-owned system involves audit, accountability, and public opinion risks at every step.
This article is one of the research notes of the Touzhong Jiachuan team on state-owned assets from the second half of last year to the beginning of this year. We surveyed 81 state-owned fund platforms in 15 provinces and cities across the country and found that state-owned institutions can be divided into four categories in terms of incentive mechanism innovation: performance, follow-on investment, Carry distribution, and rewards.
However, overall, the industry is still in the initial stage of exploration.
Category 1: Performance
The most basic approach is to link salaries with performance. The investment platform in City A in the central region is a typical example: it uses the "basic salary + bonus" model to confirm performance. The bonus is linked to multiple indicators such as corporate profits, fund management returns, new fundraising, investment, and exits.
Its assessment design uses a 100-point system, but it can be increased to 120 points. That is to say, if you exceed your tasks, you can get a bonus higher than the baseline. This is a quite flexible design within the system in the central region.
Similar practices are also reflected in provinces in the western and northern regions. By setting annual goals, scoring according to the degree of task completion, settling accounts at the end of the year, and distributing money according to the scores.
The advantage of the scoring-based performance system is that it is easy to operate and can be easily implemented within the existing salary framework of state-owned enterprises. Of course, the disadvantages are also obvious. It solves the problem of "different pay for different amounts of work", but it also has limitations in solving the problem of "different pay for good and bad investments".
Because if a fund manager completes all the procedural indicators, conducts due diligence, holds meetings, and makes investments, he may get a good score under the 100-point assessment. However, the losses of a project or fund usually do not appear until several years later, and the annual assessment is difficult to reflect the real investment situation in the long term.
Category 2: Follow-on Investment
Follow-on investment is a common market-based incentive tool in the industry (from another perspective, it is also a constraint). If a project invested by an investment fund makes a profit, the people who make follow-on investments also make money; if the project loses money, the money of the follow-on investors also shrinks. The interests are most closely bundled, and the motivation is the most direct.
However, the implementation of follow-on investment within state-owned funds may vary depending on the identities of the personnel.
The state-owned assets in City B in the central region gave an example. In a case of cooperation between state-owned assets and a market-oriented institution, the two parties jointly contributed to establish an institution. However, only the personnel sent by the market-oriented institution and the employees recruited from the society are allowed to participate in follow-on investments, and the senior executives dispatched by the state-owned enterprise are not included in the scope of follow-on investments.
That is to say, in the same investment team and for the same project, some colleagues can make money through follow-on investments, but state-owned enterprise employees cannot. The reason lies in the different identities.
Why is there such a difference? The main reason is to prevent conflicts of interest.
The "Opinions on Carrying out Pilot Projects of Employee Shareholding in State-owned Holding Mixed-ownership Enterprises" (Guozi Fa Gai Ge [2016] No. 133) clearly states that the leaders of state-owned enterprises appointed by the Party Central Committee, the State Council, and local Party committees, governments, and their departments and institutions shall not hold shares.
Since the chairmen of the first-level subsidiaries of state-owned enterprises are usually appointed by the superior group (representing the government/Party committee), they directly fall into this prohibited scope. For the same reason, the leaders of state-owned enterprises appointed by national government agencies are also not allowed to participate in follow-on investments.
In addition, even if all employees are required to participate in follow-on investments without distinction of identity, it may not satisfy state-owned enterprise practitioners.
An employee of the industrial investment company in City B in the eastern region told us, "State-owned enterprises are different from private enterprises. We cannot selectively participate in follow-on investments (in projects). We must participate in follow-on investments in all invested projects. It costs a lot of money for individuals. From the current perspective, it is definitely not a benefit." Some state-owned enterprise employees even suggested during our survey, "Should we set up a state-owned follow-on investment loan to relieve the pressure of follow-on investments for state-owned teams?" It can be seen that the salary factor of ordinary employees also restricts the implementation of the state-owned follow-on investment system.
Therefore, some regions have begun to explore the establishment of a follow-on investment mechanism in the form of SLP. The latest document in Shanghai clearly mentions that the management team is supported to obtain follow-on investment returns by holding SLP shares.
This model can solve the problem of selective follow-on investments on the one hand, because it is a holistic follow-on investment at the fund level, and both good and bad projects are borne together. On the other hand, it can effectively motivate the team. Because the follow-on investment returns obtained by employees in the capacity of LPs belong to "investment income", which is theoretically not labor remuneration and is not included in the total salary statistics and management.
Category 3: Carry Distribution
If follow-on investment is only about sharing risks, then Carry distribution is truly about allowing employees to share in the profits. However, in practice, compared with follow-on investment, there are far fewer mechanisms that allow state-owned enterprise practitioners to share in Carry.
Currently, among the 81 state-owned institutions we surveyed, fewer than 5 have established a perfect Carry incentive mechanism. The state-owned venture capital company in City C in the eastern region is the one with the most perfect system we have learned about so far.
The person in charge of this institution told us, "In terms of Carry, first ensure that the LPs get their principal back and the threshold return, and then make up for the losses of the projects. 80% of the Carry is given to all investors, and 20% is given to the venture capital platform, of which 4% is given to the management team. The internal distribution ensures that everyone does not lose money. If the projects they follow up on incur losses, they can be compensated from the profitable projects." This approach combines the needs of state-owned assets for preservation and appreciation with market-oriented incentives.
Category 4: Rewards
Of course, in addition to performance, follow-on investment, and Carry, some institutions have also explored reward systems.
For example, the state-owned assets in City D in the central region have adopted another approach: setting up personalized special rewards for different types of projects. The reward schemes for well-invested projects, successfully merged projects, and properly disposed non-performing assets are all different.
The angel guidance fund in City F in the eastern region also has a similar reward mechanism. Considering the high-risk characteristics of the angel investment stage, they combine incentives with risk control. The fund extracts 5% from the annual investment income as a risk reserve, and 40% of the remaining part is rewarded to the management institution, while 60% is rolled over for development. The fund has a risk tolerance mechanism, allowing a maximum of 40% loss, and the excess part will be compensated with the reward funds of the management institution.
Realistic Obstacles
In terms of coverage, key incentive tools such as follow-on investment and Carry distribution have not been popularized nationwide. There are several realistic obstacles here.
For example, there are restrictions on the total salary. As mentioned above, follow-on investment is limited by the pressure of employees' salaries.
From a institutional perspective, documents such as the "Measures for the Management of the Total Wage of Central Enterprises" have restricted the salaries of central and local state-owned enterprises. The core mechanism is the "two lower than" principle, that is, in principle, the increase in the total wage should not exceed the increase in economic benefits (profits), and the increase in the average wage of employees should not exceed the increase in labor productivity.
This means that state-owned enterprises have control over the total wage, and there is an upper limit on the amount of money that can be distributed each year. If Carry and follow-on investment returns are included in the total salary, it will squeeze the space for fixed salaries; if they are not included, there will be doubts about compliance. This dilemma cannot be solved within the institution.
For example, a state-owned industrial investment company in the south frankly told us, "The incentive mechanism is linked to the annual investment performance. The company's salary is competitive in the local area, and there is currently pressure to reduce salaries. Follow-on investment is not necessary, (and) the 5 + 2 - year period is too long." In other words, implementing incentive mechanisms such as follow-on investment, although not uncommon in the industry, is a bit "standing out from the crowd" in the local state-owned system.
Moreover, even if it is compliant, it may face public opinion pressure.
A state-owned institution in City C in the central region said, "There are contradictions in the management of state-owned assets. On the one hand, it is required to make good investments and avoid losses; on the other hand, if the investments are successful, the follow-on investment returns may be questioned." Normal follow-on investment returns may also be misinterpreted as "interest transfer".
Governance Structure
Of course, we also found differences in the flexibility of the incentive mechanisms among institutions with different decision - making mechanisms.
If a state-owned institution adopts the manager's independent decision - making model, then the flexibility of the incentive mechanism is generally stronger. The reason is simple: independent decision - making means that the responsible subject is clear. Since you can make decisions on your own, your income should also be directly linked to the decision - making results. The responsibilities, rights, and interests are relatively unified.
For institutions that adopt the government's final review and decision - making model, the incentive space is much smaller. From this perspective, the issue of the incentive mechanism is not just a matter for the HR department; it is a reflection of the entire governance structure.
The more concentrated the decision - making power is at a higher level, the narrower the incentive space for front - line personnel; conversely, only when the decision - making power is moderately decentralized can market - oriented tools such as follow - on investment and Carry truly come into play.
This article is from the WeChat official account "Beyond the J Curve", author: Yang Boyu, published by 36Kr with authorization.