Points allocation: dividing carry across a GP team

The pool is the aggregate carried interest available for allocation among investment professionals, and it exists inside the general partner entity. That entity is typically a limited liability company or a limited partnership, and a major reason for the form is that carried interest is taxed as capital gain rather than ordinary income so long as it is received by a professional holding an interest in a tax pass-through vehicle. The instrument is therefore an allocation of partnership profits, not a compensation formula that happens to be paid out of profits.

Two facts about pool sizing are sourced and worth stating before any division happens. The institutional position for multiple-product firms is that carry and fees generated by a fund's general partner should be directed predominantly to the professional staff and expenses related to that fund's success — which is a constraint on how much of the pool can be held by people and entities not working on the fund. And the vesting of that carry is one of the few internal arrangements disclosed to limited partners, so the pool's terms are not entirely private.

Points are conventionally expressed against a base of one hundred, but the base is a convention rather than a rule and it interacts with dilution in a way that matters. A pool of one hundred points fully allocated behaves differently from a pool of one hundred points with twenty unallocated, and the difference shows up the first time someone is hired. Deciding the base and the unallocated reserve at the outset is a five-minute decision that saves a difficult conversation later.

A point is worth the pool divided by the number of points outstanding. Both terms of that ratio are variable: the pool moves with fund performance and with everything in the waterfall that determines the carried interest the general partner receives, and the denominator moves whenever anyone is granted points. Treating a grant as a percentage without stating which denominator it is a percentage of is the most common ambiguity in a points agreement.

Two conventions handle a new grant and they produce materially different outcomes. Under pro rata dilution the point count increases and every existing holder's share of the pool falls proportionally. Under a carve from an unallocated reserve the point count is unchanged and only the reserve shrinks, so existing holders are untouched until the reserve is exhausted. The second is the reason to keep a reserve, and the choice between them should be written into the agreement rather than decided in the moment.

One fund-level term constrains the internal allocation directly and is frequently forgotten because it lives in a different document. The model limited partnership agreement triggers a change of control if key persons become legally and beneficially entitled to less than seventy-five per cent of the carried interest. So a reallocation that moves enough points away from the named key persons is not an internal matter at all — it trips a provision that can suspend the investment period.

Removal terms bound the whole instrument. On a for-cause removal the general partner is not entitled to receive further carried interest distributions and amounts retained in escrow go to the limited partners. On a without-cause removal the general partner keeps carry on pre-removal investments only, immediately and automatically reduced to a stated percentage. Points are a share of something that can be extinguished or halved by events outside the pool.

A grant of points is a grant of a partnership profits interest. Because a profits interest confers no right to existing partnership capital at grant, receipt for services is generally not a taxable event, and the holder's return is a distributive share that retains the character of the underlying income. The contrast is a capital interest, which would give its holder a share of proceeds on a hypothetical fair-market-value sale of all assets and complete liquidation tested at receipt, and whose receipt for services produces ordinary compensation income equal to fair market value.

The safe harbor covering the profits-interest grant carries three exceptions that a points agreement should be drafted against: a substantially certain and predictable income stream, disposition within two years of receipt, and a limited partnership interest in a publicly traded partnership. A subsequent revenue procedure tests profits-interest status at grant even where the interest is substantially nonvested, so neither the grant nor the vesting is taxable, provided the partnership and the service provider treat the provider as owner from grant, the provider takes its distributive share for the whole period, and no deduction is claimed for the interest's value at grant or vesting.

The general rule for restricted property runs alongside and explains why the election exists. It includes in a service provider's income the excess of fair market value, disregarding lapse restrictions, over the amount paid, at the first time the interest is transferable or no longer subject to a substantial risk of forfeiture. Absent an election the transferor is treated as owner of substantially nonvested property, so a partnership must treat a nonvested service interest as unissued and distributions on it as compensation. Application to partnership interests remains partly unsettled: the definition of property in the regulations does not name a partnership interest, and the amendment that would have added it was proposed in 2005 and never finalised.

So the protective election is standard practice even where it is unnecessary in theory. It must be filed no later than thirty days after the date of transfer, and there is a caution that applies to exactly this structure — for partnership equity and tiered ownership arrangements the standard form may be inadequate, because such elections can require more detail than the form allows, which is the ordinary case where carry is issued through a general partner entity and a separate carry vehicle. Where payment of a point holder's carry is deferred beyond entitlement, the deferred compensation rules become live and the controlling guidance for partner-partnership arrangements should be read before the deferral is documented.

A pass-through entity must allocate one hundred per cent of its income to its interest holders each year. That single fact governs the whole life of a points grant. Allocations to a holder were necessarily made as though the holder were fully vested, because the entity had no alternative — the vesting percentage does not restrict allocations while the holder is present, it restricts what the holder keeps on the way out.

On a triggering event it is advisable to recalculate the individual's capital account to reflect prior allocations at the reduced vested percentage and reallocate the unvested income to the remaining partners. If the recalculation produces a negative capital account the departed professional may be required to return distributions to the extent of that negative balance. Four documented treatments of the resulting balance exist — immediate repayment, repayment over a defined period, repayment only at the end of the fund's life, or no repayment at all, particularly in buyout funds with deal-by-deal accounting.

Vesting shapes vary widely and no clear market standard exists in how carried interest vests. Four exemplar schedules are documented, including twenty per cent per annum over five years and a construction with a back-end tranche held to final dissolution. A points grant reads very differently under each, and a grant letter that states a point count without stating the schedule has communicated roughly half of the instrument.

One reporting fact belongs in a points article because holders read it and misinterpret it. The capital account reported on a partner's annual schedule is prepared on a tax-basis method and is expressly not the partner's adjusted basis in the interest: adjusted basis includes the partner's share of partnership liabilities and the reported capital account does not, and the instructions say the reported figure cannot be used to figure adjusted basis. A holder who reads that line as the value of their points is reading the wrong number twice over.