Stretching and Flexing – Part Two: Keeping the Management Team Incentivised for the Longer Journey

Part Two: Keeping the Management Team Incentivised for the Longer Journey

• Management incentivisation remains a cornerstone of private equity value creation. With the liquidity needs of the LPs partially satiated by virtue of the interventions outlined in part one, consideration in this part two turns to how longer holding periods to exit raise challenges in keeping the management team retained and incentivised as the period to monetization grows beyond the initial outlook.
• Traditionally, a management incentive plan (MIP) is established at or around the outset of the private equity investment and is structured to deliver a share of the upside realised at an exit subject to the institutional investors achieving a minimum return (often set as an amount equal to their invested capital, and sometimes with a certain amount of interest on top). In this way, management and investors are economically joined in pursuing value creation and maximising returns upon an exit. All or a portion of each individual participant’s interest in the MIP proceeds is typically subject to remaining employed with the company for a minimum length of time, usually ranging from three to five years following the initial investment (time-vesting). The MIP’s share of the upside may also ratchet up as overall value creation increases and is realised (performance-vesting).
• When investor liquidity is achieved prior to a full exit, questions can be raised as to if and by how much the MIP participates, as well as what happens for the remaining hold period. There may also be questions about how any fresh capital that has been introduced to the structure affects the MIP. In many MIPs today, only a single MIP crystallisation event (i.e., an exit) is envisaged and, even if interim liquidity and/or new equity infusions are addressed, it can be overly simplistic in the face of what is often a complex set of circumstances. Left unchecked, sponsors may struggle to garner management support when trying to implement a liquidity event or, worse, see talent jump ship for an earlier or more certain payday.

Management Resets

Parties facing these issues often propose a MIP reset to realign management’s interests with those of the original (and, if applicable, new) sponsor until the eventual full exit. MIP resets have long been used to rescue ‘underwater’ management equity in times of distress, but they have another application in extending the life of well-performing plans and facilitating interim liquidity for management. Some prominent reset options are discussed below. The degree of tinkering often in practice is a function of how much the investment intervention is deemed a course correction versus a new start.

1. Juice Returns

   New incentive equity awards delivering greater participation in the upside at exit than the original plan afforded could be issued to management to enhance motivation for the next part of the journey. The usual management share-issuance considerations will need to be factored in with these ‘top-up’ awards, which may sit in payment priority to the original MIP equity so as to deliver more attainable returns. Such ‘top-up’ awards may track gains only from the point of the reset or look-back to some of the value already created. A valuation will likely need to be obtained to ensure members of management are paying the tax market value for their ‘top-up’ (thereby mitigating an up-front income tax charge and potentially qualifying for capital treatment). If that valuation is substantial, the company may consider providing a loan or bonus to cover the subscription costs, which in turn comes with a number of other tax and regulatory considerations.

   The existing MIP terms could also be amended for the benefit of management. For instance, the incentive equity percentage could be increased or any performance hurdles could be lowered, including by reducing or capping the interest accrual on shareholder debt or preferred equity, thereby increasing management’s return at a lower threshold. These types of amendments should be analysed from a tax perspective to mitigate a ‘dry’ income tax charge that might arise for managers from a shift in economics and/or the potential to disqualify the MIP returns from beneficial tax regimes.

   Similar economic outcomes can be achieved artificially, often with less implementation cost and complexity and without the optics of equity dilution, via synthetic or phantom equity awards or exit bonuses that mimic the payouts of a share-based plan, albeit typically in a less tax-efficient manner.

2. Crystallising Value

   There are ways to de-risk management’s equity at the time of the interim sponsor event. Time-vesting conditions can be accelerated and/or some or all of the value contained in the MIP can be crystallised so that it is no longer subject to performance conditions. This effectively converts incentive equity into ‘institutional strip’ or co-invest equity in the structure; some other preferential entitlement also could be afforded to the incentive equity in the go-forward distributions waterfall. Crystallisation may not be management’s preferred outcome, however, particularly if it removes or reduces the opportunity for increasing upside participation as performance goals are achieved in the future. The rules regarding what happens to the equity if a manager leaves prior to an exit may also be flexed, for example, by treating some or all of the award as ‘earned’ at the time of the reset event and no longer subject to forfeiture or discounted buyback if the manager departs. However, this needs to be balanced with the goal of retaining management for the longer journey, so it may be implemented in combination with a new MIP or top-up grant.

3. Sell-downs

   Certain sponsors with specific investments and special management teams may be willing to underwrite a more certain path to liquidity for managers by granting ‘put’ options for them to sell down their vested interests, typically at agreed-upon valuations either at the time of a recap event or in the years ahead. These can provide reassurance for management teams when the lack of control over exit timing might otherwise affect motivation and retention. The specific conditions that apply to the exercise of any such liquidity option for management will need to be carefully considered, including requirements for continued employment, time-based and/or performance-based criteria, reinvestment of proceeds, and whether managers can be paid in kind if there is insufficient cash available for settlement.

Getting Ahead

• All of the above MIP practices are more reactive options designed to reincentivise management in circumstances in which the holding period for a sponsor’s investment extends materially beyond what was initially envisaged. As longer exit horizons become more the norm, addressing what happens if any of these interim scenarios ever come to pass is increasingly happening at the outset of investments.
• Negotiations concerning MIP rights upon interim liquidity typically focus on what conditions need to be met for management to qualify, distinguishing between scenarios in which sponsors are comfortable releasing or de-risking some MIP value before exit and others in which they are not. For example, with cross-fund deals, while management may want a tag-along opportunity if LPs are getting liquidity and/or carried interest is being generated, the sponsor may be reluctant to commit to such co-sale rights in instances when its carried interest is being rolled over or the event is happening within close proximity to the initial investment.
• In contemplation of longer hold periods, MIPs can borrow from the world of evergreen funds and ‘patient’ capital to create liquidity options. Internal markets can be created, enabling managers to buy and sell from each other, typically during periodic trading windows and at prescribed valuations that have been independently tested. Companies can facilitate liquidity within these exchanges, including through the use of employee benefit trusts (or equivalent warehouses), which act as market makers in undertaking repurchases and disposals. Similarly, synthetic exits can be built into plans that deem liquidity events to have occurred at one or more intervals, though these can be challenging for sponsors to come to terms with if management payouts are based on paper-based sponsor returns, and flexibility may be needed where company cash is constrained at the time of payment.

Conclusion

As value creation puts extra miles on the clock, private equity is deploying creative liquidity solutions to keep the wheels turning. And while investors are banking some advance returns, management teams are looking again at when and how they get their share of the pie. Flexibility, adaptability, and liquidity are key stakeholder concerns, but not all existing investment agreements provide for equitable outcomes. Devising ways to include and reenergise MIPs within and alongside LP liquidity typically involves significant legal, tax, and commercial complexities. These will be important to engage with in sustaining LP-sponsor and sponsor-management partnerships, which tend to thrive only when alignment is reached.

Carl Bradshaw is a partner and Charles Elsom is an associate in Goodwin’s European Private Equity team based in London, UK. Other contributors to this piece include John LeClaire, founder and co-chair of Goodwin’s global Private Equity group, based in Boston, US; Jacqueline Eaves, a partner in Goodwin’s Secondaries team; and Ed Saunders, a partner and co-chair of Goodwin’s Fund Finance group.

This informational piece, which may be considered advertising under the ethical rules of certain jurisdictions, is provided on the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin or its lawyers. Prior results do not guarantee a similar outcome.