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How US private
equity compensates
management through
the investment
lifecycle
By Steve Rimmer &
Aaron SanAndres,
SanAndres, PwC
Introduction
In the private equity ownership model, compensation
is the glue that binds the interests of portfoliocompany senior management to the financial
objectives of the private equity owners. In a typical
private equity-backed acquisition, management will
be asked to deliver on challenging performance
targets with an expectation that they will share, in a
meaningful way, in the corresponding growth in the
value of the company. The compensation structures
implemented by private equity firms can be very
different from the structures that management may
have had under prior ownership regimes. This
chapter focuses on how private equity firms in the US
approach compensation design and administration in
their portfolio companies. We have outlined the key
considerations that arise in the lifecycle of the private
equity firm’s investment from due diligence through
eventual exit.
Pre-signing compensation
due diligence
US private equity firms are keen to understand a
target company’s compensation programmes early in
the diligence process. The change in ownership may
result in the acceleration of payment of certain
compensation arrangements. Establishing the
amounts involved, the triggers for payment, the
timing of payment and who will bear the financial
responsibility for making them is a critical part of the
due diligence process. A typical practice is to prepare
an exhibit detailing, for each member of the
management team, the key compensation elements,
payments that will be triggered by the closing of the
transaction, and how those payments will differ if the
individual's employment is terminated. This exhibit
is a useful tool as it sets out the potential termination
costs and the magnitude of payments across
management team members.
The private equity firm will also want to ensure that
the costs of these compensation arrangements are
fully reflected in the company’s financial model, and
that appropriate adjustments are made to reflect onetime compensation items such as any retention
arrangements implemented in connection with the
sale process. Private equity firms will also typically
back out any equity compensation expense, as these
costs are non-cash in nature and are often excluded
in calculating bank covenants. Future costs of equity
compensation will typically be reflected simply as
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dilution of the private equity firm’s interest at exit.
However, often there will be a group of employees
who received equity under the prior ownership but
who will not receive equity from the private equity
firm (as private equity firms generally limit equity
participation to the company’s most senior
employees). If annual long-term incentive grants
have been a material component to these employees,
an allowance should be made for a cash-based
replacement, either in the form of a phantom equity
plan or cash bonus (in both cases paid out upon the
private equity sponsor’s subsequent sale).
Understanding current compensation arrangements
also helps the private equity buyer to anticipate how
management and other employees will react to the
private equity firm's post-acquisition compensation
arrangements and allows them to structure those
arrangements in a manner that management will find
attractive.
Current compensation
programmes
Compensation generally comprises base salary, cash
bonus and long-term incentives. Each element has
unique characteristics that warrant attention in a due
diligence context. Private equity firms will often
conduct a competitive compensation review for select
executives as part of the due diligence process.
Salaries (and benefits linked to salaries) represent the
fixed piece of the total employee cost. The key
diligence question is: how do executive salaries
compare to market levels? Financial sponsors will
expect salaries to be within a reasonable range of
market median levels (for example, +/- 15 percent),
unless there is a clear rationale for an alternative
compensation philosophy. Companies with high
salary levels relative to market often put less
weighting on variable compensation and will likely
require a shift in the pay mix in order to align with
the pay-for-performance structure private equity
firms prefer. This shift will often involve freezing or
reducing (less common) base salaries and increasing
the annual bonus or long-term incentive elements.
Annual cash bonuses can be structured in many
different ways. Understanding how the company's
cash bonus pool is structured (for example, where the
plan fits on a continuum of formulaic versus
discretionary funding) is an important diligence area
to address. Companies with significant amounts of
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discretion in their annual incentive process deserve
special attention during due diligence. Private equity
firms will want to increase transparency and exert
control over this process, at least in terms of funding
for given levels of performance. Another area to
understand is how the company has accrued for
expected bonus payments and whether the accrual
will adversely impact working capital estimates.
Long-term incentives (any compensation earned over
a multi-year period) are of particular interest to
private equity buyers, as long-term compensation
plans are often the primary element in executive
retention and offer the most meaningful incentive
vehicle. Private equity firms are focused on the depth
of the awards (that is, how many employees
participate) as well as on the treatment of unvested
long-term incentive awards. There are generally four
ways in which a plan can treat unvested long-term
incentive awards following a change in control; each
approach can result in a different accounting impact
to the buyer:




Automatic acceleration: the cost of cashing
awards is included as part of the purchase price.
This is probably the most common approach
where the equity management has received is the
same equity that is being purchased.
Discretionary acceleration: this approach is
becoming more common but can result in postcombination expense for the private equity firm
under US GAAP, even if the company were to
accelerate (and cash out) all equity-based awards.
Rollover of unvested awards into a new
equity programme or deferred-compensation
vehicle, an approach which also results in postcombination expense for the private equity firm
under US GAAP.
Forfeiture of unvested awards: this results
in a loss in value to the management team, which
will often become a discussion point between the
PE buyer and the company. This approach is
more typical where the entity being purchased is
a subsidiary of a parent entity and the equity
management has received is denominated in the
stock of the parent.
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Executive ‘buy-in’ on
prospective compensation
At the time the purchase agreement is signed, the
private equity firm will typically want to know that
they have the key members of management on board,
assuming of course that the deal progresses to
completion. Private equity firms will often prepare a
term sheet which sets out the key elements of the
post-acquisition compensation arrangement,
including base salary, cash bonus opportunity, and
long-term incentive equity grant. In addition to these
elements, management is often expected to reinvest a
percentage of after-tax proceeds from the transaction
alongside the private equity buyer. Term sheets are
often the result of focused negotiation between
management and buyer. Private equity firms want
management to buy in to future compensation
arrangements to ensure management are both
retained and incentivised to achieve the exit desired
by the private buyer (see Appendix I at the end of this
chapter for a simplified sample term sheet).
Generally, private equity firms do not make material
changes to executive salaries, but there are
circumstances in which a material adjustment might
be warranted. Where an executive assumes increased
responsibilities following a transaction, it may be
appropriate to increase compensation to reflect the
executive’s additional responsibilities. This will often
apply in the acquisition of a subsidiary where
management takes on the increased responsibility of
managing a standalone company. A reduction may be
warranted for those salaries that are materially
higher than market practice. For example, a company
founder with an above-market salary may have to
accept a reduction to a market rate of salary if
retained by the private equity buyer.
Private equity firms will often make significant
changes to cash bonus plans if they regard payouts as
being subject to too much discretion and/or not
sufficiently tied to the performance metrics that are
critical to achieving the private equity buyer’s target
returns. Private equity firms are likely to introduce a
much higher focus on making debt repayments on
schedule and on achieving EBITDA targets; these
metrics will often find their way into the terms of the
new cash bonus arrangements. Modifications will
also be required in the acquisition of a subsidiary (or
division) of a larger company since the performance
metrics will need to reflect the standalone nature of
the business going forward.
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The area where there is the greatest difference,
however, is typically in the area of long-term equityincentive compensation. If the company was publicly
owned (or part of a publicly owned company),
executives would often have been entitled to an
annual award of long-term equity incentives (stock
options or, increasingly, restricted stock). For the
most senior executives, the grant date fair value can
be equal to, or even exceed, the executive’s annual
salary. Under private equity ownership, executives
are likely to receive a one-time ‘mega-grant’ of equity
compensation immediately following the
consummation of the transaction. Public company
equity is liquid following satisfactory applicable
vesting conditions (although it may be subject to
holding requirements or contribute to stock
ownership targets). In contrast, shares in a private
equity portfolio company will be illiquid until the
private equity firm's exit. Note that even fully vested
awards may be subject to a bad-leaver provision (see
below) which acts as an additional vesting
requirement. For these reasons, and because of the
high level of debt leverage in many private equity
investments, there is an increased risk to the
executive associated with private equity long-term
equity incentives. As a result, we typically see realised
compensation from successful exits that significantly
exceed (in absolute dollar amounts) competitive
realised compensation levels within publicly traded
companies.
Where the holding company is established as a
partnership structure, ‘profits interests’ can be used
to achieve similar economics as traditional stock
options. The profits interest gives the executive a
right to a defined share in future growth in enterprise
value (after the capital unit holders receive their
preferred return). Profits interests currently provide
certain tax advantages to the executives as the grant
of these interests is treated as a taxable event with
zero value, resulting in capital gains treatment on
subsequent sale/disposition. Note, however, that
there is no corresponding tax deduction for the
issuing entity, thus raising the after-tax cost of these
awards to the company. The accounting treatment for
profits interests is basically the same as for options.
The transition around equity compensation is often
much easier where the seller is also a private equity
firm, unless there are significant changes in the
company structure. In a recent deal we advised on,
the seller was a European private equity firm, the
entity being sold was a European holding company,
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and long-term equity incentives comprised a mix of
restricted stock with little initial value (called ‘sweet
equity’) and stock options. The buyer was a US
private equity firm, the entity would become a US
holding company, and executives were awarded
options and required to reinvest net proceeds from
the transaction on the same terms as the private
equity firm. In this situation management was very
familiar with the private equity approach to equity
compensation, but additional education was required
to help them understand the different implications of
the US reinvestment approach compared to sweet
equity.
Sizing of long-term equity
incentive awards
What is the ‘right’ percentage of shares to reserve for
management equity plans? This is perhaps the most
common question heard from private equity clients
when structuring equity plans.
As one might expect, the level of equity participation
is driven by a number of variables, such as value
generated under legacy plans and shares acquired
through rollover/investment of deal proceeds. What
is clear is that the percentage of total shares reserved
for management incentive plans (as a percentage of
the fully diluted shares) generally decreases as the
size of the private equity buyer’s initial equity
investment increases. Many private equity firms have
a house-style (or typical) approach to management
equity in portfolio companies. Even with a housestyle approach, private equity firms should still
perform economic modelling of the distribution of
value under a variety of performance and exit
scenarios to determine the appropriate share reserve
for their management equity plans. Private equity
firms will often start with a dollar amount to be
delivered to management on a successful exit and
back into the amount and form of equity required to
deliver that dollar amount based on the base-case
financial projections. This dollar amount will need to
reflect the increased risk associated with higher
amounts of leverage and lack of interim liquidity.
Once the private equity firm has settled on an overall
budget for the equity awards, they will typically work
with the company’s CEO to determine participation
and allocation of the share reserve across the selected
participants.
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Vesting conditions
Private equity firms are particularly fond of
performance-based conditions. According to the
2008 Private Equity Portfolio Company Stock
Compensation Survey conducted by PwC, over 90
percent of participants had some portion of longterm equity incentive awards subject to a
performance-based vesting condition. This figure has
increased dramatically since 2001, when only 25
percent of private equity firms surveyed had
performance-based vesting conditions. The most
common vesting conditions used among private
equity sponsors are:
1.
2.
3.
Time-based awards that vest over a set number
(typically five) years.
Exit-based vesting conditions tied to metrics
such as internal rate of return (IRR) or multiple
of invested capital (MOIC) achieved by the
private equity firm (that is, market-based vesting
conditions).
Performance-based vesting metrics such as
achieving annual EBITDA targets.
Note: there is increased use of financial metrics
as the primary vesting condition with an
additional opportunity to vest even if the
financial metrics are missed as long as stockbased metrics are realised at exit (so-called ‘last
bite at the apple’ provisions).
Equity awards are typically split 50/50 between timebased and performance-based vesting.
Vesting conditions can impact both how the expense
associated with an award is amortized and the
manner in which the expense is calculated. While
companies can use a relatively simple model (such as
Black-Scholes1 ) to calculate the fair value of a
straightforward time-based vesting equity award,
awards that vest based on IRR (or MOIC) will require
a more complex model to determine the award’s fair
value. In such cases a more sophisticated valuation
model – such as a binomial model2 or Monte Carlo
simulation3 – is required to establish the award’s fair
value.
Issues arising during
investment period
In the simplest situation, a private equity firm will
lock in management’s compensation arrangements at
closing with no (or minimal) modifications to the
arrangements until the awards pay out at the
subsequent exit. However, business conditions can
change quickly during the investment period, which
can give rise to specific issues that need to be
addressed around equity compensation plans. This
section discusses some of these issues.
Granting equity to new hires
and promotions
Private equity firms typically retain a portion of the
total management equity pool for future hires and
promotions. In recent years, the default would have
been to issue equity to a newly hired executive using
the same valuation as implied by the original
investment. For example, if the common equity was
valued at $10 immediately following the acquisition,
options will continue to be granted with an exercise
price equal to $10, even if the grant occurs more than
a year following the initial valuation. However, this
practice can create adverse tax implications. Since the
introduction of Internal Revenue Code Section
409A,4 ignoring the change in valuation can result in
a 20 percent excise tax on the entire option gain and
will trigger additional reporting obligations for the
company. As a result, we are seeing valuations
conducted at least once a year, although the best
practice in this regard is to conduct a valuation no
less than twice a year, especially if the business is
changing rapidly.
Downturns in business outlook
In the past, a failure to achieve the desired exit was
regarded as a failure by management and
corresponding adjustments to equity were not
common. The reality of the past four years (to April
2012), however, has been that many private equity
3
1 The
Black–Scholes model or Black–Scholes-Merton is a
mathematical model of a financial market containing certain
derivative investment instruments.
2 A binomial options pricing model is one which provides a general
numerical model to value options.
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Monte Carlo simulation is a computerised mathematical
technique that allows analysts to account for risk in quantitative
analysis and decision-making.
4 IRC Section 409A governs the timing of payment of deferral of
‘deferred compensation’. Deferred compensation is defined
broadly and can include stock options and restricted stock units.
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firms have been forced to lower return expectations
due to the downturn in market realities. As a result
private equity firms expect lower exit valuations,
longer holding periods, or both. These changes can
have significant implications for equity awards, the
vesting of which is often (in part) tied to an IRR or
MOIC goal that is no longer expected to be achieved.
The question arises: does this warrant a change in the
vesting metrics or should the private equity firm
resist any changes? During the recent downturn
many public companies in the US resisted adjusting
their equity plans, but continued to make annual
grants with lower bases. Many private equity firms,
however, made adjustments to their equity plans.
This was markedly different from the prior downturn
in 2002, where very few private equity firms modified
the terms of their equity plans.
We have outlined below the common approaches to
equity restructuring we have seen over the past few
years:
1.
2.
3.
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Option exchange. Also known as a repricing,
this is a straightforward repricing of old options
where, effectively, the exercise price of the
options is reset to the current fair market value
(FMV) of the underlying stock. There may be
some consideration given to reducing the
number of outstanding options in return for the
exchange or repricing.
Grant additional equity. This alternative
might be more appropriate for those companies
that want to be focused in their equity
restructuring (and retention efforts) rather than
make sweeping changes for all executives.
However, should the company recover to predownturn levels of performance, the new equity
will be dilutive to the private equity firm.
Adjust performance targets. As indicated
earlier, a significant portion of management
equity awards under private equity ownership
are subject to performance-based vesting,
including annual EBITDA-based vesting or exitbased IRR or MOIC vesting triggers. A simple
downward adjustment to the performance
targets may be appropriate for those companies
that are still expected to deliver attractive
returns but face longer holding periods or tough
earnings outlooks over the near term. For
example, some private equity firms moved away
from IRR-based exit metrics to MOIC. Other
companies lowered the EBITDA targets. In
either case, changing the vesting terms was, in
4.
5.
the private equity firm's view, sufficient to revive
the motivational and retention characteristics of
the equity plan.
Introduce a cash plan. Cash-based
alternatives can be very effective in situations
where a company is struggling to meet debt
commitments but an additional incentive is
required to retain management. Cash plans do
not necessarily need to pay out until the
company has regained its financial footing,
which adds further flexibility.
Restructure debt so that more value flows
to equity. This is the financial engineering
approach to improve a company’s equity value
and can include changing coupon rates on
preferred stock and encouraging banks to
convert debt into equity. The last thing banks (or
other creditors for that matter) want to see is a
mass exodus of management talent which may
force an immediate write-down in their position.
In these situations a bank may be willing to
adjust the debt arrangements in a manner they
would have previously been unwilling to
consider.
Addressing these challenges to portfolio-company
equity plans is the best way to ensure that the
management talent remains focused and motivated
through a successful exit. In these situations, we
suggest that private equity firms identify which
members of management are critical to a successful
exit. With that input, the private equity firm can
determine what adjustments to the current equity
compensation programmes might be necessary to
provide sufficient incentive for this key talent to stay
with the company and drive it toward a successful
exit.
Payment of special dividends
Special dividends provide the opportunity for the
private equity sponsor to take cash out of the
business without a full exit. Further, a special
dividend paid on shares owned by the private equity
owners will also automatically trigger a similar
dividend on any shares purchased by management as
part of rollover proceeds. Not as simple is the
question of how the special dividend should impact
the restricted stock and options that have been
granted to management. The appropriate treatment
is typically specified in the equity plan document or
award agreement and most often the documents
specify that an adjustment is made to preserve
management's value. Failure to make an adjustment
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would erode management’s trust in the performance
alignment and could result in unwanted management
turnover. The adjustment is typically made as an
immediate or deferred cash payment, often with
payment terms matching the vesting of the
underlying award. The adjustment can also be
achieved through a reduction in exercise price. The
following example is the best way to illustrate how
this works in practice:
Example: Adjustment achieved through a
reduction in exercise price
Equity price at initial investment = $10
All options are non-qualified stock options and have
been granted at this price.
A special dividend of $3 a share is proposed at a time
when the share value is $15.
The option holder would have a spread value on each
option of $5 before the dividend.
The special dividend would broadly be expected to
reduce the value of the shares by $3 a share.
The special dividend would reduce the option
holder’s spread value to $2 (in the absence of any
adjustment).
The option holder could receive a $3 immediate or
deferred cash payment or have the option exercise
price reduced to $7. Making this adjustment on a
discretionary basis (for example, when not required
under the plan), can result in adverse accounting
consequences. Regardless, the tax and accounting
implications of the adjustment to management
option holders should be carefully considered. Note
that any dividends paid in cash will be treated as
ordinary employment income for tax purposes.
We have seen situations where a private equity firm
has paid multiple special dividends. Initially option
holders were compensated through reductions in
strike price, but subsequent adjustments had to be
made in through a deferred cash payment due to an
inability to further reduce the exercise price. In
situations like this, any performance vested awards
that are based on achieved PE sponsor IRR could
become vested as a result of the payment of the
dividend.
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Treatment of management
equity at exit
While private equity firms may have a specific exit
strategy in mind when acquiring a portfolio company,
the recent economic downturn has shown that they
need to be flexible on the ultimate timing and form of
exit. Holding periods are becoming longer (especially
for firms acquired in the period between 2003 and
2007) and there also seems to be more variety in the
nature of the exit. Partial IPOs are now becoming
much more common as are dispositions to another
private equity buyer. Private equity firms need to
make sure their equity-based compensation
arrangements have the flexibility to adjust to the
different types of exits. Where there is a full exit,
management equity holders get to share in the wealth
creation – fulfilling risk-adjusted management
expectations. These payouts can create significant
retention concerns for the private equity buyer,
particularly for management founders who may have
rolled a portion of their prior holding into the new
structure and now have a fully funded nest egg for
retirement. The potential departure of executive
talent in this situation creates concerns for the
potential buyer about the value of the enterprise
absent that talent. In a full disposition, all unvested
options and restricted stock are typically accelerated.
If the new buyer is also a private equity firm, the
negotiation with management will commence again
around the after-tax proceeds that will be reinvested
and the pool of equity available to management as
options.
On a partial IPO exit, the IPO brings with it a clear
path to liquidity for management's equity.
Management team members can now cash out a
portion of their rolled equity as well as vested equity
awards (subject to applicable lock-up periods). The
IPO also creates an opportunity to refresh the
compensation approach across the company. This
includes top-up awards for management who are
expected to drive business performance going
forward as well as expanding equity participation
further down within the organisation.
Conclusion
Compensation lies at the heart of the private equity
investment process and is the key to effective
retention of management and the alignment of
interests essential to drive a successful exit.
Compensation issues arise throughout the
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investment process and these issues require active
management so that potential concerns are
addressed directly and early in the process. The size
of equity awards made to top management in US
private equity deals is usually a significant incentive
to drive performance through the exit. However,
inconsistencies in approach, perceptions of
unfairness, limited flexibility or a simple lack of
communication can all have serious consequences in
terms of management focus and retention
Appendix A: Sample management term sheet
Position:
CEO
Base salary
$300,000 p.a., reviewed annually
Bonus:
Target opportunity 100 percent of base salary on achieving metrics
Metrics:
Achievement of annual EBITDA and debt repayment targets and other key
metrics as agreed
Reinvested equity:
Individual to reinvest 30-40 percent of net proceeds from seller’s equity plan, at
a price of $10 per share
Equity compensation:
Two options awarded at $10 a share for each share of reinvested equity
Option vesting:
50 percent time vested with 20 percent of these awards vesting each year and
50 percent performance vested on realisation event resulting in IRR for private
equity sponsor of 25 percent or MOIC for private equity sponsor of 3x initial
investment
Severance:
On termination without cause individual will receive twice the base salary plus
twice target bonus. All vested options and reinvested equity cashed out at fair
value.
Voluntary termination:
Vested options and reinvested equity cashed out at lesser of fair value or $10
Author biographies
Steve Rimmer is the global network leader of PwC's
Human Resources Transaction Services practice, and
specialises in the human resource aspects of mergers,
acquisitions and spin-offs. Steve has 28 years of
human resource consulting experience, with a heavy
emphasis on conducting human resource due
diligence and addressing integration issues arising on
corporate transactions. Steve has worked with
numerous leading corporate and private equity
clients. He spends a significant amount of his time
advising clients on compensation issues, including
market competitiveness, retention strategies and
design, and implementation of equity compensation
programmes. He has published a survey of equity
compensation practices among private equity
portfolio companies.
Steve has been at PwC for 23 years, including 18
years in New York and five years in London. Prior to
joining PricewaterhouseCoopers, he worked for
Bacon and Woodrow, a leading UK
PwC
firm of actuaries. Steve is a UK qualified actuary, a
Certified Compensation Professional and has a MBA
from Manchester University in the UK.
Aaron SanAndres is a partner in PwC's Human
Resources Transaction Services practice in New York.
He has 13 years of professional experience in human
resource consulting. He specialises in providing
human resource transaction advisory services to both
strategic and financial buyers and specialises in the
financial services industry. Aaron’s core expertise lies
in the design, tax and accounting aspects of executive
compensation. He spends a significant amount of his
time advising his services clients on post-acquisition
executive compensation issues. Aaron has written a
number of articles around human capital issues
within the asset management industry, most recently
including the 2011 Asset Management Reward and
Talent Management Survey and a white paper on
human capital issues in asset management M&A.
Aaron received his MBA, with honours, from
Columbia Business School.
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This article was first published in Private Equity Compensation and Incentives by PEI. For more information about this publication, please see
http://www.peimedia.com/compensation.
© 2012 PricewaterhouseCoopers LLP. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC
network. Each member firm is a separate legal entity. Please see www.pwc. com/structure for further details.