How are GPs paying their top portfolio execs?

Seeking to align the interests of a portfolio company’s management team with those of its owners is a fundamental component of the private equity model. With an equity stake in the business, executives have a direct incentive to maximise its enterprise value for the benefit of all equity holders, including the private equity funds. One common approach for achieving this goal is the issuance by the portfolio company of incentive equity.

Kimberly Smith

Incentive equity programs are generally designed to reward management upon a liquidity event for incremental value created after the incentive security is granted. Furthermore, continued employment and the achievement of specified results are typically required. Within these parameters, the specific terms of incentive equity programs can vary widely.  

A successful incentive equity plan finds the inflection point at which the allocation of equity ceases to be a zero-sum game and appropriately incentivises management to grow (and then rewards management for growing) the pie for the benefit of all equity holders. An effective plan is easily understood, with targets that management believes can be achieved with hard work and a smart strategy.

In order to explore the current market for incentive equity terms, Paul Hastings recently completed a survey analysing incentive equity programs offered by private equity-owned companies. We reviewed data from 30 US-based portfolio companies owned by 20 private equity sponsors with funds ranging in size from $165 million to $3.9 billion and an average fund size of $1.05 billion.  

Key findings include:

Pool Size: The rule of thumb is that incentive equity should typically constitute between 5 percent and 20 percent of a portfolio company’s fully diluted equity. Indeed, our survey found that the mean size of the incentive equity pool was 13 percent of fully diluted equity and none of the companies surveyed had an incentive equity pool comprising less than 5 percent of fully diluted equity. However, 13 percent of the companies had incentive equity pools exceeding the recommended 5 to 20 percent general range.  

Subordinated Securities: To determine the portion of sale proceeds that incentive participants would actually receive, one must examine whether the incentive equity was placed behind an interest-bearing security. Nearly half (47 percent) of companies in the study placed the incentive equity behind an interest-bearing security for which the annual interest rate ranged between 5 and 11 percent and averaged 8.2 percent.

CEO Award: The chief executive officer received a portion of the incentive equity except where a significant portion of the company’s equity was separately held by the chief executive due to a sizable equity rollover or cash investment. The percentage of the incentive equity pool granted to the chief executive generally ranged from 16 to 50 percent, with the grant to the chief executive representing on average 37 percent of the incentive equity pool and 4.2 percent of fully diluted equity.  

Time Vesting: Almost all of the companies subjected at least some portion of the incentive equity to time vesting, with periodic vesting over five years being the most common approach.

Return-Based Thresholds: A return-based vesting threshold was established by 43 percent of companies surveyed. In these cases, a portion of the incentive equity (typically half) was subjected to scaling participation cliffs based on sponsor IRR, cash-on-cash multiple thresholds or a combination thereof.

Financial Results: A portion of the incentive equity was subjected to vesting based on financial performance by 27 percent of companies, which provided for annual tranches vesting in the event that the specified financial metric (usually EBITDA) for the corresponding year was achieved.  

Repurchase Rights:  87 percent of companies had the right to repurchase vested incentive equity following the end of employment. These companies were to pay fair market value when repurchasing vested incentive equity in this context, provided that over a majority of them agreed pay only the lower of fair market value and cost following a termination for cause or the employee’s resignation.

In analysing other key terms such as form of security and rollover mechanics, we found additional differences among the portfolio companies surveyed. While views of “best practices” therefore vary, the best incentive equity plans will continue to be those that effectively attract, retain and motivate top talent.

Kimberly Smith is a private equity-focused lawyer in Paul Hastings Chicago office.