Private equity investors (PEIs) when investing in new portfolio companies, seek to align management’s interests with that of the PEI to grow the value of the portfolio company and achieve a profitable return in the investment upon exit.
Typically, PEIs incentivize management to adopt such interests through compensation arrangements in the form of performance incentives. Generally, PEIs will grant management an interest in the growth in value of the company via an interest in the equity of the company (e.g., stock options or performance shares) or in the profit/proceeds of the company, the latter of which is typically used for partnerships.
Notwithstanding that specifics naturally differ across all PEIs, there are some common elements in the amount and vesting among performance incentives. PricewaterhouseCoopers published a survey (the Survey) and a report (the Report) in 2013 and 2012, respectively, outlining such information which is summarized below.
Amount and participation
Determining the right percentage of interest in a portfolio company (or profit/proceeds) to be granted to sufficiently incentivize management is a fact-specific question. Generally, PEIs first determine the total compensation they wish to provide management upon a successful exit then “back-solve” for the amount and form of equity required to deliver that dollar amount. Further, both the Survey and the Report note that:
- on average, PEIs reserve approximately 10% of the equity interest for management incentive plans (as a percentage of fully diluted shares) with a range of 4.5% to 17%; and
- on average, the CEO and next four senior-most executives receive approximately 50% of this reserve.
Notably, PEIs also typically tie different percentages to different performance achievements. For example, escalating percentages (e.g., 5%, 10%) can reflect different tiers, each tied to an escalating performance (or hurdle) rate.
Performance incentives are typically subject to vesting conditions. While some performance incentives are time vesting, the Report states that the following two vesting conditions are the most commonly used:
- performance based vesting conditions based on metrics related to achieving financial targets (e.g., EBITDA); or
- exit based vesting conditions based on metrics such as the internal rate of return or a multiple of invested capital achieved upon a liquidity event.
PEIs may impose additional terms which may cause a person to forfeit their entitlement to any performance incentives upon the occurrence of certain events, such as that person’s resignation or termination.
The author would like to thank Nader Hasan, articling student, for his assistance in preparing this legal update.
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