Stephen Diosi, Partner and Head of Incentives and James Paterson, Managing Associate in the Private Equity team explore how to shape management equity incentive plans in the context of a “take private” and in the current COVID-19 environment.
In 2019 and, prior to the pandemic crisis, 2020 we saw a wave of UK publicly listed companies being “taken private” by private equity sponsors. Examples of recent “take privates” include Sophos, Merlin Entertainments, Inmarsat, Charles Taylor and Ei Group.
Challenge
A key challenge for the private equity sponsors in a postlisted environment is how to appropriately incentivise the executive team and wider employee population.
Senior leadership will have been used to receiving annual grants of share options, restricted stock and deferred bonus share awards, while employees at all levels are likely to have been able to participate in share ownership plans such as Save As You Earn or a type of share purchase plan.
The profile of a private equity backed company, or indeed any company that is in private ownership, is clearly very different from that of a public one, so the ability to have a plan that enables a broad range of participation in its equity is likely to be limited.
Yet it still remains an incredibly important principle to be able to offer a sufficiently attractive incentive package to the executive team which aligns them with the private equity sponsor; providing all the necessary motivation for the executive team to drive the business to a successful exit (typically within three to five years of the “take private”) for both the sponsor and executive team.
Solutions
In a private equity context, this package will often take the form of a management incentive plan, limited to the executive team and (depending on the profile of the business) other key employees.
A MIP will typically require its participants to roll over a proportion (typically 40- 60 per cent on an after-tax basis) of their sale proceeds received from the buy-out for of their shares and share options. If the participants don’t hold equity or share options in the target at the time of the sale they would be expected to roll over the proceeds of any exit bonus. In each case, they would reinvest this sum in shares (and shareholder debt, i.e. loan notes or preference shares) in the new group structure alongside and on the same terms as the private equity sponsor. Such equity and shareholder debt is often referred to as “institutional strip”.
In addition, the MIP will create a separate class of incentive share that enables the MIP participants to share in the growth in the business, typically above a minimum hurdle (which is usually based on the sponsor’s MOM (i.e. multiple of money invested) and IRR (internal rate of return)).
These shares (known as “sweet equity”) will generally have limited rights, so they may not be able to vote or receive dividends and will be entirely focused on providing an economic benefit linked to the business plan and a successful exit for the private equity sponsor.
An executive team’s best chance of securing advantageous economic and legal terms for both their “institutional strip” and “sweet equity” is by delivering to the private equity bidders a term sheet containing the principal terms they see as aligning themselves to the sponsor and their business plan (e.g. economics which align value creation and any necessary hurdles, the size of the “sweet equity” pot, value vesting, dilution protections, what happens to the executives’ equity/ shareholder debt when they leave (both voluntarily and involuntarily) and other minority shareholder protection rights).
Agreeing the MIP term sheet takes time; using any competitive tension at the outset of the deal can be incredibly valuable. Equally important is the executive team engaging its own legal advisors and specialist management corporate finance advisors at the outset of the process to advise on and drive agreement of the MIP term sheet (and thereafter the long form documents). Furthermore, it is of great help to an executive team to have buy-in to the MIP process from the board of the target listed company: in the long run, tackling the terms of the MIP as soon as it is possible to do so in a “take private” process invariably leads to a smoother process overall and a happier executive team.
Alternatives
In founder or other privately-owned businesses, the sweet equity structure may also be an appropriate mechanism which helps to align and promote the objectives of the business as a whole. However, as an alternative, there may be some ability to create more flexible and bespoke arrangements. This may include a type of tax-advantaged employee share plan (for example Enterprise Management Incentives) or in circumstances where the founders want to create a wide-ranging employee ownership culture (particularly with succession planning in mind), they could put the business into the hands of an employee ownership trust. This will hold the business on trust for all employees, while providing tax breaks both for the founder shareholders (who can sell their shares tax-free into the EOT) and employees (who can receive tax-free bonuses up to £3,600 per tax year).
Naturally, as with any type of incentive structure and ownership profile, there will need to be proper consideration of the impact of certain events in the lifecycle of the plan, such as what happens if someone leaves (do they lose all their shares or do they get to keep some), what vesting requirements are appropriate, how should certain types of corporate events be dealt with - and tax planning.
As and when we come out the other side of the CV19 crisis it should be expected that private equity sponsors will continue to look for “take private” opportunities. Further, those businesses already acquired by private equity sponsors pre-crisis will be closely reviewing the MIPs they have in place to ensure they remain fit for purpose. If they don’t they ought to be (and executive teams will no doubt begin to request that they be) reset.
This article was originally published in the July 2020 Executive Compensation Briefing. To read the whole briefing please click here.