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Over the past two weeks, we’ve discussed how to create a culture of accountability and what is involved in long-term incentive plans. In the final installment of our compensation series, we take a look at some recent trends in compensation and ask “What is your company’s compensation philosophy?”

According to Verisight’s 2014 compensation report, 39% of the surveyed companies either did not have a formal incentive policy or they acknowledged they were below market. In addition, nearly half of those companies did not have a formal salary structure with grades, minimums and maximums.

Where does your company fit in this chart? Are your employees motivated and aligned with ownership? Can you compete for talent without a compensation philosophy?

The next question is what measures do you use for your incentive plans? According to Verisign, the most popular short-term incentive measurements are based on organizational and personal performance.

Most private equity firms believe in regimented compensation structures that tie pay to performance – both short-term and long-term. Because of our laser focus on shareholder value, we can’t afford to have misaligned managers who are not motivated in their current role. Compensation is not only a method of reward, but it also creates an immediate feedback loop between management and ownership.

Your insights are welcome

Periodically we will circulate this blog to a target market that includes successful families, wealth advisors and middle market business owners.

Please send us emails, articles, YouTube videos, tweets or even old-fashioned means of communication like voicemails, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

At CapitalWorks, we’re constantly evaluating and debating the optimum method to align executive compensation with the long-term goals of ownership. The common theory is that executives who think like owners have greater incentive to build long-term value and less incentive to push risky short-term strategies. The most common forms of long-term incentive (LTI) plans include: stock options, profits interests, stock appreciation rights, phantom stock, restricted stock, preferred stock and exit-based bonuses.

In such plans, owners look to create alignment and compensation linked to an increase in equity value. Meanwhile, executives desire a wealth creation vehicle and liquidity. Furthermore, executives expect a meaningful “pay day” upon exit around five years after the initial investment. It is important to note that PE firms and family offices that have longer hold periods need to recognize and solve the market value and liquidity requirements in order to remain competitive in almost all acquisition processes today. Every year, we see a handful of private owners either lose out on a deal opportunity or lose a key manager due to the lack of planning around LTI liquidity.

While researching this topic for our own purposes, we ran across an excellent white paper, Driving Portfolio Company Performance In A Changing Private Equity Environment, by PwC. Here are a few highlights from this paper and our research:

• 10% of fully-diluted equity is typically reserved for management LTI’s
• Share reserve ranges from 4.5% to 17% and are generally inversely related to the size of the sponsor’s equity investment
• Top 5 executives receive approximately 50% of the reserve
• Equity participation today stretches further down into organizations than historically seen with the second and third layer of management regularly receiving grants
• Performance-based vesting conditions comprise a majority of the equity awards
• 50%-75% of the total award is tied to sponsors’ financial return realized upon exit
• Sponsors generally don’t have a formal process for determining grant sizes – internal benchmarking is applied for each new portfolio company
• PE firms generally require a meaningful investment by management for “table stakes”
• Median expected LTI payouts to portfolio company executives lead those at comparable public firms by approximately 3.0x

We have found that there are many more management teams who are beginning to believe in the wealth creation promise of the private equity model. For some, they are participating in serial “pay days.” But making sure that the sponsor and its investors are aligned to the managers requires careful balancing. As Price Waterhouse points out, that balancing act is becoming more sophisticated and less generic as the private equity model continues to provide superior returns as an asset class.

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Link for the above article:

http://www.pwc.com/us/en/private-equity/publications/private-equity-stock-compensation-survey.jhtml

Your insights are welcome

Periodically we will circulate this blog to a target market that includes successful families, wealth advisors and middle market business owners.

Please send us emails, articles, YouTube videos, tweets or even old-fashioned means of communication like voicemails, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

A critical factor to a successful portfolio company is attracting and retaining motivated, high-quality executives. To motivate those executives, it is imperative for private equity-backed companies to implement compensation schemes that nurture performance-based cultures and align management with ownership.

High performing, middle market portfolio companies employ lean management teams focused on top line growth as well as margin expansion. Portfolio companies are meritocracies where top managers shine and poor managers are quickly exposed. It is truly sink or swim in a sub $100 million company trying to go head to head with multinational corporates and their endless resources. Managers who thrive in the small company environment need, want and deserve compensation that rewards short term ego and long term value creation. Likewise, owners want these managers to feel appreciated and share the opportunity for true wealth creation.

Given the importance of the topic, we’ve devoted the next three blog entries to a discussion related to compensation. We hope to stimulate thoughts on topics ranging from how to build a performance-based culture as well as issues related to short and long-term incentives.

In this week’s blog, guest author and compensation expert, Alex Freytag of ProfitWorks, discusses the first step to creating a “culture of accountability.”

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Eradicating Entitlement Mentality from Your Family Business

by By Alex Freytag, ProfitWorks

An entitled person feels they should get things because of who they are, and not what they do. Unfortunately, this type of thinking permeates company cultures all over our country today. Employees feel entitled to their jobs, entitled to the use of company assets, entitled to the use of company time for personal tasks and so on.

Where did this entitlement mentality come from? Self-esteem is certainly important and my feeling is that over the years, as our nation has gotten wealthier, we have tried to give self-esteem to our children and our employees. We give our children trophies just for participating. We don’t use red ink anymore in classrooms because it might hurt their self-esteem. We insulate them from the little failures in life so they can feel better about themselves — we try to give them confidence. But the only way to truly develop self-esteem is to earn it, and undoubtedly that means there will be some failure. Actually, fear of failure is an excellent motivator for individuals to learn and become accountable. It helps people develop confidence in their abilities and a sense of self-worth and purpose.

So, how do you eradicate entitlement and create a culture of accountability in your family business? Here are five steps you must take: [Read more…] about Compensation Series—Culture of Accountability

Todd Martin and I recently learned about a success story for a family office participating in a fully marketed industrial company. Our friends at Lincoln International were acting as the exclusive financial advisor for an industrial company that participates in the filtration industry. They had significant interest from Private Equity firms and were surprised that a family office demonstrated industry expertise, keen interest in the dataroom and an aggressive bid to obtain a management meeting.

Family Bid Was Distinctive

The family office distinguished itself with three unique features:

1. It did not require a financing contingency

2. It demonstrated sophistication about a seasonal earnings blip

3. It was attractive to management as it promised long-term ownership

In the final bidding process, the family office was significantly behind the leading PE firm, but the family patriarch was eventually convinced of his family’s need to pay up. At the end, the family prevailed as the high bidder.

Distinction Came With Complications

What was most interesting to us was the subsequent structure to accommodate management with a long-term incentive package that could rival the typical PE structure. The family could not mimic the “equity upside” (combination of outright stock ownership and exit oriented stock options or profits interests) of the rival bidders. As Lincoln International put it, “It became pretty complicated to arrange an aligning and motivating incentive compensation structure because the family intended to hold the business for the foreseeable future.” Ultimately, a structure was crafted that management could accept.

Private Equity Model Aligns With Management

The irony is that what made this family compelling to management was its long term perspective,  but the absence of a real exit eliminated tax advantages that can normally accrue to a management team through profits interests and outright stock ownership.

As families step up to compete with PE firms with unique and compelling bid characteristics, they will have to evolve competitive and aligning compensation structures to win the deal. Intermediaries do not want closing risk, especially in this robust “sellers’ market.” That risk is real where compensation plans are not competitive with PE or publicly held strategic acquirers.

Your insights are welcome

Periodically we will circulate this blog to a target market that includes successful families, wealth advisors and middle market business owners.

Please send us emails, articles, YouTube videos, tweets or even old-fashioned means of communication like voicemails, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

Tax Advantaged Structuring

Entity Structure Impacting Returns

While uncertainty still exists with the overall U.S. tax code and rates, one thing that is not expected to change is the tax advantages of structuring a business as a flow through entity to avoid the double taxation of a C-Corp. By utilizing an LLC structure, we have the ability to structure the ultimate exit of a portfolio company as either an asset or stock sale with only a slight difference in the overall tax liability. This creates significant flexibility and advantages.

During an acquisition, we are generally willing to pay more when we can acquire the assets of the business. Not only can we benefit from the tax benefits of amortizing purchased goodwill but we believe we can limit our overall liability exposure that can arise from the contingent liabilities of the seller. We believe these same favorable considerations create an opportunity for the next owner when we exit our businesses. Those advantages often lead to an overall higher valuation.

Structure Creates Tax Advantages

In the right situation, we have the ability to improve the IRR dramatically by taking advantage of the build-up in owner basis that is available when owning an LLC. This structure allows us to make a “tax free” distribution to the owners during the holding period of a portfolio company. On the other hand, due to the high “double” tax burden this would create in a corporate structure, a corporate dividend is generally not viewed as an option. If add-on acquisitions or other productive uses of cash inside the business do not make sense, the best option to a portfolio company organized as a C-Corp with excess cash flow is generally paying down debt and the most efficient way to return capital to owners is by selling the stock of the company. The LLC structure gives us many more options. It allows us to be more strategic when timing our exit without foregoing the ability to tax efficiently returning capital while still continuing to own the business.

To highlight these benefits, we have provided the following example. We assume that during the life of the portfolio company, all income is taxed at the current highest Federal rates for corporations and individuals. The rate for corporations is 35% and the rate for individuals is 43.4% for ordinary income and a 23.8% rate for dividends and capital gains.

Example of improved investor returns when utilizing an LLC structure

Assumptions:

We acquire the assets of a business that is generating $4m of EBITDA for $20m. We capitalize the business with $15m of bank debt and $5m of equity. We assume the business is able to increase EBITDA by $.5m in each year we own the company and under the LLC structure we borrow additional debt in year three to recapitalize the company and return twice the invested capital to the owners. We assume that a company owned in the C-Corp structure does not pay a dividend due to the double tax cost but instead, continues to pay down additional acquisition debt. We exit the portfolio company at the end of five years at a gross value of $35m.

We assume the buyer is willing to acquire the stock of the business, in which case we have the ability to convert the LLC to a C-Corp prior to sale so that the treatment of the gain at exit is consistent with that of the C-Corp.

Results: You “keep” more in a LLC structure

On a pre-tax basis, the C-Corp structure looks better as it returns a gross cash multiple of 7.42x versus 6.90x. However, as an LLC the after-tax cash proceeds would be $1.2m higher or a 4.7% improvement as an LLC owner benefits from the build-up in tax basis during the holding period. The after-tax IRR is higher for an LLC, 54.9% vs. 42.6%, impacted by the higher net proceeds and the recap distribution paid in year three. Not considered in the analysis are any additional returns that could be generated by our investor from the “tax free” distribution that went back to them in year three. The full distribution can be invested depending on their risk tolerances which may be different than how cash is invested in the C-Corp.

I’m happy to share my spreadsheet analysis with anyone who has interest.

Your insights are welcome

Periodically we will circulate this blog to a target market that includes successful families, wealth advisors and middle market business owners.

Please send us emails, articles, YouTube videos, tweets or even old-fashioned means of communication like voicemails, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

Mike Harding, CFO
CapitalWorks, LLC
August 15, 2014

It’s what you keep, not what you make!

For the United States, the period 1982-2000 might be regaled by financial historians as one of the greatest periods of wealth creation in the history of the world.  The U.S. stock market, as measured by the S&P 500, grew at an average annual rate of 18% (including dividend reinvestment) during that 18 year period.  Interest rates, as measured by the 10 year treasury, fell from 14% to 5% and  taxes on ordinary income fell from 50% to 39.6%.  Productivity increases through the Internet and computers lifted growth rates for almost all sectors of the U.S. economy.  It was our “Camelot” moment.

On a global basis liquidity and availability of debt were unparalleled as central banks around the world manufactured equally dazzling “Disneyland” prosperity.

Reversion to the Mean

The next 12 years have not been the same.  A stock market crash in 2000 signaled the end of the dot-com boom.  Another and more precipitous crash in 2008-2009, ended a 36 year run for seemingly invincible U.S. real estate markets where the annualized return since 1971 had been 10.3%[1] and signaled the end of an era of prosperity built on debt and accommodative fiscal policies.  The Disneyland economy has seemingly turned “goofy.”

Where do you Invest Now?

Many successful families are questioning what to do next.  Most have substantial cash reserves.  Notwitstanding a robust recovery in 2013 and 2014, most of them also have a lingering distrust of the U.S. stock market, but also understand that they cannot afford to retire on fixed income that is producing below 2% annual returns.  Many of these families are victims of negative real returns where safe interest bearing investments cannot keep up with the pace of inflation.  Instinctively, many of our families want to return to owning something tangible that makes a product which is important to industrial or consumer markets.  Many of their fortunes were converted from manufacturing to financial assets over the last 10 years.  Many may be beginning to regret the timing of that trade.

The case for private ownership of small industrial businesses has never been better; especially if you have the flexibility to utilize tax efficient structures like our model allows.  (More on this in Part Two later in August).

Top Ten Reasons for Small Manufacturers

The macroeconomic model favors private ownership of small manufacturing for these top 10 Letterman reasons.

10. Highly inflationary resistant — Pass on commodity price increases

9.   Small business job creation is a bi-partisan political cornerstone

8.   Private business is private — very little visibility.  You cannot tax wealth creation you cannot see

7.   Long lived illiquid asset based on long-term strategies — not prone to short-term trading during volatile times where you are ruled by fear of loss

6.   Capital gains have almost always been taxed at a substantially lower rate than dividends or interest

5.   Weakness in U.S. dollar due to easy money policies means that U.S. exporters of manufactured goods are benefited

4.   Leveraged private equity model is benefited by an inflationary central bank policy

3.   Profits and taxes can be deferred until the tax climate returns to favorable times.  Our model also allows tax fee dividends while you wait

2.   Wealth is shifted from paper (electronic) net worth to tangible net worth.  Your wealth is converted into means of production

1.   Supply chain miracles in China and Southeast Asia have not been the hoped for panacea. Manufacturing is returning

Back to the Future

On top of 10 good reasons to own a manufacturing company, there is also a realization that the U.S. may return to the era of high taxation that I saw in 1976 when I started my career.

	1976	2012	2014
Ordinary Income	70.0%	35.0%	43.4%
Capital Gains	49.6%	15.0%	23.8%
Dividends	70.0%	15.0%	23.8%

In 1976, AFTER TAX returns were the measuring stick of a good investment and investors with choices flocked to tax shelters to cushion the blow of a confiscatory tax regimen.  Everyone focused on what they could keep for their families and not on what they could make on paper.

We believe we are returning to a high tax environment.  Hunting successful people and redistributing their wealth through progressive taxation has again become the favored political sport.  AFTER TAX investment returns will become extremely important.  What you keep will become more important than what you make.

Flexibility to Lower Taxes

Because our investors are taxable, we can buy manufacturing companies with flow through investment entities that grow tax basis above the original invested amount. By running portfolio company operating earnings through our investors’ tax returns, we create a tax shield for future dividends.  It creates a level of complication at tax time, but our research shows that our structure creates a material AFTER TAX advantage over other private equity funds that have institutional investors like endowments and pension plans.

As we return to an AFTER TAX world like we had in 1976, a flow through investment model will be highly favored.

Your insights are welcome

Periodically we will circulate this blog to a target market that includes successful families, wealth advisors and middle market business owners.

Please send us emails, articles, YouTube videos, tweets or even old-fashioned means of communication like voicemails, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

[1] Annual returns for the FTSE NAREIT U.S. Real Estate Index

I attended a seminar recently where the host law firm reviewed the SEC audit activity of private equity firms that has been spawned by Dodd-Frank. In attendance was a private equity professional whose firm had just completed one of these audits. His experience matched the law firm’s report that the audit was more of a fact finding and information gathering exercise than an actual audit by knowledgeable industry participants.

In fact, the private equity professional had enough heartburn about the government auditors’ qualifications that he asked them about their background. He was told that they could not disclose their background. So I immediately thought about a couple of guys who had just transferred from a job at IRS where they had worked on Lois Lerner’s nonprofit team to join the Dodd-Frank audit team. They can’t tell you about their background because it might raise suspicion of bias and genuine skepticism about their prime objective.

Sweating The Little Stuff

Of course, I am kidding. The private equity professional subsequently pointed out that the auditors had, in fact, demonstrated math and auditing skills by fixating on a less than $1000 discrepancy between reimbursed organizational expenses to the General Partner and actual documented organizational expenses. This was in the context of a fundraising of more than $450 million spanning a two year time frame.

Here’s What Is Going On

A recent article in the Wall Street Journal casts light on what is going on. Evidently these auditors have a hit list of supposed abuses that range from self-dealing with portfolio companies to portfolio valuation abuses. In a few cases these audits will uncover mistakes and, in even more rare circumstances, outright deception and fraud. However, the objective appears to be much more about hunting down successful people (many of whom are prominent contributors to the opposition party) than investor protection. After all the investors in private equity funds are incredibly sophisticated with access to a wide swath of managers. In many cases the investors work with their own auditors, consultants, wealth advisors and attorneys to carefully diligence the fund managers, fund formation documents and track record.

Same Group That Missed Madoff

It is lost on me how the SEC audit program is going to improve on the Darwinism of the existing system? The Agency’s track record is lower than the worst performing manager in the history of private equity. The SEC investigated Madoff’s Ponzi scheme in 2005, but failed to verify several critical pieces of information. As result, they sadly failed to discover the scheme until after the fraud was admitted in 2008.

Manager Selection Is Bedrock

The single biggest variable in private investing is the fund manager and picking a good manager who will treat your money like his own is the key to success in this asset class. If you substitute a friend’s advice for your own due diligence and follow the frenzied herd you will likely get a Madoff result. That’s capitalism!

Your insights are welcome

Periodically we will circulate this blog to a target market that includes successful families, wealth advisors and middle market business owners.

Please send us emails, articles, YouTube videos, tweets or even old-fashioned means of communication like voicemails, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

A recent article in the Financial Times, “Private Equity Steps Up The Pace of Pass The Parcel” (Wednesday, June 18, 2014) shows an interesting trend that may affect fund of funds specializing in the private equity asset class. Anne-Sylvaine Chassany reports that the percentage of reported M&A transactions that private equity firms are completing with each other has risen from 7 percent in 2007 to more than 33 percent of the transactions announced so far in 2014.

The implication for families that are participating in large fund of fund vehicles is that you may be both a buyer and seller of the same company. Unfortunately, it is unlikely that both sides of the transaction will work out. Ms. Chassany reports that CVC Capital Partners and Leonard Green acquired Advantage Sales and Marketing, a California marketing agency for more than $4.0 billion at a multiple of 13x 2014 projected EBITDA. The Seller, Apax Partners, is projected to quadruple its equity.

So a fund of funds that owns a stake in both buyer and seller would be incurring a carried interest fee to the seller and then a management fee and possible future carried interest fee to the buyer.

This also ignores the real risk that at 13x the business has been priced to perfection. The likelihood that both buyer and seller will achieve comparable returns at this nosebleed transfer price seems remote.

That said, the practice of “passing the parcel” itself can make sense where the buyer and seller are each adding value as in the case where the seller acquired the business in a carve out transaction and added value by making the business a standalone entity. A subsequent sale to a private equity owner with a platform investment in the same industry could produce win-win economics.

The large amount of dry powder and buying power in the hands of private equity is only likely to accelerate the trend of selling to each other. It probably makes sense to look at how you are participating in the private equity asset class to determine if your approach is subject to unintended double dipping. You may also be buying what your alter ego is selling.

Your insights are welcome

Periodically we will circulate this blog to a target market that includes successful families, wealth advisors and middle market business owners.

Please send us emails, articles, YouTube videos, tweets or even old-fashioned means of communication like voicemails, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.

CapitalWorks is excited to announce its commitment to a periodic blog branded as “PE4FAMS.”

While many of our competitors in the private equity world are funded predominantly by institutional capital (pension funds, insurance companies, sovereign wealth funds, public retirement funds, endowments), all of CapitalWorks’ funding is from successful families. This has been our heritage and our unique niche in the private equity world since 1999.

Families have different objectives and distinct preferences

We believe that families have different investment objectives and distinctive preferences. Over the last 15 years, we have tried to articulate those preferences at every CapitalWorks Annual Meeting:

• Patient and discerning capital
• Seeking transparency about investment process
• And focused on after-tax returns (tax efficiencies)
• Willing to collaborate for investment advantage
• And share insights and networks

Family offices want to invest directly

We are also noticing a new trend among family offices. Increasingly, they want to invest directly and control privately held businesses within industries where the family has special expertise or interest. Our investment banking friends from Robert W. Baird, KeyBanc Capital Markets, Lincoln Partners and Western Reserve Partners, confirm the emergence of the family office as a credible bidder in many of their recent sale processes.

Because the family office is bidding directly and is not burdened by management fees or carried interests to private equity sponsors, they are conceptually able to pay a higher price and still net the same return as limited partners in a fee paying fund. However, concept and reality have not meshed in recent sale processes and few family offices have been willing to pay the high price to become the successful bidder.

Advantages for families in M&A

The family office or family capital pool has several other advantages in the M&A process versus private equity:

• Hold time — there is no fund life for family funds
• Capital structure — flexibility to over equitize/leverage is less important
• Tax efficiency — after tax returns are key
• Continuity — management teams can see a long runway
• Cash flow — can run businesses for free cash flow; no need to sell business to capture returns

Family offices partial to Midwest manufacturers

With families growing ever more sophisticated, it’s no surprise we’ve seen an uptick in family investment in our sphere of Midwestern industrial companies:

In November 2013, Stephens Private Equity, a Little Rock based family run fund, completed the acquisition of Eiko, an environmentally friendly lighting distributor. This past April, the Pritzker Group acquired Technimark, an innovative packaging company. In June, TASI Holdings, a worldwide diagnostics company, was acquired by Berwind.  Additionally, family offices such as Bratenahl Capital Partners are more active than ever in searching for new opportunities. These acquisitions underscore the growing interest in direct investment.

Family funds enjoy cyclical and tax advantages

The family investment vehicle also has a cyclical advantage. Much like Warren Buffett and Berkshire Hathaway have become the preferred provider of public company capital in periods of Illiquidity (2000-2003 and 2008-2010), these families likely emerge as preferred partners when private equity firms are sidelined due to lack of access to senior and mezzanine leverage.

Family groups with liquidity should be able to capture bargains in these periods of limited third party funding.

Finally, family funds offer significant generational tax planning and “dynasty” advantages on account of the flexibility to hold a good asset in perpetuity, especially a business that can generate tax favored cash flows.

Where families might suffer disadvantages in direct investment

However, there are several downsides to families going direct. The most daunting is infrastructure. To replicate the investment, marketing, due diligence, transactional and governance capabilities of private equity sponsors is challenging and expensive.

Also talented private equity professionals may not find the captive family office culture as appealing as the more independent and opportunistic private firms. Compensation of talented staff through tax advantaged “carried interests” may be more difficult because many families want to hold, not exit.

Finally, deal flow to private equity sponsors from investment bankers, especially proprietary opportunities, often emerge from a quid pro quo system of “paybacks” for private equity awarding lucrative sell side investment banking assignments. The family investment vehicle is less likely to have this kind of transactional leverage.

Still, families are a force

One thing is sure, the family investment vehicle, whether a dedicated fund or an opportunistic pool, is emerging as a significant participant in the M&A and capital formation process.

Your insights are welcome

Periodically we will circulate this blog to a target market that includes successful families, wealth advisors and middle market business owners.

Please send us emails, articles, YouTube videos, tweets or even old-fashioned means of communication like voicemails, mail or a phone call on the topic of Private Equity For Families. All ideas are welcome.