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
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