With the growth of long-dated funds and the rise of direct investing by alternative capital pools such as pension plans and family offices which may intend to hold portfolio investments for long, or indefinite, periods, the increasingly asked question is: How does such an investor motivate management with no exit in sight? For long-term hold investments, it is important to consider providing other liquidity outlets so that equity and long-term incentive arrangements properly align management’s interest with the interest of sponsors. This article describes some alternative liquidity programs for sponsors’ playbooks.
In Together, Out Together
Historically, direct investing was the domain of private equity funds with a finite life, which operate with plans to exit investments in three to five years. In order to align the interests of portfolio company management with those of the sponsor, management incentives are often linked to the equity of the company so that management and the sponsor are linked until the sponsor exits (i.e., management and the sponsor both enter into and exit the investment together). Vesting conditions are typically intended to incentivize one or more of (i) employee retention (e.g., continued service for three to five years), (ii) company performance over three to five years (e.g., EBITDA, revenue, etc.) and (iii) sponsor investment return (e.g., an exit in which the fund achieves a multiple of invested capital and/or IRR).
Management is obviously focused on how to monetize their equity awards. In the spirit of “in together, out together,” management equity is generally illiquid until the sponsor has a realization event (e.g., a sale of the company, a leveraged recap, or a special dividend). If an employee is fired or resigns before a realization event, the company and/or sponsor often have a right, but not an obligation, to repurchase the employee’s vested equity at fair market value (or at the lower of fair market value and its original cost, if the employee is a bad leaver). While this may provide an employee with liquidity in connection with his or her termination, the employee has no assurance that the company or sponsor will exercise the right, and the employee may need to continue holding the award until a realization event. On the other hand, if a company frequently repurchases equity from departing employees, lack of another liquidity alternative may create a perverse incentive to leave.
Early Liquidity for Long-Term Holds
The market for private equity investing has diversified in recent years and includes players who buy companies with a longer term investment horizon. Such investors need to modify the typical management incentive playbook in order for it to actually incentivize. Members of management typically want to see the fruits of their labor within the reasonably foreseeable future, and if management does not see that “light at the end of the tunnel,” alignment of management’s and the sponsor’s interests is unlikely, management may devalue the award, and the award may have reduced effectiveness inducing retention and performance.
Some investors who do not have specific exit horizons do not provide long-term incentives to management. But sponsors who wish to address these concerns may do so by providing forms of “early” liquidity for management equity through:
There are pros and cons to each of these alternatives, and care must be taken to structure a management incentive program for the relevant securities law, tax and accounting implications. Whichever alternative a sponsor chooses, however, vesting conditions, such as time-based vesting to incentivize retention and performance-based vesting to incentivize performance (e.g., EBITDA), could be used to align management’s interest with the sponsor’s interest.
Long-Term Cash Incentives
A well-designed long-term cash incentive program can be very useful in aligning management’s interests with those of a sponsor who intends to hold a portfolio company for an indefinite period of time. Such a program could motivate employee performance, reward management for company growth and provide a counterbalance against short-term risks. A major “pro” of long-term cash incentives is the flexibility in design they afford. However, there are disadvantages as well—care must be taken to avoid or comply with Internal Revenue Code Section 409A and Section 457A, and a long-term incentive program is subject to liability accounting. Furthermore, long-term incentive programs can be complex and difficult to understand and communicate. Effective long-term incentive metrics should be as simple as possible (it is best if they are limited to three or fewer measures and are quantifiable and measurable) but also sufficient to focus management on the sponsor’s business objectives and to incentivize management to achieve the desired results. Long-term incentives should be capable of factoring in changes to the company’s business and structure but also incapable of inappropriate manipulation by management.
The Choice Is Yours
There is no objectively “right” or “wrong” incentive program for management of a portfolio investment that the sponsor does not anticipate exiting in the near future. A properly designed program should be tailored to each sponsor’s needs. Most importantly, because management’s incentive program is different from the financial sponsor’s equity interests, there is added emphasis on ensuring that the program works with employee expectations. Therefore, in designing a management incentive program, an investor with a long-term investment horizon should carefully consider management’s tolerance for complexity, how to make management comfortable with the new owners and how to sell the program to management. As noted above, there are a variety of alternatives to choose from, and an appropriate incentive program can be structured to meet the needs of both management and the financial sponsor.