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:

  • Special liquidity rights. A sponsor may permit members of management to sell their vested equity awards back to the company (before a termination of employment and before a sponsor exit) at predetermined times. Factors to bear in mind in utilizing such special put rights include:

    • Making management comfortable that the methodology for determining the repurchase price is fair; and
    • Ability of the business to generate or raise the funds necessary to fund the repurchase (and making sure there is room under any portfolio company debt agreement repurchase baskets). A separate limit on put rights may be advisable to prevent a “run on the bank” (i.e., a significant drain on cash resources due to the exercise of put rights at the same time) or the loss of incentive if employees cash out 100% of their equity in a single sale.
  • Distribution rights. Distribution rights entitle the employee to receive in-service cash dividends and cash distributions on the employee’s equity awards. Factors to consider with distribution rights include:

    • Whether they should be granted on a stand-alone basis or in connection with other equity awards; and
    • Whether they should be paid at the same time as distributions made to the company’s other equity holders or upon vesting or settlement of the underlying awards to which such rights relate.
  • Internal market program. An internal market program allows employees to buy their equity interests directly from and sell their equity interests directly to one another.

    • This allows employees to monetize their awards, while avoiding liability accounting that might otherwise apply to put rights in certain circumstances and at a time when company purchases are prohibited by financing covenants.
    • However, this type of program requires participants with enough wealth and interest to fund purchases (which is a primary reason internal market programs are not typically used).

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.