How US private equity compensates management through the investment lifecycle By Steve Rimmer & Aaron SanAndres, ndres, PwC

Transcription

1 How US private equity compensates management through the investment lifecycle By Steve Rimmer & Aaron SanAndres, ndres, PwC

2 Introduction In the private equity ownership model, compensation is the glue that binds the interests of portfoliocompany senior management to the financial objectives of the private equity owners. In a typical private equity-backed acquisition, management will be asked to deliver on challenging performance targets with an expectation that they will share, in a meaningful way, in the corresponding growth in the value of the company. The compensation structures implemented by private equity firms can be very different from the structures that management may have had under prior ownership regimes. This chapter focuses on how private equity firms in the US approach compensation design and administration in their portfolio companies. We have outlined the key considerations that arise in the lifecycle of the private equity firm s investment from due diligence through eventual exit. Pre-signing compensation due diligence US private equity firms are keen to understand a target company s compensation programmes early in the diligence process. The change in ownership may result in the acceleration of payment of certain compensation arrangements. Establishing the amounts involved, the triggers for payment, the timing of payment and who will bear the financial responsibility for making them is a critical part of the due diligence process. A typical practice is to prepare an exhibit detailing, for each member of the management team, the key compensation elements, payments that will be triggered by the closing of the transaction, and how those payments will differ if the individual's employment is terminated. This exhibit is a useful tool as it sets out the potential termination costs and the magnitude of payments across management team members. The private equity firm will also want to ensure that the costs of these compensation arrangements are fully reflected in the company s financial model, and that appropriate adjustments are made to reflect onetime compensation items such as any retention arrangements implemented in connection with the sale process. Private equity firms will also typically back out any equity compensation expense, as these costs are non-cash in nature and are often excluded in calculating bank covenants. Future costs of equity compensation will typically be reflected simply as dilution of the private equity firm s interest at exit. However, often there will be a group of employees who received equity under the prior ownership but who will not receive equity from the private equity firm (as private equity firms generally limit equity participation to the company s most senior employees). If annual long-term incentive grants have been a material component to these employees, an allowance should be made for a cash-based replacement, either in the form of a phantom equity plan or cash bonus (in both cases paid out upon the private equity sponsor s subsequent sale). Understanding current compensation arrangements also helps the private equity buyer to anticipate how management and other employees will react to the private equity firm's post-acquisition compensation arrangements and allows them to structure those arrangements in a manner that management will find attractive. Current compensation programmes Compensation generally comprises base salary, cash bonus and long-term incentives. Each element has unique characteristics that warrant attention in a due diligence context. Private equity firms will often conduct a competitive compensation review for select executives as part of the due diligence process. Salaries (and benefits linked to salaries) represent the fixed piece of the total employee cost. The key diligence question is: how do executive salaries compare to market levels? Financial sponsors will expect salaries to be within a reasonable range of market median levels (for example, +/- 15 percent), unless there is a clear rationale for an alternative compensation philosophy. Companies with high salary levels relative to market often put less weighting on variable compensation and will likely require a shift in the pay mix in order to align with the pay-for-performance structure private equity firms prefer. This shift will often involve freezing or reducing (less common) base salaries and increasing the annual bonus or long-term incentive elements. Annual cash bonuses can be structured in many different ways. Understanding how the company's cash bonus pool is structured (for example, where the plan fits on a continuum of formulaic versus discretionary funding) is an important diligence area to address. Companies with significant amounts of PwC Page 2 of 9

3 discretion in their annual incentive process deserve special attention during due diligence. Private equity firms will want to increase transparency and exert control over this process, at least in terms of funding for given levels of performance. Another area to understand is how the company has accrued for expected bonus payments and whether the accrual will adversely impact working capital estimates. Long-term incentives (any compensation earned over a multi-year period) are of particular interest to private equity buyers, as long-term compensation plans are often the primary element in executive retention and offer the most meaningful incentive vehicle. Private equity firms are focused on the depth of the awards (that is, how many employees participate) as well as on the treatment of unvested long-term incentive awards. There are generally four ways in which a plan can treat unvested long-term incentive awards following a change in control; each approach can result in a different accounting impact to the buyer: Executive buy-in on prospective compensation At the time the purchase agreement is signed, the private equity firm will typically want to know that they have the key members of management on board, assuming of course that the deal progresses to completion. Private equity firms will often prepare a term sheet which sets out the key elements of the post-acquisition compensation arrangement, including base salary, cash bonus opportunity, and long-term incentive equity grant. In addition to these elements, management is often expected to reinvest a percentage of after-tax proceeds from the transaction alongside the private equity buyer. Term sheets are often the result of focused negotiation between management and buyer. Private equity firms want management to buy in to future compensation arrangements to ensure management are both retained and incentivised to achieve the exit desired by the private buyer (see Appendix I at the end of this chapter for a simplified sample term sheet). Automatic acceleration: the cost of cashing awards is included as part of the purchase price. This is probably the most common approach where the equity management has received is the same equity that is being purchased. Discretionary acceleration: this approach is becoming more common but can result in postcombination expense for the private equity firm under US GAAP, even if the company were to accelerate (and cash out) all equity-based awards. Rollover of unvested awards into a new equity programme or deferred-compensation vehicle, an approach which also results in postcombination expense for the private equity firm under US GAAP. Forfeiture of unvested awards: this results in a loss in value to the management team, which will often become a discussion point between the PE buyer and the company. This approach is more typical where the entity being purchased is a subsidiary of a parent entity and the equity management has received is denominated in the stock of the parent. Generally, private equity firms do not make material changes to executive salaries, but there are circumstances in which a material adjustment might be warranted. Where an executive assumes increased responsibilities following a transaction, it may be appropriate to increase compensation to reflect the executive s additional responsibilities. This will often apply in the acquisition of a subsidiary where management takes on the increased responsibility of managing a standalone company. A reduction may be warranted for those salaries that are materially higher than market practice. For example, a company founder with an above-market salary may have to accept a reduction to a market rate of salary if retained by the private equity buyer. Private equity firms will often make significant changes to cash bonus plans if they regard payouts as being subject to too much discretion and/or not sufficiently tied to the performance metrics that are critical to achieving the private equity buyer s target returns. Private equity firms are likely to introduce a much higher focus on making debt repayments on schedule and on achieving EBITDA targets; these metrics will often find their way into the terms of the new cash bonus arrangements. Modifications will also be required in the acquisition of a subsidiary (or division) of a larger company since the performance metrics will need to reflect the standalone nature of the business going forward. PwC Page 3 of 9

4 The area where there is the greatest difference, however, is typically in the area of long-term equityincentive compensation. If the company was publicly owned (or part of a publicly owned company), executives would often have been entitled to an annual award of long-term equity incentives (stock options or, increasingly, restricted stock). For the most senior executives, the grant date fair value can be equal to, or even exceed, the executive s annual salary. Under private equity ownership, executives are likely to receive a one-time mega-grant of equity compensation immediately following the consummation of the transaction. Public company equity is liquid following satisfactory applicable vesting conditions (although it may be subject to holding requirements or contribute to stock ownership targets). In contrast, shares in a private equity portfolio company will be illiquid until the private equity firm's exit. Note that even fully vested awards may be subject to a bad-leaver provision (see below) which acts as an additional vesting requirement. For these reasons, and because of the high level of debt leverage in many private equity investments, there is an increased risk to the executive associated with private equity long-term equity incentives. As a result, we typically see realised compensation from successful exits that significantly exceed (in absolute dollar amounts) competitive realised compensation levels within publicly traded companies. Where the holding company is established as a partnership structure, profits interests can be used to achieve similar economics as traditional stock options. The profits interest gives the executive a right to a defined share in future growth in enterprise value (after the capital unit holders receive their preferred return). Profits interests currently provide certain tax advantages to the executives as the grant of these interests is treated as a taxable event with zero value, resulting in capital gains treatment on subsequent sale/disposition. Note, however, that there is no corresponding tax deduction for the issuing entity, thus raising the after-tax cost of these awards to the company. The accounting treatment for profits interests is basically the same as for options. The transition around equity compensation is often much easier where the seller is also a private equity firm, unless there are significant changes in the company structure. In a recent deal we advised on, the seller was a European private equity firm, the entity being sold was a European holding company, and long-term equity incentives comprised a mix of restricted stock with little initial value (called sweet equity ) and stock options. The buyer was a US private equity firm, the entity would become a US holding company, and executives were awarded options and required to reinvest net proceeds from the transaction on the same terms as the private equity firm. In this situation management was very familiar with the private equity approach to equity compensation, but additional education was required to help them understand the different implications of the US reinvestment approach compared to sweet equity. Sizing of long-term equity incentive awards What is the right percentage of shares to reserve for management equity plans? This is perhaps the most common question heard from private equity clients when structuring equity plans. As one might expect, the level of equity participation is driven by a number of variables, such as value generated under legacy plans and shares acquired through rollover/investment of deal proceeds. What is clear is that the percentage of total shares reserved for management incentive plans (as a percentage of the fully diluted shares) generally decreases as the size of the private equity buyer s initial equity investment increases. Many private equity firms have a house-style (or typical) approach to management equity in portfolio companies. Even with a housestyle approach, private equity firms should still perform economic modelling of the distribution of value under a variety of performance and exit scenarios to determine the appropriate share reserve for their management equity plans. Private equity firms will often start with a dollar amount to be delivered to management on a successful exit and back into the amount and form of equity required to deliver that dollar amount based on the base-case financial projections. This dollar amount will need to reflect the increased risk associated with higher amounts of leverage and lack of interim liquidity. Once the private equity firm has settled on an overall budget for the equity awards, they will typically work with the company s CEO to determine participation and allocation of the share reserve across the selected participants. PwC Page 4 of 9

5 Vesting conditions Private equity firms are particularly fond of performance-based conditions. According to the 2008 Private Equity Portfolio Company Stock Compensation Survey conducted by PwC, over 90 percent of participants had some portion of longterm equity incentive awards subject to a performance-based vesting condition. This figure has increased dramatically since 2001, when only 25 percent of private equity firms surveyed had performance-based vesting conditions. The most common vesting conditions used among private equity sponsors are: 1. Time-based awards that vest over a set number (typically five) years. 2. Exit-based vesting conditions tied to metrics such as internal rate of return (IRR) or multiple of invested capital (MOIC) achieved by the private equity firm (that is, market-based vesting conditions). 3. Performance-based vesting metrics such as achieving annual EBITDA targets. Note: there is increased use of financial metrics as the primary vesting condition with an additional opportunity to vest even if the financial metrics are missed as long as stockbased metrics are realised at exit (so-called last bite at the apple provisions). Equity awards are typically split 50/50 between timebased and performance-based vesting. Vesting conditions can impact both how the expense associated with an award is amortized and the manner in which the expense is calculated. While companies can use a relatively simple model (such as Black-Scholes 1 ) to calculate the fair value of a straightforward time-based vesting equity award, awards that vest based on IRR (or MOIC) will require a more complex model to determine the award s fair value. In such cases a more sophisticated valuation model such as a binomial model 2 or Monte Carlo simulation 3 is required to establish the award s fair value. Issues arising during investment period In the simplest situation, a private equity firm will lock in management s compensation arrangements at closing with no (or minimal) modifications to the arrangements until the awards pay out at the subsequent exit. However, business conditions can change quickly during the investment period, which can give rise to specific issues that need to be addressed around equity compensation plans. This section discusses some of these issues. Granting equity to new hires and promotions Private equity firms typically retain a portion of the total management equity pool for future hires and promotions. In recent years, the default would have been to issue equity to a newly hired executive using the same valuation as implied by the original investment. For example, if the common equity was valued at $10 immediately following the acquisition, options will continue to be granted with an exercise price equal to $10, even if the grant occurs more than a year following the initial valuation. However, this practice can create adverse tax implications. Since the introduction of Internal Revenue Code Section 409A, 4 ignoring the change in valuation can result in a 20 percent excise tax on the entire option gain and will trigger additional reporting obligations for the company. As a result, we are seeing valuations conducted at least once a year, although the best practice in this regard is to conduct a valuation no less than twice a year, especially if the business is changing rapidly. Downturns in business outlook In the past, a failure to achieve the desired exit was regarded as a failure by management and corresponding adjustments to equity were not common. The reality of the past four years (to April 2012), however, has been that many private equity 1 The Black Scholes model or Black Scholes-Merton is a mathematical model of a financial market containing certain derivative investment instruments. 2 A binomial options pricing model is one which provides a general numerical model to value options. 3 Monte Carlo simulation is a computerised mathematical technique that allows analysts to account for risk in quantitative analysis and decision-making. 4 IRC Section 409A governs the timing of payment of deferral of deferred compensation. Deferred compensation is defined broadly and can include stock options and restricted stock units. PwC Page 5 of 9

6 firms have been forced to lower return expectations due to the downturn in market realities. As a result private equity firms expect lower exit valuations, longer holding periods, or both. These changes can have significant implications for equity awards, the vesting of which is often (in part) tied to an IRR or MOIC goal that is no longer expected to be achieved. The question arises: does this warrant a change in the vesting metrics or should the private equity firm resist any changes? During the recent downturn many public companies in the US resisted adjusting their equity plans, but continued to make annual grants with lower bases. Many private equity firms, however, made adjustments to their equity plans. This was markedly different from the prior downturn in 2002, where very few private equity firms modified the terms of their equity plans. We have outlined below the common approaches to equity restructuring we have seen over the past few years: 1. Option exchange. Also known as a repricing, this is a straightforward repricing of old options where, effectively, the exercise price of the options is reset to the current fair market value (FMV) of the underlying stock. There may be some consideration given to reducing the number of outstanding options in return for the exchange or repricing. 2. Grant additional equity. This alternative might be more appropriate for those companies that want to be focused in their equity restructuring (and retention efforts) rather than make sweeping changes for all executives. However, should the company recover to predownturn levels of performance, the new equity will be dilutive to the private equity firm. 3. Adjust performance targets. As indicated earlier, a significant portion of management equity awards under private equity ownership are subject to performance-based vesting, including annual EBITDA-based vesting or exitbased IRR or MOIC vesting triggers. A simple downward adjustment to the performance targets may be appropriate for those companies that are still expected to deliver attractive returns but face longer holding periods or tough earnings outlooks over the near term. For example, some private equity firms moved away from IRR-based exit metrics to MOIC. Other companies lowered the EBITDA targets. In either case, changing the vesting terms was, in the private equity firm's view, sufficient to revive the motivational and retention characteristics of the equity plan. 4. Introduce a cash plan. Cash-based alternatives can be very effective in situations where a company is struggling to meet debt commitments but an additional incentive is required to retain management. Cash plans do not necessarily need to pay out until the company has regained its financial footing, which adds further flexibility. 5. Restructure debt so that more value flows to equity. This is the financial engineering approach to improve a company s equity value and can include changing coupon rates on preferred stock and encouraging banks to convert debt into equity. The last thing banks (or other creditors for that matter) want to see is a mass exodus of management talent which may force an immediate write-down in their position. In these situations a bank may be willing to adjust the debt arrangements in a manner they would have previously been unwilling to consider. Addressing these challenges to portfolio-company equity plans is the best way to ensure that the management talent remains focused and motivated through a successful exit. In these situations, we suggest that private equity firms identify which members of management are critical to a successful exit. With that input, the private equity firm can determine what adjustments to the current equity compensation programmes might be necessary to provide sufficient incentive for this key talent to stay with the company and drive it toward a successful exit. Payment of special dividends Special dividends provide the opportunity for the private equity sponsor to take cash out of the business without a full exit. Further, a special dividend paid on shares owned by the private equity owners will also automatically trigger a similar dividend on any shares purchased by management as part of rollover proceeds. Not as simple is the question of how the special dividend should impact the restricted stock and options that have been granted to management. The appropriate treatment is typically specified in the equity plan document or award agreement and most often the documents specify that an adjustment is made to preserve management's value. Failure to make an adjustment PwC Page 6 of 9

7 would erode management s trust in the performance alignment and could result in unwanted management turnover. The adjustment is typically made as an immediate or deferred cash payment, often with payment terms matching the vesting of the underlying award. The adjustment can also be achieved through a reduction in exercise price. The following example is the best way to illustrate how this works in practice: Example: Adjustment achieved through a reduction in exercise price Equity price at initial investment = $10 All options are non-qualified stock options and have been granted at this price. A special dividend of $3 a share is proposed at a time when the share value is $15. The option holder would have a spread value on each option of $5 before the dividend. The special dividend would broadly be expected to reduce the value of the shares by $3 a share. The special dividend would reduce the option holder s spread value to $2 (in the absence of any adjustment). The option holder could receive a $3 immediate or deferred cash payment or have the option exercise price reduced to $7. Making this adjustment on a discretionary basis (for example, when not required under the plan), can result in adverse accounting consequences. Regardless, the tax and accounting implications of the adjustment to management option holders should be carefully considered. Note that any dividends paid in cash will be treated as ordinary employment income for tax purposes. We have seen situations where a private equity firm has paid multiple special dividends. Initially option holders were compensated through reductions in strike price, but subsequent adjustments had to be made in through a deferred cash payment due to an inability to further reduce the exercise price. In situations like this, any performance vested awards that are based on achieved PE sponsor IRR could become vested as a result of the payment of the dividend. Treatment of management equity at exit While private equity firms may have a specific exit strategy in mind when acquiring a portfolio company, the recent economic downturn has shown that they need to be flexible on the ultimate timing and form of exit. Holding periods are becoming longer (especially for firms acquired in the period between 2003 and 2007) and there also seems to be more variety in the nature of the exit. Partial IPOs are now becoming much more common as are dispositions to another private equity buyer. Private equity firms need to make sure their equity-based compensation arrangements have the flexibility to adjust to the different types of exits. Where there is a full exit, management equity holders get to share in the wealth creation fulfilling risk-adjusted management expectations. These payouts can create significant retention concerns for the private equity buyer, particularly for management founders who may have rolled a portion of their prior holding into the new structure and now have a fully funded nest egg for retirement. The potential departure of executive talent in this situation creates concerns for the potential buyer about the value of the enterprise absent that talent. In a full disposition, all unvested options and restricted stock are typically accelerated. If the new buyer is also a private equity firm, the negotiation with management will commence again around the after-tax proceeds that will be reinvested and the pool of equity available to management as options. On a partial IPO exit, the IPO brings with it a clear path to liquidity for management's equity. Management team members can now cash out a portion of their rolled equity as well as vested equity awards (subject to applicable lock-up periods). The IPO also creates an opportunity to refresh the compensation approach across the company. This includes top-up awards for management who are expected to drive business performance going forward as well as expanding equity participation further down within the organisation. Conclusion Compensation lies at the heart of the private equity investment process and is the key to effective retention of management and the alignment of interests essential to drive a successful exit. Compensation issues arise throughout the PwC Page 7 of 9

8 investment process and these issues require active management so that potential concerns are addressed directly and early in the process. The size of equity awards made to top management in US private equity deals is usually a significant incentive Appendix A: Sample management term sheet Position: Base salary Bonus: Metrics: Reinvested equity: Equity compensation: Option vesting: Severance: CEO $300,000 p.a., reviewed annually to drive performance through the exit. However, inconsistencies in approach, perceptions of unfairness, limited flexibility or a simple lack of communication can all have serious consequences in terms of management focus and retention Target opportunity 100 percent of base salary on achieving metrics Achievement of annual EBITDA and debt repayment targets and other key metrics as agreed Individual to reinvest percent of net proceeds from seller s equity plan, at a price of $10 per share Two options awarded at $10 a share for each share of reinvested equity 50 percent time vested with 20 percent of these awards vesting each year and 50 percent performance vested on realisation event resulting in IRR for private equity sponsor of 25 percent or MOIC for private equity sponsor of 3x initial investment On termination without cause individual will receive twice the base salary plus twice target bonus. All vested options and reinvested equity cashed out at fair value. Voluntary termination: Vested options and reinvested equity cashed out at lesser of fair value or $10 Author biographies Steve Rimmer is the global network leader of PwC's Human Resources Transaction Services practice, and specialises in the human resource aspects of mergers, acquisitions and spin-offs. Steve has 28 years of human resource consulting experience, with a heavy emphasis on conducting human resource due diligence and addressing integration issues arising on corporate transactions. Steve has worked with numerous leading corporate and private equity clients. He spends a significant amount of his time advising clients on compensation issues, including market competitiveness, retention strategies and design, and implementation of equity compensation programmes. He has published a survey of equity compensation practices among private equity portfolio companies. Steve has been at PwC for 23 years, including 18 years in New York and five years in London. Prior to joining PricewaterhouseCoopers, he worked for Bacon and Woodrow, a leading UK firm of actuaries. Steve is a UK qualified actuary, a Certified Compensation Professional and has a MBA from Manchester University in the UK. Aaron SanAndres is a partner in PwC's Human Resources Transaction Services practice in New York. He has 13 years of professional experience in human resource consulting. He specialises in providing human resource transaction advisory services to both strategic and financial buyers and specialises in the financial services industry. Aaron s core expertise lies in the design, tax and accounting aspects of executive compensation. He spends a significant amount of his time advising his services clients on post-acquisition executive compensation issues. Aaron has written a number of articles around human capital issues within the asset management industry, most recently including the 2011 Asset Management Reward and Talent Management Survey and a white paper on human capital issues in asset management M&A. Aaron received his MBA, with honours, from Columbia Business School. PwC Page 8 of 9

9 This article was first published in Private Equity Compensation and Incentives by PEI. For more information about this publication, please see PricewaterhouseCoopers LLP. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see com/structure for further details.