I joined Jamieson in 2019, over six years ago. With a common private equity investment life of 4-6 years, we started this year to revisit deals we had done in 2019 and 2020, assuming that they were, or shortly would be, ready for an exit by the current sponsors and the next step with new investors.
What we found particularly interesting was that there was high turnover of executives at not only levels below the chief executive officer, but also at the chief executive officer level itself.
Movements below the CEO level were often the result of the executive leaving to move up at another opportunity or the CEO reshuffling some of the executives because either the executives had stopped growing or different skill sets became more important as the Company grew. In addition, if the CEO changed, there were often significant changes in his or her direct reports as the new CEO evaluated existing senior management and brought in executives that they had prior relationships with.
In most cases, the plan structure and documents worked as they were supposed to. The departing executive vested proportionately on the time portion of the equity grants and forfeited the unvested time portion and all of the performance vesting portion of the grant. The Company would then usually call and buy out the vested portion of the grant for cash or, in some cases, a promissory note. This forfeited and recaptured equity was then used for the incentive to the executive’s successor.
The use of a promissory note always raises the issue of fairness to both the departing executive and the remaining executives and the sponsor. Some MIP’s permit use of a promissory note on all buyouts on the principle that departing executives should not receive cash before the sponsor and continuing executives receive cash on an exit. There is some logic to this, especially if the departure is voluntary, but generally a person being bought out should receive cash if the cash will not impact the company’s cash flow. Receiving cash or a promissory note will not influence a decision to leave. In many cases, use of a promissory note is only permitted if there is a cash availability issue or the debt instruments limit cash buybacks of stock and a waiver is not sought or not obtained. Often, for top executives, we argue that they should not have to accept a promissory note and should have the option to stay as an “investor” until cash can be paid. While private equity firms often argue that the priority of even a subordinated promissory note is preferable to being an equity holder, most executives, while waiting for cash, would prefer to have the potential upside as opposed to the locked in promissory note value. This preference generally applies notwithstanding the interest on the promissory note, which can vary greatly from applicable federal rate (which is relatively low) to prime.
With chief executive officers, the change usually occurs in the 18–24-month period after the investment or at around the time an exit is planned. In the 18–24-month situation, it is usually a Board decision that a change of the CEO is necessary because of business performance, the Board and the CEO not having a rapport or the Board determines that the CEO will not be able to take the company to the next level.
At the near exit level timing, it is often that the CEO does not want to commit to another 4–6-year run, seeks a new opportunity, does not want to tie up money with the required rollover or just wants a break. Alternatively, the markets may not allow the desired contemplated exit and the CEO is not prepared to take on a reset journey. This issue has even become more prevalent as market conditions often extend the time period for a full exit and continuation fund sales have become more common, especially if the continuation fund sale is not treated as a crystallization of the MIP.
In these cases, often the CEO will stay with the Company as a director or advisor, at least through the sale, sometimes to mentor his or her successor (especially if the successor is internal), sometimes as a “reserve” if the successor does not work out and sometimes to just permit vesting of some or all of his performance units. These end-of-term arrangements are very bespoke, but usually the executive gives up part of his or her unvested units (which may be needed for the successor) and retains a portion of his or her units for future vesting and value growth. Often, in these cases, the departing CEO continues to provide real value as an advisor, mentor and security blanket.
Infrastructure funds require particular attention because of the longer planned hold period that is contemplated. This is likely to result in greater executive turnover prior to exit. While many infrastructure funds create liquidation facilities around the fifth year of hold to permit full or partial realization, many do not formally do so at the creation of the investment. These funds require added attention with regard to interim exits.
A question that often comes up for the CEO or senior executive when the initial MIP is being negotiated is whether to disclose and negotiate based on a planned departure if the executive is firmly planning a limited run. If the commitment to depart is within a year or two, it is probably preferable to discuss and adjust the MIP rewards and plan for terms accordingly. If it is any longer than that, while we believe in full disclosure, we usually recommend not dealing with it at the time. The primary reason for that is that people very frequently change their mind over time. They find out that they are enjoying the job, the economics are too good to leave, their family situation changes, they don’t want to stay home or, most often, they get a new burst of energy and excitement in the new situation.
If they had negotiated based on a departure, they would have negotiated for less in the MIP and may have had the successor search begun. Once that search starts, it has its own momentum and is hard to turn off. Accordingly, it often results in acceleration of the departure because a top candidate will not want to join as a number two and have to wait for promotion, and the Board will want to “get started” with the new person.
These departure situations, however, do not justify a rethink of the broad concept of the private equity model of matching management rewards to sponsor rewards and keying at least fifty percent of the reward to being there at exit. They do, however, justify further thinking about some aspects of departures, especially as investments are leaning towards longer hold periods before exit.
While it is rare today, private equity firms in the past treated voluntary leavers the same as a for cause leaver. The concept was that the executive was signing on for the “run” of the investment to receive the larger potential reward on a risk/reward basis and leaving early was “desertion” and should be punished. Today, the market is more mature in recognizing that people leave jobs for all types of reasons and requiring full forfeiture on a voluntary departure may discourage valuable executives with other choices from taking the job.
The market on vesting focuses on 50 percent of the core incentives being time based with the other 50% of the core incentive and any ratchet being performance vesting based. This seems to be a reasonable compromise in most cases between assuring retention until exit and recognizing that executives leave positions both voluntarily and involuntarily and it is not always their fault. To attract management a fair balance is needed. What is core and what is ratchet can be argued. Usually, if the pool is over 10%, everything over 10% is treated as ratchet. In larger size deals, as to what is core and what is ratchet is often less clear.
Departures are part of every path from closing to exit. They need to be treated fairly to attract and reward executives, while at the same time strongly encouraging retention.
Jamieson Corporate Finance US, LLC is an SEC-registered broker-dealer, member of FINRA (www.finra.org) and member of SIPC (www.sipc.org). This article is for information purposes only and is not to be construed as a solicitation to invest in any securities. Jamieson Corporate Finance helped create the management advisory business and its affiliates have offices in New York, San Francisco, London, Frankfurt, Madrid, Milan and Stockholm.
For further information, please contact Mike Sirkin at msirkin@jamiesoncf.com
