Recently we have seen longer holds by private equity funds of portfolio companies. The original bargain for management was a 4 to 6 year hold from acquisition to exit. Now we are seeing more 6-8 year holds and, in many cases, sale to a continuation fund vehicle resulting in a potentially even longer hold.

Executives joining a portfolio company have recognized that the risk verse reward trade off between the public company equity grant structure and that in private equity owned portfolio companies is shifting as a result of the hold period. For some executives, the concern is that the longer hold period makes the potential dollars earned per year less. For some, it becomes a concern that what they were looking at as a couple years assignment in their career path needs to become a more defining one. For others, it becomes a concern of being terminated over a more extended period because of personalities, a new chief executive officer or other reasons, without being adequately rewarded for the period of work compared to that achievable in a public company situation.

The public company equity compensation model has generally been annual grants that vest over 3-4 years, often with graduated time vesting on options and restricted stock units and generally 3 year cliff vesting on performance units (but at times annual performance measurement with a hold retention period). In addition, there may be some type of partial vesting for Good Leavers during the vesting period. The key attraction is that there is ongoing vesting and resulting liquidity in the public market. The annual grants are usually issued at fair market value at the time of the grant. If value is increasing, this means that each year’s grants will be fewer shares if dollar value of the grant is being targeted.

In the private equity model, all the grants are upfront at, hopefully, what will be the lowest price and thereby create increased upside leverage over annual grants. However, in calculating the amount of the up-front grant, the 4-6 years until exit model is generally used. An exception would be infrastructure and other long term hold funds that recognize that the hold will be longer than the 4-6 years and build in liquidation facilities at the 6-8 year mark and also consider top up grants.

The private equity standard grant is partially time based and partially performance based. The time-based portion generally vests over 4-5 years, usually with quarterly or good leaver pro rata vesting. The remainder is performance based. The split between time and performance based is often 50-50, but larger pools relative to market (e.g. above 10 percent) tend to be over weighted towards performance.

On a termination of employment, whether voluntary or involuntary, the executive would receive the time vested grants and forfeit all of the performance-based grants. This is a concern for the executive even on a 4-6 year hold, but becomes an even greater concern if the hold period before exit extends further. It is also a concern to the executive whether the company is sold to a continuation fund without any vesting measurement.

In such situations the trade off from working for a public company with the annual grants and ongoing liquidity starts to make executives consider their desired, intended or expected stay with the private equity portfolio company when considering career advancement and growth. They may also consider the likelihood of a chief executive change in an extended period and the resulting risk to them.

Private equity will need to start to address the situation by making the portfolio equity incentive plan more secure for realization in a reasonable period of time. There are several options that could be considered to do this. They include:

1. Go to all time vesting as one prominent firm now does and, for the limited number of firms that still treat voluntary resignation the same as a for-cause termination, cease doing that.
2. Provide for pro rata vesting of the performance based vesting portion on a termination even for executives who have terminated prior to the exit, based on relative service between entry and termination verse the hold period for the investment. The negative of this approach is that it lets departing executives share in growth of the company beyond their service period.
3. Provide for vesting for an executive upon termination after 5 years based on the fair market value of the company at the time of departure and either pay out then in cash or in a subordinated promissory note that pays out on ultimate sale.
4. Combine (2) and (3) with a measurement at employment exit and a second at company exit, with the payout being at the lower of the two values and perhaps prorated based on the employment period.
5. Use performance based vesting targeting multi year goals but not the full period from entrance to exit.
6. Shrink the performance vesting performance portion as the hold period extends
7. Guarantee interim performance measurements for vesting after 5-6 years even if there is no exit by then and use such interim measurement as the minimum performance vesting and, if feasible, create liquidation facilities to provide interim cash realization to the executive.

None of the above may be the right solution and they all have positives and negatives. The goal is to make private equity portfolio company positions attractive when compared to those in a public company, even for an executive who is concerned in today’s world about the potential long time period to exit and realization for the private equity firm. The longer length of run is making executives concerned about leaving too much on the table if they don’t decide to stay indefinitely and private equity needs to consider alternatives to the partial time and partial performance, with the weight on performance structure to reward executives.

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, Singapore, Stockholm and Sydney.

For further information, please contact Mike Sirkin at msirkin@jamiesoncf.com