In private equity portfolio company transactions there is generally a pool of incentive equity, usually profits interests, that is allocated to the management team. This permits management to share in the growth in value of the company over the value at acquisition and serves as a strong economic incentive to them.

The pool is allocated over the senior management team. The amount allocated at acquisition versus the amount reserved for future hires and promotions varies depending on the business plan, planned hires and expected future needs. Generally, however, 70% to 80% of the pool will be allocated to current executives and planned immediate searches. The remaining portion is retained for future needs.

The allocated pool will vest partially on service time over 4-5 years and partially on performance measured at a change in control. If an employee leaves before full vesting, the forfeited portion goes back into the pool. Generally, the vested portion can be called at fair market value or cost depending on the type of leaver departure. If called, the repurchased units should logically go back in the pool since a future grant of them would only be measured from the value at the time of the new grant. However, in practice, this treatment varies considerably across private equity funds.

Upon the change in control, unallocated incentives and forfeited and repurchased leaver incentives will have proceeds value. When taking into account any management incentives that were initially intended for management but never issued and those forfeited or repurchased, these proceeds can be significant. Commercially, these incentives should be recycled across management, but in practice there is often large pools of unallocated value remaining at the time of sale. The issue is what should and what does happen to that value, i.e. who should it belong to.

In Europe, market practice is for the management equity pool to be ringfenced since it is accepted that all management equity, including unallocated and repurchased (there is no forfeited incentives in European MIPs because all of the sweet equity is initially purchased by the management team), is for management and should always go to management. That remaining value is commonly allocated as a bonus to management.

In the United States, there is much more diversity on how this unallocated amount should be treated. There is a belief among a significant number of private equity firms that the pool is just a maximum measurement of the amount allocated to management and it is not “a last man standing” type allocation. They believe that each executive receives a specific allocation and that unused value should be for everyone’s benefit, with the bulk of that going to the investors as the largest unitholders.

If the fund is willing to recognize ringfencing and the concept of reserving the unallocated, forfeited and repurchased value for management, it is usually handled in one of several manners.  The preferred method for the executives may be to allocate the value pro rata with the profits interests already held as additional payment on them, so arguably that value is also treated as capital gains. However, there might be concern that this allocation might just further reward executives who already may historically have been over awarded based on their expected contribution at the time of initial allocation, as opposed to their actual performance. To avoid that issue, often these provisions have a caveat that permits the Board, with the consent of the CEO, to determine to allocate the value in some other manner as bonuses. This will, of course, be less tax efficient but perhaps create a fairer reward.

Other funds feel very strongly that this amount belongs to all unitholders and won’t commit to ringfencing and will only agree to consider in “good faith” allocating the value as bonuses to those who put in extra effort on the transaction and perhaps for other executives who are under allocated or who deserve a bonus for extraordinary work on the deal with the allocation and amounts agreed at the time of exit.

While ideally the fundamental discussion of what should happen to this value should take place when the pool is formed and allocated, with a supplemental discussion at exit, in practice (whether or not stated) it is often all done at the time of the sale. This often creates tension between the sponsor and the management team based on views as to whether this money really belongs to the management team or belongs to all unitholders, with the bulk going to the sponsor.

At a minimum thought should be given to this topic at the time of formation of the management incentive pool. That focus should be on both what goes back into the pool and what happens to the unallocated value at exit.

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

In private equity portfolio company transactions there is generally a pool of incentive equity, usually profits interests, that is allocated to the management team. This permits management to share in the growth in value of the company over the value at acquisition and serves as a strong economic incentive to them.

The pool is allocated over the senior management team. The amount allocated at acquisition versus the amount reserved for future hires and promotions varies depending on the business plan, planned hires and expected future needs. Generally, however, 70% to 80% of the pool will be allocated to current executives and planned immediate searches. The remaining portion is retained for future needs.

The allocated pool will vest partially on service time over 4-5 years and partially on performance measured at a change in control. If an employee leaves before full vesting, the forfeited portion goes back into the pool. Generally, the vested portion can be called at fair market value or cost depending on the type of leaver departure. If called, the repurchased units should logically go back in the pool since a future grant of them would only be measured from the value at the time of the new grant. However, in practice, this treatment varies considerably across private equity funds.

Upon the change in control, unallocated incentives and forfeited and repurchased leaver incentives will have proceeds value. When taking into account any management incentives that were initially intended for management but never issued and those forfeited or repurchased, these proceeds can be significant. Commercially, these incentives should be recycled across management, but in practice there is often large pools of unallocated value remaining at the time of sale. The issue is what should and what does happen to that value, i.e. who should it belong to.

In Europe, market practice is for the management equity pool to be ringfenced since it is accepted that all management equity, including unallocated and repurchased (there is no forfeited incentives in European MIPs because all of the sweet equity is initially purchased by the management team), is for management and should always go to management. That remaining value is commonly allocated as a bonus to management.

In the United States, there is much more diversity on how this unallocated amount should be treated. There is a belief among a significant number of private equity firms that the pool is just a maximum measurement of the amount allocated to management and it is not “a last man standing” type allocation. They believe that each executive receives a specific allocation and that unused value should be for everyone’s benefit, with the bulk of that going to the investors as the largest unitholders.

If the fund is willing to recognize ringfencing and the concept of reserving the unallocated, forfeited and repurchased value for management, it is usually handled in one of several manners.  The preferred method for the executives may be to allocate the value pro rata with the profits interests already held as additional payment on them, so arguably that value is also treated as capital gains. However, there might be concern that this allocation might just further reward executives who already may historically have been over awarded based on their expected contribution at the time of initial allocation, as opposed to their actual performance. To avoid that issue, often these provisions have a caveat that permits the Board, with the consent of the CEO, to determine to allocate the value in some other manner as bonuses. This will, of course, be less tax efficient but perhaps create a fairer reward.

Other funds feel very strongly that this amount belongs to all unitholders and won’t commit to ringfencing and will only agree to consider in “good faith” allocating the value as bonuses to those who put in extra effort on the transaction and perhaps for other executives who are under allocated or who deserve a bonus for extraordinary work on the deal with the allocation and amounts agreed at the time of exit.

While ideally the fundamental discussion of what should happen to this value should take place when the pool is formed and allocated, with a supplemental discussion at exit, in practice (whether or not stated) it is often all done at the time of the sale. This often creates tension between the sponsor and the management team based on views as to whether this money really belongs to the management team or belongs to all unitholders, with the bulk going to the sponsor.

At a minimum thought should be given to this topic at the time of formation of the management incentive pool. That focus should be on both what goes back into the pool and what happens to the unallocated value at exit.

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