In a public company, the bulk of the shareholders are likely to be institutional investment funds, such as Blackrock, Fidelity or Vanguard. Other investors will be individuals trading directly (usually in relatively small amounts), and still others will be hedge funds or similar traders. These shareholders are not traditionally long term holders and will trade in and out of stocks. Even those that are long term holders, such as a mutual fund or ETF, have a changing group of investors in them. The executive works for the shareholders, but any shareholder in a public company (directly or indirectly) unhappy with the way management is performing can somewhat easily “walk” by selling their shares in a liquid public market, mutual fund or ETF. So, while executives work for the shareholders, in reality they work for the Board that manages the company for the changing shareholders. They have (subject to ownership requirements, securities law restrictions and public perception) the same liquidity as the public shareholders once their incentive compensation is vested (usually over a 3 or 4 year period from grant).
In a private equity owned company, on the other hand, the owner is usually funds managed by one, or sometimes several, private equity fund families. The investors in the private equity funds are generally institutional in nature and include family offices, pension funds, endowments, governmental retirement funds and wealthy investors. The investors in the funds tend to be locked into the fund investments until the end of the fund life cycle, subject to limited ability to withdraw from the fund or sell their LP interest in the fund. Management in these cases is running the portfolio company for the fund managers and the fund LP’s and their interests may be somewhat different.
Alignment
The distinction between whether, on their equity incentives, management should be aligned with the fund manager or the LP’s that are invested in the owning private equity fund impacts the appropriate treatment of the executive upon various corporate events. There is not a uniform view as to who management is really responsible to, and perhaps “both” is the correct answer. It is not, however, an answer that resolves some of the issues as to who management’s rewards should be aligned with and when “achievement” should be measured.
A typical management incentive plan for a private equity portfolio company partially vests incentive grants on service and partially performance. The most common performance measurements are money returned on invested capital (“MOIC”) and internal rate or return (“IRR”). These are basically measured on exit from the investment. So what is treated as an exit is extremely important.
Exit
Most private equity sponsors have a number of funds that are active at the same time. Sometimes they will vary in targeted industry or geographic area. Often, as one fund nears expiration of its investment period, another fund for the same purpose is raised. These funds often have some of the same investors, but there are variances and LP’s generally look at each new separate fund as a new investment decision.
Private equity firms often evaluate an investment based on when it ceases to be managed by the firm, when the carry crystallizes for the fund or when the carry crystallizes for the internal fund team working on the deal. Each of these can be different and can impact the portfolio company executive’s time of measurement and continued employment obligation in order to share in the return.
The distinction of when value crystallization occurs within the fund can create conflict in concept between management and the sponsor. Management is generally contemplating (with encouragement by the fund) a 4-6 year growth period and then realization on the value through an exit. If the investment is not sold within that period because of market conditions, that is a risk that management can accept, although at some point issues such as a liquidation facility or topping up the equity becomes a concern. In addition, if the vesting measurement is IRR rather than MOIC, revisions in the vesting criteria may need to be addressed to avoid the MIP ceasing to be an incentive because of unattainable conditions.
Continuation Funds
The more difficult issue occurs when the fund family likes the investment or feels the market will not provide an adequate return on a sale at that time. The fund then often stays in the investment for a longer than anticipated period through the creation of a continuation fund vehicle or by selling a large piece of the investment to another one of its funds. A portion, perhaps a large portion, of the LP’s in the continuation fund or other fund likely overlap the investors in the original owning fund, but the original LP’s investment is no longer continuing as such and the fund’s realization may well be measured. In a continuation fund situation, the LP’s are likely to have a choice of liquidation verses investing in the continuation fund, and the sponsor will make a decision (often in connection with the LP’s deciding as to whether to roll money or not) as to its realization and, even, if it realizes and measures carry, how much of that will be rolled over into the continuation fund.
This raises the issue of whether the change in funds owning the portfolio company, but with the same sponsor still managing the investment, should or should not cause a measurement of return for vesting purposes of management’s incentives. The arguments for not doing a measurement are that management is still dealing with the same sponsor, the sponsor is still in the investment (with its carry being or not being crystallized depending on arrangements) and many of the same LP’s are still in the investment through their likely investment in the continuation fund or later sponsor fund. The strong argument for having a measurement is that the time period of hold and, hence, continued employment obligations by management, has just been unilaterally greatly extended and separated from that of the original investors in the company.
New “Run” or Not
The continuation fund or other new investing fund is a new “run” for all concerned. The LP’s in the initial fund have gotten their investment out (or at least had the choice of doing so) and this should be the time for measuring management’s MOIC or IRR and determining vesting. Some sponsors accept this approach, but others will argue that, since the fund family is still involved, management shouldn’t be able to “desert”, and others will argue that management should have to remain tied to the portfolio company until the sponsor crystallizes its carry, or even until it closes out its involvement with the company if that is how it treats its internal team on their carry. An alternative that sometimes occurs is to measure vesting, but require roll over of all or a large portion of the vested equity interest.
It should be noted that determining a realization and measurement of incentives is separate from the timing of the payout of the incentive plan, which by its nature will be tied to the liquidation of the underlying limited liability company in which the management interests are included. This is especially true if the original investment fund still maintains a piece of the portfolio company but only sold off control.
These issues on timing should be discussed and delineated early in the process of designing and negotiating the management incentive plan and not left for resolution upon what one party considers an exit and the other doesn’t.
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
