Management are incentivised in private equity portfolio companies through a combination of the return on their own investment and a return on an incentive plan created by the portfolio company (sweet equity or incentive equity). The goal is to align management rewards (and risk) with the return to sponsors and to incentivise and energise management towards their goals. The plans are also designed to provide management with a fair return based on the risk involved and, thereby, retain them when there are other attractive or more secure alternatives.

COVID-19 and the shutdown of portions of the economy has and is placing pressure on many portfolio companies as to their ongoing business, as well as to the timing and value of a future transaction. These factors will have an impact on management incentives that will need to be properly addressed once the health impacts and business issues created by COVID-19 have been tackled. Unfortunately, there may be some businesses that will not be viable in the short to medium term.

Private equity portfolio companies are facing many of the same issues as public companies and will need to address many of the same management incentive issues that public companies are facing. However, the structure of the incentive plans are different, as are the alternatives for raising capital and adjusting to a new fair market value, either temporarily or permanently. Both have investors and stakeholders to answer to that often limit flexibility on solutions, but they recognise the need to incentivise management as circumstances change and to prevent individuals from seeking another alternative and then needing to hire new executives with a higher level of incentive not given to the current management. The starting value of any incentive plan normally becomes the hottest point of any debate with sponsors in a private company situation.

Jamieson has advised management of portfolio companies on over 500 management incentive plans over the last 15 years. We have worked with management and sponsors of such plans on both implementing them and restructuring them if necessary, including during the global financial crisis and subsequent recession ten years ago.  Jamieson is uniquely qualified to assist management in working with sponsors to find fair and equitable solutions to recasting MIP’s in light of today’s situation.

The following are some of Jamieson’s observations and thoughts on the current situation as they apply to deals and MIP’s:

NEW DEALS

Deals that were signed pre lockdown are generally being closed, although some are being done on a delayed basis.

Deals that were not signed have generally been put on hold pending all or a combination of: opening up of the debt markets, clearer picture of Covid and post-Covid trading and a better fix on valuation multiples. As a result there will be varying degrees of tension on the pricing versus what was previously being discussed.

Portfolio companies that were about to start a sales process have generally similarly gone on hold. It is likely that those not heavily impacted by the lockdown will start a process when there is some daylight but probably early autumn. The majority of businesses impacted will need to wait a considerably longer until there is more certainty in projections and solid momentum in reported numbers.

The German market is showing some signs that it may be the first where deals are again being done on a regular basis.

There is also stirring in the market by sponsors looking at opportunistic deals or add-ons. Indeed, sponsors are looking at their fund documents on flexibility to do some of these deals.

New potential lenders are beginning to open up but the leverage and terms may not be attractive, while existing lenders are concentrating on portfolio issues.

EXISTING PORTFOLIO COMPANIES THAT HAVE BEEN SEVERELY AFFECTED

In many cases where revenues have been impacted, base salary of senior management has been reduced on a temporary or indefinite time period, with an option in some cases to makeup at the end of the year.

Sponsors have or are looking at making cash infusions on a temporary or permanent basis either from the invested fund or another of their debt or equity funds.  Fiduciary issues and fund document limitations need to be considered.

Some sponsors are seeking equity or debt infusion from fund investors or other outside sources.

Pricing, preferences and terms are all issues under current circumstances.

MIP’s and other incentive arrangement rationale and adjustments are beginning to be discussed and considered including:

• the need to retain management with appropriate incentives that are likely to have value in the medium term
• the need to align management incentives generally with sponsor return to the extent feasible
• top up grants or awards
• underpinning of amounts of value to existing or newly joining executives are being considered
• on interfund transfers, closing out existing incentive plans and creating new plans
• Fixed or milestone payments made to management
• measurement of MOIC from current value for vesting or ratchet or lower MOIC multiple from original value may be considered for vesting or ratchet
• if extended time period for exit, additional grants, measurement even after a departure, freezing of hurdles, preferred coupon or IRR measurement may be considered

Fair plans will depend on realistic projections for rebound and timing for rebound, which will take time to become apparent. Sponsors do not want to lose management to more certain opportunities so management need to fully understand how plan is impacted and believe it is fair. Communications with the team are extremely important.

Jamieson can help management to understand the MIP impact, ramifications of new capital or performance impacts and work with all sides to design a fair and balanced recut if that becomes necessary.