Michael Sirkin, Chairman & Managing Director of Jamieson USA, shares his views on US vs European Management Incentive Plans
Private equity incentive plans are structured differently in the United States and Western Europe, including the United Kingdom (in the future referred to simply as “Europe”). However, they are based on the same core principle that management have the opportunity to invest alongside the private equity firms (if relevant) and new equity incentive plans are implemented that should effectively only be rewarded if the capital, i.e. the private equity investor, receives a significant return on its investment.
The structural differences are partially based on differing tax laws, but the bulk seems to be more from historic practice, custom, and expectations. The varying treatment of equity in public companies in the different jurisdictions also tends to impact the expectations.
In the United States, options were originally the most common vehicle in equity incentive plans. However, in recent years, there has been a trend to grant profits interests especially to the more senior executives of the portfolio company. Profits interests tend to provide a more favorable vehicle for senior management and sophisticated management and their advisors seek use of this vehicle. Since a profits interest can only be used in a partnership, limited liability company or other pass through taxation entity, the private equity firms are being asked to create these vehicles in the ownership chain to permit the use of the profits interests.
The primary cited advantage of profits interests is that they permit capital gains treatment of the gain and are only taxed on sale of the interest. Options, on the other hand, result in taxation on exercise of the option at ordinary income tax rates and thereafter capital gains treatment when the underlying stock obtained on option exercise is sold (the stock needs to be held for at least one year after option exercise to have the more favorable long term capital gains rates apply). It should be noted that in Canada there is favorable tax treatment on options that make their use in Canadian plans more common.
Profits interests don’t permit, as sometimes thought, a payment only if there are profits. What they are is a capital interest that only shares in the growth of the value of the company above the value that exists at the time of the grant. This so called “waterfall” or “threshold” is similar to the exercise price on an option, although usually cited based on Company value rather than individual unit value. While “catch up” allocation of distributions can be used to give value below the waterfall out of growth above, this is not common in private equity situations. To effectively use profits interests, a Section 83(b) election is made under the United States Tax Code that elects immediate taxation on the compensatory grant value assuming that the vesting forfeiture conditions don’t apply in valuing the grant. Under the guidance of Section 83, if the liquidation proceeds to the grantee upon a liquidation immediately after the grant of the grant award is zero (which is almost always the case) the grant can be treated as having no value at grant for tax purposes.
In addition to capital gains treatment, use of profits interests have additional benefit to the executives. One of the more difficult issues for executives who depart private equity portfolio companies, either voluntarily or involuntarily, is the fact that options need to be exercised within a relatively short period (usually 90 days with a longer period of 6 months to one year on death or disability). This means that the executive must come up with the cash for both the exercise price and the tax withholding that is required on the profit made on the option on exercise. Since the equity is, at this stage, illiquid this can be a significant burden on the executive. While the private equity firm is likely to call the underlying stock upon a termination, the timing is such that the exercise needs to be done prior to the call. One solution often sought by the executive is to be able to net exercise/net withhold using the growth value in the stock underlying the option. Net exercise which eliminates incoming cash to the portfolio company, but does not require outgoing cash, is often permitted. Net withholding, which requires the portfolio company, to use its cash for payment of the required withholding is less commonly permitted. Another technique sometimes requested by senior management is to ask that the exercise periods be extended to a period ending after the company is public and lock up periods have ended so the public market can be utilized to fund the exercise and withholding.
Use of profits interests avoid these issues since the departure does not require that the executive take any action with regard to the profits interest and there is no resulting tax event. While the portfolio company may call the profits interests, there generally would be cash on the call to cover the taxes.
Profits interests are not as attractive for the private equity firm as for the executive since the Company loses its tax deduction for the value created for the executive upon exercise of the option. Profits interests also, depending on how structured, can make the executive a partner in the enterprise for tax purposes. This can result in the necessity to file tax returns in many jurisdictions in which the portfolio company is doing business and also having certain payments made by the company treated as taxable income. It can also change the withholding rules between that of employees and partners and possibly create some additional legal rights as a partner. A lot of these issues are able to be structured around. However, as a result when profits interests are used, they are often only granted to the senior executives and the remaining management participants receive options.
In Europe, the vehicle used for incentive plans is “sweet equity”. In European deals, the private equity firm invests into a strip of loan notes and/or preference shares with a fixed interest of 8% to 12% and common shares often referred to as “institutional strip” or “Strip”. The concept is that the bulk of the value is in the loan notes and preference shares and the common equity will have a low or nominal value such that a pool of the common equity can be carved out for management as the incentive. Management is required to purchase the Sweet Equity at fair market value at the time of the transaction. This allows the Managers to achieve capital gains tax treatment on any gain in the new sweet equity shares. Due to the bulk of the equity capital structure being loan notes or preference shares the cost of this sweet equity is generally low. Managers use reinvested proceeds or own cash to subscribe for their portion of the “sweet” equity and the remainder of proceeds is invested on the same terms as the private equity capital. Europe does not have a concept like a waterfall liquidation value creating a zero tax value and, therefore, the sweet equity (or a profits interest if one was used) may need to be valued (if structured outside of some specific safe harbors) and taxes paid on any value above the price paid. In the United Kingdom, the taxing authorities tend to permit having a low or nominal value for the common shares/ sweet equity. In the rest of Europe, the taxing authorities require allocating more of the value to the common shares and related sweet equity. In some very large European transactions this may necessitate the use of share options as the incentive as the subscription cost of the sweet equity can become too expensive, in particular for new manager participants.
As noted above, investment by both the private equity investors and management in Europe are into the institutional strip. In the United States management also tends to invest money into the same instruments used by the private equity firm, often common stock, and separately receives its incentive as profits interests or options.
In all jurisdictions, private equity wants management to have money at risk, “skin in the game”, as a retention mechanism and having at risk invested capital, further aligning interests and not just sharing in the upside. This generally means a rollover of a portion of the amount being received by the executive in connection with the transaction on either a pretax or post tax basis depending on the structure and the ability to rollover tax free. If executives are not receiving substantial amounts on a transaction, the skin in the game is much more flexible, although it is often still desired that the chief executive officer invest in the transaction. In Europe, the amount of rollover is traditionally higher than in the US. In the U.S., there is generally more variance in the amount of rollover with it being somewhat more individualized. Early communication with the buyers on rollover intentions is usually recommended, to get buyer comfortable with intended level of commitment.
In the United States, private equity usually has a call on any termination of employment on the rollover equity. If the amount of rollover is significant for the chief executive officer, sometimes he will be treated more like a co-investor and the equity won’t be callable on a good leaver termination, but this typically has to be negotiated. The call is generally at fair market value if the executive is a good leaver (death, disability, without cause or good reason) and at the lower of fair market value and amount paid if terminated for cause. A voluntary resignation without good reason will result in a call at either fair market value or the lower of fair market value and amount paid depending on the philosophy of the private equity house, the length of service before resigning, and the leverage of the executive.
In Europe the Institutional strip, tends not to be callable on a termination, although certain voting and information rights will cease. More recently, some European private equity houses have been seeking to insert a fair market value call right or lower the coupon on the loan note or preference shares if the executive is a “very bad leaver”, which usually has to do with violating the restrictive covenants, but as a custom, has not yet been established.
In the United States, the private equity firm almost always has a call on the vested incentive equity upon any termination of employment, voluntary or involuntary, and often seeks to have a forfeiture on incentive equity if the executive leaves voluntarily (perhaps before a certain date) as it does on a cause termination or a violation of restrictive covenants. Unvested incentive equity (which usually will include all of the performance based equity on an early departure) is forfeited on any termination. In Europe, good leavers (death, disability, retirement) tend to fully vest in their incentive equity and be subject to a call at fair market value. Bad leavers (cause or voluntarily termination) tend to forfeit incentive equity (i.e. bought back for lower of cost or fair market value). On what is now being called intermediate leaver (without cause or good reason termination) sometimes there is good leaver treatment, but more often there is a call at fair market value on the vested equity with the remainder forfeited. As noted, good leaver has different meanings in the US and Europe.
As mentioned, in Europe, the sweet equity is behind a coupon on the loan notes and/or preference shares of anywhere from 8 to 12 percent and then value vests for the purposes of leaver arrangements solely based on time, i.e. the 8 to 12 percent hurdle serving as the performance requirement. The vesting only applies on leaver arrangements and not on Exit (i.e. 100% on exit). There is also often a ratchet (or step up) above the original sweet equity participation sharing if the money on money return is above a certain level (e.g. 2x or 3x investment return).
In the United States, the incentive grant is usually divided in two parts. The first part, which is almost always 50 percent or less of the total grant, is time based over 4 or 5 years. The other portion is performance based utilizing a vesting schedule based on achievement of performance goals which remains unvested in a leaver event (in addition to the unvested time part). Most plans use either a cash return on investment multiple calculation (“MOM”) or an internal rate of return (“IRR”) measurement or a combination. The performance vesting aspect is not measured until an investment realization by the private equity investor. Less often vesting based on annual EBITDA targets is utilized with a catchup on a cumulative basis or an IRR or MOM measurement upon realization.
Recently, there has been some use in the United States of hurdles, usually similar to that paid by the private equity houses to their fund investors before they start to receive their carry, but these are usually at a lower level than the European hurdles and often include a catch up once the hurdle is achieved. In addition, the US arrangements usually also have a traditional time based/performance based vesting schedule. In the United States you also sometimes see an additional ratchet amount paid to management for outperformance above a specified MOM or IRR, but it is not as common as in Europe.
As a result of the use of the hurdle in Europe, the pool size subject to the hurdle is usually significantly larger than the pool size in a US plan. This causes the US plan (as a result of the time vesting) to provide more payment protection at the lower levels of achievement but may not have as high an upside as the European style plans. This difference in structure can often cause difficulty when trying to compare a pool size with a hurdle with a US pool size and should be analyzed carefully.
In Europe, there tends to be more protection up front of expected dilution from future investment, as well as a right to have the unallocated incentive pool allocated at the time of realization. In the United States, there is more negotiation over these points since they have been less common.
As more and more private equity portfolio companies have senior management in both the United States and Europe, and more private equity firms from both sides of the Atlantic are bidding for the same entities, subject to tax structuring issues, there is more of a tendency to mesh many of the provisions. What remains unclear is whether the United States or European model, or some hybrid structure, partially reflecting both, will become prevalent globally.
Jamieson Corporate Finance US, LLC is a member of FINRA/SIPC
Michael Sirkin, Chairman & Managing Director of Jamieson USA, shares his views on US vs European Management Incentive Plans
Private equity incentive plans are structured differently in the United States and Western Europe, including the United Kingdom (in the future referred to simply as “Europe”). However, they are based on the same core principle that management have the opportunity to invest alongside the private equity firms (if relevant) and new equity incentive plans are implemented that should effectively only be rewarded if the capital, i.e. the private equity investor, receives a significant return on its investment.
The structural differences are partially based on differing tax laws, but the bulk seems to be more from historic practice, custom, and expectations. The varying treatment of equity in public companies in the different jurisdictions also tends to impact the expectations.
In the United States, options were originally the most common vehicle in equity incentive plans. However, in recent years, there has been a trend to grant profits interests especially to the more senior executives of the portfolio company. Profits interests tend to provide a more favorable vehicle for senior management and sophisticated management and their advisors seek use of this vehicle. Since a profits interest can only be used in a partnership, limited liability company or other pass through taxation entity, the private equity firms are being asked to create these vehicles in the ownership chain to permit the use of the profits interests.
The primary cited advantage of profits interests is that they permit capital gains treatment of the gain and are only taxed on sale of the interest. Options, on the other hand, result in taxation on exercise of the option at ordinary income tax rates and thereafter capital gains treatment when the underlying stock obtained on option exercise is sold (the stock needs to be held for at least one year after option exercise to have the more favorable long term capital gains rates apply). It should be noted that in Canada there is favorable tax treatment on options that make their use in Canadian plans more common.
Profits interests don’t permit, as sometimes thought, a payment only if there are profits. What they are is a capital interest that only shares in the growth of the value of the company above the value that exists at the time of the grant. This so called “waterfall” or “threshold” is similar to the exercise price on an option, although usually cited based on Company value rather than individual unit value. While “catch up” allocation of distributions can be used to give value below the waterfall out of growth above, this is not common in private equity situations. To effectively use profits interests, a Section 83(b) election is made under the United States Tax Code that elects immediate taxation on the compensatory grant value assuming that the vesting forfeiture conditions don’t apply in valuing the grant. Under the guidance of Section 83, if the liquidation proceeds to the grantee upon a liquidation immediately after the grant of the grant award is zero (which is almost always the case) the grant can be treated as having no value at grant for tax purposes.
In addition to capital gains treatment, use of profits interests have additional benefit to the executives. One of the more difficult issues for executives who depart private equity portfolio companies, either voluntarily or involuntarily, is the fact that options need to be exercised within a relatively short period (usually 90 days with a longer period of 6 months to one year on death or disability). This means that the executive must come up with the cash for both the exercise price and the tax withholding that is required on the profit made on the option on exercise. Since the equity is, at this stage, illiquid this can be a significant burden on the executive. While the private equity firm is likely to call the underlying stock upon a termination, the timing is such that the exercise needs to be done prior to the call. One solution often sought by the executive is to be able to net exercise/net withhold using the growth value in the stock underlying the option. Net exercise which eliminates incoming cash to the portfolio company, but does not require outgoing cash, is often permitted. Net withholding, which requires the portfolio company, to use its cash for payment of the required withholding is less commonly permitted. Another technique sometimes requested by senior management is to ask that the exercise periods be extended to a period ending after the company is public and lock up periods have ended so the public market can be utilized to fund the exercise and withholding.
Use of profits interests avoid these issues since the departure does not require that the executive take any action with regard to the profits interest and there is no resulting tax event. While the portfolio company may call the profits interests, there generally would be cash on the call to cover the taxes.
Profits interests are not as attractive for the private equity firm as for the executive since the Company loses its tax deduction for the value created for the executive upon exercise of the option. Profits interests also, depending on how structured, can make the executive a partner in the enterprise for tax purposes. This can result in the necessity to file tax returns in many jurisdictions in which the portfolio company is doing business and also having certain payments made by the company treated as taxable income. It can also change the withholding rules between that of employees and partners and possibly create some additional legal rights as a partner. A lot of these issues are able to be structured around. However, as a result when profits interests are used, they are often only granted to the senior executives and the remaining management participants receive options.
In Europe, the vehicle used for incentive plans is “sweet equity”. In European deals, the private equity firm invests into a strip of loan notes and/or preference shares with a fixed interest of 8% to 12% and common shares often referred to as “institutional strip” or “Strip”. The concept is that the bulk of the value is in the loan notes and preference shares and the common equity will have a low or nominal value such that a pool of the common equity can be carved out for management as the incentive. Management is required to purchase the Sweet Equity at fair market value at the time of the transaction. This allows the Managers to achieve capital gains tax treatment on any gain in the new sweet equity shares. Due to the bulk of the equity capital structure being loan notes or preference shares the cost of this sweet equity is generally low. Managers use reinvested proceeds or own cash to subscribe for their portion of the “sweet” equity and the remainder of proceeds is invested on the same terms as the private equity capital. Europe does not have a concept like a waterfall liquidation value creating a zero tax value and, therefore, the sweet equity (or a profits interest if one was used) may need to be valued (if structured outside of some specific safe harbors) and taxes paid on any value above the price paid. In the United Kingdom, the taxing authorities tend to permit having a low or nominal value for the common shares/ sweet equity. In the rest of Europe, the taxing authorities require allocating more of the value to the common shares and related sweet equity. In some very large European transactions this may necessitate the use of share options as the incentive as the subscription cost of the sweet equity can become too expensive, in particular for new manager participants.
As noted above, investment by both the private equity investors and management in Europe are into the institutional strip. In the United States management also tends to invest money into the same instruments used by the private equity firm, often common stock, and separately receives its incentive as profits interests or options.
In all jurisdictions, private equity wants management to have money at risk, “skin in the game”, as a retention mechanism and having at risk invested capital, further aligning interests and not just sharing in the upside. This generally means a rollover of a portion of the amount being received by the executive in connection with the transaction on either a pretax or post tax basis depending on the structure and the ability to rollover tax free. If executives are not receiving substantial amounts on a transaction, the skin in the game is much more flexible, although it is often still desired that the chief executive officer invest in the transaction. In Europe, the amount of rollover is traditionally higher than in the US. In the U.S., there is generally more variance in the amount of rollover with it being somewhat more individualized. Early communication with the buyers on rollover intentions is usually recommended, to get buyer comfortable with intended level of commitment.
In the United States, private equity usually has a call on any termination of employment on the rollover equity. If the amount of rollover is significant for the chief executive officer, sometimes he will be treated more like a co-investor and the equity won’t be callable on a good leaver termination, but this typically has to be negotiated. The call is generally at fair market value if the executive is a good leaver (death, disability, without cause or good reason) and at the lower of fair market value and amount paid if terminated for cause. A voluntary resignation without good reason will result in a call at either fair market value or the lower of fair market value and amount paid depending on the philosophy of the private equity house, the length of service before resigning, and the leverage of the executive.
In Europe the Institutional strip, tends not to be callable on a termination, although certain voting and information rights will cease. More recently, some European private equity houses have been seeking to insert a fair market value call right or lower the coupon on the loan note or preference shares if the executive is a “very bad leaver”, which usually has to do with violating the restrictive covenants, but as a custom, has not yet been established.
In the United States, the private equity firm almost always has a call on the vested incentive equity upon any termination of employment, voluntary or involuntary, and often seeks to have a forfeiture on incentive equity if the executive leaves voluntarily (perhaps before a certain date) as it does on a cause termination or a violation of restrictive covenants. Unvested incentive equity (which usually will include all of the performance based equity on an early departure) is forfeited on any termination. In Europe, good leavers (death, disability, retirement) tend to fully vest in their incentive equity and be subject to a call at fair market value. Bad leavers (cause or voluntarily termination) tend to forfeit incentive equity (i.e. bought back for lower of cost or fair market value). On what is now being called intermediate leaver (without cause or good reason termination) sometimes there is good leaver treatment, but more often there is a call at fair market value on the vested equity with the remainder forfeited. As noted, good leaver has different meanings in the US and Europe.
As mentioned, in Europe, the sweet equity is behind a coupon on the loan notes and/or preference shares of anywhere from 8 to 12 percent and then value vests for the purposes of leaver arrangements solely based on time, i.e. the 8 to 12 percent hurdle serving as the performance requirement. The vesting only applies on leaver arrangements and not on Exit (i.e. 100% on exit). There is also often a ratchet (or step up) above the original sweet equity participation sharing if the money on money return is above a certain level (e.g. 2x or 3x investment return).
In the United States, the incentive grant is usually divided in two parts. The first part, which is almost always 50 percent or less of the total grant, is time based over 4 or 5 years. The other portion is performance based utilizing a vesting schedule based on achievement of performance goals which remains unvested in a leaver event (in addition to the unvested time part). Most plans use either a cash return on investment multiple calculation (“MOM”) or an internal rate of return (“IRR”) measurement or a combination. The performance vesting aspect is not measured until an investment realization by the private equity investor. Less often vesting based on annual EBITDA targets is utilized with a catchup on a cumulative basis or an IRR or MOM measurement upon realization.
Recently, there has been some use in the United States of hurdles, usually similar to that paid by the private equity houses to their fund investors before they start to receive their carry, but these are usually at a lower level than the European hurdles and often include a catch up once the hurdle is achieved. In addition, the US arrangements usually also have a traditional time based/performance based vesting schedule. In the United States you also sometimes see an additional ratchet amount paid to management for outperformance above a specified MOM or IRR, but it is not as common as in Europe.
As a result of the use of the hurdle in Europe, the pool size subject to the hurdle is usually significantly larger than the pool size in a US plan. This causes the US plan (as a result of the time vesting) to provide more payment protection at the lower levels of achievement but may not have as high an upside as the European style plans. This difference in structure can often cause difficulty when trying to compare a pool size with a hurdle with a US pool size and should be analyzed carefully.
In Europe, there tends to be more protection up front of expected dilution from future investment, as well as a right to have the unallocated incentive pool allocated at the time of realization. In the United States, there is more negotiation over these points since they have been less common.
As more and more private equity portfolio companies have senior management in both the United States and Europe, and more private equity firms from both sides of the Atlantic are bidding for the same entities, subject to tax structuring issues, there is more of a tendency to mesh many of the provisions. What remains unclear is whether the United States or European model, or some hybrid structure, partially reflecting both, will become prevalent globally.
Jamieson Corporate Finance US, LLC is a member of FINRA/SIPC
