The continued influence and scale of private equity (PE)-backed corporate takeovers has increased many companies’ interests in learning about the long-term incentive (LTI) strategies that PE firms adopt and implement for their portfolio companies (PortCo).
WTW has conducted its first-ever survey of PE firms and their portfolio companies to determine common plan designs that are established by PE firms at the time of their investment. This follows an August 2022 article, which explained WTW’s findings based on publicly disclosed initial public offering data reported by PE-backed portfolio companies.
The survey included information from 18 PE investments and touched on two major topics with the following subtopics:
Equity plan design:
Co-investment opportunities provided to PortCo executives. (These co-investments are commonly called rollovers due to the requirement or ability of executives to roll over proceeds they would have received upon sale of the business into the PE-backed entity.):
There were several key themes that emerged from the findings.
The first theme that emerged was that overall pool size has remained steady in recent years, but upfront awards as a percentage of the total pool are down.
According to the WTW survey, the median equity pool reserved by PE firms for grants to their PortCo executives and key employees was 10% of total shares outstanding (TSO) (undiluted).
This percentage aligns closely with our findings in 2022: a median share pool among PE-backed portfolio companies of 10.9% of TSO. However, an average of only 63% of that 10% pool (or 6.3% of TSO) was distributed to executives and other key participants at or near the time of investment — leaving 37% of the pool available for future grants.
This is a smaller upfront distribution than historical practice, when the average upfront allocation was 70% to 80% of the total pool.
Unlike public companies, PE-backed portfolio companies do not commonly grant equity awards each year. The initial grants following the PE investment are typically significant enough to retain and motivate the recipients through the entire life of the PE’s involvement with the company.
Future grants tend to be limited to new hires, promotions or other necessary adjustments.
A second theme was that stock options remain a popular equity vehicle for PE-backed portfolio companies despite the rise in profits interest units.
Profits interest units became a common equity vehicle for partnerships and limited liability companies in the late 2010s as changes to the U.S. federal income tax rules provided these units with potential tax advantages not available to stock options or restricted share unit (RSU) awards. However, stock options remained the most common equity vehicle offered by PE firms to their PortCo executives, with 61% of survey respondents using options. Forty-four percent granted profits interest units and only 11% granted full-value share awards, such as RSUs.
Historically, appreciation awards such as stock options and profits interest units have been the most popular LTI vehicles for PE-backed portfolio companies while full-value share awards have not been granted as frequently. This reliance on appreciation awards serves to reinforce a key principle of PE incentives, which is that growth in capital and investment returns supersedes other goals.
While the survey did not specifically ask why PE firms chose to use stock options more frequently than profits interest units, we can hypothesize that options are easier to explain and better known among recipients because they are commonly offered by public companies. Profits interest units may be better suited for senior executive awards (where their potential tax advantage is greatest) while options may be valued more by non-executive participants.
The third theme that emerged is PortCo equity awards commonly come with extra performance hurdles. The survey found that 78% of respondents required satisfaction of performance conditions for all or some of their PortCo equity awards to vest rather than vesting simply based on continuous employment.
Multiple of Invested Capital (MOIC) and Multiple of Money (MOM) are the most common performance goals (57% of respondents total). MOIC measures the PE investment over the entire lifetime of the investment. Unlike Internal Rate of Return, or IRR (the third most popular performance goal with 14% of responses), MOIC and MOM do not consider timing in calculating the return. They simply divide the total cash inflows by the total cash outflows at the time of the exit.
Performance goals such as MOIC or MOM measure the return to the PE sponsor, not the growth in value of the PortCo business itself. They can take into account not just PortCo value gain but also any dividends, management fees or other distributions that the PE firm collects from the company.
Only one-third of respondents reported a rollover requirement as part of their investment, and 39% reported a voluntary rollover program. On average, only five employees were included in these plans. Lastly, rollover rates varied. CEOs were required, on average, to roll over 25% of their sale proceeds into the new PortCo investment while direct reports to the CEO were typically required to roll over 10% to 15% of their proceeds.
The most common advantage to the rollover reported by survey respondents was the ability to avoid taxation on a percentage of the participants’ gains upon sale. Other inducements such as a company match or discount on shares purchased under the plan were not common.
In our experience, rollover terms also can vary significantly based on the PE firm’s executive retention strategy. A PE sponsor that needs to retain all members of a PortCo’s executive team may have higher rollover requirements or more generous rollover terms.
Rollovers are less likely to be required or offered if all or a portion of senior leadership is expected to depart once the deal closes.
While PE firms tend to have certain guiding principles and consistency in how they approach PortCo LTI plan designs, each of these LTI design features is typically negotiated between the PE suitor and the target company as part of the deal’s terms.
Concessions made by the PE firm on certain terms (e.g., a larger share pool or a higher percentage distribution of the pool in upfront awards) may be offset by other requirements, such as a higher MOIC threshold required for vesting.
Companies will become more likely to receive offers to change ownership or be taken private by PE as the markets for alternative investments expand. Consistently tight labor markets, especially for executive-level talent, continue to require PE sponsors to retain the executive teams at their target companies.
A robust, well-designed LTI plan that gives clear direction on company goals while providing significant earning opportunities to its participants can serve as a win-win for both the PE firms and their portfolio company leadership teams.
A version of this article appeared in Workspan on August 10, 2023. All rights reserved, reprinted with permission.