Private equity (PE) firms often acquire or invest in companies with the aim of improving their performance and value over a period of time, typically three to seven years. To achieve this goal, PE firms rely on the expertise and commitment of the management teams of the portfolio companies, who are responsible for executing the strategic vision and operational plan of the PE firm. Therefore, aligning the interests of the management teams with those of the PE firm is crucial for the success of the investment.
One of the tools that PE firms use to create this alignment is the management incentive plan (MIP). A MIP is a compensation scheme that rewards the management team for achieving certain performance targets or objectives, usually linked to the growth and profitability of the company and the return to the PE firm. A MIP typically involves granting the management team a stake in the equity of the company, either directly or indirectly, subject to certain conditions and restrictions. It is designed to motivate the management team to perform at their best, to retain them for the duration of the investment, and to share the upside of the value creation with them.
A MIP can take various forms and structures. Some of the most common of them are:
- Short-Term Incentive Plans: STIPs are typically designed to reward management for achieving short-term performance goals. Common forms include: Annual Bonuses (cash bonuses based on the achievement of specific financial or operational targets) and Profit Sharing (distribution of a portion of the company’s profits to management based on predefined criteria).
- Long-Term Incentive Plans: LTIPs aim to incentivize management to achieve long-term goals. They can include: (a) Stock Options (grants that give management the right to purchase company stock in the parent company of the group held by the PE firm at a predetermined price), (b) Restricted Stock Units (company shares given to management, subject to vesting conditions) (c) Performance Shares (shares awarded based on the achievement of specific long-term performance metrics).
- Equity-Based Incentive Plans: EBIPs provide management with ownership stakes in the company, aligning their interests with those of shareholders. Common types include: (a) Employee Stock Purchase Plans (allow employees to purchase company stock at a discount and (b) Phantom Stock (provides cash bonuses based on the value of a hypothetical stock, without actual stock issuance).
- Cash-Based Incentive Plans: CBIPs reward management with cash payments based on the achievement of specific performance goals. Examples include: (a) Performance Bonuses (cash rewards tied to the achievement of specific financial or operational targets or (b) Retention Bonuses (cash payments designed to retain key management personnel over a specified period).
- Hybrid Incentive Plans: These plans combine elements of both short-term and long-term incentives to provide a balanced approach. Examples include: so-called Balanced Scorecard and Deferred Compensation Plans.
When designing a MIP, there are several key points of attention that PE firms and management teams should consider. MIP should for example:
- directly contribute to the success of the business and drive desired behaviors. The performance metrics and targets should be challenging, but achievable, and reflect the key value drivers of the company often represented by hurdle rates.
- be simple to understand and clearly communicated to the management team and other stakeholders. The MIP should also be consistent and fair, and avoid creating conflicts of interest or perverse incentives.
- be structured to optimize the tax benefits and minimize the tax liabilities for both parties. The MIP should also comply with the applicable securities laws, accounting standards, and corporate governance principles.
- be monitored and evaluated regularly to assess its cost-effectiveness and impact on performance.
A well-designed MIP can be a powerful tool for creating value and enhancing performance in PE deals. By aligning the interests of the management team with those of the PE firm, a MIP can foster a culture of accountability, collaboration, and innovation, driving the company’s growth and profitability.
An article written by Jean-Philippe Smeets and Isabelle Lentz, Partners in the Corporate/Mergers & Acquisitions department at Ashurst Luxembourg
