Using performance-based equity incentives to achieve private equity value creation

March 1, 2021 Article 1 min read

Authors:: David Howell Richard L. Lies, III

Increasingly, performance-based compensation plans, which have become popular for public companies, are taking hold in private equity firms. Here are some considerations when designing a value creation plan.

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Maximizing the value of a portfolio company from acquisition to exit is heavily dependent on the performance of its management team. Traditionally, private equity firms have rewarded management by giving them equity that vests over time and provides a share of value in an exit — thus, providing an incentive to remain with the company. Increasingly, performance-based equity compensation plans have become an additional way to align management with value creation strategies. With these programs, when the company achieves certain performance targets, such as EBITDA or levels of return for investors, management can increase its share of value.

What to consider when designing your value creation plan

1. What type of plan to consider?

Profits interests (in LLCs)
Appreciation rights
Options

2. Who will participate?

C-level
Key individuals
Board members

3. How will you measure performance?

Rate of return: IRR, ROI, or exit multiple
Target transaction value
Growth in EBITDA or revenue

4. What percent will be granted?

Total pool
Individual awards

These plans provide an incentive that further aligns management with investor objectives. A popular structure for performance-based incentives is where management gets an additional payout when the company achieves a value in an exit that provides a target rate of annual return (IRR) or multiple of invested capital (MOIC). Performance-based equity incentives are often awarded in addition to traditional units, based on continued employment. If the performance targets are not achieved, the performance units are forfeited.

As with any compensation plan, performance-based equity incentives have various legal, design, tax, and financial reporting considerations. Nevertheless, when properly structured and administered, these types of value creation plans can be highly effective at establishing an incentive for private equity value creation and promoting both better returns and a successful exit.