This is one of seven private equity value creation strategies we have compiled into our new guidebook. Download the entire guidebook here.
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 a share of value in an exit — thus, providing an incentive to remain with the company. Increasingly, performance-based compensation plans, which have become a popular option for public companies for value creation, are taking hold in private equity firms. These plans tie the equity incentive to some form of total shareholder return (TSR). They may replace or be combined with traditional service vesting plans.
What to consider when designing your value creation plan
1. What type of award works best?
- Profits interests (in LLCs)
- Appreciation rights
- Stock options
- Restricted units
- Phantom shares
2. Who will participate?
- 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
The greatest value creation benefit of TSR plans is that they more closely align management goals with those of the private equity firm. For example, plans can be structured so that management equity incentives are contingent on a target return to investors, who after all, are the ones providing the capital and shouldering the most risk. It is the ability to fine-tune these plans to investor-specific performance goals that make them especially appealing. For example, the performance targets could be a minimum ROI, multiple of capital invested, or minimum value at exit. Another attractive feature of TSR plans is the ability to set up payout ratios on a sliding scale that covers a range of results.
It is the ability to fine-tune these plans to investor-specific performance goals that make them especially appealing.
As with any compensation plan, TSR 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.