“Total rewards” refers to the full scope of a business’s compensation and benefits structure, including everything from base compensation to other employee benefits and rewards such as bonuses and incentive-based payments, healthcare, retirement plans, paid time off, professional development, work/life balance initiatives, fringe benefits, and other perks. Private equity firms considering an acquisition should conduct a due diligence review of a target’s total rewards profile with two primary ends in mind.
Start with risk. Just as you would assess a target’s financial and legal risks, it’s important to conduct a comprehensive risk analysis of the target’s reward programs. This ensures compliance with filing and funding requirements. For instance, an underfunded pension plan can represent a significant financial liability — one that must be identified, quantified, and factored into the transaction cost. Similarly, certain benefits may require upgrades to remain competitive after the deal closes, and those projected costs should be included in acquisition planning.
Next, consider alignment. Beyond risk, the question becomes: How well does the target’s compensation and benefits structure fit with the market and your overall rewards strategy? Misalignment can lead to inefficiencies and talent loss, so adjustments, whether modifications, enhancements, or eliminations, may be necessary. While these changes will ultimately occur during the value creation phase, the due diligence process should assign a financial value to anticipated adjustments so they’re accurately reflected in the deal pricing.
Why focus on total rewards at the due diligence phase?
Total rewards should be considered thoroughly in the due diligence phase. Any errors or shortcomings in the target’s funding and administrative management of these programs can result in significant financial obligations that should be factored into the cost of the deal. Underfunded or poorly administered retirement plans, for example, can lead to major liabilities — not just the cost of catching up on funding, but also penalties and interest.
But risk isn’t the only reason. Total rewards can play a big role in the success of the post-transaction entity. If the goal is to add on the target to a platform, the analysis should go beyond spotting errors. It should also examine how the target’s rewards align with those of the platform and your vision for the combined company. Which programs will support the go-forward business model? Which benefits will help retain top talent after the deal closes?
For acquisitions where the target will remain standalone, the focus shifts to competitiveness. How do the company’s current policies compare to the market? Are premium benefits delivering strong results in recruitment and retention, or are they an unnecessary expense? Conversely, is the company struggling because its rewards aren’t competitive? If improving performance means investing in better benefits, then those costs need to be part of the equation.
How do total rewards affect employee retention and value?
Two components of total rewards packages highlight the ripple effects that should be identified and evaluated during due diligence, well before a deal closes. At a family-owned target, executive pay often falls below market levels. This approach can create downstream issues, such as subordinates whose pay is tied to those lower benchmarks may feel undervalued and consider leaving after the transaction. To preserve institutional knowledge and retain key talent, an acquiring private equity firm may need to adjust compensation to market standards. This is an investment that should be anticipated and factored into the deal economics.
Defined benefit plans, while increasingly rare, provide another challenge that should be evaluated before a deal closes. Along with being expensive to maintain, they’re significant risks of additional costs if the business falls short of funding obligations. But the elimination of a plan post-transaction can negatively impact retention and employee morale. If a target isn’t already winding down its defined benefit plan, the private equity firm that acquires it needs to understand the potential impact of changing to new — and potentially less popular — retirement options on employees.
Key components of total rewards to always keep in mind
Several components of a target’s total rewards package should be closely scrutinized during the due diligence process, including:
401(k) plans
One of the hallmarks of this retirement plan option is the wide variability it offers in creative design components and employer contribution options. Each target’s 401(k) plan needs to be evaluated against competitors to determine whether it supports employee recruitment and retention or if it needs an upgrade to remain competitive.
Integration of the target plan into the firm’s go-forward strategy also needs to be considered. Each plan has its own unique design, and a private equity firm needs to determine whether it aligns with the total rewards strategy of the post-acquisition entity. Similar to the concerns with pension plans discussed above, 401(k) plans also carry significant administrative requirements. Beyond the strategic issues of alignment with the post-merger total rewards strategy, a private equity firm needs to assure itself in the due diligence phase that there are no outstanding administrative failures with the plan that could result in significant unexpected costs after the acquisition.
Relationships between compensation plans and equity stakes
In addition to the potential suppression of executive pay in a family business, private equity firms may also face complexity due to equity or ownership stakes. Executives with substantial equity stakes or transaction bonuses that create a windfall from the acquisition could be incentivized to leave after the transaction, ultimately disrupting continuity.
The total rewards due diligence process should provide the acquirer with a clear understanding of what retention agreements already exist for top executives and what additional provisions and payments may need to be included in the deal to keep key executives in place after the transaction. Plenty of options exist that can give executives a piece of the post-transaction upside whether synthetic equity, actual equity, or bonus structures based on the achievement of key post-transaction milestones.
Employee stock option plans (ESOPs)
As ESOPs have grown in popularity over the years, the number of ESOP-owned businesses that are selling to private equity has also increased. The transition of a business from the ESOP form of employee ownership to private equity ownership will often represent a major cultural shift. Where ESOP leaders might typically focus on longer-term goals tied to operating the business as a going concern into the future, private equity leaders will typically be focused much more closely on maximizing the value of a business over a shorter period to monetize those gains with a sale in a five- to seven-year time frame.
Deals come with their own unique set of challenges, but one thread that runs through many ESOP acquisitions is the challenge of morale and retaining employee-owners who relinquish their ownership benefits and return to being just employees. This aspect of the ESOP acquisition makes it much harder to forecast how many key employees will stay and how the business will operate in a post-ESOP environment.
Proactive private equity due diligence drives effective total rewards strategies
A focused review of a target’s total rewards package and how those benefits integrate with the post-transaction entity can provide a private equity firm with a strong foundation for a successful acquisition. By examining compensation and benefits during due diligence, firms can identify risks and opportunities early, including:
- Compliance gaps and remediation strategies.
- Transitions from costly pension plans to more flexible retirement options.
- Creative compensation alternatives designed to strengthen retention.
Integrating total rewards in the due diligence process enables early detection of benefits-related issues that could impact morale, hiring, and retention after the deal closes. This forward-looking approach also creates a roadmap for programs that may need improvement, modification, or elimination during the value creation phase — helping maximize the business’s attractiveness to future buyers within the typical five- to seven-year exit horizon.
