Executive Compensation – Essential Factor in Private Equity Transactions

Private equity firms create incentives to retain management teams that create value in their invested companies.

Need to Incentivize
When private equity (PE) firms invest, they want to ensure that the company executives who retain essential knowledge and relationships are fully engaged and sufficiently incentivized to drive performance at the company.

Compensation packages are designed to maintain a strong link between the management team and the company. Plans and compensation structures vary; however, executives should expect to discuss roll-over equity options, a management incentive pool and compensation plans.

Roll-Over Equity
Roll-over equity encompasses two forms of investment. If an executive held equity in the company before the PE firm’s acquisition, this equity can be “rolled” into the new transaction. For certain members of management, there may also be an opportunity to invest additional equity in the transaction. These equity contributions are direct investments in the company and, typically, not subject to the PE’s carry and management fees.

Management Incentive Pool
The management incentive pool comprises a certain percentage of the equity in the firm set aside for management in the form of options or appreciation rights. It is earned based on company performance metrics determined at the beginning of the transaction — vesting may also be a factor — and is distributed to the management team collectively.

The percentage for a pool will depend on factors including the size of the transaction but typically varies from 5% to 20% for middle-market companies. The portion generally decreases as the size of the deal decreases; management might not be allocated 10% of the equity in a $1 billion deal but could possibly receive that percentage for a deal below $100 million.

Long- and Short-Term Compensation Plans
The third component of the compensation package includes long- and short-term compensation plans, such as those put in place at most companies. Although the plans may have some similarities, each plan may be structured for the individual executive based on his/her position and responsibilities and can include both quantitative and qualitative expectations. Short-term plans are paid out annually, while longer-term plans pay out over a three- to five-year period.

Second Bite of the Apple
When a PE firm sells a company, if the buyer is another PE firm, the management team has an opportunity for the  “second bite of the apple.” When executives receive their equity stake during a sale transaction, they then have the opportunity to reinvest a portion — or all — of that equity in the new transaction.

By capturing the equity upside through the management incentive pool and rolling its increased equity stake into the new transaction, the executive team can increase their overall stake in the company. The result is that management receives a nice payout and also owns a larger share of the company.

CRO/CDMO Considerations
The three components of compensation packages would apply regardless of the type of company being acquired by the PE firm. One area where significant variation occurs is the performance metrics included in long-term compensation plans, which depend on the type of business.

For instance, the profits of many contract service providers are cyclical and fluctuate for a variety of reasons. As such, long-term compensation plans are structured over a number of years to capture those trends.

Private equity interest in contract pharma services remains strong, and management teams are compensated to make those investments successful.

Featured in the Q3 2019 edition of Pharma’s Almanac

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