Survey results unveiled today by law firm Goodwin Procter LLP suggest mid-market buyout firms are making sure their management teams have ample skin in the game. The average size of such equity incentive pools, as a percentage of fully diluted equity capitalization, is about 11.3 percent. That is down from 12.6 percent in 2013 when Goodwin Procter last published its survey, although John LeClaire, co-founder and co-chair of the firm’s private equity group, said he did not consider the difference statistically significant. (Some firms participating in the survey this time were absent in 2013.)
An important nuance: In many transactions – LeClaire in an interview said a majority of deals – the size of the ultimate payout to management depends on performance. Goodwin Procter calls this aspect of compensation “performance-based vesting.” More than two-thirds (69.6 percent) of respondents using performance-based vesting said vesting is tied to the return on sponsor’s invested capital, a third (30.4 percent) said it is tied to EBITDA, 21.7 percent said it is tied to IRR and 23.9 percent said it is tied to a combination of metrics.
Altogether Goodwin Procter surveyed more than 60 U.S. private equity firms last year on their management compensation and equity rollover practices in mid-market buyouts and majority recapitalizations. The survey report is designed to be used as a negotiating tool by sponsors. According to the report, “the use of such studies can quickly and efficiently convince the other side that your position is not novel, or unheard of, and is within the range of ‘market.’”
About half of sponsors (49.1 percent) said they set aside different percentages of the equity pool for management depending on the size of the deal or the equity investment. For those that do, sponsors said they set aside 15 percent for management in transactions involving total equity contributions of $100 million or less; 9.5 percent in transactions of $100 million to $500 million; and 8.9 percent in transactions of more than $500 million. Below are some other characteristics of management equity pools, according to the study:
* The equity set-side for the CEO is 3.8 percent; that for the CFO is 1.9 percent; that for other C-level executives is 2.8 percent; and that for outside directors is 1.1 percent.
* Restricted stock is the most common form of the management equity pool (35.1 percent), followed by options (22.8 percent), profits interests (19.3 percent) and a combination of options, profits interests or other awards (17.5 percent). According to LeClaire, profits interests are becoming more common in part because of the tax advantages they can provide to management. Nearly half of respondents said they always or usually use profits interest as an incentive for management.
* According to LeClaire, most buyout and majority recapitalizations require time-based vesting of management equity awards. The average time-based vesting for equity awards to management is 4.6 years, according to the survey; always (35.7 percent) or usually (42.9 percent) the time-based vesting accelerates on the sale of the company.
Along with management, of course, founders or current owners often maintain equity in their companies post-buyout through a so-called rollover of equity.
According to the survey, rollovers play a role in nearly four in five (78.2 percent) buyout and majority recaps. The average percentage of pre-transaction equity holdings rolled over by owners or founders stands at 24.1 percent – 28.5 percent for deals involving total equity investments of $100 million or less, 24.5 percent where total equity investment is $100 million to $500 million, and 16.8 percent where total equity investment is more than $500 million. In fact, more than two-thirds (70.7 percent) of respondents said they typically require the founders or current owners to roll over at least a part of their ownership interests. The average minimum requirement is just over 18 percent, although it is less in larger transactions.
Not surprisingly, the vast majority of respondents (93.1 percent) said that a “desire for current owner [to have] skin in the game/alignment of interests” determined the size of rollover investments by founders and owners. Other common determinants – respondents could pick more than one – include providing an opportunity for gain (75.9 percent), as well as the “capital needs” of the deal (25.9 percent).
More than half of respondents (52.6 percent) said that “yes, almost always” the rollover securities ranked pari passu with those acquired by the fund. Another 29.8 percent responded that it “depends on underlying economics of the transaction” and 17.5 percent said “no, almost always junior to us.” LeClaire said that pari passu rollovers have become much more common over the last 20 years. He added: “It’s a function of the market, with owners of strong companies having good negotiating leverage, and the willingness of sponsors to give that term rather than protecting themselves in the downside case…”
Rollover investments are made on a tax-deferred basis either usually (50.0 percent) or always (20.7 percent), according to the survey.
Sponsors would be wise to keep tabs on these and related trends in compensation in mid-market buyout deals. According to the report: “From the perspective of a founder or manager, rollover and incentive equity are among the most important economic aspects of any deal. Knowing how to structure win-win solutions and the unwritten rules and norms of middle market [compensation] are therefore critical.”