Targets’ Execs Get 13% Equity Incentive: Study

  • Paul Hastings surveyed 30 companies owned by 20 private equity sponsors
  • Management at target companies typically get 13 percent of fully diluted equity
  • Stiff competition for top management stokes equity deals

Prompted by the challenge of motivating management of portfolio companies, the survey revealed that 13 percent of companies provide incentive equity pools exceeding 20 percent of fully diluted equity. It also showed that no company has an incentive equity pool of less than 5 percent of fully diluted equity.

The survey marks the first effort by Paul Hastings to provide data on the thinly reported metrics of executive compensation at privately owned target companies.

“While the typical rule of thumb is that private equity funds should award between 5 percent and 20 percent of a portfolio company’s fully diluted equity to employees in the form of incentive equity, our survey found that a number of private equity firms are actually exceeding this range,” said Kimberly Smith, of counsel in the corporate practice of Paul Hastings Chicago office. “We expect this trend to continue in the midst of stiff competition for the top management talent that is so critical in maximizing returns.”

But one major caveat of the apparent generosity of equity compensation: nearly half, or 47 percent of the portfolio companies, placed the incentive equity behind an interest-bearing security such as preferred stock owned by the fund. These preferred securities pay out an average interest rate of 8.2 percent, with a range of 5 percent to 12 percent.

The equity payouts flow a bit like a waterfall. If preferred investors put up $150 million in equity to buy a company and earned $25 million in stock dividends during the holding period, they would be entitled to a $175 million payback when the company is sold. If there’s $100 million in bank debt outstanding, that would also be paid pack at the time of the sale. So if the same portfolio company is sold for $500 million, management would get an average incentive of 13 percent from the $225 million remaining after the other payouts.

“For management to really understand what they’re getting, they have to look at the overall capital structure to see where their piece fits into overall scheme,” Smith said. “The flip side for private equity firms is to think about the message you’re delivering to management in using this preferred security.”

Overall, the survey findings support the role of incentive equity to motivate management teams, because it aligns the interests of a private equity fund with company executives, Smith said.

“When the private equity firm sells the company, they maximize the return—management would have a stake in that return and look to grow the company accordingly,” Smith said.

Chief executive officers of portfolio companies receive incentive equity pool grants ranging from 16 percent to 50 percent. Ninety-seven percent of companies required time vesting in at least some portion of the incentive equity.

Based on surveys of platform acquisitions closed in the U.S. during 2010 and 2011 in which Paul Hastings played a role, the results reflect data from 30 portfolio companies owned by 20 private equity sponsors, with an average fund size of $1.1 billion and an overall range of $165 million to $3.9 billion.