To meet their performance objectives, private equity firms must rely on talented, highly motivated managers within their portfolio companies.
To date, aligning the financial interests of portfolio company managers with those of investors has proved to be the most motivational tool in driving them forward. But is this alignment still there in the current financial and economic downturn, which may have resulted in a drop in enterprise value?
One consequence of the current financial and economic crisis is that private equity houses may have to cope with “underwater” equity and should consider resetting management incentives so that they continue to deliver what they are intended to: retention, motivation, reward and alignment. The question is how this resetting can be appropriately structured from a tax and legal perspective.
In this respect it may be helpful to think of a deal as a “cake” with the debt and equity forming various slices. Resetting the incentive may be done by waiving shareholder debt, reducing or turning off the coupon on shareholder debt, converting shareholder debt into equity, restructuring management’s holding to rank ahead of shareholder debt, amending equity, creating new ratchets, creating preferred shares, granting share options and so on
All the alternatives will potentially result in additional value flowing into the sweet equity held by the portfolio company managers and may potentially trigger a tax and social security tax cost for management in most jurisdictions. From a Belgian tax perspective, private equity houses might validly consider granting share options to structure this flow of value to sweet equity. The advantage of share options is threefold: a proven tax treatment, high flexibility in defining the share option features, a lump-sum taxable value that could prove to be far below the actual option value.
Feel free to contact our Management Participation Team for any questions you might have in respect of resetting management incentives held by your portfolio company managers.