It was early 2021. Transaction multiples were high. Interest rates were
It was early 2021. Transaction multiples were high. Interest rates were
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Retaining and Rewarding Management When Value Drops

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April 24, 2023 | Jamieson

Thanks to Michael Sirkin

It was early 2021. Transaction multiples were high. Interest rates were low. The sale to the private equity company closed after a competitive auction. Management negotiated a generous, but fair, management incentive plan based on profits interests. It provided for incentives over a waterfall of acquisition equity value with 50% time based over 4 years and the remainder performance based using a Money on Invested Capital (“MOIC”) vesting interpolated measurement with a ratchet for outperformance.
It is now 2023. Market multiples have dropped. Debt is more expensive, if even available. Potential buyers are waiting and not buying. Liquidity is likely going to be delayed for at least two years beyond the original target. However, the private equity firm believes that there is considerable value in the Company and the drop in valuation is only because of market conditions. It believes that, once market conditions reverse, the company will quickly recover. It also believes that the existing MIP is reasonable and generous to management even under the new market conditions. So, the private equity firm is reluctant to issue MIP grants at below its investment level to new hires or drop the multiples of its investment for MIP vesting. It also does not believe new grants are necessary to existing management even though it now looks like a longer hold than projected is likely.
The chief executive officer is worried about the MIP and whether it will adequately reward based on the revised projections and valuations. He is also concerned whether it will be sufficient to retain existing management to the extent desired and attract the new people he might need. 
If the value had been maintained or was higher, all parties would agree on projected growth and desired reward for new hires over an agreed time period. For example, new MIP grants would be made, running from the then equity value to stretch projected results over an agreed time table. The MOIC vesting multiples would be geared to the desired returns to the private equity firm and the on boarded executives from either the original investment or the then company valuation, depending on time period and degree of variance. Ideally, the same should be done with a depreciated value. However, it is much harder for the private equity firm to accept a depreciated value and not to base executive reward on return from its original investment level. 
A senior new hire would think that the solution should be relatively straight forward. It would be to issue to him or her and other new hires equity based on the then current company value and use a vesting time period and MOIC multiples geared to the new value and timetable for the company. A 4 year time vesting from him or her joining (with acceleration on a change in control) would still be on target, but the existing multiples could, in his or her view, be a significant challenge if based on original investment return as opposed to then equity value. On the other hand, the private equity firm is concerned about the return for its fund. It is likely to have internal resistance to issuing equity below its acquisition cost and using MOIC or IRR levels based on that equity value, especially since it believes that the dip in value is only temporary and attributable to market conditions. In addition, it believes that the interpolated performance vesting was both generous and a result of the bidding process and the market at the time of the deal. It, therefore, believes that, even running the existing multiples from original investment, provides a fair MIP measurement based on existing equity value and that value has not “really” decreased, but it is just temporarily depressed.
The above scenario is not unrealistic considering the change in market conditions from the beginning of 2021 to 2023 and one that many private equity firms and chief executive officers are confronting as they adapt to the change in markets. This is the case whether or not a new chief executive officer or other senior executive is in the planning. The issue focuses on how to keep management incentivized in light of a longer hold, down multiples and pressure on earnings. 
A solution perhaps lies in using MOIC measurements based on the original investment by the private equity firm, but using a waterfall at the then decreased valuation of the company or, if the private equity firm does not want to write down the value of the equity of the company or such an adjustment presents tax issues, a catch up from the new lower value once the initial equity value is surpassed. This will provide him or her and other future management with a greater return (a reward for getting back to the “starting point”) if they can get the return on MOIC that the private equity firm is seeking. Assuming that the delayed projected exit gives the necessary time to build value, this could work for everyone. Another approach to be considered is to add to the executive compensation a cash bonus based on increase from the then deemed current value to the original value or capped options to cover this gap.  
The key to any adjustment for a new executive or a restructuring for existing executives is a meeting of the minds regarding the company’s growth trajectory over the desired exit horizon. It calls for the same type of investment analysis that was performed when the company was first acquired, trying to see past the prior investment thesis, but recognizing it’s influence on the investor’s objectives. Only then can a fair program be set up for new hires and existing employees, as well as the private equity firm.
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