Management Incentive Schemes: “Resets” and Affordability | UK

Private equity sponsors typically offer the management teams that run their portfolio companies the opportunity to invest alongside them in the shares of the portfolio company. That investment takes the form of a management incentive plan (MIP) and serves to align the interests of the management team with those of the sponsor: both will be financially rewarded on a successful sale or listing of the portfolio company at the end of the investment period.

One of the most common ways in which a private equity sponsor will provide the capital to fund the original acquisition of a portfolio company is by investing funds (drawn from its LPs) in a mixture of preference shares and ordinary shares in the company that will be the holding company for the operating group (the “Company”). That mixture of preference and ordinary shares is referred to as the “institutional strip” and will commonly comprise preference and ordinary shares in a ratio of between 9:1 and 99:1. The preference shares will have a right to receive sale proceeds ahead of the ordinary shares in the Company and will usually bear interest, increasing the amount ultimately payable to the preference shareholders on any distribution of proceeds. In this type of capital structure, the MIP will typically take the form of an allocation of part of the ordinary share capital of the Company (in the region of 10-20% of the total number of ordinary shares) to be held by the management team. Those ordinary shares are referred to as “sweet equity”. For discussion purposes, this article assumes the existence of the capital structure described above. In practice, comprehensive tax and regulatory analysis will underpin the terms and structure of a MIP and those aspects must be considered fully in scheme design and operation.

Sweet equity is usually issued to the management team at or very soon after the initial acquisition of the portfolio company. As new managers join, they may join the MIP by acquiring sweet equity. When managers leave the business, often their sweet equity is bought back from them and may be re-allocated to their replacement. In the UK, in order to avoid charges to income tax, it is important that MIP participants pay the unrestricted market value (UMV) of the sweet equity at the point that they acquire it.

There are two scenarios that may require a MIP to be reset or adjusted part way through the investment period: significant underperformance of the portfolio company, or a marked increase in its value.

Underperformance may lead to a situation where the sweet equity has little or no value, because upon a hypothetical exit the transaction proceeds would not be enough to repay (i) the portfolio company’s third-party debt and (ii) the amount required to be distributed to the holders of the preference shares in the Company, both of which rank ahead of the sweet equity. This would leave nothing to distribute to the holders of the sweet equity, or any other ordinary shareholders. This situation is often referred to as “value breaking in the preference shares”.  

This can mean that the MIP no longer acts as an effective incentive to the management team, as an exit scenario in which the sweet equity generates a return for the holders may seem too remote. To realign the management team and the sponsor’s interests and to motivate new management team members to join the business (often required in a turn-around) the sponsor may wish to “reset” the MIP. Effectively, this means finding a way to create a new incentive to the management team.

What is commercially appropriate and legally possible will depend on a variety of often competing factors, including planned timeline to exit, likelihood of an upturn in performance and the number of managers involved.

One good option can be the introduction of a growth share – a new class of shares in the capital of the company. The benefit of growth shares is that there is a large degree of flexibility in defining the economic rights that attach to them. In the context of a MIP reset, those rights can include the right to receive a portion of any sale proceeds alongside the preference shares as well as the ordinary shares, making the likelihood of management receiving proceeds on an exit greater. Other alternatives include the issue of preference shares to managers, or to a vehicle in which managers in turn hold shares.

When a Company has performed very strongly, the UMV of the sweet equity can be very significant, especially in the latter stages of the investment period. This poses a nice problem to have – that for new managers, the subscription price for sweet equity can be very high.

This may be addressed in a number of ways, including the introduction of a joint share-ownership plan whereby sweet equity is issued to a trustee that then issues beneficial interests representing a fraction of the economic rights enjoyed by a single sweet equity share to new managers. Another option is to provide financial support to managers to enable their subscription. That financial support could be a loan to the manager in question, or permission to leave part of the subscription price for the sweet equity outstanding. Each of those options has different tax results for the manager and portfolio company and the regulatory (not least Consumer Credit Act) considerations must be considered on a case-by-case basis.  

Although they do not offer the potential tax advantages to participants and employers that are often achieved by equity incentivisation, the utility of simple bonus schemes should not be overlooked. They are often comparatively quicker and cheaper to implement than equity schemes and have lower ongoing administration costs. In some circumstances, such as where an exit is already in contemplation, they can operate to provide an effective incentive plan for key managers where an equity scheme may be less suitable.