As we head into 2023 and given the uncertain economic outlook, Private Equity funds and portfolio companies will be looking at their management equity plans (‘MEPs') from several standpoints to ensure these have the desired incentive effect for the management team. Whilst doing nothing may seem like the easy option, often it will be in the best interests of both investors and management to restructure the management equity plan.
In this article, we look at some of the issues Private Equity funds and portfolio companies may need to address in an economic downturn in relation to their MEPs.
DOWNWARD VALUATIONS OF PORTFOLIO COMPANIES
The global economic climate means that some portfolio company valuations will be at risk of downward adjustments.
This can have a damaging (even if temporary) knock-on effect for the MEPs economic returns as value creation is reduced and, as an example, any enhanced returns which management may achieve through ratchets are eliminated. The decline in the portfolio company valuation may lead to an extension in the holding period of the asset as the fund decides to sit tight to ride out an economic downturn. Longer holding periods will also often affect managers' returns under the economic waterfall.
MEP IS UNDERWATER
In addition, where management shares are significantly underwater, the incentive effect of the management equity will be eroded.
It will then be important to consider how to continue to incentivise the management team in order that the asset may deliver the desired return to the fund and their investors.
MEP RESETS
This may require the resetting of economic hurdles in the management equity plan. It will be critical to take tax and valuation advice where there is a reset to an MEP. Where managers receive an economic benefit because of the reset which is employment-related or falls within specific and very broad tax rules for employment-related securities, there may be income tax which is payable and reportable through Pay-As-You-Earn and employee and employer national insurance contributions (NIC) to pay. This will be a dry tax charge given the illiquidity of the management equity and consideration will then need to be given to how to fund these tax liabilities. Very careful thought and structuring is necessary before any MEP reset.
MANAGEMENT CHANGES
There may be changes to the management team. Exiting managers will usually be required to sell their equity on termination of employment. The price they receive particularly for their sweet/incentive equity may depend on whether they are characterised as “good”, “bad” or in some cases “intermediate” leavers. If management equity was originally funded by loans and is underwater, careful consideration will need to be given to the terms of the loan and whether the manager is at risk to repay the loan from their personal resources. Funding the purchase of a leaver's shares is less likely to be an issue where the equity is underwater.The management equity plan may then need to be restructured for new management to ensure managers' interests are aligned with the investors.
INTERNATIONAL ISSUES
All the above issues may be further complicated where MEPs operate in several jurisdictions with different legal and tax regimes.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
