Equity programs are a common vehicle for private equity firms. They are usually called Management Equity Plan (MEP) or Management Participation Program (MPP).
With relatively high return targets, private equity firms generally have to take on more risk. But taking financial and operational risks is a prerequisite for achieving high returns.
In typical private equity transactions, i.e. leverage buyouts (LBO), the inclusion of a certain amount of bank debt (i.e. leverage) in the financial structuring of a transaction is a common procedure. It therefore needs to be considered when assessing the financial risk of a transaction.
Operational risk increases in private equity transactions in a variety of ways, depending on the company, and can include transforming the business model, investing in operations, expanding into new geographies, reducing costs or even making further acquisitions (so-called add-ons). None of these activities are small tasks, and each transformation process or project increases operational pressure and can cause the company to fail.
An equity programs seek to align the interests of the management team with the interests of private equity firms. They also aim to motivate and incentivise employees to perform to the best of their ability in order to reduce potential operational risks.
Just because private equity firms want to increase risk does not mean that management will follow suit. Management teams generally tend to be more risk-averse, especially when there is no pressing need for change. And that's understandable. While PE firms are by nature diversified and have a number of companies in their portfolios, employees are mostly dependent on their jobs for income.
Transforming a business and its operations, and investing in growth, requires experts in their fields and a management team willing to take certain risks.
That's why PE firms typically seek to implement management incentive programs in order to overcome this principal-agent conflict and align the interests of management with those of the PE firm. With the respective participation programs, PE firms want to make sure that management has some “skin in the game” as part of the transaction.
The transformation of the management from employees to entrepreneurs is used by many private equity firms to make sure that both parties will benefit from a successful exit of the company. In particular, KKR, the world's second-largest PE firm, uses MEP vehicles to align management teams with KKR's return targets.
And their success speaks for itself.
Using an MEP is probably the best way to get someone to think and act like an entrepreneur, besides being a founder. But the equity is not fully gifted to managers. PE firms mostly require a meaningful equity stake from (top) management in order to have the respective skin in the game.
Managers have to invest their own money in their company. The individual amount of money, that the manager is able to invest, might, however, vary significantly depending on the individual situation of the manager. So the total amount is, in most cases, not the dominating factor, it’s rather the necessary “skin in the game”.
The equity investment is usually structured through a separate entity that invests alongside the financial sponsor and through which the managers can participate in the transaction.
Depending on the size of the investment, management teams typically hold between 3% and 15% of the equity in a typical buyout transaction.
In the past, it was recommended to limit the people who could invest to the top management. Just because it would have been too much bureaucratic effort, to include the 2nd or 3rd level of management. But thanks to Vestlane, the operational workload per participant is greatly reduced.
With a much more streamlined process, it is possible to turn more employees into entrepreneurs, which improves the alignment of the whole management team. It motivates the entire team to outperform the envisaged targets and participate in the success with their individual stake.
Setting up an MEP can also help to retain (and attract) staff. That's why it's important to have certain ground rules about what happens when a manager leaves the company (i.e. so-called leaver cases). Establishing a balanced vesting schedule is beneficial for both the management team and the PE firm.
In order for the process and negotiations to run smoothly, it is important to try to avoid mistakes. Start negotiations early in the acquisition process. Inexperienced management teams in particular need to be involved as early as possible. It may take several rounds of discussions, Q&A sessions and workshops to help the management team understand and accept an MEP.
As an MEP is for the senior team, it is also very important that the negotiator from the PE firm is also one of the senior partners. This shows sincerity and respect.
As most of the management team will probably be going through a sale process for the first time, it is also important to keep all documents and the term-sheet as simple as possible, avoiding insider industry acronyms.
Particularly in Europe, it is also essential that all documents are translated into the local language. Even if they can speak and understand English, in this specific situation, they may not feel comfortable to read very specific documents about a concept outside their area of expertise.
Thanks to Vestlane it is possible to involve many more members of the target company in a MEP. The operational and administrative process is now significantly less complicated.
Vestlane is a fund operations platform that helps fund managers onboard investors and manage ongoing fund-related tasks. It is the perfect tool for onboarding participants to a Management Equity Plan (MEP).
Invite all participating employees to invest and manage the entire onboarding and subscription process via Vestlane.
Share all accompanying documents and the term sheet using our secure data room.
We provide guided investor workflows that explain each step of the process, helping all participants understand where they are and what they need to do next. All while maintaining 100% compliance with the highest KYC & AML regulations.
Our platforms allow you to onboard participants from anywhere in the world. Documents can be securely shared, accessed and signed – all within our digital platform.
We provide a streamlined and digital platform, so you can focus on building great relationships with your future management team.
Get in touch with us and learn more about how we can help you, offering equity plans to your management teams.
