Private equity firms have a number of tools to engage the incumbent management of a business and make the cooperation between investor and management after a transaction with the DGA a success. Examples of these management incentives are transaction performance bonuses, management participation plans or Share Appreciation Rights.
Low interest rates, the volatile stock market and property investments becoming less interesting have made a lot of money available to investment funds (private equity) in recent years. These investment funds often have different investment criteria and focus. For example, there are funds with a particular sector focus, early stage/growth focus or a geographic focus.
Positive differentiation
Thus, in the search for a potential acquisition candidate, these investment funds are increasingly coming into the picture as buyers in addition to the strategic parties. Although initially sellers may have some doubts about the long-term vision of an investment fund, this feeling is often dispelled during a first meeting with such a party. Also the way in which financial buyers deal with the remuneration of the incumbent management often provides a positive distinguishing feature compared to a strategic buyer. An investment fund often wants to commit the incumbent management team in some way after an acquisition through a management incentive. That is why more and more selling DGAs choose to sell all or part of their company (pre-exit) to an investment fund.
But what are common management incentives? Examples of management incentives include transaction performance bonuses, management participation plans or Share Appreciation Rights.
#1 Transaction and perfomance bonuses.
The transaction bonus is an instrument which can ensure that management applies all its knowledge and expertise to the successful completion of the investment until the final exit of the investor. This bonus involves, for example, a one-time payment to management when the previously set goals are actually achieved in a sale. Because this bonus is paid only once, it is difficult to adjust to changing circumstances. The disadvantage of the transaction bonus can be eliminated by agreeing on a performance bonus, which pays out periodically and is thus easier to adjust to changing circumstances. Because of the periodic payout, the performance bonus has a constant impact on the Company's financial results.
#2 Management participation plans
Since the success of a company depends largely on management, investors may also decide to have management co-invest in the acquisition. Since the management then benefits extra from positive results, this creates additional commitment. As an additional incentive, the investment fund can offer the management to invest at a lower valuation than what the investor is buying for. This benefit manifests itself in the so-called Envy ratio: the ratio between the price paid by the investment company and the price ultimately paid by management. Here the general rule applies: the higher the Envy ratio, the more attractive it becomes for management to invest.
#3 Share Appreciation Rights.
An alternative to management participation plans are Share Appreciation Rights (SARs). This is also an attractive way to create commitment without the need for management itself to participate with a lot of money. Indeed, in the case of a SAR, management is entitled to a sum of money, the amount of which depends on the increase in the value of the company's shares. The advantages of a SAR include low costs, flexibility and a tax benefit. However, it is important that the terms are carefully formulated in advance to avoid misunderstandings and (unnecessary) taxes.
Management incentives are created in response to specific situations, so there is no best practice. Both return and risk must be well matched so that cooperation between investor and management after a transaction with the DGA can be successful.
