In Q4 2022 A&L Goodbody hosted a webinar event 'Private Equity – current trends in a turbulent market'. During the event our experts considered the approach to management incentive plans, or MIPs, that they are seeing in the market in private equity transactions in Ireland. This article looks at some of the key themes and ideas discussed during the session and includes a view on the outlook for ESG-related developments in private equity transactions in the coming months.
We hope what follows is of interest – please reach out to your usual A&L Goodbody contact if you would like to discuss any matter raised in this article.
Key themes
Market participants understand the need for secure, empowered and incentivised management teams to commit to their businesses. Private equity sponsors typically place substantial reliance on management to grow a business post-acquisition, so management incentivisation is key to any private equity transaction.
This reliance increasingly extends beyond the founders – MIPs are no longer just for existing senior management. The next generation of management coming through is critical to any successful investment, and this is reflected in MIPs being made available to a broader cross-section of employees.
In Ireland, the approach to MIPs is in general a balanced one, sitting somewhere between the traditionally more investor friendly position in the US and the more management friendly position we see in UK deals. Of course, each transaction is unique and MIP terms will always reflect the realities of disparate bargaining power among the parties and the broader macroeconomic environment influencing a transaction.
What are we seeing?
We think of senior management deals as a separate strand in a private equity deal, distinct from the M&A transaction relating to the acquisition of the target in question. When we consider the management's position, we think of two key aspects: management rollover, and the MIP itself.
Rollover is the amount of existing equity ownership which is 'rolled over' into the new equity capital structure by management into the 'strip' (or the securities which the sponsor(s) invest into to fund the target purchase, typically a mix of ordinary shares and preferred shares or loan notes). Management can either roll over equity or invest their own cash.
This kind of arrangement is attractive to sponsors as it reduces the amount of investment required by funds and as well as aligning management interests with those of the PE owners of a business, and can be tax efficient for management as well as hopefully providing an uplift along the life of the deal. In Ireland, we'd usually expect management to roll over about 50% of their proceeds, although this can vary deal to deal. As we enter a phase of higher debt costs, there is likely to be pressure on management to increase amounts invested. Further, if target valuations flex downwards, management's investment may accordingly comprise higher proportions of transaction totals.
Strip equity is distinct from so-called 'sweet equity' awarded pursuant to a MIP, that is equity in the company which vests in management over the life of a deal usually on favourable terms. The size of the sweet equity pot varies by deal, by jurisdiction, and by sponsor but we commonly see a range between 10% and 20% (with US sponsor driven deals nearer the lower end of that band, and UK sponsor driven deals usually sitting towards the higher end). Sweet equity has historically been subject to compulsory acquisition in the event that the relevant individual ceases to be employed, and will vest in a time-based manner over a specified period of time, often between three to five years. Vesting is often accelerated on a successful exit.
As noted above, historically the award of sweet equity tended to be reserved for senior management only but the make-up of the recipient pot is expanding across most deals. This trend is driven in no small part by the C-suite of investee businesses who are keen to retain and incentivise talent through the entire structure of an organisation. At the same time, globalisation is driving ever more complex structures: where participants sit in multiple jurisdictions the relevant tax and regulatory analysis around vesting of sweet equity can be challenging. As a result we are seeing a move away from 'one size fits all' incentive plans to framework MIP structures that can be tailored across jurisdictions to accommodate distinct local requirements. Bargaining power will dictate the precise parameters of MIP awards. In some instances founders may be able to negotiate bespoke tax friendly MIPs while incentives available to broader categories of employee may be presented in a more neutral one-size fits all, 'take it or leave it' structure.
Leaver provisions are heavily negotiated and sponsors will have preferred positions. Founders inhabit a dual role when negotiating leaver provisions: on the one hand these are provisions that directly impact their interests (potentially causing friction with sponsors). On the other hand, leaver provisions that apply to broader management teams will see founder interests aligned with those of the sponsors in establishing economic parameters of participation in the MIP. The tension engendered by this dual role is reflected in the attention given to, and length of time that negotiating these provisions can take.
A pattern we are seeing is for leavers to be dealt with in three categories: 'good', 'intermediate' or 'very bad', with the sharpest focus on the economic implications for the latter. Where historically bad leavers might expect their rights to unvested sweet equity allocations to be extinguished, we see an appetite among sponsors to include provisions that focus on strip equity allocations for very bad leavers. In terms of economics, the question is usually what, if any, penalty applies to the strip equity. For example, parties may discuss whether there will be reduction or loss of interest on loan notes or preference shares and whether the sponsors have the right to buy back shares at the lower of fair market value or issue price. As the enforcement of leaver provisions is considered relatively comprehensively by the courts in a number of jurisdictions, the Irish market is flexible enough to respond to changing practice over time as deal party expectations and legal boundaries evolve.
Another interesting trend we are seeing is the growing presence in private equity deals of corporate finance advisory practices that focus on providing deal advice specifically to management teams. The practice hitherto has been for these firms to focus on secondary sales where management's role in a transaction can arguably be more demanding, but we are also seeing some primary transactions where these advisory firms are brought in. In either case, while this does add another set of advisors to the mix, we find they can assist with ensuring management are comfortable throughout the transaction process and can complement the advice management are receiving from their legal advisors.
Looking forward, a significant number of Irish assets are now held by private equity sponsors which are approaching end of fund life. We anticipate that as markets soften, Ireland will see a number of delayed exits and the increasing use of continuation funds in the next 18-24 months. Continuation funds have typically been employed when sponsors are unable to sell a problematic business at the end of a fund's life. They have been useful in this context because they allow the transfer of assets of incumbent sponsors between various funds without requiring a sale to a third party (sponsors 'roll over' assets from an existing fund to a new vehicle).
The use of continuation funds can provide a liquidity event for investors without requiring the sale of an asset at a cut-price valuation, although their use can be controversial due to the in-built conflict of interest engendered by having the sponsor involved on both the sell and buy sides of the same transaction. This controversy has attracted regulatory in some jurisdictions. Despite the foregoing, in a continuation fund often both sponsor and MIP participant interests can be aligned: MIP participants may be reluctant to cash out at an unfavourable time and fail to participate in the eventual growth of a company. At the same time, the sponsors may be reluctant to be forced to cash out management and risk lack of senior continuity in the business.
In light of this anticipated increase in the use of continuation funds, we expect parties to negotiations to continue to carefully examine share transfer provisions, permitted transfers and tag and drag rights, in particular around whether a sponsor can drag MIP participants into a continuation fund, and if so on what terms.
Outlook
As we head into 2023, the mounting evidence of slowing economic activity in many markets is contributing to a strong sense of investor caution. However, the fact remains that funds are sitting on record levels of dry powder which will continue to generate appetite for deals, particularly in respect of targets with strong performance and fundamentals.
As attention to ESG matters continues to permeate financial markets, investor focus on ESG as it relates to targets is increasingly at the forefront of transactions. This is reflected in a growing interest in linking MIPs to measurable management performance against sustainability metrics, a trend that is set to continue as sustainability reporting expands to pull in larger numbers of private companies. For more on ESG in the context of private equity deals in Ireland, see our previous article here.
Webinar Access
A recording of our private equity webinar is available here. This webinar provides you with 1 hour legal and general CPD for the Law Society of Ireland. You will need to log in to KnowledgePlus to access the webinar. If you have forgotten your password you can update it here. If you would like access to KnowledgePlus please get in touch with your usual ALG contact.
