Infrastructure funds are embracing management equity incentive plans (MIPs) to incentivise management teams and foster co-ownership of a business, say Peter Workman and Oliver Williams.
Management equity incentive plans (MIPs) have long been used by the buyout industry as a way to incentivise a management team. MIPs are used by private equity houses to align the interests of the sponsor and those of the top management team and to change the mind set of management from that of employees to that of co-owners of the business.
Typically, MIPs were used on high value transactions (>100m - 1bn+) within the private equity market where an equity stake in the business was (and still is) seen as an effective way to align the interests of the sponsor and the management team. In recent years, however, some clear trends have emerged which show MIPs being used in transactions of all sizes and across a range of asset classes.
Increasingly we see MIPs used in transactions from the highest value, to mid-sized and lower value deals (single digit millions). In addition, whereas previously, the use of MIPs was limited to traditional private equity buy-out structures, we now see them appear across a range of asset classes including real estate and infrastructure.
Two clear drivers
Two clear drivers of these emerging trends are evident. Firstly, real estate and infrastructure funds are becoming increasingly wise to the fact that MIPs can be an extremely effective way of aligning the interests of the fund with those of management and thus helping to deliver the desired returns for all. Giving the management team the ability to realise a significant gain based on an IRR metric that tracks the underlying required return to the fund can result in a good deal for investors and management alike and can be used as a tool to motivate senior management team members who may not be similarly enthused by the possibility of a couple of extra points in a company’s LTIP plan.
Secondly, the widespread nature of private equity-backed companies within the economy has resulted in an increased awareness of MIPs by management teams operating in various industries and market segments. This in its turn leads to an expectation that some form of MIP will be offered, over and above any existing cash-based incentive or LTIP. Certainly, a MIP is likely to be expected by an experienced management team or a management team who has previously worked with a private equity backer.
Infrastructure funds are clearly embracing MIPs and many of the terms of traditional buyout MIPs around leavers, drag and tag provisions, and liquidity events have been incorporated (with certain modifications) into the MIPs used in the infrastructure sector. The long term nature of an infrastructure fund does present some challenges for the structure and implementation of a MIP however.
A typical private equity buyout MIP may intend an exit within four years. An infrastructure fund typically deploys ‘patient capital’ where investment horizons can span 10-25 years or more. A management team may not be willing (or able) to work to these timelines and will be looking for an exit event in around five years. Aligning these competing objectives can be challenging. One way that funds have overcome this misalignment is to use ‘synthetic exit’ structures.
Synthetic exit structures
A synthetic structure assumes a specific investment period at the end of which a liquidity event is deemed to occur, depending on the performance of the business during the prior five year period and whether, at the deemed exit date, the required IRR/return metrics for the fund are met. Any payout to management will depend on the performance of the business. If the equity is underwater at that point or the business is subject to cash constraints that prevent a pay out, the management may be offered the option to roll over into the next five year incentive plan.
Offering a synthetic exit structure gives rise to many commercial considerations (including, for example, who has the right to trigger the payment (does management or the sponsor have the right to put?); what should be the impact of over performance or (from the management’s point of view) a change in market conditions giving rise to underperformance within the sector?). Regardless of whether a fund is willing to accommodate a synthetic exit structure commercially there are still significant tax, legal and valuation considerations which will need to be carefully considered to ensure that the structure works from management’s, the fund’s and the business’s point of view.
MIPs appear to be here to stay and their use across the deal value spectrum and asset classes is likely to increase. Market trends suggest that both management teams and investors see the value, in terms of incentivising management and aligning the interests of the management team and the investor, that MIPs can deliver and infrastructure funds are increasingly adopting this form of management incentivisation.
The nature of the infrastructure asset class presents its challenges, not least in terms of the mismatch of expectations between management and investors when it comes to liquidity horizon. However, notwithstanding these complexities, the increased use of this form of incentivisation in the infrastructure sector suggests that both the funds and management teams recognise that the benefits to all stakeholders of implementing a well-balanced plan can outweigh the complexities of doing so.
Peter Workman and Oliver Williams lead the management advisory team at PwC.