In every control private equity transaction, one of the most important jobs of the new owner(s) is to ensure management is properly incentivized to get the most out of the business. Because at the end of the day, PE investors are not the ones running their businesses day to day, and all the best financial modeling in the world will not mean anything if the business does not end up meeting the financial plan laid out in the model. So how is this challenge typically addressed? 

The most obvious solution is closely diligencing and picking the right management partner, which is addressed in far more detail in the Private Equity Training Curriculum. Another solution is simply offering to pay the managers running the business very large salaries and/or bonuses to encourage them to do their best work. However, the downside to this approach is that most salary and bonus compensation is linked to short-term performance (quarterly or annual results) and thus does not necessarily align management’s incentives with the investor’s longer-term horizon of 3-5 years or more. 

In order to address the issue of “short-termism” described above, most PE firms will turn to a third solution, which is the use of equity incentives, most commonly in the form of stock options. The use of options and other equity incentives ensures that a significant portion of management’s expected windfall is aligned with their PE owners in terms of when (at exit) and how (only after a good return or at least a return of capital for the investors) it will be realized. And while there are certainly pros and cons  to equity incentives and equity-based compensation, the literature – which, due to data limitations, draws primarily from the public markets – generally supports the fact that when more of a management team’s compensation is tied to equity instruments like options, the companies they run tend to perform better.   

Before we get into the nuts and bolts of equity incentives and how they are modeled, it is worth considering one extreme example of the role these type of incentives can play in incentivizing performance and their importance to management. Back in the early 1990s, when former CEO Wendelin Wiedeking joined the company, Porsche was a struggling brand that was bleeding money. Frequently, in turnaround situations like the one Porsche found itself in, it can be very difficult to attract and retain good managers. However, Wiedeking and Porsche found a way to make joining and revitalizing the company a more appealing proposition for the CEO (who went on to turn around the company and lead it to great success over more than a decade): 

When he took the position, [Wiedeking] negotiated a seemingly moot provision in his contract that would give him 1% of the company’s annual profits as bonus – in the unlikely event the company ever turned a profit. The company was losing $150MM a year at the time; no one could’ve foreseen how lucrative that provision would turn out to be. 

Though he was later criticized by investors and outside observers for what became a staggering compensation package, Wiedeking stood by the maxim that continues to drive the widespread use of equity and other long-term incentive programs in private equity and elsewhere today: “I think when the company does well, then those who have contributed should share in that.”   If managers know they are in a position to be well-rewarded for creating value over the long term, they are much more likely to stick around and do so.