What can private equity firms do to re-incentivise management if the management incentive plan (MIP) is underwater?

There are a variety of options; and which might work depends upon the circumstances. There are a number of issues to consider, such as the level of consent required to make changes to the structure. There are likely significant tax implications to consider for many routes.

The solutions that might work in one jurisdiction do not necessarily work in another jurisdiction. For example, in the US it is often easier to restructure an underwater MIP. This is because incentive equity is typically structured as profits interests, with no purchase price or taxation on issue. This makes it relatively easy to issue a new series with a threshold or hurdle at a new, lower value, resetting the economics and providing a continued incentive to management.

In the U.K., and most other jurisdictions where profits interests are not available, restructuring an underwater MIP is more difficult. This is also true in the US when, even with a lower threshold, it is unlikely that the profits interests will have value on an exit. Here is a summary of some routes to re-incentivise management in those cases:

  1. Issue a New Class of Management Equity That Sits Higher Up in the Waterfall
    If the MIP shares only participate after a certain return (IRR/MOIC) has been made by Sponsor's Strip Equity, consider introducing a new class of MIP share that participates at a lower return threshold so these new MIP shares are more likely to be in the money on an exit.

  2. Create a New MIP at the Level of a Subsidiary Company
    Equity that sits further down the stack is more likely to have value than at the top, because it will sit ahead of Shareholder Debt and equity issued by TopCo. Whilst there are complexities to introducing a MIP at a subsidiary level (and it may take some explanation to management for them to understand how this will work and why it should be preferred to TopCo equity), it is a way of creating MIP shares that can, in effect, sit alongside the Shareholder Debt (and rank ahead of or equal to Sponsor's Strip Equity). It can also avoid some consent issues as no changes will be required to TopCo Articles.

  3. Reduce the Interest/Dividend Rate on Shareholder Debt
    If the value of the MIP shares is being dragged down by the coupon on the Shareholder Debt, consider whether reducing the coupon might provide a sufficient boost to the value of the MIP shares going forward. If this has the effect of increasing the value of the shares, the reduction would generally trigger an income tax charge for the employees on the value increase. To avoid this charge, the Articles could be amended to cap the value of the current class of management equity (so that the value of those shares will not increase when the interest/coupon rate is reduced). A new class of management equity could then be introduced with a hurdle so that its value is almost nil following the interest/coupon rate reduction, allowing the managers to purchase the new class very cheaply and the new class to increase in value more quickly following the interest rate reduction.

  4. The Sponsor Could Write-Off Some of Its Shareholder Debt
    If reducing the coupon will not work to re-energise the MIP shares, the Sponsor could consider writing off some Shareholder Debt to transfer value to all ordinary shares. Again, this will likely trigger a tax charge for the employees holding the MIP shares on the increase in value of the shares. There may also be tax implications for the Company in doing this.

  5. Transferring Debt From the Sponsor to the Managers
    If it looks like value will not break into the MIP shares but the Shareholder Debt will have value on an exit, Sponsors could consider transferring a portion of the Shareholder Debt to the managers (or a ManCo to be held collectively by managers). There would be an initial up-front tax charge for the managers, but they would then have a more certain return going forward.

  6. Introduce a Share Option Plan
    Share options are generally not as tax efficient as giving managers real equity, but it is also less risky for managers because they are not required to make an upfront investment to acquire the options. This is a less attractive option in the US, where profits interests are typically available without upfront investment and superior tax efficiency.

  7. Cash Bonus
    This is the simplest solution but, as with an option plan, less tax efficient. However, if the ordinary shares and Shareholder debt are worthless and there is a chance that the Sponsor will be "handing over the keys" to the banks and walking away, a cash retention bonus is probably the only way of incentivising and retaining the management team. There is always a risk the company goes into pre-pack, in which case the company's obligation to pay the bonus will likely be set aside. In some cases, Sponsors pre-pay the bonus, subject to claw-back on resignation, to address this risk. In addition, the cash bonus could be seen as a poison pill by lenders, but this will depend on whether the banks want the management team to stay. If it is not clear whether existing equity awards will have value, the cash bonus formula can include an automatic reduction for any proceeds received from those awards, to avoid the risk of a double-dip on a successful exit.

Are There Ways To Reduce the Risk of the MIP Going Underwater in the First Place?

In the U.K., managers are often expected to pay fair market value for their equity. The more managers pay, the higher the risk of the equity falling below the original purchase price and going underwater. For that reason, it is best practice to structure the MIP equity at the outset to achieve a nominal valuation, allowing managers to pay as little as possible per share (e.g., 1 pence rather than £1 per share).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.