A cash incentive plan for a private equity owned firm

The challenge

Following the acquisition of a significant portfolio company, a private equity firm was looking to put in place cash incentives for the executive team that would encourage step changes in performance and substantially increase the awareness amongst managers of the importance of capital management.

The PE firm’s goals for the the first year of the investment included a significant reduction in debt through improved working capital management.  This, together with divestment of some business units, would help fund expansion of the business’ most promising division in the years that followed.

How we responded

We worked with the PE firm and the CEO of the investee company to develop a cash incentive program that would provide for annual rewards for senior and middle managers.  Importantly, the program used Economic Profit to measure performance, which effectively sets a price for the use of capital.  The PE firm was able to send a clear signal to management that capital tied up in the business came at a cost, both through the initial stages of the investment where stripping capital out of the business was important and through the growth phase, where careful investment was vital to improve the value of the business in the lead up to sale.

To encourage step changes in performance, incentive targets were set in place three years in advance, giving management the headroom to grow the business aggressively without having the targets ratcheted up, just when results where being realised and to drive accountability for performance come what may.

Finally the plan was uncapped, meaning there was no limit to how much management could earn if performance was good.  This was important to spur a more entrepreneurial mindset among the management team, many of whom had worked in large corporates most of their careers, without any meaningful level of ownership.  But to safeguard shareholders, rewards would be staggered and paid out over time, provided they were sustained.

Given the safeguards outlined above, the Board then felt confident increasing the cash incentive opportunity to more than double what it had been under the business’ previous owners.

The result

The plan has been well received by managers who are excited to participate and appreciative of the opportunity to be rewarded on an annual basis in a formulaic way.  The company’s PE owners feel the plan encourages greater collaboration between Board and management, reducing the incentive to sandbag budgets and helping to drive accountability for performance.  We have been asked to review arrangements at another recently acquired portfolio company.