Private Equity Club 2008 - PwC

Private Equity Club 2008Exploring what’s on the horizon*

*connectedthinking

2PricewaterhouseCoopers LLP

Management Incentive Schemes and Participation

Ashley CoupsPrivate Equity Assurance Leader, PricewaterhouseCoopers


Management Incentive Schemes and ParticipationTuesday 9 September 2008

David PayneDirector, PricewaterhouseCoopers

Management considerations

Julian SansumPartner, PricewaterhouseCoopers

Benchmarking management packages

Fiona TalbotDirector, PricewaterhouseCoopers

Tax considerations



David PayneDirector, PricewaterhouseCoopers



Management Considerations

•Management equity – conventional wisdom

•Trends across Europe

•Challenging environment for management equity



Conventional wisdom- Align management interest with focus on capital growth

Debt

Additional financing PE House(Subordinated debt, preferred shares, etc)

Earnings Growth

Shareholder

Value

EnterpriseValue

Enterprisevalue

Sh

areh

old

ers

Val

ue

Time

‘Sweet Equity’

Multiple Arbitrage

ENTRY EXIT



Trends across Europe

• General investor focus on capital gain• Generally capital gains taxed at lower rates than income across Europe• Actual or shadow equity used subject to local jurisdiction (cf USA)• Ratchet mechanisms often used in Secondaries

• Pan-European Anglo Saxons typically more generous cf local (esp inBenelux, Scandinavia & Nordics)

• Annual cash out bonus reduced in favour of capital growth

• Management awareness of Buy-out mechanics is generally high except inCE Europe



Challenging environment for management equity

• 2006 & 07 multiples at historic high

• 2008 multiples now reflecting current environmentValuationMultiples

• Banks generally looking to reduce exposures & increasereturns

• Buy & Build support difficult to obtain

• Reaction to under-performance

Post-crunchdebt markets

• Economic downturn across UK and Europe

• Top-line growth looking much more challenging

• Manufacturing, Automotive, Retail & Services affected

Currenteconomic

environment

Prevalence ofSecondaries &

Tertiaries

• Level of appetite of primary management

• Second tier investment may be based on ‘one way bet’

• Attract and Retain of best talent

• Time horizons moving out




- Equity growth via only debt repayment significantly reduces equity return

Debt

Additional financing PE House(Subordinated debt, preferred shares, etc)

Shareholder

Value

EnterpriseValue

Enterprisevalue

Sh

areh

olde

rsV

alue

Time

‘Sweet Equity’

ENTRY EXIT

Earnings Growth




• Re-structuring may wipe out value of mgt’s rollover• Senior team appetite effect at most important time (trading & banks)• Investor appetite for equity reset at time when all shareholders having

difficulty• Importance of reputation for working our situation

• Re-focus on income• Greater understanding of the risk, risk of over-reaction• Bench-marking of packages more important

• Financial issues for individual managers• Second tier very likely to borrow for secondary / tertiary deals• Conflict of interest for primary buy-out team



Summary

• Economic environment leads to increased risk of problems

• Mgt understanding of risks relating investment changed

• Change in population of available mgt

• Valuation reduction ultimately favours new deal environment



Julian SansumPartner, PricewaterhouseCoopers



Benchmarking Management Packages

Topical reward issues

1. Positioning incentive packages

2. Tier 2 plans

3. Reducing costs

4. Post IPO plans



Comments on current PE model

• Typical private equity structures are strongly geared to the delivery of valuethrough management equity

• Expectation of return moving from a few years to 5 years +

• Listed companies geared around 3 year rolling periods

• Considerable recent growth in value for listed incentives

• Need to consider remuneration model typical in listed environment forcomparison



Key features of plc and PE reward at senior levels

Listed Private EquityElement

Market median Lower quartile - medianBase

Modest ModestBenefits

Some DB, move towards DC,especially FTSE 250 DC or nonePension

• Annual awards• Basket of financial metrics (EPS,

FCF, EBITDA, sales, margin,ROCE, EVA, etc) and personal

• Upper quartile for topperformance

• Annual awards• Based on financial performance

(EBITDA, cash), not personal• May be ahead of market for

exceptional performance

Bonus

• 3 year rolling (annual) awards• Based on performance linked to:

• relative TSR• financial measure (e.g., EPS)

• Metrics not well understood• No personal investment• Modest gearing• Wide participation, 3-5 layers

• Single award, 3-5 year exit• Exit value is clear target• Substantial personal investment• Much higher gearing than plc• Narrower participation, say top 5-

10• By far the largest part of the

package

LTIP



Positioning incentive packages

• Rational model for PE house to set value of incentives

• Linked to benchmarked values in listed / survey information

• Reduce risk of overpaying or underpaying

Performance

Gain

1. Listed plans – lower leverage

a) Where should PE line bepositioned?

b) What slope should it have?c) Where should it cross the listed

line?

2. PE plan – higher leverage



Tier 2 plans

• Some medium / long-term incentive common below top tier in listedcompanies

• Competitive pressure means private equity owned businesses may needto respond

• Equity pot too distant / used for top management

• Cash alternatives worth considering



Tier 2 plans

• Gear up annual bonus & defer

• Quickly builds to major lock in

• Leavers mean bonus % can be increased

Year 1

£

Base

Bonus

DeferredBonus 1

Base

Bonus

DeferredBonus 1

DeferredBonus 2

Year 2

Base

Bonus

DeferredBonus 1

DeferredBonus 2

Year 3

DeferredBonus 3

Pays

c0.5 -1 x base deferral



Reducing costs

• Employment tax efficiency• Pension salary sacrifice, travel & subsistence, canteens, etc• Company cars v private, private fuel

• Salary costs• Benchmark

• Organisation design• Monks 6 Factor system provides objective approach to rightsizing

Ideal organisation design? More typical organisation design?

Bloated middle / senior management



Post IPO incentive plans

• PE businesses have been successful using PE pay model

• Concerns around adopting full listed model on listing

• Efficient approach:• Benchmark packages to latest listed company practice• Develop hybrid arrangements using the best of PE and listed

company models• Avoid randomisation / lack of correlation prevelant in some listed

plans• Consult with Remuneration Committee• Consult with shareholders• Develop all employee plans



Summary

• Current market means deals may take longer to exit• Need to consider competitive pressure for management talent + tier 2s and

below• Good benchmarks can be achieved by looking at the listed sector



Fiona TalbotDirector, PricewaterhouseCoopers



Tax considerations

•Income vs Gains

•Trends across Europe

•Underwater schemes



Income vs Gains

Income rates• Vary across Europe with higher rates in Nordic territories and Western

Europe (40% - 50%)• Some Eastern European territories have lower rates (13% - 30%)

Capital rates• Have traditionally been lower, ranging across Europe between 0% and

30%

Social taxes• Watch Western Europe (and Hungary) which have uncapped social tax

obligations



Income vs Gains

Current trends• Social tax obligations has always meant that non-employment income

favoured• However, across Europe we are seeing a convergence of capital and

investment income rates, e.g. Spain with a flat 18% rate• Or rates which differentiate types of income, e.g. investment income

and dividend income attracting different rates of tax



Income vs Gains

Impact for management schemes• Depending on territory, management team members may be happy or

want to take investment income rather than gains• Differing tax rates in each territory could mean offering a mix of

securities• Continued focus on moving away from employment income if at all

possible




Some territories have started to focus on the taxation of managementparticipation (and PE executive returns)

Focus varies between territories but falls broadly into three camps:• Investor status of management team member• Valuation of management securities• Recharacterisation of management securities




Investor status of management team member:• Leaver provisions (e.g. Sweden, Denmark)

- Does the use of leaver provisions link the security to employment with theresult that all returns should be chargeable as employment income?

• Share rights (e.g. Germany, Austria)- Do “vesting”, leaver or any other provision call into doubt whether

beneficial ownership of the security has passed. Is the tax point delayed?

• Investment amounts (e.g. France)- Is there a real, meaningful investment amount at risk to demonstrate

investor status?




Valuation of management securities• Capital structure (e.g. UK)

- Does the capital structure, and in particular the coupons onshareholder debt, provide values above par for managementsecurities?

Recharacterisation of management securities• Returns on PE deals (e.g. Netherlands)

- Potential specific rates of tax for investor income?



Underwater Schemes

• Management equity can be underwater for a number of reasons

• To maintain goal congruence and incentivisation impact some restructuringmay be necessary

• Two main areas of focus• Shareholder debt which stands ahead of equity• Equity itself

• The objective of any restructuring to move value into the ordinary equity(which management hold alongside the PE house)



Underwater Schemes

• Quantum of shareholder debt can have the effect of creating too high ahurdle before management equity is “in the money”

• Original structuring would utilise shareholder debt so that if interest isdeductible the group has a Corporate Tax shield

• If this shield is no longer required and the group has CT capacity then canwaive shareholder debt to lower hurdle on the equity



Underwater Schemes

• Accruing coupon on shareholder debt contributes to the hurdle onmanagement equity

• If a CT deduction is no longer required then consider “turning off” theinterest

• Again, this has the impact of reducing the hurdle and thereby increasingvalue of equity



Underwater Schemes

• If corporate restructure going on, then management can hold equity at thatNewCo level

• NewCo capital structure can reflect the desire to increase management’sshare of equity

• The type of restructuring will depend on the group’s needs

• The economic impact of the route chosen will need to be thought through –lowering the hurdle will give a different outcome to increasingmanagement’s percentage of equity for example



Underwater Schemes

• Banking and/or shareholder docs can prohibit restructuring – can anyoneblock?

• Tax will be triggered if management receive, howsoever, positive value

• In ALL cases reduce the hurdle on managements’ equity so that it is justbreaking the surface and able to breath but DOES NOT come out of thewater



Summary

• A changing landscape

• Renewed focus on management participation by tax authorities

• Changing economic climate has seen management returns falter

• Getting managements’ tax position right can have a material impact ontheir returns

This publication has been prepared for general guidance on matters of interest only, and does not constituteprofessional advice. You should not act upon the information contained in this publication without obtaining specificprofessional advice. No representation or warranty (express or implied) is given as to the accuracy or completenessof the information contained in this publication, and, to the extent permitted by law, PricewaterhouseCoopers LLP,its members, employees and agents do not accept or assume any liability, responsibility or duty of care for anyconsequences of you or anyone else acting, or refraining to act, in reliance on the information contained in thispublication or for any decision based on it.

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Private Equity Club 2008 - PwC