More than Management Equity Plans

Management Equity Plans (MEPs) are designed to align the interests of investors and management teams and help to better attract, retain and incentivise management talent. Yet, despite their value, MEPs are complex by nature and frequently misunderstood, or their value discounted by both prospective and current management teams, which can weaken their effectiveness. 

Further, the lack of standardisation often leads to the creation of custom MEPs for each investment—a costly and often ineffective approach. 

A poorly negotiated management reward plan can insufficiently motivate the CEO and management team or, worse, misalign the interests of management and the investor, affecting performance over time. 

Our view is that by reducing complexity, improving communication, and ensuring that MEPs genuinely motivate management teams, PE funds can maximise the potential of management incentives to assist to unlock greater value throughout the investment lifecycle.

This paper draws on the extensive experience of PwC Australia and the global network of PwC firms in MEP design, supplemented by surveys of PE funds and management personnel on the approach and sentiment towards MEPs. 

The survey results from both PE funds and participants found that MEPs were highly valued as a tool to align management with the strategy and financial outcomes of the sponsor. These findings included: 

• all PE funds rated the effectiveness of MEPs as ‘very good’ or ‘good’, with 96% saying they believed MEPs had a positive impact on attracting top management talent in Australia; 
• all participants said being offered an MEP was ‘very important’; 
• 92% of participants said their MEP was an effective incentive; and 
• 83% of participants said their MEP enhanced their day‑to‑day working experience. 

While the above sentiments are very positive and point to the continued importance of MEPs in a PE fund’s reward strategy, our view is that they shouldn’t be the only component. A typical remuneration framework is composed of fixed remuneration, short‑term incentives and a long‑term incentive, and each component plays a key role in the motivation and retention of participants over time. 

A study¹ by PwC and the London School of Economics on the Psychology of Incentives provides some excellent insight into executive pay. Three major findings are worth noting: 

1. executives in Australia and the UK are the most risk‑averse; 
2. complexity and ambiguity erode incentive value; and 
3. executives see deferred pay as significantly lower in value to its economic or accounting value—in other words, the longer an executive must wait to realise value, the less the incentive is worth to them.

Given most MEPs are complex and typically consist of one‑off grants (as opposed to annual grants) with a longer timeframe for payout (typically five years or more), participants in an MEP will discount the ‘value’ they attribute to MEPs. PE funds, therefore, should consider the need to have other reward levers they can pull to balance the long‑term and uncertain nature of MEP payouts. 

MEPs should be supplemented by a robust reward framework that includes short‑term performance‑based rewards that are in participants’ control, such as cash bonuses. A well‑designed bonus plan strikes a balance between rewarding short‑term performance metrics and longer‑term incentives, where the value is more uncertain, but the pay‑offs can be materially higher. It is important for participants to see that the bonuses are achievable. 

Our survey showed that only 50% of MEP participants found their cash bonus target was ‘attractive’, suggesting there is room for improvement here. 

Another consideration is to benchmark your remuneration packages. Research into the psychology of incentives¹ shows that executives need their pay to be considered ‘fair’ within their own company—and when compared to the market. Interestingly, it was not the quantum of the remuneration that was most important to executives, but rather how it compared to the remuneration of others. 

In that context, and as noted above, there is an opportunity for PE funds to think more holistically about their total reward offering. That means better integrating employee values and preferences, including market value—but also work‑life balance and career development opportunities—into the package. 

This could be effective where an exit event is likely to be more than three years away, and where the market for talent is highly competitive.

When it comes to the MEP component of the reward framework, one of the greatest challenges for PE funds is to avoid reinventing the wheel each time a new plan is negotiated. Having multiple MEPs within the same PE fund can lead to administrative complexity, inconsistent incentives, and diluted alignment with the fund’s overall strategy, which can hinder value creation. 

The purpose of a house view is to reduce some of the challenges with drafting and implementing MEPs. Once the foundational principles are in place, they should be tested against your overarching people strategy by asking the following questions: 

• What is the tone of the culture we’re trying to set? 
• How do we want to be seen in the market? 
• What behaviours are we trying to reward? 
• What will we lose if key people walk away? 

While there is no best‑practice MEP design per se, developing a house view on the core aspects that feed into an MEP can reduce some of the administrative and legal burden, and create clear, consistent incentives that resonate with management teams across the portfolio. In this way, a house view also creates efficiencies for the investment team.

Key considerations include:

Award instrument

The first, and arguably most important, consideration is what award instrument is the most appropriate. Choosing a default plan, with alternatives based on common sets of circumstances, is an important starting point when designing your house view on MEPs. 

For example, PE funds in Australia most commonly use loan‑funded share plans as their preferred structure. That’s because this type of plan gives participants an ownership interest. It is also tax effective, typically attracting capital gains tax treatment as opposed to income tax treatment. So, the loan‑funded share plan might be your default award instrument. 

However, loan-funded share plans are not always appropriate. For example, in cases where the MEP participant is already a shareholder, the loan‑funded shares become more complex to navigate. An alternative award instrument, such as a standard option or premium exercise priced option may be more appropriate here. 

Similarly, loan‑funded share plans can be ineffective for employees based overseas (because other structures are more common and therefore better understood in other jurisdictions). In these circumstances, PE funds could consider a growth share plan (also known as a flowering share plan) or a standard option as alternatives. 

The key is to simplify the types of award instrument on offer, and to align them to a defined set of circumstances. This should help reduce complexity and create better consistency and administrative efficiency across your portfolio.

Class of shares

The next consideration is what class of shares to use within your preferred plan. 

When using a loan‑funded share plan, for example, the default position is to create a special class of shares with unique rights, obligations, or restrictions that balances employee incentives with shareholder protections. This allows PE funds to more effectively administer the award, including in circumstances such as a compulsory divestiture. 

A common structure is for the special class of shares to carry differentiated dividend and capital rights and exclude voting rights. 

These shares can convert into ordinary shares with full rights upon a vesting or exit event. 

It is critically important to ensure that specific terms for a class of shares are clearly defined in the company constitution (or equivalent governing documents). Doing so establishes the legal foundation for how the shares operate, protects the rights of shareholders, ensures compliance, and minimises the risk of disputes. 

For option‑based awards, the options would typically be over ordinary shares.

Values of shares

Under a loan‑funded share plan, shares should be acquired at market value to ensure the tax outcome is as expected. Valuation discounts can sometimes be applied to reflect illiquidity, minority shareholder status, or restrictions, provided they are properly justified and documented. 

The market value may be verified by an external valuer, noting that the tax market value can be different to the accounting value and, in some cases, the ordinary value. If engaging a valuer, be clear on the type of valuation you need. 

More broadly across all award instruments, it is also important to have a house view—with supporting legal documentation—on how the value of shares will be determined on exit and in forfeiture events. For a compulsory divestiture, the valuation methodology should form part of the terms of the special class of shares themselves (with the value often set to a nominal value). 

In other cases, on divestiture, the plan may provide for the class of share to be varied to another class of share that will typically have no voting, dividend or capital rights, essentially turning it into a valueless share before it is dealt with (for example, via a share buy‑back and cancellation). 

This step ensures the company’s equity structure aligns with its goals, whether that’s simplifying ownership for a new buyer or complying with regulatory requirements for the divestiture.

Leavers

How leavers are defined should be outlined clearly in the terms of the MEP. 

A ‘good leaver’ is an employee or participant who leaves a company under circumstances that are generally viewed as favourable or beyond their control, including redundancy, retirement, disability or even death. 

Conversely, a ‘bad leaver’ is typically someone who resigns voluntarily, is terminated for misconduct, or breaches their employment contract. 

Good leavers may be able to retain some or all their vested or unvested awards, while for bad leavers, anything unvested will usually be forfeited. This allows for the equity pool to be refreshed for new grants to new hires. 

Clearly defining and applying good leaver provisions ensures fairness and consistency in managing MEPs during employment transitions. With that in mind, consideration should be given to the full set of circumstances that apply to good and bad leaver definitions. For example, what happens in the event of mutual termination, or if someone leaves before a set date?

Exit

Having a house view on exit provisions is also key. It may be appropriate, for example, that all awards vest on exit. Or, in other circumstances (e.g. where retention of management and/or other key personnel is key, such as many areas of the Healthcare and Services sectors) it may be more appropriate for a portion of awards to remain unvested. 

The key here is having a view on what proportion of the equity can be realised on exit, versus what proportion should be rolled over. This transparency is important for both participants and a potential acquirer. 

Given many exits now result in a secondary sale to another PE fund or to a long-term focused financial investor, knowing there are mechanisms within the rules to ensure the MEP can have a retentive effect beyond the transaction is important. The plan should provide maximum flexibility as to how shares can be dealt with on exit as the specific form of the transaction may have a tax and commercial impact. 

Another point to consider is what happens if the investment timeframe changes or, more specifically, if the exit is delayed beyond the initial expected timeframes. Under that scenario, you may decide there are no changes to the awards. Alternatively, you may look at short-term incentives, directing more value into the existing awards, or providing some artificial liquidity (i.e. allocating a portion of shares to be sold). 

According to our survey, 70% of PE fund personnel said their preferred MEP structure was a loan‑funded share plan. 

While this may be the most common MEP structure, it is also the most technically complex. Given complexity and ambiguity tend to erode the value participants attribute to a reward, it’s critical that the value of an MEP is clearly communicated—regardless of its structure. 

Our research showed that just 17% of MEP participants strongly agreed that MEPs were easy to follow and understand. Meanwhile, an overwhelming 91% of PE fund personnel acknowledged challenges in drafting and administering MEPs, particularly when trying to gain understanding and buy‑in from the participants.

 PE funds can take some of the complexity out of MEP structures through more effective communication—beyond the provision of documentation. There is an opportunity for PE funds to engage communication experts who specialise in translating technical or legal information into plain English for anyone unfamiliar with the subject matter (and including the use of visuals and examples). Our survey showed that most PE funds engaged lawyers (87%) or accountants (65%) to deliver MEP advice. Based on our survey results, a communication specialist should be considered to potentially be added to this list of important advisers.

If we look at what happens in listed companies, there has been a successful shift from sole reliance on paper documentation towards broader employee engagement, including dedicated sessions on MEPs. Employee forums provide excellent opportunities for funds to demonstrate the value an MEP can deliver, and to highlight areas that are typically less understood, including how the loan mechanism works, what happens with leavers, how the shares become vested and how the value is calculated and realised on exit. 

Armed with a better understanding of how the plan operates throughout its lifecycle—including what happens at key milestones along the way—MEP participants are more likely to buy in to the MEP and the associated opportunities for value creation. 

Importantly, communication should continue throughout the life of the MEP to maintain transparency about company performance and how it links back to the award. Without regular communication, participants can lose sight of the shared goals and objectives of the MEP. 

At the same time, the exit event can be a wonderful opportunity for the PE fund to promote the realised value of the MEP, and share the case study across their portfolio, driving buy‑in from future participants.

Unsurprisingly, our survey results confirmed that the preferred target for MEPs was the C‑suite. While senior executives have historically been the sole beneficiaries of equity incentive plans, that trend is beginning to shift. 

One reason is that broad‑based employee equity plans used to be difficult to administer in Australia. However, recent legal changes have made them simpler to implement. While broad‑based plans are structured differently to the common MEP, they tend to be more straightforward, reflecting smaller allocations. Their objective is also simpler: to create a shared ownership structure. 

By extending equity participation to mid-level managers and a broader set of key employees, funds can align incentives across a wider team, encouraging a culture of accountability and collaboration that supports long-term value creation. Broader-based plans also help attract and retain talent at all levels, addressing turnover risks and ensuring that critical contributors are motivated to work towards the fund’s goals. 

Research into employee equity plans also shows that a culture of shared employee ownership creates more resilient organisations in times of economic downturn.²

It’s no wonder that broad‑based employee share plans are gaining popularity in Australia and worldwide, to the point where employee equity has become a standard component of reward frameworks in both listed and unlisted organisations. 

Globally, the movement towards broad share ownership has included the establishment of a not-for-profit organisation to help public and private companies develop, implement, and evaluate holistic broad-based employee ownership programs.

While our survey respondents found MEPs to be an effective way to incentivise participants, they also cited challenges in dealing with ‘good’ and ‘bad’ leavers and rolling over participants at exit. This suggests more consideration needs to be given to the life of the MEP when the plan is first drafted and presented.  

While most MEPs include flexibility as to how rewards can be treated on exit, this is not always advantageous. In our view, MEP design should consider upfront how the reward will be treated on exit (see ‘Develop a house view’ above). For example, how much of the reward can be realised versus how much can—or will be required to be—rolled over? What happens if the exit is delayed? What impact does this have on retention and motivation? 

Funds may need to think about a form of artificial liquidity; for example, creating a sell‑down opportunity at a point in future if a transaction does not occur. If this route is chosen, consideration should be given to determining the triggers, as well as how much may be liquidated or sold. To the extent artificial liquidity is not included, could the MEP be made more attractive in another way? Or is it best to place more emphasis on other remuneration elements; for example, a well‑designed cash bonus plan to better provide a bridge to future exit? 

Either way, having clarity upfront around exit (or extension) rules will help manage expectations at the outset and ensure there are no surprises that could upset the end goal.