Increased Use of Equity-Based Comp Challenges Portfolio Companies

However, the survey by PricewaterhouseCoopers also found that these equity-based incentives could have unanticipated accounting consequences.

The high incidence of awards found by the survey, suggests that they are becoming a recurring part of management compensation, as opposed to a once-off award for conducting a successful buyout.

In addition, the survey found that portfolio companies are also using more time-based and pro-rata vesting than ever before, in line with public company practices.

Appreciating in Value

The average portfolio company CEO is expected to hold stock that appreciates $5.6 million over three years, while the top five executives collectively can expect aggregate equity appreciation of $14 million, the survey found.

In addition, the typical portfolio company expected its equity to double in value over three years, with 35% the median annual appreciation rate expected.

While equity compensation practices are in place at virtually all of the portfolio companies surveyed, only half of the private equity sponsors consistently followed established guidelines when awarding stock to portfolio company executives.

And many portfolio companies don’t structure these compensation programs to provide both performance-based incentives and favorable accounting treatment.

Variable Accounting

The survey found that about a third of portfolio companies have, at some point, used equity structures that require variable accounting and the attendant charge to earnings.

This occurs whenever the number or price of the underlying shares is unknown on the grant date. This tends to happen with incentive instruments that vest only when specific performance goals are met. Nearly a quarter of the companies in the survey grant such awards.

Fixed Accounting

While time-based equity grants employ fixed accounting, and usually no earnings charge, their effectiveness as an incentive tool is questionable since continued employment is often the only vesting criterion.

Grants that accelerate vesting if performance goals are reached, while retaining a time-vesting feature known as Time Accelerated Restricted Stock Awards, may be a better option, since the offer real incentives without diluting earnings.

Underwater

The survey also found that nearly two-thirds of private equity firms had at least one company in their portfolio with underwater options. Nearly half are doing nothing except waiting the market out.

Although this may be an appropriate strategy for weathering short-term market volatility, options that remain underwater for any period of time lose all incentive and retention value.

The survey, examined 51 portfolio companies of 19 private equity firms, looking at investments made during 1999 and 2000.

– Camilla Klein                  editors@plansponsor.com