In private equity buyouts, also known as leveraged buyouts (LBOs), retaining and incentivizing key executives is critical. As a result, the management compensation structure emphasizes performance-based compensation. Key players on the management team will be awarded a number of equity-based incentives.

A leveraged buyout involves a private equity firm acquiring another company by borrowing a large amount of money to finance the acquisition. The private equity firm, referred to as the sponsor, is acquiring the company with the goal of making a profit in the next 3-7 years. The acquired company will become one of the private equity sponsor’s portfolio companies.

Retaining the existing management team is particularly important in the private equity sponsor context. While the sponsor will be providing overall strategic direction for the acquired company, the sponsor will not be running day-to-day operations of the business. The management team will be critical to the company’s success and performance-based equity incentives are a key way to retain and motivate talented executives.

There are three main categories of management equity incentives: (i) management rollover of existing equity, (ii) management co-investment in new equity, and (iii) management promote equity. The management compensation structure used in a particular LBO transaction will depend on the specific facts and circumstances.

Management rollover is common in sponsor-backed LBO transactions. If the current management team owns shares in the existing company, they can “roll over” their existing equity into shares of the new company after the acquisition closes. This is a useful technique when management already owns a significant amount of equity securities in the existing company. A key consideration in a management rollover of existing equity is whether the rollover will be tax-free. The amount of management rollover may also depend on how much dilution in its ownership percentage the sponsor deems acceptable.

Another method used by private equity sponsors to incentivize management in an LBO transaction involves allowing management to purchase new equity alongside the sponsor. This benefit is usually only offered to a couple top executives, such as the CEO and CFO, because it requires a substantial up-front advancement of cash. Such a huge cash commitment may not be feasible for most members of management. Management co-investment also carries downside risks if the portfolio company does not perform well.

Management promote or carry makes up the bulk of performance-based compensation in private equity buyouts. The compensatory equity awards can come in many forms, including as stock options, restricted stock, restricted stock units (RSUs), stock appreciation rights (SARs), and profits interests. The management promote provides key executives with potential upside gain if the portfolio company performs well, while protecting them from downside risk.

The equity securities in a management promote program are subject to vesting provisions, which can be time-based or performance-based vesting conditions. Time-based vesting means that the equity shares granted to the manager vest according to a schedule. The manager must continue to be employed on the applicable vesting dates in order to receive the equity award. This is intended to motivate key managers to stay with the company for a number of years. Performance-based vesting means that the equity awards vest only upon satisfaction of specified performance goals. The manager must remain employed with the company until achievement of the operational goals. If the executive’s employment with the portfolio company is terminated, unvested equity awards may be subject to forfeiture.