Incentivisation in private credit portcos: equity after taking the keys?

A key focus for any private credit providers taking control of a borrower in a distressed scenario will be ensure that there are appropriate measures to turn-around the performance of the business in question. 

There will be any number of steps which can be taken to contribute to that turn around; but in all instances, the sponsor will want to ensure that the group is managed by an appropriately incentivised leadership team and that its interests are aligned with that of the new owner. 

Creating that alignment of motivation, and end goals, will be essential.

Typical structure

Following an enforcement, or other form of distressed restructuring under which control is taken by the lenders, the new owners will often look to either write down a proportion of their debt and/or exchange that debt for a new class of equity in the borrower group. That equity may take the form of ordinary equity or a preferred equity instrument with an annual coupon. 

As part of the restructuring, lenders would typically expect to retain a proportion of their senior secured creditor position and, in all cases, the return needed to “break even” on its investment would not change irrespective of the form of instrument which it holds following the restructuring. 

The presence of potentially significant outstanding debt obligations - or a significant amount of preferred equity instruments - creates a blocker to the effectiveness of conventional incentivisation mechanics.

Private equity as a comparator

The comparator that most private credit providers first look to when designing a management incentive plan (a "MIP") is that of a private equity structure. In these structures, management would invest in both the “institutional strip”, being ordinary shares and preferred equity which sits alongside the private equity sponsor, and “sweet equity”, being an incentive share which gives management an additional slice of the upside (without the need to buy in to expensive strip equity). This sweet equity is frequently augmented by a ratchet provision which increases management’s returns where specific investor returns are met. 

The difficulty with implementing a private equity style MIP in a post debt restructuring scenario, however, is that the commercial starting points are fundamentally different: 

• In a typical private equity scenario, management will start to participate alongside the investor (via the strip) and often only needs returns to exceed a c.8-10% coupon on the preferred equity in order to see value accruing on the sweet equity. The underlying portfolio, in these cases, would often be starting from a position of strong trading with a buoyant track record. 
• In a debt restructuring scenario, a lender will typically require a minimum level of return which is higher than that of a private equity investor before management would participate in any value growth. This is because the lender will want to recoup some of the foregone debt under the restructuring (or repay any outstanding debt which remains). Further, the cost of the equity (for management) following a restructuring is likely to be much cheaper than that of a private equity comparator; resulting in less “skin in the game” on the equity held by management – a low-risk high return investment for them. This must be balanced against the steeper curve to achieving valuable returns for stakeholders.

Main incentive structures

As a consequence of the significant debt within the structure or, alternatively, the significant commercial return required by the new owner to achieve an acceptable outcome post-restructuring, establishing a MIP which solely comprises equity will often not be sufficient. Where the hurdle to achieve a return is set too high, the incentive plan will lose its purpose as the targets are simply not tangible or achievable for management. 

To that end, the most common structure that lenders adopt is a combination of equity and cash plans working in tandem: 

• The cash plan: These plans are often designed to provide a level of interim returns to management by reference to the returns that the lender receives on their debt (or debt-like instruments). Management are therefore rewarded for mitigating the lender’s exposure even in circumstances where the equity component still holds no value. It bridges the gap between the current position and a far-out target.

  The benefit of a cash plan is that it can be drafted flexibly, factoring in any and all relevant commercial terms. It can also be easily amended should the structure of the group change. There are minimal up-front costs, no tax valuations are required, and the plan involves minimal administrative requirements when compared with an equity plan, e.g. awards can lapse without the need to compulsorily transfer shares away from a departing manager. 

  The downside, of course, is that payments under a cash plan will be subject to income tax and employee National Insurance contributions (currently at a combined rate of up to 47% in the UK), as well as employer National Insurance contributions (to be funded by the group at rates of currently up to 15%). Any corporation tax deduction for the cost of the cash plan may be irrelevant in the short to medium term. 

• The equity plan: When coupled with a cash plan to provide interim returns, delivering equity to management which would accrue value in a stretch case can provide to be an effective incentivisation mechanism. 

  The psychological aspect of holding equity is an effective incentive. Management will be more closely aligned with the investors and, where there is cost to the equity, have skin in the game. In addition, there is a risk and reward element to holding equity. In the event that management (and therefore the business) perform very well, they may become entitled to a significant return which is subject to capital gains tax rates, having paid relatively little for that equity.

  The benefits must be weighed against the downsides. To ensure tax efficiency, tax valuations will need to be prepared prior to issuance of the equity instruments so that management pays the market value for their shares (or, if they do not pay that amount, so that the group is able to correctly calculate any tax payable on issuance). Additional administrative steps, and tax considerations, will arise should any changes be made to the group structure during the life of the award. In essence, equity is much less flexible than cash plans. 

An atypical alternative to achieve an equity holding for management which could deliver capital gains treatment while tracking returns on the lender’s debt is the use of a subsidiary growth share plan. This works by creating a new class of growth shares in a subsidiary entity below the level of the debt instruments (or the preferred equity). Those growth shares would typically contain rights which entitle management to receive returns which correlate to a proportion of the cash returned on, or available to return on, the debt (or the preferred equity).

Additional considerations

To ensure that the process of designing and implementing a MIP is as efficient as possible, lenders should also be aware of the impact of the following:

• Existing structures: Any existing equity or cash incentive arrangements are likely to be incompatible with the new MIP. If it isn’t possible to utilise the existing arrangements, thought should be given as to how best to close out existing arrangements without giving rise to adverse tax implications for management. 
• Valuation: Consider the tax valuation of any equity delivered to management. Although given the circumstances surrounding the creation of a post-restructuring MIP it might be assumed that the valuation of any equity is low, or even nominal. However, it is the long standing view of HM Revenue & Customs (HMRC) that incentive shares must be valued on a forward-looking basis. If the equity is designed to incentivise management then, by definition, HMRC considers that it must hold some value to the purchaser on day one. 
• Accounting treatment: Consider the accounting treatment of any incentive scheme, whether that be an equity or cash scheme, to avoid any unexpected impact on the balance sheet or profit and loss (P&L) of the borrower group during the life of the scheme which could impact the group’s financial covenants under any remaining lending facilities. It is worth noting that financial reporting implications can arise even in circumstances where management acquire equity for consideration which is equal to fair value as determined for tax purposes.
• Complexity vs simplicity: An overly complex (and costly) incentive structure will reduce management engagement. Straightforward and achievable goals that resonate with management and can be easily understood are likely to be more effective than those which require substantial effort to unpick from the complex equity documents.  

Macfarlanes is a leading legal advisor within the private credit ecosystem and has a wealth of experience in dealing with situations where a fund lender has had to take control of its borrower group. If you wish to discuss the context of this article with a member of our top-rated Tax & Reward team, please contact: 

• Rasmus Berglund;

• Robert Collard;

• Mark Petch; or 

• Jat Bains.