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E-MailHannah Reich is a Consultant and Erin Bass-Goldberg and Michael Marino is a Managing Director at FW Cook. This post is based on their FW Cook report.
A recapitalization can give a private equity portfolio company the financial foundation for its next phase of growth. It can also create a compensation problem when the restructuring materially changes the equity available to management. When pre-recap awards are cancelled or replaced, management may emerge with materially lower incentive value and retentive equity just as the company is asking the team to rebuild enterprise value and deliver the sponsor’s investment thesis.
We call this the post-recap compensation dilemma. Sponsors understandably want to manage dilution following a restructuring, but changes to the post-recap equity structure can materially reduce the number or value of shares available to management. The result can be a meaningful gap between the value of original equity awards and replacement awards, with an even larger gap in potential realizable value at exit.
This gap matters. A management team that has navigated a restructuring is often being asked to execute an ambitious operating plan, restore growth, and ultimately deliver a successful liquidity event. Replacement awards with materially lower value can reduce the motivational power of the program at a time when alignment and retention become especially important.
Closing the entire gap with equity, however, may require dilution beyond the level sponsors would support. Post-recap compensation should therefore reflect the economics of the new capital structure, with the objective of retaining key leaders, restoring meaningful incentive opportunities, and reinforcing the operating path to a successful exit while preserving the sponsor’s approach to equity dilution.
A strategic approach is to preserve scarce equity for ownership alignment while using a performance-based cash LTIP to reward execution against the value-creation plan.
Strategic approach – accept the dilution constraint and tie cash to the value-creation plan
A pragmatic response starts by accepting the post-recap equity constraint and designing the new program around the capital structure that now exists. The recapitalization creates an opportunity to reconsider where scarce equity will have the greatest impact. Companies can prioritize equity for executives with the greatest influence on long-term shareholder value creation, while a performance-based cash LTIP award supplements smaller equity awards or serves as the primary long-term incentive for selected employees.
The objective generally should not be to restore all lost pre-recap value, but rather to provide a meaningful incentive opportunity that reflects the company’s go-forward economics and value-creation plan. The appropriate level will depend on the magnitude of the value gap, retention considerations, and the amount of equity available within the sponsor’s dilution constraints.
Equity should remain the primary source of ownership alignment and participation in sponsor returns. A cash LTIP can serve a complementary purpose: bridging a portion of the value lost in the recapitalization and providing a visible path to earning value while replacement equity begins to vest.
The cash LTIP should reinforce the operating performance that drives enterprise value. For many portfolio companies, EBITDA may provide the clearest metric because of its direct relationship to valuation and the sponsor’s investment thesis. A multi-year program can establish annual EBITDA goals based on the long-term plan, with annual payouts providing clear line of sight to performance while preserving a longer-term orientation.
One practical structure provides a threshold payout for performance modestly below target, interpolates between threshold and target, and caps payouts at 100%. This structure reserves leveraged upside for the equity program. The cash LTIP instead restores a defined amount of incentive value and rewards execution against the operating plan. This helps keep the design straightforward: equity captures the upside from enterprise value growth, while cash reinforces achievement of the financial plan.
Using the same financial metric in both an annual incentive and a cash LTIP requires clear differentiation between the two plans. The LTIP goals can be established at grant based on the multi-year value-creation plan, while annual incentive goals continue to be set each year and may incorporate other financial, strategic, or individual measures. The LTIP can also be structured to be self-funding, with performance goals measured net of incentive plan costs.
A refreshed equity program paired with a targeted cash LTIP can provide a practical balance between management incentives and the sponsor’s dilution objectives. Equity preserves ownership alignment and participation in long-term value creation, while cash can address a portion of the immediate incentive-value gap without requiring additional equity dilution.
The two approaches below can help mitigate common risks associated with cash LTIP awards in post-recap environments.
Mitigating potential pitfalls
A) Implement cash LTIP catch-up provision to recognize uneven path of long-term value creation
Value creation often follows an uneven path, particularly following a recapitalization. Cash LTIP catch-up provisions can recognize that value creation often follows an uneven path while maintaining accountability for performance. A company may fall short of an interim objective because of timing, market conditions, or investments that support stronger results later in the performance period. Permanently forfeiting an opportunity following each missed interim objective can place excessive weight on near-term results, while automatically restoring missed opportunities can reduce accountability for underperformance. Catch-up provisions offer a middle ground by allowing some or all initially unearned cash LTIP amounts to remain eligible based on subsequent performance.
For example, an amount not earned based on an interim performance measurement could remain eligible if specified performance conditions are achieved later in the performance period. A catch-up provision can provide an additional long-term mechanism, with achievement of a critical final-year EBITDA objective allowing remaining unearned amounts from earlier measurement periods to be earned.
Importantly, the design should preserve meaningful downside. The final-year performance objective can serve as the decisive condition for recovering prior shortfalls, with achievement allowing carried-forward amounts to be earned, but performance below the objective resulting in permanent forfeiture of those amounts. This approach provides flexibility around the timing of performance while maintaining accountability for delivering the long-term results that support the sponsor’s return.
B) Plan for award outcomes in the event of an early exit
The LTIP should also contemplate a successful liquidity event before the end of the performance period. If the sponsor achieves an earlier-than-expected exit, the plan can recognize that value creation at the time of the transaction. Future tranches could become payable at target when an IPO or sale meets a clearly defined enterprise value, MOIC, or other return threshold.
A precise definition of the qualifying event strengthens the design. Acceleration should correspond to an outcome that delivers the level of shareholder value contemplated by the program. The plan should also establish the treatment of amounts carried forward from prior-year performance. The company can choose forfeiture or acceleration based on its objectives, with the rule established at grant so participants and sponsors understand the economics from the outset.
