Most public companies have developed long-term compensation programs that measure performance metrics over time (often over three years), and that typically reward senior executives for meeting clearly identified benchmarks. These plans seek to align the interests of employees with those of owners (i.e., shareholders in the public markets). Alignment, along with the retentive value of long-term incentives, has proven to be a successful way to ensure “pay-for-performance” and continuity within an organization.
But what about the compensation plans within private companies, including family offices? Whether led by a family member or another governance structure, a comprehensive compensation program that aligns stakeholder interests is critical to a successful organization. Following the public company model, rewarding key executives for value enhancement is the cornerstone of a pay-for-performance approach to compensation planning. Pay-for-performance clearly incents internal stakeholders and aligns the interests of the family office in providing the capital for those who are directing its investments (and upon whose performance the compensation depends). Further, pay-for-performance has become an integral tool for family offices to attract and retain top talent.
Most compensation programs have a three-pronged goal to incent, motivate and retain. Prudent investment, coupled with a properly structured compensation program, enables organizations to satisfy those three prongs because the ability to tie compensation directly to profitability incents and motivates and is often an expectation of top talent. The long-term nature of many family office investments fosters retention.
Here are some key considerations and best practices for the development of compensation plans that enable family offices to engage and retain top level talent.
A well-thought-out compensation structure for executives comprises three elements: base salary, annual bonus, and long-term incentive plans (LTIPs):
- Base salary. Seemingly obvious, but meaningful base compensation rewards a professional’s time and efforts since, without guaranteed success of every initiative/transaction, compensation cannot be solely tied to successful outcomes. Otherwise, most professionals will seek to limit risk.
- Annual bonus. Although annual bonuses tend to be discretionary (see chart below), annual bonuses are useful if there are certain specific objectives that leadership would like to see achieved. For example, specific HR or operational objectives are common.
- Long-Term Incentive Plans (LTIPs). These plans intend to incent and retain talent by enabling them to create wealth alongside the family through metrics that align professionals with owners. More recently, family offices have begun to allow (or even require) their senior-most executives to co-invest (with their own funds or funds lent by the family office), which cultivates a sense of ownership and further aligns the interests of all parties.
- Vesting. Due to the long-term nature of successful initiatives/transactions, family offices often require several years of vesting even after value has been created.
It is interesting to note how many family offices report currently having short-term and long-term incentive programs.
The following two charts (per the 2018 FOX Compensation and Benefits Survey) illustrate the prevalence of short-term and long-term incentive programs at family offices:
Source: 2018 FOX Family Office Compensation & Benefits Survey
Source: 2018 FOX Family Office Compensation & Benefits Survey
Developing an executive compensation plan can also take advantage of cutting-edge income and estate tax considerations. In public companies, except in rare circumstances, taxation on compensation is at ordinary income rates. Family offices can, in most circumstances, take advantage of capital gains taxation though the use of profits interests. Structuring of profits interests can be complicated; however, the potential tax savings can be substantial.
Compensation practices within public companies are fully disclosed in public filings, which continue to become more detailed and robust; private company data that quantify executive compensation have become more accessible through subscriptions to aggregated databases. Thanks to surveys conducted and published by FOX and others, private company databases have expanded their reporting by geographies and executive level. Family offices with boards of advisors and those with family-dominated boards of directors often cite those resources as guidelines for gaining approval for high-level compensation for talented non-family executives.
Family office culture
Many talented executives come to work for family offices after success in other leadership roles, viewing family offices as an attractive alternative to the institutional environment. The appeal lies in the implied relational culture and flexible work environment of a family office. However, talent is wise to test these assumptions when negotiating employment and related compensation; those assumptions may or may not end up becoming reality, and the actual type of work environment and expectations could affect how one negotiates compensation arrangements.
Organizational culture can also affect investment direction. On the outset, understanding the level of risk a family office has experienced and is comfortable with will also influence compensation levels.
Experienced leadership is essential to developing and implementing an investment philosophy and strategy—and developing a compensation structure that attracts, motivates and retains top talent should be front and center of a family office’s hiring practices. In order to compete in today’s employment landscape, it is vital to align a compensation structure that supports the unique strategy and vision of the family office.
Jarret Sues is a managing director and co-leads the executive compensation and corporate governance practice at FTI Consulting. He specializes in creating compensation plans for public and private entities and can be contacted at email@example.com.
Mark Rubin is a senior managing director in the Private Client Tax and Advisory Services group and leads the Family Enterprise Services practice at FTI Consulting. He specializes in long-term income and estate tax compliance and planning, as well as governance planning for families and can be contacted at firstname.lastname@example.org.
David Toth is a managing director with Family Office Exchange. He oversees Research and Insights and Wealth Advisor practices. He also serves as co-leader of the Strategic CIO, MFO and Wealth Advisors Councils.
The views expressed herein are those of the author(s) and not necessarily the views of FTI Consulting, Inc., its management, its subsidiaries, its affiliates, or its other professionals.
FTI Consulting, Inc., including its subsidiaries and affiliates, is a consulting firm and is not a certified public accounting firm or a law firm.
©2019 Family Office Exchange. All Rights Reserved. Except as expressly permitted in the CLA, Licensee shall not modify or create derivative works from this FOX publication without the express written consent of FOX. Licensee may not remove, obscure, or modify any copyright or other notices in the FOX publications. The views contained within this publication are those of the authors at the time of writing.
On December 5, 2018, the Manchester office of Nixon Peabody LLP hosted a Hot Topics in the Middle Market event entitled Private Equity and M&A Outlook: Trends and Opportunities. NP partner Andrew Share moderated a discussion featuring the following speakers:
- Alan Fullerton, Partner, Mirus Capital Advisors
- Andrea Haddad, Tax Senior Manager, Ernst & Young LLP
- Bill Lemos, Resident Sales Director, Aon
- Ivan Pirzada, Managing Director, Brown Brothers Harriman
A summary of the panelists’ observations on the current state of the Private Equity and M&A market and investment trends and opportunities is as follows:
Trends and Opportunities: The panelists agreed that 2018 was a hot seller’s market. In today’s remarkably strong M&A and private equity market, sellers have been able to extract high valuation for businesses. Health care and technology are both industries that did very well in 2018. Physician groups have also become important players in the middle market. Looking into the next year, investors have little concern about interest rates and there is an expectation of continued growth. The panelists expect some softening of the M&A market, but overall are optimistic.
Tax Reform: The panel discussed the effect of the Trump tax plan on the deal community, and general concerns regarding anticipated tax reforms. The panelists anticipated that issues relating to flow-throughs and international tax reforms may be unfavorable for the intercompany perspective in 2019. Currently the comment period for new tax regulation is open and proposed international provisions will add an unknown layer regarding flow-throughs to individuals.
Diligence: There was general consensus among the panelists that investors have shifted their approach towards diligence. Although acquirers remain careful with their budgets, due to the strength of the M&A market fewer acquirers are able to remain competitive that refuse to do financial diligence before exclusivity. However, with the hot market some companies are rushing into the market without first adequately preparing themselves for the diligence process and the potential new tax issues. Another trend is that diligence of target's use and deployment of software is occurring in most deals, not only technology deals, as buyers are increasing their emphasis on the value of intellectual property in deal valuation.
Tariffs: The consensus of the panel was that the primary uncertainty regarding the global economy revolved around potential new tariffs. This is especially the case for the technology and chemicals sectors, both which face increasing exposure due to tariffs.
Family offices, which are providing billions of dollars to a wide range of investments, are gaining speed in the world of private equity. But as their popularity continues to increase, so does the competition to raise funds from these investors. How can private equity players best position themselves to successfully access that collection of capital?
There are two central interrelated components to successfully raising funds from family offices, according to Angelo Robles, founder and CEO of the Family Office Association: preferred access and effectively communicating value. Those who are looking to raise funds from family offices would do well to critically analyze their approach to both of these principles.
Preferable means of access include specialized forums and working through professionals, such as high-end lawyers and accountants and retained intermediaries. However, there is room for significant growth when it comes to inroads to family offices. Research suggests that family offices are struggling to identify and motivate professionals to provide vetted introductions. The private equity funds that are taking the initiative to sensitively market to these potential investors, such as by leveraging thought leadership content, are reaping the benefits of their efforts. Firms need to give careful and creative thought as to their avenues to this attractive source of capital.
Once a private equity fund gets the introduction, however, it must be attentive to how best to communicate the value of the investment to the family office. The pitch that has been compelling to countless other investors may well be lost on the family office. The conversation must be geared to this specific audience in order to maximize the success of the messaging. Therefore, understanding how family offices think of value is critical to tailoring this presentation. Critically, traditional thinking may not make the grade.
In fact, there is evidence that family offices are reassessing traditional approaches to asset allocation. The 2018 FOX Global Investment Survey reports that less than a third (29%) of family office respondents reported that they use quantitative modeling to determine asset class allocations and position sizes, a core tenet of academic finance and the typical approach of many investment advisors. Nearly two-thirds (65%) of family office participants rely on the traditional building block of “asset classes,” with the remaining 35% considering other asset categories (such as portfolio objectives).
This dynamic, i.e., trending away from conventional thinking in portfolio construction, may be caused by family offices’ interest in direct investments in operating businesses and real estate. Of those that use the quantitative model to determine asset allocations, 42% exclude direct investments from the model-driven outcome. Importantly, 55% of all participants report that they do not include direct investments in operating businesses in their asset allocation. Family offices view these direct investments in operating businesses as an opportunity to invest in companies that they expect to grow, with strong returns, over a longer time horizon than typical private equity funds. Bearing this information in mind may help a private equity fundraiser to have the conversation around investment in a manner that speaks to the way that a family office sees value.
Private equity firms increasingly view family offices, which have the funds and a strong interest in alternative investments, as good potential investors. Successful access to that market is keyed off of the ability to make contact with the family offices and, once contact has been established, to have a productive and persuasive conversation about the value of the proposed investments. Those private equity firms must focus on framing their discussions around value in a way that reaches these investors and suits their appetites for investment, which will require going beyond conventional thinking.
In the deal world, speed is prized and often, a key tool in establishing a competitive advantage. A quick response can signal the extent of a party’s interest, and executing a transaction expeditiously can be beneficial and sometimes, necessary to protect one’s leverage position (e.g., sellers in an auction setting).
However, patience can also be a valuable tool, particularly for family offices and the unique benefits that arise from their more “patient capital.”
As anyone involved in a recent auction process can attest to, it is a seller’s market. With all the “dry powder” waiting in the wings, rising multiples and seemingly shrinking supply of quality assets, the current environment for deal-making has become intensely competitive. Along with that, the question of – how to win deals and/or source proprietary deals – has grown in prominence, not only for traditional sponsors but also for family offices, given the growing trend of family offices making direct investments.
Much ink has been spilled on the answer to this question, and a comprehensive answer is beyond the scope of this article. Suffice it to say, the answer lies in a combination of different factors including the fundamental economics (i.e., being the highest bidder), existing relationships, and specialized or industry knowledge.
That said, one key competitive advantage for family offices is the more patient or long-term nature of their capital. Traditional sponsors typically have a four- to seven-year holding period that’s driven by the need to deliver a return within that timeframe to their limited partners. However, family offices are able to invest with substantially longer holding periods because their capital does not face the same kind of expiration date, and their investment goals stretch well beyond the next four to seven years.
Often, sellers will have concerns regarding the long-term legacy of the business, retention of the employees and “slash and burn” approach of compromising long-term growth for short-term gains – even when they don’t have a vested interest in the business after the transaction. It is in these types of situations that “patient capital” can play a key role in alleviating these types of concerns. This is especially true in smaller, low- to mid-market transactions, where the parties frequently have a more-personal relationship with the business (e.g. founders, multi-generation family owners) and ascribe a greater value to the “intangibles” involved in a transaction.
Ultimately, the fundamentals will still be the fundamentals. The highest bidder will typically carry the day, and an appeal to “patient capital” is not likely to overcome a substantial difference in purchase price. Nonetheless, “patient capital” is a unique competitive advantage for family offices, which they can use to differentiate themselves and open the door to transactions that may otherwise be closed.
A recent decision from Delaware’s Court of Chancery (the “Court”) makes clear that parties entering into an operating agreement for a noncorporate entity have wide discretion when structuring the rights of controlling and minority investors. It is possible for parties to waive fiduciary duties they might otherwise be owed, or to empower boards to engage in conflicted or self-interested transactions, and rarely will the implied covenant of good faith and fair dealing be available to a party seeking relief from onerous or unfair terms to which it expressly agreed. This freedom when contracting underpins the attractiveness of limited liability companies and limited partnerships; however, investors need to be mindful of potential outcomes permitted by a target entity’s governing documents in order to avoid a bad deal. The Court will not save them.
In Miller v. HCP, decided by the Court on February 1, 2018, a minority investor in a limited liability company challenged its board’s decision to sell the company without an auction process. The majority of the board was allied with a controlling shareholder entitled to the bulk of the modest sale proceeds due to the particulars of the entity’s operating agreement, whereas the minority investor who filed suit would receive very little compensation unless the company was sold at a much higher price. The board had little incentive to seek bids beyond what would satisfy the controlling shareholder and in fact did not pursue a fulsome auction process despite indications that other bidders might have been willing to pay significantly more for the company. The minority investor raised objections during the sale process and later claimed that the board breached its implied covenant of good faith and fair dealing by failing to try to maximize the sale price.
Significantly, under the terms of the operating agreement, the parties waived all fiduciary duties and granted the board sole discretion in pursuing a sale with an unaffiliated third party. The Court reasoned that the implied covenant of good faith and fair dealing—which is available to address contractual gaps the parties did not anticipate when negotiating the operating agreement —could not be invoked by the minority investor given there was not in fact a contractual gap implicated by the sale. Rather, since the operating agreement included an express waiver of fiduciary duty and a grant of authority to the board with respect to a sale process, and the slanted waterfall provision in black and white, the minority investor was stuck with the deal.
This unbending contractual overlay on the noncorporate form is in contrast to the world of corporations, where different standards of judicial review apply and boards have fiduciary duties to other investors that may not be waived. While the case remains subject to appeal, minority investors in LLCs or limited partnerships should be cautious since they choose to forego the statutory and common law protections tied to the corporate form and therefore must live with the operating agreement bearing their signature.
On February 8, 2018, the Los Angeles office of Nixon Peabody LLP hosted a Hot Topics in the Middle Market event entitled Private Equity Outlook: What is Next for Investing in Health Care. NP partners Stephen Reil, Jill Gordon, and Matt Grazier moderated a discussion featuring the following speakers:
- Len Anderson, Managing Director, LHA Capital Partners
- Jonathan Bluth, Sr. Vice President & Head of the Healthcare Group, Intrepid Investment Bankers
- Steven Shill, Partner/National Leader, BDO Center for Healthcare Excellence & Innovation
- Srin Vishwanath, CEO and Co-Founder, GreenWave Health Technologies
A summary of the panelists’ observations on the current state of the health care industry and investment opportunities is as follows:
Trends and Opportunities: In today’s health care market, private equity investors increasingly have the option to invest in patient-centric, cash-pay companies rather than providers that primarily rely on government and third party reimbursement models. The panelists agreed that behavioral health, including the areas of addiction, autism, and other mental disorders, represents a new frontier in the health care industry and has become increasingly viewed as an exciting area of investment. Growth in the behavioral health industry is being driven by an increasing awareness of, and a lessening of the historical stigmas associated with, mental health issues. Coupled with the sense of urgency that often accompanies patients seeking behavioral health treatment (who are increasingly connected to behavioral health communities via the internet and social media), the industry has transformed into a high cash pay, high volume and high growth sector. In addition, the panel recognized that there has been a stratification of the behavioral health field, with certain areas migrating toward in-network coverage while others remain out-of-network and primarily cash-pay. This has created a dichotomy in the sector which presents opportunities for investors. Going forward the question of whether behavioral health will be able to demonstrate patient outcomes and value will remain the critical questions for the industry and its investors. Finally, the rise of digital health has led to an explosion of international investment and medical tourism, with international investors, often from China, exporting diagnostic and digital medicine models to their home countries.
Dedicated Health Care Funds: The panel discussed the recent rise of health care specific private equity funds that not only have a high level of understanding of the field’s regulatory concerns, but also strong relationships with regulatory agencies. In the past, less-sophisticated investors have had difficulty understanding health care business valuations and deal structures due to an inability to economically quantify the industry’s risks. Now, industry savvy investors are differentiating themselves through depth of reach and connectivity. Coupled with their newfound regulatory expertise, many health care-centric private equity investors are able to not only identify appropriate targets and close deals but, post-closing, they are able to fundamentally change the growth trajectory of the target business and drive the value needle.
Digital Apps and Devices: There was general consensus among the panelists that investors are increasingly looking outside of the four walls of the hospital to alternative investment opportunities in patient-centric care. Specifically, ancillary services have become a primary area of focus as a way to identify and eliminate adverse events, and ultimately as a means to reduce the overall costs of care. In particular, investment in companies providing health services digitally through digital apps and devices and through telehealth and telemedicine (the panel used the example of rural hospitals accessing physician specialists through web and phone conferencing applications). These companies are disrupting the industry, blurring the lines of how and where care is provided and effecting how providers are paid. This growing portfolio of health care / technology hybrids has created ample opportunity for private equity investors looking for targets and, ultimately, returns.
2017 was a year of some apprehension for dealmakers. Political uncertainty in the United States and the Eurozone dampened the global economic outlook and many dealmakers remained hesitant to pull the trigger on potential transactions. In the end, however, many of these fears proved unfounded. 2017 saw steady economic growth in the United States, an economic recovery in the Eurozone, economic resilience in China and a bullish stock market (all buoyed by supportive monetary policy from central banks). As 2018 gets underway, Deloitte reports
that 68 percent of surveyed executives at U.S.-headquartered corporations and 76 percent of leaders at domestic-based private equity firms believe deal flow is set to increase in the next 12 months. For the private equity industry, this may mean that, at least in the near term, good times are ahead.
As with other dealmakers, private equity mergers and acquisitions activity in 2017 lagged behind past years due to political and regulatory uncertainty and sky-high asset valuations. Though these concerns may carry over into 2018, a massive stockpile of dry powder (a result of years of strong fundraising activity) and continued macroeconomic growth will compel private equity sponsors to seek out and close new deals. At the same time, private equity mergers and acquisitions activity in 2018 will be heavily influenced by high transaction multiples, a continued lack of high quality assets in the market and competition from strategic buyers. To maneuver in this environment and still generate the returns expected from their asset class, private equity sponsors will seek to be creative in how they approach deals in 2018. Some will look to an increasingly diverse set of transaction structures beyond the traditional buyout model, including minority investments, joint ventures and other partnerships between private equity sponsors and strategics. Additionally, private equity sponsors will continue to hone their sector expertise as a way to differentiate themselves in an overcrowded market, drive deal value and compete with rival strategics. Finally, the middle-market will remain particularly attractive for private equity mergers and acquisitions as even large sponsors will move down market in search of quality assets and add on acquisitions to drive growth in their existing portfolios.
On the wary side, private equity sponsors will likely experience increased competition in 2018 from strategic players as organic growth remains elusive. A raging stock market coupled with the newly reduced corporate tax rate will (presumably) augment corporate balance sheets and provide strategics with even more ammunition for acquisitions. In the middle-market private equity space sponsors will face increased competition from direct investors and family offices. Family offices in particular can offer long-term investing strategies, patient capital and a more personalized message to those family owned businesses that are looking to take chips off the table rather than completely exit.
Regardless, 2018 is poised to be a strong year for private equity mergers and acquisitions. Political uncertainty in 2017 proved to be little match for the resolve of dealmakers, and there is little reason to believe 2018 will be different. Despite an increasingly crowded field of competitors, private equity sponsors that are able to take advantage of sector specializations and craft creative deal structures will be well positioned to ride the tail winds of the current macroeconomic growth cycle and find returns for themselves and their limited partners.
This week, Nixon Peabody issued its 16th Annual MAC Survey, which reviews the material adverse change provisions in M&A deal documents to gauge what is market in terms of the deal protections afforded by MAC clauses. The survey analyzed over 200 publicly filed M&A agreements involving deals with values ranging from $100 million to over $85 billion.
Our annual review of MAC clauses in acquisition agreements over the past 16 years has evinced a dealmaking climate highly sensitive to developments both in the United States and globally. Each year, the survey provides a renewed opportunity to examine the market’s responses to shifts in the myriad economic, geopolitical and societal forces that shape the manner and environment in which M&A transactions are executed. With each survey we conduct, we capture a more robust picture of M&A trends.
We hope you enjoy reading this year’s survey. We will continue to monitor closely how the dealmaking market responds to these and other developments in the years to come. The survey can be found on Nixon Peabody’s web site by clicking this link
As the Republican tax reform bill moves closer and closer to becoming law, private equity dealmakers are scrambling to analyze its impact on their business models. This comes at a time when private equity firms in North America are under pressure to deploy more than $500 billion in dry powder, according to the Wall Street Journal
The boon: lowering of the corporate tax rate
If the tax reform bill successfully passes in its current state, the effective tax rate for U.S. corporations will be reduced from 35% to 20%. This reduction may, for a variety of reasons, lead to increased private equity deal activity in 2018 and beyond. First, the reduction would have an obvious positive impact on the rates of return private equity firms would realize in future deals. As private equity firms scrutinize their models, deals that would have been non-starters in light of the current corporate tax rate may suddenly become viable. Additionally, strategics looking to divest underperforming and non-core business units may look to accomplish these divestitures through outright sales rather than tax-free spinoffs, potentially bringing additional quality assets to market, thus lowering current valuations. Finally, a reduction in the corporate tax rate will be a boon for private equity portfolio companies, leading to, potentially, increased exit opportunities.
The bust: capping interest deductions
The tax reform bill also proposes reducing companies’ ability to deduct interest payments. Though the calculation is subject to change, the bill’s current form would cap the amount of interest expenses companies can deduct from their taxes at 30% of EBITDA. Private equity dealmakers worry this cap on interest deductions would stifle private equity dealmaking going forward. First, a cap on interest deductions would limit the amount of debt private equity buyers could pin to target companies, curbing potential returns. Second, the cap may reduce the type and quality of assets private equity firms will be willing to pursue. For example, companies in highly cyclical industries (such as construction or heavy equipment, which see significant shifts in EBITDA and are prone to particular suffering during recessions) may become unappealing targets or see their valuations plummet. The current Senate proposal is even less forgiving and proposes capping the interest deduction at 30% of earnings before interest and taxes, but not depreciation and amortization. This would make capital-intensive businesses (such as oil and gas or telecommunications) less attractive. Overall, capping the interest deduction amount could force private equity dealmakers to rethink the leverage-heavy buyout model and may lower the amount of potential targets, raising valuations for those targets that do come to market.
There can be no doubt that if the tax reform bill becomes law the private equity industry will experience some degree of upheaval. Private equity dealmakers will have to run the numbers individually to see if the benefits of a lower corporate tax rate offset the negative effects of capping interest deductions. However, as with any upheaval, those dealmakers who are able to get ahead and adjust to a shifting regulatory landscape will find opportunities.
It's no secret that 2017 has seen a “boom” in the fundraising space, with capital raised at an all-time high since 2007
. While this is a positive for fund managers and investors, alike, both should keep in mind the impact this increased activity has on the market, specifically with respect to fund managers’ ability to attract investors and what this increase means when it comes to eventually deploying available capital.
Competition to attract investors
Despite an increase in the number of funds being raised, including first-time funds, the vast majority of fund managers have expressed that there is more competition than last year to attract investors to their funds
. Many fund managers rely on a solid base of repeat-investors who have been satisfied with the fund’s prior key terms and economics. But, with the increase in the number of funds, fund managers may need to pay more attention to the terms they offer investors and be more willing to negotiate such terms in order to maintain their historical investor base and attract new investors. In this regard, investors (and fund managers) may want to be mindful of the investment limitations given the larger fund sizes and increase in available capital.
Along with the increase in the number of funds, there is a significant increase in the amount of available capital, which could lead to greater competition for deals, and, in turn, higher pricings for such deals. Therefore, investors should consider middle-market exposure—which could preclude potential overpriced valuations—by targeting companies not typically on the radar of the mega funds and not as likely to go through an auction process. And, while the mega funds have seen an increase in the overall size of such funds, middle-market funds account for a greater number of final closes, thus far, in 2017, so there are ample opportunities for investors