Common structures and key tax and securities law considerations 6 min read
According to the Australian Investment Council, private equity houses and venture capital firms in Australia have approximately $10bn worth of capital to deploy in 2023. This figure rises by many multiples when offshore private capital sources are added. However, in the more uncertain economic and geopolitical environment in which we currently find ourselves, execution of transactions and the ability to deliver growth post acquisition is more difficult. High quality management teams are essential in delivering on a private equity firm's objectives.
A core part of a private equity manager's focus for any portfolio company is how to align with, and incentivise, management to execute the PE sponsor's investment thesis and generate superior returns for all on exit. Management Equity Plans (MEPs), Management Incentive Plans (MIPs) and other similar arrangements are a primary tool to achieve that alignment and incentivisation.
No two plans are the same. In this Insight, we explore common structures and key tax and securities law considerations.
Common structures and common terms
Typically, there are two MEP structures we see in the Australian market: (i) loan funded MEP plans; and (ii) share option MEP plans. The former is where the issuer provides each MEP participant with a limited recourse/interest-free loan (or cash bonus) to enable it to purchase equity in a group company. By contrast, share option plans involve the grant of options to participants, to be exercised at a certain exercise price (commonly exercised at a future exit date) and sometimes with reference to time-based or performance-based vesting conditions.
It will come as no surprise that members of management can depart prior to exit. This means the circumstances under which a manager leaves a portfolio company are often subject to heavy negotiation. Concepts such as a 'good leaver', 'bad leaver' and everything in between (including the consequences for their management equity and any rollover equity that are triggered as a result of different categories of leaver) are key considerations in any MEP negotiation process. Similarly, the individual treatment of each manager can be bespoke (to achieve preferred tax outcomes) and is equally as important.
In our experience, the equity allocation under MEPs ranges from 5-15%. MEPs also need to be flexible enough to accommodate new participants after their establishment. New participants may join after the initial establishment. For example, the hire of a new manager to build depth of team or a new manager joining following a bolt-on acquisition. To provide for this flexibility, MEPs are generally established with an unallocated pool of equity to cater for such scenarios.
MEP terms also typically require managers to provide the requisite assistance to the PE shareholders when undertaking an exit. Negotiations around exit can involve an expectation that the manager 'goes around again' with the new owner.
Tax law considerations
When designing any plan, it is not surprising that the tax outcomes for management are front of mind. Management will not be pleased if they are taxed on grant (which is the default position if the managers do not pay market value), so plans are generally structured to ensure the taxing point instead aligns with the time they can realise value for their equity. This is generally at the time that genuine disposal restrictions are lifted or when their equity is sold, such as at an exit event.
There is no 'one size fits all' approach with MEP plans; small adjustments to the structure and terms of a plan can have a significant tax impact as the tax outcomes are largely determined by the actual terms of the plan (and not by an election made by the company or the manager). The first key consideration is whether management will be required to pay to acquire the shares or options, and whether that payment will be funded by a loan or a cash bonus from the company, as this changes the tax rules that will apply to management. From there, the considerations will differ depending on the plan structure, but will generally involve thinking about the nature of the shares (eg whether they have voting rights), the restrictions on those shares or options (especially disposal restrictions), and the mechanics to deal with leaver and exit events. The structure can be more complex where there is an employee share trust involved, particularly for a share plan.
Of course, it's not all about management's tax—the company also needs to think about whether it will have any additional reporting obligations or incur any tax cost as a result of administering the plan (eg fringe benefits tax or payroll tax). These obligations are generally manageable but are an important overlay to what is otherwise a management-focused conversation.
Securities law considerations
When structuring these plans, Australian securities laws also need to be considered. As a general principle under Australian securities law, any issue of equity (or other financial products) requires a disclosure document unless an exemption applies under the Corporations Act 2001 (Cth).
In Australia, the 'senior manager', 'sophisticated investor' and 'small scale offering (20 issues or sales in 12 months)' are common exemptions and may be relied upon to issue securities to Australian managers without a disclosure document. This is particularly important for MEPs (and for those overseas PE sponsors not well versed in securities law issues given the more limited regulation in their home jurisdictions). That said, the bespoke nature of MEPs (including the financial standing, number of offers and seniority of management who are subject to the offers) always varies and there is no guarantee that disclosure exemptions will apply to such offers. Unfortunately, class order relief from ASIC is not overly helpful either; the private nature of MEPs and value of the securities often means they fall well outside of any such relief.
In addition, PE sponsors must watch the various numerical limits on members under the Corporations Act. Issuing securities to too many members of management directly (such that the company has more than 50 registered shareholders) would mean the company is subject to Chapter 6 takeovers regime (defeating a number of the benefits of taking a company private). A bare trust holding structure is sometimes used in MEPs to work around this limitation. This trust structure involves the trustee acting as legal and registered owner of the MEP equity (for and on behalf of the underlying beneficial owners of the trust, ie the MEP participants). That said, the use of a trust structure does not disapply the requirement for a disclosure document where an exemption cannot be used. Therefore, when considering any MEP arrangements, PE sponsors need to be well versed in the exemptions that may apply.
Added complexity to negotiating incentive arrangements
It will come as no surprise that there are several commercial matters for private equity and management to consider when negotiating incentive arrangements. The increase in sophistication of these plans and the managers themselves now see some management teams engage their own advisors to represent them and to assist with this workstream, particularly on secondary buyout transactions. Whilst this approach can be useful, it can also draw out transaction timetables and add complexity during competitive auctions (notwithstanding their implementation on a post-completion basis).
From a legal and tax planning perspective, we have sought to highlight some of the key issues on which PE sponsors should seek advice when considering how to efficiently structure and implement the terms of their incentive plans in Australia. After all, the task of PE sponsors getting it right with management is hard enough without regulators in Australia telling them they have it wrong.