Give up your equity
Driving returns with deeper ownership
Happy Sunday. Let’s get started:
Some private equity firms have keyed in on a strategy to boost their returns by giving up more of their own equity.
While counterintuitive, the equity in question isn’t just getting thrown out the window — it’s being granted to portfolio company employees across the organization, including the rank and file traditionally left out of executive-focused grants.
Fund administration firm Carta reports that, through Q2 this year, nearly 36 percent of private equity-backed companies granted equity to non-management employees. A big jump up from 2021’s 25 percent.
What’s the Play?
CEOs and senior executives routinely receive equity-heavy compensation packages based on conventional wisdom that the structure drives both retention and incentive alignment with private equity owners.
The logical next question — why wouldn’t this work for every other employee?
Private equity’s new thesis is that, if implemented properly, broad equity participation should drive a host of improvements across the organization. Increased buy-in and retention are obvious first-order goals, along with less-obvious second-order improvements like improved happiness and reduced workplace injuries.
If you ask Matt Nord, Apollo’s Co-Head of Private Equity, he’ll tell you that the opportunity to actively participate in value creation improves employee well-being (Apollo associates may disagree). At least at his portfolio companies, Nord believes “If [they’re] happier, they’re going to stay and they’re going to be more productive.”
Happiness and Returns
More importantly, for most investment professionals, the strategy could dramatically improve investment outcomes.
Pete Stavros, KKR’s Co-Head of Global Private Equity, is perhaps the most ardent supporter of broad-based employee ownership programs and has built an impressive track record, particularly with KKR’s CHI Overhead Doors deal.
Immediately following KKR’s 2015 CHI acquisition, Stavros communicated his plan with employees: hit KKR’s hurdle and receive an equity payout that scaled upward with returns and tenure.
An eventual 10x return, KKR’s most successful deal in more than two decades, led to a $360 million windfall distributed among 800 employees.
Stavros credits a company-wide ownership mentality with dramatically altering the trajectory of the investment. Incentive alignment led to real behavioral changes, such as that of truck driver Larry Beal, recounted by Stavros in an HBS case study:
Gradual employee-led correction of previously accepted inefficiencies compounded into meaningful value creation, boosting a 20 percent EBITDA margin to nearly 35 percent by exit.
Less concrete HR metrics also flashed green — employee survey participation jumped from 30 percent pre-grant to 80 percent post, while employee satisfaction took a U-turn from 90 percent below the company’s benchmark to 60 percent above.
At exit, Stavros ventured out onto the factory floor to announce payouts — employees who had only just started went home with $20,000, while the most-tenured earned nearly $800,000. After hearing their numbers, the collective factory floor cried tears of joy, according to that same case study.
While HBS’ account reads as a sort of private equity savior complex, the reality is that the Stavros-led initiative drove a huge win for all involved.
And, though CHI is an outlier, this success has been replicated numerous times across the more than thirty investments in which KKR has leveraged a similar approach.
Execution does come with its own unique challenges.
Most investment professionals have experienced their fair share of communication and comprehension difficulties when delivering standard equity grants to senior management (for which some threshold financial acumen is assumed).
Grant communication to everyone else, likely without any corporate finance expertise, can be considerably more difficult.
An added barrier is the ingrained distrust common among American workers — directed to ownership generally, but particularly toward private equity, with whom they may have had an unpleasant prior experience.
At CHI, Stavros had to resort to an early cash dividend to prove the ownership scheme was real. Without immediate proof, he believes, there would have been limited progress.
The company also invested in a series of mandatory educational workshops, bringing in Goldman and EY to lead sessions focused on financial literacy, and going as far as opening individual Fidelity accounts to safeguard distributions.
A Trend, or Economic Realities?
Remember that Carta data on grant prevalence? Nearly 44 percent of recipients were employees in the IT sector (compared to a maximum 15 percent among other sectors).
While non-management equity participation may be growing, the trend appears driven as much by labor market realities (competition vs. FAANG and VC-backed startups) as any growth in investor appreciation of the possibility for improved operational performance.
We’re also fresh off a historically tight labor market, particularly for blue-collar and service roles. Deeper equity participation may have been seen as a temporary recruiting and retention tool — something to be reversed when economic conditions deteriorate.
Either way, rate hikes and weakened demand will reduce the number of homerun private equity exits over the coming years. Success stories to the degree of CHI are unlikely to be the norm.
Where Do We Go From Here?
Many firms do consider ownership expansion, but get hung up on whether there really will be financial justification.
Others, particularly less well-resourced firms in the lower middle market, may simply get scared by the thought of maintaining such a deep cap table.
Stavros has opted to take matters into his own hands, founding Ownership Works, a non-profit tasked with advancing organization-wide equity participation. He’s managed to sign up more than 60 participating firms, including Apollo, Ares, Leonard Green, Silver Lake, TPG, Warburg, and, of course, KKR. Each participant has pledged to institute employee ownership at a minimum of three portfolio companies by year-end.
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• Shaking off early concern over deteriorating financial performance, Arm is nearing a blockbuster Nasdaq offering that could value the business at up to $52 billion.
• That’s up from the $32 billion SoftBank paid to acquire Arm in 2016, a less than impressive gain benchmarked against public markets.
• Softbank is planning on selling just $5 billion of its holding, delivering a relatively small float (against strong demand), sparking analyst concern that Arm may trade at an artificially inflated valuation.
• They’re probably right — SoftBank is planning on borrowing against the Arm shares it maintains and is thus incentivized to maximize their ongoing value (even more so than usual).
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• Terms haven’t yet been disclosed, though management did note a combination would be called Smurfit WestRock, trading on the NYSE with headquarters in Dublin
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• The likely near-term outcome is plant closures, with capacity consolidated into lower-cost facilities. WestRock has already started, announcing a planned September closure in Tacoma, WA that would eliminate 400 jobs. Though there could be a silver lining — some city residents are cheering the closure of a mill partially responsible for the “Aroma of Tacoma,” an odor likened to rotten eggs or dog food.
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