Let's Explore - Do Incentives work!?

Show me the incentives, and I’ll show you the outcome.

Incentives are overlooked and not mentioned enough in PE deals.

Today, we cover:

1. Why do incentives matter?

2. How should they be set up?

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Why do incentives matter?

Let’s take a step back. What are you trying to achieve with your private investment?

Money? Success? Feeling of achievement?

The answer will differ for everybody.

Incentives understand that people have different objectives.

Organizations create value if there is a 1+1=3 combination, this does not happen unless you understand what people want to achieve.

As a result, people will work towards what’s in their best interest and your role is to align interests somewhere along the road.

Simple, not easy.

Actions have outcomes.

But, before that, actions have incentives which force a particular outcome.

Find the incentive that matches both of your outcomes.

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How should they be set up?

Incentives would most likely have to be set up for an operator of a business you own.

Firstly, as explained above, understand what they want.

Secondly, be self-aware about what you want.

It’s not always about making a buck, but about achieving success and growth together.

Now what you’ll want to do is dig deeper into the business being run:

Does it require a lot of capital to grow? (O&G/Manufacturing/Infrastructure)

Is inventory management key? (Distribution)

Are accounts receivables holding up working capital? (Trade services)

Is it being run awfully now and you’re bringing in a new operator?

Find that metric and structure bonuses on that.

For example -

You have a capital-intensive business in infrastructure that requires $10m and provides a return on capital of 10% ($1m) annually.

If the operator takes additional capital from you to produce the same/lower return, value is lost. Bonuses should fall.

If the operator takes $8m, and makes a return of 10%+, that is a win. Growth is maintained with lower capital - reducing your equity risk and need to pump cash into the business. Bonuses rise.

Try to incent someone towards avoiding stupid actions and you should be just fine.

It’s not a one size fits all solution and requires discretion. More importantly, if facts about the business or operator change, so do the incentives.

Don’t underestimate the power of incentives.

See you next week.