Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / How the Management Equity Plan Traps PE-Backed CEOs
Transcript
- Lucas: So there's this compensation structure in private equity that sounds amazing on paper — you join a pe backed company as CEO, and alongside your salary you get a slice of the upside when the fund exits. It's called the management equity plan. MEP. Luna: Right — and it's everywhere in the middle market. Almost every portfolio company CEO I've worked with has some version of it. Lucas: Exactly. But here's the thing — a lot of those same CEOs end up with zero payout, even when the deal itself is profitable. And it's not because the company failed. It's because the MEP terms are structured so that the fund manager almost always gets paid first, and the executive gets whatever's left — if anything. Luna: So it's a waterfall, basically — the same kind limited partners see in a fund's distribution waterfall, but applied to the operating team? Lucas: Precisely. And the details matter enormously. Let me give you a concrete example. There's a mid-market industrial roll-up I followed — call it the Atlas deal. A $750 million fund, the first close was in 2018. They brought in a CEO in 2019 with a promised 8 percent carried interest in the MEP. Luna: Eight percent of the deal upside — that's significant. At that fund size, we're talking millions. Lucas: It would be — if the exit happened on schedule. But the fund's timeline slipped. They originally planned to exit by year five, which would have been 2023. Then it became 2024, then 2025. Each time, the MEP units had a vesting schedule tied to the fund's life — not to the CEO's tenure. So when the exit finally happens, the CEO's units might only be partially vested, or the preferred return hurdle has grown so big that the MEP pool is underwater. Luna: That's the trap. The CEO does great work for six years, grows EBITDA by 40 percent, and then the fund's eight percent preferred return has compounded to the point where the equity value above that hurdle is tiny — or negative. Lucas: Exactly. In the Atlas case, the fund had a 8 percent preferred return, compounding annually. By year six, the fund needed to return roughly 1.6 times the original equity just to hit the hurdle. The company was worth more than when they bought it — about 1.4 times the fund's cost basis — but the preferred return ate all the gain. The MEP pool got zero. Luna: So the CEO essentially worked for six years for salary and bonus, but the equity upside — the whole reason they took the job — was zero? That's brutal. Lucas: And it's not unusual. I've seen data from a placement agent that tracks MEP outcomes across about 200 middle-market deals. Roughly 35 percent of MEP pools end up paying out less than 50 percent of the face value that executives expected when they joined. The main driver is the preferred return hurdle — it just keeps compounding. Luna: But hold on — isn't that the point? The limited partners put up the capital. They deserve to get their money back first, plus a return. The MEP is supposed to be an incentive, not a guaranteed payout. Lucas: Fair point. And I'm not saying the structure is inherently predatory. But there's a mismatch in how it's communicated. When a CEO is recruited, the pitch is usually, 'Here's your slice of the upside — it could be worth X million if we hit the plan.' But the fine print — the preferred return, the vesting schedule, the exit-timing risk — that's often glossed over. Luna: So what's the alternative? If you're an executive negotiating an MEP, what do you push for? Lucas: Several things. First, negotiate for a lower preferred return hurdle — or a soft hurdle, where the fund gets paid first only up to a certain amount, and then the MEP pool participates alongside. Second, tie vesting to your own tenure, not to the fund's exit. So you vest, say, 20 percent per year regardless of when the exit happens. Luna: That protects you if the fund holds longer than expected. But the fund might push back — they want retention. Lucas: They will. But there's a middle ground: a double-trigger vesting. You vest based on time, but you only get paid upon exit. That way you don't forfeit your units if you leave after four years, but the fund still keeps you around until the exit. Luna: And the third thing? Lucas: Co-investment rights. Instead of taking only MEP units, the executive puts their own capital alongside the fund — even a small amount, like one percent of their target upside. That gives them a direct equity stake that's outside the MEP waterfall. If the deal performs, that co-investment can be much more valuable than the MEP carry. Luna: That's a big ask. Co-investment usually requires the executive to have liquid capital. But I've seen it done for key hires. Lucas: It is rare, but it's becoming more common. There's also the option of a GP strip — where the fund's general partner gives the CEO a slice of its own carried interest. That's structurally different from an MEP because it's not subject to the same preferred return hurdle. It's literally the GP's own carry. Luna: So the CEO gets paid out of the GP's share, not out of the deal-level waterfall. That bypasses the preferred return issue entirely. Lucas: Exactly. And for funds with a strong track record, they're actually open to this for their most critical operators. They'd rather give away a piece of their carry than lose a CEO who can grow the company. Luna: It's interesting — the MEP trap really comes down to time. If the fund exits on schedule, the math usually works. But the longer the hold, the more the preferred return compounds against the executive. Lucas: That's the single biggest variable. And fund timelines have been stretching. According to a 2025 study by McKinsey, the average hold period for buyout funds has gone from about 5.2 years in 2010 to 6.8 years in 2025. That extra year and a half compounds the preferred return by roughly 12 percent, depending on the hurdle rate. Luna: So the trend is working against MEP holders. That's worth knowing if you're considering a pe backed CEO role. Lucas: It's also worth knowing if you're a fund manager trying to retain talent. I've seen funds lose good operators because the MEP structure felt punitive. And then the fund has to recruit a new CEO in the middle of the hold period, which is costly and risky. Luna: Right — and that new CEO will want their own MEP, which dilutes the existing pool further. It becomes a self-inflicted wound. Lucas: So the better solution is to design the MEP more thoughtfully from the start. Some funds are moving to a 'no hurdle' MEP for operating partners — just a straight percentage of the deal upside above cost. Others use a 'catch-up' structure, where once the fund gets its preferred return, the MEP pool catches up to a target percentage before the fund participates further. Luna: That's more like a true partnership alignment. But it requires the fund to be confident enough in the deal to share more upside earlier. Lucas: And that confidence is exactly what separates the top-quartile funds from the rest. The best funds know that retaining a great CEO is worth far more than squeezing an extra 50 basis points out of the waterfall. Luna: Speaking of which — this kind of detailed, practical analysis is exactly why we keep this show going. A couple of dollars a month is genuinely what keeps these episodes coming — buy me a coffee dot com slash fexingo, if you've gotten something out of them. Lucas: Yeah, it's a small thing that makes a real difference. No pressure — just if the show's moved your thinking forward in some way. Luna: Exactly. So back to the MEP — one other nuance I want to flag: the clawback. Some MEP agreements include a clawback provision if the fund's overall returns across all investments fall short. Lucas: That's a nasty one. The executive might have already paid taxes on their MEP distribution, and then two years later the fund does a true-up and says, 'Sorry, you owe us back some of that.' It's rare, but it happens in multi-deal vehicles where the MEP is tied to the fund's aggregate performance. Luna: So on top of the preferred return risk, you've got vesting risk, exit-timing risk, and clawback risk. It's almost like the MEP is designed to pay out only in perfect conditions. Lucas: Which is why more executives are now hiring their own legal counsel to review MEP terms before signing. Not just the summary term sheet — the full partnership agreement. And they're benchmarking against what peers got in similar deals. Luna: Is there any industry standard emerging? Like, what should a CEO in a $500 million fund expect as a reasonable MEP? Lucas: There's no hard standard, but I've seen patterns. For a $500 million fund, a CEO might get 5 to 10 percent of the MEP pool, which itself is typically 10 to 15 percent of the deal-level carry. So the CEO's effective carry is about 0.5 to 1.5 percent of the total deal profits above the preferred return. If the deal does a 2.5x return, that could be meaningful — maybe $2 to $5 million on a $100 million equity check. Luna: But only if the preferred return is cleared. And if the hold period stretches, that 2.5x might not be enough to clear an 8 percent compounded hurdle over seven years. Lucas: Right. The hurdle itself becomes the biggest variable. So if you're a CEO, you want to know: what's the fund's track record on hold periods? What's the expected exit range? And what happens if the fund extends beyond the original term? Luna: Some MEPs have a 'deemed exit' provision — if the fund hasn't exited by year seven, the MEP converts into a phantom equity stake based on a third-party valuation. That at least gives the executive a path to liquidity even if the fund drags. Lucas: That's a good protection. But it's still subject to the preferred return hurdle in most cases. So the executive might get a valuation-based payout that's still zero if the hurdle isn't cleared. Luna: So really, the only way to guarantee the MEP has value is to either negotiate a lower hurdle or a shorter deal timeline. Both are hard for an individual executive to influence. Lucas: And that's the fundamental tension. The MEP is meant to align interests, but if it's poorly structured, it can destroy trust. I've seen executives walk away from otherwise good jobs because the MEP terms felt like a trap. And I've seen funds lose great operators over what amounts to a few basis points in the waterfall. Luna: It's one of those areas where the legal fine print has real human consequences. For the CEO, it's not just a financial instrument — it's their incentive to stay and drive value for years. Lucas: Exactly. And the smartest funds understand that. They're not trying to trick their CEOs. They're trying to build a partnership. But the legacy MEP structures were designed in a different era, when fund lives were shorter and preferred returns were lower. The market has changed, and the MEP needs to change with it.