Hold onto your hat(s): fitting together different viewpoints on PE transactions

When a private equity investor approaches a business, much of the focus is naturally placed on valuation, growth plans and the transaction process itself. However, for management teams, the journey is often more nuanced. For many senior executives, a transaction can represent a significant personal milestone. They may have the opportunity to realise some of the value they have helped create while also reinvesting alongside the incoming investor.

Unlike selling shareholders exiting the business whose primary concern may be achieving maximum value for their shares now, management teams frequently find themselves wearing several hats at once. They are not only considering their own personal position and future incentives, but also their responsibilities as leaders and stewards of the business moving forwards.

Balancing these competing interests is an often under-appreciated aspect of a private equity transaction and can be an important factor to get right for the long-term success over the investment period.

The ‘personal’ hat

On the one hand, senior executives are negotiating their own personal arrangements, including:

• the level of cash they receive on completion;
• the extent of their ongoing investment in the business;
• the risk and reward profile of any equity rollover; and
• alignment with the investor’s vision and timescales.

These are entirely legitimate considerations. After all, their commitment and alignment are often central to the business plan and ultimately the investment case.

Naturally, they will want to preserve as much value in their shareholdings as possible by ensuring that any leaver provisions and restrictive covenant obligations are fair and proportionate should they ever leave the business. These are entirely rational considerations for individuals who have invested significant time and effort in building the business, but they must tread carefully so as not to give the wrong message to the incoming investor who has chosen to back the team to deliver business growth.

The ‘business’ hat

On the other hand, as leaders of the business, they must also consider what protections are required if another member of the management team chooses to leave following completion. In those circumstances, the focus should be on ensuring that the business has appropriate safeguards in place, for example through share vesting arrangements and restrictive covenants that provide the business with a reasonable period of protection, that incentivise long-term commitment and ensure a level of fairness amongst the remaining management team.

This can create an inherent tension and is often where a significant amount of time and negotiation focus is spent. The same executive who, in their personal capacity, is advocating for maximum value protection and minimal restrictions may, in their capacity as a leader of the business, recognise the importance of robust retention and protection mechanisms applying across the wider management equity pool.

The challenge is not choosing one perspective over the other but recognising both and striking an appropriate balance. It is, therefore, important for management teams to discuss these issues openly and at an early stage with their legal advisers and the investor, ensuring that the equity arrangements support individual incentives while also protecting the long-term interests of the business and all its shareholders.

The strength of a management equity structure is measured by its ability to achieve precisely that balance: rewarding and retaining key individuals, whilst providing the business with appropriate protection should circumstances change.

Which hat fits?

A useful question for management teams to ask themselves or their lawyer throughout a transaction is: “Which hat should I be wearing?” However, problems can arise when one perspective is considered to the exclusion of the other.

The strongest outcomes are typically achieved where senior executives acknowledge both viewpoints from the outset and work with their legal advisers to strike a balanced position. After all, the objective is not to choose one hat over the other. It is to make sure both still fit once the deal is done.