Preparing for equity resets in the new world

Businesses have been reacting to a tidal wave of challenges since lockdown. Many have furloughed a significant number of staff. Many are in discussion with debt providers over potential covenant breaches. Some are reflecting on what might have been, with exit goals shelved and old business plans destroyed before fruition.

However, in the coming months, it is right that minds will turn to the magic elements that bind successful management teams to their private equity backers: the alignment of the economic interests of management teams with their sponsors’ and delivering revised business plans with new and realistic exit aspirations. Ignoring the need for re-alignment hurts both management and business stakeholders.

Whilst the full impact on business generally in these ‘unprecedented’ times is still unknown, for management teams and others in the private equity community, the economic crisis of 2007–2008 provides some clues as to the issues likely to be encountered as management teams and their sponsors look to reset their management incentive arrangements, make them fit for purpose going forward and re-establish the ‘magic elements’ of the private equity model.

Don’t run before you can walk

The details behind what an equity reset might look like, or the way in which it may be structured and implemented, are secondary to the preparation and formulation of revised financials and forecasts in a business plan. This should be the number one priority for management teams and provides the foundation on which all equity resets are built. Consider carefully, and model the impact of, the winding-down of any government assistance programmes that your business is utilising or may be being utilised by customer/supplier counterparties.

This will take time and, for some sectors, more time than others. Rushing this process increases the likelihood that any new equity plan will not be fit for purpose and that it will require revisiting again before any liquidity event takes place. This will invariably divert time, energy and other resources away from businesses at the very time when such resources would be better employed elsewhere. Ensuring that any new business plan is as robust as possible is critical for making any equity reset a success.

What are the options?

As management teams begin to formulate a credible revised business plan, there will be a number of options available as to how the equity incentive plan may be revised to ensure ongoing alignment of interests between the management team, sponsors and other stake-holders. What those options are will depend on factors such as commercial and economic considerations, tax implications, the legal implications of the possible future arrangements as well as the framework of the existing arrangements. Management teams should seek early advice from those who specialise in providing genuinely independent advice to management teams in these fields. This approach will allow them to focus on running their businesses and stop them from being led up the garden path with proposals that do not work, are inappropriate or are unhelpful from a management/sponsor relationship perspective.

Consider your existing framework

When it comes to modifying the rights attaching to the securities (whether equity, debt or debt-like instruments) that form the basis of a management team’s incentive plan or even introducing new classes of security, there will be many legal issues to take into account. Typical private equity structures will comprise various features such as contractual management consent rights, shareholder class rights, statutory and/or contractual rights of pre-emption, emergency funding mechanisms (usually with catch-up rights for management) and drag rights for sponsors, some or all of which will have implications for the structuring and implementation of any equity reset.

In an ideal world, the relationship between private equity sponsor and the various members of the management team should be such that everyone is on the same page. However, this will not always be the case and understanding what the art of the possible is and where the pressure points are is vital to ensure a quick and smooth process.

Communication, communication, communication

Alignment of interests is at the heart of any private equity management incentive plan. A credible revised business plan (see above) is the cornerstone of any conversation in relation to an equity reset but, once that has been established, the risk/reward implications (and stake-holder hopes and expectations in relation to these) of what the future business performance may look like require early, open and clear communication. This is true both in relation to discussions between management teams and their sponsors as well as between members of any given management team.

Much has been written in recent years about the strengths that diversity brings to management teams, both in terms of growth potential and resilience to often damaging “group-think”. Yet this strength also brings challenges, including when establishing a collective way forward on the approach to an equity reset. A strong commitment to, and culture of, communication between the key members of a management team is the single most effective strategy to rising to this challenge and enabling management teams to develop a cogent approach to equity reset planning and negotiation that all are bought into.

Choose your advisory team wisely

Management incentive plans are very personal and emotive for managers – one of the many reasons I am passionate about and dedicated to advising management teams on these arrangements. For many managers they are the route to paying for the education of their children, finally repaying the mortgage, or providing the security of a comfortable retirement after years of hard work. These can sometimes include dealing with delicate issues which require extensive experience of working closely with management teams at the same time as demanding extensive expertise of private equity transactions and the latest developments in market practice. By selecting a team who combine these attributes and make advising management teams their principal focus, you and your fellow managers can be sure of putting your best foot forward when looking to implementing an equity reset.

If you would like to discuss any of the issues arising from this article or are considering implementing an equity reset and would like advice, please do not hesitate to contact Matthew Kichenside.