Two nations united with an uncommon language?

Private equity management terms have sometimes felt like a battle between the rules of cricket and baseball: a game where the Yankees arrive at Lords or an England Test XI find themselves in Fenway Park.

Years ago, I acted for the management team as part of a private equity auction process of a UK business. The bidders were European funds apart from one US institution: how times have changed. The European funds delivered up their responses to the proposed UK-style equity term sheet in the usual way, whereas the US bidder sent across a slide-deck containing its proposed US-style equity incentive package. It might have been better for management, it might have been worse; no one knew. It was a short, sharp process and there was simply not enough time or inclination to unpick the economic and commercial framework so it could be effectively evaluated.

This is an extreme scenario and I have not seen anything too similar since. That said, the conflict, and sometimes blurring in distinction, between US-style and UK-style equity terms can still cause issues for management teams in understanding the merits of what is being offered. In highly competitive auction processes where management teams can sometimes be ‘king-makers’, it could be an issue for sponsors as well. What sponsor wants to lose out on a prize asset because, liked as they were by management, the sponsor did not table something that was sufficiently capable of comparison with other proposals?

As the core investment principles of US sponsors and UK sponsors are the same, in an ideal world, sponsors and management would land in more or less the same place. But there is often an overemphasis on form over substance in ‘What’s market?’ and how equity plans are presented to management teams: inertia from the days when the US and UK markets were more separate. The use of performance vesting in the US and equity ratchets in the UK is one such example of this. I hope to discuss others in the coming months.

Performance vesting vs equity ratchets

In the US, management’s incentive equity (‘sweet’ in UK parlance) has traditionally contained an element (usually 50% or less of a manager’s total incentive participation) which is subject to vesting based on the satisfaction of certain performance hurdles. These are often constructed by reference to money multiple calculations, the sponsor’s internal rate of return, a combination of the two or (less frequently) EBITDA targets.

In the UK market, performance vesting has rarely featured due to a number of legal and tax issues, none of which I propose going into here. However, the goal (rewarding outstanding management performance in an aligned manner) is the same as an equity ratchet in the UK: management receive a larger sweet equity participation on exit subject to the satisfaction of certain (MoM/IRR) performance criteria.

Pre-Covid, there were discussions in the market as to whether ratchets were in decline in the UK in favour of more generous day-one sweet equity pots. If this was a trend, ongoing market uncertainty as lockdown restrictions are lifted may well result in pressure for its reversal. Understanding the performance vesting / equity ratchet interplay is therefore more relevant than ever when considering transactions with a transatlantic element – whether because of management team composition or the geographical flow of capital involved.

Your audience and putting your best foot forward

Given the same economic outcomes that the two structures offer, it is perhaps surprising that not more attention is given to what is appropriate for the management team in question and, in auction processes, what the team are likely to be familiar with and what other bidders might propose.

It may be unwise to put James Anderson (for US readers, an English fast bowler) up against Paul Goldschmidt (for UK readers, an MLB big hitter). If the process is a UK process, consider the benefits of framing the incentive package in a way that is relevant to the market and which your audience will be familiar with. If you are a US sponsor and usually have performance vesting within your equity plan proposals, work with your corporate finance and legal advisers to achieve the same economic and commercial goals using an equity ratchet. If the process is a US process and you are a UK sponsor, consider whether expressing any ratchet proposal in performance vesting terms will create better mood-music for management, assist them in comparing different proposals and, just maybe, help win the battle for hearts and minds.

Have the right bat

Looking beneath the linguistic differences in how US and UK equity plans are expressed could help sponsors put their best foot forwards in any process, resulting in win-win situations for sponsors and management teams and strengthening their ongoing relationship. The US and UK markets are playing the same game; they just need to make sure they have the right bat at the right time.

Matthew Kichenside is a leading private equity management lawyer who has acted on some of the most high-profile transactions and complex equity plans in the market, frequently with a transatlantic aspect. If you would like to discuss any of the issues arising from this article, please do not hesitate to contact him.