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Incentivising management

The approach a private equity firm takes with the management of its investments can be the difference between success and failure, both in winning auction deals and impacting exits, writes David Walker of Clifford Chance.

According to the latest global research from the Emerging Markets Private Equity Association and Coller Capital, limited partners are increasing their positions in emerging markets from 11-15 percent to 16-20 percent. Confidence is high, with more than half of LPs expecting annual net returns from emerging market private equity of 16 percent or more.

But as private equity houses search for opportunities throughout the world they have to respond to the challenges of local laws, regulation and taxes as well as being sensitive to local cultural issues, particularly as they relate to management teams.

Indeed, the approach a private equity firm takes with the management of its investments can be the difference between success and failure, both in winning auction deals and effecting exits.

In many emerging markets private equity firms will be dealing with the founder of a business and quite often with his other family members.  This can be challenging, not only because of the obvious difficulties of imposing private equity controls on an individual entrepreneur but also in trying to incentivise the rest of the management team of the business with shares.  There may be great reluctance to dilute the founding family’s equity stake to incentivise the next level of management.

This is particularly pertinent to the Middle East, where the private equity model is typically based on growth capital rather than leveraged buy-outs.  The private equity firm will usually invest at an early stage and often on a minority basis – not just because there are significant restrictions on foreign ownership but also because of the strong merchant family tradition.

Equity is not widely distributed in the Middle East for a variety of reasons.  For example, 'drag-along rights,' the compulsory transfer of shares on exit, are often not enforceable.  The result is that exits can potentially become very time-consuming and costly with widespread employee share ownership.

Clifford Chance is currently advising on a transaction in the United Arab Emirates that involves more than 30 private individual sellers.  The sales process has been held up for 12 months because one individual doesn’t want to sell.  A drag along right can, in some jurisdictions in the region, be included in a shareholders' agreement governed by a law that does recognise such rights. However, you first need the relevant individuals to be prepared to execute such an agreement. And then, enforcing rights in a shareholders' agreement that are the subject of a law which is different from that in force in the jurisdiction of incorporation of the relevant company (and thus the one to which the relevant shares are subject) can create difficult questions around conflict of laws.

An alternative to enforcing these drag-along provisions could be to structure the acquisition through a vehicle that is outside of the region and roll the managers' investments up to that level.  However, this is only possible if the investment is in a jurisdiction or sector where 100 percent foreign ownership is allowed.  There may also be a tax cost to this, and it requires a degree of sophistication from the individuals, as they may have little (if any) experience of personal taxation.  The private equity firm may ultimately need to enforce against that individual in his home state, and enforcement is not always easy: for example, if you want to enforce a UK arbitration award in Saudi Arabia, the arbitrator will need to be male and Muslim.

The situation in China has many similarities with the Middle East. The majority of deals are growth capital where private equity investors take a minority stake rather than seeking a buy-out. One key difference from the Middle East is that tax is a significant factor in determining management incentives, and the considerations in China are similar to those in the Western world: issuing shares to individuals is more tax efficient for them and their companies than granting options.

Aside from tax, the structure of management incentivisation is often driven by regulatory issues. If the private equity firm has invested in an onshore structure (directly into a Chinese incorporated company), under Chinese law, individuals cannot be direct shareholders of a company with foreign investment. So there is a need to set up a management company to warehouse the management shares. This then adds another level of complexity as the private equity firm seeks some control over the governance and share transfer provisions associated with that entity.

If the portfolio company intends to exit by way of an IPO on a mainland China stock market, the private equity firm needs to make sure that the total number of persons holding equity (including through the management company) does not exceed 200. If it does the securities regulator may not approve an IPO as it may consider that the company has already made a public offer without proper approvals.

Foreign exchange controls also create issues. In China an offer of shares in an offshore holding company to Chinese managers could trigger a filing with the foreign exchange authorities. A filing will be needed if Chinese managers need to convert Chinese currency into foreign exchange to pay for shares.

This filing is no longer easy to do in practice, and legal advisers need to consider the risks of not filing or come up with more innovative structures to comply with the foreign exchange regime.

Private equity may be an increasingly global business but when it comes to incentivising management a local approach is essential.

David Walker is the global head of private equity at international law firm Clifford Chance.