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Paying up for management

The management teams at private equity portfolio companies in Europe are asking for higher equity values of the business – and getting it. Separate financial advisors, long-standing management teams and secondary sales will likely sustain the movement towards enhanced management equity yields.

Frank Ballantine is a partner and co-head of the emerging growth ? venture capital team at law firm Reed Smith in Chicago. He can be reached at +1 312 207 6462 and at fballantine@reedsmith.com.

The most successful management teams running European private equity portfolio companies are negotiating for themselves dramatically larger pieces of the increased equity value when their business is sold, without increasing their investments when the private equity fund comes into their company. In some cases, the management team is receiving for its services 50 percent or more of the increase in the equity value of the business. These remarkable results upon sale of the business are coming in part because management is sticking together as a team while private equity owners come and go.

Enhanced management compensation
Historically, one would expect management's participation in the equity value of the business to be in the range of 15 percent to 30 percent. One private equity investor observed that ?ten years ago management teams got maybe 10 percent of the equity for meeting their projections.? More recently, several UK and continental private equity investors and investment bankers reported management compensation arrangements under which the management team could realize 50 percent to 70 percent of the equity value of the business (i.e. after deducting funded debt).

Two examples illustrate the sort of deals that have been struck. A UK investment banker reported a private equity transaction structured to provide 60 percent of the equity value to the investors until the value at the time of sale exceeded a four times increase over their original equity value. Once the exit value exceeded the benchmark, the equity split reversed and management received 60 percent of the equity value ? 60 percent of the entire equity value, not just of the excess equity value over the benchmark.

In another instance, the management of a French business received a scaled participation in the equity return, again without any absolute cap on the amount they received. At 15 percent annual return on the investors' original equity, the management team received 20 percent of the total equity value of the business; at 25 percent annual return on investor equity, management received 40 percent of the total equity value; and at 35 percent annual return on investor equity, management received 50 percent of the total equity value.

Conditions enhancing management's yield
Perhaps these arrangements are nothing more than the natural consequence of an overheated market; too much capital chasing too few quality deals. Also, because relatively vast amounts of equity and debt have been seeking deals, company ownership has been turning over as quickly as two years, rather than the typical three to five, or even seven, year model. One might expect management compensation arrangements to return toward historic norms as the private equity market moves down from its peak.

But even in a historically ?normalized? market it appears that the best and most committed management teams will be able to negotiate these sorts of pay packages for themselves. The instances of enhanced management returns that market participants reported shared several common attributes:

  • ? The company was much sought after by multiple investors;
  • ? The management team was highly respected; and
  • ? Perhaps most significantly, management ? rather than the supervisory board or shareholders ? controlled the decision on which suitor would get the deal.
  • An example that suggests a narrow opportunity for management to enhance its participation in equity value involved a target company described as making ?an unusual product,? which was a prominent leader in an industry sector in which three funds were ?desperate? to make an investment. Management controlled the selection of the investor and reaped the yield in equity value.

    Not every aspiring management team will be able to exact the premiums we're discussing, particularly in a softening investment market. But three structural elements appear likely to sustain this movement toward enhanced management equity yields:

  • ? The appearance of specialized investment bankers advocating to and negotiating on behalf of management;
  • ? A European tradition of continuity of management; and
  • ? The rise of the market for secondary, and subsequent, sales of portfolio companies among European private equity firms.
  • Consider each of these in turn
    The practice of management teams being represented separately by financial advisors appears to be of recent vintage. Several firms ?have developed a visible specialty advising management teams on their compensation,? according to one investment banker who is not in that business. If this practice becomes more widespread, one can anticipate that such targeted financial advice, deal savvy, and negotiation assistance will help even lesser management teams achieve enhanced equity participation.

    Much more significant in its influence, it seems, is the European predisposition toward continuity of management teams. One continental market observer said, ?Our management teams are sticking together over time, while the LBO funds come and go, turning over ownership in three years and sometimes less.? He continued, ?the culture isn't ?management for hire? in Europe.?

    This longevity of management teams enhances their power to select investors and negotiate their deals. In part this is because ?not many investors will buy businesses without management continuity? observed one market participant. It reportedly is exceptional for European private equity funds to begin with research to identify a promising market sector in which to invest, then for them to identify a business leader to build around, and then to buy a platform company in the sector for the leader to run and on to which to add acquisitions.

    Concentrated influence
    So, even if management is not separately advised, its influence shapes the employer's investment bankers' advice and conduct. An investment banker who does not represent management says that these circumstances ?create some interesting confusion. We used to devote 80 percent of our energy to existing investors and about 20 percent to management in seeking a mandate [to sell the business], about proportionate with share ownership. Now it's almost reversed because to get the mandate to sell the company we need management's approval.?

    It is not clear that this management power is detrimental to the interests of selling shareholders. For example, in one reported auction of an established middle market business, the winning bid was 22 percent above the second best bid, but management of the selling company strongly preferred working with the second bidder. In the end, the second bidder increased its offer to match the higher bid, and won the company. ?That's a lot of power for a minority investor,? an investment banker observed. ?You don't find that in the shareholder agreement.?

    Finally, the rise of secondary resales of private equity backed companies to other private equity firms enhances the power of management to negotiate its own deal, not least by educating the managers about the stakes. Secondary resales have increased significantly within the past decade. One investment banker reported handling the first third-time private equity sale of a French business in 2005, which may be sold a fourth time in 2008. A UK private equity investor described a fourth time deal in which his fund is invested.

    As investors come and go while management continues, one can expect capable executives to learn a thing or two in the process. One private equity investor in European mid-market buyouts says that management's knowledge of how financial value is created in their operating companies leads to increased demands the next time around. When he is buying secondary deals from other private equity funds, he has known management to say ?we know what we have done? in creating value ?and we want more next time.? For example, in one secondary transaction, a UK private equity investor reported that the CEO had no equity in the sale transaction and the CFO had ?a bit of equity.? The entire team was ?looking at rolling over €1 million($1.5 million) out of €40 million,? but they ended up with 70 percent of the equity return in the next transaction.

    Over several sequential transactions, the potential arises for continuing management to eventually own the entire equity outright, with debt as the sole financing. First there is the potential for management to roll over its investment gains in one round to own a larger piece of the next investment in the business that they continue managing. One observer also suggested that the rise of mezzanine funds willing to place their debt into sponsorless transactions improves management's chances of eventually becoming its own employer.

    Several circumstances may reduce European management teams' ability to capture for themselves larger portions of the increased enterprise value they help create. Business cycle declines may contribute to slower growth in company values or may put capable management teams on the street, available to replace existing management. Reduced amounts of capital seeking deals could reduce management's power as auction fervor softens. It could also extend the time required to build value between sales of the business, so that even if management has continuity with the business as it changes owners, there will be fewer transactions offering chances for managers to increase their equity participation over the course of a career. The opportunism that characterizes so many US executives in shifting careers across companies, market sectors, and geography could become more widespread in Europe, reducing the number of management teams that stick together over time.

    Despite the potential for one or more of these conditions to arise, however, it appears that the structural elements observed by European investors and investment bankers alike offer significant and sustainable support for European management teams seeking parity with their investors in splitting the returns they create together in private equity backed businesses.