Contrary to popular opinion, private equity firms are interested in risk mitigation first and value creation second. The private equity deal structure reflects this. In aggregate, the components of the deal should protect the private equity firm on the downside and incentivise the management team on the upside. This typically suits the risk profiles and expectations of each party.
Consequently, unlike venture capital, a private equity deal structure reflects more than just money for stake; there’s some sauce involved too. The following points discuss some of the components of a private equity deal that lead to the aforementioned risk and return profiles:
- Clawback (or ratchet or valuation adjustment mechanism): a clawback involves a condition whereby the private equity firm’s stake in the business increases (and the management’s stake decreases) if the business doesn’t meet certain earnings targets. The purpose of the clawback is to protect the investor against downturns in earnings. Inherently, this is a protection mechanism for the private equity firm.
- Incentive scheme (or ESOP): an incentive scheme, or employee stock ownership plan, balances the effect of a clawback. It provides incentives to management to reach certain earnings targets (or a particular exit price). It often only partly offsets the effect of a clawback, meaning that the net effect is favour of the private equity firm. Inherently, this is an incentive mechanism for the management team.
- Earn out: this is a condition whereby a portion of the purchase price is deferred and conditional upon predetermined targets. While deals involving expansion capital use clawbacks, complete buyouts of a business use earnouts (therefore, earnouts are usually mutually exclusive to clawbacks). The purpose of the earnout (just like the clawback) is to protect the private equity firm from downside volatility in earnings and from any unintended consequences to misinformation. Inherently, this is a protection mechanism for the private equity firm.
- Management Fees: these fees are paid upfront and/or periodically to the private equity firm in return for help to grow the business. They can range from reasonable to exorbitant, depending on the perceived value of the firm and the fragility of the deal and management team. Management fees are another way the private equity firms can realise a return on their investment prior to exiting. Inherently, this is a protection mechanism for the private equity firm.
- Coupon or interest payments: although the term “private equity” suggests the invested capital exists as equity, some firms prefer to invest in hybrid securities such as convertible notes (which include an equity component). The benefit to the firm is they receive the upside of equity with the protection of regular interest or coupon payments. This can seem perverse to potential investees, but it can also facilitate higher valuations. Inherently, this is a protection mechanism for the private equity firm.
- Preference subordination: private equity firms prefer to invest in preferred stock so in the case of failure, they rank ahead of common shareholders. In Venture Capital parlance, this is known as a liquidation preference. A coupon payment is often included, but even without a coupon the subordination mitigates some risk for the investor. Inherently, this is a protection mechanism for the private equity firm.
There are many other components and conditions to a typical private equity deal structure, but these are the primary tools used to manipulate the risk and return profile of the deal. They’re not always divisive in nature; they can simply make an otherwise risky deal viable.