Private equity ratchets – also known as valuation adjustment mechanisms or VAMs – are one of the more controversial tools in the deal structuring toolbox. This post covers how an equity ratchet actually works, then the honest pros and cons from the investor’s side of the table.
How an Equity Ratchet Works
So, you’re about to invest in Acme Inc., but you’re concerned about future underperformance and you’re looking for ways to protect your investment. In the VC world, you may rely on the ability to dilute the founders in subsequent rounds at a lower valuation, but in private equity, you have much more in your toolbox.
An equity ratchet works around the management team achieving a predetermined level of earnings (the budget). If they underperform the budget, you’re granted more stock and a higher ownership percentage of the business. If they perform according to budget, then the equity ratchet expires and everyone remains happy.
So, let’s say you own 75% of Acme Inc. and the executive team owns 25%. Your original investment terms state that by year-end EBITDA must be at least $20m, otherwise your equity will increase by 1 point for every $1m of budget underperformance. Usually, there’s a cap to prevent the private equiteer from taking complete control in a bad year. So, let’s say the cap is at EBITDA of $10m. That means if Acme’s EBITDA is $10m or below, your firm’s ownership increases to a maximum of 85%. If it is somewhere in between, your equity increases accordingly.
This is just one example. In practice, ratchets can become quite complex, incorporating other measures of performance, multi-year targets, and adjustments for binary one-off events. However, the idea behind the equity ratchet is simple: to motivate the management team on the downside (as opposed to motivating on the upside, as option schemes are designed to do). This is controversial because it goes against the concept of positive reinforcement. But as parents, we all know how well talking nicely works.
And why is it called an equity ratchet? Because it only goes one way: in favor of you.
Pros of Private Equity Ratchets
- If the investment doesn’t turn out the way you planned, you receive more of the business for the same original investment. E.g. if you pay 5x for a business with earnings of $20m, and then earnings drop to $10m, that original 5x multiple is now a 10x multiple. If you only purchased 20% of the business originally, a private equity ratchet could increase that to 40%, in which case you’ve still only paid 5x (all else equal).
- Often a private equity ratchet can give you a greater share of a business due to short term hiccups, even if the business outperforms in the long term. So taking the example above, earnings could have dropped to $10m due to a one time event, but next year they could return and grow to $25m. Now you own 40% of a business doing $25m even though you only purchased 20% at an original multiple of 5x.
- A ratchet can motivate managers if they’ve invested alongside you. If they know they own a lesser class of equity and are at risk of being ratcheted down, they may work harder to keep earnings up.
Cons of Private Equity Ratchets
- A private equity ratchet creates misalignment with other investors since you’re essentially punishing them for underperformance of which you’re partly responsible. It makes any pitch about aligned interests weak.
- Once an equity ratchet is enforced and a private equiteer’s ownership is increased, an adversarial relationship is often born. If the other investors include executives in the business, it can lead to lasting effects on performance and morale. This is especially likely if the executives’ ownership ratchets down to almost nothing.
- Private equiteers talk about their focus on long-term performance and differentiate themselves from public markets for this reason. However, ratchets are inherently short- or medium-termed. The idea that other investors (sometimes executives) are punished for short-term performance doesn’t sit too well with private equity traditionalists.
- The misalignment and short-term focus of ratchets motivates managers to report higher earnings, which in turn motivates manipulation. While this may sound fraudulent, in practice it’s more about debating normalizations to reported earnings. You’ll find yourself spending days negotiating the timing of sales, the timing of costs, the cases behind numerous normalizations (transaction costs, advisory costs, etc.), and a plethora of other things.
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Explore more: Private Equity 101, Getting a Job in PE, or Compensation Data.