My last post described how equity ratchets work in private equity. In this post I’d like to raise a few thoughts on the pros and cons of private equity ratchets (also known as valuation adjustment mechanisms or VAMs).

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 along side 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 for. 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.

Related

Explore more: Private Equity 101, Career Guide, or Compensation Data.