Managing portfolio companies

The most compelling means of achieving this is equity participation in the deal. As with GP commitments to their funds, management teams investing their own money in the company can be an effective tool for focusing the mind. “To structure deals effectively, you have to put yourself in the shoes of the management team,” says Paul Thomas, chief operating officer at Gresham Private Equity. “You can quickly work out whether they are more interested in their salaries or in the equity. If they have high salaries, then they are likely to be more interested in keeping the business going than driving for capital uplift.” But slashing salaries is not the way forward either. “You’re not going to get a motivated team if you pay them a pittance,” he adds.

Quite how the equity is structured is different in every deal – it has to be. The total package needs to take into consideration the personal circumstances of each management team as well as what private equity investors want to achieve. Key to ensuring that everyone knows where they stand is an agreement of where the company should be in, say three years’ time, and what it needs to do to get there. “The driver of aligning everyone’s interests is having a clear value creation plan from the outset,” says Patrick Dunne of 3i. “You want to set out how you are going to turn x into 3x and get management completely bought into the plan.”

As each deal is structured differently, there is probably less potential for interests to become misaligned in this part of the picture than with the LP-GP relationship, where terms tend to be more standard. But even here, there can be difficulties. The simple mechanism of management putting in their own capital works well in most instances. But the waters become a little more muddied when it comes to secondary buy-outs where the same team continues at the company. Management will still be expected to invest a significant amount in the new deal, but they will also be able to cash in some of the proceeds. If they have made a decent slug of money, how can an incoming firm be sure they will continue to be as motivated?

Most say it comes down to judgment more than anything else. “It’s a much harder dynamic to get comfortable with than a straight buy-out deal,” says one seasoned investor. “There are some secondary buy-out teams I’d back without hesitation, even if they took 50 per cent out of the business. There are others I wouldn’t. You just have to take it on a case-by-case basis.” Thomas agrees: “The core skill in our industry is getting judgments on management right. You have to look at what, in real terms, these people have pocketed. You have to judge how hungry they still are.”

Disagreements on the value of the business can often also cause a potential for conflict of interest. One means of getting round a difference in pricing could be by using ratchets, which increase the amount of equity available to management based on certain targets. The problem here is that management is working towards those targets to increase its equity share while the private equity house does not want management to hit the targets. “Some people think ratchets are a good way of solving problems surrounding the value of the business,” says Thomas. “And it is possible to structure them well. But in practice, it’s usually just delaying an unpleasant argument.” This kind of structure can also prove detrimental to the business. “If you give management the incentive to perform well to a chosen metric, the team will do everything it possibly can to maximise performance in this area,” says Michael Elias, managing director of Kennet Partners. “So if you choose revenue, for example, management will be incentivised to sell everything at the expense of focusing on other areas.”

Much of this can be avoided, however, by non-financial incentives, say some. “There has to be a strong element of financial alignment,” says Dunne. “But there also has to be emotional alignment. There needs to be a good level of trust between management and their backers. During and after negotiations, there are plenty of stress points, but if you have a good ongoing working relationship, the potential for misalignment is much lower.”

Not everything comes down to financials, adds Thomas. “One of the things that people often miss when they talk about incentives is that people are rarely motivated just by money,” he says. “Most successful entrepreneurs like making money, but that is usually just a scorecard. They do what they do because they are passionate about it.”