Managers’ Equity Incentive Schemes in Private Equity LBO Transactions

Manuel Echenique Sanjurjo.

2009 Butterworths Journal of International Banking and Financial Law, n.º 11

The leveraged buyout (‘LBO’) practice initiated in the 60s by the Anglo-Saxon countries has been regularly followed and implemented in Spain during the last 20 years; notably led by US and British private equity houses. The acronym LBO is commonly used to refer to those kind of companies’ acquisition transactions whereby the acquirer (typically an instrumental special purpose vehicle (‘SPV’) incorporated by the sponsor of the deal) gets ownership of the target by payment of the acquisition price with substantial external financing debt (with the new financing environment between 50 per cent and 80 per cent of the price) which is later repaid with the cash flows and distributable net profits generated by the target.1

    This high external financing element of LBOs’ structures has meant that when used by private equity investors they are commonly applied in order to finance acquisition transactions in mature and/or developing/growing markets. The rationale behind this is that both the sponsor of the deal (eg private equity) and the financing provider need to have some degree of certainty from investment inception about the generation of future cashflows by the target. The reasoning for the financing entity is driven by the need to ascertain whether the business of the target going forward will make enough profit to meet the debt service of the acquisition finance, whereas the private equity motivation would not only need to consider the burden on such financing repayment but also the internal rate of return (‘IRR’) expected from the investment in order to maintain the yield for the private equity ultimate investors/owners.

    Aside from the above preferential requirement of the target’s capability to generate enough cashflow, which acts as a primary beacon in the current private equity environment, we find nowadays that the immediate subsequent tier of importance when assessing a private equity LBO is the involvement of the managers of the target2 in the deal.


Experience has traditionally shown that management involvement is key to the success of a private equity LBO transaction. More so over the last 18 months where the financial turmoil has almost frozen the availability of external bank financing for these investments. Two clues help to explain the significance of managers’ support:

    Private equity houses are, by their very nature, ‘financing investors’ which rarely get actively involved in the day-to-day management of participated entities. This seems logical if we consider the wide variety of sectors which they pursue and the temporary profile of their investments (which normally range from three to seven years). It is not unusual, therefore, for private equity investors to lack exhaustive experience or specific technical knowledge of the business activity of some of their prospective targets. In these cases, the private equity house will generally assess, structure and follow up the investment with an objective financing criterion – which main drivers will vary, on a case-by-case basis, depending on the specific circumstances of the sector analysed. This objective financing assessment, however, does not guarantee the success of the investment since it lacks the specific knowledge of the industry (in general) and the target (in particular) and the required manpower skill to profitably run the business.

    Frequently, the most suitable individuals to provide these skills are the managers of the prospective target. Typical in MBO transactions, the management’s willingness and commitment vis à vis the private equity house to support the transaction and remain in office to run the company during the envisioned life of the investment becomes crucial for the success of the deal.

    (ii) The managers’ involvement with the private equity investor is relevant both in a real and ‘apparent’ sense:

In a real sense because, in addition to the above, a management’s thorough knowledge of the business will help the private equity house to understand at the outset whether the average standard IRR of the private equity fund investments is achievable in the prospective transaction. In the early stages of assessment, the managers will usually assist the investor in the creation of a ‘viable’ business plan that will verify whether the profitability yield can be obtained.

In an ‘apparent’ sense, because managers’ involvement is essential in the eyes of (a) the external financing provider and (b) the internal investment committees of the private equity house which will approve the transaction. Without managers’ endorsement and commitment to stand by the investor, it is likely that neither the financing would be obtained nor the transaction investment approved by the internal committees of the private equity house.


The managers’ decision to uphold and support a project sponsored by a private equity house is not, however, generally granted for free. The ‘toll’ is usually settled by the financing investor through the offering of a specific tailor-made retribution programme.

These schemes are commonly offered in addition to the managers’ ordinary salary retribution in the target, and may be structured in different ways. The most common are the following:

    (i) Salary linked retribution programmes: Ordinarily configured as a bonus. Payable by the target and triggered in the event that certain predetermined benefit thresholds or business goals are achieved. Usually, such a bonus is considered as employment remuneration of the manager and, thus, taxed at the general marginal rate (up to a maximum of 43 per cent). In some circumstances, however, depending on how the incentive is structured, the managers may take advantage of a tax benefit consisting of a reduction in their taxable base by 40 per cent of the amount of the incentive.3

    The main identifying feature of these salary retribution schemes is that the managers do not personally invest or commit any funds into the project.

    (ii) Debt linked participation programmes: Generally established as PIK (payment in kind) profit sharing facilities held by the managers (as creditors) vis à vis (usually) the SPV used for the acquisition (as debtor). The main feature of these facilities is their variable remuneration component which is linked, and thus becomes payable to the managers, depending on the IRR obtained by the private equity investor at exit.

    (iii) Equity linked participation programmes: These have been very common in the Anglo-Saxon private equity practice and have been imported into Spain by international players. Frequently they are configured by way of a complex mix of corporate and contractual structures whereby, in addition to the execution of a shareholding agreement between the private equity house and the managers in respect of the SPV, the investing SPV issues different types of shares in favour of the managers and the private equity investor. The incentive normally consists of vesting the managers’ shares with special economic rights some of which are linked to the IRR of the private equity investment.

The decision to implement one programme over another is usually employment and tax driven.4 This, however, can be surpassed in practice by a more conceptual or philosophical driver backed by the sponsoring financing investor which prevails above all: guarantee of the managers’ compromise with the venture and full alignment with the risks assumed by the private equity investor.

    Leaving aside any employment or tax incentives, the foregoing goal may be better secured via the implementation of an equity linked incentive programme since this generally ensures the managers’ commitment:

(a)  to devote personal funds into the project, usually via acquisition of a shareholding interest in the acquiring SPV; and

(b)  to remain in office whilst the private equity house holds shares in the target in order to collect the incentive.

    It is clear that if managers invest alongside the private equity house they will be equally exposed to the same venture risks, thereby benefiting or suffering from a potential rise or fall in the value of the target. The obvious conclusion to this is that managers will surely adopt a ‘more proactive’ management attitude towards maximising the value of the target and its business with the final aim of achieving the highest return possible for their personal investment upon the private equity exit.

Equity incentive programmes: envy ratio, ratchets and other ancillary shareholding and political rights

There are several formulae to structure management equity incentive schemes in a buyout transaction. All of them have a common denominator: the trigger event for the payment of the incentive is the success of the investment (normally based on a predetermined IRR) for the private equity investor.

    The schemes are created via a mixture of complex corporate and contractual arrangements between the managers and the private equity investor. Some of the key terms of these convenants are set out below:

(i) Envy ratio: Also known as ‘sweet capital’. It represents the ratio between the price paid by the private equity investor and that paid by management for their respective shareholding interest in the acquiring SPV. It amounts to an offer for the management to acquire their shareholding interest at a lower target valuation price than that paid by the private equity investor. In practice, this results in the management acquiring a higher stake by way of their equity contribution than that which they would have been entitled to receive in ordinary circumstances. The envy ratio in private equity LBOs usually enables management to multiply their initial equity investment within a range which may vary depending on the sector of activity and prospective development of the target.

    The implementation of an equity envy ratio scheme varies depending on the jurisdiction where the SPV is based5 and the potential corporate restrictions to the issuance of

(a)  specific preferred shares (ie, with particular reference to the economic rights vested upon them) and/or

(b)  shares with different share premium in one or subsequent share capital increases.

    Below is an example of how this incentive could work in practice. The hypothesis is based on a scheme of preferred and ordinary shares. There are, however, other available options such as the implementation of various share capital increases whereby shares are issued with (in favour of the private equity investor) and without share premium (in favour of the managers); a combination of share capital increases subscribed in equal economic conditions by managers and the private equity house plus a profit sharing loan granted to the SPV by the private equity house, etc:

    Hypothesis of an acquisition transaction valued at €100m where:

(a) €60m is financed with external debt;

(b) €36m is financed by the private equity investor; and

(c) €4m is financed by management.

    If the transaction was implemented without an envy ratio covenant or related equity linked agreement, the equity interest would be allocated at investment inception as follows: 90 per cent for the private equity investor and 10 per cent for the management. If, however, there existed an envy ratio agreement of, for example, two and a half times (2.5x) the managers’ investment, this would imply that management would achieve at investment inception an (overvalued) shareholding interest of 25 per cent (thereby diluting the original private equity interest to 75 per cent).

    As for the legal structuring of an equity envy ratio, it could be implemented by means of two separate share capital increases at the level of the SPV whereby different classes of shares (ordinary and preferred) are created. Considering the hypothetical figures:

(a)  the first share capital increase would entail the funding by the private equity house of its committed €36m. In exchange, the SPV would issue to the private equity house ordinary voting shares at nominal value without any kind of preferred rights. As a consequence, the private equity house would become the sole shareholder of the SPV (and indirect sole owner of the interest held by the SPV in the underlying target).

(b) the second share capital increase would entail the €4m committed funding by the managers. In exchange, the SPV would issue to the managers special preferred shares at nominal value vested with the following special economic rights (which represent the agreed envy): (1) a right to a preferred dividend consisting of 1/4 parts of the total dividend agreed by the SPV at any time and (2) a preferred right in the case of an SPV liquidation (ie following divestment of the target) to receive 1/4 parts of the liquidation proceeds. Depending on the agreed covenants with management (ie level of political control that the private equity house wants to concede) and the particular corporate regulations of the SPV, these preferred shares may be created as non-voting shares.

    (ii) Ratchet: An incentive whereby depending on the final money multiple effectively obtained by the private equity house out of the disposal of its interest (via the SPV) in the target, management is given the opportunity to achieve additional economic compensation.

    As with envy ratios, the scale and implementation of the ratchet may vary, in comparison with the private equity initial investment, depending on the specific activity of the target and the prospective development of its business, the tax and employment considerations affecting the payer and payee, the jurisdiction where the SPV is based and the potential corporate restrictions to the issuance of preferred shares vested with specific economic rights.

    When creating a ratchet it is essential (particularly from a private equity perspective) to cap the maximum entitlement of the managers. There are many methods for this: eg establishing a top figure payable to the managers, linking the amount payable to a maximum participation percentage in the target by the managers taking into account the transaction acquisition value, etc.

    In addition, a ratchet requires a clear determination (a) of the triggering event for its payment (ie, a clear concept and definition of the private equity capital gain that will unleash the incentive); and (b) the date and form of payment. This latter issue will very much vary depending on the agreements reached by the private equity house with the secondary buy out acquirer at the time of the divestment (ie, the impact of a potential retention of price as security for representations and warranties; the scope of representations and warranties given by the managers in the secondary buy out contractual documents; managers’ non compete covenants or commitment to stay in office with the new owner, etc).

    Taking the above example, an equity ratchet could be legally structured by including this concept as an additional economic right attached to the preferred shares of the managers in the case of a liquidation of the SPV. Accordingly, provided that the potential liquidation proceeds of the SPV (following the SPV’s disposal of the target) exceed the agreed money multiples of the private equity original investment, the preferred shares of the managers would be entitled to receive an additional share in the liquidation proceeds.

Such additional share (which represents the ratchet) would be determined in accordance with a formulae and capped at a maximum economic participation of management in the SPV. The ratchet so created would become a kind of second tranche (ie, subsequent to the first tranche represented by the envy) of preferred right in the case of a liquidation of the SPV which would become payable solely in the event that the private equity house multiplies its initial investment by a certain number.

    It is worth assessing when creating both envy ratio and ratchet incentives, the impact of potential partial sales by the SPV (as opposed to a full divestment which would trigger the incentives as explained above) of its interest held in the target. If the agreement between management and the private equity house is that partial sales of the target should produce the same effect as a total divestment this may be obtained through the SPV acquiring its own shares (treasury shares), ordinary and preferred, on a pro rata basis. In such event, preferred rights (ie, envy ratio and ratchet) granted to the reacquired shares would be applicable, taking the price received by the SPV as a consequence of the partial sale of the target as notional liquidation proceeds. In these cases, subject to applicable regulations in the jurisdiction of the SPV, treasury shares may be held by the SPV until its liquidation or may be immediately redeemed against the SPV’s equity.

    (iii) Ancillary shareholding and political incentives: Envy ratio and ratchets incentives are usually accompanied by a set of ancillary political and shareholding rights offered to management which cannot be economically determined but which are deemed very relevant for the managers. These usually include: (1) veto rights for certain qualified matters at the SPV general shareholders meeting and board of directors level; (2) certain pre-emption acquisition and tag-along rights in case of the sale of shares by the private equity house; and (3) ‘good leaver’ provisions which enables the managers to collect the appreciation of their investment in the case of fair6 abandonment of the target.

    The reverse of the coin for these managers’ incentives are the standard ‘in return’ provisions that are customarily imposed (and accepted) by private equity investors:

(i)   a lock-up period for the transfer of the manager’s shares and the commitment of management to stay in office until exit of the private equity house;

(ii) a drag-along provision for the private equity house in case it finds a buyer for 100 per cent of the SPV;

(iii) a step in (protection) right of the private equity house to acquire 100 per cent of the investment in extraordinary circumstances; and

(iv) ‘bad leaver’7 provisions which enables the private equity house to acquire the managers’ stake at the lower of its acquisition and market price (thus causing the management to lose its economic incentive rights).

    These covenants in respect of transfer of shares and political rights are generally set out in a shareholders’ agreement in respect of the SPV between the private equity house and the managers. Usually, for the sake of political efficiency, the private equity house would require that the managers be grouped in a joint ‘feeder’ vehicle. The managers’ ‘bad leaver’ and ‘good leaver’ provisions would likewise generally be captured in the shareholders’ agreements. However, their effective implementation in practice is ordinarily carried out by means of the granting by each of the managers of an American call option over their preferred shares, with no premium (tax wise), which strike price for the private equity house may vary depending on whether a ‘good’ or ‘bad leaver’ provision applies.

1 The assumption of the acquisition debt by the target has thus far usually been implemented by means of a merger between the acquirer SPV and the target; either via a so called forward merger (where acquirer acts as absorbent entity) or via a reverse merger (where, conversely, the absorbent entity is the target). The economic outcome in both cases is the same: ‘pushing down’ the acquisition debt hence making viable the possibility of serving payment thereof with the cash flows and assets of the target. Although it is beyond the remit of this article, it is worth noting that these kind of mergers, subsequent to an LBO transaction, (which are very common in Spain) have to face the uncertainties brought about by (i) the recent law 3/2009, of 3 April, on structural modifications to commercial companies (ie, the requirement for an independent expert report which opines on whether the merger involves financial assistance) and (ii) two recent court rulings which have challenged the alleged financial purpose of the LBO mergers and have, therefore, denied the tax neutrality regime set forth under the European Merger Directive. It remains to be seen how the LBO practice in Spain is going to develop in the light of these new hurdles.

2 We are referring throughout the present piece to the so-called management buyout (‘MBO’) transaction whereby the managers of the target are those who support and co-invest with the private equity house in the acquisition of the target.

3 Although tax aspects go beyond the remit of this article, it is worth noting that in order to benefit from the 40 per cent tax reduction, the bonus needs to be carefully designed so as to comply (among others) with the requirement that its generation period is above two years and that it is not payable on a periodical basis.

4 Having reiterated that tax or employment considerations are not covered in the present briefing, it is worth mentioning that from a manager’s stand alone tax perspective, the equity participation programme would, prima facie, be the most attractive route. However, if the target position is included in the plan assessment equation, depending on how the incentive is designed, it is possible that salary retribution or debt linked programmes may prove more efficient tax wise.

5 Decision on the nationality of the SPV used for the transaction is usually tax driven.

6 Fair abandonment provisions are generally limited to those in which the manager abandons the company for death, permanent disability, unfair dismissal, etc.

7 ‘Bad leaver’ provisions are construed as a negative concept of the ‘good leaver’ element. Accordingly, any abandonment of the company for any reason different to a ‘good leaver’ reason will amount to a ‘bad leaver’ provision. These will generally include, without limitation, fair dismissal, voluntary resignation, breach of shareholding contractual covenants, etc.