Equity Trends
Management reinvestment amounts remained steady at an average of 48% of proceeds (net of tax and costs)
The average sweet equity pot remained at 16% of the ordinary share capital, a figure which has remained steady over the past three years
Ratchets were used on 50% of transactions, an increase from 44% in 2022 and 35% in 2021
Strip equity was subject to some form of leaver provisions on more than 90% of transactions
71% of deals had a fourth “very bad leaver” concept applying to certain securities
The most common coupon on shareholder debt increased to 12% from 10%
Management Reinvestment
The average proportion of sale proceeds (net of tax and costs) that management reinvested increased slightly from 45% to 48% in 2023 but remained generally in line with percentages from previous years. Traditionally, reinvestment amounts have been between 25% and 50%, but since 2020 they have remained at the top end of that range, averaging between 41% – 48%.
Sweet Equity
The average sweet equity pot remained at 16% on mid-upper UK focused deals. However, 2023 continued to see a range of pot sizes depending on: the (i) size of the deal; (ii) amount of shareholder debt including the coupon applicable to it; and (iii) the dynamics of the management team. Generally, the examples which sit furthest from the average are a result of larger transactions or transactions with more international investors (in particular, US investors, where management incentive arrangements have historically tended to be less favourable to management).
The use of ratchets has continued to increase in 2023, with ratchets featuring on 50% of deals (up from 44% in 2022 and 35% in 2021). Ratchets continue to be used as a tool to bridge any gap in expectations between investors and management regarding the size of the sweet equity pot. This has been particularly relevant in the current economic climate where there has been higher scrutiny on valuations and a greater divergence in views on potential returns for investors. In this climate, where pricing and other terms have trended less favourably for management, the use of a ratchet can allow investors to further incentivise management while maintaining a cautious approach. The amount of additional equity available in excess of the hurdle typically ranges from 3.5% to 20% on mid-upper UK focused deals, with most ratchets involving a money (or invested capital) multiple test and, often, an additional IRR test. Ratchets continued to be predominantly “top slice” ratchets (where additional equity is calculated by reference to the proceeds above the relevant hurdle only) as opposed to ground up or “cliff” ratchets (where additional equity is calculated by reference to all proceeds).
Shareholder Debt
The trend for preference shares becoming the predominant form of shareholder debt continued in 2023, with almost all transactions using preference shares as the only fixed coupon instrument and only a small minority of deals using both preference shares and loan notes. This trend reflects the prevalence of US investors in funds who tend to favour preference shares over loan notes, due to the poor tax treatment of loan notes in the US. There are also an increasing number of limitations on the tax deductibility of loan note interest as a result of the corporate interest restriction and anti-hybrids rules, making loan notes generally less attractive than they once were. Where transactions utilise a blend of preference shares and loan notes this is often for deal specific reasons with the aim of facilitating the extraction of cash without any requirement for distributable reserves, which can be a particular concern if the AIFMD asset stripping rules apply.
Shareholder debt coupons increased in 2023, with 12% becoming the most prevalent coupon, compared to 10% in 2022. This reflects the increase in prevailing interest rates globally over the last 12 months which has increased the pricing of third party debt financing and made a higher coupon on shareholder debt necessary for investors to deliver the required returns. The level of increase is nowhere near the level of increase seen on third party financing, which reflects the need for sweet equity to continue to act as an effective incentive for management teams to hit the agreed business plan. To illustrate this, coupons materially higher than 12% remain rare. In all cases, the coupon compounded annually, rather than semi-annually or quarterly.
It is anticipated that global interest rates will start to drop in 2024 as inflation is brought under control, and it remains to be seen whether this will lead to a corresponding reduction in the coupon on shareholder debt over the next 12 months.
Follow-on Funding
The use of non-dilutive funding (where the investor agrees that, should any further funding be provided post-closing, such funding would be structured so as to not dilute management’s equity) continues to be a key part of the sponsor proposition and remains one of the ways in which an investor can differentiate itself in a competitive process. This is obviously of particular relevance for those businesses with a strong M&A platform and a buy-and-build strategy, or other strategies where significant capital investment is key.
However, the number of deals involving a non-dilutive element remained a minority, averaging 33% of all deals over the last 24 months (compared to 31% in 2022), with investors and management teams now sometimes opting to agree the relevant valuation and impact of dilution on different classes of securities ‘in good faith’ at the relevant time following completion when the follow-on funding is provided. Where non-dilutive funding provisions were included, the average amount of non-dilutive funding made available on those transactions also fell slightly from 6% of enterprise value in 2022 to 4% in 2023. Typically sponsors do not agree to provide more than 10% of the initial equity cheque on a non-dilutive basis.
Leavers
Sweet
The good leaver, intermediate leaver and bad leaver construct continues to be the most prevalent construct for valuing a leaver’s sweet equity.
The most common vesting period remains 4 years (and was used on 83% of deals, compared to 77% in 2022). Vesting linked to an exit (where management are only entitled to receive full value for their sweet equity if they remain with the business until exit) also remained the most commonly adopted approach, being used on 60% of deals. Value vesting (rather than ownership vesting) also remains the standard on UK deals.
The most common method of pricing shares held by leavers in 2023 continued to be: (i) fair market value for shares held by good leavers and for vested shares held by intermediate leavers; and (ii) the lower of issue price and fair market value for shares held by bad leavers and for non-vested shares held by intermediate leavers.
Strip
The use of “very bad leaver” provisions which apply to strip equity in limited circumstances (such as summary dismissal or breach of restrictive covenants) continued to be prevalent in 2023. This was the case on almost 80% of transactions in 2023 (compared to 73% for 2022).
The consequences when leaver provisions are applied to strip equity typically include forfeiture of some or all of the ordinary equity component, reduction of future coupon accrual or, on some transactions, forfeiture of accrued coupon.
The circumstances in which leaver provisions are applied, and the consequences when they do, continue to be subject to specific negotiation on a deal-by-deal basis and on 43% of transactions in 2023, different leaver provisions applied to Tier 1 and Tier 2 management. In addition, we are continuing to see a trend for certain individuals to negotiate personal leaver terms by way of a separate agreement or side letter (most commonly (i) senior individuals that are close to retirement and the business need for their continued contribution has influenced their negotiation power; and (ii) CEOs agreeing favourable terms outside of more investor friendly terms referred to above).
Restrictive Covenants
The most common duration for the restrictive covenants given by Tier 1 management was 24 months in 2023, representing an increase on the 18 months which was most common in 2022 and reflecting the more cautious approach taken by investors in the current market. The most common length for Tier 2 management remained the same, at 12 months.
Warranties
The scope of investment agreement warranties has remained relatively unchanged in recent years, with key members of management typically being asked to warrant (on a several basis) certain factual information in the core due diligence reports and personal questionnaires. Caps on liability remain at 1 – 2x the manager’s salary, with more deals in 2023 sitting at the lower end of this spectrum and adopting a 1x cap. The continued use of low liability caps demonstrates that the purpose of these warranties is primarily to elicit disclosure and focus the minds of key members of management, rather than to achieve substantive financial recourse. The most common time period for these warranties was 12 months, which was adopted on 83% of transactions. The second most common time period was 18 months, which was seen on a small minority of deals.
2023 also continued the trend of additional limitations (e.g. blanket awareness, de minimis and thresholds) which were historically more commonly used in respect of acquisition warranties, increasingly applying to investment agreement warranties.
Investors’ Fees
The percentage of deals involving arrangement fees, monitoring fees and director fees remained steady in 2023, as did their quantum. This suggests that the use and quantum of such fees is typically dependent on the terms agreed between a sponsor and its limited partners, rather than market conditions.
