The formulas, tricks and trade secrets of Private Equity

Private Equity Earn Out Ratchet

Sample Chapter

I’ve harped on a little (or maybe a lot) about how iniquitous and unscrupulous earn out ratchets are. I’ve said they misalign interests from the outset and lead to adversarial relationships when triggered. So, are there any equitable ways to structure earnout ratchets? And, if not, why do we still use them?

Like most things, there are shades of grey. At one end, we have short-term one-way earnings-based ratchets that go against the mantra of private equity and pin executives to short-term performance. At the other end, we have long-term two-way returns-based ratchets that create much better alignment across the entire stock register.

So, let’s check out these characteristics:

  • One-way vs. Two-way - A two-way earn out ratchet simply means that executives aren’t only punished for underperformance, but they’re rewarded for outperformance. A two-way earnout ratchet supplants the need for executive option schemes and further encourages executives to invest their own cold hard cash. The only other consideration here is the rates at which the earn out ratchet moves in each direction (more on this later).
  • Shorter-term vs. Longer-term - we can link our one-way ratchet to something that makes more sense for everyone… the exit. We lament public markets for their short-termism, so why do the same by using short-term ratchets? If we are going to align interests and have longer-term investment horizons, then we should use longer-term ratchets and give executives a chance to make a difference.
  • Earnings-based vs. Return-based - continuing with the concept of aligning interests, private equiteers are rewarded for returns, not earnings. Higher earnings certainly help boost returns, but there’s much more to a great return, like higher exit multiples and good leverage. If you want executives to maximise your exit return, then it makes sense to incentivise them on the return-side via a earnout ratchet linked to IRR or cash multiple (thanks to a recent reader for this suggestion).

There’s one more consideration for two-way ratchets… the ratchet rate. Should the rate be equal for the downside and upside? Well, it depends. In all fairness it should, but sometimes the ratchet rate is adjusted to bridge valuation gaps. Managers may opt for a higher ratchet rate in exchange for a lower initial valuation, or vice versa. Also, the private equiteer must ensure the upside ratchet rate isn’t so aggressive as to eat into their target return (I’ve seen this happen).

So, it’s best to plot out a range of scenarios before agreeing to a ratchet to make sure that, a) everyone is sufficiently incentivised, b) your target returns are possible in most scenarios, and c) misalignment and adversarial terms are minimised. Good luck.

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