Unlike typical venture capital deals, private equity firms try to take quite significant stakes in their investees. Expansion deals involve smaller stakes because the existing (and continuing) owner/manager retains his/her equity. Buyout deals involve much larger stakes because incoming management aren’t wealthy enough to buy anymore than a few percent. (If they were, they’d probably live-out their days on the Seine.) These are typical private equity terms.
But, there’s a reason why the stake owned by a private equity firm sizzles and the stake of the management team doesn’t (or at least not as much). Private equity firms look to control their risk by commanding strict terms on their invested equity. To make the deal appear somewhat fair, they provide the management team with other incentives on the upside. The outcome of this is that if the business develops lemon-like qualities, the private equity firm won’t suffer as much. Whereas if it ripens into a plum, the management team will benefit a little more.
The underlying objective of this is for the private equity terms to limit the fallout of a bad investment, while still benefiting from a good one.
In practise, preference equity or hybrid instruments help manage risk. In rocky times, like we’re experiencing now, the higher ranking capital will be returned before lower ranking capital. So even if you own 50% of an investee and the current value (determined in the recent round of valuations) is below your initial investment amount, you will be allocated 100% of the equity if it’s on a preferred basis. This is sizzzzzling for the private equity terms (from a risk control perspective) and a bad day for the other owners. But, of course it’s only a bad day if an exit is triggered and this situation is realised, which we’re all desperately trying to avoid. And in good times of course, the management team has the ability to realise a much higher return with their upside incentives.