Alternative investors with a long-term view can beat private equity firms at their own game when it comes to management incentives. We explain how internal markets for shares work
Private equity (PE) fundraising hit record highs in 2017 and, despite a slight drop off in 2018, there are record levels of dry powder remaining that can be invested. In addition, the lines between styles of investment are blurring. Increasing numbers of new competitors are entering auctions for private companies, traditionally dominated by PE houses. These new competitors include alternative investors with longer investment horizons, such as listed buyers or industry competitors, pension funds, sovereign wealth funds and family offices. They often have common characteristics that contrast with traditional PE. Primarily, they are not necessarily looking to exit an investment after three-to-five years, so perhaps can be considered more ‘patient capital’. Such providers of this capital need to ensure their bids are attractive to selling shareholders and the management teams of potential targets they are backing. Selling shareholders are primarily attracted by the headline price, but the investor who is holding for the long-term also needs to act to retain and motivate the management team to run the business. How can these investors compete with PE-style management incentive schemes?
Across Europe there is a well-established expectation that management teams will invest in the PE-backed company they are running. Typically, PE firms offer an investment in the form of shares or other securities that increase in value as the portfolio company’s value increases. This aligns the interests of the management team and the PE firm in an arguably better way than option schemes or cash bonuses. Management investment in equity also usually benefits from a better tax treatment for management. Management sell their equity at the same time as the PE fund exits the business and realise the gain on their investment. All pretty simple and well known in the corporate finance community.