Control Mechanisms in Private Equity Transactions

In most private equity firms, the businesses, their ownership, and control are concentrated in the same hands. Private equity firms can also increase control if any venture capital investee firm does not meet specified targets.

The following clauses can be contained in a contractual agreement. They explain how private equity firms ensure that the management team is encouraged to achieve the set business plans.

Compensation

The reward offered to managers of portfolio firms is closely linked to a firm’s performance. The reward contract encompasses sections that encourage the achievement of a firm’s business targets.

Tag-along, Drag-along Clauses

Anytime an investor obtains control of a firm, the investor must extend the acquisition offer to all shareholders, including the management of the firm.

Board Representation

A private equity firm guarantees control through board representation when a portfolio firm undergoes a significant event, e.g., a takeover, restructuring, initial public offering (IPO), bankruptcy, or liquidation.

Noncompete Clauses

Company initiators should always agree with management on clauses that stop them from competing within a predefined period.

Priority in Claims

Private equity firms receive their returns on investments before other shareholders. This is especially applicable to preferred dividends and, it is at times, specified as a multiple of the original investment. They also have priority on a firm’s assets during a portfolio firm’s liquidation process.

Requisite Approvals

The private equity firm must approve strategic importance changes (e.g., acquisitions, divestitures, and business plan change).

Venture Capital Earn-outs

Earn-outs link the purchase price paid by a private equity firm to the portfolio company’s future performance over a specified period, generally between 2-3 years.

Question

Which of the following choices is least likely to be contained in a private equity term sheet?

1. Tag-along, drag-along clauses.
2. Earn-outs that ensure portfolio firm manager compensation.
3. A clause that guarantees private equity firm membership on the portfolio firm board.

Solution

The correct answer is B.

Earn-outs do not ensure portfolio firm manager compensation since they tie the acquisition price paid by private equity firms to the portfolio firm’s imminent achievements. These are principally common in venture capital investments.

A is incorrect. Tag-along, drag-along clauses are primarily included in a private equity term sheet.

C is incorrect. The private equity term sheet typically includes a clause that ensures private equity firm representation on the portfolio firm board.

Reading 38: Private Equity Investments

LOS 38 (b) Explain how private equity firms align their interests with those of the managers of portfolio companies.