Private equity sponsors are offering sellers less attractive rollover equity terms as valuations soar.
Law firm Goodwin’s 2018 Rollover Survey found that 94 percent of sponsors now subject rollover securities – in which management teams, founders or owners are required to reinvest a portion of their proceeds – to “drag-along provisions” on exit, meaning they are obliged to sell when the new buyer does so.
The findings are up from 75 percent in 2015.
Similarly, just 8 percent of management teams are “usually” successful in negotiating larger equity incentive pools from their sponsors as part of rollover deals, with 62 percent securing better terms “sometimes” and 28 percent “rarely”. This compares with 12.3 percent of management teams “always” securing larger incentive pools in 2015 and 56.1 percent “usually” having success.
“Some of the terms we’re seeing in rollovers are a little less advantageous for the person rolling over their equity,” partner Jon Herzog told Private Equity International.
“It’s a little more common to be junior to the new money than it ever was before, and relatedly it’s a little more common now for a manager who rolls over their equity to have their rollover equity subject to repurchase if they leave the company,” he said.
Higher valuations are causing people to roll over a little less, he added. “Those valuations are testing the model in a way that causes the sponsor to say ‘I’ve got to be a little less generous with the terms in order to hit the return I want on this investment, because of the amount of money I put into this deal’.”
Rollover equity is primarily driven by a desire for the current owner to have skin in the game, the report noted. Other motivations include an opportunity for current owners to gain from the transaction where they believe the business will continue to grow, or to bridge a funding gap in cases where the buyer needs additional transaction capital.
The average minimum rollover size required by sponsors fell to 20.6 percent this year from 24.1 percent in 2015. This is due partly to inflated valuations meaning founders can roll over meaningful amounts of money as a smaller percentage of proceeds than in previous years, Herzog said.
The proportion of managers requiring existing owners to rollover also dropped to 63 percent, down from 70.7 percent in the previous report. This decline could be attributed to a robust debt market reducing the need for additional finance, or a trend towards acquisitions from strategic owners, which do not have the option to roll over.