Following the early success of concepts such as PizzaExpress, Wagamama and Café Rouge, private equity is becoming increasingly involved in the world of restaurant operators. David Roberts, the head of the leisure team at leading law firm Olswang LLP, looks at the types of incentivised deal being offered to management teams to push concepts forward.
One of the consequences of the growth in the size of restaurant groups is that the casual-dining sector has registered on the radar of the private equity (PE) industry.
This has led to the growth in incentivised, PE-backed management teams whose job is to roll out concepts on behalf of their PE lords and masters to enable the PE house to exit in due course at a healthy multiple, delivering significant capital growth.
The positive thing for restaurant management teams is that the PE industry is very good at incentivising management; the houses are often generalists with no specialist restaurant operational expertise, meaning that they rely on management.
There are, effectively, two deals that management need to be aware of.
The management ‘roll over’
The first relates to their ‘roll over’. Most management teams in larger operators are already incentivised to a certain degree in their existing concept and many are already PE backed. These members may have shares and share options, loan notes that bear interest and may even have a ratchet mechanism, which delivers additional value depending on the sale price they ultimately achieve.
These packages deliver rewards to the management team on an ‘exit’, which leads to a conundrum for a PE buyer wanting a management team that is motivated to push forward. Thus, while a PE buyer will be happy to permit the team to take some cash off the table, they will insist that key management ‘roll over’ and invest a percentage of their cash into the new purchasing vehicle that acquires the concept (newco).
In some cases, management roll over or reinvest all of their cash proceeds in return for being ‘reloaded’ by the PE buyer.
Thus, in practice, the management team (via their advisor) will have to negotiate several different deals with the PE buyer as the team may have, for instance, a founder that is no longer key to the growth of the concept and wants to cash out, or a founder that is prepared to work longer and then exit. The latter will roll over a large percentage of their shares, while the first will probably not be interested in any roll over.
In addition, the team may have operational or finance members who have only recently joined the business and may not yet hold a significant equity stake, but will be critical for delivering the new growth plan. These members may be allowed to cash out all of their value as a gesture and be handsomely incentivised in their new package.
It’s generally up to the finance advisor and lawyer acting for the management team to negotiate these deals with the PE buyer and represent the management’s interests.
Incentives on offer
Critical to the negotiations is the incentive package the PE buyer is offering the management team. At this point, it’s important for management to understand how the investment by a PE buyer is structured. The PE buyer has to inject cash into newco to enable it to pay the purchase price and also to fund the new business plan. This is typically funded in part by cash from the PE buyer, but a larger portion comes from a third-party bank, which takes security over the assets of the target group.
The cash from the PE buyer is used to subscribe for what is known as the ‘institutional strip’. The institutional strip will include shares and interest-bearing loan notes issued by newco, but could extend to preference shares as well.
Where management has previously paid for or earned the equity they agree to roll over, they may well be able to roll these shares into the institutional strip, which generally enjoys the most preferential terms. Further, if a member of the team wants to invest further capital, again, they may subscribe alongside the institutional strip. If management do not all have shares, or if some, not large holdings, the PE buyer will often set aside an additional pot of equity known as ‘sweet equity’, which can consist of ‘free’ shares issued to the management team at par value (as opposed to fair value). Thus some members of the team participate in the institutional strip, while others participate in the sweet equity.
Using loan notes
Part of the value the management team rolls over is also used to subscribe for loan notes in newco. These notes should, in a perfect world, rank alongside the loan notes given to the PE buyer in the institutional strip in all respects, but sometimes they are subordinated. Depending upon the terms of issue of the loan notes, these can provide the management with additional income during the course of the investment or could be repayable only on a subsequent sale. There are specific tax rules regulating such matters.
Loan notes (or preference shares) typically eat into the equity value of the business, so any management team that does a deal that sees the management receive only shares in newco, while the PE buyer invests largely by loan notes, will find their equity value erode over the life of the investment.
Given that there is sometimes a difference between the management’s view of the value of the business and the PE buyer’s view, there can be a valuation gap. This can be bridged in part by the use of a performance-based ratchet, as follows.
The rights attached to one class of the management’s shares (as often there are several classes of management roll-over shares to cater for the individual deals done for each member) will have built into them a right that operates to deliver value to that class of shares if, but only if, the sale proceeds achieved on an exit exceed a nominated threshold, for instance, if the PE buyer achieves a 30% internal rate of return.
Readers will now understand that management have to negotiate their roll-over deal plus their new deal. There are a number of related tax and legal issues to be considered, far beyond the scope of this article.
On the tax side, it is vital to ensure that when the management roll over their shares into shares in newco, this is not treated as a disposal for capital gains tax purposes. Relief should be available. It is also critical to ensure, wherever possible, that each member of the management team (and potentially new members) is able to qualify for entrepreneur’s relief (ER). This delivers favourable tax treatment and is available to employees who own shares that are at least equal to 5% of the nominal capital of the company and control at least 5% of the votes at a general meeting. If a team member qualifies for ER, they should benefit from a 10% capital gains tax treatment on a subsequent sale (subject to conditions).
There are other issues that need to be addressed by the management team, not least of which is to what extent their roll-over shares should be taken away from them if they leave the business before the next exit. The concept of ‘good leaver/bad leaver’ is relevant here; the rule of thumb is that if a team member leaves (ie is dismissed or resigns) they should expect to have to hand back their sweet equity, but if they have previously earned their roll-over shares or paid for them, they should fall outside the good leaver/bad leaver regime (they can keep their shares); or, if they have to be forfeited, the manager must get ‘fair value’ for such shares with no minority discount (ie be a good leaver, as opposed to a bad leaver, who gets nil value for their shares).
Clearly, the management deal involves a complex set of interrelated issues that can test the strength of the team’s resolve during negotiations. Many of the concepts in this article have been simplified, but at least now readers will understand what an institutional strip is and perhaps avoid embarrassment over the negotiation table.