The average proportion of sale proceeds (net of tax and costs) that management reinvested remained steady at 45% in 2022.
The average sweet equity pot remained at 16% on mid-upper market deals, with a range of pot sizes between 11% and 25% of the ordinary share capital. The pot size was typically driven by the (i) size of the deal; (ii) amount of shareholder debt and the coupon applicable to it; and (iii) the dynamics of the management team.
The average allocation to CEOs in 2022 was between 22-30% of the sweet equity pot.
Following the decrease in the use of ratchets identified in 2021, the past 12 months have seen an increase, with ratchets featuring on 44% of deals in 2022 (up from 35% in 2021). Ratchets continue to be used as a tool to bridge any gap in expectations between investor and management regarding the size of the sweet equity pot. The amount of additional equity available in excess of the hurdle ranged from 3.5% to 20%, with ratchets typically involving both a money (or invested capital) multiple test and an IRR test. Clearly the terms of each ratchet are deal specific and ultimately management teams and sponsors look at the economic deal for the team as a full package in the context of the business plan and likely exit routes. The vast majority of ratchets were "top slice" ratchets (where additional equity participation applies to the proceeds above the relevant hurdle only) as opposed to ground up or "cliff" ratchets (where additional equity is calculated by reference to all proceeds).
Ratchets were used on 44% of deals in 2022, an increase on the previous two years.
The use of preference shares as a form of shareholder debt remained common, with 44% of transactions using preference shares as the only fixed coupon instrument and 50% using both preference shares and loan notes. Approximately 6% of transactions used only loan notes (a significant decrease from 29% in 2021).
Shareholder debt coupons remained steady and 10% was, once again, the most prevalent coupon. In most cases, the coupon compounded annually, rather than semi-annually or quarterly.
It remains to be seen whether upwards pressure on third party debt pricing will lead to an increase in shareholder debt coupon levels in 2023.
The number of deals with a non-dilutive element (where the investor agrees that, should any further funding be provided post-closing, such funding would be structured so as to not dilute management's equity) continued to be relatively high, albeit a downward trend at 31% (compared to 40% in 2020 and 37% in 2021). The average amount of non-dilutive funding made available on those transactions increased slightly from 4.5% of enterprise value in 2021 to 6% in 2022, reflecting a benchmark of 10% of the sponsor's equity cheque. For businesses with a buy and build strategy or high levels of anticipated capex, this remains an area of focus.
Agreement that an element of any further funding provided by the investor would be non-dilutive to management's ordinary equity was reached on 31% of deals.
The good leaver, intermediate leaver and bad leaver construct continues to be the most commonly used construct for valuing a leaver's sweet equity.
The most common vesting period remains 4 years (and was used on 77% of deals). Vesting linked to an exit (where management are only entitled to receive full value for their sweet equity if they remain with the business until exit) also remained common and was used on 72% of transactions (compared to 60% in 2021). Value vesting (rather than ownership vesting) remains the standard on UK deals.
It is becoming increasingly common for leaver provisions to apply to strip equity. This was the case on 73% of transactions in 2022.
Strip equity was subject to some form of leaver provisions on 73% of deals.
The consequences when leaver provisions are applied to strip equity depend on the reason for leaving. A good or intermediate leaver will expect to retain or receive fair market value for their strip equity, but the consequences for a bad or very bad leaver (such as summary dismissal or breach of restrictive covenants) may include forfeiture of some or all of the ordinary equity component, reduction of future coupon accrual or, on some transactions, forfeiture of accrued coupon.
The circumstances in which leaver provisions are applied, and the consequences when they do, continue to be subject to specific negotiation on a deal-by-deal basis. However, on 44% of transactions in 2022, different leaver provisions applied to Tier 1 and Tier 2 management.
The scope of investment agreement warranties has remained relatively unchanged in recent years, with key members of management typically being asked to warrant (on a several basis) certain factual information in the core due diligence reports and personal questionnaires. Caps on liability remain at 1–2x the manager's salary (with 1.5x being the most common), although 2022 has increasingly seen additional limitations (e.g. blanket awareness, de minimis and thresholds) which are more commonly seen applying to acquisition warranties, also applying to investment agreement warranties.
Arrangement fees, monitoring fees and director fees still feature on a number of deals. The quantum of any such fee, where charged, is often dependent on the terms agreed between a sponsor and its limited partners, rather than being driven by the market.