January 23, 2018
Interviewed by: Privcap
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The Complexities of Management Company Investments

Geoffrey Newton of Baker Botts LLP explains the dynamics between PE funds and management teams.

Geoffrey Newton of Baker Botts LLP explains the dynamics between PE funds and management teams.

The Complexities of Management Company Investments

Geoffrey Newton, Baker Botts:

Normally, the way this is done is that if you have a management team that you know you want to work with, but they haven’t yet purchased an asset or identified an asset, you start small. So, what you do is tie up the team. You also agree to pay their G&A, so you bear the freight, the fund bears the freight and the management team begins to work on the process. But the fund doesn’t really have to make a large commitment at that time financially because they don’t know whether the commitment needs to be for $100 million or $400 million, so they start small and then they adjust to fit whatever is ultimately found.

What are the contractual commitments between the private equity fund and the management team?

Newton: If a private equity fund is going to invest in a management team, they don’t control the asset, so what they really need to do is control the people. It’s a people business. They say, “We’ll invest in you, but you have to promise us several things. The first thing is that you’ll devote 100% of your time to this platform. Second thing is that any opportunities you find in the energy industry, you will refer to this platform and you won’t have any outside interest. The third thing is that you have to avoid conflicts of interest. So, if there are other transactions that would affect this company, you’ll avoid it. The funds are very strict about this. They really enforce this. If, for example, they require management teams to list every oil and gas interest they own when the team is formed … you typically tell them, “You can continue to hold those, but you can’t buy any others while you’re working for this company.”

How is control allocated between the private equity fund and management?

Newton: These companies are typically 100% funded by the private equity fund, so that the private equity fund will require that management put in a certain amount of skin in the game, a certain amount of equity. But typically, if it’s going to be a pretty big company, if the private equity fund puts in $400 million, management might put in $4 million or $8 million, but nothing meaningful compared to what the private equity fund does. The string that goes with that is the private equity fund will insist on controlling almost all major decisions for the company. Management would be on the board, but would always be outvoted if it disagreed with the fund.

What are some standard incentive terms around this relationship?

Newton: Here’s where it gets interesting for management. We’ve already mentioned that they’ll get paid their G&A. So, their salaries will get paid, but that’s only the table stakes for the fund. What the management really is in there for is to get the carried interest on the investment, or incentive distributions, as they refer to it. These are very generous, typically, for these companies. Sometimes there are two, three or four tiers of incentives and they’re based on things like internal rate of return or ROI. So, once the initial investment is made and once it’s been returned, they’ll get quite a high return. They may start at an 8% or 10% return at the first hurdle, but they may get up to as high as 40% of the profits at the high end of the return.

What are some disputes that could take place between management teams and the private equity funds that a well-structured partnership would hope to avoid?

Newton: You can spend as much time thinking about structures as you want, but it’s really hard to avoid some of the disputes that might arise. As you can imagine, when bad things happen, that’s when disputes tend to arise. Probably the most typical dispute that comes up is that the management team has signed up to work with a private equity fund. It’s made its first investment and the first investment wasn’t a success. So, instead of making a big profit—perhaps it has broken even or it’s even lost money—at that point, management has very little incentive to keep working for that company. So, in essence, in some cases, they stop working hard on the projects and they go to the private equity sponsor and say, “You need to fix this or else this platform’s not going to be worth anything to you.”

Other examples that are very frequent are if you have a management team, it’s not atypical for three people in a management team to work out fine, but for one person not to get along with the sponsor. In most cases, in my experience, the sponsor reserves the right to fire someone from the team if they have to. So, if you’ve got four people, even though they say we’re a team, the sponsor says, “If this person isn’t working out, I can ask them to leave.” Maybe that person retains his interest, but the sponsor needs to be able to make sure the deal rolls forward.

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