Sellers in middle-market private equity deals are driving harder bargains on the terms of the equity—or rollover–they receive as payment, according to a new report by Goodwin Procter. That trend and others outlined in the report, based on a survey of the law firm’s network of PE clients and associates, are signs that sellers seem to be gaining more of an upper hand in deal negotiations, says Goodwin partner Chris Wilson, a collaborator on the report.
For middle-market deals—those with less than $2 billion in enterprise value–Goodwin’s 2018 Rollover Survey report shows that the practice of requiring some level of rollover has decreased to 63 percent from 70.7 percent in 2015. The form of the rollover equity in the post-acquisition companies that is paid to the sellers is increasingly identical or nearly identical to the equity that the buyers issue to themselves, says Wilson, who is based in Boston.
Previously, more buyers would issue rollover equity to sellers that came with restrictions, such as allowing the buyers to receive their investment capital back before the sellers were paid in any future sale of the company, Wilson says.
“I’m seeing less and less of that; less and less of these protected provisions that operate to the benefit of the buyer. And buyers are saying: ‘You’ll get the same ownership interest in the acquisition vehicle that we’re getting,’” he says.
According to the report, 59 percent of the survey respondents reported that they ranked sellers’ rollover securities on equal footing with the securities purchased by the buyers’ funds, up from 52.6 percent in 2015.
Other middle-market transaction trends have been driven by higher valuations, the report states. The average rollover size (as a percentage of equity value) reported by the survey respondents was 16.6 percent, down from 24.1 percent in 2015, which was partly due to higher valuations enabling sellers to rollover a meaningful amount of capital at a lower percentage, according to the report. Also, 94 percent of respondents stated that their firms always subject rollover interest to drag-along rights, meaning that the seller must agree to any future sale of the post-acquisition company initiated by the PE firm. That figure was up from 75 percent in the 2015 Goodwin survey, and a sign of higher valuations putting pressure on rollover terms.
Another trend related to higher valuations, according to Goodwin: The average size of the management equity incentive pools offered by the sponsors in the survey was 9.5 percent, down from 11.3 percent in 2015 and 12.6 percent in 2013, indicating that increased valuations are driving an enhanced sensitivity to dilution from a manager pool.
For management team and employee incentive plans, more buyers are turning to awarding new equity stakes, or profits interest: 43 percent of the respondents, up from 22.8 percent in 2015. Profits interest is now the preferred structure for management equity in their transactions, more popular than stock options partly because of the tax advantages for the employees, Wilson says.
The Goodwin report also details some potential market benchmarks that could help PE firms in their negotiations with sellers over rollover and other terms of acquisitions. For example, when rollover securities are subject to a buyback at fair market value, 47 percent of the survey respondents had the issuer’s board determine the value; 18 percent had an independent appraisal determine the value.