The Management (in)equity dilemma

Navigating competing interests in management equity structures in private equity transactions

Management equity is vital to almost every private equity transaction. Even in the age of AI, management remains both the greatest value creation driver and one of the biggest risks for most sponsors, making commitment and incentivisation a critical balancing act. For managers, the lure of potential returns is tempered by deeply personal feelings of trust, fairness and security. Separating ‘morality’ from commercial reality often unlocks discussions and drives genuine alignment between the key protagonists for the next phase of growth. 

Management teams who can decouple morality from practical reality when negotiating equity terms will gain traction with sponsors. Equally, sponsors who demonstrate empathy and transparency, rather than relying on rigid ‘house’ positions, will build the trust and loyalty that protect long-term value.

"Management teams that separate morality from practical reality when negotiating equity terms will gain traction with sponsors."

The following areas show where this tension between emotional and practical realities is most pronounced in negotiations.
 

Leaver provisions 

Leaver provisions traditionally apply to sweet equity held by managers who leave the business, but are increasingly being applied to management strip in circumstances where managers are deemed culpable for egregious acts. Leaver categorisation determines the value at which leaver equity can be repurchased and can therefore be highly emotive, especially where management strip is affected. Sponsors are hyper-focused on retention and protecting value, while managers are acutely aware that no fault scenarios, or circumstances outside their control, could result in a material loss of value. 

Sponsors may argue that not every scenario can be addressed – traditionally the rationale for introducing an intermediate leaver category – and that, specific circumstances must therefore be ‘taken on trust’, with sponsor discretion to upgrade a leaver category providing sufficient protection. This may be more palatable where categorisations are drafted empathetically but it is unlikely to satisfy managers where provisions are more punitive, for example where the ‘catch all’ sits within the bad leaver category or vesting applies irrespective of categorisation. Managers may also see a lack of reciprocity: if they are being asked to accept certain risks ‘on trust’, where is the equivalent sponsor risk? That perceived imbalance is often where any sense of parity breaks down. 

There is no one-size-fits-all approach, but sponsors that explain leaver categorisations clearly and with a degree of empathy will secure greater buy-in from their teams. This is particularly true of senior managers, whose interests are often more closely aligned with a sponsor in preventing value leakage through leavers.

Tax

Tax is often (if not always) at the forefront of structuring private equity transactions. For management teams, the essential foundation to any deal is ensuring optimum tax treatment. 

In the UK, this principally comes down to achieving: 

1. deferral of gains tax on rolled equity;
2. minimising any employment income tax charges arising on the acquisition of sweet equity; and
3. ensuring capital gains rather than income treatment on a future exit.
4. The tax implications of these can vary drastically across jurisdictions dependent on local tax rules.

"Buy-side structuring must be examined carefully to identify and mitigate potential tax leakage..."

Buy-side structuring must be examined carefully to identify and mitigate potential tax leakage.  It must also account for situations where an approach that works for some managers does not work for others, particularly when managers have a tax nexus in different jurisdictions. Structures that overlook this basic premise are likely to create deliverability concerns. 

A common example in the UK is an insistence on using loan notes rather than preference shares on management strip investment. Economically, they may deliver a similar return, provided there are sufficient distributable reserves. The tax treatment may differ materially, however: an accrued and unpaid coupon on a loan note is taxed as interest income for the holder even if the loan note is sold. In contrast, an accrued coupon on a preference share that is realised as part of the disposal of that share may form part of capital proceeds and be taxed as capital. This can deliver a tangible tax benefit to management with little or no economic cost to sponsors in most structures.

Employment and restrictive covenants

Restrictive covenants occupy an uncomfortable middle ground between commercial necessity and personal liberty. Sponsors rightly seek protection against the risk that departing management will compete with or solicit from the portfolio company. 

For management teams – particularly those that have built the business over many years –  post-termination restrictions can feel like a constraint on both their professional identity and future livelihood.  Negotiation their scope, duration, and geographic reach is therefore rarely a purely legal exercise; it is also a conversation about trust, loyalty, and what each party considers fair. 

Employment and unfair dismissal

Neither party wants to contemplate the employment relationship ending. In some cases however, managers may fail to meet the required standard or engage in conduct that could harm the business, leaving sponsors with little choice but to pursue termination. A fair performance management or disciplinary process is rarely followed; sponsors typically prefer to negotiate a financial package for the manager to leave under a settlement agreement. 

Assuming it is a straightforward matter of performance or conduct, sponsors can usually calculate their maximum exposure at around the compensation cap for unfair dismissal (currently £123,543), and base their negotiations on that. However, with effect from 1 January 2027, that cap is being abolished, shifting the leverage in such discussions and making a rapid exit, rather than through a formal process, significantly more expensive. Sponsors may therefore need to take a more proactive approach to formally managing poor performance or misconduct before moving straight to a discussion about departure. This is also likely to influence how management equity and wider incentives are structured from day one, reinforcing the need to align employment risk with the overall management proposition.

Balancing interests, building value

These tensions are deal-specific and unavoidable, but they all point to the same underlying principle: people remain central to growth and value creation. AI will continue to augment that contribution, but private equity remains a people-business. Those who recognise this – and structure management arrangement accordingly – will be best placed to thrive.

"These tensions are deal-specific and unavoidable…people remain central to growth and value creation."