Even CEOs who have been through private equity deals before often find the world of PE opaque. The rules, incentives and language can feel like a black box – so we recently hosted an event for CEOs where they could get a clear candid explanation in respect of how our world works, whilst being given a safe forum to ask questions. This guide shares some key topics that can catch CEOs and managements off guard during PE investment cycles:
1. The CEO-PE dynamic: It’s not about pleasing the investor
Many management teams assume that post-investment, their main job is to keep their private equity backer happy. This can actually create a misalignment between the parties as successful partnerships are built on transparency, robust challenge, open debate and mutual respect. The old adage that a problem shared is a problem halved applies here. That means, most PE investors would prefer to hear bad news quickly, rather than leadership teams dwelling on issues or waiting for problems to resolve before the subject is communicated. PE investors often have a lot of situational experience of things not quite going quite to plan and therefore can help and draw on a wealth of experience of other comparable situations. The growth plan set out at the start of an investment rarely identical to the one you see at the point of exit (Covid, Brexit, tariffs and the mini-budget were all curveballs for example), so it’s important not to let a good crisis go to waste and to use the skills of both operators and investors to build better businesses over the medium to long term.
The dynamic in a good PE relationship is not parent-child, it is partner to partner. The importance is shared alignment on increasing value, and if the investment period is typically three to five years, short term issues or targets are not as important as the right direction of travel. That is only achieved through transparency and shared focus.
2. The J-Curve: Why things often get tougher before they get better
Ideally, all founder, managers and shareholders would like a straight or accelerating line of top and bottom-line growth post-investment. However, experience has told us that the reality is often a dip before the climb. Nobody wants this, but it is often the reality. The J-curve is real – performance can soften after a deal due to the distraction a M&A process can cause.
What surprises many: the best PE partners aren’t typically phased by this and support management through it. The journey is rarely linear, and understanding this dynamic helps CEOs focus on the long-term prize, not just the first few quarters of performance.
3. Positioning and multiple arbitrage: Value is more than just numbers
It’s not just financial metrics that drive value in a PE-backed business. CEOs are often surprised that how a business is positioned can matter as much as its growth metrics. A high multiple, which is driven by several things (some tangible some slightly intangible), but is most highly correlated to a company’s growth prospects – can be achieved by repositioning a company’s strategy. This can’t just be a lick of paint; it has to have substance and reflect the high-level strategy and operational reality of the business. If a business is successfully repositioned in line with a compelling growth strategy it can deliver tangible material value to shareholders. For example, Peoplesafe underwent significant digital transformation during our partnership, transitioning from a device‑led service to a modern, platform‑first tech company. This led to a successful exit delivering a 2.7x return. Clearly the business also grew substantially and had a great team, but that strategic repositioning enhanced its prospects resulting in a different multiple.
The lesson: It’s not just about rear-view mirror growth but about where the business sits in its market and its prospects for the future. The clarity of vision and market positioning ensures that a business is seen in the best possible light by the market.
4. Sweet Equity: The most misunderstood (and lucrative) incentive in private equity
Sweet equity is a special class of shares for management, structured to deliver outsized returns if the business outperforms (so-named because management’s deal is sweeter than that of the investors). The catch, it only has value after the investors and reinvesting individual shareholders achieve a minimum return (the “hurdle”). Typically, this hurdle is 10% a year. This reflects the private equity mindset of rewarding management teams through capital value achieved through the growth in the value of the shares of the company. This is why investors reward management teams with sweet equity rather than large amounts of cash comp (as might be found in a corporate). The advantage of this is that management teams can make generational wealth through creating long-term shareholder value through profitable growth. High management or employee cash comp, reduces profits and therefore the value of the shares and sweet, which has the potential to be far more valuable over the medium term (and is importantly is taxed at a much lower rate than salaries and bonuses).
What surprises many: non-founders can build significant personal wealth through multiple PE cycles, sometimes eclipsing the capital value realised by founders if the structure is right and the business delivers. The rules are nuanced, and the upside only materialises if the business performs (it’s not always easy!), but there are significant rewards available for management teams that back themselves to deliver.
5. What is the role of the Investment Committee?
The Investment Committee is the ultimate decision-making body for approving investments in private equity firms. They also have a governance responsibility for the overall funds within which individual investments (i.e. businesses) sit.
This can make it appear as a shadowy board operating in the background that gives Roman style thumbs up or a thumbs down to individual business decisions. This typically isn’t the case, but it is something worth understanding with any prospective investor. It isn’t uncommon to hear of Founders who have had positive mood music from their deal lead, only to get turned down at IC approval well into the process. At ECI, there is an IC member involved on every deal from the outset, to avoid that exact misalignment. Furthermore, our model at ECI is that the deal partner is heavily empowered, so your company Board upon which an ECI Partner sits, remains the decision-making forum for the business, not the ECI investment committee. Ultimately, a PE fund doesn’t have the desire, experience or capacity to be involved in day-to-day company operational decisions but does want to be consulted about big strategic decisions a business might make (e.g. opening an international office, completing M&A, or changing the capital structure). A PE investor can help here having seen success and failure in respect of these initiatives (more common than you might think) across multiple businesses, so they can bring a wealth of experience in respect of the growing pains companies can face as they scale.
Conclusion – the foundation of successful partnerships
The best PE partnerships are built on trust, alignment, and a shared focus on long-term value creation.
The Jargon Trap: A CEO’s guide to private equity terms
What is a typical capital structure in private equity?
A typical private equity capital structure combines equity from the PE fund and management with debt from banks or specialist lenders. The equity is usually split between ordinary shares (with unlimited upside) and preference shares (which accrue a fixed return, usually +/- 10%). Debt is used to enhance returns for all shareholders but must be set at a level the business can comfortably service. Management are given “sweet equity” to incentivise performance and make their deal better than the investors. The whole capital structure is carefully balanced to align interests and support sustainable growth.
What is Sweet Equity?
Sweet equity is a special class of shares solely reserved for management, structured to deliver outsized returns if the business performs, but only after investors achieve a minimum return (the “hurdle”). It’s a powerful incentive for management to drive value.
What is an investment/shareholders agreement?
An investment or shareholders agreement sets out the expectations and responsibilities of both the private equity investor and the management team following an investment. It covers key areas such as board composition, information rights (what information an investor is entitled to), decision-making thresholds (where investor wants to be included in a strategic conversation and where it doesn’t), and the warranties given by management (about their knowledge of the business at the point an investor invests). While these agreements are painfully long and can appear highly formal, in practice they are designed to ensure healthy communication, alignment of interests and protect all parties, while allowing pragmatic, day-to-day decision-making.
What is EBITDA?
EBITDA stands for Earnings Before Interest, Tax, Depreciation, and Amortisation. It’s a proxy for operating cash flow, key measure of operating performance and the primary metric for valuing businesses in private equity.
What is Multiple Arbitrage?
Multiple arbitrage is the process of increasing a company’s valuation by getting a higher multiple on exit than that was achieved when an initial investment was made. This can be achieved in many ways, but often through strategic repositioning thereby enhancing growth prospects, international expansion, or business model evolution to enhance resilience or cash generation.
What is the J-Curve?
The J-curve describes the typical pattern in private equity where shareholder value growth stalls in the immediate period post investment, before rising thereafter. This isn’t desired by anyone, but is fairly typical and is not a cause for undue concern.
What is an Envy Ratio?
The envy ratio compares the return on management’s equity (including sweet) to the return on the PE fund’s money. It is called an Envy Ratio because the investor is envious of management’s better returns!
What is management rollover?
Management rollover refers to the requirement for management or founders to reinvest a portion of their proceeds – often around 50% – into the new capital structure when a business is invested in by private equity. This ensures management has “skin in the game” and remains aligned with the PE fund, sharing both risk and reward as the business grows under new ownership.
