Sweet equity
LBOThe thin, highly geared strip of ordinary shares management subscribes for in a European buyout, sitting behind the sponsor's loan notes.
Also written: sweet equity strip, management strip
In most United Kingdom and continental European buyouts the sponsor funds the bulk of its investment as shareholder loan notes or preference shares carrying a fixed accruing return, and takes only a thin slice of ordinary shares alongside it. Management subscribes for ordinary shares in cash, at a low price. That strip is sweet equity.
The gearing is the whole design. The ordinary shares are worth nothing until the loan notes and their accrued return are repaid, so every euro of value above that threshold flows disproportionately to a small pool of ordinary shares. Management therefore commits a modest amount of its own cash for a meaningful share of the upside, and carries a genuine risk of losing it.
A ratchet frequently sits on top, stepping management's proportion of the ordinary shares up as the sponsor passes stated multiple or IRR thresholds. It costs the sponsor nothing in the scenarios where it does not trigger, which is the point: management is paid more only out of outcomes the sponsor wanted anyway.
Economically this is the same as an American style option pool struck at entry value, a geared claim on value above a threshold, but the plumbing differs. Shares subscribed for in cash rather than options, driven substantially by how employment related securities are taxed, which varies by jurisdiction. Knowing that the European version is usually shares, and why, is a small point that reads as experience rather than revision.
Worked example
A sponsor invests 250, of which 240 is shareholder loan notes accruing a fixed return and 10 is ordinary shares for 80% of the ordinary equity.
Management subscribes 2.5 in cash for the remaining 20% of the ordinary shares. Until the loan notes and their accrued return are repaid, that 20% is worth nothing at all.
Above that threshold it is worth a fifth of everything, which is why a modest cash outlay can produce a large payout, and why an underperforming deal can wipe the strip out completely.