Envy Ratio

describes the price paid by the investors per share relative to the price paid per share by the business management team for their respective shares in private equity

The envy ratio describes the price paid by the investors per share relative to the price paid per share by the business management team for their respective shares in private equity.

The ratio is an opportunity for management buyouts, where-in the management team buys the shares of the private equity to increase their ownership over the company, and the team is incentivized for the company's profits

This concept works similar to financial leverage, where the management team's investment is leveraged via the investments of the company's private equity investors. Management uses investments by investors to further profit for their respective firms.

As the company's success depends on the commitment made by its management team, they are subsequently provided with "sweet equity," and the stocks are therefore more valuable for the outside investors. 

What is a management buyout?

In a management buyout, a company's management team acquires a large(or all) portion of their respective company's equity, either through the parent company or a legal person. Though it originated in the US, this concept is now globally used.

What is financial leverage?

Leverage in Finance is defined as leveraging a person's funds by borrowing capital and using that capital to profit more than the rate at which the money was borrowed. 

Leverage, even though it increases the opportunity of earning amplified profits, it also increases the level of risk taken by the individual, as losses will also get amplified. Usually, the contract has a permitted risk position where-in losses are capped at the total (or less than) non-leveraged fund.

What are sweet equity shares?

Sweet equity refers to the equity reserved for the management to buy at a discount as an incentive for working in the respective company. Sweet equity is priced lower than the equity available to purchase for outside investors.

Interpreting Envy Ratio

The ratio measures the discount the management offers compared to the investors for owning a stake in the company's equity. A higher envy ratio translates to a lower cost basis for the management relative to investors.

The formula for envy ratio

The formula for calculating the ratio goes as follows:

Example

Let's say a company wants to go private, and due to lack of capital, it goes to private equity firms for the company's buyouts.

To compare the deals offered by the firms, the envy ratio is used as follows: 

Firm A offers 45 million dollars for 80% of the company's equity, and management will buy the other 20% for 5 million dollars.

While Firm B offers 40 million dollars for 70% company's equity and management will buy out the other 30% for 10 million dollars.

Envy ratio for firm A = [45/80] / [5/20] = 2.25

Envy ratio for firm B = [40/70] / [10/30] = 1.71

The deal offered by firm A is better as it provides equity at a lower cost to the management, but at the same time, the percentage of ownership by management is also low compared to firm B's deal.

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Key Takeways

1. Management is given a discount by investors as management will be directly liable to the company and its profits after owning a part of the equity

2. A higher ratio equates to a lower price per portion of the company for the management

3. Envy Ratio is used to compare the more possible deals provided by firms during management buyouts

Researched and Authored by Abhijeet AvhaleLinkedIn

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