What is Envy Ratio?
In private equity, envy ratio is a ratio that determines the price paid by the investors in relation to the price paid by the management team for their respective shares of the company’s common equity. In other words, envy ratio indicates how much the company’s managers spent relative to private equity investors on the acquisition of their respective equity share.
The concept of envy ratio is primarily used in the context of management buyouts (MBOs) when the current company’s management aims to acquire a larger part of the company from the current owners.
In buyout deals, the success of a deal is highly dependent on the commitment of the company’s current managers. Due to this reason, the sweet equity (i.e., the equity reserved as an incentive for the management) is frequently included in the buyout. Furthermore, outside investors (private equity investors) usually acquire an equity stake in the company at a higher valuation target that of the managers of the company.
Importance of Envy Ratio
Envy ratio is a metric that can help determine the success of a deal and its attractiveness to each party. The general rule is that a higher envy ratio indicates a better deal for management. A higher ratio shows that the private equity investors are willing to reward the company’s management for their experience and ability to generate value for the company. In addition, a high ratio can indicate intense competition among the different groups of private equity investors seeking to enter the deal.
At the same time, using envy ratio, the company’s management can also assess the commitment of private equity investors to the deal. A higher envy ratio may indicate that the outside investors are strongly committed to the deal.
How to Calculate Envy Ratio
Envy ratio can be calculated using the formula below:
Example of Envy Ratio
The management of RedWhite Corporation considers a management buyout of the company as an exit strategy to make the company private. The company’s managers are willing to closely align their incentives with the company’s goals.
However, the company’s managers lack adequate capital to acquire a sufficient equity stake in the company from its current owners. Thus, they decide to finance the deal with private equity firms.
The managers approach two private equity firms: ABC Capital and XYZ Capital. ABC Capital offers the managers the following deal: ABC Capital will acquire an 85% stake in the company for $38M, and the managers will acquire 15% of equity for $2M. XYZ Capital offers to finance the purchase of 75% of equity for $35M, and the managers will acquire the other 25% for $5M.
The managers can select the better deal by calculating the envy ratio of each offer:
The managers will choose ABC Capital’s offer because it provides a much higher envy ratio (3.35).
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