In private equity, the envy ratio is a ratio that shows the price paid by investors in relation to the price paid by the management team for their respective shares of the company’s common equity. In other words, the envy ratio indicates how much the company’s managers spent relative to private equity investors for the acquisition of their respective equity shares.
The concept of the envy ratio is primarily used in the context of management buyouts (MBOs). The envy ratio can be a key metric for management when aiming to acquire a larger ownership share of the company.
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 management) is frequently included in the buyout. Furthermore, outside investors (private equity investors) usually acquire their equity stake in the company at a higher valuation than that of the company’s managers.
Importance of the Envy Ratio
The envy ratio is a metric that can help determine the attractiveness of a deal to each investor party. The general rule is that a higher envy ratio indicates a better deal for management. A higher ratio shows that private equity investors are willing to reward the company’s management for their ability to generate value for the company. In addition, a high ratio indicates intense competition among private equity investors seeking to enter the deal.
Using the envy ratio, the company’s management can assess the commitment of private equity investors to the deal. A higher envy ratio indicates that outside investors are strongly committed to the deal.
How to Calculate the Envy Ratio
The ratio can be calculated using the formula below:
The management of RedWhite Corporation considers a management buyout of the company as an exit strategy to make the company private. However, the 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 identify the better deal by calculating the envy ratio of each offer:
The managers choose ABC Capital’s offer because it provides a much higher ratio (3.35).
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