performance ratchet

Also known as equity ratchet. A common feature of private equity transactions, designed as an incentive for owner managers. The effect of the ratchet is to increase the amount of equity held by managers if certain performance targets are reached. The terms of the ratchet are normally contained in the company's articles of association.

A performance ratchet arrangement is designed to have the effect that the percentage of the new company's (Newco) equity held by management will vary according to the performance of the company after the investment is made, rising if the company performs well and falling if it does not. This is often introduced into pricing negotiations between management and private equity providers to bridge the gap between management's optimistic performance forecasts and private equity providers' more conservative projections.

The performance measure for this type of ratchet can either be profits or, more usually, the realisation proceeds or the market capitalisation of the company on a sale or listing. These ratchets may be structured so that the private equity provider's preferred shares will convert into ordinary shares or be redeemed on a formula basis, such that the percentage of the ordinary equity held by management will increase.