Management Rollover: Keeping Skin in the Game

A rollover is an exchange rather than a sale. Management gives up its shares in the company being bought and receives shares in the buyer's new holding company instead. At Sankalp Industrial Systems Limited, an invented manufacturer, the senior team holds 2,00,00,000 shares worth Rs 200.80 crore at Rs 100.40 each, rolls half of that and takes Rs 100.40 crore in cash. The rolled half then earns exactly what the buyer earns.

Underneath that sits a distinction between a price and a position. Everybody else selling into a transaction turns a position into a price and walks away with a number; once the money is received, nothing that happens to the business afterwards reaches them. A rollover refuses that conversion for part of the holding. The shares are swapped for shares in the new structure, so the holder stays attached to whatever comes next. The arithmetic that follows is trivial and the arrangement is not. An exposure is being arranged, not a return. Hold on to that sentence. Almost everything written about rollovers gets it backwards.

What actually happens to the shares when management rolls over?

Picture a shopkeeper selling a stall in a market. The straightforward version is that a buyer hands over cash, the shopkeeper hands over the keys, and the two of them are finished with each other. Now picture a different arrangement: the buyer is assembling four stalls into one business, and instead of cash the shopkeeper accepts a share of that new business for part of the stall. There is no moment where the shopkeeper is holding money. One thing became another thing, in a single move, and the shopkeeper is now a part owner of something bigger and more indebted than what was given up.

The exchange the shopkeeper made is a rollover, and the single move is the part people get wrong. A sale followed by a purchase is the tempting description, and it is the easier one to say: management sells the shares for Rs 100.40 crore, then invests that Rs 100.40 crore back into the buyer's new holding company. Described that way the rollover sounds harmless, and it is not. The description invents a movement of cash that never occurs, and that invented movement is the root of the funding error set out below. At Sankalp Industrial Systems Limited the rolled shares are exchanged directly. No cheque is written for them, no cheque is received for them, and the only thing that happens is that a claim on one company is replaced by a claim on another.

How big is the holding, and what is it worth at the transaction price?

Before anything can be rolled there has to be something to roll, and the size of it is the first thing to pin down. The senior management team of Sankalp Industrial Systems Limited holds 2,00,00,000 shares. The company has 20,00,00,000 shares in issue, so the team holds 10.0 per cent of it. Sthira Capital Partners, also invented, is the sponsorA buyer whose business is acquiring companies with a mixture of borrowing and its investors' money, holding them for a few years, and selling them on. buying the whole of the equity, and it is paying Rs 100.40 for each share.

Multiply the two and management's holding is worth Rs 200.80 crore at the transaction price. Every choice management makes from here is a choice about what to do with that Rs 200.80 crore. Notice what the figure ignores. Rs 200.80 crore does not depend on what the shares cost management originally, on their value last year, or on anybody's opinion of what they should be worth. The figure is the transaction price times the number of shares, and the transaction price is Rs 100.40 whether a share is sold or exchanged.

How much gets rolled, and how much is taken in cash?

Management rolls half of it. Rs 100.40 crore of the holding is exchanged into the new holding company, and Rs 100.40 crore is taken in cash on completionThe day a transaction actually closes and what was agreed changes hands.. In share terms that is 1,00,00,000 shares exchanged and 1,00,00,000 shares sold, out of the 2,00,00,000 held.

The split is a decision about proportion and never about price. Proportion and price get confused constantly, so the distinction is worth being precise on. Both halves are valued at Rs 100.40 a share. The rolled half is not exchanged at a discount, and the cash half is not sold at a premium. Management is choosing how much of a fixed pot to convert into a number and how much to leave attached to the business. Think of somebody selling a flat and agreeing to leave a quarter of the proceeds with the buyer as a stake in the buyer's next building. The flat's price does not change. The change is in how much of that price the seller ends the day actually holding.

What share of the new holding company does the rolled amount buy?

Now the rolled amount has to turn into something the holder can point at, and it does so by one division. Equity in the new holding company that Sthira Capital Partners has formed comes to Rs 1,200.00 crore in total. Management's rolled Rs 100.40 crore goes into that pot on the same terms as every other rupee of it. Divide one by the other: Rs 100.40 crore over Rs 1,200.00 crore is 8.3667 per cent, written 8.37 per cent.

From that division onwards, every figure about the rolled stake is 8.37 per cent of the equity, and nothing else needs working out. The stake is worth 8.37 per cent of the equity today. At exit the stake is worth 8.37 per cent of the equity at exit. If the business falls apart the stake loses 8.37 per cent of what the equity loses. The percentage is the whole of the position, so the denominator is worth a moment. The denominator is the equity of the new holding company, Rs 1,200.00 crore. The denominator is not the Rs 2,448.00 crore the business itself cost, and it is not the 20,00,00,000 shares of the old company. Getting that denominator wrong is the commonest slip on this arithmetic and it changes the answer by roughly half.

Does the rollover reduce what the buyer has to fund?

This is where instinct fails almost everybody, and the instinct is a reasonable one. Management is putting Rs 100.40 crore of value into the structure, so surely Sthira Capital Partners needs Rs 100.40 crore less to complete the transaction. The answer is that the total does not move at all.

Work through the five things the money actually pays for. Sthira Capital Partners is paying Rs 2,008.00 crore for the whole of the equity of Sankalp Industrial Systems Limited, repaying Rs 600.00 crore of the company's existing borrowing, buying out a Rs 60.00 crore minority holding, and paying Rs 32.00 crore of financing feesAmounts paid to arrange the borrowing. They leave on day one and buy no asset at all. and Rs 20.00 crore of advisory and other transaction fees. The five items come to Rs 2,720.00 crore, and not one of them gets smaller because management chose to roll. Every other shareholder still has to be paid in full. Management's own cash half, Rs 100.40 crore, still has to be paid too.

The rollover changes the composition of the Rs 1,200.00 crore of equity, never its size: Rs 1,099.60 crore is new money from Sthira Capital Partners and Rs 100.40 crore is management's rolled stake. Think of four friends buying a shop together for a fixed price. One of them already holds a bit of the shop and agrees to leave that bit in rather than being bought out. The shop costs the same. The other three now write smaller cheques between them, and the fourth holds a smaller slice than the money would have bought. Nobody got a discount from the seller.

What does the rolled stake earn, and why exactly that?

Five years on, Sthira Capital Partners sells Sankalp Industrial Systems Limited. The borrowing has been paid down out of the business's own cash, the business is earning more than it was, and after the remaining lenders are repaid the equity in the new holding company is worth Rs 2,880.15 crore. The Rs 2,880.15 crore assumes the price the business fetches, measured against its earnings, is the same on the way out as it was on the way in, so none of what follows comes from the market paying more for the same business.

Management's stake is 8.37 per cent of that equity. Take 8.3667 per cent of Rs 2,880.15 crore and the answer is Rs 240.97 crore, against the Rs 100.40 crore rolled. As a money multipleHow many rupees came back for each rupee committed. The length of the holding period plays no part in it. that is 2.40 times, and as an internal rate of returnWhat a year of holding earned, expressed as one percentage that reconciles the money going in with the money coming out. it is 19.14 per cent a year, precisely what Sthira Capital Partners earns on its own Rs 1,200.00 crore.

Check it a second way. A figure that arrives by two routes is worth more than a figure that arrives by one. The equity went from Rs 1,200.00 crore to Rs 2,880.15 crore, a rise of 2.400125 times. Multiply Rs 100.40 crore by 2.400125 and the answer is Rs 240.97 crore again. Both routes land on the same rupee, and they are bound to. A proportionate holding means exactly that.

The reason the rates are identical fits in one line, and it is a condition rather than a result. The rolled stake is the same instrument as the sponsor's: the same class of equity, ranking in the same place, bought at the same moment and sold at the same moment. A proportionate holder of the same thing over the same period cannot earn a different rate. Change any one of those conditions, and the identity breaks immediately.

If the return is identical, what is the point of rolling at all?

This is the central point. The return is not the point, and the figure that is the point is the Rs 100.40 crore of downside management is now carrying alongside Sthira Capital Partners.

The 19.14 per cent says nothing at all about the management team of Sankalp Industrial Systems Limited. The rate is not an achievement, and it is not even a choice: a proportionate holder of the same equity earns that rate by construction, and the number would have been identical had management rolled a rupee or rolled everything. Reporting it as though management had done well is like congratulating somebody for the tide coming in.

The change is in where the money sits. The Rs 100.40 crore is now behind Rs 1,300.00 crore of borrowing: Rs 900.00 crore of senior term loanBorrowing that stands at the front of the repayment queue and is normally paid down in instalments rather than in one lump. and Rs 400.00 crore of subordinated notesBorrowing that waits behind the senior lenders for its money, and charges a higher coupon for agreeing to wait.. Both of those get paid before any equity holder sees a rupee. If the business does badly enough that the borrowing consumes everything, management's Rs 100.40 crore is gone, in exactly the same way and at exactly the same moment as the sponsor's Rs 1,099.60 crore. Rank is the real subject of the arrangement, and rank is invisible in a return figure.

What did management give up by rolling half the holding?

Certainty, and it is worth stating in rupees rather than describing. Taking the whole Rs 200.80 crore in cash produces a known outcome: Rs 200.80 crore, in hand, on completion day, whatever happens to Sankalp Industrial Systems Limited over the next five years. There is no arrangement under which that figure becomes smaller. It is finished.

Rolling half replaces half of that known outcome with a claim. Management ends completion day with Rs 100.40 crore of cash that behaves exactly as it would have done, plus a stake worth Rs 240.97 crore on the assumptions the transaction was built on, worth less if the business does worse than those assumptions, and worth nothing at all if the equity is wiped out by the borrowing that ranks in front of it. Management gave up the certainty of Rs 100.40 crore in cash on completion day, and that sentence, rather than the 19.14 per cent, is the whole of what a rollover means.

Everyone has met a small version of this. A carpenter finishing a kitchen for a new restaurant is offered the bill in full on the day, or half the bill on the day and a small share of the restaurant's takings for five years. The second offer might well be worth more. The second offer is also the one where the carpenter can end up with half a bill and nothing else, and no amount of arithmetic about the likely takings turns that into the same kind of thing as a paid invoice. The two are not more and less of one quantity. They are different quantities.

What does this arithmetic refuse to show?

Everything above is symmetrical. Rs 100.40 crore in, Rs 240.97 crore out on the stated assumptions, nothing out in the worst case, and the same proportions for the sponsor. The arithmetic treats management and Sthira Capital Partners as two holders of the same instrument. For the purpose of the return calculation that is exactly what they are.

No line of that arithmetic can show that the two holders are not in the same situation. One of them also works there. The sponsor holds Sankalp Industrial Systems Limited alongside other investments and can be wrong about it without much else changing. The management team has its savings in the same structure as its salary, and both depend on the same five years going the way the transaction assumed. The asymmetry is genuine, and it points in more than one direction: it can concentrate attention usefully, and it can also make a person unwilling to say out loud that a plan is not working.

The asymmetry has no figure attached to it. Nothing in the record for Sankalp Industrial Systems Limited measures it, and a number invented to fill that space would look derived and be fiction. Where the arithmetic runs out, say so, and resist the temptation to keep computing.

How does a lender, an analyst or an investment committee read a rollover?

Three different people look at the same Rs 100.40 crore, and each wants something quite different out of it. The differences are worth knowing. Between them they explain why the arrangement exists at all.

A lender to the new holding company reads it as equity that showed up without the sponsor having to raise it, and then checks that it really is equity. The question is whether the rolled stake ranks behind the borrowing in the same place as everything else in the Rs 1,200.00 crore. If it does, the Rs 1,300.00 crore of lending has Rs 1,200.00 crore of cushion underneath it in the ordinary way. If the rolled stake had been given a preference or a right to be repaid early, the cushion would be thinner than the Rs 1,200.00 crore figure suggests, and the lender would be looking at a different transaction from the one on the term sheet.

An analyst reads it as a fact about the people, not a fact about the price. The Rs 240.97 crore is unremarkable, and it follows mechanically from the 8.37 per cent and the exit figure. The Rs 100.40 crore of exposure is the figure worth writing down. The exposure says that the people running the business have accepted an outcome that depends on the next five years. The exposure is information about incentives, and it survives even when every projection in the transaction turns out wrong.

The sponsor's own investment committee reads it as the answer to a question it always asks: what happens to this business if the management team leaves in year two. A team that has taken Rs 200.80 crore in cash is free in a way that a team holding Rs 100.40 crore of the structure is not. The rollover buys the sponsor a form of commitment that no contract produces as reliably. Buyers ask for it for that reason, and the phrase about skin in the game has outlived every fashion in transaction structuring for the same one. None of that shows up in the return arithmetic, and all of it is why the arithmetic is done.

Five settings of that control are printed below, so the whole of it is readable without touching anything. Read across any row and the pattern is the same: the certain cash falls in a straight line, and the share, the exit value and the downside carried all rise in a straight line together. Each is the rolled amount multiplied by a fixed number. The row for half rolled is the transaction as it was actually done.

One thing in that table is a trap, so name it before somebody trips on it. A little under a third of the way along, at about 29 per cent rolled, the exit value of the stake passes the cash left on completion day: both land near Rs 141.74 crore. The crossing is real and it means nothing at all. The two quantities being compared are not the same kind of thing. One of them is money in a bank account and the other is a claim that ranks behind Rs 1,300.00 crore of borrowing and holds only if five years go as assumed. Putting them on one scale makes them look comparable, and that is exactly why the downside carried is printed beside the exit value at every setting.

What would change if the rolled stake were a different instrument?

Everything after the split depends on one condition: the rolled Rs 100.40 crore buys the same class of equity as the sponsor's, ranking in the same place, entered and exited at the same moments. The condition produces the identical 2.40 times and 19.14 per cent, and nothing else produces them.

Loosen any part of that condition and the identity breaks, so a note that keeps quoting the same rate afterwards is quoting a figure that no longer applies. If the rolled stake sat ahead of the sponsor's in the queue, it would lose less in a bad outcome and would have given up some of the good one. If it were an instrument with a fixed entitlement rather than a share of whatever is left, the exit equity would stop being the right number to multiply. If management could exit at a different moment, the holding period would differ and the annual rate would differ with it.

The transaction record for Sankalp Industrial Systems Limited locks none of those alternatives. A different instrument would give a different answer, and a number invented for an arrangement nobody specified would look derived and be nothing of the sort; a derived-looking wrong number is far more dangerous than an admitted gap.

Sankalp Industrial Systems Limited and Sthira Capital Partners are invented.
Educational material. Not advice on any investment, tax, budget or market position.