The Road Ahead for Private Equity: Workforce Management

The Non-Compete Landscape

In the past two years, there has been a significant move across the United States to effectively ban the use of noncompetes and other restrictive covenants in employment agreements. We have seen this taking place through a combination of statute and court decisions, creating a varied landscape across the country as different states pursue different routes, including outright bans or bans beyond a certain salary threshold.

In California, it has long been difficult to enforce noncompete and certain non-solicit clauses, with the state passing additional laws in 2023 that expand on those restrictions, effective January 1, 2024. The first of two new laws will prohibit employers from enforcing or entering into any contract containing such provisions, regardless of where and when the contract is signed and whether the employee is employed outside of California. The second law explicitly voids and prohibits the inclusion of non-competes in employment contracts and in the employment context.

While New York Governor Kathy Hochul ultimately vetoed a complete ban on non-competes passed by the New York legislature, it is likely that additional legislative efforts will be made to limit their enforceability in the state with a particular focus on having a salary threshold for those subject to such restrictions.

For private equity, Delaware has always been the favored jurisdiction but recent court decisions have struck down non-competes there too, including in the sale of business and profits interest context. We expect more states to go down the same route, leaving employers to look for more favorable jurisdictional alternatives and to review the enforceability of the language in their agreements.

Outside of California, non-solicits remain broadly acceptable as long as they are not drafted in such a way as to be considered a non-compete.

At a federal level, the Federal Trade Commission (FTC) has proposed a rule banning non-competes but it is not expected to vote on that until April 2024 and the National Labor Relations Board’s general counsel declared that noncompetes violate employees’ rights under Section 7 of the National Labor Relations Act. It remains unclear whether the FTC has the authority to institute a nationwide ban. 

In the U.K., the government has indicated an intention to restrict non-competes to three months, and has said it will introduce legislation in due course. We see private equity firms have not historically relied on non-competes in employment contracts increasingly looking to include those in the current environment, given that bonuses may be lower and therefore less likely to act as a retention lever. Other European countries, such as the Netherlands, are considering restrictions on non-competes, while many jurisdictions like France and Germany already have restrictive laws in place.

Executive Compensation

With sponsors getting less retention value out of bonuses this year, there was some movement at the start of 2023 to reset executive rewards and re-incentivize management at a number of funds, but that effort has largely slowed down. 

Where management equity is underwater, sponsors are looking at ways to keep management aligned. In the U.K., managers will have paid for their equity, so creative thinking is required. Often management equity only participates after the sponsor has made a return or IRR hurdle, so that hurdle can be reduced to boost the value of equity. 

A second option is to put the management equity higher up, potentially alongside the shareholder debt so that it can make a return regardless of whether the value breaks into the equity. Or sponsors can reduce the interest rate on their debt to minimize the drag on profits. In the U.S., where incentive equity is typically in the form of profits interests (with no up-front payment or tax), it is relatively simple to reset the awards by resetting the threshold or issuing a new series.

Unionization

Another issue capturing employer attention in the U.S. is the increase in union activity taking place in various jurisdictions. While unionization is still a small proportion f the private workforce, sponsors considering acquisitions of targets with unionized workforces will want to pay close attention to the terms of any applicable collective bargaining agreements, including defined benefit pension obligations.

Furthermore, even if the company is not in an industry that is widely unionized, in the current climate the potential for unionization of plants or assets down the line should be given careful consideration.

UK Political Outlook

From a political perspective, the prospect of the election of a Labour government in the U.K. in 2024 could result in moves to tax carried interest as income for private equity professionals. With many deal teams in London staffed primarily by non-U.K. residents, we anticipate a heightened focus on the mobility of the workforce and renewed efforts to incentivize general partners outside of carry.