Employment law reform: PE sponsors should be paying attention now
Hannah Netherton, Oyin Olukotun, Ben Booker-Moore and Narinder Jugpal at CMS outline what upcoming changes under the Employment Rights Act will mean for private equity firms.
They examine the potential implications for management changes, deal-making and equity arrangements, and set out the steps firms can take ahead of the changes coming into effect in January 2027.
Private equity has always been able to move relatively quickly when management change is needed.
If a portfolio business is not performing, leadership is often one of the first areas that investors assess. This primarily involves supporting the existing team, but there are some circumstances where a change in leadership becomes necessary to drive growth, execute a turnaround or prepare for exit. Either way, sponsors have generally been able to make those decisions with a fairly clear understanding of the main statutory employment law risks involved, namely a two-year qualifying period for ordinary unfair dismissal claims and a cap on compensatory awards of around £125,000 (assuming there are no discrimination or whistleblower protection issues, liabilities for which are already uncapped). Whilst no employee dispute is ever welcome, unfair dismissal has often been viewed as a manageable risk, even where senior executives are highly compensated, since there has always been a degree of assurance around potential exposure.
The Government's upcoming unfair dismissal reforms are set to change that.
Amongst some other wide-ranging changes under the Employment Rights Act 2025, from 1 January 2027, employees will only need six months' service (rather than two years’) to bring an ordinary unfair dismissal claim and – even more significantly – the current cap on compensatory awards will be removed.
The result is not that management change becomes impossible, but rather that it becomes more expensive, and riskier to get wrong.
Why PE sponsors should care
Without the cap, exiting highly remunerated individuals who then experience a prolonged search for an equivalent role, will likely materially increase the cost of the management change. Potential losses for ordinary unfair dismissal could now include future salary, bonus arrangements, pension contributions and other remuneration that an employment tribunal accepts the individual has lost because of the dismissal.
The position becomes even more complicated where equity is involved.
Management incentive plans (including LTIPs), growth shares, share options and other equity arrangements frequently distinguish between different categories of leaver, so dismissals can have consequences extending beyond employment rights into the economics of the MIP itself. Depending on the arrangements, recoverable losses may include lost equity value or the lost chance of participating in a future exit, subject to scheme terms and valuation evidence. A dismissal shortly before vesting or an anticipated exit may affect an executive’s expected return far more than the loss of salary alone.
The removal of the cap does not change the basis on which compensation is assessed during employment litigation. Losses must still be proved and mitigated, and compensation may be reduced to reflect the likelihood of a fair dismissal occurring anyway or the employee’s contributory conduct. An unfair dismissal finding also does not necessarily overturn a bad-leaver classification or confer good-leaver rights; those consequences depend on the relevant underlying documents. However, removing the cap may make losses arising from those provisions more significant, alongside any separate contractual dispute.
Where significant value is at stake, departing individuals and their advisers may have greater incentive to challenge a dismissal or hold out for a more substantial package.
Implications during deal-making
Commercial due diligence has always involved an assessment of whether the existing leadership team can deliver the investment strategy. These legal reforms may increase the value of making those decisions earlier. This is not necessarily an employment law point, it is a commercial one and could have an impact on deliverability of transactions.
However, employment legal due diligence may also take on greater significance. Ongoing grievances, disciplinary issues, performance management processes, and employees nearing the six-month qualifying threshold may all become more relevant pre-completion considerations, especially where management restructurings or wider workforce changes are anticipated.
For equity arrangements, sponsors should understand what triggers each leaver category, how departure affects vesting and value, and who exercises any discretion. Employment contracts and equity documentation should be reviewed together rather than in isolation with closer thought given to how the additional exposure is anticipated and allocated within equity documentation.
The reforms are also likely to influence transaction planning. If management transitions are expected, sponsors may wish to negotiate and document those departures as part of the transaction rather than deferring until after completion, particularly where management leavers are receiving value from equity arrangements. Any agreed departure should address both employment claims and equity rights.
Portfolio company considerations during the investment
As is typical in PE investment, the replacement of underperforming executives or the restructuring of senior leadership teams is commonplace. Under the new regime, those decisions are unlikely to disappear, but the execution of them may need to look different due to the increased costs of getting it wrong.
With a known ceiling on compensation, many portfolio companies and sponsors may have grown accustomed to proceeding with dismissals with little or no formal process. Once the changes take effect, they may need to place greater emphasis on documenting performance concerns, conducting fair processes and ensuring there is a clearly identifiable, potentially fair reason for a dismissal. A sponsor’s preference for a different management team, for example, does not necessarily establish a fair reason. Even where a negotiated exit is the intended outcome, establishing a sound procedural foundation at the outset may assist in managing exit costs and strengthening the employer’s position should settlement discussions prove unsuccessful.
Bear in mind also that unfair dismissal claims are not limited to employer-initiated dismissals. Constructive dismissal claims, brought where an employee resigns in response to a fundamental breach of contract, may also become more attractive to executives, as well as where contractual leaver treatment is more favourable in the event of a constructive dismissal.
What should sponsors be doing now?
The reforms are unlikely to change the fundamentals of investing, but the level of diligence, planning and process required to achieve those outcomes may increase.
Sponsors should be thinking ahead about how management transitions are identified, documented and executed (including how new senior hires are onboarded and actively assessed during probation), and whether existing diligence processes adequately identify employment risks that could become more significant under the new regime from January 2027.
For many sponsors, the key takeaway is: management change remains possible, but the cost of getting it wrong is increasing. Those who plan early and address issues before they become disputes will be in a stronger position once the new rules arrive.
Authored by Ben Booker-Moore,
Partner, Corporate, CMS
Authored by Hannah Netherton,
Partner, Employment, CMS
The views expressed in this article are those of the authors. Contact [email protected] or [email protected] for more information, as well as visiting https://cms.law/en/gbr/publication/employment-rights-act/employment-rights-act-tracker.