private equity
PRIVATE EQUITY “Private equity fund” = money to be invested. - Variety of sources: individuals , companies, institutional investors (pension funds, banks and insurance companies). - Specialist funds are created where investors agree to provide funds to be invested in particular types of private companies, usually in the form of a Limited Partnership (tax advantages). - Usually an agreed internal procedure for approval of opportunities (i.e. min/max investment or stake) “Private equity provider” = investors give money to them by way of a PE fund to invest in deals - Makes their profit by successful investment of PE funds - Often through fees based on percentage profits of successful investment returns. - Will try to maximise profit for the investors whilst minimising the risks of the investment in order to grow its own business successfully and develop a good rep in the private equity market. Types of investment 1. Start-up capital (providing financing at the outset of a business); a. Investment usually by way of subscription of shares in existing co 2. Development capital (providing finance for expansion); and a. Investment usually by way of subscription of shares in existing co 3. Buyouts (where finance is provided for the acquisition of a business) a. Small management buyout = a direct subscription for shares may be made in the acquiring company. b. Large management buyout = will be a substantial amount of debt finance as well as PE so a corporate structure may be created for the acq; and c. Large institutional leveraged buyouts = a fairly complex corporate structure will be used to cope with the numerous layers of investment and debt finance. Management Buyouts
(1) Management buyout (MBO)
(2) Management buy-in (MBI)
(3) Buy-in Management buyout (BIMBO)
Buyout by the existing management team
Buyout by an external management team
Combination of both (1) and (2).
Through a newco established for purpose of MBO Share or asset acq – will likely want majority SH Existing management draw up IM and PE providers bid to fund the deal – existing 0
management expected to fund too so they’re focused on success Funded by a combo of equity finance by management team and PE provider and debt funding over assets of target Institutional buyout
Leveraged buyout
Institutional investors looked for the opportunity themselves and are the driver of the process.
Majority of buyouts will be funded by institutional investors, but won't necessarily be an institutional buyout (e.g. if it is existing management driving the process).
Hope to acquire majority stake in target – will need potential to generate sig profits
PE provider will try to achieve best debt-to-equity mix in order to maximise profit. PE will consider its internal rate of return (how much gain will be achieved on the sale based on projections for the increase in value of the target ). Will depend on how much equity needed: the lower the equity, the greater the gains per share.
Debt funding can be secured against target assets
Leveraged buyouts are where acquisitions are funded through a significant amount of debt finance (bonds and loan notes). Management will not be driving force but instrumental because of knowledge to maximise profitability of target – will be incentivised to give successful exit (e.g. sweet equity) Management on a LB will be either existing, PE appointed NED’s, or a combo of both Management team will be expected to give warranties in relation to its business plan and information provided by it about the target.
Structure: (1) Holding / topco = act as the investment vehicle for all the equity funds (those provided by the PE provider and management team). (2) Wholly-owned subsid of topco = will undertake the bank borrowing needed to provide the balance of the acq cost. The actual purchase of the target company may be made by this subsid,or [(3) Wholly-owned subsid of the subsidiary = may instead make the purchase of target if that suits the tax and other circumstances of the transaction.] 1
Senior Debt vs.
Senior debt is the first ranking secured debt. Mezzanine debt is Second ranking secured debt.
Mezzanine lenders will not recover any debts until Senior Debt is repaid in full, and has a higher rate of interest than a Senior Debt as it is more risky.
An equity kicker is a 'warrant' offered to Mezz lenders, which gives them the lender the right to convert its loan into equity shares for par value. This is beneficial as it can convert its loan to equity shares just before the equity investors are going to float/exit (when there is no risk to being a shareholder) and float its shares above the value it would have received had it remained as a debt.
Mezzanine Debt Equity Kicker
Equity Investor Loan
Sweet Equity
Redeemable fixed cumulative preference shares
Redeemable can sell back to the company just before exit or flotation (can’t float preference shares)
Ordinary A Shares
Equity investor lends money to the company rather than (or as well as) shares. May have a high rate of interest: (i) unsecured; (ii) ranked high; (iii)but tax deductible for the company Management pay £X amount to take equity in the company. Why is it sweet? Because the management obtain same shares with same value as the equity investors, but the investors have to risk a substantially larger sum of money (e.g. £15m preference shares to the £800,000 equity of the management) to obtain Same amount of return. Isn't this just a loan? Here's £X, at the end of the period pay me back. In the meantime I will get a fixed return of X% p/a Looks like a loan - why not just do a loan? (i) no tax (ii) no voting rights (iii)makes company look healthier (lender has no rights and it is equity, rather than debt finance). Ranks behind lenders, always
Fixed cumulative preference receive a fixed dividend in preference to all other dividends (e.g. 4% p/a) the dividend is cumulative, which means that if the investor does not get a dividend in one year, it rolls over into the next year. fixed because the value of shares never changes (get back what you put in) Generally have Same rights as ordinary shares: (i) voting rights (ii) rights to dividend (iii)rights to capital
BUT, crucially they rank behind everything but ahead of ordinary shares. Check articles of association for the rights attached to Shares. 2
Ordinary Shares
Right to vote Right to receive dividend/capital Essentially what CA 2006 envisaged.
Good / Bad leaver
Set out in the Arts Investment is an incentive, so PE fund will require that any managers leaving will be required to sell their shares in a prescribed manner and at a prescribed price. o Price will depend on the circumstances for the departure under good/bad leaver provisions Bad leaver generally get the lower of (a) market value and (b) price when shares were issued Good leaver will get market value GOOD LEAVER = leaving on death, disability, or retirement or may include any dismissed without cause o what constitutes without cause may be contentious. BAD LEAVER = those leaving for no good reason (e.g. a new job) or who are dismissed with cause.
Drag Along
Tag Along
Investment agreement and Arts power to force other shareholders to sell their shares if an offer is received from a third party for a controlling interest in Newco 1. o Operates by specifying that minority shareholders must transfer their shares to that third party on same terms as those proposed by the PEP. Triggering of drag along rights is subject to negotiations o e.g. the minority shareholders may be able to impose restrictions on the timing of any sale and what would be an acceptable form of consideration. Investment agreement and Arts A drag along provision will not ensure management's shares are included within an exit sale. Tag along provision provides that the majority are unable to sell all or a substantial proportion of their shareholding without B also agreeing to buy a corresponding proportion of the minority shares on same terms. Allows management to participate in an exit
Structure of a typical buyout
Equity Finance £20m Inter-company loan **Inter-group facility agreement**
Newco 1 (top company)
Private equity fund (£19.2m) A Ordinary shares (84%) (£4.2m) Preference redeemable shares (£15m)
2.
**Investment Agreement**
Management (£800k) Ordinary shares (4% each)
3
Scenario Newco 2
Debt Finance Mezzanine Lender (£10m)
£10m Intercompany loan
**Facility agreement** **Inter-creditor agreement?**
Newco 3 (acquisition company)
Debt Finance cont. Senior Debt Lender (£30m) **Facility agreement**
£60m Consideration for Target **Acquisition Agreement**
Target LTD (target company)
Target LTD is a wholly-owned subsidiary of S PLC. Private Equity Fund wishes to acquire Target LTD for £60m using a combination of equity finance and debt finance.
Equity finance (£20m) £19.2m equity finance will be provided for by the private equity fund in exchange for 84% A ordinary shares and preference redeemable shares. £800,000 will be provided by 4 of the existing management team equally (£200k each) in return for ordinary shares representing a 4% holding each. The whole £20m will be paid into Newco 1 (the top company) which has the effect of structurally subordinating the equity investors to both the Mezzanine and Senior Debt lenders. Debt finance (£40m) £10m debt finance will be provided by a Mezzanine lender into Newco 2. £30m debt finance will be provided by a Senior Debt lender into Newco 3. This will have the effect of structurally subordinating the Mezzanine lender (Newco 2) to Senior Debt lender (Newco 3).
S PLC (S) 100% shareholder of Target LTD
Why is it structured like that?
Order of Repayment
The above structure achieves 'structural subordination', meaning that any debts will be paid out in the order of:
1. 2. 3. 4. 5. 6.
1. Senior Debt will be repaid in full 2. Mezzanine debt will be repaid in full and finally 3. SH of Newco 1 will be paid in accordance with Arts This can also be achieved contractually, but banks prefer structural subordination as it provides more clarity and they do not have to worry about the top company.
Senior debt Mezzanine debt Any high yield bonds Loan notes held by private equity provider Preference shares are redeemed Any balance shared between holders of ordinary shares in Topco in accordance with any order of priority set out in Topco's articles of association.
Key documentation Principal Documentation in a Buyout
4
(1)Acquisition Documents
(2)Equity Finance
(3)Debt Finance
Parties: 1. S 2. Newco 3 (acquisition company)
Parties: 1. Private equity fund 2. Management 3. Newco 1 (top company) 4. [Lender]
Documentation 1. SPA 2. Disclosure letter and bundle 3. Tax deed of covenant 4. DD (legal)
Parties: 1. Banks 2. Newco 2 + Mezzanine debt lender 3. Newco 3 + Senior debt lender
Documentation 1. Investment Agreement 2. Service Contracts 3. Newco 1 Articles of Association
Documentation 1. Facility Agreement 2. Charge document (where taking security) 3. Inter-creditor Agreement
Principal Documentation - Summary Service Contrac ts
Parties:
SPA
Parties: 1. Seller 2. Newco 3 (acquisition company)
Normal SPA which sets out the terms on which S sells the target company and on which B is prepared to buy.
Parties:
What is it? Will take precedence over any other docs. Sets out the details of the equity investment being made, how much, and the purpose of those investments (i.e. to acquire the target). Sets out the details of the ongoing relationship between the PE provider and the management team taking an equity stake, including details of corporate governance of Target and vehicles created to undertake its acquisition (Newco 1, 2 and 3). The Investment Agreement is a private document and
Investm ent Agreem ent Private docume nt which requires unanimit y to
1. Private equity fund (on behalf of the private equity investors) 2. Management 3. Newco 1
1. Private equity fund (on behalf of the private equity investors) 2. Management 3. Newco 1 (top company) 4. Providers of
What is it? Management will be employees of Newco Group, and will have service contracts to reflect this. They will usually be in a standard form and deal with matters as you would expect, as well as the following contentious issues: (i) whether the manager can be placed on gardening leave (ii) restrictive covenants (iii)whether any bonus scheme is contractual or discretionary
It will cover the following matters: (i) Consideration Newco 3 pays 60m In exchange for 100% shares in Target LTD (ii) Warranties (iii)Disclosures (iv) Limitations
5
change Governs terms of investme nt
debt fund may also be party
unlike the constitution of Newco 1, does not need to be publicly disclosed. Comprehensive guide to all the parties involved - very lengthy will need to be reviewed in depth. Will include realisation provisions (usually 5y) – listing, sale to trade/PEP What does it contain? Other documents annexed in "Agreed Form" (i) Articles of Association (ii) Service Contracts and other related documentation Conditions precedent (i) Investor will only complete its investment in Newco 1 when conditions precedent have been satisfied, such as: management has subscribed in full, articles of association have been adopted, and Newco is properly insured. Warranties/Disclosure from Management (i) Investor will insist on management giving extensive warranties as they will invariably have more knowledge about Business. (ii) Investor will ask the management to verify key information on which it is basing its investment (such as the managers' business plan and projections, DD reports, etc). Right to appoint Investor Director & Chairman (i) Investors will have the right to appoint at least 1 non-executive director to Board of Newco 1 (and the target company) as well as an independent Chairman. (ii) Investor director will monitor the performance of the Target company. (iii)Fast-track procedure for the appointment and removal process Provision of Information (i) Require Newco to provide the investor with all the information and access it may need to monitor Newco and the Target effectively, such as: (a) monthly management accounts (b) audited consolidated annual accounts (c) minutes of each board meeting Restrictive Covenants (i) Prevent the management from engaging in competing businesses or soliciting customers, suppliers or employees for a period of time following completion of the investment Managerial Restrictions on Newco Group (i) Restrictions on what the management can and cannot do without the consent of the private equity provider (known as veto rights or negative covenants) Transfer of shares (i) Comprehensively dealt with in the Articles, but common to provide a contractual acknowledgement of this. Issue of shares 6
(1) Management buyout (MBO)
(2) Management buy-in (MBI)
(3) Buy-in Management buyout (BIMBO)
Buyout by the existing management team
Buyout by an external management team
Combination of both (1) and (2).
Through a newco established for purpose of MBO Share or asset acq – will likely want majority SH Existing management draw up IM and PE providers bid to fund the deal – existing 0
management expected to fund too so they’re focused on success Funded by a combo of equity finance by management team and PE provider and debt funding over assets of target Institutional buyout
Leveraged buyout
Institutional investors looked for the opportunity themselves and are the driver of the process.
Majority of buyouts will be funded by institutional investors, but won't necessarily be an institutional buyout (e.g. if it is existing management driving the process).
Hope to acquire majority stake in target – will need potential to generate sig profits
PE provider will try to achieve best debt-to-equity mix in order to maximise profit. PE will consider its internal rate of return (how much gain will be achieved on the sale based on projections for the increase in value of the target ). Will depend on how much equity needed: the lower the equity, the greater the gains per share.
Debt funding can be secured against target assets
Leveraged buyouts are where acquisitions are funded through a significant amount of debt finance (bonds and loan notes). Management will not be driving force but instrumental because of knowledge to maximise profitability of target – will be incentivised to give successful exit (e.g. sweet equity) Management on a LB will be either existing, PE appointed NED’s, or a combo of both Management team will be expected to give warranties in relation to its business plan and information provided by it about the target.
Structure: (1) Holding / topco = act as the investment vehicle for all the equity funds (those provided by the PE provider and management team). (2) Wholly-owned subsid of topco = will undertake the bank borrowing needed to provide the balance of the acq cost. The actual purchase of the target company may be made by this subsid,or [(3) Wholly-owned subsid of the subsidiary = may instead make the purchase of target if that suits the tax and other circumstances of the transaction.] 1
Senior Debt vs.
Senior debt is the first ranking secured debt. Mezzanine debt is Second ranking secured debt.
Mezzanine lenders will not recover any debts until Senior Debt is repaid in full, and has a higher rate of interest than a Senior Debt as it is more risky.
An equity kicker is a 'warrant' offered to Mezz lenders, which gives them the lender the right to convert its loan into equity shares for par value. This is beneficial as it can convert its loan to equity shares just before the equity investors are going to float/exit (when there is no risk to being a shareholder) and float its shares above the value it would have received had it remained as a debt.
Mezzanine Debt Equity Kicker
Equity Investor Loan
Sweet Equity
Redeemable fixed cumulative preference shares
Redeemable can sell back to the company just before exit or flotation (can’t float preference shares)
Ordinary A Shares
Equity investor lends money to the company rather than (or as well as) shares. May have a high rate of interest: (i) unsecured; (ii) ranked high; (iii)but tax deductible for the company Management pay £X amount to take equity in the company. Why is it sweet? Because the management obtain same shares with same value as the equity investors, but the investors have to risk a substantially larger sum of money (e.g. £15m preference shares to the £800,000 equity of the management) to obtain Same amount of return. Isn't this just a loan? Here's £X, at the end of the period pay me back. In the meantime I will get a fixed return of X% p/a Looks like a loan - why not just do a loan? (i) no tax (ii) no voting rights (iii)makes company look healthier (lender has no rights and it is equity, rather than debt finance). Ranks behind lenders, always
Fixed cumulative preference receive a fixed dividend in preference to all other dividends (e.g. 4% p/a) the dividend is cumulative, which means that if the investor does not get a dividend in one year, it rolls over into the next year. fixed because the value of shares never changes (get back what you put in) Generally have Same rights as ordinary shares: (i) voting rights (ii) rights to dividend (iii)rights to capital
BUT, crucially they rank behind everything but ahead of ordinary shares. Check articles of association for the rights attached to Shares. 2
Ordinary Shares
Right to vote Right to receive dividend/capital Essentially what CA 2006 envisaged.
Good / Bad leaver
Set out in the Arts Investment is an incentive, so PE fund will require that any managers leaving will be required to sell their shares in a prescribed manner and at a prescribed price. o Price will depend on the circumstances for the departure under good/bad leaver provisions Bad leaver generally get the lower of (a) market value and (b) price when shares were issued Good leaver will get market value GOOD LEAVER = leaving on death, disability, or retirement or may include any dismissed without cause o what constitutes without cause may be contentious. BAD LEAVER = those leaving for no good reason (e.g. a new job) or who are dismissed with cause.
Drag Along
Tag Along
Investment agreement and Arts power to force other shareholders to sell their shares if an offer is received from a third party for a controlling interest in Newco 1. o Operates by specifying that minority shareholders must transfer their shares to that third party on same terms as those proposed by the PEP. Triggering of drag along rights is subject to negotiations o e.g. the minority shareholders may be able to impose restrictions on the timing of any sale and what would be an acceptable form of consideration. Investment agreement and Arts A drag along provision will not ensure management's shares are included within an exit sale. Tag along provision provides that the majority are unable to sell all or a substantial proportion of their shareholding without B also agreeing to buy a corresponding proportion of the minority shares on same terms. Allows management to participate in an exit
Structure of a typical buyout
Equity Finance £20m Inter-company loan **Inter-group facility agreement**
Newco 1 (top company)
Private equity fund (£19.2m) A Ordinary shares (84%) (£4.2m) Preference redeemable shares (£15m)
2.
**Investment Agreement**
Management (£800k) Ordinary shares (4% each)
3
Scenario Newco 2
Debt Finance Mezzanine Lender (£10m)
£10m Intercompany loan
**Facility agreement** **Inter-creditor agreement?**
Newco 3 (acquisition company)
Debt Finance cont. Senior Debt Lender (£30m) **Facility agreement**
£60m Consideration for Target **Acquisition Agreement**
Target LTD (target company)
Target LTD is a wholly-owned subsidiary of S PLC. Private Equity Fund wishes to acquire Target LTD for £60m using a combination of equity finance and debt finance.
Equity finance (£20m) £19.2m equity finance will be provided for by the private equity fund in exchange for 84% A ordinary shares and preference redeemable shares. £800,000 will be provided by 4 of the existing management team equally (£200k each) in return for ordinary shares representing a 4% holding each. The whole £20m will be paid into Newco 1 (the top company) which has the effect of structurally subordinating the equity investors to both the Mezzanine and Senior Debt lenders. Debt finance (£40m) £10m debt finance will be provided by a Mezzanine lender into Newco 2. £30m debt finance will be provided by a Senior Debt lender into Newco 3. This will have the effect of structurally subordinating the Mezzanine lender (Newco 2) to Senior Debt lender (Newco 3).
S PLC (S) 100% shareholder of Target LTD
Why is it structured like that?
Order of Repayment
The above structure achieves 'structural subordination', meaning that any debts will be paid out in the order of:
1. 2. 3. 4. 5. 6.
1. Senior Debt will be repaid in full 2. Mezzanine debt will be repaid in full and finally 3. SH of Newco 1 will be paid in accordance with Arts This can also be achieved contractually, but banks prefer structural subordination as it provides more clarity and they do not have to worry about the top company.
Senior debt Mezzanine debt Any high yield bonds Loan notes held by private equity provider Preference shares are redeemed Any balance shared between holders of ordinary shares in Topco in accordance with any order of priority set out in Topco's articles of association.
Key documentation Principal Documentation in a Buyout
4
(1)Acquisition Documents
(2)Equity Finance
(3)Debt Finance
Parties: 1. S 2. Newco 3 (acquisition company)
Parties: 1. Private equity fund 2. Management 3. Newco 1 (top company) 4. [Lender]
Documentation 1. SPA 2. Disclosure letter and bundle 3. Tax deed of covenant 4. DD (legal)
Parties: 1. Banks 2. Newco 2 + Mezzanine debt lender 3. Newco 3 + Senior debt lender
Documentation 1. Investment Agreement 2. Service Contracts 3. Newco 1 Articles of Association
Documentation 1. Facility Agreement 2. Charge document (where taking security) 3. Inter-creditor Agreement
Principal Documentation - Summary Service Contrac ts
Parties:
SPA
Parties: 1. Seller 2. Newco 3 (acquisition company)
Normal SPA which sets out the terms on which S sells the target company and on which B is prepared to buy.
Parties:
What is it? Will take precedence over any other docs. Sets out the details of the equity investment being made, how much, and the purpose of those investments (i.e. to acquire the target). Sets out the details of the ongoing relationship between the PE provider and the management team taking an equity stake, including details of corporate governance of Target and vehicles created to undertake its acquisition (Newco 1, 2 and 3). The Investment Agreement is a private document and
Investm ent Agreem ent Private docume nt which requires unanimit y to
1. Private equity fund (on behalf of the private equity investors) 2. Management 3. Newco 1
1. Private equity fund (on behalf of the private equity investors) 2. Management 3. Newco 1 (top company) 4. Providers of
What is it? Management will be employees of Newco Group, and will have service contracts to reflect this. They will usually be in a standard form and deal with matters as you would expect, as well as the following contentious issues: (i) whether the manager can be placed on gardening leave (ii) restrictive covenants (iii)whether any bonus scheme is contractual or discretionary
It will cover the following matters: (i) Consideration Newco 3 pays 60m In exchange for 100% shares in Target LTD (ii) Warranties (iii)Disclosures (iv) Limitations
5
change Governs terms of investme nt
debt fund may also be party
unlike the constitution of Newco 1, does not need to be publicly disclosed. Comprehensive guide to all the parties involved - very lengthy will need to be reviewed in depth. Will include realisation provisions (usually 5y) – listing, sale to trade/PEP What does it contain? Other documents annexed in "Agreed Form" (i) Articles of Association (ii) Service Contracts and other related documentation Conditions precedent (i) Investor will only complete its investment in Newco 1 when conditions precedent have been satisfied, such as: management has subscribed in full, articles of association have been adopted, and Newco is properly insured. Warranties/Disclosure from Management (i) Investor will insist on management giving extensive warranties as they will invariably have more knowledge about Business. (ii) Investor will ask the management to verify key information on which it is basing its investment (such as the managers' business plan and projections, DD reports, etc). Right to appoint Investor Director & Chairman (i) Investors will have the right to appoint at least 1 non-executive director to Board of Newco 1 (and the target company) as well as an independent Chairman. (ii) Investor director will monitor the performance of the Target company. (iii)Fast-track procedure for the appointment and removal process Provision of Information (i) Require Newco to provide the investor with all the information and access it may need to monitor Newco and the Target effectively, such as: (a) monthly management accounts (b) audited consolidated annual accounts (c) minutes of each board meeting Restrictive Covenants (i) Prevent the management from engaging in competing businesses or soliciting customers, suppliers or employees for a period of time following completion of the investment Managerial Restrictions on Newco Group (i) Restrictions on what the management can and cannot do without the consent of the private equity provider (known as veto rights or negative covenants) Transfer of shares (i) Comprehensively dealt with in the Articles, but common to provide a contractual acknowledgement of this. Issue of shares 6
