The strong U.S. initial public offering (IPO) market, coupled with favorable regulatory changes and market acceptance of innovative transaction structures, has increased the attractiveness of the IPO as an exit alternative to financial sponsors.
In 2014 the U.S.IPO market was more active by several measures than at any time since the end of the Tech Boom in 2000. There were 288 initial public offerings in the United States in 2014, the highest total since 2007 according to IPO Watch, a quarterly survey by Pricewaterhouse Coopers. Total IPO proceeds reached US$83.9 billion in 2014, which approached the aggregate proceeds of US$92.6 billion raised in 2000. High stock market valuations and an energetic IPO market have led many financial sponsors to take their portfolio companies public. According to IPO Watch, financial sponsors backed 61 percent of all US IPOs by number and 71 percent by value in 2014.
In addition, new and innovative transaction structures, such as the so called “Up-C” or Umbrella partnership C-corporation structure, have provided financial sponsors with attractive, flexible tax structures to consider in evaluating whether to test the public markets. Specifically, these structures allow financial sponsors to maintain advantageous flow through tax treatment and certain indicia of control over their portfolio companies even after an IPO -- rights which were formerly lost for a sponsor in a traditional IPO. These structures combined with the regulatory changes brought by the JOBS Act, have created an environment that give financial sponsors more options than ever before when considering the exit strategy for their portfolio company investments.
Innovative Corporate Financing Structures Enable Financial Sponsors to Perpetuate Attractive Tax & Governance Characteristics of Recently Private Companies
The robust 2014 IPO market was driven by more than just a general increase in stock market valuations. Critical changes in US regulation, increased acceptance of sponsor-friendly governance provisions and the development of attractive corporate financing techniques combined to drive a surge of financial sponsor participation in the new issue market.
Controlled Company Structures
Since 2002, the Sarbanes Oxley Act has heightened the corporate governance standards of US public companies and, by design, has increased the regulatory burden and cost of compliance applicable to US public companies, including those seeking to complete an IPO. However, many of the restrictions applicable to public companies under the Sarbanes-Oxley Act and the related regulations and listing rules implementing that law are relaxed for “controlled companies,” which are companies a majority of the voting shares of which are held by another company or entity.
The derogation from corporate governance standards for controlled companies has particular relevance for financial sponsors and the portfolio companies they take public. Most financial sponsors do not sell all or even any of their interest in a portfolio company at the time of its IPO, which is generally reserved for additional issuances of primary shares by the portfolio company. Rather, a financial sponsor will typically look to exit completely or in stages after the IPO pursuant to privately negotiated block sales or registered secondary offerings. In this way, the financial sponsor obtains the benefits of a liquid market for its interest in the portfolio company and a clear indication of the value of its investment, without placing undue pressure on the portfolio company’s prospects for a successful IPO or post-offering stock price through excessive selling. As a result of this typical IPO process, most sponsored portfolio companies that complete an IPO remain “controlled companies” under the parlance of the Sarbanes Oxley Act.
As a result of these factors, the controlled company exceptions under the Sarbanes-Oxley Act have created numerous avenues for financial sponsors, or groups of financial sponsors acting in concert, to retain a measure of control over their portfolio companies even after such companies complete an IPO. For example, a controlled company is not required to have a board comprising a majority of independent directors. In contrast, a majority of the board of directors of a non-controlled company must be independent within one year of listing on either the New York Stock Exchange (NYSE) or NASDAQ. As of 2011, the median level of director independence among a group of 28 controlled companies was 37 percent, and 64 percent of such companies had classified, or staggered boards. This percentage is significantly higher than non-controlled listed companies and contrasts sharply with the guidance of stockholder advisory firms such as RiskMetrics/ISS. Such classified boards can enable financial sponsors to retain disproportionate representation on the board of directors of a portfolio company following an IPO. And, while controlled companies are legally required to have fully independent audit committees within one year of listing on either the NYSE or NASDAQ, they are not required to have independent nominating and corporate governance committees, as are non-controlled companies.
Likewise, controlled companies are not required to undertake an independent nominating process for directors if they are subject to contractual provisions regarding the nomination of their directors. As a practical matter, this means that financial sponsors can, by retaining control over a portfolio company following its IPO, subject such company to restrictions on the ability of its independent directors, or board of directors generally, to nominate directors for election by the stockholders. Financial sponsors have utilized these provisions of the law to retain the right to nominate or designate directors to serve on the board and/or specific committees of the board of directors of companies which they control. Controlled companies often have other provisions in their organizational documents that serve to enable their control persons, which often include financial sponsors or groups of financial sponsors, to retain control over such companies, including multiple share classes with disparate voting rights, veto rights or limitations over specified actions by such company or the board of directors (including amendments to the organizational documents, change of control, liquidation, non-pro rata dividends or repurchases), provisions permitting stockholder action by written consent, favorable fee arrangements for affiliates of the financial sponsor(s), limitations on access to information by prescribed persons and transfer restrictions imposed on certain key stockholders (including rights of first offer and tag-along rights) that are more typically found in private companies. These contractual rights have been increasingly preserved, along with pre-IPO beneficial tax treatment (as more fully described below), as part of the “Up-C” structure, which based on the number of successful offerings over the past three years seems to have gained market acceptance as evidenced by the fact that 75% of the Up-C IPOs reviewed by Dechert since 2005 priced at or above their initial filing ranges.
Taking a page from the market for real estate investment trusts, financial sponsors and other significant stockholders have pioneered the use of the so-called Up-C structure in connection with IPOs. Prior to an IPO, many portfolio companies of financial sponsors are organized under state law as limited liability companies that are treated as partnerships for income tax purposes. As a result, such portfolio companies pay no entity level corporate income tax. Until fairly recently, the convention was to convert any such limited liability company into a C-Corporation prior to the closing of its IPO (and typical sponsor-backed portfolio company LLC agreements contain provisions providing for automatic conversion upon an IPO). As a result, stockholders of the new corporation experienced double taxation in respect of their share of the income of such corporation after the IPO was completed, with the corporation first paying corporate income tax and then the stockholders paying income tax on any dividends they received.
To avoid this outcome, or at least to defer the onset of double taxation for as long as possible, financial sponsors and other controlling stockholders have developed and adopted the Up-C structure. In this structure, the original portfolio company (“OpCo”) is restructured as a less than wholly owned subsidiary of a C-corporation (“HoldCo”). The incumbent owners of such OpCo continue to hold their interests in the OpCo directly in the form of limited liability company interests or some equivalent interest. Public investors in the IPO actually acquire shares of common stock in HoldCo, through which they own an allocable portion of OpCo. HoldCo becomes, as a result of the IPO, the public company that is listed on a national securities exchange, houses the executive management team of the company and its board of directors. In connection with the pre-IPO restructuring, the incumbent investors in OpCo receive a non-economic interest in HoldCo that entitles them to vote their allocable portion of the voting stock in OpCo at the HoldCo level. As a result of these machinations, the incumbent investors in OpCo retain their ability to receive distributions from OpCo directly, and not through a taxable corporation, thereby avoiding double taxation on any such distributions; however, they do not suffer any diminution of their proportional voting interest in HoldCo as a result of such structuring. In most cases, if an interest holder in OpCo subsequently transfers its interest to a third-party, such interest is automatically converted into a share of common stock in HoldCo. Through this mechanism, incumbent OpCo investors (including financial sponsors) do not suffer any adverse liquidity consequences from their ownership of securities at a level in the capital structure below HoldCo. Additional benefits are typically realized by the sponsor in the Up-C structure through the implementation of a tax receivable agreement between HoldCo and the sponsor and other owners of OpCo equity. Under the terms of such a tax receivable agreement, HoldCo pays to the owners of OpCo equity, including the sponsor, a portion (typically more than 50%) of the amount of any tax benefits realized (or deemed realized) by HoldCo as a result of increases in the tax basis of the assets of OpCo resulting from any redemptions or exchanges of OpCo equity interests by HoldCo.
As a result of the financial sponsor’s ownership of the non-economic interest in the public HoldCo, the listed company will typically be a “controlled company” of the financial sponsor under the Sarbanes-Oxley Act. Over the last several years we have seen multiple successful deals come to market where, through rights embedded in a Shareholders Agreement or the OpCo organizational documents, which are publicly disclosed in the IPO process, financial sponsors are able to maintain real control rights in the listed company, even after an IPO has been completed. These control rights are extremely valuable to financial sponsors because it gives them increased comfort that their representatives on the HoldCo Board will be able to continue to guide the portfolio company even after the IPO, helping to ensure an ultimately successful exit.
We reviewed approximately 20 recently completed Up-C IPO transactions involving financial sponsors. We found that many of the following rights were generally successfully maintained by the financial sponsor after the IPO in a majority or more of the identified transactions:
- the right to appoint and remove directors;
- the right to approve of the hiring or firing of the Chief Executive Officer;
- the right to approve of any change in business strategy or business plan by OpCo;
- the right to approve any acquisition or disposition by OpCo or incurrence of indebtedness by OpCo or HoldCo;
- the right to approve any change of control of OpCo or HoldCo;
- the right to approve of any issuances of additional equity interests;
- the right to approve of the payment of any dividend or distribution; and
- the right to approve or amend any equity incentive plan.
In addition to the rights noted above, in a limited subset of sponsor-backed Up-C IPOs, the financial sponsors were able to retain additional control rights, including the right to appoint OpCo’s auditors, the right to control the making of OpCo tax elections and the right to approve the OpCo budget. In certain of these Up-C IPO transactions the financial sponsor’s approval rights, or a subset of those rights, terminated upon a decrease in the voting equity position held by the sponsor. In transactions in which the financial sponsor’s approval rights were tied to voting equity ownership, the sponsor’s rights typically diminish in accordance with significant step downs generally corresponding to the thresholds at which the sponsor is entitled to appoint HoldCo directors.
Regulatory Developments Facilitate Capital Formation
Recent regulatory changes under The Jumpstart Our Business Start-ups (JOBS) Act appear to have boosted the overall IPO market as well as the number of financial sponsors seeking IPO exits for their investments. Additionally, the benefits available to IPO issuers under the JOBS Act are applicable to both qualifying non-controlled company and controlled company issuers alike, further facilitating the ability of financial sponsors to more efficiently implement the innovative transaction structures noted above.
Among its many provisions, the JOBS Act (1) enables companies that meet the broad definition of an “emerging growth company,” or EGC, to benefit from provisions that streamline and simplify the IPO process and (2) assists newly public companies in adjusting to the rigors of public ownership and SEC reporting in the first years after an IPO. The JOBS Act defined an EGC as any company having total gross revenues of less than US$1 billion during its most recently completed fiscal year prior to commencing an IPO. Thereafter, a company remains an EGC and continues to benefit from the favorable provisions of the JOBS Act until (1) the end of its first fiscal year in which it has gross revenues over US$1.0 billion; (2) the end of the fiscal year ending after the fifth anniversary of its IPO; (3) the date on which it issues more than US$1.0 billion in non-convertible debt in any three-year period, and (4) the date on which it becomes a “large accelerated filer” under the Securities Exchange Act of 1934 (“Exchange Act”), meaning its total market capitalization exceeds US$700.0 million. In light of this expansive revenue threshold, approximately 77% of the companies brought to market met the EGC definition in 2014.
Under the JOBS Act, an EGC may elect to comply with several relaxed disclosure and operational requirements under the Securities Act of 1933 (the “Securities Act”) that otherwise apply to companies seeking to register with the SEC. For instance, an EGC is only required to provide two years of audited financial statements rather than the three years mandated for non-EGC registrants, and need not provide selected financial data for any years prior to the first of its two required audited years. This shortened disclosure period can yield significant savings for portfolio companies of financial sponsors and often will allow sponsors to take portfolio companies to market faster, particularly as many such companies will often have undergone complex change of control transactions during the five fiscal-year period prior to an IPO. Absent such relief, these portfolio companies would have to audit a third fiscal year to include in their registration statements and prepare unaudited financial statements for two additional years.
The JOBS Act also enables EGCs (or persons acting on their behalf) to “test the waters” by communicating with certain sophisticated investors, including qualified institutional buyers and institutional accredited investors, to gauge their interest in investing in such companies even before filing a registration statement with the SEC. Prior to the passage of the JOBS Act, any such communication would have constituted unlawful “gunjumping” and led to a cooling off period before an IPO registration could commence. Another provision of the JOBS Act facilitates research coverage of IPO candidates by enabling the publication of research reports by brokers, dealers and exchange members during the “quiet” period after an EGC’s IPO and prior to the expiration of any IPO underwriter’s “lock-up” period. The law also facilitates the publication of research regarding EGCs by specifying that research regarding an EGC that has filed or intends to file an SEC registration statement does not constitute an “offer” of the EGC’s securities under the Securities Act. Absent such relief, publication of research concerning a candidate for an IPO would raise the specter of liability for the firm publishing such research and for the company that is the subject of such report. The impact of these changes in the regulations governing the publication of research at or around the time of an IPO remains unclear, as the SEC continues to interpret such regulations, market practice continues to evolve, and certain leading investment banks must navigate between the flexibility afforded by the JOBS Act and continuing restrictions to which they are subject under a 2003 Global Research Analyst Settlement with the SEC.
Finally, and perhaps most importantly, the JOBS Act facilitates IPOs by permitting EGCs to file their initial registration statement and subsequent amendments with the SEC on a confidential basis until 21 days prior to the commencement of the EGC’s roadshow. While this confidential filing provision has been well received by all manner of potential IPO candidates, it is particularly attractive to financial sponsors, as it permits them to undertake a discrete “dual tracking” exit process, whereby a financial sponsor can privately market a portfolio company to potential strategic buyers or other financial sponsors without necessarily disclosing that it may elect instead to exit through an IPO if the prices offered by potential buyers are not sufficiently high, and without losing any time in bringing such portfolio company to market if disposition negotiations break down. Allowing financial sponsors to confidentially dual track a proposed exit for their EGC portfolio companies provides sponsors with greater flexibility and control than ever was available before in managing a contemplated exit.
The strong IPO market of the past few years has provided opportunities for financial sponsors that have not existed in the past. These opportunities have resulted from the general strengthening of the public capital markets combined with favorable regulatory changes under the JOBS Act as well as market acceptance of innovative structures which have given financial sponsors a stronger position in post-IPO companies than was previously considered possible. These structures are being used now with increasing frequency by financial sponsors to manage successful exits from their portfolio company investments, and we believe have achieved market acceptance.