Since 2012, the U.S. initial public offering (IPO) market has once again offered a robust option for private equity sponsors seeking to exit portfolio company investments. There were more than 100 IPOs of sponsor-backed companies in 2013, and 2014 is on track to match that total.
A viable IPO market allows a sponsor to conduct a “dual-track” process by pursuing an IPO, while at the same time conducting a private auction to sell the portfolio company. Many sponsors believe that the existence of the IPO alternative serves as an incentive for potential buyers in the auction to move more quickly and bid up the price. When an IPO is viewed as the preferred option, such as when the sponsor believes that the company is being undervalued by potential buyers or the sponsor otherwise wishes to benefit from the company’s future growth in the public markets, the dual-track process allows the sponsor to protect itself from the fickleness of the public markets by keeping the sale option on the table.
While an IPO offers the potential for greater returns in the long-term than a sale, sponsors must carefully manage the dual-track process and make sure the proper structure is in place in order to be in the position to obtain the maximum benefit from an IPO.
Managing the Dual-track Process
One of the historical considerations that companies have had in pursuing IPOs as part of a dual-track process is that they were required to publicly file their registration statements, including sensitive financial information, at the outset of the process when the ultimate success of the offering is uncertain. The recently enacted Jumpstart Our Business Startups Act (the JOBS Act) has made the dual-track process more attractive. Under the JOBS Act, companies that qualify as emerging growth companies (EGCs) may confidentially submit their registration statements for review by the staff of the Securities and Exchange Commission (SEC) and maintain that confidentiality until just 21 days before they launch the offering. While a sponsor-backed company conducting a dual-track process may still consider making a public announcement of the submission of the registration statement so that the broadest set of potential buyers in the concurrent sale process are made aware of the IPO alternative, the contents of the registration statement can remain out of the public eye until the company decides to choose the IPO path.
In addition, the JOBS Act allows EGCs to test the waters for their potential IPOs by engaging in oral or written communications with qualified institutional buyers (QIBs) and other institutional accredited investors before or after the initial filing of a registration statement in order to gauge investor interest in a proposed offering. Before the JOBS Act, oral communications with potential investors prior to the filing of a registration statement and written communications other than the prospectus, even after the filing of a registration statement, could have been considered impermissible “gun jumping.” In the context of a dual-track process, this meant waiting until late in the IPO process to commence the sale process. With the ability to test the waters, EGCs can begin the sale process at an earlier stage.
Putting the Proper Structure in Place
When structuring their investments in companies that are going public, sponsors must strike a balance between maintaining controls that will allow them to continue to make or influence certain decisions of the company following the IPO against the potential that a company with such controls in place may be perceived by the non-controlling stockholders as having less value to them, resulting in underperformance of the stock in the market.
When a sponsor or group of sponsors will continue to own more than 50 percent of the company’s stock following the IPO, the most basic question is whether the company will take advantage of the controlled company rules of the stock exchanges, which provide an exception to the general requirement that a majority of the board and certain board committees be independent (although the audit committee of the board will still need to be comprised of at least three independent directors). Unsurprisingly, Institutional Shareholder Services and other investor advocates disfavor controlled companies, especially if the control results from a dual-class stock structure. Nevertheless, sponsors often take advantage of the controlled company exemptions under stock exchange rules. When controlled company status is conferred by virtue of a group of sponsors banding together in a club deal to vote for each other’s director nominees, the sponsors likely will be consider a “group” under SEC rules, resulting in increased reporting obligations and restrictions. Sponsors who seek to maintain a representative on the board of directors without entering into a voting agreement and triggering group status may, instead, put in place a three-class staggered board, with the sponsor-nominated directors in the class expiring at the third meeting following the IPO. This would at least ensure that these directors would remain on the board for the initial three-year period.
Sponsors may also wish to continue to have certain control rights, such as the ability to nominate board members even if their share ownership dips below a majority, as well as negative covenants requiring their approval over certain corporate decisions. Rights to approve certain corporate decisions are often viewed as important, even if a majority of directors are elected by the sponsor, because the directors have fiduciary duties to all of the company’s shareholders, not just the sponsor, whereas the sponsor generally can act in its own self-interest when exercising veto rights. When such rights stay in place, they often exist until the sponsor’s shareholdings dip below a specified level.
Sponsors also need the ability to liquidate the shares they continue to hold in the portfolio company following the IPO. Registration rights give sponsors the ability to have their shares registered with the SEC for resale following the IPO, so that the sponsor can sell shares in underwritten offerings or in non-underwritten offerings where the amounts to be sold exceed the volume limitations imposed by SEC rules for unregistered sales by company affiliates. In addition, in order to give a sponsor the ability to sell large stock positions, sponsors often have the portfolio company opt out of Section 203 of the Delaware General Corporation Law, which imposes future restrictions on a buyer who acquires 15 percent or more of a company’s stock, unless the acquisition is approved by the company’s board or stockholders. Sponsors also should consider potentially distributing the shares they hold to their limited partners instead of selling the shares themselves, to the extent permitted by their fund documents. A number of issues are raised by such distributions, which should be carefully considered.
Other continuing rights may include tag-along, drag-along and other rights among a group of large shareholders, which are put in place in order to coordinate orderly exits. These rights may also trigger group status under SEC rules and, therefore, should be structured carefully.
Sponsors also often have the company going public waive the corporate opportunity doctrine so that their director representatives on the board may avoid situations where these directors will have a conflict of interest in deciding whether to allocate a corporate opportunity to the sponsor or the company.
Sponsors should also address any monitoring or similar fee arrangements they have in place with the portfolio company to determine if they continue or are terminated and, if terminated, whether a fee is payable upon termination. These fees have proven controversial recently, with one labor union waging a public battle against payment of such fees to a particular sponsor, and they may have other regulatory consequences.
Tax structuring must be considered carefully as part of the process, including potentially putting in place a tax receivable agreement or implementing a so-called Up-C structure, where appropriate.
The matters discussed above are only some of the issues sponsors must consider when their portfolio companies proceed down the IPO path. While the IPO process is complex and requires close coordination with the company’s lawyers and bankers, sponsors will continue to pursue the IPO path for their portfolio companies if they believe that it offers a significantly greater potential return than a sale process.