ASIC consultation paper 312 on stub equity in control transactions takes aim at a perfectly legal acquisition structure that is commonly used by private equity buyers. In our view, the case for change has not been made out and ASIC’s proposal would only serve to deprive target shareholders of the opportunity to share in the benefits of take private transactions, or worse, reduce the safeguards available to them.
Stub equity has been a feature of the Australian M&A landscape for over a decade. Essentially, the structure allows target shareholders to elect to take up a limited number of shares in the bidder or its holding company, as consideration for the acquisition of their target shares. That option may appeal to a target shareholder who wishes to retain exposure to the target business or to take advantage of scrip for scrip rollover relief.
The stub equity option is often put forward by the acquirer with a particular shareholder or group of shareholders in mind. The option needs to be made available to all shareholders however, as to do otherwise would breach the equal treatment rules in a takeover or risk creating a different class of voting shareholders in a scheme.
Stub equity structures are regularly used by private equity acquirers in take private transactions. Under the private equity form of the structure, the issuer of the stub equity will be a non-listed entity and sometimes a proprietary company. Therefore, target shareholders who choose to take up the stub equity acquire a relatively illiquid security and are usually subject to restrictions on their ability to sell and to drag rights which require them to sell into a private equity exit. Those limitations need to be fully disclosed in the transaction documents, so that shareholders who take up the stub equity are fully informed of the nature of the security they are acquiring.
The offer of stub equity is typically made on the condition that accepting shareholders must hold their shares through a custodian. This allows the acquirer to manage the number of shareholders that will be on the corporate register post acquisition.
This is an important issue, as a private equity acquirer will be concerned to ensure that the stub equity vehicle does not become exposed to the takeovers regime in Chapter 6 of the Corporations Act 2001 (Cth) or to the disclosing entity provisions of Part 1.2A. The use of a custodian structure means that the private equity proponent can be confident that the number of registered shareholders post transaction will not cross the thresholds at which those regimes kick in (being 50 members in the case of takeovers and 100 members for the disclosing entity regime).
The custodian arrangements can also be used to keep the number of shareholders below 50, such that a proprietary company structure can be used. That structure confers the additional benefit (from the private equity owner’s point of view) that the acquiring entity does not become subject to the reporting requirements and other procedural requirements that apply to public companies.
Again, these are issues that need to be fully explained to target shareholders. In fact, it is not uncommon for target directors to recommend that retail shareholders do not take up the stub equity specifically for these reasons.
ASIC has become increasingly concerned about the use of stub equity in control transactions in recent times. Following the Capilano Honey scheme in late 2018, ASIC published media release 18-376MR in which it warned the market that transaction structures using proprietary companies as stub equity risked ASIC intervention.
In consultation paper 312, it goes further, also proposing to prohibit the use of custodian arrangements in connection with the issue of stub equity. This would mean that bidders who offer stub equity in a control transaction would have to take the risk that the acquisition vehicle may become subject to the takeovers and disclosing entity regimes if enough target shareholders take up the equity. That would be of real concern to private equity buyers, as it denies them some of the benefits of the take private transaction and complicates their potential exit.
ASIC’s objection to the use of proprietary companies as stub equity is not without merit. It is a maxim of Australian corporate law that proprietary companies are not permitted to raise funds from the public. As a result, they are not subject to the usual checks and balances that apply to a public company. It is therefore not surprising that ASIC takes the view that a proprietary company is not an appropriate vehicle for a widely held entity and is seeking to address this issue.
ASIC’s proposal that the entity that issues the stub equity must be a public company subject to the takeovers and disclosing entity regimes, however, is concerning. ASIC argues that the application of these regimes provides important benefits to shareholders of a public company. While that is clearly true, the fact remains that a public company might not be subject to one or both of those regimes for a variety of reasons. Not all public companies are subject to the disclosing entity regime. Likewise, the number of members in a public company might drop below the relevant takeover thresholds as a result of a number of factors. It follows that it is not an inherent characteristic of a public company or a condition to raising public funds that the disclosure and takeovers regimes must always apply.
The rising influence of private capital in Australian public markets transactions makes this debate an important one. As public capital becomes increasingly expensive (due in part to the high level of regulation that comes with it), private equity players are seeking to create value by taking public listed assets private.
Stub equity allows target shareholders, including retail shareholders, to participate in that value.
While it is true that shareholders who participate in the stub equity accept lower levels of ongoing disclosure as the price of participating in the stub equity, they do so on a fully informed basis. The question must be asked whether it is appropriate to deny them that choice.
ASIC is understandably responding to what it perceives to be an erosion of disclosure standards. The practical reality, however, is that stub equity is not going away. Private equity will continue to turn to stub equity as a way of providing flexibility where it is needed to encourage major shareholders to support a transaction.
If ASIC’s proposals are implemented, private equity will likely turn to structures in which the stub equity is issued by an overseas company outside ASIC’s regulatory reach. That can hardly be a good outcome for retail shareholders.