In brief: acquisition and exit strategies for private equity firms in USA

Acquisition and exit

Are there any legal requirements that may impact the ability of a private equity firm to acquire control of a public or private company?

Under applicable US state and federal law, there are no statutory requirements to make a mandatory takeover offer or maintain minimum capitalisation in connection with shareholders acquiring controlling stakes in public or private companies. However, under applicable US state law, the board of directors of public and private companies have fiduciary duties to their shareholders that they must be mindful of when selling a controlling stake in the company. In Delaware, for example, and in many other US states, a board of directors has a duty to obtain the highest value reasonably available for shareholders given the applicable circumstances in connection with a sale of control of the company. In certain states, the applicable law permits a board of directors to also consider ‘other constituencies,’ such as the company’s employees and surrounding community, and not focus solely on the impact that a sale of a controlling interest in the company will have on its shareholders. Private equity sponsors must be mindful of these duties of target company boards of directors as they seek to negotiate and enter into an acquisition of a controlling stake of a target company, as they may result in the target company’s board of directors conducting a market check by implementing a pre-signing ‘auction’ or post-signing ‘go-shop’ process to seek out a higher bid for a controlling stake (or even the entire company) in order for the board to feel comfortable that it has satisfied its fiduciary duties to the target company’s shareholders. In addition, US target companies in certain regulated industries may be subject to certain minimum capitalisation requirements or other restrictions that may impede a private equity sponsor’s ability to acquire the company.

What are the key limitations on the ability of a private equity firm to sell its stake in a portfolio company or conduct an IPO of a portfolio company? In connection with a sale of a portfolio company, how do private equity firms typically address any post-closing recourse for the benefit of a strategic or private equity acquirer?

A private equity sponsor will generally seek to retain flexibility on its ability to sell its stake in an acquired company, which may include having the right to require the acquired company to undertake an IPO and the right to drag along other investors in the event of a sale by the private equity sponsor of all or a significant portion of its investment in the company. The ability to achieve a tax-efficient exit and the ability to receive dividends and distributions in a tax-efficient manner will also be critical factors in determining the initial structuring of a transaction, including the use of acquisition financing or other special-purpose vehicles. Private equity sponsors must also consider the interests of company management in connection with any exit and must agree with management on any lock-up or continued transfer restrictions with respect to the equity of the target company held by management as well as ongoing management incentive programmes that will continue following an IPO. In an exit (or partial exit) consummated pursuant to a portfolio company IPO, private equity sponsors typically remain significant shareholders in the company for some period of time following the IPO and, thus, continue to be subject to fiduciary duty considerations as well as securities laws, timing and market limitations with respect to post-IPO share sales and various requirements imposed by US stock exchanges with respect to certain types of related-party transactions.

When private equity sponsors sell portfolio companies (including to other private equity sponsors), buyers may seek fairly extensive representations, warranties and covenants relating to the portfolio company and the private equity sponsor’s ownership. Private equity sponsors often resist providing post-closing indemnification for breaches of such provisions. In limited situations in which a private equity firm agrees to indemnification following the closing of a portfolio company sale, sponsors often use a time and amount limited escrow arrangement as the sole recourse that the buyer may have against the private equity sponsor. Sponsor sellers and buyers have also addressed disagreements over indemnity through the purchase of transaction insurance (for example, representations and warranties insurance) to provide post-closing recourse to the buyer for breaches of representations or warranties. In such a case, the cost of purchasing the transaction insurance is typically negotiated by the buyer and seller as part of the purchase price negotiations.

What governance rights and other shareholders’ rights and restrictions typically survive an IPO? What types of lock-up restrictions typically apply in connection with an IPO? What are common methods for private equity sponsors to dispose of their stock in a portfolio company following its IPO?

Private equity sponsors take a variety of approaches in connection with the rights they retain following a portfolio company IPO, depending on the stake retained by the private equity sponsor following the IPO. In many cases, the underwriters in an IPO will seek to significantly limit the rights that a private equity sponsor will be permitted to retain following the IPO as it may diminish the marketability of the offering to the public. For example, tag-along rights, drag-along rights, pre-emptive rights, and rights of first offer or rights of first refusal, in each case, for the benefit of the private equity sponsor, frequently do not survive following an IPO. Except as described below, US regulations and US stock exchange rules do not generally legislate which governance rights may survive an IPO. In addition, private equity sponsors should consider the impact of share-holder advisory firms, such as Institutional Shareholder Services (ISS), that provide guidance to shareholders with respect to public company governance practices. For example, ISS has announced that for newly public companies it will recommend that shareholders vote against or withhold their votes for directors that, prior to or in connection with an IPO, adopted by-law or charter provisions that ISS considers adverse to shareholders’ rights, including classified boards, supermajority voting thresholds and other limitations on shareholders’ rights to amend the charter or by-laws and dual-class voting share structures.

Private equity sponsors will often retain significant board of director nomination rights, registration rights and information rights following an IPO, and may, in certain limited circumstances, retain various veto rights over significant corporate actions depending on the board control and stake held by the private equity sponsor. Under applicable US stock exchange rules, boards of directors of public companies are typically required to be comprised of a majority of ‘independent’ directors, but certain exceptions exist if a person or group would retain ownership of more than a majority of the voting power for the election of directors of the company, in which case the company is referred to as a ‘controlled company,’ or if the company is organised outside of the US. However, in order to improve the marketability of the offering and employ what are perceived to be favourable corporate governance practices, many private equity sponsors forgo the benefits of controlled-company status or those applicable to foreign private issuers and employ a majority of independent directors and only retain minority representation on the board of directors following the IPO.

In addition, private equity sponsors typically retain the right to cause the company to register and market sales of securities that are held by the private equity sponsor, including requiring the company to file a shelf registration statement once eligible, and to permit the private equity sponsor to participate in piggyback registrations following an agreed-upon lock-up period (which typically expires 180 days after the date of the IPO), subject to any applicable black-out rules and policies of the company and US securities laws. Private equity sponsors often seek to control the size and timing of their exits, including sales of their equity securities following an IPO within the confines and restrictions of the public company environment. As a result, many private equity sponsors often seek to sell large blocks of their securities in an ‘overnight’ shelf takedown off of the company’s pre-existing shelf registration statement. Given the timing limitations on such shelf takedowns, it is not uncommon for such registered offerings to be exempt from, or have very truncated notice provisions relating to, piggyback registration rights of other holders of registrable securities.

What types of companies or industries have typically been the targets of going-private transactions? Has there been any change in industry focus in recent years? Do industry-specific regulatory schemes limit the potential targets of private equity firms?

Private equity sponsors select companies as attractive acquisition candidates based on a variety of factors, including steady cash flow, strong asset base to serve as loan collateral or as the subject of future dispositions, strong management team, potential for expense reduction and operational optimisation, undervalued equity and limited ongoing working capital requirements. Private equity sponsors look toward targets across a wide spectrum of industries, including energy, financial, food, healthcare, media, real estate, retail, software, technology and telecoms. In recent years, private equity sponsors have become increasingly interested in the technology sector, which has historically been considered to be the predominant domain of venture capital firms. In addition, certain private equity funds have a specified investment focus with respect to certain industries (for example, energy, retail and real estate) or types of investments (for example, distressed debt).

Many regulated industries (for example, banking, energy, financial, gaming, insurance, media, telecoms, transport, utilities) must comply with special business combination laws and regulations particular to those industries. Typically, approval of the relevant federal or state governing-agency is required before transactions in these industries may be completed. In certain situations, regulators may be especially concerned about the capitalisation and creditworthiness of the resulting business and the long and short-term objectives of private equity owners. In addition, as a result of the extensive information requirements of many US regulatory bodies, significant personal and business financial information is often required to be submitted by the private equity sponsor and its executives. Furthermore, in certain industries in which non-US investments are restricted (for example, media, transport), private equity sponsors may need to conduct an analysis of the non-US investors in their funds to determine whether specific look-through or other rules may result in the sponsor investment being deemed to be an investment by a non-US person. While none of these factors necessarily preclude private equity sponsors from entering into transactions with regulated entities, all of these factors increase the complexity of the transaction and need to be taken into account by any private equity sponsor considering making an investment in a regulated entity.