The Private Equity Review: investing in United States

This article is an extract from TLR The Private Equity Review - Edition 12. Click here for the full guide

I Overview

i Deal activity

In spite of high inflation, rising interest rates, geopolitical uncertainty following the Russian invasion of Ukraine and a decidedly more hostile posture from the US executive branch to the alleged anticompetitive effects of mergers and acquisitions,² private investing in the United States remained resilient in 2022. Although 2022 – in particular, the fourth quarter – was a down year compared with 2021's historic activity, industry activity still outpaced the pre-covid era. Certain investing strategies, including take-private transactions and growth equity investing, nearly matched 2021's historic volume, although credit markets seized up in the second half of the year, creating more challenges for dealmakers in the leveraged buyout space.

Buyouts

Overall private equity deal activity in the United States – including buyouts, add-ons and growth equity – totalled US$1.0144 trillion in value during the 2022 calendar year; total deal count was estimated to be 8,897.³ These figures represent a notable decline from 2021 (down 19.5 per cent on value, although only 2.4 per cent on deal count), but still far outpace other prior years. For example, overall US private equity deal activity in 2019, the highest year on record before 2021, was US$759.8 billion in value and 6,019 on a deal count basis.⁴ Compared with the historical period, add-on transactions and growth equity investments accounted for a larger share of 2022's deal activity when considered from a deal count perspective.⁵

The median size of a platform buyout deal in 2022 was US$301 million, compared with median deal size across all private equity investment types of US$50 million.⁶ Median add-on deal size was US$51.2 million, and add-ons in 2022 represented 77.7 per cent of all buyouts, up from 72.8 per cent in 2021. Platform buyouts and add-on transactions together accounted for nearly 90 per cent of deal value activity in 2022.⁷ Carve-out transactions as a percentage of total buyout activity resurged in 2022, after a relatively long-term decline, up to 7.7 per cent of total buyouts in the fourth quarter and 6.2 per cent on the full year. Over two-thirds of carve-out transactions (74.1 per cent) in 2022 were add-ons.⁸ The increasing share of buyout deal volume accounted for by add-ons and carve-outs in 2022 is consistent with prior periods of market stress or financing market slowdowns, or both (e.g., during the 2020 covid period or following the global financial crisis).

Notable buyout transactions in 2022 included Blackstone's carve-out acquisition of Emerson Electric's climate technologies business at a US$14 billion enterprise value, Kohlberg & Company's deal to acquire 50 per cent of USIC from Partners Group for an implied enterprise value of US$4.1 billion and Madison Dearborn Partner's acquisition of Unison from Carlyle.

Take-private transactions

In a take-private transaction, one or more private equity sponsors (or other private buyers) acquires a publicly traded company, the equity securities of which cease to be traded on the public markets. Take-private transactions typically employ significant amounts of debt financing, historically as high as 61.5 per cent of enterprise value in 2013, but decreasing in recent years.⁹ Perhaps the most publicised take-private transaction in history occurred in 2022 when Elon Musk acquired Twitter at a valuation of US$44 billion.

US private equity investors announced 79 take-private deals in 2022, which volume was likely supported in part by falling public market valuations that began early in 2022. Although lower than 2021 on a deal count basis, 2022's take-private activity represented US$224.3 billion in deal value, the highest volume since 2007.¹⁰ However, the number of take-private transactions declined sharply in the second half of 2022, and, in fact, no such deals were announced in November 2022.¹¹ Although, in December, three more take-private investments for the year were announced – including Advent's US$6.4 billion deal for Maxar and Thoma Bravo's US$8 billion acquisition of Coupa – it appears that tightening credit markets may slow take-private deal volume in 2023. Other notable take-private transactions in 2022 included TPG Capital's take-private of Convoy Health Solutions Holdings, Inc (which TPG had taken public via initial public offering in June 2021), a Brookfield Asset Management-led club deal to acquire Nielson Holdings Plc (valued at US$15.03 billion, the largest take-private transaction in 2022) and Thoma Bravo's acquisition of Anaplan, Inc (which was repriced after announcement when the buyer alleged that the target company breached the merger agreement).

Growth equity investing

In growth equity investing, private equity firms acquire minority interests in relatively mature, but typically still founder-owned, private companies. Growth equity investors expect to play a more active role in determining a company's strategy and direction, as compared with venture capital investors, including, in many instances, support for add-on M&A. Growth equity investors also look to assist in solidifying a company's past strong performance, including by sustaining (or increasing) revenue or improving operating margins. After this period of co-management and expansion, investors typically exit a growth equity investment through an initial public offering or perhaps an exit to buyout sponsor.

Because growth equity deals do not typically require debt financing, this investing strategy remained strong in 2022, even as credit markets tightened. According to PitchBook's market data, growth equity investments exceeded US$102 billion in 2022, representing a decrease from 2021 of almost US$27.5 billion, although still in excess of historical levels. There were a reported 1,479 growth equity deals in the United States – including two rounds of growth equity financing at Fanatics by BlackRock, Fidelity, MDS Capital and the National Football League in March 2022 and Clearlake, Silver Lake, SoftBank and LionTree in December 2022, ultimately valuing Fanatics at US$31 billion – which was down from 1,599 such transactions in 2021. Growth equity transactions accounted for 19.7 per cent of US private equity deal volume in 2022, slightly up from 17.5 per cent in 2021.¹²

Exits

Private equity exit volume in 2022 declined by 67.2 per cent over 2021 levels, with exits via initial public offerings at their lowest level since 2008.¹³ Sponsor-to-sponsor sales represented 29.9 per cent of total exits in 2022 (down from 33.3 per cent of the total in 2021), and trade sales (to strategic buyers) accounted for 63.5 per cent of exit transactions (up from 53.9 per cent in 2021).¹⁴ Private equity investors sold 1,274 companies in the United States in 2022, generating US$295.8 billion in deal value, the lowest exit value since 2021.¹⁵ On a deal count basis, 2022 represented a 28.3 per cent decline from 2021,¹⁶ suggesting that exit valuations fell more dramatically than the number of completed deals – perhaps due to the relative unavailability of initial public offerings for the largest companies. For example, in 2022, over 50 per cent of exits comprised deals under US$1 billion, whereas, in 2020 and 2021, such transactions accounted for approximately 40 per cent of exits.¹⁷ Compared with 2020 and prior years, however, 2022 did not represent such a dramatic decline, as 2022's total exit activity was more in line with that of 2019 (US$336.4 billion across 1,293 deals) and 2020 (US$432.3 billion across 1,161 deals).¹⁸

Notable sponsor-to-sponsor exit transactions in 2022 included Hellman & Friedman, Bain Capital and GIC's acquisition of Athenahealth from Vertial Capital (US$17 billion) and the sale of Sequa, a portfolio company of Carlyle, to Veritas Capital (US$1.9 billion). On the strategic buyer side, 2022 saw Warburg Pincus and Sallyport Investments sell Navitas Midstream Partners to Enterprise Products Partners (US$3.3 billion) and Riverstone Holdings and Goldman Sachs Asset Management exited Lucid Energy Group to Targa Resources (US$3.6 billion), among others.

In light of the more challenging market for regular way exit transactions in 2022, the secondaries market and, in particular, general partner (GP)-led 'continuation fund' transactions surged in 2022. In the first half of 2022, secondaries market volume, including both limited partner (LP)- and GP-led deals, totalled US$57 billion (up from US$48 billion in the first six months of 2021), with the GP-led portion of that accounting for US$24 billion (or 42 per cent of total volume, down 17 per cent from the comparable period of 2021, but 71 per cent higher than the first half of 2019).¹⁹ Eighty per cent of GP-led deals during the first half of 2022 were continuation fund transactions and 60 per cent of those were single-asset continuation funds.²⁰ North American deals accounted for 69 per cent of GP-led secondary transactions between 1 January 2022 and 30 June 2022.²¹ Although early data suggests that the secondaries market slowed in the second half of 2022, market commentators expect the overall upward trend in the secondaries market to hold for 2022 and continue into 2023, with GP-led deals anticipated to remain at 50 per cent or more of total secondaries market volume.²²

Fundraising

Private equity sponsors posted lower numbers in the fundraising category in 2022 compared with 2021, with 405 funds raised (compared with 733 in 2021). Fundraising on a dollar basis was down much less sharply: US$343.1 billion in capital raised in 2022 compared with US$362.9 billion in the prior year, due in part to the success of a few mega-funds that raised 52 per cent of the capital across just approximately 3.2 per cent of the funds.²³ For example, in 2022, Advent International raised a US$25 billion buyout fund and Thoma Bravo raised US$24.3 billion.

The reduction in private equity fundraising in 2022 is attributed in part to the 'denominator effect', whereby an asset manager's target allocation between private and public markets is disrupted by falling public market valuations that do not equally impact on private assets, as well as to the industry's overall step back from the post-covid rebound that was viewed by both GPs and LPs as unsustainable. The slower pace of exits discussed above, which results in less capital being returned to LPs, further impeded private equity fundraising in 2023. In addition to lower fundraising totals, funds in 2022 took longer to raise, with an average fundraise of 15.4 months for 2022 funds compared with 13.8 months, on average, in 2021.²⁴ However, the trend of more rapid fund deployment continued in 2022, with the average time between funds from a given sponsor continuing to fall, hitting three years.²⁵

ii Operation of the market

The US market for corporate control is very efficient. Many private targets are sold through an auction run by investment bankers or similar intermediaries. While a smaller proportion of public targets are sold through a full-blown auction, the legal framework (in general) attempts to duplicate an auction by encouraging a target's board of directors to follow a process designed to secure the highest reasonably attainable price for stockholders.

Public targets

From a legal point of view, the US market for sponsor-led going-private transactions is driven primarily by the following considerations:

1. the fiduciary obligations of the target's board of directors, as defined by the laws of the target's state of incorporation (most frequently, Delaware);
2. financing risks; and
3. the rules of the Securities and Exchange Commission (SEC) regarding tender offers or proxy solicitations.

Each of these factors influences not only the time required to purchase a US public target, but also the transaction's structure. Delaware courts have held that when a target's board decides to sell the company, it must satisfy what are known as Revlon duties.²⁶ Revlon requires a contextually specific application of the board's normal duties of care and loyalty designed to ensure that it conducts a process to seek and attain the best value reasonably available to the target's stockholders. There is no single court-prescribed course of action for a board to follow (e.g., conducting a pre-signing auction for the target or always using a special committee of disinterested directors to negotiate with a suitor). However, certain conventions – such as fiduciary outs and limits on termination fees and other deal protections – have arisen in response to guidance from Delaware courts to balance the target board's obligation under Revlon and the bidder's desire to obtain deal certainty. For example, many deals feature a 'go-shop' exception to a target's customary 'no-shop' covenant.²⁷ In a typical go-shop, the target is given a window – usually 25 to 40 days – to actively seek a superior offer. If a qualifying topping bid emerges during the go-shop period, the target may terminate its agreement with the original acquirer by paying a reduced termination fee and enter into a new agreement with the higher bidder. Most importantly, from a private equity bidder's perspective, Delaware courts have concluded that a target board that does not conduct a pre-signing auction or market check can satisfy its Revlon duties by including a go-shop in the merger agreement, as long as the rest of the process and other deal protections are satisfactory.²⁸ Go-shop provisions are extremely rare in private target transactions and, in fact, no-shop provisions may be even tighter, prohibiting the target from responding to unsolicited proposals. Accordingly, private transactions do not customarily entail a 'forward' break fee that would be payable by the target to the buyer.

Parties to a US leveraged take-private must contend with the risk that debt financing may not be available at closing. Unlike in some other countries (e.g., the United Kingdom), 'certain funds' (i.e., a fully negotiated and executed credit agreement between a buyer and its lenders delivered at deal announcement) are neither required nor available in the United States, and financing commitment letters, no matter how 'tight' (i.e., lacking in preconditions), cannot be specifically enforced even if the providers of the letters have clearly breached their terms. In response, dealmakers have crafted a reverse break fee and limited specific performance deal model that has become the most common (but by no means the sole) way to allocate the risk of financing failure (even in purely private deals such as sponsor-to-sponsor exits).

This model generally allows a target to obtain, as its sole pre-termination remedy, an order from a court, known as an order for 'specific performance', forcing a buyer sponsor to make good on its commitment to provide the necessary equity financing and to complete the merger if, and only if, all the conditions to the merger are satisfied, the debt financing is available for closing and the target agrees to close when the equity is funded. If, however, the target chooses to terminate the merger agreement, either because the private equity sponsor is unable to close because the necessary debt financing is not available or because the private equity sponsor otherwise breaches the merger agreement, then the sponsor must pay the target a reverse break-up fee (usually an amount greater than the target's termination fee) and the transaction is terminated. Receipt of the reverse break-up fee is the target's sole and exclusive remedy against the sponsor and its financing sources, even in the case of a wilful breach.²⁹

Parties to a sponsor-led take-private transaction add yet another level of complexity when they choose to proceed via a two-step tender offer (rather than a one-step merger). In a tender offer, the sponsor offers to purchase the shares of the target directly from the stockholders, obviating the need – at least in the initial step – for a stockholder vote. The sponsor's obligation to complete the tender offer is typically conditioned upon stockholders tendering more than 50 per cent of the outstanding shares. If this 'minimum tender' condition is satisfied, the sponsor must acquire all untendered shares in a 'back-end' merger, the terms of which are set out in a merger agreement executed by the target and buyer on the day they announce the tender offer. Depending on the circumstances of the deal, including the target's state of incorporation, the back-end merger can be completed immediately after the closing of the tender offer; otherwise, the buyer must engage in a long (three- to four-month) and expensive proxy solicitation process and hold a target stockholders' meeting before it can complete the back-end merger.

Failure of a sponsor to acquire all of the target's outstanding stock on the same day the tender offer closes makes it much more difficult to use debt financing because of the application of US margin stock rules, a highly complex set of laws and regulations that, in general, prohibit any person from financing the acquisition of US public company stock with more than 50 per cent debt financing that is secured by the target's stock or assets. Many sponsor-led take-private transactions in the United States are more than 50 per cent leveraged, so parties to such transactions must find solutions that satisfy the margin rules if they wish to enjoy the benefits of a tender offer.

The easiest way to avoid a delayed back-end merger is for the buyer to acquire in the tender offer a supermajority of the target's shares – in Delaware, 90 per cent – allowing the buyer to complete a 'short-form' merger immediately after closing the tender offer. By completing the back-end merger essentially simultaneously with the tender offer, a sponsor can more easily structure its debt financing to comply with the margin rules and lender demands for a lien on the target's assets. In most deals, however, it is not realistic to expect stockholders to tender such a large proportion of the outstanding shares. Tender offer and margin requirement rules are not generally applicable to private target or private seller transactions.

Dealmakers address the potential delays of a full-blown back-end merger process and the complications presented by the margin rules largely by relying on a 'top-up' option or Delaware General Corporation Law Section 251(h).

Top-up option

In a top-up option, the target agrees, upon completion of the tender offer, to issue to the buyer a sufficient number of its authorised but unissued shares to allow the buyer to reach the threshold required for a short-form, back-end merger. Delaware courts have approved the top-up option structure, with a few easily satisfied caveats,³⁰ largely because it puts money in stockholders' hands more quickly without harming their interests. The primary limitation of the top-up option is mathematical: the number of shares required to hit 90 per cent may be very large because the calculation is iterative, so it is often the case that a target does not have enough authorised but unissued shares in its constituent documents to utilise the top-up option.

Section 251(h)

Section 251(h) eliminates, subject to certain conditions, the requirement for stockholder approval of a back-end merger after a tender offer for a listed company, or one with more than 2,000 stockholders of record, if the buyer acquires more than the number of shares required to approve a merger (typically a bare majority, but it could be more if the target's certificate of incorporation so requires) but less than the 90 per cent threshold for a short-form merger.

Section 251(h) allows the buyer to acquire all the outstanding shares and the non-tendering stockholders to receive the merger consideration without the lost time and expense of a three- to four-month proxy solicitation process.³¹ Furthermore, in June 2016, Delaware passed an amendment to Section 251(h) giving target management and other target stockholders the opportunity to exchange all or a portion of their target stock for buyer stock without running afoul of Section 251(h) rules, a limitation that had previously favoured the use of the top-up option in certain circumstances.

Private targets

Because it is easier to maintain confidentiality and the consequences of a failed auction are less dire, a full-blown auction for a US private target is more common than for a public target. In an auction for a US private target, the target's advisers typically invite several bidders to conduct limited due diligence and submit indicative bids, with the highest and most credible bidders invited to conduct further due diligence and submit final bids. The time required to sell a private target can vary considerably: an auction and sale process for a desirable private target can take, from start to finish, as little as two months, whereas other processes may take many months. If the buyer requires debt financing, the health of the debt markets also affects the length of the process.³²

In an auction, a private equity firm must compete not only on price, but also on terms (e.g., post-closing exposure in the form of purchase price adjustment mechanisms and seller indemnification provisions), timing (with sellers desiring to close the transaction as soon as any mandatory regulatory approvals (e.g., expiration of the Hart-Scott Rodino Antitrust Improvements Act (the HSR Act) waiting period) are received) and attractiveness to management (go-forward compensation and equity incentives). As noted above, many private-target acquisition agreements contain the same conditional specific performance and reverse break fee mechanism now common in take-private transactions, or go a step further with the sponsor assuming all of the financing risk.

The use of commercial insurance policies to protect buyers against various transaction-related risks, such as breaches of representations and warranties, has saturated the US buyout market, with such policies (or a buyer's willingness to consummate a transaction without any post-closing protection) now being almost mandatory in any private target auction. These insurance products allow parties to bypass difficult negotiation over post-closing indemnification by shifting specified transaction risks to sophisticated insurance companies in the business of pooling and pricing such risks.

Management equity

Management equity practices vary across US private equity firms, but certain themes are common: executives with sufficient net worth are expected to invest side by side with the sponsor to ensure that they have sufficient 'skin in the game'; management equity entitles the holder only to modest stockholder rights – in some cases, only the right to be paid in connection with a distribution or liquidation; holders of management equity get liquidity when and to the same extent that the sponsor gets liquidity; and incentive equity (and at times part or all of management's co-invested equity as well) is subject to vesting, whether upon passage of time, achievement of various performance goals or a combination of the two. The size of the management incentive equity pool generally ranges from 5 to 15 per cent, depending on the mix between time- and performance-based vesting, with smaller deals generally congregating at the upper end of the range, and larger deals generally at the lower end.

The prospect of participating in a potentially lucrative incentive equity pool can be powerful motivation for management to prefer a private equity buyer over a strategic buyer unlikely to offer a similar plan (and who might fire management instead). A private equity bidder for a private target can use this to its advantage, particularly when management cooperation is key to a successful sale. When pursuing a public target, however, such a strategy carries additional risk, as Delaware courts, the SEC and the market are sensitive to the conflict of interest presented when a target officer – particularly the CEO – has a personal incentive to prefer one bidder over another.

For this reason, the board of a public target often instructs its management not to enter into an agreement with a private equity suitor regarding compensation or equity participation before the stockholders have voted on the deal (or tendered their shares to the buyer). Indeed, it is often in a private equity buyer's interest not to enter into an agreement with management before the stockholder vote, because the SEC (by way of its Rule 13e-3) requires substantial additional disclosure in such situations. In addition, management participation in a transaction prior to a stockholder vote may increase the risk (and potentially cost) of stockholder lawsuits opposing the deal.

II Legal framework

i Acquisition of control and minority interests

The US federal system – in which the federal (i.e., national) government exercises supreme authority over a limited range of issues, and the individual states exercise authority over everything else occurring within their respective jurisdictions, with overlaps seemingly everywhere – presents private equity firms with a complex legal maze to navigate when acquiring control of or investing in the equity of a target company. A private equity firm contemplating an investment in the United States confronts the following regulatory regimes:

1. federal securities laws and regulations, administered by the SEC;
2. state corporation law (usually the Delaware General Corporation Law), alternative business entity law (usually the Delaware Limited Liability Company Act or the Delaware Limited Partnership Act) and securities laws (called 'blue-sky' laws);
3. federal, state, local and foreign tax laws and regulations;³³
4. the HSR Act pre-merger antitrust review;
5. particularly when making a minority investment in a public target, the rules of the stock exchange where the target's shares are listed, such as the New York Stock Exchange or the Nasdaq National Market;
6. potential review by the Committee on Foreign Investment in the United States of an investment by a non-US investor in a US target, if the investment threatens to impair national security; and
7. industry-specific regulatory schemes – such as those found in the energy, pharmaceutical, medical device and telecommunications industries – that may require advance notification to or even approval by a governmental authority.

The first three regulatory schemes – federal securities laws, state corporate and securities laws, and tax – affect every investment a private equity firm may make in the United States. The HSR Act applies only if a deal exceeds specified levels,³⁴ and the applicability of the others depends on the nature of the target and, in some cases, the characteristics of the buyer as well.

In general, neither US federal securities laws and regulations nor Delaware corporate and other business entity laws focus on the substance of a transaction. Rather, the federal scheme is designed to ensure that parties to the transaction – whether a direct sale of stock, a merger, a tender offer or issuance of shares – receive adequate disclosure, and in some cases adequate time to make a fully informed investment decision, and Delaware law is chiefly concerned with the process followed by the company's governing body when considering the transaction, except in the case of interested transactions, which are subject to entire-fairness review (looking at both process and price).

Regulatory schemes outside Delaware law and US federal securities laws and regulations, however, often do look at the substance of transactions and can be influenced by political movements. Indeed, the Biden administration has announced a firmer stance on antitrust review of transactions, including the release of an Executive Order on Promoting Competition in the American Economy in July 2021,³⁵ and the executive branch's posture to transactions has become markedly more hostile over time.³⁶

ii Fiduciary duties and liabilities

Corporations

In general, stockholders of a Delaware³⁷ corporation do not owe any duty, fiduciary or otherwise, to one another. Thus, a private equity firm is free to act in its own interest, subject to very limited exceptions,³⁸ when deciding to vote or sell its stock in a portfolio company, subject to contractual rights (e.g., tag-along or registration rights) of the company's other stockholders. On the other hand, a controlling stockholder may be liable to the corporation or its minority stockholders if the controlling stockholder enters into a self-interested transaction with the corporation at the expense of the minority.³⁹

All directors (and officers) of a Delaware corporation, including sponsor representatives on the board, owe the corporation and its stockholders the following duties: a duty of care, requiring a director to be reasonably informed and to exercise the level of care of an ordinarily prudent person in similar circumstances; a duty of loyalty, requiring a director to act in the interests of the corporation and its stockholders and not in his or her own interest; and a duty of good faith, or perhaps better stated a duty not to act in bad faith, often described as the intentional or reckless failure to act in the face of a known duty, or demonstrating a conscious disregard for one's duties.

Subject to limited exceptions, when reviewing the conduct of a corporation's directors, Delaware courts will apply what is known as the 'business judgement rule', which presumes that a director acted with reasonable care, on an informed basis, in good faith and in the best interest of stockholders, and not second-guess the director's decisions. Only if a plaintiff proves that a director made an uninformed decision or approved a self-interested transaction will the courts apply the 'entire fairness' doctrine and require the director to prove that the price and the process leading to the disputed transaction were fair to the corporation and its stockholders. In addition, when reviewing certain transactions, such as the imposition of defensive measures (e.g., a poison pill) or the sale of control in the absence of a 'fully informed' disinterested shareholder vote⁴⁰ (see the Revlon discussion, above), Delaware courts apply what has come to be known as 'enhanced scrutiny', a standard more rigorous than the business judgement rule but less than entire fairness, in which the court reviews the adequacy of the process leading to the challenged transaction and whether the price was reasonable.

Delaware law also allows a corporation to exculpate its directors (but not officers) from monetary liability for a breach of the duty of care,⁴¹ and to indemnify its directors and officers against claims and expenses arising out of the performance of their board duties.⁴² Such exculpation and indemnification are not available, however, for any director or officer found to have breached the duty of loyalty.

A sponsor representative on the board of a Delaware corporation must also be aware of the corporate opportunity doctrine, under which a corporate officer or director must offer the corporation any business opportunity that the corporation is financially able to undertake, that is within the corporation's line of business, and in respect of which the corporation has an interest. The corporate opportunity doctrine can cause a problem for a sponsor owning or expecting to invest in a competing or similar business, but it can be disclaimed if appropriate language is included in a company's articles of incorporation (which is nearly universal in private equity investments).

If a Delaware corporation has preferred and common stock, its board owes its duties only to the common stockholders if there is conflict between their interests and those of the preferred stockholders.⁴³ If a corporation is insolvent (or in bankruptcy), then the board's fiduciary duties are owed to the corporation's creditors, not its stockholders.⁴⁴ If a financially struggling corporation is in a grey area known as the 'zone of insolvency', then its directors have a duty to maximise the enterprise value of the corporation for the benefit of all those with an interest in it.⁴⁵

Limited liability companies

Most private equity-led investments in the United States are now structured as Delaware limited liability companies (LLCs) or limited partnerships (LPs), rather than corporations. Delaware law allows sponsors and their co-investors to craft custom LLC or LP governance provisions, including the total elimination of voting rights and fiduciary duties (other than the contractual duty of good faith and fair dealing),⁴⁶ which streamline decision-making and avoid potential personal liability of sponsor board representatives. The added flexibility of an LLC or an LP is both a benefit and a burden, as Delaware courts have consistently held that any modification to traditional corporate principles must be clearly and unambiguously stated in the LLC's operating agreement; otherwise, traditional corporate principles will apply (perhaps in unexpected ways).

Using an LLC, which is treated like a partnership for tax purposes (unless an election is filed with the Internal Revenue Service to be taxed as a corporation), or an LP eliminates corporate-level tax and thus can also be more tax-efficient for certain investors – although the reduction in the corporate-level tax rate and other changes implemented as a result of the Tax Cuts and Jobs Act passed in December 2017 has made that benefit less certain. Non-US investors who are not US taxpayers, however, must exercise caution when investing in an LLC, as they may be obligated to file a US tax return and pay US income tax on their US effectively connected income. Some non-US investors may have a preference for investing in an LP, rather than an LLC.

III Debt financing

The market for acquisition debt financing is highly sophisticated and efficient, with many experienced investors and service providers and multiple options for a private equity sponsor seeking to finance an acquisition.

No two deals are the same, and the availability of certain types of debt financing depends on market conditions, but US leveraged buyout (LBO) financing structures typically fit into one of the following categories:

1. senior and bridge loans, with the bridge loan usually backstopping a high-yield bond offering, typically used in very large deals;
2. first-lien and second-lien loans, typically used in upper-middle-market deals, with the availability and pricing of second-lien debt highly dependent on market conditions;
3. senior and mezzanine loans, typically used in middle-market deals;
4. unitranche loans, which combine senior and mezzanine features into a single blended loan, typically used in middle-market deals; and
5. senior loans only, typically used only in smaller deals or deals in which the private equity sponsor is using very little leverage.

Because UK-style certain-funds debt financing is not available in the United States, the parties to an LBO – the lenders, the private equity sponsor and even the target – inevitably face market risk between execution of the acquisition agreement and closing. Those parties, particularly the sponsor, must therefore carefully manage that risk in the agreements, especially in the interplay among the debt and equity financing commitment letters and the acquisition agreement.⁴⁷

The non-pricing terms (i.e., excluding items such as fees, interest rates and original issue discounts) of an LBO loan – such as affirmative, negative and financial covenants, collateral requirements and defaults – vary considerably from one deal to the next, based on the size of the transaction and the perceived creditworthiness of the borrower.⁴⁸ In general, however, loans for smaller deals are more similar to one another in respect of affirmative, negative and financial covenant requirements. Non-pricing terms for larger loans occupy a wide spectrum ranging from a full covenant package to 'covenant-lite' loans. In a syndicated loan, key terms, including pricing and debt structure, are typically subject to some limited changes in favour of the lenders – referred to as 'flex' – in the event that the loan cannot be syndicated in the absence of these changes (which may not include, however, additional conditions precedent to funding).

IV Outlook

The early months of calendar year 2022 continued to exhibit the same boomtime deal volumes and fundraising activity as 2021; however, by the second half of the year, private equity activity had slowed. Looking ahead to 2023, US private equity investors expect the slower pace of late 2022 to continue, especially in light of tightening financing markets. However, given the dislocation in public markets, there may be some investing strategies (carve-outs and take-privates) that suffer less than others. In addition, investors who can access private credit markets (as opposed to syndicated bank credit facilities), or investors completing add-on transactions on the basis of existing underwritten credit, may be able to continue dealmaking in 2023. In any event, private equity dry powder remains at elevated levels compared with historical periods, and sponsors feel pressure to return capital to limited partners, so the industry will be searching for creative paths forward in 2023.