Minority Equity Arrangements
Given the increasingly competitive conditions for the deployment of capital by private equity sponsors and the desire for certain categories of owners to explore alternative opportunities for liquidity, we have seen increasing numbers of funds in private equity buy-out transactions in Europe (and in particular, credit/debt funds and other alternative capital providers) being willing to take minority positions in the equity interests of targets as a way of gaining foothold positions in trophy assets.
Additionally, the increasing growth of consortium acquisitions of high value targets has led to accelerated development of market practice and expectations for minority investors.
This publication identifies certain key legal considerations for a minority investor (the “Minority Investor”) pursuing such an investment.
Minority Investors will typically obtain protection that their equity interest will not be diluted and this shouldn't be a controversial point. The equity documentation may however provide for circumstances where Minority Investors may be diluted. For example “rescue issues” or other situations where the lead sponsor may be able to fund the target group on short notice in exchange for additional securities. Minority Investors will generally be entitled to catch-up where there has been an emergency/rescue issue of securities. There have however been a number of instances (albeit rare) where, as a result of the bargaining power of the lead sponsor, a basket has been reserved for additional issues which are not subject to anti-dilution.
One recurring issue in equity documentation is the scope of the anti-dilution protection. Shares and instruments exchangeable for or convertible to shares are typically covered and allow the Minority Investor a pre-emption right on the issue of such securities. Minority Investors may seek to extend the scope to include debt securities, which would generally cover the issue of loan note instruments but not instruments issued in connection with a third party arms’ length financing.
The lead sponsor will likely control the board with Minority Investors holding at least 10 per cent. of the equity able to appoint at least one director. Where the Minority Investor is taking a passive role in the investment or the interest is less than 10 per cent., a board observer right may be more appropriate.
The right to appoint a board observer should be considered in light of the information rights that the Minority Investor is entitled to (see below) – parties often use the board observer right as a bargaining chip to obtain increased information rights and vice versa.
The Minority Investor would generally receive the same information that the lead sponsor would receive pursuant to the equity documents.
In the case of credit funds, who would ordinarily receive extensive information under the finance documents, the Minority Investor should consider the scope of information required to properly monitor its investment. Some lead sponsors are reluctant to allow credit funds to have information rights in both the finance documents as well as the equity documentation and will try to limit what information can be obtained in the equity documentation. In any event, where the Minority Investor is also a financing party, it should include provisions in the equity documents which cater for circumstances where there is a refinancing and the Minority Investor is no longer a debt provider, and as a result, does not have the benefit of the information rights in the finance documents.
Exit/Path to Liquidity
The timing and manner of an exit will be controlled by the lead sponsor. While the Minority Investor cannot dictate a full exit, it should seek to be able to exit pursuant to a “right-of-first-offer” mechanic.
Increasingly, we are seeing the starting negotiation position on transfers being that transfers are generally prohibited other than transfers to permitted transferees (which are defined in the constitutional documents) or pursuant to an exit event. Funds should be particularly careful that the definition of permitted transferees allows them to transfer freely between funds and affiliates. This isn't usually a controversial point but can often be missed in initial drafts prepared by lead sponsors’ counsel.
Minority Investors should also consider the expected life of the fund or funds investing when agreeing to limitations on transfers and “lock-in” periods.
A pro rata tag-along right should be sought where the lead sponsor sells in excess of a particular percentage (usually 50 per cent.). This is the customary position but we have seen instances where the lead sponsor has agreed to alternative structures, for example, a pro rata tag along right where the sale is lower than 50 per cent. and a “full” tag along right where there is a sale of equal to or greater than 50 per cent..
The lead sponsor will typically seek a drag-along right with respect to other shareholders. This is generally accepted by parties where the consideration and mechanics on completion are the same for all holders of the same class of equity.
Whether or not a Minority Investor will have a drag-along right over other investors will ultimately be a commercial decision usually agreed at term sheet stage. Minority Investors do not generally obtain a right to drag other investors but we have seen Minority Investors, who have a particularly strong bargaining position, obtain a drag. In these circumstances, the drag was, however, tied to the Minority Investor obtaining a third party offer which achieved for the lead sponsor a minimum net cash multiple return on its investment.
Alternative Drag/ The “Ticking Clock”
In circumstances where there is a “lock-in” period or a mismatch in the anticipated investment periods between shareholders, the Minority Investor may seek to include a put option in the equity documentation to allow the Minority Investor to put its equity to the lead sponsor/ other shareholders. This provision is only really helpful where the counterparty has deep pockets or is otherwise able to fund the acquisition of the Minority Investor’s equity. However, it should in any event incentivise the lead sponsor/ other shareholders to pursue an exit.
For additional protection, the Minority Investor may seek to include a mechanism whereby it would receive a form of preferred equity or an elevated proportion of the proceeds if an exit is not achieved within a particular time or a minimum return is not achieved.