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Transaction formalities, rules and practical considerations
Types of private equity transactions
What different types of private equity transactions occur in your jurisdiction? What structures are commonly used in private equity investments and acquisitions?
US private equity transactions may involve the acquisition by a private equity sponsor of a controlling stake in a private or public company, which is typically structured as a stock purchase, asset purchase, merger, tender offer or leveraged recapitalisation. Private equity sponsors may also make minority investments in public or private companies, which typically involve the purchase of common stock, preferred stock, convertible debt or equity securities, warrants or a combination of such securities. Private equity transactions involving the acquisition of a private or public company are generally structured as leveraged buyouts (LBOs) in which a significant amount of the purchase price is paid with the proceeds of new debt; this debt is usually secured by assets of the target company and serviced from its cash flows. In acquisitions of a public company, a private equity sponsor may engage in a going-private transaction, which typically involves a one-step transaction via a merger or a two-step transaction involving a tender offer followed by a merger. As discussed in question 4, going-private transactions that are subject to rule 13e-3 of the US Securities Exchange Act of 1934 generally require significantly greater disclosure than other types of private equity transactions.
Private equity funds typically create one or more special purpose shell acquisition vehicles to effect an investment or acquisition, and commit to fund a specified amount of equity capital to the acquisition vehicles at the closing. Various considerations dictate the type and jurisdiction of organisation of an acquisition vehicle, including, among others, tax structuring issues, desired governance structure, number of equity holders, equity holders’ (and the private equity sponsor’s) exposure to liability by use of the applicable vehicle, general ease of administration and any applicable regulatory requirements.
Private equity funds may seek out add-on acquisitions whereby one of the private equity fund’s existing portfolio companies acquires a target company in the same or an adjacent industry. This combination allows private equity sponsors to tap into scale opportunities and revenue and cost synergies, which may increase the valuation of the overall combined portfolio company. These factors in turn may enhance returns for the fund’s investors in a shorter time horizon than what could otherwise be obtained through natural growth of the original portfolio company. Add-on acquisitions may be financed by a variety of means, including existing cash on the portfolio company’s balance sheet, additional equity financing from the private equity fund and/or third-party debt financing. Private equity funds considering an add-on acquisition should be mindful of the considerations typically inherent in strategic acquisitions, including possible enhanced regulatory and/or antitrust scrutiny and potential integration issues following the closing of the transaction.
Corporate governance rules
What are the implications of corporate governance rules for private equity transactions? Are there any advantages to going private in leveraged buyout or similar transactions? What are the effects of corporate governance rules on companies that, following a private equity transaction, remain or later become public companies?
The Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley Act) and related Securities and Exchange Commission (SEC) and stock exchange rules raise a variety of issues relevant to private equity transactions, including the following:
- if the target company in a private equity transaction continues to have common equity listed on a national stock exchange, subject to certain exceptions discussed below, a majority of the target’s board of directors, audit committee, nominating or corporate governance committee and compensation committee must meet stringent independence requirements;
- the New York Stock Exchange and Nasdaq Stock Market do not require ‘controlled companies’ (namely, companies in which more than 50 per cent of the voting power is held by an individual, group or another company) to maintain a majority of independent directors on the board or have a nominating or compensation committee comprised of independent directors; however, controlled companies are still required to maintain an audit committee comprised entirely of independent directors, and following implementation of reforms pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act, a compensation committee is required to meet enhanced independence standards, which have been adopted by the New York Stock Exchange and the Nasdaq Stock Market;
- in conducting due diligence on a public target, private equity sponsors must carefully review the target’s internal financial controls, foreign corrupt practices and anti-bribery law compliance and prior public disclosures to evaluate any potential liability for past non-compliance and to avoid stepping into a situation in which significant remedial or preventive measures are required;
- if a private equity sponsor requires management of a public target to purchase equity of the target or a new vehicle formed in connection with the transaction, the sponsor should be aware that a public target is generally not permitted under section 402 of the Sarbanes-Oxley Act to make loans or arrange for the extension of credit to any directors or officers of the target to fund such purchases;
- if a sponsor intends to finance a transaction with publicly traded debt, following the issuance of such debt, the target must have an audit committee comprised entirely of independent directors and must comply with enhanced disclosure requirements (eg, the target must disclose any off-balance sheet arrangements); and
- if a private equity sponsor intends to exit an investment following an initial public offering (IPO) of the target’s stock, the exit strategy must take into account the time, expense, legal issues and accounting issues that may arise in connection with the target becoming a public company.
A number of public companies consider going-private transactions in light of the stringent corporate governance regime and scrutiny of accounting and executive compensation policies and practices that apply to US public companies. Companies that do not have publicly traded equity or debt securities are exempt from complying with the corporate governance rules in the Sarbanes-Oxley Act and related SEC and stock exchange rules. Some of the other advantages of a going-private transaction include the reduction of expenses relating to compliance and audit costs, elimination of public disclosure requirements, decreased risks of shareholder liability for directors and management and the flexibility provided for long-term strategic planning without the focus on quarterly earnings by public investors. Going-private transactions can also help avoid the risk of activist investors seeking to replace directors or implement other corporate governance or strategic changes.
Issues facing public company boards
What are some of the issues facing boards of directors of public companies considering entering into a going-private or private equity transaction? What procedural safeguards, if any, may boards of directors of public companies use when considering such a transaction? What is the role of a special committee in such a transaction where senior management, members of the board or significant shareholders are participating or have an interest in the transaction?
When the board of directors (or any special committee thereof) of a public company reviews a going-private or private equity transaction proposal, the directors must satisfy their fiduciary duties, as would always be the case, and their actions must satisfy the applicable ‘standard of review’ under the law of the state of organisation of the target company, which may affect whether the directors could be personally liable in any lawsuit that challenges the transaction. In addition, there are various disclosure issues to be considered by the board of directors in considering a going-private or private equity transaction proposal. Generally, before the target company discloses confidential information regarding itself to a prospective private equity sponsor, management of the target company will consult with the board of directors and the target will enter into a confidentiality agreement, which may include additional important terms with respect to the sponsor, such as an employee non-solicitation provision and a ‘standstill’ provision that prevents the sponsor and its affiliates from acquiring or making proposals to acquire any securities of the company without the board’s prior consent. Note that, under US securities laws, a sponsor and its affiliates may be restricted from acquiring securities of a public company if the sponsor or its affiliates are in possession of material, non-public information with respect to such company whether or not a standstill is in place. Also, as discussed in question 12, boards of directors must consider fraudulent conveyance issues presented by the incurrence of any proposed debt by the target company in connection with the private equity transaction.
A critical threshold determination to be made by a board of directors regarding its consideration of a going-private or private equity transaction proposal is whether the board should form a special committee of directors to consider and make decisions with respect to the proposed transaction. Under Delaware law (the leading US corporate jurisdiction), if, for example, a controlling shareholder or a majority of the board of directors has a conflict of interest with respect to the going-private or private equity transaction proposal (in other words, if they are on both sides of the transaction or expect to derive a personal benefit from it), Delaware courts reviewing the transaction will apply the ‘entire fairness’ standard. The entire fairness standard places the burden of proof on the board to show that both the transaction process and the resulting transaction price were fair to the disinterested shareholders. In the event that a transaction could be subject to the entire fairness standard, a board of directors will typically form a special committee comprised entirely of disinterested directors to shift the burden of proof to any person who legally challenges the transaction. Generally, best practice would also result in the special committee having the right to engage its own financial adviser and legal counsel and being authorised to independently negotiate and evaluate the transaction as well as strategic alternatives on behalf of the target company, including pursuing other acquisition proposals or continuing to operate as a stand-alone company. The board can also shift the burden of proof under entire fairness to a person challenging the transaction by conditioning the transaction on the approval of a majority of the outstanding shares owned by disinterested shareholders (known as a ‘majority of the minority’ vote). Through recent case law, Delaware courts have developed a roadmap that parties can follow to avoid entire fairness review altogether and instead become subject to the more deferential ‘business judgment’ standard of review. To obtain business judgment review, a going-private transaction with a controlling shareholder must be subject to both the approval of a special committee of independent directors that is fully empowered to select its own advisers and veto the transaction and the approval of an uncoerced, fully informed majority of the minority vote. Under business judgment review, Delaware courts generally will apply the principle that they should not second-guess the decisions of impartial decision-makers with more information (in the case of the board of directors) or an economic stake in the outcome (in the case of the disinterested shareholders) and will apply a presumption that the action taken was in the best interests of the company.
Are there heightened disclosure issues in connection with going-private transactions or other private equity transactions?
Generally, going-private transactions and other private equity transactions involving a public target are subject to the same disclosure requirements under the US securities laws that are applicable to other merger and acquisition transactions. However, certain going-private transactions are subject to rule 13e-3 of the US Securities Exchange Act of 1934, which mandates significantly greater disclosure than is ordinarily required by the federal proxy rules or tender offer rules. Generally, rule 13e-3 will apply only if the going-private transaction involves a purchase of equity securities, tender offer for equity securities or proxy solicitation related to certain transactions by the company or its affiliates (which includes directors, senior management and significant shareholders); and if it will result in a class of the company’s equity securities being held by fewer than 300 persons or a class of the company’s equity securities listed on a stock exchange to no longer be listed. The heightened disclosure requirements applicable to going-private transactions subject to rule 13e-3 include, among other items, statements by the target company and other transaction participants as to the fairness of the transaction to disinterested shareholders, plans regarding the target company, alternative transaction proposals made to the target company, disclosure regarding control persons (eg, information about directors and officers of private equity sponsors) and information regarding the funding of the proposed transaction. Also, the target company will need to publicly file or disclose any report, opinion or appraisal received from an outside party that is materially related to the transaction and any shareholder agreements, voting agreements and management equity agreements.
If the going-private transaction (whether or not subject to rule 13e-3) is structured as a tender offer or transaction requiring the vote of the target company’s shareholders (eg, a cash or stock merger), the company’s shareholders will be required to receive a tender offer disclosure document or a proxy statement or prospectus containing disclosure that satisfies the applicable US tender offer rules, proxy rules or Securities Act requirements (these generally require disclosure of all material information relating to the offer or transaction). In addition, a target company’s board of directors effecting a going-private or other private equity transaction must still comply with any applicable state law requirements. For example, the Delaware courts are increasingly requiring additional disclosure in proxy and tender materials disseminated to shareholders with respect to prospective financial projections and forecasts that the target company has shared with the private equity sponsor.
What are the timing considerations for a going-private or other private equity transaction?
Timing considerations for a going-private or other private equity transaction depend upon a variety of factors, including:
- the time necessary for the target company’s board or special committee to evaluate the transaction proposal and any alternative proposals or strategies;
- the first date on which public disclosure of any proposal to acquire a public company target must be made if the proposal is being made by any person who has an existing Schedule 13D or 13G filing;
- the time necessary for arranging the acquisition financing, including the syndication of bank financing, sales of debt securities, tender offers or consent solicitations relating to existing debt securities and any attendant delays;
- the time necessary for US and/or foreign regulatory review, including requests for additional information from antitrust or other regulators;
- the magnitude of disclosure documents or other public filings and the extent of SEC review;
- timing relating to solicitation of proxies, record dates and meeting dates in connection with a shareholder vote;
- timing relating to solicitation of tenders and other required time periods under the US tender offer rules (eg, tender offers must remain open for a minimum of 20 business days);
- the risks of significant litigation related to the transaction; and
- the time necessary to establish alternative investment vehicles and special purpose vehicles or to complete a restructuring of the target company prior to closing.
Dissenting shareholders’ rights
What rights do shareholders have to dissent or object to a going-private transaction? How do acquirers address the risks associated with shareholder dissent?
Although the details vary depending on the state in which a target company is incorporated, in connection with a going-private transaction of a Delaware corporation, shareholders who are being cashed out (including pursuant to a second-step merger following a first-step tender offer) may petition the Delaware court of chancery to make an independent ‘appraisal’ of the ‘fair value’ of their shares in lieu of accepting the consideration they would otherwise receive in the going-private transaction. Both the dissenting shareholders seeking appraisal and the target company must comply with strict procedural requirements under Delaware law and the record owners of the dissenting shares must demonstrate that they did not vote such shares in favour of the transaction. Such shareholder appraisal actions can be costly for the acquirer (including as a result of the imposition of a statutorily designated interest rate on the value of the dissenting shares) and often take years to resolve. To the extent that there are a significant number of shares for which shareholders are seeking appraisal, it will create a potentially unknown contingent payment obligation many years post-closing, which may complicate the acquirer’s financing depending on how the transaction is structured. As such, some acquirers seek the inclusion of a closing condition in the acquisition agreement providing for the maximum number of shares for which appraisal may be sought; however, such appraisal conditions are not commonly found in acquisition agreements following competitive auctions. Recent judicial decisions in Delaware support the view that deal price may be the best evidence of fair value, a development that may diminish the frequency of appraisal claims in merger transactions.
What notable purchase agreement provisions are specific to private equity transactions?
Historically, to the extent private equity sponsors required third-party financing to complete a transaction, they negotiated for the right to condition their obligation to consummate the transaction upon their receipt of the financing proceeds. Current market practice, however, is that private equity buyers typically agree to buy companies without the benefit of a financing condition but instead have the right to pay a ‘reverse termination fee’ to the sellers as the sole remedy of the sellers or target company against the buyer in the event that all of the conditions to closing have been satisfied (or are capable of being satisfied on the applicable closing date) and the buyer is unable to obtain the third-party debt financing necessary to consummate the transaction. Because the acquisition vehicle that is party to the transaction is almost always a shell entity (and, as such, is not independently creditworthy), target companies typically require the acquisition vehicle’s potential obligation to pay a reverse termination fee to be supported by a private equity fund limited guarantee. In addition, target companies often require a limited right to enforce the ‘equity commitment letter’ provided by the private equity fund to the acquisition vehicle, pursuant to which the fund commits to provide a specified amount of equity capital to the acquisition vehicle at closing. Most purchase agreements providing for a reverse termination fee include provisions that deem payment of such fee to be liquidated damages and otherwise cap the private equity fund’s liability exposure to an amount equal to the reverse termination fee amount. Particularly in transactions involving third-party financing, private equity firms rarely agree to a full specific performance remedy that may be enforced against the private equity sponsor’s fund or special purpose acquisition vehicle used in the transaction.
In addition to the circumstances above, participants on the other side of a private equity transaction (whether sellers or buyers) will frequently require evidence of the creditworthiness of any special purpose acquisition vehicles used in the transaction to ensure they have a sufficient remedy in the event that the acquisition vehicle breaches its obligations under a purchase agreement or is required to satisfy an indemnification obligation. Participants in private equity transactions may attempt to negotiate guarantees, equity commitments or other support arrangements from a private equity sponsor, but most private equity sponsors resist indemnification, guarantee or other obligations that permit recourse directly against the private equity fund. However, as described above, in circumstances where a sponsor has agreed to pay a reverse termination fee, private equity funds frequently agree to provide a limited guarantee of the payment of the reverse termination fee or may provide the target company with a right to specifically enforce the equity commitment letter from the private equity fund to the extent of the reverse termination fee.
Both sellers and buyers in private equity transactions will generally seek to obtain fairly extensive representations, warranties and covenants relating to the private equity sponsor’s equity and debt-financing commitments, the private equity sponsor’s obligation to draw down on such financing and obtain any required alternative financing and the target company’s obligation to assist with obtaining the financing and participating with any required marketing of the financing. These types of provisions, as well as various other financing-related provisions, are discussed further in question 11.
Participation of target company management
How can management of the target company participate in a going-private transaction? What are the principal executive compensation issues? Are there timing considerations for when a private equity buyer should discuss management participation following the completion of a going-private transaction?
In a private equity transaction, the management of a target company may be offered the opportunity (or may be required) to purchase equity of the target company or the acquisition vehicle, which investment may be structured as a ‘rollover’ of such management’s existing equity holdings. Whether and to what extent such investments are made may depend heavily on the type and amount of the management’s historic compensation arrangements as well as the amount, if any, of cash payments management will receive in the going-private transaction, in respect of current equity and equity-based awards and payouts under deferred compensation and other plans. In connection with such investment, management typically also receives equity incentive awards (eg, stock options in a corporation or profits interests in a partnership). These equity awards generally become vested based upon continued employment, the achievement by the company of specified performance targets, the private equity sponsor achieving a particular return on its investment or a combination of the foregoing conditions. These agreements also typically provide for repurchase or forfeiture of the equity incentive awards upon a termination of employment and, in some circumstances, may provide for full or partial acceleration of vesting (the acceleration, repurchase or forfeiture depends upon the circumstances for the termination of employment) and often impose on the employees post-termination covenants not to compete with, or disparage, the company and not to solicit company employees or clients. All equity acquired by an employee will typically be subject to an equityholders’ agreement, which customarily includes transfer restrictions, a repurchase right held by the company upon the employee’s termination of employment for any reason (with the price varying based on the circumstances for the termination), drag-along and tag-along rights (which are described in question 13) and, in some cases, piggyback registration rights. Customary terms of shareholders’ agreements are discussed in question 13.
Historically, one of the key concerns in private equity-led going-private transactions has been continuity of management under the theory that sponsors do not have the time, resources or expertise to operate the acquired business on a day-to-day basis. As such, the principal executive compensation issues in a private equity transaction relate to ensuring that equity-based and other compensation has been appropriately structured to provide an incentive to management to increase the company’s value and remain with the company following the closing. To this end, primary questions involve whether management may rollover existing equity on a tax-free basis as part of their investment, the accounting and tax treatment (both for the company and management) of equity incentive awards and other compensation arrangements, and to what extent management can achieve liquidity under their investment and equity awards. It should also be noted that other issues, such as ongoing employee benefit protections (eg, post-termination welfare and pension benefits) and certain compensation arrangements (eg, base salary and annual cash bonus opportunities), will factor into any private equity transaction negotiation with management of the target company.
As described above, management participating in a private equity transaction may have several opportunities to earn significant value (both in the primary transaction and upon a successful future exit event). As a result, shareholders of a public company engaged in a going-private transaction are particularly concerned about conflicts between management’s desire to complete a transaction or curry favour with the private equity buyer, on the one hand, and shareholders’ desire to maximise value in the going-private transaction, on the other. In recent years, this issue has received significant attention, resulting in some boards of directors restricting their senior management from participating in certain aspects of going-private transaction negotiations or discussing post-closing compensation arrangements with the private equity firm until after the price and material terms of the sale have been fully negotiated with the private equity firm and, in some cases, the transaction has been consummated. In addition, in circumstances where a target company has negotiated the right to conduct a post-signing market check, or ‘go-shop’, or where an interloper has made an unsolicited acquisition proposal after signing that the board of directors of the target believes may result in a superior transaction for its shareholders as compared to the transaction entered into with the private equity firm, the target board may further restrict its senior management from participating in negotiations or discussions regarding post-closing compensation arrangements with all bidders, including the private equity firm, until the final winning bidder is agreed upon. Given the importance to private equity firms of the continuity of management and the structure of their equity and compensation-based incentives, which they often prefer finalising before entering into a going-private transaction, there is often a tension between the time when the board of directors of a target company will permit its senior management to negotiate such arrangements with a potential private equity buyer and when such a private equity buyer desires to have such arrangements agreed upon with such senior management. In addition, the SEC has required significant disclosure regarding management’s conflicts of interests, including quantification of the amount to be earned by executives of the target company in the transaction.
What are some of the basic tax issues involved in private equity transactions? Give details regarding the tax status of a target, deductibility of interest based on the form of financing and tax issues related to executive compensation. Can share acquisitions be classified as asset acquisitions for tax purposes?
Many US private equity funds are structured as limited partnerships or limited liability companies, which are generally treated as pass-through entities for US tax purposes. Private equity transactions can sometimes be structured such that the target is also a pass-through entity for US tax purposes to avoid or minimise the effect of ‘double taxation’ that results from investing directly into entities that are treated as corporations for US tax purposes. However, such ‘flow-through’ structures could create US tax issues for tax-exempt and non-US limited partners of private equity funds that require special fund structures to address. More typically, private equity transactions involve investments in target entities that are treated as corporations for US tax purposes (such an entity sometimes referred to as a ‘C corporation’). Generally, the substantial amount of debt involved in LBO transactions affords a target company significant interest expense deductions that could be available to offset taxable income. However, as a result of the Tax Reform Bill (as defined below), for tax years beginning on or after 1 January 2018, with respect to entities that are treated as C corporations, deductions for interest paid or accrued on indebtedness properly allocable to a trade or business (with certain specified exceptions)(business interest) in excess of the sum of business interest income and 30 per cent of the adjusted taxable income of the business are generally disallowed. Adjustable taxable income is computed without regard to business interest income or expense, net operating losses or deductions for pass-through income (and for taxable years before 2022, excludes depreciation and amortisation). In addition, careful attention must be paid to the terms of the acquisition debt to ensure that the interest is deductible under any other applicable US tax rules.
Private equity sponsors must also be aware of tax issues relating to management and employee compensation, which will be relevant to structuring management’s investment and post-closing incentives. An example of one such tax issue is that compensation triggered by a change of control, including certain severance and consideration for equity holdings, may be ‘excess parachute payments’, which are subject to a 20 per cent excise tax (in addition to ordinary income taxes) and which may not be deducted by the target. Another example involves the tax treatment of different types of stock options. If an option is an ‘incentive stock option’, under typical facts, no income is realised by the recipient upon grant or exercise of the option and no deduction is available to the company at such times. Employees recognise tax at capital gains rates when the shares acquired upon option exercise are ultimately sold (if the applicable holding period requirements are met), and the company takes no deduction. If the award is a non-qualified stock option, no income is recognised by the recipient at the time of the grant and no deduction is available to the company at such time; rather, income is recognised, and the deduction is available to the company at the time of option exercise. There are a number of limitations on incentive stock options, and private equity sponsors generally prefer to maintain the tax deduction; accordingly, non-qualified stock options are more typical. A final example involves ‘non-qualified deferred compensation’. If a deferred compensation plan is ‘non-qualified’, all compensation deferred in a particular year and in prior years may be taxable at ordinary income rates in the first year that it is not subject to substantial risk of forfeiture, unless payment is deferred to a date or event that is permitted under tax code section 409A’s rules governing non-qualified deferred compensation.
In certain transactions in which the shares of a target corporation (or entity treated as a corporation for US federal income tax purposes) are purchased, a seller and buyer may elect to treat the acquisition of stock of such corporation as an asset acquisition for US federal tax purposes. Such an election can lead to a ‘step-up’ in the target’s tax basis in its assets to fair market value, resulting in additional depreciation or amortisation deductions that provide a tax shield to offset future taxable income. A section 338(h)(10) election is one such election that is available when the target is a US subsidiary of a consolidated tax group or an ‘S corporation’ and can be advantageous because asset sale treatment can be achieved with only a single level of taxation. A ‘qualified stock purchase’ of the target’s stock (generally an acquisition by a corporation of at least 80 per cent of the target’s issued and outstanding stock) must be made to make this election. Certain typical structures used in LBOs (eg, rollover of management equity to a newly formed vehicle that purchases target stock) must be carefully analysed to determine whether such structures will render the 338(h)(10) election impermissible. Another such election is a section 336(e) election, which has similar considerations to a section 338(h)(10) election, but applies to a somewhat wider range of targets and transactions (eg, US corporate targets that are not part of a consolidated tax group). For a section 336(e) election to be available, the target must be a US corporation and the seller must be a US corporation or shareholder of an S corporation.
Debt financing structures
What types of debt are typically used to finance going-private or private equity transactions? What issues are raised by existing indebtedness of a potential target of a private equity transaction? Are there any financial assistance, margin loan or other restrictions in your jurisdiction on the use of debt financing or granting of security interests?
Private equity buyouts generally involve senior bank debt, which is typically committed to by commercial lending institutions in the form of a senior secured revolving credit facility and senior secured term loans (which are typically syndicated to a broad array of financial institutions), and junior debt, which is typically provided in the form of a second lien term loan facility or rule 144A offering of high-yield bonds. Private equity transactions that include an anticipated rule 144A offering of high-yield bonds include ‘bridge-financing commitments’ pursuant to which a commercial lending institution agrees to provide ‘bridge’ loans in the event that the high yield bonds cannot be sold prior to the closing.
The vast majority of private equity transactions include a complete refinancing of third party debt for borrowed money in connection with the closing of the LBO. In connection with such transactions, a private equity sponsor must determine the manner in which and the cost at which existing indebtedness may be repaid or refinanced and evaluate the cost of the existing indebtedness compared with acquisition-related indebtedness. However, in transactions where target indebtedness is not expected to be retired at or before closing, the private equity sponsor must determine whether such indebtedness contains provisions that could restrict or prohibit the transaction, such as restrictions on changes of control, restrictions on subsidiary guarantees, restrictions on the granting of security interests in the assets of the target or its subsidiaries, restrictions on debt incurrences and guarantees and restrictions on dividends and distributions.
Generally, acquisitions of a US target company are not subject to any statutory financial assistance restrictions or restrictions on granting security interests in the target company’s assets, except as described below or in the case of target companies in certain regulated industries. If a ‘shell’ company issues unsecured debt securities in a non-public offering with the purpose of acquiring the stock of a target corporation, such debt securities may be presumed to be indirectly secured by ‘margin stock’ (namely, any stock listed on a national securities exchange, any over-the-counter security approved by the SEC for trading in the national market system or any security appearing on the US Federal Reserve Board’s list of over-the-counter margin stock and most mutual funds). If so, such debt would be subject to the US Federal Reserve Board’s margin requirements and thus could not exceed 50 per cent of the value of the margin stock acquired. Private equity sponsors may avoid these requirements by utilising publicly offered debt or having the debt guaranteed by an operating company with substantial non-margin assets or cash flow.
Debt and equity financing provisions
What provisions relating to debt and equity financing are typically found in going-private transaction purchase agreements? What other documents typically set out the financing arrangements?
Purchase agreements for going-private transactions typically include representations and warranties by the private equity sponsor regarding the equity-financing commitment of the private equity sponsor and, in the case of LBOs, the third-party debt-financing commitments obtained by the private equity sponsor at the time of entering into the purchase agreement. An equity commitment letter from the private equity sponsor as well as the debt-financing commitment letters obtained by the private equity sponsor from third-party lenders are customarily provided to the target company for its review prior to the execution of the purchase agreement. In US transactions, definitive debt-financing documentation is rarely agreed at signing; instead, the definitive debt-financing documentation is typically negotiated between signing and closing on the basis of the debt-financing commitment letters delivered by third-party debt-financing sources at signing. Purchase agreements in LBOs also contain covenants relating to obligations of the private equity sponsor to use a certain level of effort (often reasonable best efforts) to negotiate definitive debt-financing agreements and obtain financing, flexibility of the private equity sponsor to finance the purchase price from other sources and obligations of the target company to assist and cooperate in connection with the financing (eg, assist with the marketing efforts, participate in road shows, provide financial statements and assist in the preparation of offering documents).
Purchase agreements typically do not condition the closing of a transaction on the receipt of financing proceeds by the private equity sponsor. If the closing is not conditioned on the receipt of financing proceeds, the purchase agreement would typically provide for a ‘marketing period’, during which the private equity sponsor will seek to raise the portion of its financing consisting of high-yield bonds or syndicated bank debt financing, and which begins after the private equity sponsor has received certain financial information about the target company necessary for it to market such high-yield bonds or syndicate such bank debt. Alternatively, the purchase agreement may provide for an ‘inside date’ before which the parties cannot be forced to close, which similarly allows for a period to finalise any debt-financing arrangements and call capital for the equity financing. If the private equity sponsor has not finalised its financing arrangements by the end of the marketing period or the inside date (and all other relevant conditions to closing have been satisfied or waived) and fails to close the transaction when required, the private equity sponsor may be required to pay a reverse termination fee - which often functions as a cap on the maximum amount of damages the target company (on behalf of itself or its shareholders) is permitted to seek from the private equity sponsor for its failure to close the transaction.
In recent years, private equity funds have increasingly utilised full equity backstop commitments. A full equity backstop commitment provides the target company assurance that the private equity sponsor is willing to fully fund the purchase price using sponsor equity if debt financing is unable to be obtained from third-party lenders by the transaction’s closing date, which can increase the attractiveness of a private equity sponsor’s purchase proposal relative to other bidders seeking debt financing from third-party lenders. A full equity backstop may also provide an opportunity for a private equity sponsor to obtain more favourable terms from third-party lenders, because of the credible alternative the private equity sponsor has to proceed with the transaction if debt financing is not obtained on satisfactory terms and in a timely manner from the third-party lenders prior to the signing date.
Fraudulent conveyance and other bankruptcy issues
Do private equity transactions involving leverage raise ‘fraudulent conveyance’ or other bankruptcy issues? How are these issues typically handled in a going-private transaction?
Generally, under applicable US state laws, a company may not transfer assets for less than fair consideration in the event that the company is insolvent or such asset transfer would make it insolvent. Thus, in highly leveraged transactions, there is some concern that when a target company issues or transfers its assets or equity to a private equity sponsor in exchange for the proceeds of acquisition financing, which is secured by the assets or equity of such target company, the lender’s security interests in such assets or equity securities may be invalidated on a theory of fraudulent conveyance (namely the target company has transferred its assets for inadequate value). It is common for a certificate as to the ongoing solvency of the continuing or surviving company to be obtained from the target company’s chief financial officer prior to closing a leveraged transaction. Purchase agreements in leveraged transactions may also include representations and warranties made by the private equity buyer as to the solvency of the company after giving effect to the proposed transaction.
Fraudulent conveyance issues should also be carefully considered by sellers in highly leveraged transactions. A board of directors considering a sale of the company should review the financial projections provided by management to a prospective buyer and the indebtedness that the prospective buyer proposes the company incur in connection with the transaction to evaluate any fraudulent conveyance risks. Directors of a target company must be particularly cautious in highly leveraged transactions in which the company has existing debt that will remain in place following the closing of the transaction. In Delaware (the leading US corporate jurisdiction), creditors of an insolvent corporation have standing to bring derivative actions on behalf of the corporation directly against its directors because, when a corporation is insolvent, creditors are the ultimate beneficiaries of the corporation’s growth and increased value.
Shareholders’ agreements and shareholder rights
What are the key provisions in shareholders’ agreements entered into in connection with minority investments or investments made by two or more private equity firms? Are there any statutory or other legal protections for minority shareholders?
Depending on the size of the private equity sponsors’ respective ownership stakes, shareholders’ agreements entered into in connection with minority investments or ‘consortium’ deals may include the right of the minority investors to designate a certain number of directors and the right to approve (or veto) certain transactions (eg, change in control transactions, affiliate transactions, certain equity or debt issuances and dividends or distributions). Private equity sponsors may also seek pre-emptive rights to allow them to maintain the same percentage equity ownership after giving effect to a primary equity issuance by the target. In addition, shareholders’ agreements frequently include transfer restrictions (which prohibit transfers of target securities for a particular time period and in excess of specified percentages, or both), tag-along rights (namely, the right of a shareholder to transfer securities to a person who is purchasing securities from another holder) and drag-along rights (namely, the right of a shareholder, typically the largest shareholder or a significant group of shareholders, to require other holders to transfer securities to a person who is purchasing securities from such shareholder). Private equity sponsors typically seek other contractual rights with respect to receipt of financial and other information regarding the target company, access to the properties, books and records, and management of the target company, and also rights relating to their potential exit from the investment, such as demand and piggyback registration rights (which may include the right to force an IPO), and, in some cases, put rights or mandatory redemption provisions. In certain circumstances, shareholders’ agreements in private equity transactions may also contain ‘corporate opportunity’ covenants that either restrict (or, in some cases, expressly permit) the ability of shareholders (including private equity sponsors) to compete with the target company or make investments in other companies, which may otherwise be a potential investment or acquisition opportunity for the target company. Target companies or large shareholders that are party to shareholders’ agreements may also ask for a right of first offer or right of first refusal, which would require any shareholder seeking to transfer its shares to offer to sell such shares to the company or other shareholders.
To the extent that a minority investment is made, the new shareholder should be careful to consider potential misalignment issues between the parties that may arise from its and the existing shareholders’ differing investment prices, particularly as such issues may arise in terms of liquidity rights. In these types of transactions, the new shareholder often will seek one or more of:
- the right to control the timing of the liquidity event (whether it be a change of control transaction or an IPO) or the right to block such a liquidity event unless it will achieve a required minimum return on its investment;
- the right to cause a sale of the company or an IPO after some specified number of years; and
- in the event the company effects an IPO, the right to sell more than its pro rata portion of any equity securities in any registered offering of registrable securities relative to the number of equity securities sold (or to be sold) by the existing shareholder.
In the US, minority shareholders often have limited protections outside of what may be contractually negotiated in a shareholders’ agreement. Generally, under applicable US state laws, the board of directors of corporations are subject to certain fiduciary duties in respect of the minority shareholders (eg, heightened scrutiny in controlling shareholder transactions with the target company, etc), and certain minimum voting requirements may apply for significant corporate actions, such as a merger. However, in most states, provisions in a target company’s organisational documents may supersede the underlying statutory approval requirements. In addition, many private equity investments are held through non-corporate structures, which can be subject to more restricted fiduciary duties and other minority equityholder protections in the applicable limited liability company agreement, partnership agreement or other similar governing arrangements than would otherwise apply under applicable law. For private equity transactions structured as tender offers, US securities laws provide certain protections for minority shareholders (eg, the soliciting person is required to offer the same price to all holders of the applicable security and the tender offer must be open for 20 business days).
Acquisition and exit
Acquisitions of controlling stakes
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, as discussed in question 17, 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 buyer?
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 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 (eg, 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.
Portfolio company IPOs
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 the applicable 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. 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 shareholder 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 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’ underwritten shelf takedown off of a 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.
Target companies and industries
What types of companies or industries have typically been the targets of going-private transactions? Has there been any change in 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 (eg, energy, retail and real estate) or types of investments (eg, distressed debt).
Many regulated industries (eg, 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 (eg, 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.
What are the issues unique to structuring and financing a cross-border going-private or private equity transaction?
The structure of a cross-border private equity transaction is frequently quite complicated, particularly given the use of leverage in most transactions, the typical pass-through tax status of a private equity fund and the existence of US tax-exempt and non-US investors in a private equity fund. Many non-US jurisdictions have minimum capitalisation requirements and financial assistance restrictions (which restrict the ability of a target company and its subsidiaries to ‘upstream’ security interests in their assets to acquisition financing providers), each of which limits a private equity sponsor’s ability to use debt or special purpose vehicles in structuring a transaction. As noted in question 17, non-US investors may be restricted from making investments in certain regulated industries, and similarly, many non-US jurisdictions prohibit or restrict the level of investment by US or other foreign persons in specified industries or may require regulatory approvals in connection with acquisitions, dispositions or other changes to investments by foreign persons. In addition, if a private equity sponsor seeks to make an investment in a non-US company, local law or stock exchange restrictions may impede the private equity sponsor’s ability to obtain voting, board representation or dividend rights in connection with its investment or effectively exercise pre-emptive rights, implement capital raises or obtain additional financing.
US sponsors seeking to sell portfolio companies to non-US buyers or considering other transactions involving sales to foreign acquirers should be aware of the possibility of review by the Committee on Foreign Investment in the United States (CFIUS). CFIUS is a multi-agency committee authorised to review transactions that could result in foreign control over US businesses for potential impacts on US national security. CFIUS has authority to negotiate and implement agreements to mitigate any national security risks raised by such transactions. In the absence of a mitigation agreement, CFIUS can recommend that the President suspend, prohibit or unwind a transaction. A CFIUS review can add delays and meaningful uncertainty to transactions depending on the nature of the target business and the identity of the foreign acquirer. In transactions involving the sale of a portfolio company that is in a sensitive industry or that handles sensitive data, especially to buyers that CFIUS considers are from countries of concern, sponsors will be prudent to consider whether a CFIUS filing is advisable, to propose reverse termination fees or pre-emptive divestitures, to discuss possible mitigation efforts the buyer is willing to make and to build political support for the transaction. While the regulatory and other challenges in cross-border sponsor exits and other transactions, including CFIUS review, are often manageable in many contexts, they increase the level of resources required and may otherwise complicate the process for executing such transactions.
Furthermore, in a cross-border transaction, the private equity sponsor must determine the impact of local taxes, withholding taxes on dividends, distributions and interest payments and restrictions on its ability to repatriate earnings. Private equity sponsors must also analyse whether a particular target company or investment vehicle may be deemed to be a controlled foreign corporation or passive foreign investment company, both of which can give rise to adverse US tax consequences for investors in the private equity fund. Any of these issues may result in tax inefficiencies for investors or the violation of various covenants in a private equity fund’s underlying documents that are for the benefit of its US tax-exempt or non-US investors.
Club and group deals
What are some of the key considerations when more than one private equity firm, or one or more private equity firms and a strategic partner or other equity co-investor is participating in a deal?
Private equity sponsors may form a consortium or ‘club’ to jointly pursue an acquisition or investment for a variety of reasons, including risk-sharing and the ability to pursue a larger acquisition or investment, since most fund partnership agreements limit the amount a fund may invest in a single portfolio company. In addition, private equity sponsors may form a consortium that includes one or more strategic partners who can provide operational or industry expertise, financial resources or both on an ongoing basis. Partnerships with a strategic buyer can be mutually beneficially insofar as the strategic partner may provide the private equity sponsor with a potential liquidity option upon exit if it is willing to purchase the sponsor’s stake in the future. Moreover, the strategic partner can mitigate the risk of the investment by negotiating the flexibility to either buy out the private equity sponsor if projected synergies are realised with the target company, or, if synergies are not realised, exit its investment along with the private equity sponsor.
An initial consideration to be addressed in a club deal is the need for each participant’s confidentiality agreement with the target company to allow such participant to share confidential information regarding the target company with the other members of the consortium. Such confidentiality agreements may permit the participant to share information with co-investors generally or with specifically identified co-investors or may restrict the participant from approaching any potential co-investors (at least during an initial stage of a sale process) without obtaining the target company’s prior consent. Private equity sponsors may also consider including provisions in such confidentiality agreements permitting or restricting the members of the consortium from pursuing a transaction with the target on their own or with other co-investors or partners in the event that the consortium falls apart. Potential buyers’ compliance with confidentiality agreements, including provisions limiting the ability of the potential buyer to share information with co-investors, has received significant attention in the US, with various litigations having been commenced with respect to these issues.
Counsel to a consortium must ensure that all of the members of the consortium agree upon the proposed price and other material terms of the acquisition before any documentation is submitted to, or agreed with, the target company. In addition, counsel to a consortium must ensure that the terms of any proposed financing, the obligations of each consortium member in connection with obtaining the financing and the conditions to each consortium member’s obligation to fund its equity commitment have been approved by each member of the consortium. It is not uncommon for consortium members to enter into an ‘interim investors agreement’ at the time of signing a definitive purchase agreement or submitting a binding bid letter that governs how the consortium will handle decisions and issues related to the transaction that may arise following signing and prior to closing. An interim investors agreement may also set forth the key terms of a shareholders’ agreement to be entered into by the consortium members related to post-closing governance and other matters with respect to the acquisition. Members of a consortium that involves a potential strategic partner should be mindful of potential increased regulatory and antitrust risk if a target company has operations that compete with or address the same market as the operations of the strategic partner.
Each member of the consortium may have different investment horizons (particularly if a consortium includes one or more private equity sponsors and a strategic partner), targeted rates of return, tax or US Employee Retirement Income Security Act issues and structuring needs that must be addressed in a shareholders’ agreement or other ancillary documentation relating to governance of the target company and the future exit of each consortium member from the investment. Particularly where a private equity sponsor is partnering with a strategic buyer, the private equity sponsor may seek to obtain certain commitments from the strategic buyer (eg, non-competition covenants and no dispositions prior to an exit by the sponsor), the strategic buyer may seek to limit the veto rights or liquidity rights (or both) of the private equity sponsor. As discussed in question 13, a shareholders’ agreement would typically provide the consortium members with rights to designate directors, approval rights and veto rights and may include provisions relating to pre-emptive rights, tag-along and drag-along rights, transfer restrictions, future capital contributions, put rights, mandatory redemption provisions, rights of first offer or first refusal, and restrictive covenants that limit the ability of each consortium member to engage in certain types of transactions outside of the target company. The various rights included in a shareholders’ agreement are frequently allocated among consortium members on the basis of each member’s percentage ownership of the target company following the consummation of the acquisition.
Issues related to certainty of closing
What are the key issues that arise between a seller and a private equity buyer related to certainty of closing? How are these issues typically resolved?
Target companies and their boards of directors generally seek to obtain as much certainty with respect to closing a transaction as possible, which includes limited conditions to the buyer’s obligation to close the transaction and the ability to specifically enforce the obligation to close a transaction against the buyer. In private equity transactions without a financing condition, many private equity sponsors have made efforts to ensure that the conditions to their obligation to consummate the acquisition pursuant to the purchase agreement are substantially the same as the conditions of the lenders to fund the debt financing to the private equity sponsor’s shell acquisition vehicle or are otherwise fully within the private equity sponsor’s control.
Private equity sponsors have historically resisted a specific performance remedy of the sellers in acquisition agreements. Private equity sponsors often use third-party debt financing in acquisitions and generally do not want to be placed in a position where they can be obligated to close a transaction when the third-party debt financing is unavailable and the ability to obtain alternative financing is uncertain. In addition to the fact that the transaction may no longer be consistent with the private equity sponsor’s financial modelling in the absence of such debt financing (namely, the transaction would be unlikely to generate the private equity sponsor’s target internal rate of return), private equity sponsors are limited in the size of the investments they are permitted to make pursuant to their fund partnership agreements and therefore may not be able to purchase the entire business with an all-equity investment. As a result, private equity sponsors commonly require the ability to terminate the purchase agreement and pay a specified reverse termination fee to the target company in the event that all of the conditions to the closing have been satisfied (or are capable of being satisfied on the applicable closing date) but the sponsor is unable to obtain the debt financing necessary to consummate the closing, as described in question 11.
Current market practice provides that some private equity sponsors agree to a limited specific performance remedy in which, solely under specified circumstances, target companies have the right to cause the shell acquisition vehicle to obtain the equity proceeds from the private equity fund and consummate the transaction. In the instances in which such a limited specific performance right has been agreed, such right will arise solely in circumstances where:
- the closing has not occurred by the time it is so required by the purchase agreement (which is typically upon the expiry of the marketing period for the buyer’s third-party debt financing);
- all of the conditions to closing have been satisfied (or will be satisfied at the closing);
- the debt financing has been funded (or will be funded if the equity financing from the private equity sponsor will be funded); and
- in some cases, the seller irrevocably confirms that, if specific performance is granted and the equity and debt financing is funded, then the closing will occur.
In recent years, some private equity sponsors have been willing to provide an equity commitment at signing that backstops the entire purchase price for a transaction, allowing the target company to cause the sponsor to consummate the transaction even if the third-party debt financing is not available at the time of closing. Whether a private equity sponsor is willing to provide a full equity backstop depends largely on the size of the sponsor’s fund relative to the size of the target company and the ability under the fund’s partnership agreement to draw sufficient capital for a single transaction, as well as the competitiveness of the sale process. A full equity backstop can meaningfully increase the attractiveness of a sponsor’s proposal by removing financing risk.
In addition, it is not uncommon for private equity sponsors to agree to give the seller the right to specifically enforce specified covenants in the purchase agreement against the private equity sponsor’s shell acquisition vehicle (eg, using specified efforts to obtain the debt financing, complying with the confidentiality provisions and paying buyer expenses).
Update and trends
Update and trends
Have there been any recent developments or interesting trends relating to private equity transactions in your jurisdiction in the past year?
On 22 December 2017, President Trump signed major tax reform legislation passed by the House and Senate under the Tax Cuts and Jobs Act (the Tax Reform Bill), which is generally effective as of 1 January 2018. Among the numerous changes included in the Tax Reform Bill are:
- a permanent reduction in the corporate income tax rate;
- a partial limitation on the deductibility of interest paid or accrued on indebtedness properly allocable to a trade or business (subject to certain exceptions);
- a new deduction for individuals receiving certain business income from ‘pass-through’ entities; and
- a partial shift of the US taxation of multinational corporations from a tax on worldwide income to a territorial system (along with a transitional rule that taxes certain historical accumulated earnings and rules that prevent tax-planning strategies that shift profits to low-tax jurisdictions).
The impact of the new and sweeping tax law changes on private equity transactions is uncertain.
Committee on Foreign Investment in the United States (CFIUS)
In 2017, we have seen sponsors and other dealmakers assessing cross-border transactions pay increased attention to CFIUS risk and measures designed to mitigate CFIUS risk. Given the new administration’s avowed trade policies and increased protectionism, as well as diplomatic tensions involving North Korea, many practitioners have seen increasing and unprecedented scrutiny of inbound investments, particularly from Chinese buyers, and expect this trend to continue. For example, in September 2017, the President issued an executive order blocking the proposed US$1.3 billion sale of Lattice Semiconductor Corp to affiliates of Canyon Bridge Capital Partners, a private equity firm managed by US nationals whose investors include several Chinese state-owned enterprises. Consequently, in recent cross-border transactions, and in particular in transactions involving sales of portfolio companies that are in sensitive industries or possess sensitive data or technology and that implicate national security concerns, we have seen some sponsors consider or utilise creative mechanisms for allocating CFIUS risk, including negotiating pre-emptive divestitures of certain assets and specific termination fees tied to CFIUS approval. In addition, we have seen some foreign buyers structure deals as minority or passive investments, rather than acquisitions of control, which may, in certain cases, have been done in an effort to avoid or mitigate CFIUS risk.