Fundamentals of Private Equity Deal Structuring

Fundamentals of Private Equity Deal StructuringLaura O’NeillPartnerSJ Berwin LLP27 February 2009

CP3:804204.1

Contents

The main players

The classic buyout structure

Equity finance

Debt finance

The principal legal documents

Equity documents - the main points to consider

The main players (1)

Sellers/existing shareholders


Bank/Debt provider


Private Equity house


Management


Accountants, financial, tax and other advisers


and finally….the lawyers

The classic MBO structure

InvestorManagement

Banks

Target

eg 85% eg 15%

Senior/mezzanine

debt

Ordinary shares

Vendor£ Price

Shares

Inter-company loan

Topco Ltd(Investment vehicle)

Newco Ltd(Purchasing and debt vehicle)

Ordinary shares (“sweet equity”)

Shareholder debt

Equity finance (1)• subscription for ordinary shares by:

– PE house/Investor

– Management - incentive to make business succeed (‘sweet equity’) (ranks behind all other debt and equity)

• further funds invested:

– usually by way of loan notes or preference shares

– give Investor a preferred right to income and to capital on a winding up but unsecured and subordinated to bank debt

– form the majority of Investor’s equity contribution

– interest rolls up or “PIK” notes used

– no payments during term of the notes - return back-ended

Equity finance (2)• What is sweet equity?

– say Management cut a deal with Investor whereby Investor will acquire the target for £100 million and Management will have 20% equity in the buy out vehicle

– all things being equal Management will have to pay £20 million for their 20% stake

– however, with leverage of, say, £60 million, the equity requirement is £40 million, hence Management need to provide £8 million but Management is unlikely to have this sort of money

– so Investor provides the majority of the equity requirement in the form of “quasi-equity” (loan notes or preferred shares) - in this example say £39 million with the balance of £800,000 in the form of ordinary shares (the real equity)

– Management, therefore, only needs to subscribe £200,000 for 20% of the ordinary shares to entitle it to 20% of any upside

Debt finance (1)• Usually forms largest part of required funding

• 2 sources of this debt: “senior debt” and “junior debt”

• Senior debt– so called because it ranks ahead of all other debt of Newco group

– often divided into two types of facility being:

(1) term facility– to finance the acquisition and associated costs and expenses

– also to refinance existing Target indebtedness

– sometimes a capex facility will be put in place to fund large ongoing capital costs

(2) revolving credit facility– to fund ongoing working capital needs of the business

– larger transactions will be syndicated (i.e. underwriting banks will sell part of commitment to participant banks to reduce balance sheet exposure)

Debt finance (2)• Junior debt

– so called because it occupies a position between debt and equity

– subordinated (junior) to the senior debt but will usually receive interest payments (provided no major event of default occurs)

– generally shares the senior security, but on a second ranking basis

– sometimes attaches warrants giving lenders the right to shares in Topco

– warrants allow mezz provider to share in increase in value of equity of Target group and provide higher return on investment to compensate for subordinated nature of debt

• How does leverage work?

– say a business has an enterprise value (EV) of £100 million - without any leverage it will cost Investor £100 million

– if it is then sold a year later for £120 million, a £100 million investment has generated a £20 million profit (i.e. a 20% profit)

– if, however, Investor used debt of £80 million to buy the business then business has only cost it £20 million

– hence selling the business a year later for £120 million generates a net return of £40 million – a £20 million investment has generated a £40 million profit or a return of 2 x the original £20 million investment (or a 200% profit)

Debt finance (3)

The principal legal documents (1)• A buyout essentially involves 3 separate processes/transactions:

– the acquisition

– between Newco and Sellers for acquisition of Target

– the equity arrangements

– deal between Investor and Management

– debt finance

– between Newco and banks/providers of finance for acquisition of Target/working capital etc.

The principal legal documents (2)• Acquisition documents

– Sale and Purchase Agreement (‘SPA’)

– contains the terms of the sale whether it is of shares, assets or a business

– Disclosure Letter

– will contain disclosures against the warranties in the SPA

– Tax Deed

– trade mark/trade name licences

– property documents/transfers

– transitional service agreements

The principal legal documents (3)• Equity documents

– Investment Agreement (aka Subscription and Shareholders Agreement)

– governs relationship between Management and Investor, contains equity and shareholder debt subscription mechanics, Investor rights, Management obligations and restrictions and provisions governingoperation of business going forward and “exit”

– new Topco Articles

– provisions controlling the constitution and share capital of Topco, including dividend rights, transfer restrictions and good leaver/bad leaver provisions

– shareholder debt instrument

– constitutes shareholder debt (loan notes, deep discount bonds, PIK) which forms majority of equity funding

– new Service Agreements for Management

The principal legal documents (4)• Finance Documents

– Senior Finance Agreement (‘SFA’)

– contains terms on which senior lenders will advance funds and restrictions on operation of Target going forward and ability of Investor to extract cash from the business

– Mezzanine Finance Agreement (‘MFA’)

– broadly mirrors terms of SFA with minor changes (e.g. increased pricing and weaker financial covenants - 10% extra headroom)

– security agreements

– details what security is taken over what assets (eg. debentures (incorporating fixed and floating charges) from Newco and guarantees from Target/subsidiaries guaranteeing Newco’s borrowings)

– Intercreditor Agreement

– details the ranking between lenders (senior and mezz) as well as loan note holders of Investor and any preferred equity

Equity documents – main points to consider• Warranties

• Board representation

• Default/swamping rights

• Vetoes/consent matters

• Information rights

• Drag-along/tag along

• Restrictive covenants

• Leaver provisions

• Share transfers

• Ratchets

Warranties (1)

Warranties (2)

• Contractual statements by Management, confirming accuracy of position/events

• Primarily to focus Management’s mind and force disclosure

• Management can be sued if inaccurate

• Covers matters such as:– business plan properly and diligently prepared/reasonableness of

assumptions

– accuracy of due diligence reports

– personal information, including other business activities, financial background, no criminal record, no pending litigation etc.

– no breach of the SPA (in particular Seller warranties)

• Contentious issues include scope, financial thresholds and caps,and whether joint and several or several and proportionate liability

Board representation (1)

Board representation (2)• Investor director(s)

– entrenched rights with “fast-track” appointment/removal procedures

• Observer(s)

• Notice of meetings, quorum, blocking vote

• Committees: Remuneration, Audit, Nominations, others

• Boards of subsidiaries

• Directors’ fee

• Chairman

Default/Swamping rights (1)

Default/swamping rights (2)

• Enables Investor to ‘step in’ and take voting control if Topco underperforms

• Board and/or shareholder level

• Triggered by defaults, e.g. banking covenants about to be breached, failure to pay loan stock interest, failure to hit budget, bad behaviour etc.

• Contentious issues include materiality, remedy period, duration,and whether and when they lapse

Vetoes/consent matters (1)

Vetoes/consent matters (2)• Management essentially have day-to-day control of Target but

important decisions require “Investor consents”

• Cover trading matters such as:

– entering into material contracts

– pursuing litigation

– major capex

– hiring/firing

– major leases

– disposing of business/major assets

• Cover structural matters such as:

– issuing shares

– raising finance

– paying dividends

– exit

– buying-back shares

– reconstructions

– share transfers

Information rights (1)

Information rights (2)

• Monthly Management accounts

• Minutes of each board meeting held

• Projected cashflows & P&L

• Testing against banking covenants

• Audited accounts

• Annual business plan & budget

• Rights of inspection/audit

Drag-along/tag along (1)

Drag-along/tag along (2)• Drag-along:

– ability for Investor to enforce sale of whole

– all other shareholders have to sell at same time

– usually on same terms and at same price unless there are different classes of shares with different orders of priority on an exit

– often a moratorium for initial period, say two years

– sometimes a right for Management to match any offer received by Investor

• Tag-along:– right for minority shareholders to block a transfer unless they are also

given an opportunity to exit on the same terms

– should not catch permitted transfers (e.g. syndication and intra-group)

• Should not catch permitted transfers (e.g. syndication and intra-group)

Restrictive covenants (1)

Restrictive covenants (2)• Protective undertakings covering:

– non-compete

– no poaching of staff, customers, suppliers

– confidentiality

– no ‘bad mouthing’

– use of business names

• Contentious issues include duration, territories, scope and carve outs for existing interests

Good leaver provisions (1)

Good leaver provisions (2)

• Where a manager ceases to be employee/director – what happens to his/her shares?

• Usually bought back/sold – if “good leaver” then typically get higher of price paid/fair market value

• “Good Leaver” = death, permanent illness/disability, if Investor agrees

• Others may include – unlawful termination, resignation after ‘x’years service

• Vesting of shares as time passes, e.g.

– ⅓ after year 1, ⅔ after year 2, rest after year 3

– once vested, shares not subject to good leaver/bad leaver provisions

Bad leaver provisions (1)

Bad leaver provisions (2)

• “Bad leaver” = typically “if not a Good Leaver” or gross misconduct, voluntary resignation, breach of restrictive covenants

• Price would be lower of subscription price paid or fair market value

Share transfers• General prohibition unless it triggers drag-along/tag-along rights

• Investor’s right to syndicate and/or transfer to other funds

• Permitted transfers, i.e. to family trusts, privileged relations or other funds or with Investor’s consent

• Otherwise pre-emption rights apply

• Deed of adherence to investment agreement

Ratchet• Increases Management’s equity if certain performance criteria are

met

• Performance criteria usually based on a realisation (target IRR/minimum multiple based return eg. 2.5 times) but can follow targets such as EBIT

• Part of Investor’s preferred shareholding converts into worthless deferred shares

• Means of bridging the commercial gap between Management optimism and Investor conservatism