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Presenting a live 90-minute webinar with interactive Q&A
Negotiating Private Equity
M&A Key Deal Terms Rollover Equity; Bolt-on, Tuck-in and Platform Acquisitions; Earnouts and More
Today’s faculty features:
1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific
WEDNESDAY, OCTOBER 25, 2017
John J. McDonald, Partner, Troutman Sanders, New York
Michael Weinsier, Partner, Troutman Sanders, New York
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PRIVATE EQUITY M&A KEY DEAL TERMS:
ROLLOVER EQUITY, BOLT-ON, TUCK-IN AND PLATFORM ACQUISITIONS, EARNOUTS, SELLER PAPER, REVERSE
BREAK FEES AND REP &WARRANTY INSURANCE
John McDonald
Partner
Troutman Sanders LLP
Michael Weinsier
Partner
Troutman Sanders LLP
CURRENT TRENDS IN PRIVATE EQUITY M&A DEALS
Positives for M&A Deals
• M&A deal volume remains quite strong, although activity has leveled off as
compared to 2016. According to PitchBook, there were 45,665 M&A deals worth a
combined $2.166 trillion announced during the first half of 2017, compared to
$2.776 trillion across 50,641 deals in the second half of 2016.
• Consumer confidence continues to be high, although there is widespread sentiment
that a correction is coming in the financial markets.
• Despite two interest rate hikes earlier in 2017 and more expected in the future,
interest rates are likely to remain well below pre-financial-crisis levels for years.
• Historically high EBITDA multiples have motivated private equity firms to sell their
portfolio companies now. According to PitchBook, the median EBITDA multiple of
about 13.6 has stayed well above the historical average of 12.0 and is close to the
ten-year high of 13.7 in 2007.
• Strategic investors hold large cash reserves, which they are using to make
acquisitions given relatively limited prospects for organic growth.
• Private equity firms have significant “dry powder” and are coming up against the
ends of their funds' investment periods.
6
CURRENT TRENDS IN PRIVATE EQUITY M&A DEALS
Negatives for M&A Deals
• Volatility due to Trump administration actions and statements. Dealmakers are
uncertain whether President Trump’s pro-dealmaking perspective will stimulate US
economic activity or be outweighed by the uncertainty resulting from the frequent
changes within his administration and his public statements.
• It is unclear whether Trump proposals for tax reform and infrastructure spending,
which could be a major boon to corporate America, will actually occur.
• Restrictions by the PRC government on outbound investments have caused a
substantial decline in M&A activity by Chinese companies in the US in 2017, as
compared to prior years.
• President Trump’s actions relating to Obamacare have caused substantial
uncertainty in the healthcare industry, which has recently been a major source of
economic activity in the US.
• M&A transactions are subject to increasing antitrust scrutiny, both domestically and
internationally.
• Unclear global geopolitical outlook – North Korean nuclear activity is a cause of
great concern.
7
CURRENT TRENDS IN PRIVATE EQUITY M&A DEALS
Positives for Private Equity Deals
• The private equity fundraising market remains robust, and more funds are seeking capital commitments than ever before, with 1,289 private equity funds in the market at the start of 2017, representing a 12% increase since the beginning of 2016.
• In 2016, 830 private equity investment vehicles raised about $347 billion in capital commitments, with the largest funds (over $5B) reporting a higher percentage of the capital raised, continuing a trend of the last three years.
• According to one recent survey of institutional investors, 89% of respondents expected to maintain or increase their capital allocated to private equity investments in the next 12 months. This trend is likely fueled at least in part by continued record distributions, which outpaced capital calls in the first half of 2016.
• Private equity funds that held closings in the years leading up to the financial crisis have begun reaching the end of their initial ten-year terms. Vintage 2006 to 2008 funds represented $524 billion of total unrealized assets as of June 2016, a sharp decrease of nearly 50% from the $1.1 trillion in total unrealized assets for such funds as of June 2015.
• As PE funds approach the end of their terms, sponsors are focused on exits from portfolio companies as well as sponsor-led recapitalizations.
8
CURRENT TRENDS IN PRIVATE EQUITY M&A DEALS
Negatives for Private Equity Deals
• Excessive competition – at no point in history has the private equity space been as competitive as it is today. Between 2000 and 2016, the number of private equity firms globally has tripled and the amount of assets under management has grown from almost $600 billion in 2000 to almost $2,500 billion. The huge amounts of capital that have flowed into the private equity industry also mean that accumulated “dry powder” is at record highs. Dry powder grew to more than $500 billion by March 2017.
• Increased competition from strategic buyers – strategic buyers have accumulated vast amounts of cash and often compete against PE funds in the acquisition of target assets.
• Increased regulation – further evidence that private equity is a maturing industry is the increased amount of regulation the sector has experienced in recent years.
• LP scrutiny and pressure – according to a survey conducted by Preqin in June 2016, LP investors in private equity funds are increasingly requesting lower management fees, asking for more transparency from fund managers, and requesting reduced “carried interest” performance fees.
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KEY TERMS IN PE M&A – ROLLOVER EQUITY
Rollover Equity - Introduction
• To enhance alignment of interests between the PE sponsor and the portfolio
company’s management team and increase their “skin in the game”, the PE sponsor
often requires management team members to roll over some of their existing equity,
rather than permitting them to cash out all of their target company holdings in the
buyout.
• In a rollover, the management team members exchange a portion of their equity in
the target company for one or more classes of equity in the PE sponsor’s acquisition
vehicle, which is usually the parent company of the portfolio company.
• Rollover meaningfully reduces the size of the PE sponsor’s equity check for the
acquisition, enabling it to invest its fund’s capital across a broader range of portfolio
companies, enhancing diversification.
• Rollover requires requires the management team to take ownership of the higher
valuation for the target company that they advocated in the sale process, while
creating an additional means of wealth creation for them upon exit if their
projections concerning valuation of the target company are actually realized.
10
KEY TERMS IN PE M&A – ROLLOVER EQUITY
Amount of Rollover Equity
• The amount of equity rolled over by the management team in a particular buyout
transaction varies depending on several factors, including:
The amount of available debt financing for the buyout and resulting need for the
PE sponsor to fill any gap in the capital stack for the acquisition.
The amount of equity financing that the PE sponsor is willing to commit to the
buyout and the ownership dilution that the PE sponsor is willing to accept due to
the rollover.
The aggregate amount and percentage of existing equity of the target company
owned by the management team, as opposed to non-management
equityholders.
The amount of co-investment by the management team (i.e., new money
invested), if any, that is expected in connection with the buyout, in addition to the
rollover.
The expected tax treatment of the rollover.
• Management team members typically rollover into 15-25% of the equity of the post-
buyout entity.
11
KEY TERMS IN PE M&A – ROLLOVER EQUITY
Rollover Equity – Tax-Free Exchange
• A key structuring issue in any rollover is whether the rollover can be accomplished
on a tax-free basis, so that management is not taxed upon exchange of its existing
equity in the target company for equity in the post-buyout entity (i.e., the acquisition
vehicle).
• A successful tax-free rollover defers (but does not permanently eliminate) payment
of capital gains taxes resulting from appreciation in the value of the equity from the
management team member’s original acquisition of the target company equity until
the subsequent liquidity event for the portfolio company.
• The tax is deferred (and not permanently forgiven) because the management team
member receives a carryover tax basis in the post-buyout entity equity issued in the
rollover exchange.
• The management team members use that carryover tax basis (subject to any
adjustments during their ownership period) to determine any taxable gain or loss
upon sale of the post-buyout entity equity in the subsequent liquidity event for the
portfolio company.
12
KEY TERMS IN PE M&A – ROLLOVER EQUITY
Equity Securities Received in the Rollover
• In the buyout, the sponsor usually receives a combination of common and preferred
equity or a single class of preferred equity with characteristics of both common and
preferred equity.
• Generally, the bulk of the PE sponsor’s investment is in preferred equity that:
Has a liquidation preference ahead of all common equity.
Often has participation rights to share pro rata with the common equity in
liquidation proceeds following payment of the preferred equity’s liquidation
preference.
• The equity securities received by the management team members in the rollover
are often (but not always) the same equity securities received by the PE sponsor in
the buyout. This is distinct from any incentive equity that they receive without being
required to pay for it, which is typically common equity.
• Management team members are usually required to execute a stockholders
agreement or a limited liability operating agreement subjecting the rollover equity to
right of first refusal, tag-along, drag-along and other transfer and voting restrictions.
• Rollover equity is sometimes subject to vesting requirements, particularly if options
or other deferred compensation are rolled over that were subject to vesting before
the buyout. 13
KEY TERMS IN PE M&A – BOLT-ON, TUCK-IN & PLATFORM ACQUISITIONS
Bolt-On Acquisitions
• In a bolt-on acquisition, a PE sponsor typically causes an existing portfolio company
(the “platform company”) to acquire another, usually smaller, company in the same
or an adjacent industry as the platform company, sometimes as part of a “roll-up”
strategy of consolidating companies in a fragmented industry.
• A bolt-on target company typically produces products or services that are one of the
following:
The same product or service as the platform company, but which distributes to
or services a different geographical area.
Products or services that are an extension of, or in an adjacent or
complementary category to, the platform company’s existing products or
services.
• A bolt-on acquisition can involve a stand-alone company or a product line or division
of a larger company.
• Enables the platform company to take advantage of built-in efficiencies of the
combination and realize economies of scale.
• The terms “bolt-on” and “add-on” are often used interchangeably.
14
KEY TERMS IN PE M&A – BOLT-ON, TUCK-IN & PLATFORM ACQUISITIONS
Structuring Bolt-On Acquisitions
• A bolt-on acquisition can be structured as a equity purchase, an asset acquisition or
a merger.
• An asset purchase structure can help protect the buyer from historical liabilities of
the target company, but will trigger anti-assignment clauses in its contracts and that
will require consent of the contract counterparties, and is often the least tax efficient
from the seller’s perspective. Use of an equity purchase or merger structure avoids
much of the anti-assignment clause issue and is more tax efficient from the seller’s
perspective, but results in retention of the target company’s historical liabilities.
• The most common structure is a purchase by the platform company of the bolt-on
company’s equity, with the bolt-on company becoming a subsidiary of
the platform company parent.
• However, if the bolt-on target is a product line or other part of a larger company, or
there are otherwise only specific assets of the bolt-on target that
the platform company wants to acquire, an asset purchase is typically the best
structuring option. Bolt-on asset purchases are typically structured as an acquisition
by a newly-created entity that is a subsidiary of the platform company.
15
KEY TERMS IN PE M&A – BOLT-ON, TUCK-IN & PLATFORM ACQUISITIONS
Platform Company vs. Bolt-On Company
• A platform company must have all resources necessary to run as a stand-alone
operation, including:
Human resources
Information technology
Accounting, payroll and finance
Sales and marketing
Customer service
Back-office operations
• A bolt-on acquisition target company can be much more limited (sometimes
consisting merely of a product line or other select assets) and can have significant
operational deficiencies that would be an issue for a buyer looking to acquire the
target company as a stand-alone business.
• However, that may not be not problematic for the PE sponsor because its platform
company has the necessary resources.
16
KEY TERMS IN PE M&A – BOLT-ON, TUCK-IN & PLATFORM ACQUISITIONS
Platform Company vs. Bolt-On Company (cont.)
• When acquiring a platform company, a PE sponsor seeks target companies that
have significant market share and a strong market position, with earnings that are
both consistent and predictable.
• However, when acquiring a bolt-on company, consistent and predictable earnings
may be less important to the PE sponsor because:
The acquisition is being made to take advantage of specific target company
assets or abilities, which may make the historical profitability of the target
company less important.
The target company may be losing money due to high costs or expenses, which
can be eliminated by the PE sponsor as the target company is integrated with
the portfolio company’s operations.
• The PE sponsor is typically looking to improve the performance of the platform
company and by taking advantage of:
The target company’s expanded product line or geographical reach.
Operational synergies that can enable it to pay a multiple comparable to that of
a strategic buyer.
Economies of scale.
17
KEY TERMS IN PE M&A – BOLT-ON, TUCK-IN & PLATFORM ACQUISITIONS
Bolt-On vs. Tuck-In Acquisition
• “Bolt-on” generally refers to an acquisition of a business that supplements or
otherwise adds to services performed/products sold by the platform company, while
“tuck-in” usually refers to an acquisition of a business that performs a service that is
already performed, or sells a product that is already sold by, the platform company.
• “Bolt-on” acquisitions often add geographic or market diversity to a platform
investment, while “tuck-in” acquisitions may involve a product line acquisition or
other discrete assets.
• “Bolt-on” acquisition targets are typically larger, relative to the platform company, as
compared to “tuck-in” acquisition targets.
• All of the above being said, in practice, the terms are sometimes used
interchangeably and there may be overlap between the characteristics of target
companies that are the subject of “bolt-on” and “tuck-in” acquisitions.
18
KEY TERMS IN PE M&A – EARNOUTS
Earnouts Generally
• An earnout is a mechanism used in M&A transactions in which a portion of the
purchase price is determined based on the performance of the target company over
a specified period of time after the closing of the acquisition.
• Earnouts are typically used where there is a gap between the seller’s and buyer’s
beliefs about the valuation of the target company. Earnouts can be attractive to PE
sponsors because they help reduce the risk of overpaying by calibrating the
purchase price to the target company’s future financial performance.
• Typically, an earnout is structured as one or more contingent payments of purchase
price after the closing that become payable if specified earnout targets are satisfied
within specified periods.
• If the target company fails to achieve the earnout targets within the specified
periods, the buyer either isn’t required to make the earnout payments or they are
paid in smaller amounts.
• In addition to addressing valuation gaps, earnouts also act as a form of seller
financing, in which the buyer effectively pays the purchase price to the sellers out of
the profits of the acquired company. That can be attractive because it reduces the
size of the PE sponsor’s equity check for the acquisition.
19
KEY TERMS IN PE M&A – EARNOUTS
Earnout Structures and Targets
• Earnout structures can vary widely because they must be tailored to suit the target
company’s business and the parties’ expectations. However, there are some
common issues in all earnouts, including:
Determining the earnout targets and the method for determining how they are
satisfied.
Setting the earnout periods and structuring the payments.
Sometimes, providing for a buyout or acceleration of the earnout payments, as
discussed below.
• Parties can use either financial targets or non-financial criteria for earnouts. Most
earnouts involve financial targets such as revenue, net income or earnings before
interest, taxes, depreciation and amortization (EBITDA).
• However, some earnouts are based on achievement of non-financial criteria such as
receiving FDA approval of a drug being developed by the target company, which will
substantially increase the value of the target company’s business.
20
KEY TERMS IN PE M&A – EARNOUTS
Earnout Period, Timing and Payment
• The length of earnout periods will subject to negotiation by the parties based on the
target company’s business. Most earnouts last between one and three years after
closing of the acquisition, but there are earnouts with shorter or longer periods.
• The amount of the earnout payments can be:
A fixed dollar amount if the earnout target is met. If there are multiple earnout
payments, their amounts can be increased, decreased or kept constant during
the earnout period.
A multiple of the amount by which the target company’s performance exceeds
the earnout target.
A percentage of the earnout target amount (for example, a percentage of an
EBITDA target).
Determined using another agreed upon formula.
• There are sometimes “catch-up” or “aggregation” concepts, in which the seller
receives an earnout payment if the target company’s performance in subsequent
earnout periods overcomes shortfalls in earlier periods.
21
KEY TERMS IN PE M&A – EARNOUTS
Acceleration and Buyout of Earnouts
• Acceleration provisions cause all earnout payments to become immediately due
upon the occurrence of certain events before the end of the earnout period, such as:
Sale of the target company or a substantial amount of its assets.
Breach by the buyer of covenants relating to post-closing operation of the target
business.
Termination by the buyer of target company employees (but note that this can
have adverse tax consequences for the seller).
Bankruptcy or insolvency of the buyer.
• These provisions protect the seller from changes that adversely affect the target
company's ability to satisfy the earnout targets or the buyer’s ability to make the
earnout payments when they become due.
• Buyout provisions enable the buyer to pay a specified amount to satisfy any
remaining earnout payment obligations to the seller. This can be useful when a
buyer wants to sell the target company before the end of the earn-out period and
would like to avoid having to work around seller earnout rights that can impede the
sale of the target company.
22
KEY TERMS IN PE M&A – EARNOUTS
Avoiding Earnout Disputes
• A Delaware Chancery Court judge once remarked that earnouts “convert today’s
disagreement over price into tomorrow’s litigation over the outcome.” As a result,
great care needs to be used in defining the events that will result in earnout
payments to help avoid subsequent disputes.
• Parties can help avoid disputes by clearly stating in the purchase agreement the
accounting methodology that will be used in calculating any financial earnout targets
and attaching example calculations showing the earnout payment amounts under
various scenarios.
• Some other key issues to address in order to avoid earnout disputes include:
The buyer’s obligation to support the target company during the earnout period
by, for example, making capital expenditures and/or routing business toward the
target company.
The seller’s decision making authority (if any) regarding operation of the target
company business during the earnout period.
Whether the target company’s operations must be conducted by the buyer in the
same manner during the earnout period as they were by the seller prior to
closing of the acquisition.
23
KEY TERMS IN PE M&A – SELLER PAPER
Seller Paper Generally
• Seller paper is promissory notes issued by the target company to the seller as part
of the purchase consideration in an acquisition.
• Although seller paper can be a primary financing source for an acquisition, it is more
typically mezzanine debt financing that is a part of the capital stack constructed by a
PE sponsor for the acquisition, which is subordinated to the senior debt financing
obtained from an institutional lender.
• Seller paper is used for a variety of reasons, including:
To fill the gap between the purchase price and the amount of senior debt
financing available.
To “stretch” the purchase price beyond market value, while minimizing the risks
to the buyer and its financing sources.
To help incentivize the seller to stay actively engaged in the target company
business after closing.
To enable the seller to defer taxes on a portion of the purchase price into future
tax years when its marginal tax rate is lower.
• Subordination provisions and default remedies are particularly important to sellers.
24
KEY TERMS IN PE M&A – SELLER PAPER
Typical Seller Paper Terms
• PE sponsors often advocate use of seller paper by noting that it can provide the
seller with an attractive interest rate, as compared to other investments
opportunities in today’s low interest rate environment, which is coming from a
business that the seller knows very well.
• Some typical terms of seller paper include:
The Seller paper is typically unsecured and subordinated to the senior debt.
However, monthly interest and sometimes principal payments can typically be
made on the seller paper as long as no event of default has occurred under the
senior debt financing.
Seller paper typically constitutes from 10-40% of the total purchase price.
Interest rates on the seller paper are typically comparable to unsecured
mezzanine debt – 6-10% per annum.
The maturity of the seller paper is often the same as the senior debt financing –
5-7 years after closing of the acquisition, subject to acceleration upon a
subsequent sale of the target company.
25
KEY TERMS IN PE M&A – REVERSE BREAK-UP FEES
Reverse Break-Up Fees Generally
• A reverse break-up fee is a payment that the buyer makes to the seller if the
transaction fails to close because of the occurrence of a specified event.
• Reverse break-up fees have become the norm in acquisitions of publicly-traded
companies since the 2008 financial crisis, particularly in deals in which the buyer is
a PE sponsor, as the buyer wants to protect itself from potentially substantial liability
to the seller if it cannot close the acquisition.
• The most common trigger for a reverse break-up fee is the buyer’s failure to obtain
debt financing necessary to close the acquisition.
• Additional reverse break-up fee triggering events include failure to obtain antitrust
and other regulatory approvals necessary to close the acquisition.
• The buyer typically is prohibited from exercising the termination right if it purposely
engages in conduct that results in occurrence of the event that triggered the
termination right.
26
KEY TERMS IN PE M&A – REVERSE BREAK-UP FEES
Payment of Reverse Break-Up Fees
• The reverse break-up fee caps the buyer’s monetary liability to the seller due to its
inability to close the acquisition transaction at the stated amount.
• Reverse break-up fees are usually larger in amount than conventional break-up fees
– 4-5% of purchase price, as opposed to 2.5-3.5% of purchase price – although the
percentages can vary depending upon the size of the transaction.
• It is unusual for a buyer to have “pure optionality,” in which it can elect to pay the
reverse break-up fee and walk away from the acquisition for any reason.
• The parties typically specify in the purchase agreement that the "specific
performance" provision, under which the seller can force the buyer to close the
acquisition, does not apply if the buyer exercises its right to terminate the
transaction and pay the reverse break-up fee.
• The reverse break-up fee is typically payable by the buyer to the target company, in
full, upon its exercise of the termination right.
27
KEY TERMS IN PE M&A – R&W INSURANCE
Rep and Warranty Insurance Generally
• Representation and warranty (R&W) insurance provides a source of recovery to the
insured (typically the buyer) if the seller’s representations and warranties in the
purchase agreement are inaccurate.
• R&W insurance has gone from being virtually non-existent to very common within
the last five years, particularly in M&A transactions involving PE sponsors.
• The key benefit is that the amount of purchase consideration placed into escrow
and seller recourse are substantially reduced (typically 1-5% of purchase
consideration, rather than 10-20%), while the buyer can recover an additional
amount through claims against the R&W insurance policy.
• R&W insurance is particularly attractive to PE sponsors selling portfolio companies
because it increases the amount of purchase consideration received upon closing,
which helps maximize their return on investment (ROI) and carried interest
compensation from portfolio company investments.
• While coverage under the R&W insurance policy adds expense to the transaction
(premiums are typically 1-4% of the coverage amount, plus expenses), it can
expedite the process of negotiating the purchase agreement. That is particularly
true for negotiating the materiality thresholds in the reps and warranties, the escrow
amount and the indemnification deductible/threshold and cap. 28
KEY TERMS IN PE M&A – R&W INSURANCE
Advantages of Rep and Warranty Insurance
• In competitive auction processes, the smaller escrow amount and more limited post-
closing liability of the seller resulting from use of R&W insurance can provide a
buyer’s bid with a significant strategic advantage over other bidders not utilizing
R&W insurance.
• R&W insurance can provide the buyer with broader or longer duration protection
against breaches of the target company’s reps and warranties than it may otherwise
be able to negotiate with the seller.
• R&W insurance policies can be either “buyer-side” or “seller-side.” Buyer-side
policies are more popular because claims are not precluded if the target company’s
management team or stockholders had knowledge of the issue.
• Coverage under the R&W insurance policy starts once the “retention” has been
satisfied – typically the amount of the deductible, plus the amount of transaction
consideration placed into escrow.
• R&W insurers typically want sellers to have some “skin in the game,” but coverage
can be obtained with no recourse against the seller (although at a higher insurance
premium amount).
29