fundamentals of private equity deal structuring
TRANSCRIPT
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Fundamentals of Private Equity Deal StructuringLaura O’NeillPartnerSJ Berwin LLP27 February 2009
CP3:804204.1
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Contents
The main players
The classic buyout structure
Equity finance
Debt finance
The principal legal documents
Equity documents - the main points to consider
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The main players (1)
Sellers/existing shareholders
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The main players (2)
Bank/Debt provider
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The main players (3)
Private Equity house
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The main players (4)
Management
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The main players (5)
Accountants, financial, tax and other advisers
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The main players (6)
and finally….the lawyers
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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
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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
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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
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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)
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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
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• 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)
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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.
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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
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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
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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
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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
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Warranties (1)
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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
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Board representation (1)
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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
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Default/Swamping rights (1)
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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
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Vetoes/consent matters (1)
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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
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Information rights (1)
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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
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Drag-along/tag along (1)
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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)
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Restrictive covenants (1)
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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
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Good leaver provisions (1)
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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
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Bad leaver provisions (1)
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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
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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
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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