Egypt: Private Equity

In February 2022, according to an info graph the cabinet’s Information and Decision Support Centre (IDSC), Egypt ranked second most attractive country for merger and acquisitions (M&A) deals in 2021, after the US, growing by 49% in comparison with 2020. It is concluded that the Egyptian M&A market has seen a notable surge over the past year in international and domestic transactions, notwithstanding the economic backdrop and adverse effects of the COVID-19 pandemic, fluctuating crude prices, economic uncertainty and disruptions to global markets. Deal activity was significantly driven by involvement of private equity (PE) or sovereign wealth funds (SWF).

With respect to the management of the business, a financial sponsor do not usually participate in the day-to-day operation; while, on the other hand, the trade seller is more active in the portfolio company through representation on the board of directors. This does not mean that financial sponsors tend to be silent partners or sitting on the sidelines. They aim to preserve their rights by requiring obtaining their consent to pass certain resolutions that may have an impact on their return on investment.

Furthermore, the private equity sellers will always attempt to secure a safe exit by limiting their liability arisen from the sale of the portfolio company to the greatest degree possible, in order to return a clearly defined amount of proceeds to the investors in a timely manner, and hence maximising their return on investment, knowing that any unreasonable extension of the return time will affect the fund’s performance. Therefore, the private equity sellers tend to assume a minimal liability under the purchase agreement of the transaction. This is achieved by ensuring that warranties given under the purchase agreement will not give a rise to any post-closing liability. Thus, typical warranties given by the private equity seller under the purchase agreement will be limited to the fundamental obligations and warranties (ie., transfer the shares free of encumbrance, the fund’s ownership of the shares, powers and authority to enter into the purchase agreement, permission of leakage, running the portfolio company in the ordinary course of business until completion).

As for the portfolio company’s sale price, financial sponsor sellers tend to structure sales to provide for an adjustable purchase price based on working capital; and have same secured by an amount deposited with an escrow until price is adjusted and determined.

Commonly, the buyer and the seller typically commence the transaction by signing a purchase agreement together with the remaining transaction documents and ancillary agreements (eg. shareholders’ agreement, management agreement, etc.), and in some cases include specific transition agreements (eg., trademark licencing agreement, service agreement, etc.), yet depending on the nature and type of the target. However, from a procedural standpoint, the process for consummating a transfer of shares/quotas depends on the type of the portfolio company. The most common acquisition structures in Egypt involve the transfer of shares in joint stock companies (JSCs) and quotas in limited liability companies (LLCs).

Unlike the transfer of shares of the joint stock companies, the quotas of the limited liability companies do not need to be transferred through the EGX and can be transferred via quota sale agreement only. The transfer is effectuated upon, inter alia, convening the general assembly whereas the quota-holders resolve on updating the bylaws to provide for the new list of the company’s owners.

On the other hand, in case of a direct acquisition through a transfer of shares of a joint stock company, the transaction will take place on a cash basis (with certain limited exceptions requiring the prior approval of the regulator) and through the Egyptian Stock Exchange (EGX), via a designated local broker; and must be on cash basis.

As for the timeframe, if the acquirer is a foreigner, a security clearance must be obtained. Generally, foreign investors are able to operate locally while undergoing the security screening process. However, and by way of exception, some foreign nationalities (which are generally subject to change) require the security clearance to be issued prior to starting the business. Furthermore, transferring the shares via the EGX may be time consuming in case of direct or indirect acquisition of at least one-third of the share capital of listed or unlisted companies on the EGX; as this results in an extended timeline due to the requirement of issuing a mandatory tender offer to acquire up to 100% addressed to all shareholders of the target entity after obtaining the prior approval of the Egyptian Financial Regulatory Authority. Furthermore, acquirer must note that any transaction exceeding EGP20 million must be pre-approved by the EGX Pricing Committee, which convenes on a weekly basis to analyse and resolve on each envisaged transaction.

With respect to taxation, the Egyptian Income Tax Law imposes a fixed tax rate on capital gain at 22.5%.

The manner of addressing the sellers’ concern related to the payment of the transaction consideration is one of the heavily negotiated items in an M&A transaction. Guaranteeing the payment of the price varies from a transaction to another depending on the type of the target company. For example, in case the target company is a limited liability company, the financial sponsors may provide the seller with an equity/debt commitment letter, which provides comfort to sellers that the SPV will have the sufficient fund to pay the transaction consideration at closing. Parties may also agree to involve an escrow who would release the purchase price at closing.

On the other hand, in case the target company is a joint stock company, the transfer of shares must take place before the EGX on cash basis through a licensed broker to effectuate the transfer. Accordingly, the sellers have comfort that the purchase price must be paid so that the title of the shares are transferred thereto. In most of the cases, the parties agree that the purchase price is to be deposited in the bank account of the broker, who by law, would be acting as an escrow. In some other cases, the parties may agree on the appointment of an escrow who will release the purchase price to the broker upon satisfaction of the agreed upon conditions precedents and by the time of consummating the transfer before the EGX.

Furthermore, it is possible for the Include a reverse termination fee in the purchase agreement while delivering a separate guarantee pursuant to which the financial sponsor backstops the obligation to pay, if the deal fails to close if, for example, the debt financing fails to materialize.

The locked-box mechanism remains the dominant pricing mechanism of consideration structure in Egypt, which is particularly suited to transactions where the parties require economic certainty in case, for example, private equity exits. Hence, the price payable for the target is based on a balance sheet prepared at an agreed date prior to completion providing for a fixed equity price. Usually the most common locked-box date used is the target’s last financial year end. In this respect, and although the locked-box is protected by the restrictions on ‘Leakage’ and ‘Permitted Leakage’ under the purchase agreement, the buyer, for certainty purposes, may require the audited financial position of the target company for a specific period preceding the completion, as well as the management accounts covering the gap between the audited financials and completion, especially the completion date usually falls after the locked-box date in a relatively long period of time. The purchase agreement usually provides for a level of protection, which is commonly given by the seller not the buyer (eg., restrictions on ‘Leakage’ and ‘Permitted Leakage’ and business warranties in relation to accounting and the financial position of the target). Said level of protection does not usually differ irrespective of the nature of the seller, whether a private equity seller or corporate seller.

Private equity sellers tend to assume a minimal liability under the purchase agreement. As mentioned hereinabove, a private equity tends to leave the day-to-day operation management of the portfolio company to the trade seller. Where liability is assumed by a private equity seller, the latter needs to make sure that warranties given under the purchase agreement will not give a rise to any liability. Thus, typical warranties given by the private equity seller are limited to the fundamental obligations and warranties (ie., transfer the shares free of encumbrance, the fund’s ownership of the shares, powers and authority to enter into the purchase agreement, permission of leakage, running the portfolio company in the ordinary course of business until completion). Further, the private equity seller will opt to negotiate the possible minimal perception period of the warranties given under the purchase agreement, which in most cases ranges between (6) to (24) months. In the event the private equity fund is a buyer, the fund expects to receive a list of warranties (ie., business and core warranties), subject to the outcome of the due diligence.

The W&I insurance is not common in Egypt. Typically, the private equity seller does provide the ordinary core and business warranties. Nonetheless, the parties may agree to cover certain risks post-closing through various mechanisms. For instance, tax-related risks are a common concern among businesses in Egypt. Thus, a common approach to safeguard the purchaser is to retain a portion of the transaction consideration for an agreed period to cover any potential tax exposure. Purchasers tend to make deferred payments, pricing adjustments and escrow arrangements rather than to resort to indemnity claims covering potential liabilities.

Generally, the financial sponsors are active in the Egyptian market. However, we witness the financial sponsors are active in the privately held companies rather the publicly listed ones.

Generally, the regulatory control over the foreign investment in Egypt varies, and yet depends on the target industry. Accordingly, the key consents required can be highlighted, as follows: 1. prior consent of the FRA on the transfer of ownership of a business (eg., acquisition of 10 per cent of the voting rights or shares of a holding company and companies operating in a non-banking financial activity); 2. prior consent of the General Authority of Investments and Free Zones on the transfer of ownership of companies established in a free zone; 3. prior consent of Central Bank of Egypt on change of ownership of an Egyptian licensed bank; 4. prior consent of the Ministry of Health on the transfer of ownership of hospitals; 5. prior consent of the Ministry of Education on the transfer of ownership of schools; 6. foreign ownership restrictions apply in some industries such as commercial agency, where an agency company shall be fully owned by Egyptians. Unlikely the said case, a (51%) of the share capital of a company operating in importation activity shall be Egyptian; and 7. prior consent of Sinai Development Authority on the transfer of shares of a company owning assets or operating in Sinai Peninsula.

Merger clearance is generally co-regulated under the Competition Law, which regulate competition and monopolistic practices. Said law requires a post notification to be served to the Egyptian Competition Authority (“ECA”) within 30 days of completion of the transaction, subject to certain conditions. Nevertheless, we recently witnessed an unprecedented approach of ECA, where the latter issued a decision, in October 2018, on a landmark merger transaction between two main market players in the transportation sector, where ECA requested suspension of any negotiations being carried-out between the parties and deemed the said transaction (although occurred on an offshore level) a breach of the Competition Law and jeopardizes competition; as it would affect the price of services provided by both competitors and restrict the provision of those services, which can negatively affect consumers. This is a novel and rather liberal interpretation of the law, which reflects a change in the ECA’s approach towards market players by resorting to provisions other than those dealing with merger notification to control mergers prior to their occurrence. To date, the question remains on whether the same approach would also apply to the future transactions.

In principal, financial sponsors undertake minority investments in portfolio companies. According to the Capital Markets Law, a private equity must determine, in its prospectus, the maximum percentage of investing in one portfolio company and the cases where, exceptionally, a majority investments may be undertaken in one company. Accordingly, the common practice in Egypt is that a financial sponsors undertake minority investments as equity investments together with, of course, minority protections (eg. veto right, drag-along right, pre-emptive right, right of first refusal); while we have also witnessing a few deals where a larger stake is acquired. On the other hand, given that debt-like investments are subjected to a lengthy and complex regulatory process, they are not frequent in Egypt.

In general, the incentive schemes are structured on the offshore SPV level for tax efficiency purposes; and given that the incentive scheme related provisions (including the respective calculation) may be incorporated under the constitutional documents of the offshore SPV. Yet, contractual phantom equity and other cash incentives upon achieving certain KPIs can also be implemented in the transaction documentation on the offshore level despite applicable tax. The management is often incentivized, where the right for incentive shares can exercised by the managers simultaneously with the time of closing the transaction by the private equity fund. The key purpose of the vesting provisions is to incentivize the managers to maintain their high performance with the private equity fund and to retain the “right” deal executives until the end of the private equity fund’s investment period.

If the incentive scheme of the management is applied on the offshore SPV level, the applicable tax rules will be the jurisdiction where the offshore SPV is incorporated. In the event that the incentive shares granted to the management are in Egypt, the relevant rules under the Egyptian Income Tax Law will apply. To this effect, the Egyptian Income Tax Law imposes a fixed capital gain tax rate of 22.5%, in case of sale of the incentive shares. Accordingly, we usually advise our client to clear such tax matter with a tax adviser.

The managers are typically bound by non-compete and also by non-solicitation covenants with the same duration as the non-compete and perpetual confidentiality covenants. Typically, the non-compete term is set for the neighborhood of two years, yet it is consensual.

Typically, the financial sponsor can ensure control over the material business decisions made by portfolio company via adoption of several mechanisms incorporated contractually under the shareholders’ agreement. Usually, the financial sponsor imposes a proper framework of the company’s corporate governance (e.g., shareholders meeting, board, and executive team composition). Moreover, the financial sponsor often opts for specific voting arrangements (e.g., veto rights for certain matters being exercised directly or through the director designated by the financial sponsor). The typical documents that are often used to regulate the governance of the portfolio company encompass, for example, shareholders’ agreement and articles of association (where possible). It is worth highlighting that the private equity funds tend to indirect acquisition through an offshore SPV, where the room of incorporation of certain veto rights and reserved matters under the constitutional documents is more flexible.

While is not legally prohibited, the management pooling vehicles are not typical in the Egyptian market.

Although most private equity funds tend to finance the deals via the equity commitment, being provided by the fund to the SPV, the deals can be financed by a mixture of both the equity committed to the SPV and debt financing through third-party lender (eg. banks). In all events, the SPV should have the sufficient funding to finance the deal, which is usually availed by the private equity fund to the SPV at the time of executing the purchaser agreement.

With respect to financial assistance, the Central Bank of Egypt issued Circular 501/2016 on 7 March 2016, which sets out the legal framework for extending loans by the local banks to the acquirer (eg. private equity fund) for the purpose of M&A. One of the key highlights under said circular is the banks shall not extend a loan exceeding 50% of the total transaction consideration, excluding the LGs issued for an offer to purchase listed companies. The circular further requires, inter alia, exercising legal and financial due diligence by independent experts to ensure that the acquirer, the target (in case of an acquisition) or the surviving company (in case of a merger) is able to repay the extended loans.

With the assistance of their counsel, Private equity sponsors tend to utilize their own precedent forms including the boilerplate provisions. However, depending on the nature of the deal, specific documentation precedent for a transaction and the commercial terms remain a substantial and material element of the negotiations between the lender and the borrower (e.g., loan amount, loan term, interest rate, etc.).

The Key areas of negotiation remain same, and negotiations mainly tackle, for instance, loan term, interest rate, events of acceleration, guarantee and its terms, interest on late payments, remedies etc.

In principle, the private equity credit funds are not regulated under Egyptian laws. Furthermore, the financing, as an activity, is permitted under the relevant regulations for private equity funds. Therefore, the private equity funds are not allowed to invest in debt financing.