Turkey: Private Equity

In Turkey, the overall M&A transaction volume in 2019 was at the lowest level since 2009 and was approximately USD 5.3 billion with 233 transactions according to a review of disclosed transactions. The low level of M&A activity in 2019 mainly resulted from challenges faced by the Turkish economy in the context of high inflation and the depreciation of the Turkish currency. In 2019, financial investors were involved in 87 transactions (accounting for 37% of the total number of M&A deals) with a total value of approximately USD 0.9 billion, according to the Deloitte’s Annual Turkish M&A Review Reports. Compared to 2018, the number of such financial investor transactions in 2019 decreased by 17%. We believe that in practice the actual number is significantly higher than this but deal values tend not to be disclosed in the market particularly by financial investors.

Most of the transactions that involved a financial sponsor in 2019 resulted from the interest of venture capital firms and angel investors in Turkish start-up companies. On the other hand, the number of private equity deals went down to a total number of 9 in 2019, according to the Deloitte’s Annual Turkish M&A Review Reports. That said, the second largest M&A transaction in 2019 was the acquisition of 43.9% stake in Boyner Perakende by the foreign private equity firm Mayhoola with a disclosed purchase price of USD 405.2 million.

In 2020, the COVID-19 pandemic had a major impact on the Turkish M&A market as it did elsewhere with a sharp drop off in the number of deals. According to an analysis by KPMG, the overall M&A transaction volume in the first quarter of 2020 was around USD 812 million (around USD 450 million of this derived from a single transaction: the acquisition of Total Oil Turkey and M Oil by OYAK, the pension fund of the Turkish armed forces). This volume denotes a decrease of 31% when compared to the volume in the first quarter of 2019, which was around USD 564 million.

As of September 2020, the overall M&A transaction volume reached approximately USD 3.6 billion with 117 transactions. In line with global trends, deals in the TMT sector dominated M&A activity in 2020 in Turkey and most of the TMT deals have involved financial sponsors as a buyer or seller. As of September 2020, there were 73 deals in the TMT sector in Turkey with a total transaction value of USD 2.8 billion. The biggest transaction of 2020 in Turkey so far is the acquisition of Peak Games, a mobile gaming company based in Istanbul, by Zynga, with a transaction value of USD 1.8 billion and involved various financial sponsors (such as Earlybird, Endeavour Catalyst and Hummingbird) as sellers. A significant private equity acquisition in the second quarter of 2020 in the TMT sector was by the Turkey-focused private equity fund Actera Group which acquired a majority stake in the leading online furniture retailer Vivense for a disclosed investment value of USD 130 million.

The main difference between the exits of a financial sponsor and a trade seller in Turkey is that the financial sponsor will usually strive to avoid any post-closing undertakings (such as non-compete or non-solicitation) and any deferred payments of consideration (through escrow mechanisms or otherwise). Moreover, whilst a trade seller is more favorable to provide a full set of representation and warranties in relation to the target’s business and operations, a financial sponsor will try to limit those to fundamental representation and warranties (such as those regarding the ownership of the shares and no insolvency of the target) and, albeit less frequently, a financial sponsor may agree to provide representation and warranties regarding the tax liability of the target. The main justification put forward by financial sponsors for this approach is its limited degree of participation in the target’s operation, whereas the trade seller is much more active in the target’s operations. As a corollary, the indemnification obligations and liability caps that a financial sponsor is willing to bear thereunder are also much more limited than a trade seller. Finally, the financial sponsors generally prefer transactions based on locked box structures (as explained under question 5 below), while this is far less frequent in transactions with trade sellers.

The process for effecting the transfer of the shares depends on the legal form of the target. The most common legal forms used in practice are (i) joint stock companies (anonim şirket) and (ii) limited liability companies (limited şirket).

In joint stock companies, the transfer process depends on the type of shares issued by the company. Registered shares of joint stock companies are transferable by endorsement and delivery of the share certificates to the purchaser. The endorsement must identify the purchaser and contain the date of the transfer and signature of the seller. Such transfer is effective in relation to a joint-stock company only when the transfer is evidenced to the joint-stock company recording such transfer to the share ledger of the company. The company has the right to refuse to register the transfer for reasons specified in the articles of association. If the transfer is refused by the company, the purchaser will not acquire full ownership status and is prevented from exercising its governance rights, such as the right to vote, until the registration is completed. On the other hand, bearer shares of joint stock company are transferred by and at the moment of their delivery or at any later moment stipulated in the share purchase agreement.

Share transfers, which directly or indirectly result in the shares in the capital of a company to exceed or drop below 5%, 10%, 20%, 25%, 33%, 50%, 67% and 100%, must be notified to the target company and such notification must also be registered before the competent trade registry. Failure to notify will result in the inability to exercise rights associated with the share, including the right to vote.

Shares of a limited liability company may be freely transferred unless otherwise provided in the articles of association. Regardless of whether such shares are issued or not, in order to realise such share transfers, the share purchase agreement must be in writing and executed before a notary public. Parties to the share purchase agreement must notify the company regarding the transfer of shares and request its approval. Share transfers must be approved in the general assembly with a decision quorum representing the majority of votes present in the meeting, unless otherwise provided in the articles of association of the company. Such share transfers will be registered with the relevant trade registry within 30 days from the date of approval of the share transfer.

Share purchase agreements entered into to effect share transfers of joint stock companies, limited liability companies and limited partnerships are in principle exempt from stamp tax. Moreover, capital gains derived from transfers of shares are exempt from income tax in certain cases. Normally, capital gains derived from the disposal of shares are subject to tax at the generally applicable income tax rates, transfers of shares of Turkish companies which have been held for at least 2 years are in principle exempt from capital gains tax.

This issue is usually heavily negotiated and often comfort beyond the level of the special purpose vehicle is not given in order to protect fund investors. Sometimes financial sponsors may provide sellers with a form of proof of funds undertaking through an equity commitment letter and/or debt commitment letter for the purchase price (or at least a part of the purchase price). A parent guarantee from the financial sponsor is rarely given in transactions unless the financial sponsor is effectively operating as a captive investment fund of a larger conglomerate rather than a typical private equity vehicle.

Purchase price adjustments by reference to closing accounts are still the most common adjustment mechanism for determination of the final equity value in Turkish M&A practice, particularly where anti-trust merger clearance and/or other regulatory approvals are required for closing. Transactions involving financial sponsors on the other hand tend to favor locked box pricing mechanisms, which limit the balance sheet risk, provide fixed price certainty and ultimately allow the possibility of a clean exit.

The typical tools used for risk allocation are representations and warranties for general business and operational risks and indemnities for purchaser protection against specific risks which are identified in the due diligence process. Representation and warranties are usually qualified in favor of the seller by disclosures or negotiation to limit the scope of the representations and warranties. Allocation of risk between signing and closing often involves negotiation of material adverse change clauses which are common in Turkish practice and may even extend to the circumstances arising from COVID-19 outbreak or other risks that are either macro-economic or specific to the business being acquired.

The locked box mechanism may be used in practice as an important construct to allocate the risks following the locked box date to the buyer, and leads buyer to manage the risks by due diligence, leakage structures and material adverse change clauses.

W&I insurance is relatively new to the Turkish market, and has been slow to gain popularity in practice. One of the reasons for its slower pace of popularity is the unavailability of specific legislation regulating W&I insurance in Turkey and, as a result, it is not a product widely offered by Turkish insurance companies. It is generally obtained from foreign insurance companies particularly where the transaction involves foreign parties. Accordingly, the premium payments for W&I insurance can be expensive for the transaction parties due to the small number of competitors in Turkey offering W&I insurance and the occasional difficulties for foreign insurers in evaluating a risk of warranty breach that may arise from unclear regulatory framework in respect of such warranty. It is also very rare to see the use of W&I insurance in the context of M&As resulting in a joint venture, which is perhaps the most common form of transaction in the Turkish market since most investors will want to continue with a local partner in the running of a business.

Financial sponsors acquiring publicly listed companies or buying infrastructure assets have not been a common practice in Turkey in the last 24 months period, other than the acquisition in 2019 by Mayhoola of 43.9% stake in Boyner Perakende, which was a publicly listed company (Boyner Peakende was delisted following the transaction as of the end of 2019). Investment by infrastructure funds in Turkish infrastructure assets has not been a common feature given especially the size and scale of large infrastructure assets in the market which may be difficult for a fund to acquire without local partners to share risk.

The Turkish legal framework encourages foreign direct investment and therefore acquisitions by foreign financial sponsors will typically not be subject to additional governmental consents compared to local investors apart from certain defined and narrow sensitive areas such as the defense sector. The main legal instrument setting forth the rules governing foreign investments in Turkey is the Foreign Investment Law of 2003. The objective of the Foreign Investment Law is to regulate and encourage foreign direct investments and to protect the rights of foreign investors. The Foreign Investment Law does not require any governmental consent or approval process for foreign investments in Turkey. Pursuant to the Foreign Investment Law, a non-Turkish financial sponsor acquiring an unregulated asset will typically only need to provide a simple post-closing notification to the Ministry of Treasury and Finance.

Under the Turkish merger clearance regime, a merger or an acquisition that (i) leads to a change of control in the target company, and (ii) exceeds certain turnover thresholds is subject to the approval of the Turkish competition board. As the Turkish merger clearance regime focuses on the turnovers of the transaction parties, transactions involving financial sponsors are usually subject to merger clearance if they obtain at least joint control over the target.

When required, merger clearance is included in the agreement as a condition precedent to the completion of the transaction. Typically, by their very nature, a financial sponsor would not have significant market overlap with the target entity and, therefore, usually the Turkish competition board will approve the transaction without opening a full investigation. If merger clearance cannot be obtained, the agreement usually provides a mechanism for automatic termination and, in some cases, an allocation of the transaction costs between the parties.

For merger clearance, the competition board makes an assessment as to whether the transaction would result in creating or strengthening a dominant position in the relevant market. Accordingly, the risk of non-clearance is not significant in transactions involving financial sponsors, unless the investment portfolio of a financial sponsor is particularly strong in the relevant market in which the target is active.

We have indeed seen an increase in the number of minority investments undertaken by financial sponsors as a result of the increasing number of deals that involve venture capital firms. In the last 24 months period where the investments of private equity firms have been in decline, the venture capital firms have been very actively investing in many start-ups particularly in sectors such as technology, internet and mobile services. Such investments are usually structured as equity investments with protections with respect to exit, anti-dilution and liquidation, and veto rights in the governance of the target, such as the approval of the budget or business plan and appointment of key management. Private equity funds will, depending on their fund mandates and market approach, either acquire majority or minority positions generally through equity investments and there is no particular trend towards minority investment positions.

There are also instances of debt-like investments, but there are restrictions on providing foreign-denominated debt to Turkish companies under Decree No. 32 regarding the Protection of Value of Turkish Currency (for instance, in the absence of sufficient foreign-denominated income of the Turkish company, only the 100% foreign shareholder can only provide foreign-denominated loan to such Turkish company) which make it difficult for Turkish start-ups to receive debt or convertible debt funding from foreign financial sponsors.

Management incentive schemes are commonly structured as equity based in Turkish market. In practice, such schemes are based on performance criteria and linked to an exit event. They are planned as schemes for issuance of real shares or as phantom or synthetic shares (which mimic the economic benefits of shares but are in reality contractual commitments given to the management by the company as bonus payments in the event of an exit). Whilst there is no legal prohibition on the issuance of shares to management, phantom share structures are more common in practice for non-founder management. This is mainly because Turkish corporate law does not allow non-voting shares, which means that employees who hold real shares will have voting rights at shareholder general assemblies, and could seek to set aside general assembly decisions for non-conformity with the Turkish commercial code.

It is important that such schemes should take into account the principle of equal treatment under Turkish labor law, which requires the employer to treat equally employees who hold the same or similar positions.

There are no general tax reliefs aimed at encouraging of the introduction of management’s incentive schemes. Issuing shares to the management immediately at nominal value at establishment of the scheme may bring certain benefits to such individuals since if they sell out their shares after a 2 years holding period they would be able to sell without the proceeds of sale being subject to capital gains tax. In phantom shares structures, any payment by the company to the relevant individuals would constitute a payment of employee entitlements, and the company is required to apply payroll taxes to such payments.

In management incentive schemes, the senior managers are commonly subject to non-competes that apply not only for the duration of the employment but also post-termination. As per the mandatory rules of the Turkish code of obligations, non-compete restrictions should not apply for more than 2 years after the termination of employment, unless there are special circumstances. Further, as per the mandatory rules, the non-compete undertakings must specify the territory and the type of relevant activities in defining the scope of a non-compete.

Financial sponsors typically ensure control over material business decisions of the portfolio company through board representation and veto rights typically structured (in the case of minority investments) through the issuance of privileged (or class) shares which are recognized under the Turkish Commercial Code. Veto rights are usually applicable to such issues as budget, business plan, major investments, disposal of an important asset or appointment of key management. The relevant rules in this respect are set forth in a shareholders’ agreement and the articles of association of the company. The signature authorities are also determined in accordance with the veto rights of the financial sponsors so that the company cannot be represented and bound by the directors or other representatives with respect to relevant transactions without the signature of the director appointed by the financial sponsor. These aspects are accordingly reflected to the signature circulars and the internal directive of the company (that indicates the limited signature authorities).

Management pooling vehicles involving a large number of employees is not common in equity-based incentive schemes, as Turkish law does not recognize the use of trustee schemes which would allow a trustee to hold all the shares under an employment scheme for the benefit of employees. This means that individual employees would hold shares.

Therefore, if utilized, widespread schemes are generally based on phantom share structures rather than issuance of real shares to the employees for reasons explained under question 12 above.

Debt financing is typically provided by way of loans from banks or multilateral financial institutions, such as the European Bank for Reconstruction and Development and the International Finance Corporation. The most common structure utilized by lender is senior secured debt that includes both a term loan and a working capital facility. The lenders usually require a comprehensive security package that includes share pledges, assignments of receivables, mortgages or pledges over assets or accounts.  In some cases, the senior secured debt is complemented by a mezzanine facility.

Debt financing from a shareholder is also utilized in some cases. However, such financing is subject to thin-capitalization rules if the debt-to-equity ratio exceed 3:1, in which case the exceeding portion is deemed as disguised equity and becomes non-deductible for corporate tax purposes, and the interest payments are deemed as disguised dividends and would be subject to withholding tax. There are also restrictions arising from the provisions of Decree No. 32 regarding the Protection of Value of Turkish Currency which require the Turkish companies to have a certain amount of foreign-denominated income or to qualify for one of the specific exemptions provided therein in order to obtain any foreign-denominated loans, making it difficult to structure debt in foreign currency, in particular for small and medium enterprises.

Financial assistance legislation is applicable to debt financing arrangements for the acquisition of shares in joint stock companies and the provisions mostly reflect the EU Company Law Directive. Joint stock companies are not allowed to provide loans or guarantees or grant security on their assets (such as share pledge, mortgage or account pledge) for the purpose of acquisition of their own shares by a third party. Transactions breaching this prohibition are null and void. Structures to comply with this restriction have been developed, such as mergers of the target with the acquiring SPV, and banks in the market are familiar with issues relating to acquisition finance.

Each bank in Turkey has its own standard from of credit agreement. Although those contain similar clauses in the sense that they are very protective of the bank’s interests, there are no standardized clauses accepted in the market for a typical financing. The banks usually do not enter into any negotiations with respect to the terms of the standard form credit agreements and they prefer the execution of a separate document usually titled “special conditions” where there is some leeway for negotiations (depending on the bargaining power of the relevant parties) in order to include in the deal some tailor-made clauses. We observe that a number of “special conditions” in some cases are modelled after the standards of the Loan Market Association. However, in a typical financing, such special conditions usually complement rather than prevail over the standard form of credit agreement.

In leveraged finance transactions, the key areas of negotiation in the last 2 years from the perspective of the lenders have been the broader identification of events of default and material adverse change clauses, due to the currency depreciation and heightened concerns for potential defaults in current economic conditions. The key areas of negotiations for the borrowers typically concern the financial covenants and scope of recourse of the lenders.

Private equity credit funds have occasionally been used as sources of debt capital particularly in mezzanine structures. In recent years, we have seen an increase in transactions where private equity credit funds are utilized as a source of direct financing as well. This is partly because of the amendments introduced in 2018 in Decree No. 32 regarding the Protection of Value of Turkish Currency which limited the availability of foreign currency loans to the Turkish companies, and made such loans subject to certain foreign currency income criteria that must be met by the Turkish company to the extent it does not benefit from an exemption. One of the exemptions is applicable to the loans extended by foreign shareholders to their 100% subsidiaries in Turkey. Accordingly, in practice, where a Turkish company is 100% directly or indirectly owned by a foreign company, such foreign company may obtain foreign currency loans from a third-party lender, and such loans can then be injected into the Turkish company by the shareholder as either equity or debt. Private equity credit funds have increasingly appeared as the lending party in such transactions.