United States: Private Equity

According to data from Refinitiv, financial sponsor activity accounted for approximately 36.4% of the total of M&A activity by volume in the Americas during 2022 (data as of December 1, 2022) and financial sponsor-involved deals accounted for 36.5% of the total deal value.

Financial sponsors strive towards a “clean exit”, which can be achieved by excluding potential post-closing liabilities to the greatest degree possible. A clean exit allows the financial sponsor to distribute to its investors a clearly defined amount of proceeds from the portfolio company sale more quickly and with greater certainty. Financial sponsor sellers typically structure sales to provide for (i) a working capital based purchase price adjustment, with sole recourse to an escrow amount for downward purchase price adjustment, (ii) the buyer obtaining R&W insurance, with the buyer’s recourse limited to the coverage of such R&W insurance (or R&W insurance and a specified, limited escrow amount, which is often expressed as a portion of the deductible / retention under the applicable R&W policy (typically, 50%)) and (iii) survival of claims for a limited period of time following closing, if at all. While trade sellers are increasingly employing these same tactics with success, in our experience, the full suite of these limitations are more prevalent in financial sponsor backed transactions.

The buyer and the seller typically sign a purchase agreement and, upon the closing, the seller delivers either (i) in the case of a corporation, an original stock certificate (endorsed to the buyer or accompanied by stock power endorsed to the buyer) as evidence for the transfer of stock, or (ii) in the case of a limited liability company, a form of assignment of interests as evidence for the transfer of membership interests. Private company equity transfers are not filed in any public registers in the US. There is no transfer tax on transfers of stock of a corporation or interests of a limited liability company.

US financial sponsors often use newly formed special purpose vehicles and a combination of debt and equity to fund the purchase price. Financial sponsors typically provide additional comfort by (i) delivering to sellers an equity commitment letter pursuant to which the financial sponsor commits to invest certain funds in the newly formed acquisition vehicle at the closing of the acquisition to fund the equity portion of the purchase price plus sufficient amounts to equitize expenses and fund the target post-closing, (ii) delivering to sellers adebt commitment letter for the remaining portion of the purchase price setting out the terms on which the debt provider is prepared to lend the funds to the acquisition vehicle (generally accompanied by a term sheet setting out the loan terms) subject to limited conditionality, (iii) including a reverse termination fee in the purchase agreement, and (iv) delivering a separate guarantee from the fund whereby the fund backstops the reverse termination fee if the deal fails to close because, among other things, the debt financing fails to materialize. The equity and debt commitment letters as well as the sponsor guarantee are delivered at the time when the purchase agreement is executed to serve as evidence that the acquisition vehicle will have sufficient funds at closing to consummate the acquisition. The forms of equity and debt commitment letters and sponsor guarantees have become relatively standard, in particular for conditions and provisions addressing deal certainty.

While we have seen locked box pricing mechanisms used in transactions in the US, these transactions represent a small minority of overall transactions and, in such minority of transactions, often involve transactions with European buyers of US targets as the locked box pricing method is more prevalent across Europe. The significant majority of US transactions advised by Baker McKenzie contain working capital purchase price adjustment provisions as opposed to locked box mechanisms (according to Baker & McKenzie’s Global Deal Points Study, approximately 75% of US transactions include a completion account purchase price adjustment). According to the American Bar Association’s most recent private target Deal Points Study (which analyzed transactions from 2020 and Q1 2021), 93% of transactions during that time frame included a post-closing purchase price adjustment, highlighting that this is still the preferred pricing mechanism in the US. As the locked box mechanism is generally more seller friendly (providing certainty with a fixed purchase price) and US financials sponsors have become more familiar with this approach, US sellers may seek to use it more frequently to avoid post-closing price adjustments.

The current market for sale terms remains seller friendly, although in deals where R&W insurance is used, buyers are often able to obtain more comprehensive representations and warranties. Two of the principal concepts of risk allocation involve deal certainty/closing risk (which is primarily addressed through closing conditions and a combination of termination fees and specific performance requirements) and business risk (which is primarily addressed through representations and warranties, indemnification and R&W insurance). According to SRS Acquiom’s 2022 Deal Terms Study (which analyzed more than 1,900 private-target acquisitions that closed from 2016 through 2021), a reverse termination fee payable by the buyer for failure to close was included in approximately 10% of deals in 2021 with a median reverse termination fee of 5.5% of enterprise value. SRS Acquiom’s study also found that a termination fee payable by the seller in the event it terminates the deal was included in 1% of transactions in 2021 with a median termination fee of 8.5% (1% of transactions included a two-way reverse termination fee, while 89% of transactions included no fee). The buyer’s obligation to close is typically conditioned upon the seller’s/target’s compliance with its pre-closing covenants in all material respects and the accuracy of the seller’s/target’s representations and warranties. The majority of transactions we have worked on required the representations and warranties to be true and correct as of closing subject to a material adverse effect qualifier (scraping the representations and warranties of materiality), with the balance subject to a materiality qualifier or no qualifier at all. It is highly unusual to have a financing “out”; however, the buyer and the seller typically allocate financing risk by agreeing to either (i) a “traditional” private equity deal model, which provides that if all the closing conditions are satisfied and the debt financing is available, the seller has a right to force the buyer to close and obligate the sponsor to draw down on its debt financing commitment, but if the debt financing is not available, the seller receives a reverse termination fee as its exclusive remedy, or (ii) a full equity backstop, which provides that if all the closing conditions are satisfied, the seller has a right to force the buyer to close (whether or not the debt financing is available) or sue for damages although a financial sponsor will typically seek a cap on potential damages claim equal to an amount lower than the purchase price (typically 10-20% of the purchase price). Although a large majority of the deals use the “traditional” private equity deal model, a full equity backstop has become a useful option for financial sponsors willing to be aggressive and wanting to distinguish themselves in competitive auctions (and with sufficient equity resources or other borrowing capacity). We have seen an uptick in the use of full equity backstops in smaller and mid-market deals particularly given the higher interest rates and more limited availability of debt financing in the current market. A large portion of the sales by financial sponsors are run through a competitive auction process. Buyers are increasingly willing to forgo historically traditional, general post-closing indemnification from sellers and limit their recourse to an R&W insurance policy, although we’ve also seen an increase in limited, specific indemnification obligations for certain claims not covered by R&W insurance. In the deals where post-closing indemnification is provided, the limitations on indemnification obligations generally have become more seller friendly (which is a function of the availability of R&W insurance impacting deal terms more broadly). When buy-side R&W insurance is present, sellers’ indemnification obligations are overwhelmingly likely to be structured as non-tipping or “true” deductibles instead of tipping baskets, which mirrors the insurance retention under R&W insurance. As R&W insurance use is prevalent in deals with financial sponsor buyers, escrows/holdbacks for indemnification claims quite often are eliminated entirely, although a separate escrow for purchase price adjustment remains in place in a majority of deals.

W&I Insurance, known as R&W insurance in the North American market, remains a commonly used risk allocation mechanism in the United States (and throughout North America). According to the ABA’s 2021 Private Target Deal Point Study, 65% of transactions in 2020 and Q1 2021 expressly referenced R&W Insurance in their acquisition agreements. Of those agreements that expressly included R&W Insurance, 51% had policies that were expressly bound at signing. In the United States, R&W Insurance remains a predominantly buyer-side protection mechanism, as policies were acquired by the buyer in 95% of the deals that expressly referenced R&W Insurance. For deals with a financial sponsor buyer and/or seller on which we worked over the past 12 months, an overwhelming majority used R&W insurance. We also continue to see the use of R&W insurance become more prevalent in deals with strategic buyers, particularly in mid-market and large deals. The premium for the R&W insurance policies had been decreasing over the past few years as its use became more prevalent and more underwriters entered the market and competing to insure transactions; however, the strong M&A market and wide adoption of R&W insurance has resulted in increased premiums from the range of 2.5% – 3% of insured risk, to upwards of 5% (particularly in sectors with limited underwriting capabilities, such as healthcare and life sciences) as well as heightened underwriting standards. Although the process of obtaining R&W insurance did not typically have a material impact on the deal timetable, as insurance providers became very responsive to demanding timelines, the growing demand for RWI has led to longer timelines to quote, underwrite and bind a policy. Insurance products have also expanded from a basic insurance solution to cover operating representations and warranties to also cover title representations and warranties, provide specific tax insurance and accommodate zero seller liability structures (i.e., no “skin-in-the-game” by the seller), in each case without incurring substantial additional premiums. Importantly, although the use of R&W insurance is prevalent and often alters the total composition of risk allocation, R&W insurance is not an exclusive alternative to traditional indemnification or escrow/holdback requirements. R&W insurance only covers breaches of representations and warranties but not seller covenants or purchase price adjustments. Additionally, the typical R&W insurance policy will include exceptions (e.g., known losses, issues or breaches, employee misclassifications, pension liabilities, certain tax and environmental matters) and have a liability limit of approximately 10% of purchase price (which leaves buyer exposed for extraordinary losses in excess of the liability limit). However, we are now seeing some carriers provide coverage for “interim breaches” of representations and warranties – those breaches that occur and are discovered between sign and close. Such matters not covered by a R&W insurance policy can result in bespoke indemnification constructs and separate escrow/holdback requirements as an ancillary feature to an R&W insurance policy.

Financial sponsors have been relatively active in acquiring publicly listed companies through take-private transactions. Based on data from Refinitiv from 2019 to 2021 YTD, the number of take-private transactions (in which a financial sponsor has acquired a publicly-listed company) was flat in the last two years, with 175 deals in 2020 and 176 deals in the 2021. YTD 2022 (as of December 1, 2022) the number of deals reached 136.

In certain transactions (e.g., transactions involving “critical technologies”), foreign investments in the US may require pre-closing filings to the Committee on Foreign Investment in the US (CFIUS), with penalties for non-compliance running as high as the value of the investment. Even where a filing is not required, CFIUS has broad authority to review foreign investments, before and after closing, for national security concerns. Private parties can insulate their transactions from after the fact review by CFIUS (and potential divestiture orders) through making a filing with CFIUS and securing a clearance. CFIUS has jurisdiction to review investments where foreign persons may acquire “control” over a US business, with control being broadly defined to include the power to decide significant matters of the US business. CFIUS has even broader jurisdiction over investments involving US businesses developing certain critical technologies, operating critical infrastructure, or those handling certain categories of sensitive personal data. In those cases, jurisdiction may be triggered by certain information access and governance rights (short of “control”). This broader jurisdiction often impacts investment funds where limited partners may seek relevant information access or governance rights. When reviewing a transaction, CFIUS focuses on whether the US target presents national security vulnerabilities and whether the foreign investor presents a national security threat. Where CFIUS finds a national security risk, it can mitigate those risks through imposing conditions on the transaction or, if it determines that the national security risk cannot be mitigated, recommending to the President that he issue an order blocking or requiring divestiture of the transaction.

In the US, the Hart-Scott-Rodino (HSR) antitrust review process is mandatory for most acquisitions whose value exceeds a statutory threshold (currently $101.0 million and adjusted annually with the next adjustment to be announced in January 2023 and become effective near the end of February / beginning of March 2023). However, where a newly formed fund or other entity is used to make an acquisition, an HSR notification may not be required under the existing HSR regulations. Note, however, that the Federal Trade Commission has proposed rule changes that would broaden the scope of coverage for many private equity funds (although, at the time of publication, that rule has not yet been finally adopted). Other exemptions from the HSR filing requirements may also apply and, as a result, a careful analysis should be conducted to determine whether a filing is necessary. Outside of the US, foreign antitrust agencies often take a broad approach regarding which portfolio companies are under common “control” and therefore relevant when determining whether a transaction satisfies relevant revenue or asset notification thresholds. Note that for those transactions that do require a notification to be filed with the US antitrust agencies (the Department of Justice and the Federal Trade Commission) or a foreign regulator, expiration of the HSR waiting period or receipt of clearance from a foreign competition regulator will be a closing condition. The antitrust clearance risk is usually passed to the buyer by relying on some form of a strict “hell or high water” clause for the merger clearance, a reasonable best efforts clause or an obligation to pay a reverse break-up fee if the clearance cannot be obtained. It is not unusual for a financial buyer to accept a “hell or high water” provision where the risk is believed to be very low although with the current Federal Trade Commission focus on private equity and enhanced scrutiny of M&A in general, the willingness of financial buyers to accept a strict hell-or-highwater clause has lessened in recent months.. Where the financial buyer’s portfolio contains companies that overlap with the target or the acquisition is a bolt-on to an existing portfolio company, the risk tends to be shared between buyers and sellers, with the allocation often being an important part of the deal negotiations.

Minority deals in the form of growth capital and PIPE deals have become increasingly prevalent in transactions by financial sponsors over the last few years and we expect this trend to continue. We have seen various investment models from common equity investments with certain consent rights for the operating business as well as preferred equity or debt-like structures with limited governance rights but with the ability to participate in equity returns (e.g., through warrants, equity kickers or within the capital rights of the securities themselves). Continuation fund, and GP led secondary transactions have also become quite common as financial sponsors and their limited partners seek to match timing for exits with the need for limited partners to obtain added flexibility in rebalancing their private equity portfolio.

Management incentive programs tend to be structured to grant the managers direct equity interests or the value of the equity interest in the buyer’s group structure. Equity grants generally result in gains on the disposition of the equity being subject to the lower tax rate for capital gains rather than ordinary income tax rates. Profits interest structures in which management team members receive an interest in a tax transparent entity that allow them to participate in any increase in value above the time in which the interest is granted, are increasingly becoming a popular choice. Profits interest typically results in preferential capital gains tax treatment upon disposition. In addition, stock options and restricted stock units are sometimes used, which, upon exercise or settlement, result in ordinary income to management and a compensation deduction for the portfolio company that employs them, while the subsequent disposition of the shares acquired may result in capital gains tax treatment. Phantom equity or other cash incentives are less tax efficient as they are taxed as ordinary income upon receipt and tend to be more difficult to structure to meet typical commercial goals due to tax code restrictions on deferred compensation arrangements. Often a portion of management’s equity is structured to vest and deliver a return on exit after a certain IRR and cash exit multiple is achieved by the financial sponsor to align the management team’s returns with those of the fund management team, while another portion of management’s equity is often structured to vest and deliver value over a 3-5 year period, subject to continued employment through each vesting date and the value of management’s equity appreciating above the buyer’s acquisition cost.

The key features of profits interest and stock options are for those awards not to have any built-in value at the time of grant (i.e., they should not be “in-the-money” at the time of grant). Profits interests can only participate in the appreciation of value that occurs after the grant date and options must be granted with an exercise price that is at least equal to the value of the underlying equity on the date for grant. Standard valuations are often carried out to provide supporting evidence of this.

While this issue is state-specific, senior management is typically required to sign non-competes. The maximum period of a non-compete that can generally be enforced in an employment context is 1-2 years post-termination of employment. A large majority of states do not require the company to pay compensation to the individual in order to enforce noncompetes. Typically, the more important issue in the US turns on whether the consideration for entering into a non-compete is sufficient. If the manager is also a seller or an equityholder post-closing, then there may be the ability to extend the non-compete period. The managers are also typically bound by non-solicitation covenants with the same duration as the non-compete and perpetual confidentiality covenants.

Financial sponsors’ governance rights are typically covered in the company’s constitutional documentation (such as certificate of incorporation for corporations or operating agreement for limited liability companies) and the management team’s employment contracts. Depending on the investment, the target and the sponsor may also enter into a shareholders agreement (sometimes also called an investor rights agreement) which would provide for the financial sponsor’s right to make appointments to the board, specific voting/consent rights over material business decisions and the right to receive certain financial and management reports for the purpose of monitoring its investment.

Management pooling vehicles are not typically used in the US as equity incentive awards granted to management do not usually provide voting rights and management is typically required to sell their equity interests upon a change of control of the company. However, where executives receive interests in the entity is treated as a pass-through for income tax purposes and at which they are also employed, separate pooling or parallel vehicles are often used to separate their ownership from their employment to avoid self-employment tax issues.

In the small and mid-cap market, a trend that will likely continue is that leading credit managers will raise credit vehicles that provide private equity sponsors with one-stop financing away from the syndicated loan market via direct lending facilities. While the 2008-2009 credit crisis resulted in various regulatory constraints that affected the US leveraged loan industry, the leveraged loan market today is at least two times greater than it was a decade ago; in particular, the market has expanded to include direct lender capacity to provide loans in the small and mid-cap market. In the small and mid-cap market, mezzanine financing or convertible loans (often with much higher margins for lenders) are also helpful structures for deals with high leverage or for borrowers with less credit recourse. In the large cap market, private equity sponsors are able to choose among a variety of capital providers and financing structures. Whether a private equity sponsor seeks to deploy a mix of bank debt and senior secured or unsecured notes and/or a privately placed second lien, is deal and investor-dependent. The largest deals will often feature a bank/bond structure. In the current large cap market, however, bank led syndicated facilities deals and high-yield deals have become challenging to place in the light of some high profile syndication and placement failures, the current uncertain market conditions and increase of capital costs overall.

Not in the US context. It is not analogous to financial assistance legislation in applicable European jurisdictions, but in the US there are fraudulent conveyance statutes which effectively limit the amount of indebtedness that a borrower can incur. For example, the federal Bankruptcy Code empowers debtors to avoid pre-bankruptcy transfers where any such debtor did not receive reasonably equivalent value for the transfer and was left insolvent, unable to pay its debts or with unreasonably small capital as a result of the transaction. In addition, states have fraudulent transfer statutes with respect to which private equity sponsors have utilized certain conventional methods (e.g. the use of solvency representations and the issuance of solvency certificates and opinions) to mitigate against the risk of facing a claim that any such private equity sponsor has not complied with such fraudulent conveyance statutes.

Debt financing in the context of a leveraged buy-out is often bespoke and highly negotiated. Private equity sponsors, with the assistance of their counsel, will utilize their own precedent forms and will often successfully negotiate to use a specific documentation precedent for a transaction. In recent years, financing commitments which are negotiated in advance of entry into definitive documentation have featured more detail concerning materially important commercial points. Such greater detail at the financing commitment stage has resulted in a more efficient and reliable definitive documentation process for private equity sponsors while also providing lenders with greater clarity concerning the terms that they are agreeing to underwrite.

Given increased competition for deal origination among market participants, the middle market in particular has experienced an importation of financing terms that, up until several years ago, tended to be found primarily in large cap financings. For example, in recent years private equity sponsors have been able to successfully negotiate for portfolio company borrowers to have the ability to incur additional debt either within or outside the credit facility as well as via “ratio debt” provisions which originated from the high-yield market. In a similar vein, there continues to be intense negotiation around incremental facility provisions (e.g., “most favored nation” pricing protections). Many lenders have been proactive in managing their portfolios, staying in close touch with borrowers and sponsors and keeping open lines of communications to collectively address situations with partnership. During 2022, borrowers in certain sectors started to feel the liquidity squeeze as a result of the ripple effects of supply chain issues and increased costs, and have been experiencing more pressures to seek amendments or refinancings.  Given the uncertain market conditions and the increased interest rates, we see that lenders become a lot more cautious on their underwritings and are overall in a better position to request for tightened covenant packages (including maintenance financial covenants).

Yes. The major private equity firms have active credit arms. In recent years, their market share has not only increased, but at times the private equity credit funds have effectively substituted financing from traditional commercial bank providers. Private credit providers have raised funds that have enabled them to compete against banks in underwriting leveraged loans on an increasing scale.