United States: Private Equity

Based on data from Bloomberg, financial sponsors (either as buyers or sellers) were involved in transactions having an aggregate deal value of $450 billion. As of mid-year 2019, deals involving financial sponsors represented approximately 30% of all US M&A transactions by 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 so that the funds can flow to the sellers for a portion of the purchase price, (ii) as a financial sponsor’s equity commitment typically does not cover 100% of the purchase price, the financial sponsor also usually procures a debt 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), which is also provided to sellers and (iii) including a reverse termination fee in the purchase agreement and delivering a separate guarantee pursuant to which the financial sponsor backstops such obligation 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 with very little negotiation of terms.

Although locked box transactions are used in a small minority of transactions in the US, we have seen an increase in their use within the last 12 months, especially in transactions with European buyers of US targets.

The current market for sale terms tends to be more seller friendly, although in deals where R&W insurance is used, buyers are often able to obtain more buyer-favorable terms for insurable risks, including 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 data, a reverse termination fee is used in approximately 15% of deals, with a median reverse termination fee of 6% of enterprise value (although we have increasingly observed lower termination fees as a percentage of enterprise value in larger deals).

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 not market standard to include a condition that the buyer shall have obtained financing. 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 equity 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 and expect that trend to continue for desirable assets.

A large portion of the sales by financial sponsors are run through a competitive auction process. For desirable assets, 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.

During the last few years the use of R&W insurance has increased significantly. According to data analyzed by Advisen, from 2008 to 2018, total use of R&W insurance policies per year rose from 40 deals providing $541 million in coverage to over 1,500 transactions providing aggregate coverage of $38.6 billion. 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. The use of R&W insurance is less prevalent in deals with strategic buyers, although strategic buyers have become increasingly comfortable in using R&W insurance and its use by strategic buyers is on the rise.

The premium for the R&W insurance policies has been decreasing over the past few years as its use becomes more prevalent and more underwriters enter the market. The process of obtaining R&W insurance does not have a material impact on the deal timetable, as insurance providers have become very responsive to demanding timelines.

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. The typical R&W insurance policy will include exceptions (e.g., seller covenants, known losses, issues or breaches, certain tax and environmental matters), which can result in bespoke indemnification constructs and separate escrow/holdback requirements as an ancillary feature to an R&W insurance policy.

According to Bain sources, in 2018, public-to-private deals reached their highest level since 2006-2007, both in terms of count and value. According to data from Dealogic, as of August 2019 there were $69.6 billion in deals involving public companies being taken private by US private equity sponsors, a marked increase from $53.3 billion for all of 2018. This trend is expected to continue to accelerate as private equity firms seek to make use of record amounts of cash on hand and avoid the scrutiny of public company disclosure regimes.

Infrastructure (along with energy) exhibited the most growth of any private asset class among the largest US financial sponsors as of Q3 2019. This trend is expected to continue as investors look for consistent income. According to McKinsey data, private market fundraising for infrastructure in 2018 totaled $42 billion, representing 17% increase from 2017.

In certain transactions (e.g., transactions involving “critical technologies”), foreign investments in the US may require pre-closing declarations 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 declaration 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) only 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 widely defined to include influence over significant decisions of the US business. CFIUS has broader jurisdiction over investments involving US businesses developing critical technology, operating critical infrastructure and handling sensitive personal data. In those cases, jurisdiction may be triggered by certain information access and governance rights. This broader jurisdiction often impacts investment funds where limited partners may want 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 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 $90.0 million and adjusted annually). However, where a newly formed fund or other entity is used to complete a transaction, an HSR notification may not be required. 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 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, inevitably 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; the clause protects the seller against an undisclosed competitive overlap within the buyer’s portfolio. Where the financial buyer’s portfolio contains companies that overlap with the target, and this overlap is known or disclosed, the risk tends to be shared, with the allocation often being an important part of the deal negotiations.

Minority 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).

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 result in gains being subject to the lower tax rate for capital gains rather than ordinary income tax rates. Profits interest structures are the most popular choice, which generally results in capital gains tax. In addition, stock options, phantom equity and restricted stock units are often used, which results in ordinary income to management and a compensation deduction for the portfolio company that employs them. These are therefore less tax efficient, but sometimes easier to administer.

Often a portion of management’s equity is structured to vest and deliver a return on any 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. Another portion of management’s equity is often structured to vest and deliver value over a 4-5 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). Standard valuations are 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 non-competes. 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 a shareholder post-closing, then there may be the ability to extend the non-compete period.
The managers can be bound by confidentiality restrictions for longer periods.

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 management is not usually granted voting rights and is usually required to sell interests in connection with a change of control sale.

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 unitranche or similar 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 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; according to data from Refinitiv, high-yield bond issuance in 2019 increased by 62% compared to 2018 levels.

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 leverage 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 about two 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).

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.