A Practical Guide to Private Equity Transactions
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107
Competition matters
4.7 Relevant turnover
So far as Target is concerned, the relevant turnover is generally that attribut-
able to what is being acquired.
37
Calculating the turnover of the acquirer can,
however, be a complex matter in the context of a private equity investment.
Generally, the rst question is who is acquiring control over Target?
This will often be a question of a case-by-case analysis. It is straightforward
when the acquirer is a trade buyer in the form of a limited company. However,
it can be more difcult with private equity structures. For example, for private
equity funds set up in the form of limited partnerships, investors participating
as limited partners normally do not exercise control (either individually or col-
lectively); while the fund might acquire the shares and voting rights which give
it control over Target, it is generally the investment company which has set up
the fund that exercises that control. That control is exercised either because the
investment company is the general partner, or through a management contract
(or a combination of the two). In such circumstances, the investment company
will be regarded as having acquired control over Target.
38
The second question is what is the relevant turnover of the acquirer? Under
the ECMR, it is usual to take the turnover of the acquiring entity and all of
the group to which that entity belongs (a ‘group’ is dened in the ECMR
39
).
In the context of a private equity acquirer that again can be complicated. For
example:
(a) if the acquirer is an investment company then its turnover is likely to
include:
(i) its own turnover (generally, fee income); and
(ii) the turnover (i.e. sales) of all portfolio companies controlled by the
funds set up and managed by the investment company.
40
(b) if the acquirer is the captive arm of a larger nancial institution (e.g. a
bank) then its turnover may well include:
(i) its own turnover (generally, fee income);
(ii) the turnover of the wider banking group;
41
and
(iii) the turnover (i.e. sales) of all portfolio companies controlled by the
captive investor.
The issue can be further complicated where the transaction is a co-investment
by two or more private equity investors. Where the investors have the ability
to exercise joint control (for example, where the co-investors each have a veto
right over the Business Plan and budgets: see above), each jointly controlling
37 Article 5(2) ECMR.
38 See Commission Jurisdictional Notice, paragraph 15.
39 Article 5(4) ECMR.
40 See Commission Jurisdictional Notice, paragraphs 189–191.
41 There are special rules for the calculation of the turnover for credit and other nancial institu-
t i on s : see Ar t i cle 5 ( 3) E C M R .
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Acquisition issues
investor will be regarded as an acquirer
42
and the relevant turnover will be that
of each acquirer and its group (plus that of Target). This increases the risk that
the relevant ECMR turnover thresholds will be met.
4.8 Notification: mandatory system
Where a transaction amounts to a concentration with a Community dimension,
it must be notied to the European Commission for investigation by complet-
ing the required Form CO.
43
The ECMR sets out when a concentration must or
may be notied. The parties may notify if they can show a ‘good faith intention’
to conclude an agreement to merge or if they have made a public announce-
ment of their intention to merge. Notication must be made once the parties
have reached agreement, a public bid has been announced or a controlling
interest acquired, and, in any event, prior to implementation.
44
Implementation
of the transaction is automatically suspended until the Commission has com-
pleted its review.
45
Once the transaction has been notied, the Commission must adhere to
strict time periods to decide whether or not the deal raises competition con-
cerns. However, these time periods commence only once there is effective
notication, that is, when the Commission has received complete, accurate
and up-to-date information in the Form CO.
46
The submission of incomplete,
inaccurate or misleading information can delay merger clearance and therefore
completion of the transaction. The (management) time and resources required
to complete the Form CO should therefore not be underestimated.
A simplied procedure exists for the handling of routine transactions
which do not raise signicant competition concerns.
47
Although such transac-
tions must be notied in advance to the Commission, the parties are able to
complete a short-form Form CO. This procedure will often be appropriate for
private equity investments (provided there is no overlap between existing port-
folio companies and Target).
There are penalties (nes up to 10 per cent of turnover) for failing to notify
a transaction or implementing a transaction in breach of the suspension provi-
sions, and penalties (nes up to 1 per cent of turnover) for providing incomplete
or misleading information.
48
The Commission also has wide-ranging powers
42 See Commission Jurisdictional Notice, paragraphs 139–141.
43 Form CO is in Annex I to the Commission Regulation of 21 April 2004 implementing Council
Regulation (EC) No. 139/2004 on the control of concentrations between undertakings (OJ
L133, 30.4.2004, p. 1).
44 Article 4(1) ECMR.
45 Article 7 ECMR.
46 Article 10(1) ECMR.
47 Commission Notice on a simplied procedure for treatment of certain concentrations under
Council Regulation (EC) No. 139/2004 (OJ C56, 5.3.2005, p. 32).
48 Articles 14 and 15 ECMR. For example, in June 2009, the Commission ned Electrabel €20
million for acquiring control of a competing electricity producer, CNR, without notifying the
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Competition matters
of investigation, including powers to request information, conduct interviews
and carry out on-the-spot investigations by entering and sealing premises,
taking documents and seeking explanations. The Commission may exercise
these ‘dawn raid’ powers at any time prior to notication as well as during its
investigation.
49
(a) Phase 1 investigation
On receipt of a complete Form CO, the Commission carries out an initial,
Phase 1, investigation. Within twenty-ve working days
50
from receipt of the
complete Form CO, the Commission must either:
(a) clear the transaction (either outright or subject to conditions); or
(b) launch an in-depth Phase 2 investigation (initiate proceedings).
(b) Phase 2 investigation
The Commission will enter a Phase 2 investigation if it has serious doubts
about the compatibility of the transaction with the common market. The
Commission must reach a nal decision within ninety working days following
the initiation of proceedings. This period may be extended by no more than a
total of twenty working days.
51
(c) Substantive test
Under Article 2(3) of the ECMR, the EU Commission must prohibit concen-
trations with a Community dimension that would ‘signicantly impede effect-
ive competition’ in the EU (the ‘SIEC test’). The Commission has the power
to accept undertakings (commitments) from the parties to remedy any com-
petition concerns in order to prevent a prohibition by the Commission. Such
undertakings can be given in either Phase 1 or Phase 2.
52
4.9 Appeals and jurisdiction
Decisions of the Commission may be the subject of appeal to the Court of First
Instance (CFI) by way of application for annulment under Article 230 of the
EC Treaty. Such an application may be brought by the addressee of the deci-
sion or by any other person for whom the decision is of direct and individual
concern. From the CFI, points of law may be appealed to the European Court
of Justice.
acquisition and waiting for Commission approval. Electrabel has acquired just under 50 per
cent of CNR which the Commission concluded gave it decisive in uence over CNR given
the wide dispersion of the remaining shareholders. Following notication, the Commission
cleared the acquisition as it did not raise any competition concerns.
49 Articles 11–13 ECMR.
50 Article 10(1) ECMR.
51 Article 10(3) ECMR.
52 Articles 6(2) and 8(3) ECMR.
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Acquisition issues
Although as a general rule concentrations with a Community dimension
fall within the exclusive jurisdiction of the Commission and those without
a Community dimension fall to be considered under relevant Member State
national laws, the ECMR contains a number of exceptions where jurisdic-
tion can be transferred back to a Member State or from Member States to the
Commission for decision. Where these exceptions apply and are used, there
can be an adverse impact on the timetable for review as they can involve, in
addition to the actual notication, written submissions either by the parties
and/or by Member States as part of the process of determining which competi-
tion authority will review the transaction. However, in appropriate cases, they
can reduce the number of lings needed to be made on a transaction.
53
A Member State may carry out a parallel investigation into a transaction
falling within the ECMR if its legitimate interests are affected (for example,
national security, the plurality of the media or prudential rules).
54
5 Tax
5.1 Background
In a UK share sale transaction, it is almost invariably the case that a seller will
be required to agree to pay to the buyer an amount equal to certain tax liabili-
ties of Target. This is variously referred to as a ‘tax indemnity’, ‘tax deed’,
‘tax covenant’ or ‘tax schedule’, and such promise will be set out either in a
schedule to the acquisition agreement or in a deed entered into pursuant to the
agreement. Although the form of each such deed varies slightly, the basic obli-
gation is the same: the seller promises to pay the buyer, on a pound-for-pound
basis, an amount equal to any unexpected tax liabilities of Target. For ease of
reference in this section, we refer to each such promise as a ‘tax covenant’.
Initially, tax covenants were used to cover secondary liabilities; broadly
speaking, tax liabilities of persons (other than the Target) which the Target
became obliged to pay if the primary obligor failed to meet such liability.
Such liabilities can typically arise where a company is a member of a group
of companies and one of the other members fails to pay tax for which it is pri-
marily liable. Such liabilities can also arise in certain circumstances where a
shareholder of a company fails to meet its own tax liabilities. In such cases, it
was considered that warranties, no matter how widely drafted, might not catch
all such liabilities, and that in any event an indemnity basis of recovery was
more appropriate for any such taxation liabilities. Over time, the scope of a
tax covenant has therefore expanded away from this original purpose, and has
became a more general underwriting of the tax affairs of the Target.
53 See Articles 4(4), 4(5), 9 and 22 ECMR; and Commission Notice on case referral in respect
of con centr ations (OJ C 56, 5.3.2005, p. 2).
54 Article 21(4) ECMR.
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Tax
5.2 Matters covered by tax covenant
Generally, the tax covenant will apply to all tax liabilities of Target arising as
a result of an event occurring on or before completion of the share sale and, in
very limited circumstances, to some liabilities arising as a result of a combina-
tion of events where some have occurred before completion, and some after
completion. The tax covenant is given by reference to a set of accounts, with
the seller not being liable to make a payment to the buyer in respect of any tax
liability of Target to the extent provided for in such accounts. If the relevant
accounts are not made up to completion (e.g. if the tax covenant is given by
reference to the last set of audited accounts), then it would also be usual for the
seller not to be liable to make any payment under the tax covenant in respect of
any tax which arises in the ordinary course of business of Target between the
date to which the accounts were made up and completion.
The tax covenant is given by the seller to the buyer rather than to Target.
This arises as a result of case law during the 1980s (and in particular the
case of Zim Properties Ltd v. Proctor)
55
which led to a concern that if Target
receives a direct payment from the sellers this could be taxed as a capital gain
within Target. This would have the consequence that the net amount received
by Target (after paying tax on the receipt from the seller) would be insufcient
to settle the liability for which it was paid. Buyers therefore usually required
that the payment by the seller should be grossed up, that is to say, increased so
that the net amount received and retained by Target (after taking account of
any tax which Target suffered on the receipt) is equal to the amount required to
meet the particular liability in question. Clearly, this was unattractive to sellers
who risked having to pay more than the actual tax liability in Target in respect
of which they had agreed to indemnify.
In 1988, HMRC published an extra-statutory concession (ESC D33) con-
rming that a payment between a seller and a buyer (but not a payment between
a seller and Target) under a tax covenant will generally be treated for tax pur-
poses as an adjustment to the purchase price rather than as a taxable receipt
of the buyer. In view of this, it is now invariably the case that tax covenants
are given by the seller to the buyer rather than to Target. On this basis, whilst
a seller is still generally obliged to give a gross-up clause in favour of a buyer,
it will be comparatively rare for circumstances to arise where the gross-up
clause is called upon.
5.3 Limitations in the tax covenant
In relation to limitations:
(a) Usually, claims under the tax covenant will be subject to the overall cap
on claims, i.e. that the seller is not liable to the buyer in respect of claims
55 [1985] BTC 42.
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Acquisition issues
under the sale and purchase agreement to the extent that the aggregate
liability under all claims exceeds the purchase price (or some lesser g-
ure as may be agreed between the parties).
(b) There is no hard and fast rule as to whether threshold and de minimis
nancial limitations should apply to tax covenant claims. Some buy-
ers take a purist view that a tax covenant is a pound-for-pound recov-
ery mechanism and therefore that such limitations should not apply.
However, there is no standard market position on this point.
(c) As noted in section 2.9 above, the usual time period for making tax
covenant claims is seven years from completion, which is far longer than
for commercial warranty claims. This period stemmed originally from
the fact that HMRC generally had up to six years from the end of an
accounting period to raise additional assessments to corporation tax or
to enquire into tax returns. The statutory periods for raising enquiries
have varied over the years and are due to change again on 1 April 2010.
However, a seven-year window for tax covenant claims is very much the
market standard position.
(d) There will be a raft of specic tax limitations designed to apportion
risk (e.g. which party bears the change-of-law risk) and, from a seller’s
perspective, seek to limit liability for tax liabilities to the extent they are
attributable to actions or omissions of the buyer or Target post-comple-
tion (e.g. failures to make appropriate tax claims and elections).
(e) It is extremely rare for disclosures in the disclosure letter (or for knowl-
edge of the buyer prior to completion of potential tax covenant claims)
to limit or prevent a buyer from making a claim under the tax covenant.
Thus, if the seller wants to exclude liability under the tax covenant for
known issues, it is necessary to incorporate a specic exclusion into the
tax covenant.
Given the nature of the tax covenant, i.e. that it is based upon a pound-for-pound
recovery rather than having to establish loss, a seller will wish to include provi-
sions designed to ensure that a buyer is merely put in the position in which it
would have been had the relevant accounts properly provided for tax. Thus, typi-
cally, there will be credit mechanisms for dealing with situations where the buyer
or Target recovers any amount in respect of the tax liability from a third party,
where the tax liability itself results in Target saving some other tax, and/or where
the relevant accounts overprovide for certain taxes. In addition, there will also be
provisions governing which party has responsibility for submitting and dealing
with pre-completion tax returns and for conducting any dispute with HMRC.
5.4 Tax covenant on a private equity acquisition
In principle, there are no particular differences between the tax covenant in a
buyout and the tax covenant in any other sale and purchase. Even if the seller
runs the argument that the managers’ role and knowledge mean that the seller
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Conclusion
should warrant less to a buyout vehicle than to a trade buyer, this argument is
rarely successful in the context of the tax covenant – not least because the tax
affairs of the Target (especially in a group where it was a subsidiary) are often
undertaken at a level above the day-to-day running of the Target by the man-
agers. It would be extremely rare for the disclosure letter or the knowledge of
the buyer to qualify the seller’s exposure under the tax covenant. Tax enjoys a
special status in the negotiation of risk allocation.
6 Conclusion
In this chapter, we have considered the key aspects of the acquisition of a pri-
vate company in the UK, and have focused, in particular, on the aspects which
are of direct relevance where the buyer is backed by private equity. A key issue
is the precise nature of the warranties to be given and the effect which the
knowledge of the managers may have, rst, to reduce the matters the sellers
will warrant, and, secondly, to reduce the effectiveness of those warranties by
providing a defence to the sellers for anything known by the managers when
their knowledge is attributed to the buyer. We have also looked at some of the
issues that can cause conditionality and delay to the transaction (in particular,
competition law) and the consequences of this for the transaction, not least in
the context of any material change in the business of Target between the signa-
ture of the agreement and completion.
Market practice in these areas has been affected in part by the bargaining
power of the parties. Broadly speaking, as buyer vehicles in a buyout have
become predominantly controlled by the investors (that is to say that the inves-
tors increasingly have a majority of the equity in the Newco), the practice in
these areas for private-equity-backed buyers is aligning more closely to the
practice of a trade buyer. Accordingly, private-equity-backed buyer vehicles
are receiving broadly equivalent protection in terms of warranties and other
cover as a trade buyer would receive notwithstanding the inside role of the
managers in the transaction, which may otherwise be seen to differentiate the
two potential buyers. Such trend is only likely to continue in the more buyer-
friendly market in the UK following the credit crunch.
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5
Equity documentation
1 Introduction
In this chapter, we will consider the principal equity documents that form part
of a relatively standard buyout structure. Broadly similar documents would
be used in other private equity transactions (for example, in a secondary or
on a public-to-private transaction, tailored to reect the particular differences
inherent in such a deal). For this reason, the general overview set out in this
chapter should also be considered in the context of those transactions.
This chapter will focus on the two key equity documents, namely the
investment agreement and the articles of association of Newco. It will explain
the reasons why there are two documents, and the key terms found in them
in the context of the relationships between the different parties and the over-
all investment. It also includes comments on three key ancillary documents,
being the equity offer letter or termsheet, the investment disclosure letter and
the loan note instrument. The service agreements that govern the relationship
between Newco and the managers in their capacity as employees are consid-
ered in chapter 7.
2 Equity offer letter
The equity offer letter (sometimes referred to as the equity termsheet) sets out,
in a non-binding form, the key terms of the equity funding offer. It is usually
written by the private equity investors to the managers and/or to Newco, and
in effect provides a template for the drafting of the principal equity documents
(in the same way that the heads of terms agreed with the seller(s) will provide
a template for the acquisition agreement).
The offer letter will set out the amounts to be invested both by the pri-
vate equity investors and by the managers, and also the form of those invest-
ments (by identifying the different classes of shares and loan notes that will
be established in the Newco structure). It will also set out details of the fees
and expenses payable to the investors for its investment and its ongoing moni-
toring. The offer letter will often then address other key commercial terms to
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Equity offer letter
be included within the equity documents as explained in more detail in this
chapter, such as the yield on the loan notes, any liquidation or dividend prefer-
ence on the investor shares, any ratchet, and drag and tag along rights. If the
investors or the managers wish to see such matters resolved upfront, it may
also go on to address other issues which often prove to be particularly sensitive
in negotiation, such as the approach to cessation of employment and equity
(i.e. good and bad leaver provisions and any vesting arrangement, as explained
below), the nature of the investment warranties to be given by the managers
and any key limitations that will apply, and the notice period and remuneration
to be offered under each manager’s service agreement.
Traditionally, the equity offer letter tended to be a short document, often
providing the key nancial details only without going into the more detailed
legal areas of negotiation. However, the more recent trend is for more of the
key equity terms to be agreed in advance by way of a detailed offer letter or
termsheet. There are two main drivers for this. First, many investors are keen
to see such matters resolved early (and perhaps outside the more adversarial
context of the legal negotiation of detailed documents) as this can help ensure
that the relationship between management and the investors is not soured, and
that the equity documentation is completed more efciently. Secondly, a more
competitive market for deals has led to management teams wanting to explore
deal terms in more detail before a preferred bidder is selected – even where
the management team are not sellers themselves and so do not decide who the
preferred buyer is, their views will in any event be very inuential as it will
have a signicant impact on the deliverability of the transaction. In the buoyant
market during the period leading up to the summer of 2007, it was not uncom-
mon for the managers or their advisers to issue their own pro forma termsheet
with some of the sections pre-completed, and others left blank, so that the key
terms could be ushed out and the various bidders played off each other before
exclusivity was granted.
Although equity offer letters are usually expressly stated to be non-binding
and based on key assumptions (such as satisfactory due diligence, legal doc-
umentation being agreed, and so on), they will sometimes include a legally
binding exclusivity clause (separate to the exclusivity arrangement agreed with
the sellers) seeking to tie the management team to the relevant private equity
house for a period of time. As explained in section 3.3 of chapter 2, such an
agreement cannot impose a positive duty on the parties to negotiate but, in
principle, it can bar them for a time from seeking funding elsewhere. How use-
ful such a provision will be is debatable in the event of a breach. The measure
of loss suffered could be construed to be the private equity investors’ abortive
costs, but there will always be some doubt if a deal to buy the business could
have been concluded in any event on acceptable terms, even if the management
team had honoured the exclusivity arrangement. The question also arises of
whether the management team are of sufcient nancial means to provide an
effective remedy in the event of a breach. Nevertheless, tying management as
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Equity documentation
<RRH>
well as sellers into an exclusivity arrangement should be considered, as this
will usually have a deterrent effect. If the managers or their advisers have
been playing one potential funder against another, it may be more reasonable
for the successful party to seek formal exclusivity with some level of binding
costs cover.
3 The investment agreement
3.1 Background and parties
The investment agreement (occasionally in the more traditional style referred
to as the ‘subscription and shareholders’ agreement’ or similar) is the princi-
pal contractual document regulating the terms and conditions upon which the
private equity investors will invest in the ultimate parent Newco in which the
investors and managers will hold shares (and, where relevant, any other sub-
sidiary companies in the group structure
1
), and sets out other relevant matters
for the ongoing operation of the group as an investee company in the portfolio
of the private equity investors.
As a general rule, Newco itself and everybody who will become a share-
holder of Newco as part of the initial completion process will be a party to
the investment agreement, together with any subsidiary of Newco which is
receiving a direct investment for loan notes. As explained in chapter 3,
2
in
certain cases private equity investors will expect their shares (and sometimes
loan notes) to be issued to and held in the name of a custodian or nominee.
However, it will be usual for the fund itself to be a party to the agreement,
rather than that custodian or nominee (although the custodian or nominee will
usually be mentioned in the relevant operative provision).
Where there will be many employee shareholders with relatively small
equity stakes, it would be unusual for such shareholders to have to sign up to
the investment agreement. In these situations, it is particularly key that any
provisions which are needed to bind these minority shareholders are reected
in the articles, as the articles bind all shareholders automatically by virtue of
their membership of Newco.
3
If anyone not already signed up to the investment agreement acquires shares
at a later stage, whether as a result of a new allotment or by a transfer of shares,
that person will be expected to join into the investment agreement (usually by
way of a deed of adherence) as a condition to receiving those shares, unless
the investors agree to the contrary. The deed of adherence is usually an agreed
form document, often incorporated as a schedule to the investment agreement.
1 As explained in chapter 3, section 2.3, a buyout often requires a group structure with investors
holding shares in the ultimate parent company, and investing by way of loan notes in a wholly
owned subsidiary of that parent.
2 See chapter 3, section 3.3.
3 Section 33 of the Companies Act 2006.