A Practical Guide to Private Equity Transactions
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would be diminished if the departing manager could call the bluff of the pri-
vate equity investor, knowing that it would be unlikely to proceed if it also had
to proceed against (or risk the departing manager bringing some claim for con-
tribution against) the continuing managers. Similar considerations would not
normally arise in the mind of the buyer in relation to potential claims against
multiple sellers under the acquisition agreement, assuming such sellers are no
longer within the business.
It is a standard provision of an investment agreement that, if a claim is made
by the private equity investors under the warranties, the manager will not seek
any contribution from Newco, or from any of its group companies, employees
or ofcers, or bring any claim against them as a consequence. It would be mate-
rially disadvantageous to the private equity investor if a warranty claim by it
against a particular manager could, in turn, diminish the value of its investment
further through some form of third party claim or counterclaim by the relevant
manager against Newco, Target or its group or employees. This is similar to the
position that a buyer would seek from a seller in the acquisition agreement.
In any situation where Newco does give warranties, it would usually be sub-
ject to the same time limit in respect of claims as the managers giving warranties
under the investment agreement have negotiated for themselves. However, the
monetary limit would usually be set at the total amount invested by the private
equity investors. There is a reasonable case to be made for limiting the liability
to the amount which the investors are investing for their equity shares. The argu-
ment is that, if the loan notes are repaid together with relevant interest, then there
is no loss in respect of them in any event. If the loss giving rise to the warranty
claim is sufcient to prevent full repayment of the loan notes and interest, then
the private equity investor has as much remedy as it needs by seeking to pursue
its right as a creditor to receive that money (subject to the intercreditor and other
applicable rules), and does not need an additional or substitute remedy under the
warranties for any diminution in value of the loan notes. If Newco cannot repay
the loan notes, it is also unlikely to be able to pay up on any claim for their loss
resulting from a breach of warranty in the investment agreement. Having said
that, this argument does not usually prevail and, where Newco does give warran-
ties, it remains usual to set that limit at the total amount invested.
One nal issue which can arise in relation to the ability of investors to claim
under the investment agreement warranties is the question of whether the investors
have knowledge of any circumstances that may give rise to a claim. It is common
for the investment agreement to include a provision which states that, save for any
matters that are disclosed in the disclosure letter, no knowledge of the investors
(whether actual, implied or constructive knowledge) shall preclude the investors
from making a claim. This mirrors the issue already explored in chapter 4 as to
whether Newco should be able to claim in respect of matters of which either the
management team or the investors are aware under the acquisition agreement.
12
12 See chapter 4, section 2.8.
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Legal advisers to management may seek to delete this clause on the basis
that the investors should not be able to seek a remedy where the common law
would prevent such recovery based on the investors’ knowledge, or may go
even further than this and suggest that the investors should provide a con-
rmation that they are not aware of any matters that may give rise to a claim
under the investment agreement warranties. Both of such amendments would
usually be resisted by the investors. As the purpose of the investment agree-
ment warranties is principally to elicit disclosure, investors would argue that
such amendments create a far more signicant risk that the disclosure exercise
will not be conducted with appropriate diligence. It may also be argued that
the subject matter of the warranties – relating principally to the managers’ per-
sonal circumstances, their own knowledge of matters relating to Target, and
the Business Plan which the managers are responsible for – are issues on which
only the managers can offer a true perspective, and as such the knowledge of
the investors is not relevant.
3.7 Restrictive covenants
The investment agreement will include restrictive covenants from the manag-
ers in favour of the private equity investors and usually, though not invariably,
in favour of Newco also. This is in addition to the restrictive covenants that a
manager would normally be expected to provide in his service agreement to
Newco (or whichever other company in the group will be his employer). In a
secondary buyout, where a manager is often also a seller, that manager will
usually provide a third set of restrictive covenants to the buyer in the acquisi-
tion agreement in his capacity as a seller.
Subject to the comments which follow, the format of the restrictive cov-
enants in an investment agreement is broadly the same as in a typical acquisi-
tion agreement. It will preclude direct competition with the Newco group and
the solicitation of key employees, customers or suppliers as is appropriate to
protect the underlying business, and will contain a prohibition against the use
of specic trade names or marks of the group’s business as it exists at the time
of the cessation of employment. It will also usually have an acknowledgment
of the reasonableness of those covenants on the part of the manager, and typi-
cal ‘blue pencil’ wording (so that, if the court did nd the covenants as a whole
to be unreasonably restrictive, it may be willing to enforce them by deleting
the offending part or otherwise reducing their scope).
13
Two or, in some cases, three sets of restrictive covenants may often appear
excessive, and this can give rise to some protracted negotiation. However, it is
important to note that the restrictive covenants are given in different capacities,
13 Generally speaking, courts are more likely to delete an offending part of a covenant (pro-
vided the restriction following such deletion makes sense and is not unreasonable) than to
amend wording, but in any event it is preferable to ensure the coven ant is reasonable from the
outset rather than to rely on the ‘blue pencil’ clause.
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The investment agreement
in favour of different parties, and to protect different goodwill. By way of
example (and assuming for this purpose the manager is also a seller, and there-
fore providing three different sets of restrictive covenants):
(a) In the acquisition agreement, the manager is providing restrictive cov-
enants in his capacity as the seller of an asset. The time period for the
restriction will run from the date of completion of the acquisition, and
the goodwill to be protected and geographic extent of the covenants will
be judged by their reasonableness in the context of that share sale, and
the goodwill of the Target group at the time of that sale. Accordingly,
where the manager remains in the business and that business in turn
develops and changes after the sale, it would be unusual (and probably
unenforceable) to seek to protect that new or enlarged goodwill under
the acquisition agreement. All restrictive covenants under English law
are prima facie void save and to the extent to which they are reasonable
as between the parties and in the public interest. The argument here
is that the reasonableness of the acquisition agreement restrictive cov-
enants should be judged as between a share seller and a buyer (on an
arm’s length basis), and in the context of the general public interest in
enabling sensible restrictive covenants to be given (without which no
seller could extract any meaningful value for the goodwill associated
with what is sold, creating little incentive to generate that goodwill in
the rst place). In the same way that the buyer could seek to en force a
restrictive covenant (so far as it is reasonable) from a seller who takes his
proceeds and moves on, the buyer can seek the same restrictive covenant
from a seller staying on in the business as a director and/or shareholder
in the buyer group.
(b) In the service agreement, the manager is entering into the transaction
as an employee, albeit usually a senior one. Accordingly, the courts will
look at the restrictive covenant by reference to what is reasonable in the
context of a senior employee who has a similar role, and similar interac-
tion with customers, suppliers and employees. However, this covenant
will generally be written to protect the goodwill existing at the time the
employment ends. To that extent, although it is subject to the generally
shorter periods and higher standard of reasonableness expected in an
employment situation, the service agreement covenants have the advan-
tage that they can protect the goodwill as it evolves following the buyout
and up to the time when the employment ceases.
(c) In the investment agreement, as in the service agreement, this covenant
is designed to protect not just the goodwill at the time of the acquisition,
but also the goodwill as it evolves and develops from that date until the
date of cessation of employment (or in some cases, the date on which
the manager ceases to be a shareholder). It is usually ar gued that the
investment represents a form of joint venture between co-owners (more
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similar, say, to a partnership) than the transaction between an employer
and employee, and therefore the courts should allow a more onerous set
of covenants than would be acceptable simply in an employment situa-
tion. This is reinforced by the fact that often (although not always) there
may be a share transfer at the time the manager ceases to be employed,
reinforcing the argument that this relationship is more akin to that of co-
owners, and therefore any assessment by the courts as to what is reason-
able should be closer to that which would be applied in the context of the
acquisition agreement restrictive covenants, rather than in the context of
the service agreement.
One interesting area of overlap is the general rule of law that a party who is in
repudiatory breach of contract cannot also seek to hold the other party to the
terms of that contract (at least where the party not in breach has accepted the
repudiatory breach).
14
As is explored further in chapters 7 and 11,
15
the ending
of a senior manager’s employment often occurs in situations where it is not
practicable to comply with the terms of the service agreement, or with employ-
ment legislation. It is not, therefore, uncommon to nd that the employer
company is in repudiatory breach of the service agreement, even where there
may be sound commercial reasons why the employment of a manager must
end (from the point of view of the private equity investors and the rest of the
Newco board). In particular, there is often a compelling business need to do so
quickly to avoid the risk that a recalcitrant manager may seek to inuence oth-
ers (whether inside or outside the company), or to harm the business in some
way during a protracted disciplinary or consultation process. For this reason,
a restrictive covenant in the service agreement is often of little practical use at
the very time when a private equity investor would most want to use it. Having
a separate set of restrictive covenants in the investment agreement, to back up
the employment restrictions and protect the goodwill of the group at the time
of the cessation of employment, is therefore of particular advantage. Whilst
it is not necessarily clear that the courts will fully uphold the argument that
they are separate arrangements, and that a repudiatory breach of the service
agreement should not be taken into account in determining the validity of the
obligations in the investment agreement, it is clearly a better position to be in
than having to rely solely on restrictive covenants in the service agreement.
Similarly, unless management is in a very strong position, it would be unusual
for the investors to agree to express contractual cross-default (i.e. for a provi-
sion to be included in the investment agreement stating that the restrictive
covenant in that document cannot be relied on where the manager has been
wrongfully dismissed under that manager’s service agreement). To accept such
a cross-default would signicantly damage the value of the separate restrictive
covenant in the investment agreement.
14 See General Billposting Company Ltd v. Atkinson [1909] AC 118.
15 See, in particular, chapter 7, section 2.4, and chapter 11, section 5.
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The investment agreement
Another area of overlap is the subject of garden leave.
16
It is generally
accepted that, if a manager is placed on garden leave (so that he remains
employed but is not required to do any work, and is usually excluded from
the company’s premises, personnel and facilities), then the time spent on gar-
den leave should be offset not only against the restrictive covenant that may
otherwise arise in the service agreement, but also against any time limits
on the restrictive covenant in the investment agreement. If such a provision
is not included, then the courts are arguably less likely to consider that the
restrictive covenant is enforceable. In Credit Suisse Asset Management Ltd v.
Armstrong,
17
the Court of Appeal stated that there was no automatic princi-
ple that the periods should be offset, but that the existence of a garden leave
clause would be a factor taken into account in determining the validity of a
restrictive covenant, and, as a result, an express provision offsetting the two
has emerged as market practice in both the service agreement and the invest-
ment agreement.
The precise terms of the restrictive covenant in the investment agreement
do need to be considered in the context of particular managers. There may well
be certain managers who are particularly key to the business, or whose ability
to damage the goodwill is greater, such that a longer or otherwise more restric-
tive covenant can be justied. As a general rule, a chief executive or sales
director is usually more able to damage the goodwill than a nance director.
The reasonableness and the validity of any restrictive covenant will vary from
transaction to transaction, and from individual to individual.
3.8 Confidentiality obligations
The investment agreement will also contain condentiality obligations, drafted
so as to apply for so long as the relevant information of the group is con-
dential, with customary carve-outs for any disclosure which must be made
by law or under the requirements of regulatory bodies. This condentiality
obligation will be expected from each of the managers. In contrast, the private
equity investors themselves will usually be reluctant to give express contrac-
tual condentiality obligations, and may ask the managers to rely on common
law obligations of condentiality. If the investors do accept an obligation (and
some will not as a matter of policy), it will inevitably be subject to specic
exceptions to permit communication between different investors, between any
investor directors or the chairman and the investors, and between the inves-
tors and the banks or any other funders or potential funders to the business.
Disclosure to a potential buyer is also often negotiated as a specic carve-out
to any express condentiality obligation on the part of the investors.
16 On garden leave generally, see chapter 7, section 2.3.
17 [1996] IRLR 450.
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3.9 Board composition
The investment agreement will often contain provisions as to the composition
of the board, although, as noted in section 4.14 below, these will often be sup-
plemented by similar provisions in the articles. Notwithstanding the fact that
in many situations the private equity investors have a majority equity interest,
it is still usual to nd express provisions in the investment agreement dealing
with the ability of the investors to appoint and remove directors.
The private equity investors will usually have the right to appoint a par-
ticular number of investor directors (two is most common, although sometimes
only one may be appointed). Occasionally, there will be some restriction as
to who may be appointed as investor director (for example, that the investor
director should be either an employee of the private equity investor, or should
be approved by the board of directors). Usually, however, the ability to appoint
and remove investor directors is entirely a matter for the private equity inves-
tors themselves without any such restrictions. It should be noted that not all
private equity investors will exercise this power to appoint investor directors
as a matter of course. Many prefer to keep it in reserve, not least given the
extensive duties which any directors owe to a company under common law
and statute.
18
Any fee payable for the investor directors is usually paid directly
to the private equity investors (or, more specically, to the manager of the rel-
evant funds), rather than to the individuals concerned.
The clause may also deal with the appointment of the chairman. This is
often subject to some obligation on the part of the private equity investors to
consult with the board (or perhaps manager shareholders), although in practice
the private equity investors will usually have the nal say on the identity of the
chairman. Private equity investors are very keen to nd a chairman who can be
of genuine value to the business, and who will be seen by the executive direct-
ors as bringing desirable qualities to the board. Most chairman appointments
are non-executive, and the chairman is not usually an employee of the private
equity investors (although investors have formal or informal panels of chair-
men whom they look to for appointments, often on a sectoral basis). A chair-
man will usually be expected to take an equity shareholding in the company.
This may simply be sweet equity, or more unusually might include a small
strip of shares and loan notes on the same terms as the investors, and a further
strip of shares on the same sweet equity terms as the managers.
19
The chair-
man may also be expected to sign up to the investment agreement, although
if this is the case he would not normally have any liability under the warran-
ties. Practice in relation to the restrictive covenants will also vary, as most
18 See, in particular, sections 171–179 of the Companies Act 2006. Private equity investors need
to bear in mind that their actions may also subject them to such responsibilities as a shadow
director, if the board is inclined to behave in accordance with the instructions of a particular
individual. For more on these duties, see chapter 11, section 6.
19 For the meaning of ‘sweet equity’, see chapter 3, section 2.2(c).
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The investment agreement
chairmen would not wish to accept the full extent of the restrictions set out
for executive managers in a typical investment agreement. The chairman will
usually be entitled to a fee payable by Newco directly to him, or sometimes to
a consultancy company which is providing his services. It is usually desirable
for the rst chairman to be appointed at the time of completion, although this
is not always possible in practice.
Although the investment agreement may specify which of the managers
will be on the board of Newco at completion and their executive roles, it is
unusual for there to be a hard right for the managers to appoint a director
or a particular number of directors to the board, particularly if the investors
have voting control of the company. Private equity investors (particularly in a
majority position) would seek to resist any provisions in the investment agree-
ment or in the articles which could be seen to give a hard right to management,
or to any particular manager, to have a board position. If any such provisions
are conceded in negotiation (which is unlikely without strong commercial jus-
tication, perhaps on a secondary transaction), there will usually be a carve-
out which reduces or removes them in certain underperformance situations so
that, in practice, they will not be able to prevent the private equity investors
being in the ultimate position to take any action they believe necessary to
rescue the investment or to make changes to the board composition in those
circumstances.
Similarly, where the private equity investors are in a majority equity pos-
ition, the investors will often request an express right to appoint and remove
any person as a director of the company (and not just their own appointees). As
a matter of general company law, as shareholders with a majority of the votes
available at general meeting, they would have the power to do this in any event.
However, the investment agreement and/or the articles will usually contain
express provisions to reinforce this power, not least because the time period
required to remove a director under the statutory procedures in the Companies
Act 2006 (which can be twenty-eight days or longer)
20
can be seen as unhelpful
if a swift decision needs to be made. This power for controlling shareholders
to appoint or remove directors immediately is not peculiar to private equity.
A similar provision will often appear in the articles of subsidiary companies
within groups, so as to enable holding companies to have the same power of
immediate appointment or removal without notice at that level. The position
varies more widely where the private equity investors have a minority stake.
Some investors will insist on a hard right to appoint or remove directors being
granted in favour of the investors, or at least the remuneration committee.
21
Other investors might accept that a majority of the shareholders or directors
20 Section 168(2) of the Companies Act 2006 requires special notice of any resolution to remove
a director, dened in section 312 to require notication to the company at least twenty-eight
days before the meeting at which it is moved.
21 For committees, see section 3.10 below.
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are required for any board changes in the ordinary course, and then take a hard
right only in circumstances of underperformance.
22
Often, the investment agreement will enable the private equity investors to
appoint an observer. If so, the investment agreement provides that the observer
is not a member of the board and cannot vote at board meetings. He will,
however, be entitled to receive copies of all papers and to attend and (usually)
speak at the board meeting. This ability is helpful for certain private equity
investors who wish to have a close connection to board meetings without their
appointee taking on the full statutory and duciary responsibilities of being a
legal director of the company. For this reason, the power to appoint an observer
is sometimes expressed to exist only whilst there is no investor director in
ofce. However, practice does vary, so an observer may be entitled to attend
board meetings irrespective of whether there are investor directors in ofce.
An investor director faces a clear potential conict of interest in his role in
that, in addition to his duties to Newco, he may well also be an employee or
even a director of the private equity investor, and a director of other companies
in which that private equity investor has invested. The interests of Newco and
of the private equity investor do not always align, particularly if there is a need
to rescue the transaction. Chapter 11 sets out a more detailed analysis of direc-
tors’ duties generally (which include the duties of any investor director), and
also highlights certain provisions which are now often included in the articles
to seek to regulate the conicts that may otherwise arise, particularly in the
context of the new statutory duty to avoid conicts under section 175 of the
Companies Act 2006.
23
3.10 Board committees
It is usual for the investment agreement to provide that there will be a remu-
neration committee, similar to that found in a listed company. The remunera-
tion committee will usually comprise the chairman, the investor directors and
the chief executive (although members of the committee are usually precluded
from taking part in any vote in relation to their own remuneration). The remu-
neration committee will have the effective say in relation to salary and other
benets of the managers (and, sometimes, other senior employees). In many
cases, it will also have the power to exercise other provisions in the service
agreement, for example the power to suspend or dismiss the manager as an
employee.
Many investments will also feature an audit committee, usually compris-
ing the chairman and the investor directors. The nance director will usually
attend meetings of the audit committee but will not normally vote. The role of
22 For a further analysis of enhanced investor rights on underperformance, see section 4.3
below.
23 See further chapter 11, section 6.
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The investment agreement
the audit committee will again be similar to that in a listed company, includ-
ing reviewing the work of the auditors and the internal accounting systems of
the group.
3.11 Information
The investment agreement will contain provisions requiring Newco to pro-
vide regular management information to the private equity investors, includ-
ing monthly management accounts in a format approved by them, statutory
accounts within a given period, and draft budgets for approval in advance of
each nancial year. There will usually also be a provision requiring Newco
to provide such other information in relation to the business and affairs of its
group as the investors may specify. Investors may have more detailed require-
ments as a matter of house style (for example, to be informed of material litiga-
tion or disputes), or to reect the sector in which the investee company trades
(for example, weekly sales data in a retail business).
These information obligations are usually reinforced by an express right
for the private equity investors, at the expense of Newco, to send in their own
accountants to obtain the information if there is any material delay or default
in compliance.
24
3.12 Investor consents
The investment agreement will normally contain a comprehensive list of mat-
ters requiring prior approval from the investors (or, sometimes, an investor
director) before any such transactions or dealings are entered into by the group.
The precise list of veto matters varies based on the preferences of investors,
although a relatively standardised list of ‘must haves’ has emerged. Typical
examples of investor consents include:
any change to the share capital of Newco, including the granting of any •
options or warrants, or any share reduction or own share purchase;
any change to the constitution of Newco or any other group company;•
any exercise by the board of rights set out in the articles (for example, in •
relation to share transfers);
material capital expenditure;•
material litigation;•
appointment and removal of directors (other than the investor directors •
or the chairman) or any change to or termination of their service agree-
ment or other terms of appointment;
25
any transaction or arrangement between the group and any manager (or •
any connected person), or any variation or termination of the same;
24 See further chapter 11, section 2.3.
25 Note that, even where the investors have no hard right to appoint or remove a director, they
would still expect a veto on any appointments or removals.
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any material departure from the Business Plan or agreed annual •
budget;
any material acquisition or disposal by the group;•
any proposal for the listing or sale of a member of the group;•
any change of auditors or accounting policies, practices or standards •
(beyond those required generally by a change of law or to ensure com-
pliance with generally accepted accounting practices); and
any change to the bankers or other funders of the business.•
The purpose of these business covenants is to ensure that any material matter
outside the ordinary course of the business of the group, or which may materi-
ally and adversely affect it in the context of the ultimate exit, are brought to
the attention of the private equity investors and approved by them. There is
a sensible balance to be struck between, on the one hand, imposing such a
restrictive regime upon the company that the managers are not able to carry on
the day-to-day operation of the business without pestering the private equity
investors constantly for consents and, on the other hand, having such limited
control over the business that the investors are not sufciently informed of
material issues on a timely basis, or able to exercise the proper controls that
they would wish to in respect of their investment.
Certain of these restrictions may be subject to specic monetary thresholds
or other carve-outs. Similarly, particularly where a decision needs to be reached
in a hurry, there may well be a procedure to enable the investor director to give
certain consents at board meetings or by way of e-mail. Sometimes, managers
will ask for a time period to be built around consents, perhaps reinforced by a
provision that the private equity investors are deemed to give consent if they
do not object within a particular period. However, such mechanisms are usu-
ally resisted by the private equity investors to ensure there is absolute clarity in
practice (in other words, to ensure that, until an express consent is given, there
is no consent, to avoid any doubt). Investors prefer to ensure the consents only
cover the fundamental or material concerns, such that (once agreed) there is
no fetter on the exercise of such veto rights. They would not generally agree to
have to be ‘reasonable’ in the exercise of a discretion, for example.
The investment agreement will often provide that, where any such con-
sent is given subject to conditions, it will be a breach of the agreement if the
matter in question is implemented without complying with such conditions.
The investment agreement will also usually require Newco to meet any out-
of-pocket expenses incurred by the private equity investors in considering any
application for consent, whether or not that consent is given. This is in addition
to any monitoring or similar fees (see section 3.13 below).
Traditionally, many of these consent rights were supplemented by express
provisions in the articles seeking to provide that it would be a breach of the
class rights attached to the private equity investors’ shares in Newco if the rel-
evant matter occurred without the necessary consent. This list of specic class