A Practical Guide to Private Equity Transactions
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it is the one most often seen, especially if there is a material price to be
paid for the shares clawed back.
All of these warehouse mechanisms (apart from direct transfers to suc-
cessors) also raise the question of what should happen to any clawed-back
equity that is not used for a successor, perhaps because not all is needed
for that purpose, or possibly because an exit occurs more quickly than was
envisaged. If the shares are being warehoused by the private equity inves-
tors, there may be an arrangement that they will be transferred to the other
managers (typically, at acquisition cost, plus an interest charge to reect the
carrying cost), in effect replicating the position that would have applied had
the pre-emption provisions been applied on a class-by-class basis. Where
the EBT is to act as the warehouse vehicle, the question of how any unal-
located value in the trust should be distributed is a matter for the trustees,
although management at least have the comfort that such proceeds may only
be applied to the benet of employees and not the investors. If a buyback is
used, no adjustment is usually made if not all the shares are reissued, such
that any advantage that arises from this is, in effect, shared pro rata by all
existing equity holders.
4.13 Drag and tag
Private equity articles will usually include ‘drag and tag’ provisions (also
referred to as ‘drag along’ and ‘tag along’).
(a) Drag rights
A ‘drag’ is a mechanism whereby, if a particular group of shareholders (often
dened as a majority in value of the equity shareholders, or perhaps simply as
the private equity investors) wish to sell their shares to a third party, all other
shareholders can be compelled to sell on the same terms per share. This drag
along right is supported by a power of attorney to ensure that the relevant share
transfers can be delivered. A drag mechanism is very important to private
equity investors and will be common to most transactions, with the exception
only that it is not seen in situations where the private equity investors have a
very small minority position (and therefore cannot exert enough inuence to
demand that a right is included). Even in those minority cases, investors may
still insist on such a right being included on a postponed or conditional basis,
for example a right that is only triggered after a period of time, or on an under-
performance. Since the mid-1990s, there are very few private equity investors
in the market who would agree to being locked into a Newco with no hard right
to exit at some point in the future. Sometimes, other tactics are used to drive
exit (an increasing, stepped dividend in favour of the private equity investors
as outlined in section 4.4 above, for example); but a mechanism to focus the
minds of other shareholders on the need for an exit is a key factor for most
private equity investors.
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Sometimes, whilst accepting the general principle of a drag, the managers
will seek to fetter or limit it in some way, for example by proposing that the
drag should not be available before a particular time period has elapsed (to
enable the management team time for the Business Plan to be rolled out to a
stage where a higher valuation may be expected). In other situations, they will
seek to limit the drag so that it must pay in cash (so that the managers cannot
be dragged into a non-cash consideration sale, for example receiving shares in
a public limited company buyer). They may also seek to provide that the per-
son acquiring Newco under the drag mechanism must be independent of the
private equity investors, and that the offer must be bona de. This nal point
is usually acceptable to investors, and indeed similar wording often appears in
the rst draft document issued by the investors’ lawyers. There is often resist-
ance, however, to the other provisions, which are generally viewed by investors
as limiting a legitimate ability for the private equity investors to realise their
investment. It is a question of bargaining power.
If any time or similar fetter is accepted on the drag, it would be usual
to draft it so that the drag can be applied without such fetter if a particular
proportion of the managers agree (this has the advantage of stopping any one
manager blocking a sale, even if his colleagues wish to accept it), or in an
underperformance situation (where the private equity investors will want the
unfettered right to act and, if necessary, to drag all the shares into a sale).
Assuming that the circumstances triggering underperformance rights
47
are
dened in a way that marks a serious diminution in performance compared to
the forecast in the Business Plan, or is linked to some other signicant adverse
event such as a breach of bank covenant, this latter point should not be objec-
tionable to managers. If the business is underperforming to that extent, for all
practical purposes the game is over, and it is unlikely that the managers would
have any legitimate reason to wish to avoid a drag because it denies them real-
istic upside. The value of their shares in that situation is likely to have already
substantially diminished, if not completely collapsed.
One issue sometimes raised by the managers is that they should have a right
to match, whereby, if the private equity investor is willing to sell on particular
terms, the managers have the right to be offered the chance to buy the shares
from the private equity investors at that valuation (if they can), rather than being
required themselves to exit the investment (for example, if the managers believe
that a higher value can be achieved if they run the business to a later date).
Of course, in practical terms, it is often unlikely that the managers would be
able to fund the purchase of the private equity stake from their own resources.
Accordingly, if a right to match is accepted, there would need to be a reasonable
period of time to enable the managers to nd alternative funding and for the new
funders to carry out any due diligence into the business and the new Business
Plan. The right-to-match deal would, in effect, be a secondary buyout.
47 See section 4.3 above.
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Private equity investors generally do not like rights to match, for two
reasons. The rst is that it may distract the managers from the main sale
process at the time of an exit (as would happen, of course, in any secondary
transaction, but, if there is no hard right agreed upfront, the private equity
investors can take a decision at the time as to whether they would wish to
encourage the managers to pursue such an opportunity). The second, and in
many ways the greater concern, is that the existence of a right to match may
discourage other potential buyers from negotiating to acquire the business.
They may believe they are simply a stalking horse, or may not be willing to
wait for the right to match to elapse before their offer can be accepted and
closed. The potential distraction of management time, and the likelihood
that the managers are looking to pursue their own interests rather than facili-
tating the sale process, will also be of concern. If the management team is
in a position where they are able to make an offer, they are always free to
do so (subject, of course, to agreeing the necessary dispensation from their
service agreements to enable them to pursue the opportunity). Therefore, the
private equity investors would argue that no formal right to match is needed;
if the managers at the time are able to make the best offer (whether best is
determined in terms of price or deliverability), it is unlikely that the private
equity investors would choose to accept an offer from a party whose offer is
less attractive. For all of these reasons, a right to match is usually strongly
resisted, and rarely given.
It is important that, if a drag right is agreed, the drafting catches what are
often described as ‘after-acquired shares’. For example, if the manager (or any
other person for that matter) has any subscription or call options, or other right
which means that he may ac quire shares in Newco at the time of the sale or
even a fterwards, the buyer will also wish to have the right to ac quire these
shares. In other words, a future buyer will not allow any options to continue
to subsist once they have acquired the company, and the private equity inves-
tors will want to ensure that the interests of any option holders are effectively
delivered on sale. In practice, the person who has the right to subscribe for
the shares is often paid a cash cancellation payment not to exercise the right.
However, it is important that the drag provision is drafted in a way to catch any
such after-acquired shares, not least if a cash cancellation agreement cannot be
reached at the time of the exit.
(b) Tag rights
In many ways, a tag right is as important to the managers as the drag right
is to the investors. A ‘tag right’ is the right for a minority shareholder to tag
along with any exit by the other shareholders. The idea is that one or more
shareholders should not be able to exit his or their investment(s) (demanding
a premium for the sale of a signicant or controlling stake), whilst the other
minority shareholders are left as shareholders in the investment, and do not
share in the value realised.
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Historically, tag rights were common features of transactions where the
private equity investors were minority shareholders, granted in favour of all
minority holders including those investors. They have survived in favour of
management as the trend has shifted towards investor-led and investor-control-
led deals for various reasons, including:
(a) fairness and alignment of interests;
(b) management expectation based on market practice;
(c) arguably, there is no real detriment to the investor (see below); and
(d) the inclusion of tag rights is often seen as the mirroring trade-off to
the managers accepting the drag rights that the investors will usually
insist on.
In practical terms, there is little detriment to private equity investors in conced-
ing a tag right, as any genuine sale to a third party is most likely to be designed
to sell 100 per cent of the equity in any event. A buyer rarely wishes to acquire
a majority controlling stake alongside other shareholders, particularly where
those shareholders are managers who may otherwise feel aggrieved by the
transaction. If the investors merely wish to complete internal transfers, so as to
change the proportions of the equity held by their own funds for example, this
is usually possible under the permitted transfer provisions,
48
provided that the
transfers contemplated are between existing investors, or amongst funds man-
aged by the same private equity house or syndicate.
There are some additional issues that can cause practical and technical
problems on both drag and tag mechanisms without careful drafting.
(c) Threshold
The rst issue is the setting of a suitable threshold for each mechanism, i.e.
what proportion of the equity share capital of Newco must be sold before the
drag or tag rights arise. On the drag, the relevant threshold is often a control-
ling interest (commonly dened as shares which together have over half the
voting rights). Where the investors are in a minority, however, the threshold
will usually be dened simply as an offer which is acceptable to all of the
investors or, at worst, a majority of the equity shareholders of which the inves-
tors form part. It would be unusual for investors to accept a position where
they themselves can be dragged, unless they have a particularly insignicant
minority stake, and very little inuence, for historical reasons.
This same logic is sometimes also applied to the tag right, and the apparent
symmetry between the drag and the tag right aids this outcome. However, it
is not that uncommon to nd a lower proportion (say, 25 or 30 per cent) of the
equity shares triggers tag rights, so that a signicant minority sale would offer
the other shareholders protection. In that event, the protection may be offered
on a proportionate basis, such that, where investors wish to transfer shares
48 See section 4.8 above.
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amounting to, say, 40 per cent of their holding, the other shareholders are able
to join in and sell the same proportion of their equity shares on like terms.
This proposition is occasionally accepted in negotiation, although it is not too
common in mid-market deals where the reality is that investors are most likely
to exit entirely, or not at all.
(d) Interaction with pre-emption rights
It is also important to check the interaction between the drag and tag rights
and the pre-emption rights arising on any normal voluntary transfer. In the
case of the drag, the articles should be drafted so that service of a drag notice
(or any other exercise of the drag right) has the effect that no other right of
pre-emption arises on a share transfer to the intended buyer (whether by the
shareholders exercising the drag, or the shareholders being dragged). To apply
normal pre-emption in a drag situation would, in effect, provide the dragged
shareholders with a right to match.
Tag rights that bite at the same level as the drag right are normally worded
so that no tag arises if the drag is exercised (which means that the pre-emption
rights on a voluntary transfer normally fall away on the same basis). If for
some reason the drag is not exercised (even though available), or if the tag
arises on transfers at a threshold below the level at which a drag right can be
exercised, then it is not as usual to disapply pre-emption. This means that the
other shareholders get not only a tag right, but also a right to buy under the
normal voluntary transfer mechanism. If this scenario is considered likely,
then both the managers and the investors should consider carefully whether
this is what they would want; in practice, however, such tag offers are unlikely
to arise.
(e) Treatment of non-cash consideration
A further issue on drag and tag rights arises if the consideration offered on any
sale of shares includes anything other than simply cash. Where, for example,
the consideration includes shares or loan notes to be issued by the buyer, or
involves a choice as to the form of consideration, then complications can arise.
One possibility, more likely in situations where the private equity investor is
a minority shareholder, is that the private equity investors may look to obtain
priority for the cash element, leaving the managers with the less liquid forms
of consideration. Beyond the practical difculties of dening ‘an equal price
per share’ if the investors get cash and the managers receive, say, consideration
shares in the capital of the buyer, such a position will most likely be viewed by
the managers as unfair.
Even if such a priority claim for cash consideration arguably has some
merit to protect a minority private equity investor (who is less likely to drive
the exit negotiations), this is much harder to argue where the private equity
investor is in a controlling position and leads the sale negotiation. In those
cases, managers may look to argue that they themselves would not wish to be
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dragged into some form of illiquid consideration – especially if there is invest-
ment or credit risk in the shares or loan notes, and no ready market in which to
sell them – and seek priority on the cash consideration for their own shares.
Inevitably, the usual compromise is that each form of consideration will be
split and shared amongst the sellers pro rata to their respective shareholdings.
However, the nal outcome on the apportionment of any non-cash considera-
tion may be a function of the bargaining power of the parties, as well as their
respective shareholdings.
4.14 Directors: appointment, removal and conflicts
The articles will usually set out more detailed provisions relating to the rights
of the private equity investors to appoint investor directors and the chairman,
as described in section 3.9 above. Similarly, if the private equity investors have
a hard right to appoint or remove any director, this provision is often found in
the articles. There are advantages to placing this mechanism in the articles,
as the articles can confer a constitutional right upon the relevant member or
members to exercise the power; if the member serves the relevant notice, then
the appointment or removal takes effect automatically assuming the right is
drafted correctly. For the reasons noted in chapter 11, it is preferable that a
right of removal in particular is included within the articles should the inves-
tors wish to remove a director.
49
Chapter 11 also describes the new statutory duties of directors in some
detail, including the new statutory duty on all directors (including any investor
director) not to allow himself to be in a situation where he has a duty or inter-
est which conicts or may possibly conict with his duties to the company.
As described in that chapter, many private equity investors have adopted the
practice of including wording in the articles to approve, in advance, the situ-
ational conict which can arise where a private equity director is also inter-
ested in, or has a duty to, the private equity investor or one of its other investee
companies.
50
4.15 Quorum
The articles will normally contain express quorum requirements for general
meetings and for board meetings. The precise terms may vary, but typical pro-
visions would be that a general meeting is not quorate unless a private equity
investor is present by corporate representative or by proxy, and that (if there is
an investor director in ofce) a board meeting is not quorate unless the investor
director is present or agrees to it taking place in his absence. In deals where
the private investors are in control or have a material minority stake, this is
normally not viewed to be controversial. More challenging is the suggestion
49 See chapter 11, section 5.3.
50 See chapter 11, section 6.7.
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sometimes made that a manager shareholder (or a manager as director) must be
present as part of the quorum at the relevant meeting. This is normally strongly
and successfully resisted by the private equity investors, principally because
they do not wish the meeting to be delayed or its business frustrated by man-
ager non-attendance. This is particularly sensitive if urgent action is needed, or
some disagreement exists or is anticipated between the private equity investors
and the managers.
4.16 Class rights for investors
As mentioned in section 3.12 above, the traditionally long list of class vetoes
has been shortened in more recent transactions, mainly reecting the shift
from minority investments to institutionally controlled buyouts. However, it is
still usual to see a brief list of class vetoes in the articles. Such provisions will
usually state that the class rights attached to each class of shares may not be
varied or abrogated without the consent of the holders of a particular majority
(typically, 75 per cent) of that class, and will then state that for these purposes
the rights attached to the investor class of shares are deemed to be varied
or abrogated if certain matters are transacted without their consent. This has
the effect of enshrining within the articles a list of fundamental matters that
should not be transacted without investor consent.
A typical list of explicit class rights includes:
(a) changes to the authorised share capital of Newco or to its issued share
capital (including consolidation, sub-division, redemption or buyback);
(b) reduction or return of capital;
(c) allotment of shares, or the granting of share options or share conversion
rights;
(d) any change to the memorandum or articles of association of Newco;
(e) re-registration of Newco as a public limited company, or as unlimited;
and
(f) registering any transfer of shares not permitted by the articles.
Such rights are often included within the separate list of investor consents
included in the investment agreement as described in section 3.12; however,
it is quite common to see the ‘belt and braces’ approach of these more funda-
mental concerns being included as a separate class consent as well, to provide
an additional level of protection for the investors.
The question sometimes arises of whether any specic class rights should
be given in respect of the manager shares. This will normally be resisted by the
private equity investors, particularly if the investment is institutionally con-
trolled. It is perhaps more likely that managers will be able to negotiate some
explicit class rights in the context of a secondary buyout – due both to the
increased bargaining power of the rolling managers, and to the more compel-
ling need for the managers to protect their rolled investment. If any class rights
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are agreed to, there will usually be a mechanism to reduce or cancel these
rights in a distress or underperformance situation.
5 Investment disclosure letter
A more detailed explanation of the role of the disclosure letter in the acquisi-
tion agreement as a defence to warranty liability is set out in section 3.1 of
chapter 4. Those general comments apply also to the investment disclosure
letter written by the managers to the private equity investors in respect of the
warranties in the investment agreement. However, it is important to realise
that, in practice, the investment disclosure letter is generally a much shorter
document than its equivalent in the acquisition process. In some transactions,
there may be no investment disclosure letter at all.
To understand the reasons for this, it is helpful to consider the typical war-
ranties in the investment agreement (already highlighted in section 3.4 of this
chapter):
(a) Warranties about the manager and his personal and business history.
Depending upon how these are worded, it is often the case that no
actual disclosure is necessary. Assuming the manager has a relatively
clean history, nothing may need to be said. The former practice of ask-
ing detailed questions of the managers as part of the warranties (which
would require detailed disclosure of matters such as employment his-
tory or previous directorships) has been superseded by the completion
of a manager’s questionnaire or declaration containing that factual
information, with a straightforward warranty that the content of such
document is true.
(b) Warranties on the preparation and reliability of the Business Plan. Some
disclosure may be needed here but, generally speaking, if something has
changed or come to light since the draft Plan was rst prepared, most
private equity investors would rather that the Plan itself was altered to
be in a form that matches the warranty by the time the investment agree-
ment is signed. Indeed, some private equity rms will not accept any
disclosure against the Business Plan warranty for exactly this reason.
(c) Warranties on the accountants’ report and other commissioned due dili-
gence reports. Some disclosure may be needed here. Again, the private
equity investors would rather that the managers fed any comments to
the accountants or other reporters on the various drafts of the reports
so that, by the time the nal versions of the reports are issued, they can
be covered by the warranty without the need for disclosures. However,
if there is a difference of view (the managers believe one thing and the
accountants or other reporters another), or if there is a time pressure
which prevents the reports being completely updated, some disclosures
will usually be accepted.
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(d) A back-to-back warranty conrming the acquisition agreement warran-
ties. Again, some disclosure may be needed here. However, if the man-
agers are also involved in the preparation of the acquisition agreement
disclosure letter, that letter should contain details of all relevant matters
within their knowledge, and as a result there should be no need for sepa-
rate disclosure in respect of the back-to-back warranty in the investment
agreement.
Occasionally (as highlighted in section 3.5(a) of this chapter), the private equity
investors will be persuaded to rely only on warranties from management in
relation to certain historic matters relating to Target that the seller is not pre-
pared to warrant in the acquisition agreement. In these cases, it is more likely
that additional disclosures will need to be made in the investment disclosure
letter on those matters. If this is the case, the disclosures against those warran-
ties are clearly more likely to resemble the disclosures that would usually be
found in the acquisition disclosure letter. Similarly, in those circumstances, the
managers are more likely to seek more extensive and protective limitations in
the investment agreement than they would seek on the more typical investment
agreement warranties. This extends to seeking more extensive general disclo-
sures in the investment disclosure letter akin to those found in the acquisition
disclosure letter. In the absence of such warranties, however, the general dis-
closures contained in the investment disclosure letter will be far more limited,
again to reect the reduced need to qualify warranties of the nature described
in paragraphs (a) to (d) above.
6 Loan note instrument
As outlined in chapter 3, most modern private equity transactions involve the
investors subscribing for loan notes rather than preference shares, in addition
to equity shares.
51
There are several different forms of loan note used by dif-
ferent investors and the tax, regulatory and banking issues that arise in respect
of those different loan notes can create bespoke, and complex, drafting.
52
However, there are also some common features and issues that arise irrespec-
tive of the type of loan note used.
It is important to bear in mind that the terms of the banking documentation,
in particular the intercreditor agreement, will regulate the ability of a private
equity investor to exercise any of the rights in the loan note instrument, or the
ability of the issuing company to honour it. As described in chapter 6, the inves-
tors are often not entitled to receive any payments until both the senior debt and
any mezzanine debt has been repaid in full without the lenders’ consent.
53
51 See chapter 3, section 2.2(b).
52 See chapter 9, section 2.2, for details of certain types of loan note, and their respective tax
treatments.
53 See further chapter 6, section 4.3.
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6.1 Form of instrument/loan notes
The loan note instrument is usually a deed poll executed by the issuer which
confers rights on the note holders for the time being, but does not require a
note holder to be a party to it. The loan notes will usually be in registered form,
that is to say that the issuer will maintain a register of note holders, and legal
title is proved by entries in the register. The instrument will set out the relevant
provisions for such registration. Once the relevant holder is entered in the loan
note register the terms of the loan are prescribed by the loan note instrument,
in much the same way as the rights of a shareholder are set out in the articles of
association upon that shareholder being entered in the register of members.
6.2 Yield and repayment
The instrument will set out the rate of interest that is payable on the notes, how
it is calculated, when it is paid (or compounded), and what happens if it is not
paid. As noted above, whilst it is possible that loan note interest will be paid
on the notes, it is more common for the intercreditor agreement to prohibit the
payment of any cash interest (or at least a substantial proportion of it) until any
prior-ranking bank debt has been repaid in full. In those cases, as outlined in
chapter 9, interest payments may instead be satised by the issue of Payment
In Kind notes (‘PIK Notes’). These are simply loan notes, usually in the same
form as the existing notes, which are issued to the existing note holders for an
amount equal to the amount of accrued interest.
The loan note instrument will also set out details of when the loan notes
are repayable and the terms and mechanics for this. Usually, there will be a
bullet or single repayment of the loan notes scheduled for a future date which
is at least twelve months following the date on which all prior-ranking bank
debt has been repaid.
6.3 Events of default
The loan note instrument will include details of the circumstances in which
note holders are able to demand repayment of the loan notes ahead of the nor-
mal due date. The precise terms will vary, but typical events include:
late payment of interest (after a grace period);•
other breaches of the loan notes instrument;•
other breaches of the investment agreement or the articles (if included, •
this may be limited to breaches of certain clauses, and subject to a grace
period to remedy rst);
cross-default in the event that any senior term debt becomes repayable •
early;
insolvency or administration affecting the issuer (or sometimes other •
key members of the group); and
a sale, listing, winding up or other exit event.•