A Practical Guide to Private Equity Transactions

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•

it is duly incorporated and validly existing

•

its obligations under the SFA and other financing and transaction documents are legal,

valid and binding

•

entering into the financing documents will not conflict with other obligations binding upon it

•

it has the power and authority to enter into the financing documents and the other

transaction documents

•

the law chosen to govern the financing documents is valid and the documents will be

admissible in evidence

•

it is not insolvent

•

no stamp duty or filing taxes will be payable in connection with execution of the financing

documents

•

none of the information it has provided in relation to the transaction is misleading

•

its financial statements give a ‘true and fair’ view of (if audited) or ‘fairly represent’ (if

unaudited) its financial position for the period to which they relate

•

no material litigation or proceeding is pending or threatened against it

•

all taxes due have been paid

•

it has good title to all its assets

•

it legally and beneficially owns all shares in Ta rget (or will upon completion of the acquisition)

•

all material intellectual property is beneficially owned and not infringed

•

the documents recording the terms of the acquisition that have been supplied to the debt

providers are true and complete and record all terms of the acquisition

•

Topco and Bidco are holding companies only and have not engaged in any activity

other than the acquisition of the Ta rget group

•

all pensions are fully funded or operated and maintained in accordance with all applicable

laws (including statutory funding objectives and minimum funding requirements)

•

no security or financial indebtedness is in place other than as permitted under the SFA

Figure 6.1 Representations and warranties

certain circumstances. As a result, the negotiation of the terms of the represen-

tations and warranties is a good opportunity to ush out any potential issues

with the Target group or business that may not have come to light through

other means.

(f) Positive and negative undertakings

The various members of the group will also be required to adhere to cer-

tain positive and negative undertakings. The essence of the undertakings

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•

obtain and maintain all authorisations required

for business

•

comply with all applicable laws and regulations

•

ensure its obligations to the debt providers rank at

least pari passu with its obligations to all other

creditors

•

maintain adequate insurance

•

maintain material intellectual property

•

maintain its accounts with approved banks and

implement agreed cash management processes

•

pension schemes to be fully funded or, in case of

defined benefit schemes, to be operated and

maintained in accordance with applicable laws

•

allow lenders access to books and records

following defaults

•

enforce its rights under the acquisition documents

•

pay all taxes when due

Figure 6.2 Positive undertakings

ensures that the business is maintained and operated lawfully and within

certain agreed parameters so as to prevent any leakage or diminution of

value, or any activity that could be considered to be prejudicial to the posi-

tion of the debt providers. The exact nature and extent of the undertakings

will be subject to considerable negotiation between the debt providers and

the investors.

The right balance needs to be struck between preventing actions that could

be considered to be prejudicial to the position of the debt providers, and allow-

ing sufcient operational exibility on a day-to-day basis. Figures 6.2 and

6.3 list the main positive and negative undertakings that would typically be

included. As with the representations, the nature and extent of the undertak-

ings may be expanded to deal with specic matters relating to the transaction

or specic circumstances affecting the Target group or the type of business in

which it is engaged.

(g) Financial covenants

Whilst the positive and negative undertakings will monitor operational per-

formance, nancial covenants will be included in the SFA to monitor the

nancial performance of the business. The role of the nancial covenants can

be summarised as:

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• not to create security over any of its assets

except as permitted or arising by operation of law

• not to dispose of any assets except as permitted

• not to incur financial indebtedness except as

permitted

• not to make acquisitions, or enter into joint

ventures or mergers, except as permitted

• not to change the nature of its business

• not to grant loans or give guarantees in favour

of third parties

• not to pay or make dividends or make any

payment in relation to any mezzanine debt or

investor loan notes except as permitted

• not to enter into any transactions other than on

arm’s length terms

• not to amend the acquisition documentation

• not to enter into treasury or derivative

transactions except as permitted

Figure 6.3 Negative undertakings

ensuring nancial discipline within the group;•

monitoring the nancial strength of the group;•

ensuring that the nancial performance of the group remains acceptable •

and grows in line with the expectations of the debt providers and the

projected growth set out in the base case model in the Business Plan;

in the case of a breach of covenant, giving the debt providers an ability •

to accelerate the debt, cancel their commitments and/or put the facilities

on demand at an appropriate stage before the value in the group has been

signicantly eroded due to underperformance.

Typically, the following nancial covenants will be sought by funders:

(a) Leverage, being the ratio of total debt to earnings of the group. The

funders will expect the group to de-lever over time as debt is amortised/

prepaid and earnings grow.

(b) Interest cover, being the ratio of earnings of the group to debt service

costs. This will test whether the group can generate sufcient earnings

to more than cover its interest payments and other nance charges.

Whilst the interest cover covenant will measure business performance,

the cash ow cover test will measure whether the group has enough

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actual cash to meet all payments that are due in respect of its debt

(including interest, fees and scheduled principal repayments).

Each of the above covenants will be measured at the end of every nancial

quarter on a rolling twelve-month basis by reference to the nancial perform-

ance of the group over the prior four quarters. Special provision will usually

be made for the rst three quarters following completion of the acquisition in

order accurately to test early performance. This may take the form of: (a) tak-

ing into account pre-acquisition performance to achieve a full twelve-month

testing period; (b) testing at the end of each quarter on a ‘last quarter annu-

alised’ basis; or (c) testing against the actual results achieved over the actual

period elapsed since the completion of the acquisition.

In addition to the above, the debt providers may also wish to place cer-

tain annual limits on the amount of capital expenditure that can be made

by the group in each nancial year. This could be tested by reference to

actual monetary limits or a limit set at a percentage of the projected capital

expenditure set out in the base case model in the Business Plan (e.g. 110

per cent).

Financial covenants are very carefully negotiated. History shows that they

are often the rst covenants to be breached in a transaction. Consequently, far

from being standard, the actual detail of the covenants and the way in which

they are calculated will be deal-specic and will need to be tailored to reect

the basis on which the group draws up its accounts, and the assumptions and

criteria on which the Business Plan has been prepared. The ratio levels for the

leverage and interest cover covenants will usually be set at a certain headroom

to the ratios that are projected to be achieved in the base case model in the

Business Plan (typically, 20 per cent). The cash ow cover covenant will typic-

ally be set at a constant level of 1.1:1 or 1:1.

In recent years, investors looked to secure mechanisms that would allow

them to remedy nancial covenant breaches so as to avoid funders cancel-

ling the funding commitments and accelerating their loans for temporary peri-

ods of underperformance that are not representative of an ongoing downward

performance trend. These so-called ‘equity cure’ provisions effectively allow

the investors to put in additional equity capital (or subordinated loans) which

would be treated (depending upon the mechanisms that are negotiated and

agreed) as bolstering earnings or cash ow or perhaps notionally reducing debt

by, in effect but not in reality, treating the new cash as having been used to pre-

pay debt. Once the cash is injected, the covenants would then be recalculated,

and if the relevant ratios are met following the recalculation the breach will be

treated as having been cured.

Where these cure provisions are agreed, the investor would have a limited

period of time following the occurrence of the nancial covenant breach to

opt to put in additional capital. In addition, the debt providers would also

place limitations on the number of times (typically, two or three) that the

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cure provisions may be invoked, and prohibit the use of the cure on two con-

secutive covenant test dates. The rationale for that is that a need to cure more

frequently suggests a more general downward performance trend within the

business.

Given the current market circumstances, and the fact that banks are likely

to be more rigorous in their funding terms going forward, it is questionable

whether they will continue to agree to the inclusion of equity cure provisions

in mid-market transactions.

(h) Events of default

Certain specied triggers will be included in the SFA which will lead to an

ability on the part of the funders to accelerate and demand repayment of

their debt: these are referred to as ‘events of default’. These will relate to

situations where the group breaches the terms on which the debt has been

provided or situations that materially impact on the viability of the busi-

ness, its value or the legal efcacy of the transaction. Figure 6.4 sets out

brief details of the events of default that will customarily be included in

the SFA.

The private equity house will be concerned to avoid hair-triggers leading

to a withdrawal of the debt funding. Consequently, cure rights (where defaults

can be cured) allowing the group to take immediate steps within a specied

period of time to reverse the breach and other materiality thresholds will be

negotiated.

4.2 Mezzanine facility documents

(a) Mezzanine Facility Agreement

Mezzanine nance is a secondary source of nance for Bidco in the context

of an acquisition. As has already been outlined, the advent of mezzanine orig-

inally came about to provide investors with a source of nance that would

bridge the gap between (a) the purchase price and acquisition costs and (b) the

aggregate of the amount of funding that the investor is prepared to commit and

the amount of senior debt that can be raised in the market.

The Mezzanine Facility Agreement (MFA) will set out the terms and

conditions attaching to the provision of the mezzanine debt. It will be based

upon and follow very closely the terms and conditions set out in the SFA,

and will usually be prepared once the SFA negotiation is well progressed.

The key differences between the MFA and the SFA can be summarised as

follows:

(a) Mezzanine debt will comprise only a term loan to be utilised in conjunc-

tion with the senior term loan to meet the purchase price and acquisition

costs. Working capital facilities and ancillary facilities will not be pro-

vided on a mezzanine basis.

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• failure to pay sums when due

• breach of positive or negative undertakings

• breach of financial covenants

• representations or warranties found to be untrue or misleading when made or

deemed repeated

• cross default with other indebtedness (subject to de minimis thresholds)

• material adverse change in the business

• insolvency and related events

• unlawfulness, invalidity or rescinding of the financing documents or

the acquisition documents

• material audit qualification to the group’s accounts

• failure to comply with the terms of the intercreditor agreement

• material litigation

• expropriation of assets

• default under the mezzanine facility agreement (if applicable)

• change of ownership

Figure 6.4 Events of default

(b) Mezzanine debt will be junior to the senior debt. In other words, it will

rank in right of repayment at all times behind the senior debt and will

usually take the benet of a second-ranking interest in the security pack-

age taken by the senior debt providers. Consequently, whilst the provi-

sions relating to mandatory prepayment in the SFA will be mirrored in

the MFA, they will be disapplied until the senior debt facilities have

been prepaid and discharged in full.

two years of the loan.

(d) The nancial covenants set out in the MFA will mirror those set out in

the SFA but the testing ratios will be set at a level which provides addi-

tional headroom (typically, 10 per cent) over the testing ratios set out in

the SFA.

(e) Due to the junior nature of mezzanine debt, and consequently the greater

risk to the mezzanine debt providers of ensuring repayment in full, mez-

zanine debt will command a higher rate of return than senior debt.

As outlined in chapter 3, this higher rate of return would typically be

achieved through:

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a higher interest rate on the debt which may be split into a rate of •

cash pay interest (interest that must be paid on a quarterly or six-

monthly basis by Bidco) and non-cash pay interest (interest that is

calculated on the outstanding debt on a quarterly or six-monthly

basis, but is rolled up and only payable at the end of the term when

the principal is repaid). This is referred to as payment in kind (PIK)

interest; and

possibly, an ‘equity kicker’. This refers to the issue of warrants by •

Topco to the mezzanine debt providers which will allow them to sub-

scribe for shares in Topco at the time, for example, of a sale or list-

ing of Topco. These warrants are aimed at providing (it is hoped)

an enhanced performance-related return for the mezzanine providers

over and above the cash pay interest and the PIK (see section (b)

below).

Investors are generally opposed to the equity kicker because it has the effect

of diluting the share capital owned by the investors at the time of the sale

or listing of Topco, and ultimately reduces the rate of return on their equity

investment. However, this view is not universal as there can be a tangible rela-

tionship, and other benets, by ensuring that the mezzanine provider has an

equity interest in the business.

Prior to August 2007, the market saw a growing trend in warrantless mez-

zanine with the mezzanine providers receiving only cash pay interest and PIK.

This move was principally driven by investors to avoid the dilution issue but,

whilst not necessarily welcomed by the traditional mezzanine houses, the cer-

tainty of return on warrantless mezzanine appealed as an investment to the

increasingly prevalent CDO and CLO funds that became more active in the

leveraged funding market. Current market circumstances will most likely see

a return of warrants into typical funding structures.

(b) Mezzanine warrants

A warrant instrument will be entered into, enabling Topco to grant an option to

the mezzanine funder(s) to subscribe for new shares in Topco. In appearance it

is similar to a loan note instrument, in that it entitles Topco to issue certicates

to the relevant funder(s) who are entered into a register of warrant holders, and

with effect from such registration the holders are bound by the general terms

set out in the instrument. The exercise price of the warrants is normally par, so

that it entitles the mezzanine funder to low-cost equity in order to provide the

kicker referred to above.

The following commercial issues arise when drafting or negotiating a mez-

zanine warrant:

(a) How many warrant shares? This is not as straightforward a question as

it may seem. Mezzanine funder termsheets will typically say that war-

rants are to be granted over a percentage of the fully diluted share capital

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of Topco (e.g. warrants representing 3 per cent of the fully diluted share

capital). However, what is often unclear is whether the warrant will be

over a xed number of shares that represent that proportion of the equity

as at the execution of the warrant instrument, or whether the warrant

will be over such number of shares as represents that percentage of the

equity upon it being exercised. For example, in the event of future fund-

ing rounds by way of share issue, a warrant holder entitled to 3 per cent

of the equity as at the exercise of the warrant would effectively get a

‘free ride’ on that future funding round (i.e. it would remain entitled to 3

per cent of the enhanced equity even though it has not put any money in

at the time of the further funding round). Similarly, in the event of any

shares being bought back by Topco in the future, a mezzanine funder

entitled to receive a xed percentage of the share capital would receive

fewer shares upon the warrant being exercised (i.e. its overall stake is not

increased pro rata by virtue of the buyback being completed, which it

would be if it were a shareholder). A mezzanine funder’s starting-point

will often be that it wants the xed number of shares, or (if greater) that

number of shares which entitles them to the relevant percentage stake –

but this can be negotiated, for example by stating that dilution should

apply if warrant holders choose not to participate in the funding round

on a pro rata basis (see also below).

(b) When can the warrants be exercised? As a warrant holder typically

holds a warr ant in order to participate in the exit, it follows that a mezza-

nine warrant should in practice only be exercisable conditionally upon

an exit occurring. Notwithstanding this, many mezzanine funders start

negotiations by requesting that their warrant should be exercisable at

any time (in order that they could exercise their discretion to become

a shareholder before an exit actually arises), although the investors and

management shareholders may well resist this. Where a warrant is to be

exercised at any time, provision should nevertheless be included for the

warrant to be exercised conditionally upon an exit occurring in order

that a mezzanine funder can elect to serve a notice that it will be enti-

tled to the warrant shares only upon an exit arising should that become

necessary. Consideration should also be given as to whether the warrant

can be exercised in whole and once only, or whether it can be exercised

in part and on a number of different occasions. The shareholders will

prefer a warrant holder only to be entitled to exercise its warrant once in

respect of all of the relevant shares to avoid inconvenience, and in prac-

tice most mezzanine funders would have no objection to this.

typically start from the perspective that their warrants should be freely

transferable. However, in theory, this could allow external warrant hold-

ers of whom the other shareholders do not approve – and accordingly it

is usual to include restrictions such that the mezzanine warrants can only

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be transferred (a) to persons to whom the mezzanine facilities themselves

are transferred (which will usually be prescribed by the MFA) or (b) to

such other persons as they would be entitled to transfer the underlying

warrant shares if they had exercised their warrants (effectively ensuring

that the mezzanine shares are subject to the same pre-emption rights and

any other restrictions on transfer as any issued shares). It is important

to ensure that any such transfer restrictions do not operate in any way

which may hinder the ability of all of the shareholders, and the mez-

zanine funder, to achieve the relevant exit. Equally, provisions should

be included to ensure that a sale of the entire issued share c apital can be

completed (and that the warrant will lapse if not exercised), provided the

mezzanine funder has been given an opportunity to exercise any war-

rants and participate in the exit.

(d) Should the warrant holder be entitled to board representation? Warrant

holders may request the right to appoint a representative director to

the board, although this would usually be resisted by the investors. An

observer might be an acceptable compromise, or agreement could be

reached that any such party may attend board meetings only if there is a

default under the MFA.

(e) Anti-dilution protection. In the event of any future funding rounds

involving the issue of shares, the mezzanine funder will typically

require protection that no new shares can be created without the con-

sent of the warrant holder(s), unless such new shares created are either

offered to the warrant holder(s) pro rata as if it were already a share-

holder, or alternatively are taken into account when determining the

overall proportion of the equity which the warrant entitles the holder

to obtain (in the event that the warrant is over a xed percentage of the

share capital, rather than a xed number of shares). It is also possible

that future bona de reorganisations could affect the position of the

warrant holder (for example, bonus issues, or a consolidation of share

capital). Accordingly, provisions should be included for an adjustment

to the number of warrant shares and/or the exercise price in order to

ensure that the warrant holder’s position is not affected by any such

restructuring. This will typically be subject to independent verication

(if required) to be undertaken by the group’s auditors, or by an inde-

pendent accountant.

(f) Should the warrant holders have any other protections? For example,

a prohibition on the payment of dividends or excessive remuneration to

management without the warrant holder’s consent is often required (as

paying such dividends would effectively dilute the value of the under-

lying business and hence the warrant). The warrant will also usually

include rights to receive nancial information (at least the audited and

management accounts). Provisions are also usually included for the war-

rant holder to be kept informed of the progress of any exits, and with

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a time period for notication of that exit to the warrant holders prior

to such exit being transacted (e.g. no exit may arise unless the warrant

holder has had ten business days’ prior notice), during which period the

warrant holder may exercise its rights to participate in the exit.

4.3 Intercreditor Agreement

Given the different levels of debt being provided to Bidco on different risk/

rate of return proles, it is essential that the respective rights and rankings of

each type of creditor throughout the term of the nancing are regulated. As

discussed in chapter 3,

the rights of the various creditors can be regulated in

two ways:

(a) contractual subordination: a position where the competing rights of

creditors against the same corporate entities within a group are regulated

by contract; and

(b) structural subordination: a position where the rights of creditors are

regulated in their priority by principles of company and insolvency

law, with the result that the closer a creditor is to the operating/current

assets or cash ows the more it will be structurally senior in right of

payment.

Figure 3.3 in chapter 3 sets out a diagrammatic representation of how true

structural subordination may be achieved, although it is probably fair to say

that most transactions will incorporate an element of both structural and con-

tractual subordination.

This would particularly be the case where a transaction contains both

senior secured and mezzanine secured indebtedness. In this situation, whilst

the senior debt may be funded directly to Bidco, the mezzanine debt to Midco

and the investor debt to Topco (giving the appearance of structural subordin-

ation of the mezzanine debt and the investor debt), it would be usual for both

the senior and mezzanine facilities to be guaranteed by and secured against the

assets of the whole group (including the Target group) (see Figure 6.5). This

effectively creates competing rights of the senior and mezzanine creditors at

every level of the corporate group structure, and competing rights of the senior

and mezzanine creditors and the investors at the Topco level. Ultimately, there-

fore, this will lead to a need for the priority of those competing claims to be

regulated by contract.

Typically, the intercreditor agreement will be signed by Topco, Midco,

Bidco, the members of the Target group and all debt (senior, mezzanine and

investor) providers.

Intercreditor agreements by their very nature are heavily scrutinised by

each group of debt providers and will invariably be heavily negotiated. A brief

16 See chapter 3, section 2.3(b).