A Practical Guide to Private Equity Transactions

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197

Financing documentation

Key:

debt

security trust arrangements

provision of guarantees and security for the senior and mezzanine debt

Senior debt providers

Security trustee (as trustee

for the senior and mezzanine

debt providers)

Mezzanine debt

providers

Target

Target Subsidiaries

Topco

Midco

Bidco

Figure 6.5 Security structure

summary of the key matters that will be covered in an intercreditor agreement

is set out below.

(a) The rights of the investors in respect of any loan notes will be deeply

subordinated to the rights of the senior and mezzanine debt providers.

This essentially means they will not be entitled to receive any payments

until both the senior and mezzanine debt are repaid in full. In some

cases, there may be negotiated exceptions which might allow for a run-

ning yield to be paid on the loan notes. If this is accommodated by the

senior and mezzanine debt providers, it would usually be subject to con-

ditions around nancial covenant compliance (both on a look forward

and look back basis), and no default having occurred or subsisting under

the senior and/or mezzanine facilities.

(b) Mezzanine debt providers will be subject to certain payment restric-

tions. The previous section of this chapter explained that the terms of

the mezzanine debt will usually have the debt principal repayable in one

bullet repayment, scheduled to occur twelve months following the con-

tractual term of the senior debt. On top of that, the servicing by Bidco

of periodic cash pay interest obligations on the mezzanine debt will

198

Debt funding

generally be subject to restrictions should an event of default in respect

of the senior debt occur. Such payment blockage would typically remain

in place until the senior event of default is cured.

event that Bidco is unable to service its debt and, accordingly, the secu-

rity package is enforced. In keeping with the intended priorities of senior

and mezzanine debt, once all costs of enforcement have been met, the

remainder of the proceeds of enforcement will be applied, rst, to meet

outstanding obligations in respect of the senior debt and, secondly, to

meet outstanding obligations in respect of the mezzanine debt.

(d) Certain restrictions will be placed on the ability of the mezzanine funders

to take any of the following actions in circumstances where Bidco is in

default under the terms of the MFA:

(i) exercising any right to enforce any security;

(ii) suing or instituting any other creditors’ process against any mem-

ber of the group;

(iii) petitioning for or taking any steps to initiate any insolvency, liquid-

ation or dissolution proceedings against any member of the group; or

(iv) accelerating and calling for immediate repayment of any of the

mezzanine debt or otherwise putting the mezzanine debt due and

payable on demand.

These restrictions are generally designed to ensure that the senior debt provid-

ers retain as much control as possible over the destiny of the group in a default

scenario, since they would typically have the most to lose. Rather than being

a strict prohibition, these restrictions are usually coupled with a concept of

standstill. Standstill puts a maximum time limit on the inability of the mezza-

nine debt providers to take action following an event of default under the MFA

(usually between 90 and 180 days).

This standstill period affords the senior debt providers a period of time in

which to work out a strategy to deal with the default, but gives the mezzanine

funders comfort that they can ultimately take action at the expiry of the stand-

still period if a suitable strategy for maintaining the facilities has not been

agreed and the event of default under the mezzanine debt continues to subsist.

As the loan notes held by the investors are usually deeply subordinated

to the senior debt and any mezzanine debt as referred to above, the loan note

holders are generally prohibited from taking any of the actions in paragraphs

(i) to (iv) in respect of amounts due under the loan notes without the consent of

both the senior and mezzanine lenders.

5 Security requirements of funders

The debt providers will require the legal due diligence on the Target group

to include a detailed analysis of its existing indebtedness, and an appraisal

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Security requirements of funders

of the existing security interests that subsist over its property and assets. The

results of this analysis will be material to the debt providers (both senior and

mezzanine) since they will be reliant upon recourse to those assets to protect

their debt investment. It will also, with few exceptions, be a condition to the

provision of funding that all existing nancing arrangements of the Target

group are discharged in full, and all associated security for those arrangements

released.

An example of how a security package may be structured is set out in

Figure 6.5. Essentially:

All the companies within the group will provide guarantees of the sen-•

ior and mezzanine debt. This will be achieved by the accession of the

members of the group to the guarantee provisions that are included in

each of the SFA and the MFA. In the case of Bidco, this will still be a

requirement notwithstanding that it is the main borrower. This is essen-

tially because other companies within the group may become borrowers

under the senior working capital facilities and incur a portion of the debt

funding themselves.

Under the terms of the intercreditor agreement, each of the senior debt •

providers and the mezzanine debt providers will appoint a common

institution to act as their security trustee. The trustee will then take

the benet of all the security interests granted by the members of the

group and hold them on trust for the debt providers. The intercreditor

agreement will contain detailed provisions as to how the security is to

be held, what the security trustee can do, whose instructions it must act

upon and how proceeds of the security (in circumstances of enforce-

ment) are to be allocated among the debt providers, in each case in

line with the agreed priority between the senior and mezzanine debt

providers.

The security will comprise: (i) full xed and oating charges over all •

the assets of each member of the group (including the shares in their

subsidiaries); (ii) an assignment by way of security of rights in respect

of material contracts (including the acquisition documents, any hedg-

ing agreements and potentially certain material customer contracts); and

(iii) an assignment of any keyman insurance policies put in place by the

group in respect of key members of management.

Until recently, English law prohibited companies from giving nancial assist-

ance for the purchase of their own shares or the shares in their parent com-

pany. Looking at the security structure set out in Figure 6.5, the giving of

guarantees and security by members of the Target group to support the debt

incurred by Bidco to acquire the shares of Target would historically have con-

stituted prohibited nancial assistance. Notwithstanding the prohibition, in the

case of private companies the assistance could be given if the company went

through a procedure (known as the ‘whitewash’ procedure) specied under

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Debt funding

the Companies Act 1985.

Depending upon the size of the Target group, this

process could be very cumbersome and costly, and was a key feature of lever-

aged acquisitions. To the relief of many, with effect from 1 October 2008 the

prohibition on the giving of nancial assistance by UK private companies was

abolished, although the prohibition still remains in the case of public com-

panies and subsidiaries of public companies (see further chapter 10

), and the

situation must also be checked for any overseas subsidiaries. However, each of

the relevant directors will still need to be mindful of their duciary duties to

every company of which they are a director that is granting security, and must

therefore be satised (by way of example) that there is a corporate benet of

doing so for each such company, and that this will not result in any unlawful

distribution.

6 Alternative ﬁnancing structures for larger transactions

6.1 Background

In the context of larger transactions, prior to the credit crunch there was an

increasing trend for funding to be drawn from a combination of senior debt

nance and high-yield debt, with the high-yield debt being utilised in favour

of mezzanine debt. This alternative was only really available in the context of

larger deals since, in general terms, the minimum size of offering worth pursu-

ing in the high-yield bond market is about £150 million.

In such larger deals, the utilisation by Bidco of the capital markets to raise

nance by issuing medium-to-long-term debt instruments presented an attrac-

tive source of nancing for the following reasons:

(a) the term of high-yield bonds usually ran to between ten and twelve

years, which is longer than the term usually seen in mezzanine nance

agreements;

(b) high-yield bonds generally attracted a lower rate of return than mezza-

nine nance; whilst the interest payable on high-yield bonds would all be

cash pay (i.e. no deferred PIK), high-yield bond holders did not require

the provision of warrants;

(d) high-yield bonds did not have the same strict package of maintenance

covenants and undertakings as would otherwise be included in the SFA

or MFA; and

17 See sections 151–157 of the Companies Act 1985 (now repealed by virtue of the Companies

Act 2006). Essentially, the procedure involved all the directors of a company intending to

give nancial assistance swearing certain statutory declarations as to solvency that were

reported on by the auditors.

18 See chapter 10, section 4.2.

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Alternative ﬁnance structures for larger transactions

(e) in transactions that utilised a combination of senior debt and high-yield

debt, it has historically been possible to achieve higher leverage ratios.

In other words, Bidco was able to raise higher levels of debt, thereby

increasing the debt-to-equity ratio and consequently facilitating higher

rates of return for the private equity investors on a successful exit.

Recently, given the downturn experienced in condence in the capital markets,

the use of high-yield bonds has been almost non-existent. However, the market

will no doubt return and this type of nance will again be considered in the

context of acquisition nance structuring.

One of the key problems with using high-yield debt funding in the context

of an acquisition is the logistical issue of ensuring that Bidco has access to

sufcient funding on the day that the acquisition is due to close in accordance

with the terms of the acquisition agreement (and, in the case of a public-to-

private transaction, the requirements as to certain funding, discussed in chap-

ter 10,

are satised). Given the nature of raising nance in the capital markets

it is unlikely that this certainty would be afforded, and consequently ‘bridge

nancing’ techniques are utilised to deal with this.

6.2 Bridge debt

The use of bridge funding ensures that Bidco has committed bank facilities in

an amount sufcient to pay the purchase price for Target and meet all acqui-

sition costs on the date on which it is obliged to do so. However, due to the

perceived benets and the cheaper cost of high-yield debt, the full intention of

Bidco and its investors is to have this bridge funding renanced very quickly

following the completion of the acquisition with high-yield debt.

Given the nature of bridge lending, there are two particular features of this

type of nance that should be noted.

(a) Interest rates are typically subject to a ratchet. Essentially, the longer it

takes before the high-yield take-out offering is completed and the bridge

debt repaid, the higher is the rate of interest on the bridge debt. The fre-

quency of the ratchet and the amount of each increase in interest rate will

be negotiated on a deal-by-deal basis, but they are intended to be painful

since the underlying rationale is to incentivise a renancing of the bridge

debt as soon as possible.

(b) Cramdown. This term refers to a situation where, if the proposed high-

yield take-out has not occurred within a specied period of time, then

the bridge lenders can arrange a high-yield offering on the terms that

they feel are required in order to ensure that such offering is successful,

and require the private equity investors to accept such terms and proceed

with such offering.

19 See chapter 10, section 4.

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Debt funding

6.3 Structural subordination

One further nancial structuring issue that needs to be borne in mind for such

larger deals is the potential requirement for true structural subordination. It

was noted in section 5 above that the relative priorities and rankings of senior

and mezzanine debt were ordinarily likely to be policed and regulated by the

terms of an intercreditor agreement between the nancing parties and Bidco.

In other words, they were policed by contract. Senior lenders are often more

tolerant of such contractual subordination arrangements in mezzanine deals,

since the mezzanine market has historically comprised fewer participants and

these are well known to the senior lenders in the UK and Europe (and whose

behaviour in the context of an insolvency situation may be predicted).

In contrast, the high-yield market would invariably comprise a diverse,

global, anonymous community of bond holders that changes frequently.

Consequently, senior lenders are for more likely to insist that any high-yield

bond debt must be structurally subordinated to the senior debt funding.

7 Conclusion

There is no doubt that investors and nancial institutions face interesting

times. In the wake of the credit crunch, nancial institutions are re-pricing

risk, unwilling to offer high leverage multiples (anything above three times

EBITDA is proving more difcult to achieve), demanding lower gearing and

seeking to keep a tighter control on the businesses to which they lend money.

It has only been possible in this chapter to provide an overview of the his-

torical context that has shaped the current market, and to offer some thoughts

through experience about how the debt nancing of an investor acquisition

may look moving forwards and beyond 2009. There will be activity in the

mid-market in the UK, but it will likely be muted in the short term. It will be

more difcult for investors to identify opportunities that are attractive to them

as lower leverage, lower gearing and higher priced debt funding impact their

ability to meet their return hurdles (or at least meet them quickly).

The prevailing view is that mid-market activity is set to return more quickly

than activity in the high-value leveraged acquisitions market – good deals can

still be done, and debt funding is available. It is just going to take a little longer

to broker deals on terms that are acceptable to all involved.

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Employment-related issues

1 Introduction

In this chapter, we consider the key employment terms of the managers that

will need to be negotiated alongside the other transaction documents. Issues

concerning remuneration, notice periods, grounds for dismissal and the like

will often be emotive, and the negotiation of the managers’ service agreements

in the (often adversarial) context of the wider deal can accentuate this further.

Of course, it is important to the managers that their legal adviser ghts their

corner in negotiating a fair position. However, it is also true that a manager

needs to be mindful of the fact that generous terms negotiated for the benet

of that manager and his or her colleagues may come back to bite, should one

of those managers fail to deliver and need to be replaced. Like the negotiation

of the other equity documents discussed in chapter 5, the key is to ensure that

each manager balances his or her position as a director and shareholder of

Newco with their requirements as an employee.

We will also consider the interaction of the termination of employment

provisions in a service agreement with the equity position of the manager.

There is usually signicant overlap, such that an employment lawyer negotiat-

ing these terms needs to be familiar with the issues being discussed and nego-

tiated in the investment agreement and articles of association, and vice versa.

Common approaches to ‘Good Leaver’ and ‘Bad Leaver’ denitions, high-

lighted in chapter 5,

will therefore be considered again in the context of the

termination of a manager’s employment. In this chapter, we also address the

issues that arise on the termination of the employment of a manager, includ-

ing the manager’s potential contractual and statutory claims, and the common

terms of any settlement agreement.

Finally, we briey consider the ways in which employees who fall outside

the senior management team may be offered incentives linking their own remu-

neration to the performance of the business. Many private equity investments

rely on a signicant contribution being made by the so-called ‘second tier’

1 See chapter 5, section 4.11.

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Employment-related issues

within the management structure, and it is therefore common to see an incen-

tive scheme put in place to motivate those individuals towards the achievement

of a successful exit. Whilst the terms of such incentives may be less generous

than for the senior team, the rewards made available to such employees in the

event of an exit may nevertheless be signicant.

Throughout this chapter, we refer to Newco on the assumption that Newco

is the company employing the manager. This is usually, although not invari-

ably, the case, and therefore should be claried for any particular transaction.

Where a multiple Newco structure is adopted,

the Topco would usually (but,

again, not always) be the employer company.

2 Employment terms

2.1 Introduction

Whilst the equity terms are likely to be of primary importance to the man-

ager, there are certain employment terms that are also material, and therefore

likely to be the subject of negotiation. It is often sensible for these terms to

be highlighted in any initial equity termsheet or questionnaire, so that the

position may be ushed out or agreed at the outset of the deal, particularly

from the management team’s perspective if there is a competitive process

which may enable a more favourable position to be negotiated than if such

terms are left until the formal legal process when the service agreements are

documented.

These key terms may also have a direct impact on the manager’s equity

position, by virtue of the interaction of the relevant provisions and denitions

between the service agreement and the investment agreement and articles of

association. Care is needed to ensure that documentation is consistent, and

that such interaction does not inadvertently lead to an undesirable or otherwise

incorrect commercial outcome.

2.2 Notice

The notice period has a signicant bearing on the negotiation of any severance

package should a manager be dismissed. In practice, once the investors and/

or the other directors have decided that a manager should leave the business, it

would be rare for that manager to work during their notice period. Instead, it is

more likely that the manager will be placed on ‘garden leave’ (see section 2.3

below), or that they will be paid in lieu of notice (see section 2.4 below). It is

therefore important that both of these options are covered in the drafting of the

manager’s service agreement. Subject to that, the notice period will directly

inuence the quantum of any severance payment in the event that the employer

2 See further chapter 3, section 2.3.

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Employment terms

makes a payment in lieu of notice, or the quantum of any damages claim in the

event that the employer dismisses without giving due notice.

It would be usual for the service agreement to include a notice period that

is consistent whether the manager or Newco decides to terminate the rela-

tionship, although in some cases unequal notice periods are agreed, with the

longer period invariably required from Newco. A notice period of six months

each way is common for senior managers, with a period of three months each

way being an alternative for less signicant junior managers. Periods of nine

months or twelve months may arise for particularly senior, experienced man-

agers who are considered essential to the group’s success (from the employer’s

perspective), or who are able to negotiate a more favourable package (from

the employee’s perspective), but most investors will resist periods in excess of

six months other than in exceptional circumstances. Occasionally, there are

circumstances where an initial xed term is seen, for example on a secondary

buyout where the commitment of a rolling manager for a reasonable handover

period is considered important.

The notice period may also have an impact on the manager’s equity vesting,

if it is included for the purpose of determining whether shares have vested or

not. As vesting periods are generally stated to expire when employment is

terminated, it might appear obvious that any notice period served would count

towards determining whether shares are vested. However, many articles of

association are drafted so as to dene the termination date for these purposes

as the date on which any notice is served, rather than the date on which any

notice expires (or would be deemed to expire, but for a payment in lieu of

notice provision being exercised). This should always be a point for explicit

instructions in the event that a time-based vesting approach is agreed.

2.3 Garden leave

Any employer would generally be advised to ensure that it has the express

right to place the manager on garden leave during any period of notice.

Accordingly, most investors would include this as a standard requirement in

their service agreements. As noted above, it would be unusual for a manager to

be dismissed in circumstances where he would be required to continue to work

for his full notice period in a private-equity-backed company.

As is discussed in more detail in chapter 11, the rights of a manager as a

director must be considered on the termination of any employment, in addition

to the rights of the manager as an employee. To ensure that such rights do not

hinder the ability of Newco to exclude a manager from the business, inves-

tors will generally ensure that Newco can require the manager to resign any

3 See chapter 5, section 4.11.

4 It is advisable to include an express right to place an employee on garden leave in order to

make it clear that the employee does not have an implied right to work which precludes garden

leave: see William Hill Organisation Ltd v. Tucker [1998] IRLR 313.

206

Employment-related issues

directorships during the garden leave period. If this right is not included, the

manager may have a continuing right to be a director and, as such, have the

right to attend board meetings and to see board papers. The right to require the

manager to resign any directorships is often supported by an express power of

attorney enabling any director of Newco to serve notice terminating such dir-

ectorship on his behalf, and provisions in the articles of association enabling

the investors to remove any director on notice in any event.

The employer should also insert an express obligation of good faith and

exclusive service during any period of garden leave.

In the absence of such a

provision, the employee may argue that he is permitted to take up new employ-

ment during the garden leave period.

If Newco places the manager on garden leave without the express right to

do so, and/or refuses a manager who is a director access to board meetings

without the express right to do so, this may amount to a repudiatory breach

of the employment contract which, if accepted by the employee, brings the

employment to an immediate end and releases the employee from his own

obligations under his service agreement (including, most notably, any post-

termination restrictive covenants in the service agreement).

A manager will wish to ensure that the right to place that manager on gar-

den leave only applies once notice has been served, and that it will not be

applied for more than six months (in the event that the notice period is longer

than six months). The latter point is consistent with the current approach of

the courts.

2.4 Payment in lieu of notice

As mentioned in section 2.3, a party in repudiatory breach cannot rely on post-

termination restraints if the repudiatory breach is accepted by the employee.

was for this reason that employers originally began to include payment in lieu

of notice (PILON) clauses in employment contracts, which enable employers

to lawfully terminate the employment before the expiry of the notice period.

Therefore, in order to preserve any restrictive covenants in the service agree-

ment (which will be in addition to any restrictions under the investment agree-

ment which apply to the managers by virtue of their equity participation

), the

investors will want to ensure that a PILON clause is included in the service

agreement.

Although the employer may ordinarily wish to terminate the employment

contract lawfully by giving full notice or making a PILON, it may in some cases

5 For further discussion on the drafting and enforceability of such provisions, see chapter 11,

section 5.3.

6 Following on from Symbian v. Christensen [2001] IRLR 77 (CA), it is recommended that this

right is expressly set out in the employment contract.

7 General Billposting Company Ltd v. Atkinson [1909] AC 118.

8 See chapter 5, section 3.7.