A Practical Guide to Private Equity Transactions
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7
Background to private equity in the UK
Since these buoyant times, the fallout from the credit crunch which began
in Autumn 2007 has been well documented in the business press and the wider
media. The structuring of LBOs has left private equity investors exposed to a
signicant, or possibly full, write-off of their investments in the event of busi-
ness failure, whilst the increased leverage of existing businesses to facilitate
deals made such failure more likely. At the time of writing it is unlikely that
debt funding is going to be readily available to facilitate higher value LBOs in
the foreseeable future,
5
and the political pressures on both sides of the Atlantic
and in particular at EU level for increased regulation of alternative assets, and
the wider nancial services industry, is likely to have a signicant impact on
the private equity landscape.
The Walker Report
6
is a case in point. Commissioned during the boom
period in February 2007, and published in November that year, Sir David
Walker’s guidelines for disclosure and transparency in private equity require
additional disclosure and communication by private equity rms and their
portfolio companies where particular thresholds apply, namely, where such
portfolio companies:
(a) have more than 1,000 UK employees; and
(b) generate more than 50 per cent of their revenues in the UK; and
(c) either had an enterprise value of more than £500 million when acquired by
one or more private equity rms or, in the case of a public-to-private trans-
action, had a market capitalisation together with a premium for acquisition
of control of more than £300 million.
Given the substantial nature of these thresholds, the application of these guide-
lines is limited to a relatively small number of investments held by the larger
players. However, private equity rms whose investments fall below the radar
may do well to become familiar with the requirements; given the continued
political scrutiny (particularly in the European Parliament), and public and
media interest, it seems inevitable that similar transparency requirements will
emerge in a form that will have implications for a larger proportion of private-
equity-backed companies.
7
That said, there is also little doubt that private equity will continue to play
an important role in the UK economy. Whilst critics may highlight excessive
leverage, cost-cutting measures or so-called asset-stripping, supporters of the
industry will point out that an effective incentive for management to grow,
5 For more detail concerning the impact of the credit crunch on the availability of debt for lever-
aged deals, see chapter 6, section 2.
6 Sir David Walker, Guidelines for Disclosure and Transparency in Private Equity (20
November 2007). The independent review was carried out at the request of the BVCA and a
group of private equity rms.
7 A practical checklist of the requirements for a company’s accounts incorporating the Walker
Guidelines can be found on the BVCA website.
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An introduction to private equity
or otherwise improve the performance or competitiveness of, the underlying
business is inherent in the buyout model. This in turn can lead to increased
employment, and the distribution of a substantial part of the prots to wider
society as a result of the considerable participation in private equity funds by
many pension schemes.
2.3 Types of private equity investor
In the UK, private equity rms come in a variety of shapes and sizes. It is
important at the outset to distinguish between a private equity rm and a pri-
vate equity fund. A private equity rm is an investment manager which raises
pools of capital, typically in the form of private equity funds, to invest. These
rms receive a periodic management fee for doing so, as well as a share in the
prots known as a ‘carried interest’ from each of the private equity funds that
it manages. As is outlined in chapter 3,
8
the typical arrangement in the UK is
for the private equity funds to take the form of limited partnerships, with the
private equity rm being the general partner of such limited partnership. A
transaction usually involves the private equity rm arranging an investment by
two or more limited partnership funds under its management in parallel. As a
result of this structure, the investors in private equity funds are often referred
to as ‘LPs’, and the private equity rms themselves as ‘GPs’, in the business
and nancial press.
Private equity rms are often ranked based on the value of the funds under
management, or typical deal sizes for that investor. Common terminology is
to divide the UK buyout market into upper-market, mid-market and lower-
market – although the deal sizes falling within each category are not always
consistent, and the mid-market is itself sometimes then divided into lower and
higher sub-divisions. As a general rule of thumb, as at January 2009 most
would describe deals with a transaction size of less than £50 million as lower-
market, those with a size of £50 million to £500 million as mid-market, and
those exceeding £500 million as upper-market.
The upper-market is dominated by the larger American and UK rms.
Firms operating in the UK in the mid-market are often distinguished based on
whether they are ‘captive’, ‘semi-captive’ or ‘independent’. A captive investor
obtains their funds exclusively from a parent company – usually a nancial
institution. These include those rms investing on behalf of the well-known
UK banks. An independent rm will source all of its capital from external
investors. A semi-captive combines the two approaches – investing the parent
company’s money alongside externally raised funds. Many of the independent
rms operating in the mid-market in the UK were established by individuals
who had previously worked in the larger buyout houses or within a captive
or semi-captive environment, and similarly a number of such independents
8 See chapter 3, section 3.3.
9
Background to private equity in the UK
were created as a result of the buyout of a captive or semi-captive rm by its
managers.
Another way to categorise the UK market is by the sectors in which the
various rms invest. Some rms will state that they do not focus on specic
sectors, preferring a general approach, whilst others limit their investments to
a particular sector or small number of sectors. In reality, the generalists will
still have certain sectors in which they prefer to invest, or would like to invest,
inuenced by their existing funds, the sector experience of their key managers,
and their view of where the best returns may be made.
Venture capital investment is typically the focus of distinct venture capital
houses. Some investors in the upper-market and mid-market buyouts sector
will also provide a separate venture capital offering too (especially where the
rm is captive or semi-captive), although this may be presented using a simi-
larly named but separate venture capital brand. Many venture capital invest-
ments are made by venture capital trusts (VCTs), a quoted entity which offers
individuals the opportunity to participate in venture capital with particular tax
advantages. The requirements for such investors are not detailed in this book,
which focuses on the buyout market rather than the venture capital market, but
it should be noted that there are strict requirements for the structuring of VCT
investments which must be adhered to if the favourable tax treatment is to be
obtained. These requirements can result in a VCT being less exible than an
LP structure.
Unsurprisingly in the economic climate subsisting at the time of writing,
an increasing number of distressed and special situation funds have emerged,
although this is by no means a new concept; successful specialist investors
have existed for many years. In a private equity context, the expression is gen-
erally used to describe those investors who look to acquire distressed busi-
nesses (often at a signicantly discounted, or even negligible, price arising
from an insolvency process), and then implement strategic and operational
improvements with a view to a successful turnaround of the fortunes of the
business. Whilst many investors may claim interest in this particular area,
quite different skills and expertise are required when compared with more
conventional buyouts. It should also be noted that a range of alternative asset
classes exist in the distressed and special situation arena outside these types of
transaction – for example, hedge funds and other investors often employ strat-
egies for dealings in debt in distressed companies.
Other sources of funding are also available to businesses which, in the
broader sense, constitute private equity. For example, ‘business angels’ (high
net worth individuals, often investing via an informal syndicate led by a rec-
ognised intermediary) often fund investments in the so-called ‘equity gap’ –
a phrase typically used to describe transactions requiring equity investment
of less than £1 million which most mainstream private equity investors have
moved away from. At the other end of the scale, ‘sovereign wealth funds’
have emerged as key players in the upper market, often competing with the
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An introduction to private equity
more traditional large private equity rms in the higher prole deals during
the 2003–7 buyout boom. This book focuses on the typical requirements, and
issues faced, in a more traditional buyout – although a number of these points
will still be relevant to these alternative investors. The legal practitioner should,
however, always be mindful of the need to t the legal documentation to the
deal, rather than the other way around; the principals will become frustrated
if excessive cost is incurred negotiating comprehensive content on a smaller
deal, particularly if the issues are not of concern to the investor, or worse still
simply not relevant.
2.4 Sourcing the deal
One of the most important aspects of any management buyout process from
the private equity funder’s perspective is the identication of a suitable oppor-
tunity. This will vary according to the circumstances in which each particular
deal arises – although general trends also emerge based on the prevailing mar-
ket conditions.
For example, in the bullish market in the UK leading up to the summer of
2007, the opportunities often presented themselves – that is to say, the sellers
(whether corporate or private individuals) instructed corporate nance advisers
to undertake a formal marketing process, typically involving an extensive auc-
tion. An information memorandum relating to the Target, its business affairs
and prospects would be prepared by the sellers’ corporate nance advisers
and made available to potential bidders. The bidders approached would often
include both trade buyers and private equity or other nancial buyers (in the
latter case, these would usually be selected having regard to their interest and
credentials in relation to that particular sector, and at the relevant deal size).
Assuming there was signicant interest, an aggressive deal process ensued,
with tight timescales for completion of the transaction.
Although this formal marketing process, and resulting wider auction,
has its attractions to any seller seeking to maximise value from disposal, it
can be unattractive to private equity buyers and trade buyers alike (with the
result that, during that bullish market, many credible buyers were reluctant
to participate in such auctions). Some private equity funds have been set up,
formally or informally, on the basis that they will not take part in auction
processes. The strength of bargaining power of the seller demonstrated by a
strict process, designed both to maximise value and to achieve a high level
of execution certainty before agreeing to proceed exclusively with a particu-
lar bidder (or even without granting such exclusivity at all) meant that each
potential bidder had to undertake ever increasing amounts of preparatory
work including, in many cases, the incurring of legal, accounting and other
professional costs. The fact that each potential bidder was exposed to these
considerable costs and expenses, and also seeking to maximise its offer in
such a way as to exclude other bidders, meant that many interested parties
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Background to private equity in the UK
decided simply not to embark on the process at all. Bidders who did pursue
the process diligently could still nd themselves frustrated if a particular bid-
der was able to come in with a credible ‘knockout’ bid (with a unique ability
to see value in the business, or a reckless misreading of that value, depending
on your point of view).
Contrast this with the changing mood to reect the more challenging mar-
ket conditions experienced since summer 2007, and it is clear that the balance
of negotiating power has swung back in favour of the buyer. On the one hand,
this assists those buyers who were reluctant to participate in auctions for the
reasons outlined above, by ensuring that exposure to costs and expenses before
exclusivity can be minimised, and allowing sufcient periods of exclusivity
to ensure a transaction can be fully assessed. However, the absence of formal
auction processes and a shortage of willing sellers (understandably reluctant
to sell their businesses for a signicant discount on their perceived value at the
height of the market) makes the identication of potential transactions more
challenging. A distressed seller may have no choice but to accept the best price
he can in a difcult market; however, not all buyers are interested in distressed
assets (which, as mentioned above, requires a particular approach and skill
set). In any event, the structuring of any buyout relies on debt funding, and
the difculties in raising debt (or relatively unattractive terms on which debt
is offered) makes the execution of deals, or matching of private equity offers
with sellers’ aspirations, increasingly difcult.
9
In these challenging situations, however, the door is left open to possibil-
ities for those private equity rms with the skills to source or develop what
might be considered the Holy Grail for a private equity buyer – an exclusive
(or near exclusive) introduction to an attractive business. Private equity rms
will use their own internal research capabilities, and their network of con-
tacts (including accounting and legal advisers, as well as those in industry) to
source opportunities for direct discussions with sellers and/or the incumbent
management teams. In the ideal scenario, a deal might be concluded without
the competitive tension of other bidders in a formal process. More realistic-
ally, not least to ensure that sellers can feel comfortable that the correct deal
has been struck, a formal sale process may follow such approaches – although
quite possibly to a more limited audience. In any event, the earlier introduc-
tions may well put the private equity house in a strong position to win the
race, especially if a rapport has been achieved with the sellers or the man-
agers whose ability to inuence the deliverability of any offer should not be
underestimated.
A comparison of the deal processes involved in an originated transaction
versus an auction is set out in chapter 2.
10
9 See chapter 6, section 2, for more background on the impact of the credit crunch on debt
nancing in the UK.
10 See chapter 2, section 2.
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An introduction to private equity
3 The Business Plan and financial returns
3.1 General
The Business Plan is a cornerstone requirement for any private equity prop-
osition. It is a critical document outlining management’s strategy for the busi-
ness, key milestones (and how these will be achieved), and an assessment of
the outlook for the business within its market.
In very general terms, the private equity investors are typically searching
for a business which satises the following criteria, all of which should be
addressed by the management team within a robust and well-structured Plan:
(a) experienced and committed management;
(b) good product/service;
(c) strong market position;
(d) high/predictable margins;
(e) the potential to double the money within three years (generating an IRR of
25–35 per cent);
11
(f) running yield and the capacity for the payment of arrangement and moni-
toring fees; and
(g) foreseeable exit opportunities.
Typically, the management team will appoint corporate nance advisers to help
compile the Business Plan. The corporate nance advisers bring a robust dis-
cipline to this process – acting as devil’s advocate, challenging management’s
assumptions and preparing professional documents (including the critical sell-
ing points) to help attract interest and support from private equity rms. The
preparation of the Business Plan is in many ways a balancing act. On the one
hand, it must describe the Target’s business and opportunity accurately and
with appropriate prudence; however, it must also help sell the opportunity to
potential funders. Members of the management team may have strength in
either of these areas, but only very talented or experienced managers (or well-
balanced teams) combine the two effectively. Corporate nance advisers are
there to help management achieve this balance, as well as to provide ongoing
guidance throughout what is invariably a challenging transaction process.
The facts and opinions expressed in the Business Plan will, by neces-
sity, remain those of management. Given the fundamental importance of the
Business Plan to the decision of the investors to invest, the management team
will be required to warrant the content of the Business Plan to the investors
in the legal documentation.
12
Typically, the managers must conrm that the
factual information in the Business Plan concerning the Target is correct, and
that the opinions and assumptions expressed in the document are reasonable
11 For an outline of the meaning of IRR, see section 3.4 below.
12 See further chapter 5, section 3.4.
13
The Business Plan and financial returns
(having made suitable enquiries, and otherwise having given such opinions
and assumptions appropriate consideration).
3.2 Business Plan contents
Although the Business Plan is a bespoke document addressing specic areas
relating to the business and its markets, there are a number of general areas
that are invariably covered. Figure 1.1 shows the typical contents that private
equity rms would expect to see – interested private equity investors will
review each section with a particular focus.
Executive summary. The executive summary provides a brief, but compre-
hensive, overview of the key points in the Business Plan. This is a critical section
of the document – as it is the rst section that is read by recipients, and is likely
to determine whether private equity investors are sufciently interested to con-
sider the remainder of the document in any detail. The executive summary will
usually consider each of the following: the nature of Target’s business; the ultim-
ate goal(s) of the management team with Target, and strategy underpinning such
goal(s); a summary of the market and Target’s position in it; signicant features
relating to the existing, or planned, products or services of Target; the manage-
ment team; nancial highlights (both in relation to historic results and future pro-
jections); and the funding requirements including projected returns. It is worth
noting that private equity rms typically receive hundreds of Business Plans
every year; a strong executive summary is therefore critical to grab the attention
of the investors, particularly at a senior (usually decision-making) level.
Background. This section will include a brief history of the creation, devel-
opment and growth of the business, including reasons for its inception, and the
current (and perhaps historic) group structure and ownership details. The track
record of Target in its market will be of vital importance to the private equity
house in assessing the risks of the potential investment opportunity.
1. Executive summary
2. Background
3. Products and production
4. Operations
5. Market analysis
6. The management team and organisation
7. The strategy
8. Financial summary
9. Funding requirements
10. Milestones
11. Risk assessment and sensitivity analysis
12. Exit review
13. Appendices
Figure 1.1 Typical contents of a Business Plan
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An introduction to private equity
Products and production. An explanation of the products and/or services
should be included, with details of applications, principal features and any
unique selling points. Any technology, intellectual property and research and
development activities would also be covered in this section. As noted in sec-
tion 2.3 above, many private equity houses will be interested in businesses in
specic sectors, either to build on their positive experiences and expertise as a
result of historic and existing investments in the same sector, or to expand their
portfolio into a new sector which it has identied as particularly attractive.
Operations. This section will include details of all premises, facilities and
plant and machinery (including capacity), supplier relationships, quality con-
trol, and IT and management information systems. Private equity investors
will consider whether the company can demonstrate adequate capabilities and
capacity for Target to be able to deliver its outlined strategy, and the extent of
any capital expenditure requirement, which in a growing business will under-
pin the valuation of Target to the investors. Investors are also interested in the
strength of the balance sheet – in particular whether Target owns the prem-
ises, plant and machinery and other signicant xed assets. This will be a sig-
nicant factor in determining the extent to which secured borrowings can be
raised to fund the transaction, and might also provide a means for generating
cash to reduce borrowings post-acquisition (for example, by way of a transac-
tion to sell and lease back any substantial property).
Market analysis. Areas covered in this section include: identication and
characteristics of the market and Target’s position in it; the size of the spe-
cic market segment and forecast market growth; current and forecast market
share, with details of how increases in market share will be achieved; research
on customers and potential customers, explaining their needs and decision-
making factors; a marketing and selling strategy, including pricing policy; and
an assessment of competitors in the market.
This section is of vital importance to any private equity investor. An
attractive growth market, and a strong defensive position within that market,
will help to build the investment case for the investor. The anticipated growth
in a market, and the correlation to the forecast sales, will have a direct impact
on the investment return and will therefore be subject to considerable scrutiny,
including commercial due diligence.
13
For example, businesses with a particu-
lar niche in the market are often of great interest to investors, but the robust-
ness of management’s strategy will be challenged. Frequent issues raised are
whether the Target truly has a unique offering and position in its market, and
whether there are sufcient barriers to prevent new entrants coming into that
market.
The potential investor will want to know any information about the cus-
tomers and competitors that could prevent Target from delivering on its strat-
egy. For example, is there over-reliance on any one particular customer, which
13 See further chapter 2, section 4.5.
15
The Business Plan and financial returns
would increase the risk prole of Target? What factors and inuences exist in
the market which are beyond Target’s control? Will Target compete effectively
with its competitors, and what is the likely response of competitors to Target’s
strategy? Pricing policy, and anticipated pricing movements in the future,
will be equally important; not only to assess the prospects for the market as a
whole, but also to assess the likely impact of such trends on Target’s own mar-
ket share (and the resulting impact on margin, protability and ultimately the
anticipated investment return).
Management. An equally critical section of the Business Plan to a private
equity house is the ‘Management’ section. The achievement of the objectives
and strategy within the Business Plan depends upon the capabilities of man-
agement to execute that strategy. This section should include the key members
of the management team, their specic skills, sector credentials, achievements
and experience. Brief details of the other staff should also be included along
with an organisational chart showing responsibility and reporting lines. A
private equity house is likely to be particularly interested in the quality and
strength of the managing director and the nance director.
Private equity houses may, however, put in place their own management
team as part of the transaction, or will add to the existing team if they do not
believe the existing management team can deliver the Plan themselves. This is
particularly the case if the private equity rm already has an investment, and
therefore a management team, in the same business sector, and has adopted a
‘buy-and-build’
14
strategy.
Strategy. The Plan will include an overview of the team’s strategy for Target
including objectives, implementation, ultimate exit routes and a timetable. The
timing and manner of exit is of particular importance to private equity inves-
tors, as they rely on those exits to generate their expected return (see further
section 3.4 below).
Financial. The Plan will include both historical nancial analysis and
nancial projections, along with the key assumptions, and justication of
those assumptions, underpinning the projections. The data will encompass
prot and loss statements, balance sheets and cash ows for, typically, a
three-year period on a historic basis, and up to ve years on a forecast basis.
The main body of the Plan usually includes a summary of key data, with the
full nancial model being supplied as an appendix (see further section 3.3
below).
The nancial data underpins the determination of the funding requirement,
and the calculations of the projected investment return. The nancials need to
reect management’s strategy and objectives, and so must be consistent with
the rest of the content of the Business Plan. This nancial data will be subject
to stringent due diligence, and ultimately the performance of the management
team will be measured against these projections.
14 See section 2.1 above.
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An introduction to private equity
Investors are understandably attracted to projections which forecast a trend
of increased protability, with such increases being achieved as soon as pos-
sible. Investors also speak of their attraction to a high visibility of earnings,
meaning future turnover of sufcient certainty to enable the investors to feel
comfortable that the nancial projections will be delivered; as a result, busi-
nesses with signicant long-term contractual commitments are often well
received. Strong operational cash ows are essential, particularly in a more
challenging economic climate, to ensure that Target can satisfy debt interest
and capital repayments as they fall due without this resulting in a breach of
banking covenants (which breach might, in turn, necessitate further equity
investment or cause the investment to fail).
15
Funding requirements. The Plan will outline the current nancial structure,
and the immediate and future funding requirements (and their intended uses),
along with anticipated sources of funding. The returns which investors look
to achieve are explained in more detail in section 3.4 below, whilst the way
in which such investments are typically structured to generate those required
returns is explained in chapter 3.
Milestones. The key stages necessary to achieve the Plan, and how they
should be attained, will be detailed in the Plan. Private equity houses will
need to understand the key milestones envisaged as part of their ultimate
exit route, to assess whether the strategy is achievable, and be in a position to
monitor progress against those objectives post-investment. It is now custom-
ary for investors to require the production of a 90 or 100 Day Plan setting out
the activities which must be undertaken in that period immediately after the
investment is made, to ensure a seamless transfer of ownership so that Target
can ‘hit the ground running’. This is often prepared also to address any urgent
or important issues that are highlighted by due diligence.
Risk assessment and sensitivity analysis. The Plan should include details of
the critical success factors for the achievement of nancial projections, includ-
ing a SWOT analysis (assessing the strengths, weaknesses, opportunities and
threats applicable to Target). It should explain in some detail how the risk, and
impact on nancial projections, of weaknesses and threats can be minimised.
Investors will want the management team to demonstrate that they have been
thorough in their analysis and are well prepared.
A Business Plan is normally accompanied by a number of appendices, the
nature of which will vary depending on the investment opportunity, and the
nature of Target. Typically, they will include the more substantial detail and
analytical data required to support the information in the body of the docu-
ment, particularly the historic nancial information, nancial projections and
assumptions underlying those projections, all of which will also be encapsu-
lated in the nancial model.
15 On banking covenants, see also chapter 6, section 4.1(g).