A Practical Guide to Private Equity Transactions
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Funding issues on a public-to-private transaction
the guarantees and security from P2P Target and its subsidiaries cannot be
provided until P2P Target has been re-registered as a private company. Public
companies cannot grant nancial assistance for the acquisition of their own
shares and, in addition, the subsidiaries of P2P Target cannot give nancial
assistance while their parent is still a public company. As noted in section 3.5
above, the re-registration of P2P Target as a private company requires a special
resolution of the shareholders of P2P Target. Consequently, the debt providers
will be keen to ensure that the offer cannot be capable of being closed unless
and until they are sure that this special resolution can be passed.
In light of this, it will be common to see a covenant in the debt docu-
mentation that will restrict Bidco from declaring the offer unconditional as to
acceptances unless the level of acceptances of the offer (when combined with
the number of shares in P2P Target already held by Bidco) represents either:
(a) not less than 90 per cent of each class of share capital of the P2P Target; or,
(b) in some circumstances, not less than 75 per cent of the issued share capital
of the P2P Target.
In the former case, the debt providers can take comfort from the fact that, once
the 90 per cent threshold is reached, Bidco can invoke the compulsory acquisi-
tion provisions referred to in section 3.5 and acquire the remaining shares leading
to 100 per cent ownership. In these circumstances, they will be certain that the
necessary resolution will be obtained. In the latter case, the position is slightly
more problematic. Control of 75 per cent of the issued share capital of P2P Target
would be sufcient to pass the necessary special resolutions. However, during a
period of twenty-eight days following the date of the resolution, members repre-
senting not less than 5 per cent of the issued share capital of the P2P Target, or
being not less than fty in number, can apply to the court for the cancellation of
the resolution re-registering the P2P Target as a private limited company (pro-
vided that those shareholders did not vote in favour of the special resolution).
15
Debt providers will look to build certain protections into the debt docu-
mentation addressing each of these potential issues, which may take one of a
number of forms:
(a) A covenant that Bidco will not declare the offer wholly unconditional at
the 75 per cent acceptances level unless the debt providers are satised that
there is no reasonable likelihood of a shareholder or group of shareholders
looking to have the required resolution cancelled.
(b) An event of default in circumstances where the security to be given by
P2P Target is not supplied by a certain date. This would trigger a potential
acceleration of the debt and the obligation of Bidco to repay the whole of
the funding. It should be noted however, that this is clearly of limited value
as the repayment obligation, whilst crystallised, is still an unsecured obli-
gation of the group.
15 See section 98 of the Companies Act 2006.
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Public-to-private transactions
(c) Increasing the interest rate applicable to the debt in the event that the secur-
ity to be given by P2P Target is not supplied by a certain date. Such an
increase in interest would be sized to reect the increased risk perceived
by the debt providers.
5 Conclusion
In the market conditions being experienced at the time of writing this book,
many public companies are viewed by commentators as undervalued. Their
share prices having fallen dramatically – either in line with the market due to
the general macro-economic environment, or perhaps due to specic short-
comings in their business model to tackle more challenging times. In principle,
it might be assumed that such conditions would result in an increased volume
of public-to-private transactions, with private equity bidders more likely to be
able to fund a comparatively attractive offer.
However, the reality is that there have been relatively few recent public-to-
private transactions completed. In an illiquid market, share prices are volatile;
small volumes of trading in a company’s shares may have a disproportionate
effect on share price (particularly in the case of small and medium-sized com-
panies). Valuing a company in these conditions becomes difcult, and there is
often a marked difference in expectations between the board and shareholders
of a public company on the one hand and a private equity buyer on the other.
Market volatility therefore inevitably serves to heighten the risk that a poten-
tial public-to-private transaction will fail due to a disagreement on valuation,
sometimes at a point when a large amount of time and cost has been invested
in conducting due diligence. This heightened execution risk, coupled with the
uncertainty that a takeover offer will be successful, and the complexities of the
process that we have explored in this chapter, is enough to deter some private
equity investors from embarking on ‘take private’ transactions as a matter of
principle. The signicant costs of a public-to-private can also be a deterrent,
particularly for those public companies with a low market capitalisation.
It is unsurprisingly those public companies with features that may miti-
gate some of these execution risks that tend to make more attractive targets.
For example, a public company with a concentration of shares in the hands
of a small number of shareholders, possibly including members of the board,
who can be persuaded to give irrevocable commitments to accept an offer
will make a far more attractive proposition to a potential private equity bid-
der than a company with a diverse shareholder register, or with no signicant
institutional or management shareholdings. As market volatility is replaced
with some sense of order in the markets, public-to-private transactions still
offer good opportunities for those private equity houses with the capabilities to
identify the best deals and deliver them.
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11
Living with the investment
1 Introduction
In this chapter, we will look at some of the issues faced by the private equity
investors and the managers during the lifetime of the investee company. In
particular, we will look at issues related to the ongoing funding of the business,
underperformance of the investment, parting company with a manager, and
restructurings including debt capitalisation. These are challenges in all mar-
kets, but have become ever more pressing in the market conditions prevailing
from 2008 onwards.
Such matters put to the test the mechanisms included in the documenta-
tion at the time of the buyout, and afford the opportunity to see how theory
and practice combine to protect the interests of both the company and the
investors. The implications of employment law, the relationships between the
investors, the management team and the senior lenders, the taxation aspects
of any changes to the deal structure and the overriding objective to protect
and, where possible, enhance the value of the investment must all be consid-
ered. Such factors operate to set the environment in which often challenging
business decisions must be made and implemented under tight commercial
time pressure.
We will also examine directors’ duties and, in particular, the new statu-
tory code relating to directors’ duties in the Companies Act 2006. Conicts of
interest can be particularly acute given the various agendas of the parties to the
investment, and their different roles and responsibilities. This is especially the
case in an underperformance situation, but the duties of directors exist at all
times, and are of increasing importance as a result of ever closer governmen-
tal, regulatory and media scrutiny of the industry.
2 Monitoring the investment
2.1 Approach to monitoring
An important part of the activities of the private equity rm, on behalf of
its underlying investors, is the monitoring of its portfolio of investments.
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Living with the investment
Monitoring enables the private equity rm to report regularly to its own inves-
tors, and periodically to review its own internal valuation of the investment.
Monitoring also ensures a continued review of the strategies adopted for the
purpose of achieving the ultimate aim of a successful exit.
In general terms, two different approaches are seen as to who carries
out such monitoring. In some cases, the executives within the private equity
house who negotiated the original transaction are also involved in its monitor-
ing, whilst other private equity rms prefer to separate out their ‘deal-doing’
executives from their portfolio executives, and transfer much of the day-to-day
monitoring of investments to a separate portfolio team. There are advantages
and disadvantages to each approach. Those who favour the deal executives
continuing with the monitoring of the investment argue that this helps preserve
the personal relationships created on the original buyout with the manage-
ment team, and ensures that executives responsible for the transaction remain
responsible for the performance of the investment they have backed. Others
argue that the management of the portfolio requires a different skill set to
the origination of transactions, and that a separated approach ensures that the
investee company will always have access to a contact at the private equity rm
irrespective of whether the ‘deal-doers’ are in the midst of a time-consuming
new transaction. In some rms, a combined approach is seen, where specialist
portfolio executives work alongside the original investment executive to moni-
tor the investment and manage the ongoing relationship.
Investors also differ in their level of engagement with the investee com-
pany. Some are very active and ‘hands on’ in their approach, such that the
private equity investor directors or portfolio managers are almost a day-to-day
part of the business, with a detailed knowledge of what is happening within the
business and changes to its prospects. Others have a more passive monitoring
role, watching the management accounts as they come in, but only becoming
active if a possible exit opportunity arises, if something alarming is detected,
or if a consent matter is brought to them. The approach is largely inuenced by
factors such as the number and size of the investments in the investor’s port-
folio, and the relative size of the private equity investor’s stake. If investors
have a minority stake with relatively weak controls, their ability to manage
and inuence the investment in a ‘hands on’ way will be much diminished.
On balance, however, the push towards investor-led equity positions, and the
increasing complexity of the nancial gearing involved in larger buyouts, have
tended to push all funds towards a more ‘hands on’ approach.
2.2 Tools for monitoring
The private equity investors will be able to keep a close watch on what is
happening to its investment through the appointment of investor directors or
observers to attend board meetings. In addition, the investment documents will
contain various provisions enabling the investors to monitor performance.
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Monitoring the investment
(a) Financial and other information
Whichever approach to monitoring is adopted, monitoring begins with the
nancial and other information to which the private equity investors are enti-
tled under the investment agreement. The investment agreement will require
that Newco send the investors monthly management accounts, usually show-
ing in detail how performance compares against the Business Plan or the latest
annual budget, and the key banking covenants. Investors will also usually be
entitled to receive details of other signicant matters such as material litiga-
tion, or correspondence with the bank outside the ordinary course.
1
(b) Annual budget
Another important part of the monitoring process is achieved by the require-
ment for agreement of an annual budget. The investment agreement will
require that the annual budget for each nancial year of Newco and its group
must be approved in advance with the investors, usually around thirty to forty-
ve days before the start of the nancial year to which it relates. The Business
Plan at the time of the buyout is normally used as the budget for the nancial
year in which the buyout occurs. Going forward, however, there will invariably
be changes to the business and its evolution compared to what was assumed
and forecast in the Plan. The annual budgeting process enables the parties to
reassess matters in light of their ongoing experience with the business, and the
prevailing environment and trading conditions in which the business has to
operate. This process necessarily involves investors understanding the busi-
ness, and being briefed by executive management on the state of the business
and its prospects for the next nancial year. This is a useful check back on the
decisions underlying the investment’s strategy, and allows a continued review
of the positioning of the business towards a suitable exit.
(c) Investor consents
The investor consent requirements (whether under the investment agreement
or the articles of association) also full a monitoring role. The need for the
managers to seek approval to material matters, or indeed any matters out-
side the ordinary course of business, acts as a warning mechanism to alert
the investors on signicant matters arising within the business.
2
The annual
budget will set out that year’s provision for key expenditures such as mater-
ial property or business acquisitions, or other capital expenditure. To ease
the investor consent process for some matters, investor consents may be tied
in to the budgeting process, such that the need for investor consent is lim-
ited to any expenditure that represents a departure from that agreed budget
provision.
1 For information requirements, see chapter 5, section 3.11.
2 For more detail on investor consents, see chapter 5, section 3.12.
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Living with the investment
(d) Post-completion action plan (90 or 100 Day Plan)
As we have seen,
3
the investors will usually require an action plan to be pre-
pared and actioned immediately following completion of the buyout, to iden-
tify those activities that must be undertaken to ensure a smooth transfer of
ownership of the business, and to address any pressing issues highlighted by
due diligence that were not addressed before completion of the acquisition.
The progress of such action plan will usually be monitored by way of reporting
back and discussion at board meetings in the rst few months after completion
of the transaction. The investment agreement may include specic obligations
on the managers to procure that such plan is nalised and actioned within the
relevant timescale, and for regular written reports of progress to be provided
to the investors until all steps set out in the plan have been concluded.
(e) Interaction with bank monitoring and consent mechanisms
In most deals, there is signicant third party debt in the structure. As illustrated
in chapter 6, the banks providing senior debt will also have an active interest in
monitoring the business, and will impose a consent regime for material matters
in the business that may alter their lending risk or security.
4
The private equity
investors will also wish to see copies (preferably in advance) of any nancial
or other information that is to be supplied to the banks or any other funders, in
case that information may suggest a breach of covenant or other difculty in
the business now or in the near future. The same point arises on any applica-
tion for a consent or waiver from such funders. Prior notication of any such
information to be supplied, or consent or waiver to be sought, gives the private
equity investors an opportunity to mitigate any problem, or possibly to inu-
ence the decisions to be taken by the bank lenders when difculties do occur.
2.3 Remedies to facilitate monitoring
Monitoring is important. Private equity investors can become particularly con-
cerned if there is any delay in the preparation of management accounts or other
nancial information, or any serious doubts about the adequacy and reliability
of that information. They will also become extremely frustrated if managers
take their responsibilities under the investment documents for granted; whilst
the occasional brief delay in delivering information due to the need to address
issues within the business may be tolerated, regular failures to provide what
the investors require, on the basis that was agreed and documented at the time
of the original deal, will be frowned upon.
As an ultimate measure, the investment agreement will normally reserve
the right for the private equity investors to appoint investigating accountants to
check and/or obtain the necessary information if there is any delay or default
3 See chapter 1, section 3.2.
4 See chapter 6, section 4.1(f).
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Further funding
in the preparation of nancial information. If the investors were to exercise
that right, it is usual that the cost of the review is borne by the investee com-
pany. It is relatively rare for such clause to be relied upon in practice, but the
threat of this as an ultimate sanction may often help ensure that corporate gov-
ernance procedures are improved, and that the appropriate level of information
is provided in a timely fashion. The confrontational nature of such remedy
means that this provision is sometimes known as the ‘blockbuster clause’.
In extreme cases, a material or persistent breach, or a material misreport-
ing, will undermine the condence between the private equity investors and
the managers (or some of them), particularly if real problems are being hid-
den or their discovery delayed. This may in turn lead to disciplinary matters
under the service agreement, or even to a termination of the employment of the
manager(s) concerned, which is considered in section 5 below.
3 Further funding
3.1 Reasons for seeking funding
Sometimes, private-equity-backed companies will require further funding
beyond the levels provided for at the time of the buyout. For some venture
or development capital deals,
5
this is part of the original model – the initial
funding commitment is staged as a series of xed instalments, and linked to
the achievement of particular milestones (for example, in relation to the testing
and licensing of a drug being produced by a pharmaceutical or biotech com-
pany, the opening of new retail outlets, and so on). Generally, in the case of the
buyout of a mature company, all the funding that is expected to be required
is made available as part of the initial funding round (albeit that some of the
senior debt may be on revolving credit terms), and accordingly the intention of
the parties is that upon completion it should have adequate funding in place or
committed from the banks and investors for its foreseeable needs. The inves-
tors and other funders would not choose to go into an investment knowing that
the core funding levels are not adequate, given the risk of any further funding
not being available in future, or only being available on unattractive terms.
Although there is usually only one formal funding round envisaged in the
documentation, circumstances could arise where a further funding round is
desirable or even necessary in the business. This most frequently arises in
an underperformance situation, which is also considered in section 4 of this
chapter. However, other opportunities may also arise which require further
funding, for example the company may be able to make a strategic acquisition
or expansion of its business which was not part of the original Business Plan
but nevertheless has a very signicant potential advantage to the company. In
this situation, a revised Business Plan would inevitably be required from the
5 See further chapter 1, section 2.1.
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Living with the investment
management team to enable the private equity investors to see the advantages
of the further funding and to obtain the necessary internal approvals. A simi-
lar process is likely to be required by the bank if additional bank debt is to be
sought as part of the funding.
3.2 Dilution and the structuring of further funding
As we have seen, a key feature of a buyout is that the private equity investors
put in proportionately more money for their equity than the managers. The use
of debt funding by private equity investors to ‘sweeten’ the equity deal for man-
agers is inherent in most buyouts, as is discussed in more detail in chapter 3.
6
Where further funding is required from private equity investors during the
life of the investment (typically, only when the bank funder(s) cannot provide
the full amount required), the question arises as to whether that too should
be in such a blended form, or whether all of such funding should be provided
in the form of equity or possibly debt. Also, the issue arises of the price at
which any new equity should be introduced, or the interest rate that should be
attached to any debt instruments.
Managers would normally share in the right to participate in any new equity
fundraising; that is to say that they would be entitled to subscribe for a propor-
tionate amount of any new shares at the same price per share as the investors.
In theory, therefore, managers have a protection to avoid being diluted pro-
vided they put in their fair share. However, in practice, private equity investors
are usually in a much stronger nancial position to provide any extra funding
required. As a result, there is a very real possibility that management’s equity
percentage will be diluted because they cannot afford to put in the necessary
monies to take up their new equity in full. Even if the new money goes in on
arm’s length terms, so that the dilution is one of percentage rather than of value
(the argument being that management’s smaller stake has the same, or substan-
tially the same, value as before due to the new monies being introduced – a
smaller share in a bigger pie), there can be both emotional and practical conse-
quences in having a reduced equity percentage.
Where the funding is related to a good news situation (for example, a stra-
tegic opportunity), it is possible that the private equity investors and the banks
will be persuaded to fund it on a non-dilutive basis. In that case, the new money
will come purely in the form of debt (or, perhaps, preference shares) which will
require an appropriate, or even generous, return, but the private equity inves-
tors would not seek to have a higher proportion of the equity. Of course, if the
return is too generous, the dilutive effect of the more expensive debt instru-
ment may in itself have an adverse effect on the motivations of management.
Irrespective of the split between debt and equity, there can be tax implica-
tions for the management team in a new equity fundraising. This is particularly
6 See in particular chapter 3, section 2.
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Further funding
the case if, as a consequence of the terms of the fundraising, it is necessary to
alter any ratchet
7
or similar mechanism that formed part of the original trans-
action. However, if the opportunity is good enough and the parties can agree
the broad commercial criteria of the deal, it is usually possible to plan this in
a tax-efcient manner.
Where the news is not so good, and the further funding is required to rect-
ify some problem in the balance sheet or to persuade the senior lender or other
funders not to take more drastic steps to protect its existing position, the pri-
vate equity investors are far less likely to offer any sweet deal to managers for
the further funding. In those cases, the managers often do not put in any new
money, and are simply diluted by the further funding. As has already been
explained in chapter 3, management equity ranks at the bottom of the pile on
a failure of the investment and, as such, management’s investment is fully at
risk in the event of an underperformance. Having said that, if management are
to remain motivated to ensure that the business is turned around following an
underperformance, some form of incentive will usually be necessary, whether
within the funding structure or otherwise.
8
3.3 Further funding checklist
When drafting documentation for a new funding round, the existing invest-
ment documents must be reviewed carefully to ensure that any relevant pro-
cedures for the new investment are followed. The existing documents must
also be checked to ensure that any new commercial requirements are properly
incorporated within the existing structure, and that any obsolete or redundant
provisions are varied or removed accordingly.
The circumstances that give rise to a need for further funding, and the
commercial terms agreed between the parties to reect those circumstances,
will vary. As a result, the requirements in terms of legal documentation will
also be specic to the situation in which the investee company has found
itself. Generally speaking, the documentation for a further funding round will
include a supplemental investment agreement, revisions to the articles of asso-
ciation, and (where debt investment is involved) modications to the inter-
creditor agreement with the bank and possibly the banking facilities. Points
to be checked by the legal adviser on a further funding round include the
following:
obtaining full details of all funding to be provided, and the parties provid-•
ing it, including the interest rate (or dividends accruing, as the case may
7 For ratchets generally, see chapter 3, section 3.2, and chapter 5, section 4.6.
8 See further chapter 7, section 5, concerning management incentives. Incentives of the type
made available to second-tier managers on a successful buyout may also be used for senior
managers in an underperformance situation, either on a stand-alone basis or in combination
with the existing equity stake.
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Living with the investment
be) and repayment dates for any loans or preference share instruments, and
conrmation of whether any loans will be secured;
where shares are to be issued, the class in which shares will be issued to each •
subscriber (or, where the rights attached to the shares differ from the exist-
ing classes, or rights attached to any of the existing classes are to be varied,
details of the rights to be attached to each relevant class);
the procedure for issuing new shares as prescribed by the existing invest-•
ment agreement and articles;
details of whether any further debt funding is to be secured and, if so, the •
ranking of that debt against the existing secured loans, both in terms of
repayment in the ordinary course and in the event of a default;
clarication of whether the Business Plan is to be updated and, if so, whether •
it should be warranted by the management team (whilst this is invariably a
prerequisite to the initial deal, it may not be commercially viable on a fur-
ther funding round, depending on whether the further funding offers any
benet for management);
details of any other warranties that may be required from management, if •
these can be negotiated, for example to conrm that no material issues have
arisen since the time of the original buyout other than those of which the
investors are aware;
conrmation of whether any individuals who were not party to the original •
investment agreement will become a party at this stage of the renancing,
so that they give warranties (where relevant) and are bound by the restrictive
covenants and other obligations set out in that document (which is often rele-
vant, as a further investment is often accompanied by a change or addition
to the management team);
checking the investor consents required, and consents required under the •
banking documents, and ensuring that all such consents are in place;
clarifying who is currently a director and will be a director of each relevant •
company in the group going forward, and the quorum requirements under
each relevant set of articles of association for approval of the funding docu-
ments and completion of the investment;
checking adherence requirements for new debt funders to become a party to •
the intercreditor arrangements, where relevant; and
carrying out new money-laundering checks where necessary for the inves-•
tors, and carrying out company searches and bankruptcy searches to ensure
there are no new issues revealed before the further investment takes place.
4 Underperformance and debt restructuring
4.1 Background and reasons for underperformance
Underperformance is a major issue for private equity investors. Most private
equity investors will have, at any one time, some underperforming assets in