A Practical Guide to Private Equity Transactions
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Implications of a secondary on the legal documentation
warranties and the investment agreement warranties should properly be distin-
guished, such that it is unreasonable for the rolling managers to be expected to
bear a higher exposure on those warranties which are more forward looking in
nature, and are predominantly designed to elicit disclosure.
If this position is not accepted by the investors, then a compromise might
be to see the monetary limit under both sets of warranties limited to the cash
proceeds which each manager has received for his shares (but not the full
consideration, i.e. ignoring the value of the rolled investment). Clearly, this
is potentially a much higher exposure for the managers than the usual salary-
based cap in the investment agreement, but it at least ensures that the warranty
claims under both agreements cannot exceed the cash that the managers have
actually received. A position might be agreed between these two extremes
depending on the circumstances – for example, limiting the rolling managers’
exposure under both documents to a proportion of the cash consideration, rather
than the full amount. Whatever the compromise reached, it is important that
any possible liability under both documents is considered in tandem. Investors
also need to bear in mind that, as funders to the buying Newco, the rolling
managers will suffer nancial detriment if the value of their rolled investment
diminishes as a consequence of a failing within the business – and that, as for
any sale, it is a far more attractive proposition for the investor to pursue exiting
sellers for a warranty claim, rather than their own management team.
One other legal provision which may require a different treatment in a sec-
ondary is the back-to-back warranty, that is to say the warranty usually sought
by private equity investors in the investment agreement that the management
team is not aware of any claims under the acquisition agreement.
9
Whilst this
is not uncommon in a typical buyout, there may be less obvious justication for
it in any secondary buyout, in particular if all the managers under the invest-
ment agreement are also sellers in the acquisition agreement.
3.5 Tax considerations for the rolling managers
The rolling managers will wish to ensure that the exchange of their shares in
Target for an issue of loan notes and/or shares in the new Newco is treated as a
rollover for tax purposes (a ‘tax rollover’),
10
as the result is that no capital gains
tax is triggered in respect of the Newco loan notes and/or shares received.
Instead, tax only arises on disposal of such loan notes and/or shares.
To achieve a tax rollover, a number of mechanical conditions must be sat-
ised. In the context of a secondary, the main point to note is that to secure
a tax rollover it is the buyer (i.e. Bidco) which must issue the loan notes and/
or shares to the rolling managers. Where there is more than one Newco in
the acquiring structure, it would be usual for Bidco to issue loan notes to the
9 For further discussion, see chapter 5, section 3.5.
10 Meaning it falls within the provisions of section 135 of the Taxation of Chargeable Gains Act
2002.
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Secondary buyouts
rolling managers with those loan notes then being exchanged for loan notes
and/or shares up through the chain until such point as the rolling managers hold
shares and/or loan notes in the right vehicle in the chain. Each such exchange
is also structured to be a tax rollover. These so-called ‘ip up’ arrangements
are illustrated in chapter 3.
11
In order to achieve a tax rollover, one of the conditions which must be sat-
ised is that the issue of loan notes and/or shares is effected for bona de com-
mercial reasons, and does not form part of a scheme or arrangement of which
the main purpose or one of the main purposes is avoidance of liability to tax
(this is known as the ‘motive test’).
12
Where a rolling manager holds no more
than 5 per cent of any class of shares in the Target (taking into account any
shares held by connected persons such as relatives), there is no need to satisfy
the motive test in order to obtain a tax rollover.
13
In other cases, it is possible to
apply in advance for conrmation from HMRC that it accepts that the motive
test is satised.
14
It is not a pre-condition in order to obtain a tax rollover that
an advance clearance is obtained, but it would be usual for clearance to be
sought, and the timetable for any secondary buyout will therefore generally
accommodate the time required to seek such conrmation.
In certain circumstances, HMRC can tax some or all of the proceeds of
a disposal of shares in the same way as a dividend rather than as capital pro-
ceeds.
15
In order to do so, HMRC must give notice to counter the tax advantage
which it identies as having arisen on the disposal. It may do so if any one
of ve sets of circumstances is satised. One of them would be satised if a
person receives consideration which represents the value of assets which are
or would be available for distribution by way of dividend in such a way as to
avoid a charge to income tax. Arguably, this could be the case where a Target
has distributable reserves available to it (taking account of any reserves of its
subsidiaries). This is disadvantageous because the effective rate at which tax
is paid on dividends is currently 25 per cent compared to the capital gains tax
rate which is currently 18 per cent.
The treatment referred to above does not apply in relation to a rolling man-
ager if the manager can demonstrate that:
(a) the transaction is carried out for bona de commercial reasons or in the
ordinary course of making/managing investments; and
(b) the transaction is not carried out with the object (or a main object) of avoid-
ing tax (this is often referred to as the ‘escape clause’).
16
11 See further chapter 3, section 3.5.
12 Section 137(1) of the Taxation of Chargeable Gains Act 2002.
13 Section 137(2) of the Taxation of Chargeable Gains Act 2002.
14 Under section 138 of the Taxation of Chargeable Gains Act 2002.
15 Under section 684 of the Income Tax Act 2007.
16 Section 685 of the Income Tax Act 2007.
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Conclusion
It is possible to apply in advance for conrmation from HMRC that it
accepts that the escape clause applies,
17
although there is no requirement to
seek such conrmation. In recent years, it has been relatively common for
HMRC to refuse to give such conrmation for rolling managers receiving cash
and/or loan notes as part of their consideration for selling their shares in Target
where such managers as a whole are increasing their equity stake, and/or the
aggregate equity stake of the managers in the new Newco is 20 per cent or
more.
The effect of HMRC refusing clearance is not that it will seek to tax the
cash and/or loan notes received in the same way as a dividend, but rather that
it is reserving its right to seek to do so at a later stage.
4 Conclusion
Secondary buyouts represented a signicant proportion of private equity trans-
actions in the UK market in the buyout boom period from 2005 to 2007. In
an economic climate where it is proving more difcult to raise debt nance
for acquisitions, there have inevitably been fewer secondary transactions.
Generally, secondaries tend to involve a higher consideration than rst gener-
ation buyouts – resulting in the need for more signicant debt funding. A trade
buyer, perhaps sitting on rmer funding, able to offer more security or, in par-
ticular, having signicant cash already in its balance sheet, will be in a better
position in many circumstances to close a transaction, and should therefore be
able to offer greater transaction deliverability. However, in time, we are likely
to see the return to prominence of the secondary as a transaction which helps
to oil the wheels of private equity, by encouraging the churn of investments
which has traditionally driven growth in the sector. Secondaries by rescue or
turnaround funds should also prove prominent during more challenging eco-
nomic times.
It remains to be seen if, in the more challenging environment being expe-
rienced at the time of writing, selling private equity investors will be able to
preserve their ‘take the cash and don’t look back’ approach by refusing to offer
general commercial warranties on sale. In the UK at least, the no-warranties
policy adopted by most private equity rms has weathered signicant pressure
in the past. It is perhaps most likely that the practice on secondaries will follow
any trend that emerges on share sale exits to trade buyers, given that secondary
interest and trade buyers will be competing to acquire more attractive busi-
nesses. However, it may be that an investor buyer on a secondary deal is more
sympathetic to the absence of warranty cover than a trade buyer (the secondary
investor’s investment documents will no doubt include provisions stating that
they will not give warranties on exit, making it more difcult for those inves-
tors to argue that the selling investors should accept a different position).
17 Section 701 of the Income Tax Act 2007.
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Secondary buyouts
Secondaries represent a hybrid between a typical management buyout and
a trade sale. Issues of conict can often arise, most notably for the rolling man-
agers who must balance their interests as both seller and buyer. The more sig-
nicant investment which a rolling manager makes in a secondary also brings
legal complications – in particular, concerning the ranking of the various loan
notes and shareholdings that emerge in the structure, and the consequences
for a rolling manager if his employment is terminated. That said, with suf-
cient focus on the specic issues that arise on a secondary, the standard model
for a private equity transaction in the UK can readily be adapted to suit these
transactions.
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13
Exits
1 Introduction
In this nal chapter, we turn to look at some of the issues that arise on a
successful exit by the investors from a private-equity-backed company. We
will concentrate on two types of transaction in particular: a share sale; and an
Initial Public Offering (IPO).
In relation to share sales, this chapter will touch on some areas that are
relevant to any disposal of a private company. However, the main focus will be
on those specic issues that can arise on the sale of a company that is private-
equity-backed, and the consequences for each of the parties to the transaction.
This approach is consistent with the approach taken in chapter 4, where the
specic issues that arise on a share purchase by a private-equity-backed buyer
were highlighted; inevitably, many of the areas considered overlap, although
the position taken by the buyer and the seller(s) on such issues can be markedly
different.
On the face of it, an IPO is a very different transaction to a share sale, not
least because of the highly regulated environment in which the transaction is
taking place, and the high prole and publicity it attracts. However, many of
the same features and commercial concerns for the private equity investors
and managers can arise, and it is informative to see how these consistent issues
are addressed in the two different exit transactions. Either exit will tend to
require the unpicking of the funding structure from the buyout, and the repay-
ment or renancing of the debt put into the structure at that time. There may
also be a need to involve regulators and other third parties, for example in
respect of pension schemes, competition matters, or key customer or supplier
relationships. The transaction may therefore involve many more parties than
simply the selling shareholders and the buyer.
Before considering the specic issues on these two types of exit, however,
it is worthwhile reecting on how the focus on an ultimate exit lies at the heart
of any private equity investment from the very beginning.
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E x i t s
2 Exit focus
2.1 The importance of the exit and exit planning
It is sometimes said that a private equity investor plans for the exit even before
it acquires Target. This does not mean to say that it has already lined up a
protable buyer – if that were the case, then the sellers’ marketing exercise
has missed a good opportunity. However, being as certain as they can be that
there will be a sale opportunity for an investment is a critical part of the assess-
ment of a potential investment before the private equity investor completes
the acquisition. It would be usual, however, for the investor to have asked its
nancial and commercial due diligence advisers to consider the various routes
to exit, including identied buyers (whether trade or nancial buyers) and any
IPO prospects, as part of their remit.
This does not mean to say that the business can simply be carried on ‘as is’
for a period, and sold in the state in which it is bought. As we have seen, the
Business Plan will envisage changes to the structure of the business to increase
its value. This may include further expansion of the business, the launch of
new products or services, rationalising parts of the cost base and/or splitting up
and dividing the business. Other possible models could include the introduc-
tion of an ‘opco/propco’ structure (whereby a company which owns the prop-
erty in which it operates restructures itself to a trading company occupying
that property pursuant to a lease, enabling a separate sale of the freehold), or
some other change to the business model such as the manner in which it deals
with its customers, suppliers or employees.
Some businesses by their nature are more attractive to trade buyers as a
future exit opportunity, and some may be more suited to other private equity
houses via a secondary deal, particularly where Target is in a sector which is
favoured by that market. Other businesses may be more suitable to an IPO or
other transaction involving the public markets. It is not essential that the pri-
vate equity investor has determined precisely how it will sell the business at
the time of purchase. What matters is that there is a good prospect of being
able to exit the investment at a successful valuation in a sensible timeframe.
Everything that the private equity investor does in relation to the investment
both during the acquisition and in the life of the investment is therefore focused
upon ensuring these exit opportunities are available, and maximising the over-
all exit value. Value in this context means the combination of the proceeds
received on the exit and the length of time before the exit occurs – both elem-
ents are key in the private equity evaluation of the business opportunity, as they
will determine the key measure of return to their ultimate investors, being the
internal rate of return (IRR) (as explained in section 3.4 of chapter 1).
2.2 The role of due diligence
This exit focus should be on the minds of the investor, and all relevant advis-
ers to the investor, throughout the acquisition due diligence process. In order
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Exit focus
to maximise the ultimate gain on exit, it is essential to buy at the right price,
and otherwise on the right terms, at the start of the process. Accordingly, the
Newco buyer backed by private equity funding will utilise the acquisition due
diligence as fully as possible, in order to ensure that any risks or liabilities
identied in the business are either left with the seller, or otherwise under-
written by the seller, to the fullest extent possible. Ideally, the investor will
look to factor any material issues into the price on acquisition (which can lead
to strained negotiations as transactions enter exclusivity, as sellers to private
equity may sense the investors taking any opportunity to ‘price chip’, as dis-
cussed in chapter 2).
1
Following the acquisition, however, the acquisition due diligence can be
equally important as a way of ensuring that the problems and opportunities
are, where necessary, addressed at a sensible cost and in a realistic timescale.
As we have seen,
2
good legal due diligence will distinguish between those fun-
damental issues which must be addressed by way of price adjustment, indem-
nities, warranties or other protections at the time of the deal, and those which
may be addressed by suitable remedial action post-completion. As noted in
earlier chapters, it is common for the private equity investors to require the
managers, with the assistance of the relevant due diligence providers, to prod-
uce a document (often referred to as the 90 Day or 100 Day Plan, reecting
the period following completion in which it is prepared) setting out a sensible
plan for rectifying any such issues, together with a timescale, costings and
suitable milestones for monitoring progress. If these remaining issues are not
addressed after the acquisition, they will usually still exist at the time that the
owners are seeking to exit the investment. The focus on exit requires that the
private equity investors and the managers put the business into the best state
possible to maximise exit value, by utilising the issues identied in due dili-
gence and, where it is sensible and cost-effective to do so, rectifying them.
2.3 Exit focus during the life of the investment
Of course, during the life of the investment, other issues and opportunities
will arise that were not known or identied at acquisition. From a legal per-
spective, changes in law and practice, or in the regulatory environment, can
create a potential problem within Target, or may create a possible solution for
an already known difculty. In the wider sense, commercial opportunities and
threats will emerge on a continuing basis. The investor and managers will be
keen to understand all of such issues as fully as possible and, where neces-
sary, to address them in a way that best preserves or enhances the exit value.
The exit focus means that there is an ongoing exercise to maximise value and
to quantify, reduce or eliminate risk and liability. For these reasons, private
equity is often championed by its supporters as an environment that stimulates
1 See chapter 2, section 3.3.
2 See chapter 2, section 4.3.
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E x i t s
value creation; the interests of the shareholders and the management team are
aligned to create meaningful and sustainable value in the business over the
medium term, rather than having a focus on short-term prot distributions or
remuneration.
Even in underperforming investments, the major decisions that may have to
be made and that were explored in chapter 11 (for example, in relation to re-
nancing, restructuring or changes to the management team or Business Plan)
will be made with a sharp focus on exit value – even though, on these facts,
that may well be with a view to minimising the loss rather than maximising the
gain. The private equity investor only stops thinking about an exit when there
is no prospect of preserving any of the value already invested and no sensible
case for investing further funds – only at that stage is any realistic hope in the
investment lost.
3 Share sale
3.1 Parties
As explained in chapter 4, a share sale of a UK company typically proceeds
by way of a formal written contract between the existing shareholders (sell-
ers) and the buyer.
3
When a private-equity-backed company is sold, there-
fore, the sellers are the private equity investors and the managers. In some
cases, other people may become shareholders in the company just before
the sale, and join in to receive some of the consideration – this could arise,
for example, if the holders of employee share options choose to exercise
their options, or a bank or mezzanine lender elects to exercise its warrant to
become members and to share in the gain on the sale. In many cases, how-
ever, such option or warrant holders receive a cash cancellation payment
instead from the buyer, and do not actually exercise their rights to become a
member of the company (and accordingly do not become sellers in the share
sale). Another seller sometimes seen is an employee benet trust (EBT), if
any of the shares are held in such a trust. Again, practice varies as to whether
the shares held by the EBT are sold by the EBT with proceeds passed to the
employee beneciaries, or the shares are transferred out to such beneciar-
ies before the time of the sale, so that the proceeds end up directly in their
hands.
4
The special factors that arise when the transaction is a secondary buyout
are considered in more detail in chapter 12. When an auction arises, there
may well be tension between any possible trade buyer and the prospect of a
secondary buyout. This chapter will focus on a full exit, that is to say where
3 See chapter 4, section 2.1. Target itself will not usually be a party.
4 See further chapter 6, section 4.2(b), on mezzanine warrants; and chapter 7, section 5, on share
options and similar incentives.
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Share sale
the managers either leave the business altogether at completion of the sale, or
stay on as employees but have realised their full capital gain by selling all of
their shares on sale. In some cases, the managers may go on to hold shares in
the buyer (for example, if a listed company is the acquirer, it may issue its own
shares to the sellers as part of the price); however, in those circumstances, the
sellers have typically agreed to sell on those terms because they considered
it to be the best deal on offer overall, rather than because those individuals
are expected to be material equity participants in the buyer’s business going
forward. Many of the issues outlined in this chapter will also be relevant on a
secondary deal.
3.2 Typical features of a share sale exit process
Chapter 2 summarises, from a buyer’s perspective, the steps involved in a typ-
ical share sale transaction.
5
Whilst the precise process will vary depending on
the factors explored in detail in that chapter, it will typically involve the fol-
lowing steps:
selection of advisers;•
initial marketing process;•
non-binding offers;•
heads of offer letter agreed with preferred buyer;•
due diligence;•
share sale agreement drafted and negotiated;•
share sale agreement signed;•
conditions satised post-signing (where relevant); and•
sale completes and price paid.•
We shall now examine some of these steps in more detail, and in doing so
highlight the differences that can arise from a seller’s perspective when the
Target is private-equity-backed.
(a) Selection of advisers
In most transactions, the sellers will retain a number of advisers, including at
least a corporate nance adviser and a legal adviser to act for them on the sale.
In the sale of a private-equity-backed company, the investors will generally
have the nal say on the choice of advisers, unless they are in a minority equity
position. The rms selected often have a delicate balance to strike, especially
if any real issue arises between the investors and the managers. Most managers
tend to regard such advisers as inclined more to the views and interests of the
private equity investors, especially when they are the majority equity owners.
Whilst the investor preference generally prevails on the choice of corporate
nance adviser in particular, the management team may be able to exert more
5 See chapter 2, section 2.
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E x i t s
inuence on the choice of legal adviser – as the remainder of this chapter high-
lights, the managers will invariably have a greater need for legal advice, and
engagement in the legal process generally, than the investors.
(b) Marketing process
The managers have a key role to play in this process, not only in provid-
ing detailed information about the existing business, but also in the prepar-
ation of future forecasts, and the other aspects of the marketing dealing with
prospects and outlook. Potential bidders will usually want to meet the man-
agers, especially private equity bidders. A formal process and rm regime
are usually in place to ensure that this is done in a way which best pro-
tects the interests of all sellers, normally in the form of formal management
presentations.
(c) Due diligence
The preferred buyer will inevitably wish to undertake due diligence. In some
auction processes, the sellers will already have undertaken substantial vendor
due diligence to be made available to the bidders (or, at least, to the preferred
bidder). This is intended to shorten the due diligence process and timetable,
with the intention that any further buyer due diligence will be very limited (if
it is permitted at all), and principally conrmatory. It also has the advantage of
allowing the advisers who carried out the due diligence exercise for the inves-
tors on the original buyout simply to update their reports, rather than a pro-
spective buyer’s advisers having to start the whole exercise from scratch. As
discussed in chapter 2, in the height of the seller market in the UK during 2006
and 2007, there was a considerable emphasis on auction and similar processes,
and an extensive use of vendor due diligence and other techniques to maintain
a tight timetable pressure. The change in market conditions since then has led
to a more orthodox buyer-driven process, where the buyer will prefer to take
its time and undertake relevant due diligence itself, through its own nominated
advisers. The precise scope and nature of the due diligence will vary accord-
ing to the size of the deal, the sector in which Target operates, and the nature
of the assets and liabilities (or potential liabilities) relevant to Target. Whatever
the form of due diligence undertaken, the managers are a key part of the pro-
cess on behalf of the sellers, as they will be best placed to provide the access
and information that the preferred bidder will need.
(d) The share sale agreement
6
In all share sales, the share sale agreement is the key transactional document.
The key commercial issues that arise on that document which are specic to a
private equity sale are discussed in sections 3.3 to 3.8 below.
6 For a more comprehensive analysis of some of the content and features of acquisition agree-
ments, see chapter 4, section 2.