A Practical Guide to Private Equity Transactions

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Initial Public Offerings

4.3 Typical transaction structure

A typical IPO of a private-equity-backed company will involve a placing of

shares in the company with institutional investors on a global basis, in combin-

ation with admission of the company’s share capital to trading on a public market.

Unlike America, in the UK a public offer to retail investors is relatively unusual.

The placing will often involve both the issue of new shares by the company (to

raise new capital for the repayment of debt, the funding of its future strategy

and for working capital, as well as to pay the fees connected with the IPO and

fundraising), and the sale of existing shares by the private equity investors.

It is unusual for the investors to achieve a full exit in an IPO; most often,

investors will retain a stake post-IPO. The level of the retained stake will often

be a function of the level of demand from investors in the IPO: the company

will often require a xed amount of new capital to satisfy working capital

requirements and therefore a private equity investor will only be able to sell to

the extent there is excess demand for shares from investors. In addition, inves-

tors may well wish to see the private equity investor retain a stake to demon-

strate an alignment of its interests to those of the new investors.

Given the likelihood of a retained stake in the business, not surprisingly a

private equity investor will be cautious about preparing a company for IPO if it

does not have faith in that company’s ability to produce long-term growth and

value for shareholders such that the investor will be able to achieve a full exit

over a one to two year timeframe at least at the valuation set at the point of IPO,

or better. The prospect of a retained stake in the company beyond IPO also gives

rise to a number of corporate governance issues which the private equity investor

should consider at an early stage in the process – in particular, the retention of

board representation by the private equity investor, and the nature of any restric-

tions on the future sale of that stake (see further sections 4.6 and 4.7 below).

The liquidity of the company’s shares in the after-market will be important

in achieving good share price performance (and thus ultimately realising value

for the private equity investor with a retained stake), and in giving the private

equity investor the best possible chance of trading out its position over the

long term. The initial valuation and free oat at IPO are key factors in deter-

mining initial liquidity in the market. The market on which the company’s

shares are admitted will also have an inuence. The London Stock Exchange’s

AIM market for growth companies has attracted criticism from investors and

other market participants for poor liquidity and underperformance, particu-

larly among many of the smaller companies admitted to that market. As a

result, if the company in question satises the criteria for admission to the

London Stock Exchange’s Main Market and for admission to the Ofcial List,

then this is likely to be the preferable route to market as it will give access to a

wider potential investor base. In the current climate, a company should have a

minimum valuation of £100 million and a free oat of at least 25–30 per cent

at IPO to make the transaction viable.

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4.4 Grooming a company for IPO

A company contemplating an IPO should start preparing itself well in advance

for the rigours of life as a public company. At least twelve months prior to

starting the IPO process itself, thought should be given to a number of key

areas of the business, and steps taken to remedy any issues, including:

(a) The executive management team. Are the CEO and CFO of the company

of the right calibre to lead the company through an IPO process and in its

initial stages as a public company? The team will be responsible for leading

the business through an intense period of preparation during the IPO pro-

cess and, crucially, will be key in selling the company to potential investors.

In just the same way as the private equity investor has relied heavily on the

skills of the management team in delivering value during its period of invest-

ment, potential institutional investors in the IPO will be looking for the same

qualities of leadership and condence in their ability to deliver shareholder

value following the IPO. If additions or changes to the management team are

necessary to achieve an IPO, then the changes will need to be implemented

and given time to demonstrate value well before an IPO is launched.

(b) Non-executive directors. The board may well comprise a number of non-

executive directors, but again their experience of the public markets should

be considered. In most circumstances, UK corporate governance standards

are likely to demand that the majority of the board (excluding the chair-

man) comprises independent non-executive directors. It may be necessary

therefore to consider augmenting the existing board with additional dir-

ectors, or to consider certain changes to the board in order to achieve an

appropriate balance of independence and expertise. The role of chairman

will be particularly important for a public company and should be some-

one with appropriate ‘City’ credentials. As a public company, the company

will also need to establish audit, remuneration and nominations board

committees; the board should include an independent non-executive dir-

ector with appropriate nancial experience to chair the audit committee.

commercial, nancial and legal due diligence exercise. Thought should

be given well in advance to any areas of the business which may need to

be addressed, for example consistency of application and presentation of

accounting policies, the level of distributable reserves and any dividend

traps in the group, any key commercial contracts with unusual or onerous

terms (especially change of control clauses which may be triggered by the

IPO), the terms of existing debt facilities (especially any covenants which

may need renegotiating as part of the IPO process), the share capital struc-

ture of the company (including the terms of any warrants and options) and

the changes necessary to achieve a single class of shares at the IPO.

12 Including any changes necessary to give effect to a proceeds ratchet: see chapter 5, section 4.6.

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4.5 Starting the IPO process

The rst step in the formal IPO process is for the company to appoint an

investment bank to act as nancial adviser, sponsor and underwriter to the

IPO. These roles may be fullled by more than one investment bank, although

a syndicated approach is only usual where a large fundraising is involved.

The selection of the right investment bank is key to the success of the trans-

action. Although it is ultimately the decision of the board of the company, it

is typical to nd the private equity investor taking an active role in the selec-

tion process. Aside from the obvious issue of valuation, the selection process

should focus on the bank’s sector expertise, the rating of its research analyst in

the sector, and the commitment of its sales team to the transaction. Wherever

possible, the company’s management and the private equity investor should

meet with the relevant research analyst

and the head of sales at the bank

concerned to get an understanding of their initial opinions on the company

and their commitment to the process. Although the track record and personal

chemistry with the advisory team at the bank are important, the research and

sales sides of the bank will be instrumental in selling the IPO, and fundamen-

tal to the company’s life as a public company post-IPO.

In many instances, not enough attention is paid to the key commercial

terms of the fundraising at this early stage. The company and private equity

investor should seek to agree a number of important terms with the investment

bank before awarding the mandate and signing an engagement letter with the

bank. Although the underwriting fees and commissions are a key component

of this, it is sensible to agree a termsheet with the bank concerned at this stage

which covers all of the key terms of the underwriting agreement whilst the

company is in a strong negotiating position.

4.6 Key terms of the underwriting agreement

The key terms of the underwriting agreement should be agreed with the invest-

ment bank in the form of a termsheet at the outset of the transaction, prior to

agreeing to the bank’s engagement terms, as set out below.

(a) Fees and commissions

These vary widely depending on the size of the fundraising and market condi-

tions. It is often the case that the bank will ask for a xed advisory fee (often

payable in whole or in part even if the transaction ultimately fails) plus com-

missions for a successful fundraising. Private equity investors often complain

that the most unattractive aspect of an IPO is the uncertainty as to valuation and

13 Pursuant to the UK Financial Services Authority’s Conduct of Business Sourcebook, an ana-

lyst producing independent investment research is prohibited from participating in a pitch by

an investment bank for new business. However, those restrictions do not apply to an analyst

producing non-independent research (a more common business model among traditional UK

mid-market-focused investment banks).

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therefore realisation on exit. Consideration should be given to incentivising the

bank appropriately to maximise value by building in a ratchet to the commis-

sions earned by reference to a range of valuations (although the highest valu-

ation at IPO will not necessarily attract long-term investors and produce the

best share price performance in the after-market). An alternative commission

structure which has been in vogue in the last few years is to include a discretion-

ary element to the commission (0.25–0.5 per cent), payable at the discretion of

the board of the company if the bank has performed well. However, in practice

it is rare for this payment not to be made if the IPO occurs.

It is usual for the company to also reimburse the bank for its expenses, such

as legal fees. These can be considerable and costly to bear if the transaction

aborts, so thought should be given to negotiating caps or discounts in respect

of the bank’s expenses in the event of an aborted deal or a mechanism agreed

for pre-approval by the company of signicant expenses.

(b) Warranties and indemnities

The company will be expected to give the underwriter a wide range of warran-

ties relating to the disclosure document (most commonly a prospectus) to be

published in connection with the IPO and generally in relation to the company

and its business, as well as an indemnity for claims or losses incurred by the

bank in certain circumstances. Banks will often seek to assert that others con-

nected with the transaction should provide the same comfort, especially the

directors and proposed directors of the company and any shareholders selling

shares in the IPO. This gives rise to two issues for a private equity investor:

(a) The scope of any warranties and indemnities to be given by the investor.

Private equity investors will be reticent to provide any warranties or an

indemnity to the underwriter in respect of the transaction. However, in most

transactions, a compromise position is reached where the private equity

investor provides a restricted scope of warranties only, relating to a limited

range of matters relevant to the investor itself such as ownership and title of

shares, capacity to enter into the agreement and the accuracy of informa-

tion relating to the investor contained in the disclosure document. Given the

fundamental nature of these warranties, it is not unusual to see such war-

ranties given without any contractual limitations, such as a monetary cap on

liability or any restriction on the time within which a claim must be made,

although these are clearly areas for negotiation on a case-by-case basis.

(b) The scope of any warranties and indemnity to be given by any represen-

tative of the private equity investor who is to remain on the board of the

company as a non-executive director at IPO. There is often a distinction

drawn in an underwriting agreement between executive and non-execu-

tive directors of the company both in terms of the scope of contractual

comfort they provide to an underwriter and in terms of the limitations on

their liability. This is not a reection of the position at law – all directors,

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Initial Public Offerings

regardless of title and function, have potential liability for a prospectus and

statements made by the company during the IPO process. In the context of

an IPO, non-executive directors can often be relatively new to the business

and, in any event, due to the nature of their duties, do not have the intim-

ate knowledge of the business that the executive directors possess. On that

basis, the underwriter is often prepared to accept a lesser level of contrac-

tual comfort from the non-executive directors compared to the executive

directors. One common compromise position is that the non-executive dir-

ectors will only give warranties on an awareness basis as to the accuracy

of the disclosures in the disclosure document and warranties as to personal

information relating to themselves, with liability often limited in both time

and amount. The private equity investor will be keen to understand the

precise nature of the liability its representative is being asked to assume,

and to ensure appropriate insurance is in place to cover the risks.

An underwriter will expect to obtain the agreement of all existing sharehold-

ers that they will only transfer or dispose of interests in shares following the

IPO with its prior consent. This is to ensure an orderly market in the com-

pany’s shares following the IPO. Many private equity investors initially look

to resist such a lock-up although, in practice, most will eventually agree to such

a restriction for a limited period of time, ranging from three months to twelve

months, provided it is subject to certain exemptions (such as acceptance of a

recommended takeover offer and intra-group or intra-fund transfers).

4.7 Relationship agreement

If a private equity investor holds a substantial shareholding in the company

following an IPO, it is likely to continue to exert signicant inuence on the

company and its board. Depending on the size of its stake, it may be able to

achieve a certain amount of control of the company through its voting power at

shareholder meetings. It may be the case that the company agrees with such an

investor that it should retain the right to nominate a representative to the board

of the company.

In any of these circumstances, it is likely that potential investors in the IPO

will expect to see, as a matter of good corporate governance, a relationship

agreement in place at IPO between the company and the private equity investor

which seeks to regulate the dealings between the private equity investor (as a

substantial, or controlling, shareholder) and the company. The key elements of

a typical relationship agreement include:

(a) the agreement of the relevant shareholder to interact with the company in

all dealings with it on an arm’s length basis and on normal commercial

terms;

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(b) if the shareholder has the right to appoint a director to the board of the

company, details as to when this right will terminate; typically, such right

will exist for so long as the shareholder retains a shareholding in excess of

an agreed level (often a 10 per cent stake);

the approval of any dealings between the shareholder and the company;

(d) limited shareholder protections, which may be negotiable in specic cir-

cumstances; and

(e) restrictions on the ability of the board representative to pass condential

information to the shareholder and restrictions on share dealings by the

shareholder in certain circumstances.

4.8 IPO process

The overall timetable for a London IPO from the time of appointment of advis-

ers to admission of the company’s shares to trading on the market will vary

depending on a range of issues, such as the scale of the company’s business

(and therefore the extent of the due diligence exercise which will need to be

undertaken), the complexity of any restructuring that may need to be under-

taken prior to IPO, the number of issues which may need to be addressed as

a result of due diligence prior to IPO, the structure of the fundraising and

the nature of the disclosure document (for example, a prospectus will require

the prior approval of the UK Listing Authority, whereas an AIM admission

document will not). As a general rule, the IPO process is likely to take at least

twelve weeks, and perhaps longer.

The key work streams, many of which will run in parallel, are as follows:

(a) Due diligence. This will usually comprise a full commercial, legal and

nancial review of the business. This will result in a detailed written

report by both a rm of reporting accountants and the company’s legal

advisers. In some cases, more specic commercial due diligence may be

commissioned by the investment bank concerned, for example a valuation

report in respect of a real estate portfolio or a geological report in respect

of a mining company.

(b) Pre-IPO research. The investment bank’s research analyst will prepare a

research note on the company which will be issued at least two weeks prior

to any formal marketing of the IPO by the company or its advisers. This

will be key to beginning to educate potential institutional investors on the

investment case for the company, and establishing an independent view on

valuation of the business based, in part, on the analyst’s nancial projec-

tions for the company. This research will be informed by data provided by

the company, but will represent the analyst’s own views. In reality, it is a

key part of the marketing process, and will set the market’s expectations

as to the company’s future performance.

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management of the company to present the company’s story to potential

investors in a series of short meetings, known as a ‘roadshow’. These meet-

ings will take place in the last two to three weeks of the process prior to

listing, and are the key tool in testing market appetite for the IPO. The

investment bank’s sales team will follow up each roadshow meeting with

a telephone call to the potential investor to seek to elicit an order. This

process results in a book of orders at a range of prices which will inform

the investment bank’s nal recommendation as to the price at which the

IPO should be launched and the shares sold. The nal decision as to price

should take into account not only the range of prices in the order book, but

also the nature of the investors. Those institutions which are known to be

longer-term investors may be preferred to a shareholder register comprised

of hedge funds with a shorter-term investment horizon, which could have a

negative impact on share price performance.

(d) Disclosure document. The preparation of a prospectus (or AIM admission

document, if appropriate) will be a key focus of the company’s advisers.

This will also be a key part of the marketing process, as well as satisfying

the relevant disclosure requirements of the Prospectus Rules and/or the

AIM Rules for Companies.

(e) Underwriting agreement. This agreement will be negotiated between the

investment bank and its legal advisers on the one hand, and the company

and selling shareholders and their respective legal advisers on the other. It

will set out in detail the mechanics of the fundraising and admission pro-

cess as well as dealing with the matters referred to in section 4.6 above.

A private equity investor should be heavily involved throughout this process; a

thorough process and well-presented investment case will maximise value for

shareholders. The investor should ensure representation on the steering group

for the project and be closely involved in the key stages of the process. For

example, the appointment of independent non-executive directors to the board

will be a key decision, not only because of the positive effect this may have

on the marketing of the IPO, but also (and more importantly for the private

equity investor) because this group of directors, plus the investor’s own nom-

inee, are likely between them to have the majority vote at board meetings. The

composition of the board thus becomes key to the investor’s condence in the

leadership of the business, and its ability to deliver shareholder value following

the IPO.

The private equity investor will naturally be involved in the nal decision

as to pricing of the IPO, but equally important is the publication of research

earlier in the process. This will set the market’s expectations of the company’s

future performance, and in turn will inevitably inuence the company’s future

share price performance and hence directly impact the private equity invest-

or’s realisation of value.

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4.9 Post-IPO

Following admission of the company’s securities to a public market, the pri-

vate equity investor and its board representative will need to operate within the

regulatory regime for UK publicly traded companies. Particular care will be

needed to ensure compliance with insider dealing laws, the Financial Services

and Markets Act 2000, the Disclosure and Transparency Rules and the City

Code on Takeovers and Mergers.

The private equity investor will need to ensure it has sufcient internal

systems and procedures in place to ensure compliance with its obligations, for

example monitoring its dealings and interests and making disclosures to the

company and the market where appropriate.

The presence of a board representative may increase the risks of insider

dealing and/or market abuse to the extent unpublished price-sensitive infor-

mation is known to the board member, who will in any event be bound by

the company’s sharedealing code. This is an area where the private equity

investor and the individual board member should take specialist advice about

the appropriate procedures to implement.

5 Conclusion

In this chapter, we have examined the two most hoped for forms of exit for a

successful private equity investment: the private company sale; and the IPO.

We have also looked at the importance of exit focus in the overall analysis of

a transaction from the outset, and the particular factors that can arise on each

type of exit. A recurring theme is the desire for investors to achieve max-

imum liquidity with minimum redress, and to be in a position to return the

proceeds to the underlying investors in the funds as soon as possible. For many

businesses, a trade sale will be the most efcient method of achieving the

objectives desired, and it would be fair to say that this is usually the invest-

or’s preferred exit route given the relative certainty and liquidity inherent in

the transaction when compared with an IPO. However, there will be circum-

stances where an IPO creates the best opportunity for maximising value on the

investment and, where relevant, enabling the private equity investors to main-

tain an ongoing (albeit diluted) stake in the business going forward. An IPO

may also be attractive to the managers, who may wish to guide the business to

the next stage of its evolution in the very different business environment of the

public markets.

As has been highlighted throughout this book, the period leading up to

the summer of 2007 was something of a boom period for private equity. The

apparently ever-increasing private equity marketplace, and the willingness of

banks and others to provide liquidity, generated very signicant returns for the

majority of investors in the period prior to the credit crunch. The market con-

ditions since the credit crunch, with restricted liquidity and general hesitancy

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over asset valuations (not to mention the increased focus that investors have

had to place on their existing portfolio companies) has led to a reduction in

market activity both in terms of investment and exits. However, the consider-

able contribution that private equity has made to UK industry in recent years,

and the opportunities which it affords both to investors and to managers by

aligning their interests in the ownership and management of businesses, means

that there is likely to remain an ongoing role for private equity for many years

to come. The exibility shown by the private equity industry to date suggests

that it has the will and the resourcefulness to adapt in the ever-changing condi-

tions which we now face.

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ACAS conciliation 219

accountancy rms

engagement letters 28–30

accounting basis

dened benet pension schemes 230

accounting policies

completion accounts 72, 370

nancial due diligence 41

accounting procedures

due diligence 41

acquisition agreement 69, 113

assignment 95

competition matters: merger control 99–101

EC rules 104–10

UK rules 101–4

conditionality 77–81, 118, 257

consequences of 81–3

conduct of Target between exchange and

completion 82

condentiality 94

disclosure

acquisition disclosure letter 97–9

principles 95–6

double counting 76

parties 70–1

price and price adjustment 71–4, 89

price reduction: other risk allocation during

negotiations 75–6

rescind, right to 83

restrictive covenants 70, 94–5, 129

retention accounts 76–7

risk in business between exchange and

completion 82–3

tax schedule/indemnity/deed/covenant

110–13

warranties, indemnities and risk allocation

84–5

interaction with warranties in investment

agreement 122–4

limitations 89–93, 98

secondary buyouts: warranty limitations

356–7

warranties: knowledge/awareness 85, 113

of buyer 87–9

of seller 86–7

acquisition documents

disclosure letter 97–9, 165

overview 66–7