A Practical Guide to Private Equity Transactions

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Preliminary matters

An important consideration for private equity investors when engaging

advisers is the question of costs. In completed deals, adviser costs are gen-

erally met by the buyer (or possibly another company in the buyer group,

where there is a more complex group structure

), and accordingly the amount

of such aggregated costs are taken into account in determining the funding

required for the deal and a suitable provision will be included in the relevant

section of the nancial model. As we have seen, many potential private equity

opportunities that are investigated do not lead to a concluded transaction for

the party investigating, however. Accordingly, there is an increased risk for

private equity investors that they will have a liability for the costs of any

advisers retained personally if a transaction ultimately aborts or is closed by

another bidder.

In the competitive auction processes seen in the period up to summer 2007,

this became an increasing concern for private equity investors – as highlighted

in section 2, the methods in which these auctions were run required poten-

tial bidders to do an ever increasing amount of work before exclusivity. Every

transaction has some abort risk, although if exclusivity is obtained there is

usually a fair chance that the transaction will proceed. However, the auction

processes had effectively increased the costs exposure, in many cases to sig-

nicant levels, even before exclusivity.

In the UK, as a result of this exposure, an emerging dynamic in the rela-

tionship between private equity investors and their retained advisers has been

the sharing of this transaction risk between them. For example, certain advis-

ers may agree to carry out work for a limited fee (or even at no cost) up to the

stage of exclusivity. In the more orthodox market operating before the height of

auction processes, this may well have been a reasonable exposure for the advis-

ers to accept (as highlighted in section 2, the work required before exclusivity

may have been limited to a very preliminary review of data, a very limited

amount of due diligence, and negotiation of the heads of agreement or perhaps

only an indicative offer letter). As the auction processes became more promin-

ent, however, the amount of work the potential bidder had to do before getting

exclusivity (and the risk of not getting exclusivity) signicantly increased; as

a result, the costs exposure before exclusivity tended to escalate, and there-

fore other arrangements were sometimes agreed. Those rms with strong links

with trusted advisers might negotiate a contingent arrangement, on an under-

standing that any fees accrued from an aborted deal would be carried forward

to the next engagement until a deal was ultimately concluded. Others would be

left incurring far more signicant costs on aborted transactions.

It is important to note in this context that the professional rules applicable

to certain advisers limit or preclude the undertaking of certain work on a con-

tingent basis, particularly in the area of nancial due diligence. Practice in this

respect also differs in certain jurisdictions and, accordingly, where advisers

4 See further chapter 3, and in particular section 3.4 concerning transaction costs.

The deal process and preliminary matters

are retained overseas for a cross-border transaction, the local rules in relation

both to market practice and to professional conduct should also be checked.

It remains to be seen whether the abortive costs risks associated with car-

rying out signicant work before exclusivity is granted will be reduced in the

more buyer-friendly market conditions prevailing since summer 2007. Rather

than the competitiveness of auctions leading to a number of disappointed

buyers on the chase for exclusivity, it is likely that other factors will cause

potential transactions not to proceed (for example, scarcity of debt funding, or

an inability to meet or modify the seller’s price expectation).

3.2 Engagement letters

A lawyer appointed by investors will clearly need to agree the terms of that

rm’s engagement by way of an engagement letter with the relevant private

equity rm. However, in addition to this, it is usual for any engagement let-

ters proposed by other advisers or due diligence providers to be passed on to

the law rm for review on the investors’ behalf. This review exercise can be

substantial, particularly in the case of accountancy rms or investment banks

where a detailed engagement letter is often accompanied with ‘small print’

standard terms and conditions. In addition to general advice concerning the

scope of work, fees payable and other key contractual terms, there are certain

areas of negotiation where some background information and context is help-

ful to the lawyer.

(a) Limitations on liability

The Big Four

(or, as they were previously, the Big Six) accountancy rms

have, like many other advisers, sought over the years to limit their profes-

sional liability where possible. This became an increasingly contentious mat-

ter in the mid-1990s in the UK, and led to delays on transactions (or at least on

agreeing engagement letters) until this issue was addressed. Partly to reduce

the time spent on these matters, a Memorandum of Understanding was agreed

between the Big Six (as they then were) and the BVCA in February 1998.

Whilst this is not a legally binding document, in practice it has gained accept-

ance throughout the private equity and banking industries and beyond, and

throughout accountancy practices both within and, in some cases, outside the

current Big Four.

The most notable content of the Memorandum of Understanding is the pre-

scribed amounts given for the cap on the accountancy rms’ overall liability

from an engagement based on the transaction value. The liability caps pre-

scribed by the Memorandum of Understanding are as follows:

if the transaction value is less than £10 million, the transaction value;•

5 Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers.

6 Memorandum of Understanding, 18 February 1998.

Preliminary matters

if the transaction value is greater than £10 million, but less than £55 million, •

an amount equal to £10 million plus one-third of the amount by which the

transaction value exceeds £10 million; and

for transactions with a value of more than £55 million, £25 million.•

For these purposes, the ‘transaction value’ is dened as the aggregate of the

new equity and debt being invested relating to the transaction. Some commen-

tators have suggested (in response to the larger deals transacted in the period

since the Memorandum of Understanding) that these limits, and especially the

overall cap at £25 million, should be revised to reect the increasing size and

complexity of many of the more recent deals. However, advisers have gener-

ally been able to hold the line on this (in the mid-market at least). In the more

buyer-friendly markets prevailing into 2009, with fewer deals and a greater

keenness on the part of advisers to win advisory work, it will be interesting to

see if attempts to reopen these thresholds meet with any more success.

(b) Proportionality

The Memorandum of Understanding also includes provisions relating to pro-

portionality wording in accountants’ engagement letters. Many advisers have

historically tried to include a proportionate liability clause that seeks to miti-

gate the adviser’s liability to the extent that the courts might consider it just and

equitable to view some other person as principally responsible for the losses

in question. Such clauses are an attempt to extend further the general defences

that are available to adviser rms in respect of such matters, such as causation

principles, contributory negligence, the ability to join in or seek contributions

from third parties and common law duties to mitigate loss. Such clauses have

therefore proved to be contentious, with many investors (or their legal advisers)

arguing that such general principles should be relied on, without the need for

an additional contractual defence.

Proportionality matters to advisers, however, because, without it, all advisers

who contributed to a loss are generally jointly and severally liable to the claimant

for the full amount of that loss (with a right on the part of the advisers to pur-

sue each other adviser for a contribution). Accordingly, one adviser who might

be considered to be, say, 20 per cent at fault may nevertheless face 100 per cent

of the claim – and any right of contribution in favour of that adviser from other

advisers might be worthless (for example, if the other responsible parties, or their

insurers, are no longer trading or otherwise not good for their share).

In the Memorandum of Understanding it was agreed that no specic pro-

portionality provisions would be included in smaller or mid-market transac-

tions (at that time dened as transactions with a value of up to £55 million).

Beyond this amount, however, it is stated that proportionality wording may

be included, given the larger exposure on such transactions. In any such case,

it may be necessary to consider and negotiate such wording (which can vary

from accountancy rm to accountancy rm) having due regard to the nature of

the transaction and the bargaining position of the relevant parties.

The deal process and preliminary matters

One nal clause which is often found in an adviser’s engagement letter is an

indemnity or ‘hold harmless’ provision. This should be distinguished from the

hold harmless or indemnity provisions often included in a separate letter for

the release of audit papers for due diligence purposes, which is referred to in

section 4 below. This provision in the engagement letter is intended to ensure

that the relevant client will indemnify the adviser rm for any losses it suffers

as a result of a claim by a third party against it relating to the transaction. Some

of these provisions are drafted very widely, so care is needed in their negoti-

ation, although most rms will be sensible in limiting the recovery to those

situations which they are really trying to cover.

Private equity investors and banks may well be subject to their own internal

rules and policies as to whether they are able to provide any such hold harm-

less provision at all, or whether they are able to give such an undertaking on an

indemnity basis, in which case it may be necessary for such qualication only

to be given by the management team personally and/or by the buyer Newco

(which is of limited value unless and until the transaction actually completes,

and even then Newco may offer little comfort if the dispute which has arisen is

signicant and reduces the value of that company).

3.3 Heads of agreement and exclusivity

In order to give some structure to the transaction, and to satisfy both the seller(s)

and the buyer that the time and professional costs to be incurred (in negotiat-

ing an acquisition agreement, carrying out due diligence, securing funding and

negotiating funding documents) are likely to be justied, it is usually the case

that the parties will seek to agree heads of agreement (often referred to simply

as ‘heads’) at an early stage in the acquisition process. With certain import-

ant exceptions, the provisions in these heads are usually expressly stated to

be non-binding, and accordingly do not amount to a contractual commitment.

However, they are important in satisfying each party that the key commercial

terms are being addressed and that there is, in principle, a transaction in reach.

The heads will set out the nature of the transaction (for example, whether it

is to proceed by way of a share sale or an asset sale), the consideration payable,

and any conditions attached to that consideration (for example, any net asset

or working capital test, or earn out arrangements

). It may also contain outline

details in relation to the warranties and limitations, the restrictive covenants to

be provided by the seller(s) and any other important commercial arrangements

to be entered into between the seller(s) and the buyer.

There has been a tendency for heads to become ever more complicated

and protracted. Clearly, there is a balance to be struck between ensuring that

7 See chapter 4, section 2.2.

8 These matters are considered in more detail in chapter 4.

Preliminary matters

there is agreement in principle on the key points (thereby reducing the risk

that the transaction may fall over during due diligence and negotiation of the

detailed legal documentation), and making the heads such an exhaustive docu-

ment that it starts to resemble the acquisition agreement itself. In particular,

in the absence of substantial vendor due diligence,

the buyer is unlikely to be

in a situation where it has all the material facts necessary to agree all of the

key terms. Accordingly, heads are inevitably expressed to be conditional upon

the outcome of due diligence. For this reason, there is usually a desire (on the

buyer’s part in particular) to move on from discussing the heads so that this

due diligence process may be undertaken once the key commercial terms (and

particularly the price) have been agreed, rather than seeking to agree abso-

lutely everything upfront. The buyer is particularly driven to secure exclusiv-

ity, which is usually dealt with in the heads.

Although the heads are generally non-binding for this reason, there are

certain key clauses which the parties (or at least one of them) will insist should

be legally binding.

(a) Conﬁdentiality

The seller(s) and the Target have a keen interest in protecting the condential

information of the business. Although this is perhaps a more obvious issue

when dealing with a trade buyer, a similarly cautious approach is neverthe-

less usually adopted when the buyer is a private-equity-backed company.

Accordingly, it will be usual for the seller(s) to require any interested buyer

to enter into a formal condentiality letter at an early stage, sometimes as a

prerequisite for access to the information memorandum or other details of the

sale process. In the case of a private equity bidder, this may be signed not only

by the private equity investors themselves, but also by the buyer Newco (if that

company is already established, which is not always the case at this prelimin-

ary stage). Assuming such a condentiality letter or agreement (also referred to

as a ‘non-disclosure agreement’, or NDA) was in place prior to the heads being

entered into, it is customary for the parties to conrm that such arrangements

continue to bind them in respect of their ongoing negotiations.

Prior to 1999, the form of condentiality agreement was often an area of

detailed and time-consuming negotiation between the parties. Whilst the core

principles of the agreement seem simple enough, the legal detail can become

demanding where provisions are proposed and negotiated to deal with every

possible exposure. For example, the inclusion of clauses designed to make

the private equity investor responsible for any breach of condentiality by its

advisers or other agents, or requiring it to indemnify the seller(s) in the event

of any breach, often led to protracted legal debate – it could sometimes take

a week or even a fortnight simply to agree the condentiality terms to allow

commercial discussions and information sharing to begin.

9 See section 4.2 below.

The deal process and preliminary matters

Condentiality is clearly important – but it should not be allowed to intro-

duce any unnecessary delay into a transaction which the parties otherwise

wish to explore, or to create unwanted early friction between the parties. For

this reason, in 1999, the BVCA produced a standard form condentiality

agreement, which it has since revised and amended in minor ways. Although

this is not binding on parties wishing to participate in buyouts in any legal or

regulatory sense, it has achieved a high level of acceptance, and now is often

the basis used for condentiality terms (even in deals with no private equity

involvement). Indeed, many private equity investors are willing to sign a con-

dentiality agreement in this standard form for the purpose of initial explora-

tory talks before involving their own legal advisers. Accordingly, if the sellers

are willing to accept this form of agreement, it can accelerate the process and

enable the parties to focus on what are usually more important matters.

Irrespective of whether condentiality arrangements are stated in full in

the heads, or the heads simply make reference to an existing document, the

parties will wish to ensure that such provisions are legally binding. A buyer

may also wish to include an obligation on the part of the seller(s), and vice

versa, that the fact that negotiations are taking place is treated in condence.

(b) Exclusivity

The principle of exclusivity has already been referred to, namely, an arrange-

ment between the parties that negotiations will take place only between the

seller(s) and that particular party to have been granted exclusivity. Under these

provisions, the seller(s) are obliged not to negotiate with any other party or

provide information to them, and to break off any such discussions that are

already taking place. English law draws a distinction between an obligation

actively to negotiate with the particular preferred bidder (which is generally

too vague to be enforceable as a matter of law) and a negative obligation not to

speak to or have any dealings with any other bidder. This latter obligation will

generally be enforceable under English law – see the House of Lords decision

in Walford v. Miles.

In considering the detailed terms of any exclusivity arrangement, the

seller(s) must have regard not only to whether the price and other terms set

out in the heads are acceptable, but also to related factors concerning deliver-

ability. As well as the obvious question of for how long exclusivity will be

granted, sellers may also require certain milestones to be achieved at particu-

lar stages in the transaction for exclusivity to remain in place, or particular

evidence of the availability of appropriate funding (including debt nance) to

fund the acquisition to be provided or conrmed at such stages. Exclusivity

may then be revoked before the agreed end date if certain milestones are not

achieved, or if the buyer seeks to renegotiate key commercial terms. This is

particularly important to sellers who feel that the buyer may look to reduce the

10 [1992] AC 128.

Preliminary matters

price; sellers are often of the view that private equity buyers have a habit of

‘chipping’ the headline price during (and often late on in) the acquisition pro-

cess. Whether this is entirely a fair reputation (and whether they are any more

‘chippy’ than trade buyers) are moot points – it is perhaps fairer to say that the

negotiating styles of different buyers will vary, whether they are private equity

rms or not. Tying exclusivity to milestones and continued deliverability in

this way at least gives the sellers the opportunity to consider other approaches

if the favoured bidder does start to chip.

The heads may include some form of costs underwrite or indemnity, usually

in favour of the buyer, which is often linked with the exclusivity terms. Under

these provisions, the buyer’s costs (or costs up to a capped amount) are under-

written by the seller(s) if the transaction does not proceed because of a breach

of exclusivity.

In a public-to-private transaction (where the Target is a public limited com-

pany) special rules apply, as discussed in chapter 10.

In other circumstances, a

costs underwrite is usually only available in the context of exclusivity, such that

a contribution to the buyer’s costs (often a xed amount, or limited by way of a

cap) is payable in the event that the seller(s) breach the terms of the exclusivity

clause. In a seller-friendly market, costs underwrites are of course less com-

mon, or may be capped at relatively low amounts in the context of the potential

abortive costs of the buyer. As the market becomes more buyer-friendly, there

is likely to be an increasing emphasis on these costs underwrites, especially if

more time and attention will be needed (and accordingly more fees and costs

potentially incurred) to get the banking in place and the deal over the line.

It is possible that costs underwrites may be triggered in other circum-

stances. A common proposition is that either party should be protected where

the other seeks materially to change the terms set out in the heads. This is most

obviously introduced by sellers to mitigate the risk of ‘chipping’, although it

can work both ways; however, private equity buyers are often unwilling to pro-

vide such underwrites, and in any event the fact that an offer is usually subject

to broad conditions such as satisfactory due diligence means that the effective-

ness of such protection is limited anyway.

In negotiating a costs underwrite, it is important to bear in mind that there are

many reasons why a transaction may not proceed other than because the sellers

seek to back out or breach exclusivity. These could include any of the following:

problems identied in due diligence which cannot be addressed in negoti-•

ation or in the legal agreements;

competition or other regulatory consents or approvals not being received;•

11 See chapter 10, section 3.1.

The deal process and preliminary matters

shareholder approval (for example, where the seller is a listed company•

)

not being obtained;

debt or other funding not being available on suitable terms or being with-•

drawn; and

failure to agree the key equity terms or ancillary documentation.•

All of these factors should be taken into account when advising clients on the

effectiveness of a costs underwrite. Generally speaking, clients should under-

stand that a costs underwrite will only protect them if a deal does not proceed

for the specic reasons covered. The other party will be extremely diligent in

trying to ensure that they do not breach the relevant obligations, and in any

event it can be very difcult to prove that a breach actually occurred. For this

reason, recovery under a costs underwrite is extremely rare; however, the focus

that it imposes on the parties to ensure strict compliance with the relevant

terms means that they are nevertheless of some value.

4 Due diligence

4.1 Overview of due diligence

The buyer of a business will rely on his legal advisers to ensure (insofar as

possible) that he is afforded sufcient protection in the acquisition agreement

or other legal documents in the event that the Target acquired does not perform

as was envisaged in the Business Plan, or if a material issue arises within the

business post-acquisition which, had he been aware of such risk before com-

pletion, may have affected his decision to proceed at the originally offered

price, or possibly at all. However, the limitations of a buyer relying on such

legal protection alone should be obvious. For example:

A buyer would prefer to know about any such issues before transacting, and •

to negotiate with the seller to reect the implications of those issues, rather

than chasing the seller for nancial compensation by way of an action for

damages after the deal.

The ability of the buyer to pursue such an action under general law is lim-•

ited. In theory, an action may be possible based on deceit, misrepresentation

or possibly a breach of statutory duty,

but this will generally be limited to

more extreme cases of dishonesty, so in most circumstances the principle of

caveat emptor prevails.

The prospect of a successful contractual action against either the seller(s) or •

the management team for a breach of the warranties set out in the relevant

transaction documents may also be severely limited. As is outlined later in

12 See further chapter 4, section 2.5(b).

13 For example, section 397 of the Financial Services and Markets Act 2000 provides that

persons making misleading, false or dishonest statements may in certain circumstances be

guilty of a criminal offence.

Due diligence

this book, such warranties will be subject to comprehensive limitations of

liability on the part of the relevant warrantors, and proving that an actual

breach has occurred and the damages that have arisen as a consequence is a

signicant hurdle (not to mention the fact that an investor would prefer not

to sue the management team, and a seller may no longer be ‘good for the

money’ even if a claim were to be successful).

A private equity rm (like most other buyers) will therefore insist on a thor-

ough process of due diligence before completing any proposed acquisition or

investment. For the lawyer, the most relevant process is that of legal due dili-

gence. However, a lawyer advising on private equity transactions must under-

stand the nature and function of all types of due diligence carried out by the

investors and their advisers.

4.2 Vendor due diligence and data rooms

As was highlighted earlier in this chapter, the auction processes which became

so prominent during the boom period up to the summer of 2007 invariably

included an increased level of control by sellers on the scope and extent of due

diligence.

Wherever there is an auction process, or the sellers are otherwise suf-

ciently sophisticated to undertake a measured and controlled process for the

release of due diligence information, it would be usual to nd that the sellers

and their advisers have established a data room as part of the transaction pro-

cess. The traditional data room takes the form of a secure and continually

monitored room, normally in the ofces of the sellers’ lawyers, which the bid-

ders and their advisers will visit in order to inspect and report on the various

documents included in the room.

The traditional hard copy data room has now largely been replaced by vir-

tual data rooms – essentially an internet site with secure, controlled access

being made available to possible bidders. Although some sellers may be ner-

vous as to the security of such sites, the industry is now well developed and the

protection afforded to sellers is probably more substantial than in a traditional

data room. For example, the ability of persons accessing the site to forward,

copy or print any of the materials supplied can be restricted. There are also

commercial advantages – the amount of time that each bidder team is spending

in the site can be monitored, and multiple bidders can have access to the site at

the same time without knowing the identities of each other.

By preparing a data room, sellers can ensure that all bidders receive con-

sistent information. They can also control the addition of new data to the data

room in stages, as the more credible bidders emerge – this is particularly

important where bidders include trade competitors, to whom the sellers may

14 For more on warranties and limitations, including the practical considerations before pursu-

ing a claim against management, see chapter 4, section 2.7, and chapter 5, section 3.4.

The deal process and preliminary matters

well be reluctant to provide sensitive or condential nancial information until

a very late stage. The corpor ate nance adviser for the sellers will often begin

the process of compiling the data room, setting out the scope of information

to be included which the sellers then provide in relation to Target. However,

if possible, it is preferable for the sellers’ lawyers to supplement this list of

required information with comprehensive enquiries from their own standard

information request. This reduces the possibility of the data room being criti-

cised for being inadequate or incomplete by the lawyers acting for the buyer

(who may, in turn, advise their client signicantly to renegotiate terms later in

the deal process when these issues emerge, reducing the competitive advantage

which the data room process can otherwise provide to the sellers). Vendor due

diligence also allows problematic issues to be identied before detailed discus-

sions begin, enabling sellers to be better prepared in negotiating those aspects

or, better still, to take action to resolve them.

The sellers may go further than this and ask its accounting, and possibly

legal, advisers to prepare a vendor due diligence report. A due diligence report

is prepared by those advisers, based on the information provided in the data

room, as if they were acting for the buyer, and such draft reports are made avail-

able to bidders as part of the data room content. Bidders are asked to put forward

nal offers based on the content of those reports, and, once a preferred bidder is

selected, an already prepared form of engagement letter is signed which allows

that bidder to rely on the report as that adviser’s own client; in essence, the

adviser switches sides at that point for the purpose of its due diligence work.

Whilst a vendor due diligence exercise allows sellers to exercise a further

level of control over the deal process, there are disadvantages. In a less com-

petitive market, buyers may be more bullish about wanting their own advisers

to conduct the due diligence, which can make vendor due diligence wasteful in

terms of cost and time. Even if a bidder is prepared to accept vendor due dili-

gence, the question of how the costs of preparing that report will be met must

still be addressed. Whilst sellers may argue that a bidder would have to cover

the cost of a due diligence exercise in any event, buyers may be reluctant to pay

all or any of the cost involved when they have not been involved in choosing

the adviser or scoping their review, particularly where they feel that some ‘top

up’ work is needed once they are selected as preferred bidder to address any

gaps or specic areas of concern (as is usually the case). Accordingly, the add-

itional control provided to sellers may well come at a price.

4.3 Legal due diligence

The key objective of legal due diligence is to enable the private equity investors

(and the bank funders, who are usually also an addressee of the report) to under-

stand and, where possible, quantify any legal risks associated with completing

the transaction or within Target itself. It is essentially a legal audit; each key area

of Target’s business is investigated, and a report is produced highlighting any