A Practical Guide to Private Equity Transactions

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Transaction structures and deal documents

1 Introduction

In this chapter, we will look at some typical structures for transactions featuring

private equity funding in the UK. This has become an increasingly complex

area in recent years for a number of reasons. As private equity investors have

looked to acquire larger target companies, and utilised leverage as much as

possible in doing so (as we saw in chapter 1), so structures have become more

complex to accommodate that debt. A growing number of transactions involve

the acquisition of a target with substantial operations outside the UK, which

may necessitate a more complicated deal structure. Tax matters dominate,

however, as rules governing the taxation of returns payable to both managers

and investors must be borne in mind, in addition to any specic tax issues in

respect of the target group.

These issues now have such a far-reaching impact that even a relatively

low-value and simple private equity deal may nevertheless involve a complex

structure. As a result, it can be difcult for anyone embarking on a private

equity transaction for the rst time to appreciate the fundamental commercial

dynamics of a deal, and how a particular deal structure accommodates them.

For that reason, this chapter will begin by examining the key players in a simple

transaction, and the most straightforward deal structure that might emerge in

that situation, which helps to demonstrate how private equity investors look to

achieve the returns referred to in chapter 1.

From this starting-point, it is then

easier to explore the additional factors that may inuence the structure, and the

consequences that result. This, in turn, helps the lawyer to appreciate the key

requirements for the structuring of any particular transaction (and, indeed, to

advise on whether all appropriate considerations have been borne in mind).

The chapter considers, in the rst instance, a typical MBO or MBI trans-

action. However, many of the principles apply equally to venture capital and

development/growth capital transactions, and certain specic implications

applying to secondary buyouts are also touched upon later in the chapter.

1 See chapter 1, section 3.4.

Transaction structures and deal documents

Similarly, this chapter principally looks at the downstream activity of private

equity funders investing, rather than the numerous structures involved in the

establishment of private equity funds themselves (which is outside the scope

of this book), although certain features of the most common form of private

equity investor in the UK (being a limited partnership model) are highlighted

where this assists the understanding of the structuring of the investment deal.

The chapter concludes by providing an overview of the main transaction docu-

ments, which are then considered in more detail in the chapters that follow.

2 A typical MBO/MBI deal structure

2.1 A simple structure

A simple starting-point is to consider a transaction whereby a management

team wishes to acquire Target utilising funding from a single senior bank

funder (which we will refer to in this chapter as the ‘senior lender’) and a single

private equity investor.

In order to achieve this, each of the providers of funding (being the man-

agers, the investor and the senior lender) will provide the funding required

for the acquisition of Target, together with such further funding as may be

necessary for the ongoing working capital requirements of Target, to a newly

incorporated company (Newco) which can then acquire the shares or assets of

Target (as the case may be).

Assuming that Newco acquires the entire issued share capital of Target

(which, in turn, will therefore result in any subsidiaries of Target being

Newco

Target

Subsidiaries

Target

Sale of Shares

Senior LenderInvestorManagers

Term Loan/Working

Capital Facilities

Loan Notes and

Equity and

Debt

Investment

(£)

Equity Investment

(£)

Debt Investment

(£)

Seller(s)

Payment of

Consideration (£)

Subsidiaries

Figure 3.1 Typical single Newco structure

A typical MBO/MBI deal structure

incorporated within the newly formed group of companies), Figure 3.1 shows

the typical instruments used (together with a ow of funds) for such a deal.

2.2 The players and their instruments (risk and return)

In this straightforward deal structure there are three parties providing funding

for the transaction, and each investment takes a different form. Those invest-

ments can be distinguished by reference to the risk (per pound) in making the

investment, and the return (per pound) that the party expects for taking such

risk with the parties taking the most risk expecting the higher return.

(a) The senior lender

A more simple transaction will involve Newco taking debt facilities from a

single bank, often sourced via the acquisition nance team of one of the main

clearing banks. Where the debt is limited to a single layer of debt, from a sin-

gle bank, then this usually comes in the form of a rst-ranking secured term

loan, together with ongoing working capital facilities.

The term loan is the acquisition nance, that is, the nance required to pur-

chase Target, and is often split into a range of alphabetically identied tranches

(i.e. Tranche A, Tranche B, etc.), each with its own repayment and/or interest

proles. Repayment may be by a single ‘bullet’ repayment at the end of the

term, by instalment repayments on scheduled dates over time, or a combin-

ation of the two. Interest tends to be charged at a xed number of percentage

points above LIBOR.

The working capital facilities are those facilities required to fund the day-

to-day requirements of Target, and so will vary according to the underlying

business, but often include an overdraft facility, letters of credit, bank guar-

antees or revolving credit facilities. Note that the rst secured position of the

bank would typically extend to all monies owed under all facilities, unless

there are unusual commercial reasons for certain parts of the overall package

to be carved out of the rst-ranking security.

The risk and return prole of the senior lender’s investment is therefore rela-

tively straightforward. The relevant bank will expect rst-ranking security for

the amount loaned, and will apply their then current lending criteria to deter-

mine the extent of the facilities it is prepared to offer, and the interest margin it

requires in offering such facilities, based on forecasted prots and cash ows as

set out in the Business Plan and as tested by nancial due diligence.

(b) The investor

A private equity investor will usually invest by way of two different instru-

ments. A loan investment will be made (or, possibly, a preference share

investment with economic features similar to a loan investment) alongside a

subscription for equity shares.

2 For more on senior banking terms, see chapter 6, section 2.

Transaction structures and deal documents

In most modern UK transactions the loan investment typically takes the

form of loan notes. A loan note is simply a loan security (in effect, a sophisti-

cated IOU) issued by Newco entitling the registered holder to receive interest,

capital repayments and any other payments as they fall due. The loan note may

well be unsecured, or alternatively any security granted will be subject to an

intercreditor agreement or deed of priority which effectively subordinates such

security behind the senior lender.

Payments of interest or repayment of capital

on the loan notes will be restricted pursuant to the relevant intercreditor agree-

ment. In any event, repayment of capital on the loan notes would not usually be

scheduled until a time when all loans advanced by the senior lender have been

repaid in full (typically, twelve months after the due date of the last repayment

to the senior lender).

It is also common for the interest accruing on the loan notes to remain out-

standing either throughout the life of the loan notes, or at the very least for an

initial period. The interest which would usually have been paid on a particular

interest payment date (usually a quarter date) is instead added to the capital

sum outstanding on the loan notes (or ‘rolled up’). Interest then continues to

accrue, at the agreed interest rate, on the increased rolled-up amount. The

extent to which any interest may be payable to the investor, or should be rolled

up, will be a matter for discussion and negotiation between the senior lender

and the investor, and their respective advisers, by reference to what seems

feasible based on the Business Plan prepared by the managers (and supporting

nancial due diligence exercise). As larger private equity transactions may

utilise a signicant amount of leverage from one or more senior lenders, or

other priority debt funders (see further below), it is not unusual for interest to

continue to roll up until the date of redemption of the loan notes. In any event,

even where loan note interest may be payable, the intercreditor documentation

will invariably allow the interest payment only if Newco is up to date with all

amounts payable to the senior lender (whether capital or interest), and where

the payment will not result in a breach of the banking covenants set out in the

bank facilities.

The rolling up of interest on investor loan notes in this way has signicant

tax implications for both the Newco group and the investor. For that reason,

other more complex forms of loan note are often utilised such as PIK notes,

deep discounted bonds and Eurobonds.

Prior to 1997, it was quite common for the ‘debt’ element of the invest-

or’s investment to be made by way of subscription for redeemable preference

shares in the share capital of Newco. The preference shares would be redeem-

able by Newco on certain agreed dates set out in Newco’s articles of associ-

ation, which would match the dates on which capital repayments would be

repayable under a more modern loan note structure. Similarly, the holder of the

3 For more detail concerning intercreditor arrangements, see chapter 6, section 4.3.

4 For more on the tax implications, including these forms of loan note, see chapter 9, section 2.

A typical MBO/MBI deal structure

preference shares would be entitled to a xed priority dividend on a quarterly

or half yearly basis (analogous to the interest payments under loan notes). The

intercreditor agreement would then set out restrictions prohibiting the pay-

ment of any such dividends, or redemption of the preference shares, other than

in agreed circumstances, to afford the senior lender the same protection as

is achieved in the loan note scenario described above. With careful drafting

in the articles of association of Newco, it is also possible for preference share

dividends to be ‘rolled up’ in the same way as interest on loan notes.

In addition to the restrictions set out in any intercreditor agreement, the

ability of Newco to pay any dividends or to redeem any preference shares is

limited by the Companies Act. In general terms, a company may only lawfully

pay dividends

or redeem any redeemable shares

where there are distributable

reserves enabling it to do so. As a consequence, even where there is no senior

lender for whatever reason (perhaps because the senior facilities have been

repaid), or a senior lender is willing to permit a payment to the investor, it may

not be possible for Newco lawfully to make the payment. Where an investment

is to be renanced or restructured in a situation where preference share divi-

dends or redemptions are in arrears, this can be a hindrance to a renancing

or restructuring proposal that would otherwise be commercially acceptable to

the parties.

Another advantage of a loan note investment rather than a preference

share investment is that, if structured in the correct way, it may be possible for

Newco to claim tax deductibility on the interest payments due under the loan

notes, whereas preference share dividends will be paid after tax from Newco’s

distributable reserves. The rules governing the deductibility of interest are

complex, and have been subject to recent change, and so must be considered

with great care (and are a dominant factor in determining the type of loan note

instrument, and nal transaction structure).

As a consequence of these factors, a loan note structure is almost invari-

ably preferred to a preference share structure on modern UK transactions.

However, preference share subscriptions do still occur, as the tax and account-

ing considerations in each particular transaction will differ. They have the

advantage of presenting Newco with a stronger balance sheet, and therefore

may often be created as part of an agreed restructuring or renancing. A legal

practitioner may also come across companies which secured private equity

investment prior to 1997 (the date of abolition of advanced corporation tax),

when preference share subscriptions were far more common.

5 Section 830(1) of the Companies Act 2006.

6 Companies Act 1985, section 160, to be superseded by Companies Act 2006, section 687, on

1 October 2009. Note that a redemption is possible without reserves from the proceeds of a

fresh issue of shares to facilitate the redemption, or from capital where a strict statutory pro-

cedure is followed.

7 See chapter 9, section 2.2.

Transaction structures and deal documents

In terms of risk and return, the investor will expose itself to a higher risk than

the senior lender as its investment ranks entirely behind the senior lender on any

insolvency event. As a consequence, the investor requires a greater reward on its

investment. In part, this is often achieved by charging a higher rate of interest

than the senior lender. More signicantly, though, the investor expects to make

a signicant return on exit, so for that reason its loan investment is accompan-

ied by a subscription for equity shares in Newco. Whilst the proportion of the

total amount invested by the investor which is used to subscribe for equity is

low, the investor will expect a signicant percentage equity stake in Newco.

the transaction takes the form of an institution-led buyout, rather than a more

traditional management-led buyout, the investor will determine what propor-

tion of the equity must be offered to management to ensure they are sufciently

motivated, but will usually retain a signicant majority stake.

Whilst the investor equity may entitle the investor to receive dividends from

any prots earned by Newco,

it is common for the investor and other share-

holders not to receive any dividends, as the key return the investor is looking to

obtain from its equity investment is the proceeds from exit whether by way of

the sale of Newco, its otation, or a disposal by Newco of its assets followed by

a winding up (although the latter situation is uncommon save for an insolvency

situation, where the likelihood is that there would be no proceeds for distri-

bution to shareholders in any event). The proportion of the equity which the

investor holds in Newco will, accordingly, be directly derived from the return

which the investor expects on exit, determined by reference to the Business

Plan. As explained in chapter 1, investors measure the return achieved by ref-

erence to the internal rate of return (IRR).

Financial advisers to the investor

and the managers will negotiate the appropriate split of the equity share cap-

ital between their respective clients as the Business Plan and due diligence is

nalised, and terms of the bank funding are understood and worked through

the nancial model.

The managers in a private equity transaction will typically invest only a small

proportion of the total funding required to nance the acquisition of Target.

That is not to say that it is necessarily a small investment in the eyes of the

managers – on a mid-market private equity deal

each of the main managers

would usually be expected to contribute sums to the order of tens of thou-

sands of pounds. The investor will be concerned to see that the managers are

nancially committed to the success of Target post-acquisition, and that their

faith in the underlying Business Plan is given a meaningful context.

8 See also section 3.1 below.

9 See further chapter 5, section 4.4.

10 See chapter 1, section 3.4.

11 See chapter 1, section 2.3, for denitions of market sizes.

A typical MBO/MBI deal structure

This investment by the managers normally takes the form of a subscription

for ordinary shares in the issued share capital of Newco.

As such, the entirety

of their investment is subordinated behind all creditors of Newco, including

the senior lender and the debt instruments held by the investor and general

trade or other creditors. In addition, the articles of association of Newco may

also state that on any winding up or other return of capital all amounts sub-

scribed by the investor for its equity shares in Newco must be repaid before

any monies are distributed to the managers as shareholders (often referred to

as the investor’s ‘liquidation preference’, although pari passu ranking on such

a return of capital is also seen). In that sense, the managers take the most sig-

nicant risk, as all of their investment will rank behind the senior lender and

investor in the event of a business failure.

However, the managers stand to make the highest return per pound

invested on any successful exit. After repayment of the debt obligations, all

proceeds from exit will usually (subject to any ratchet arrangement – see

further section 3.2 below) be shared between the investor and the managers

on a pro rata basis. As the managers have not usually subscribed for loan

notes, preference shares or similar instruments alongside their equity (unlike

the investor), the return received by the managers on a successful exit, per

pound invested, is signicantly greater. For this reason, the equity issued to

managers is often described as ‘sweet equity’, whilst the combined debt and

equity funding provided by the investor is sometimes described as the ‘insti-

tutional strip’.

Figure 3.2 provides a simple illustration of the risk and return prole for

each type of investor on a successful, or unsuccessful, transaction. This high-

lights the very different perspectives each party has when investing.

2.3 Multiple Newcos

For the purposes of most private equity transactions in the UK, the transac-

tion structure set out above is too simplistic. In many cases, there will be more

than one bank funder and/or more than one private equity funder (see section

3.3 below). Similarly, there may be additional leverage in the form of junior

debt (see section 2.4). Finally, most transactions will require the incorporation

of more than one new company in a structure (although it is often only one of

those Newcos, sometimes referred to as ‘Bidco’, that acquires Target). Multiple

Newcos may be required in a transaction structure to facilitate the acquisition

of multiple Targets (especially where overseas Targets are involved), as a con-

sequence of tax planning, or to achieve structural subordination of the various

debt instruments. Some examples of circumstances in which multiple Newcos

arise are set out below.

12 As discussed later in this chapter, in some circumstances (particularly secondary buyouts),

the managers may hold debt investments in addition to ordinary shares.

Transaction structures and deal documents

(a) Multiple Targets

A transaction may involve the acquisition of more than one Target, for example

combining two separate businesses with particular synergies, or the consolida-

tion of one or more businesses in a fragmented market sector. Larger deals may

involve the acquisition of separate parent companies in two different jurisdic-

tions, for example a UK and Dutch parent company with trading groups under-

neath each.

In many such deals, the different Targets may all be acquired by a single

Bidco. However, there may be tax or accounting reasons which require one or

more additional Newcos to be incorporated to acquire the different Targets.

For example, where the Targets are incorporated in different jurisdictions,

there may be reasons for the senior debt funders to provide part of its loan to an

overseas Newco directly in a local currency. In those transactions, a separate

Bidco might be incorporated in each of the two jurisdictions, with a common

parent Newco in which the investor and managers will subscribe for shares.

(b) Structural subordination

As noted above, the senior lender and the investor will enter into a deed of priority

or intercreditor agreement which ensures that the investor loan notes are effect-

ively subordinated behind the bank debt. However, the senior lender may also want

the comfort of achieving such subordination structurally. This involves a separate

Newco being incorporated to receive the senior lender debt funding, which sits

beneath the Newco in which the investor loan note funding is provided.

Subordination is effectively achieved on a contractual basis by way of the

intercreditor agreement. The senior lender also has prior-ranking security to

Enterprise

Value on

Exit

Senior Debt

Investor Debt

Investor Equity

Manager Equity

Senior Debt

Investor Debt

Time

Enterprise

Value on

Investing

Senior Debt

Investor Debt

Investor Equity

Manager Equity

Enterprise

Value on

Investing

Senior Debt

Investor Debt

Investor Equity

Manager

Equity

Time

Unsuccessful

Successful

Enterprise

Value on Exit

Figure 3.2 Risk and return

A typical MBO/MBI deal structure

protect it on any business failure. However, a legal or accounting adviser to the

senior lender may insist that subordination is achieved structurally, in case the

validity of the security may be challenged. This is particularly likely in trans-

actions of a more signicant value (i.e. in upper-market and larger mid-market

transactions), although it has become such a common practice that it might

also be encountered on smaller deals.

Figure 3.3 shows a deal structure incorporating structural subordination

between a senior lender and investor, as well as separation of the investor’s

debt and equity investments for the reasons described in section (c) below.

Where structural subordination is required, intercompany loan arrange-

ments are utilised to ensure that the relevant funds are passed down to the

ultimate Bidco to acquire Target. Such loan accounts may then be capitalised,

whereby each parent company subscribes in cash for shares in its subsidiary,

with such cash subscriptions immediately being satised by settling the sum

payable against the intercompany loan which is owed. By structuring the trans-

action in this way, the senior lender would rank ahead of the investor upon any

winding up or other distribution of assets by the Newco to which the senior

lender has advanced its facilities (Bidco in this example), even if the security of

the senior lender is unenforceable. The investor will only be able to participate

in such assets after all creditors of Bidco (or other companies below Bidco in

the group, depending on how assets are realised on the insolvency) have been

paid, as its loan is entirely to Midco. If Midco gets nothing as a shareholder in

Sale of Shares

Payment of

Consideration

Senior

Debt

Midco

Bidco

Target

Senior Lender

Loan Note

Investment

Topco

100%

owned

Seller(s)

Subsidiaries Subsidiaries

100%

owned

Target

Managers Investor

Figure 3.3 Structural subordination (single lender, with subordination of investor debt)

Transaction structures and deal documents

Bidco as a result of the insolvency of the companies below it, the loan that the

private equity investors have in Midco is worthless.

Another reason for the creation of additional new companies within the buyer

group is to try to ensure that the relevant Newco will obtain a tax deduction for

interest payable on the investor’s loan notes. As is explained in more detail in

chapter 9,

where there is a connection between the shares held by the investor

and the investor’s debt instrument, then HM Revenue & Customs (HMRC)

may treat the whole of the interest upon the debt as a distribution. This conclu-

sion is commonly considered to be avoided if the investor’s debt investment is

in a separate company to its shareholder investment, which can be achieved by

introducing another company into the group, as shown in Figure 3.3. However,

it should be noted that such measure will not mitigate an attack under the UK

transfer pricing and other rules, which are also discussed in chapter 9.

2.4 Higher leverage: junior debt

As has already been mentioned, private equity funders have used increasing

levels of debt funding to facilitate acquisitions which would otherwise be out

of reach due to the signicant enterprise values involved. This necessitates debt

being introduced to the transaction ranking behind the senior lender, but ahead

of the investor loan notes, which is often described as ‘junior debt’. Whilst the

turbulent credit markets encountered in recent times generally mean that debt is

less readily available for transactions, it does not necessarily follow that all junior

debt will cease to feature in deals. Indeed, the reduced availability of senior debt

might result in the more established (and often perceived to be less risky) form

of junior debt, being ‘mezzanine debt’, featuring with increased prominence.

As the name implies, mezzanine debt sits between the investments by

the senior lender and those of the investor in terms of both risk and return.

Accordingly, the investment typically takes the form of a secured loan, which

is subordinated fully behind the senior debt pursuant to the relevant inter-

creditor agreement, and will usually be repayable in one bullet instalment a

short period (six to twelve months) after the senior lender’s term debt has been

repaid in full but ahead of the investors’ loan notes.

Given the additional risk attached to its loan investment, the mezzanine

lender seeks a higher reward than the senior lender (typically, mezzanine lend-

ers target a return on an IRR basis of between 20 per cent and 25 per cent per

annum). It achieves this by way of a combination of arrangement fees and a

higher margin on its loan (typically, around 7–10 per cent greater than the

senior lender), together (in most cases) with an equity interest by way of war-

rants to acquire shares in Newco.

13 See chapter 9, section 3.2.

14 See chapter 9, section 3.3.