A Practical Guide for Private Equity Investing

By Mohammed Assayed, Head of M&A and Restructuring

1.      Private Equity: Methods of generating value and capturing positive synergies 

Generating value and capturing positive synergies is the ultimate goal for Private Equity (“PE”) firms. Throughout the years it has been proven that an ultimate strategy to capture positive value does not exist. Alternatively a combination of strategies and factors should be used. 

First, identifying target portfolios, which can only be done by undertaking a comprehensive due diligence that includes both financial and legal aspects.[1] In most cases, an investment shall be determined after evaluating the following factors:[2]

·         target company management team;

·         industry dynamics;

·         upside and downside risk;

·         corporate structure;

·         competitors and the target competitive position;

·         target financials and liabilities;

·         equity and debt market perspective; and

·         environmental, political and regulatory risks.

By doing so, PE firms can increase operational efficiencies by highlighting operational cost savings and cash flow optimization, which in turn increases the possibility to capture positive synergies.[3]

Second, incentivising the target management to produce healthy positive returns and in-lining their interest with the interests of the PE firm. This strategy is a clear blueprint for the target’s organic growth and ensures commitment to the target’s success. [4]

Third, the sensible use of financial leverage. This is an important element as it can either multiply positive returns or multiplying losses. Historically, PE transactions have been structured with a combination of debt and equity. The right proportions of each are driven by many factors including the relevant sector; geography; size of the deal; market conditions; and the relative cost and availability of debt.[5]

Fourth, an exit strategy. Identifying the right exit route is the most important consideration for any PE firm. Only by achieving a successful exit can the sponsor realise any increase in value and return to the funds it manages to the investors of said funds. Such successful realisation will need to be clearly defined in the exit strategy at the very beginning of the investment. An active evaluation of these strategies is vital throughout the life of an investment and discipline to take suitable methods when investment objectives have been met or prospects for an investment deteriorates.[6]

To properly understand the efficient techniques to achieve the aforementioned strategies to generate value of the target company, we shall exemplify it by discussing a hypothetical PE takeover transaction. Let’s assume that Company X would like, after a comprehensive analysis and due diligence, to acquire Company Y, a medium size healthcare provider. To incentivise management of Company Y and align their interests with Company X’s interests, X shall offer them an equity share in Company Y. This is can be done by undertaking the following forms:

·      Shares: by taking the form of an institutional strip i.e. such form will be ranked equally with the PE firm, and sweet equity. Sweet equity is generally acquired for a nominal value and if a profitable exit occurs, it grants capital appreciation. Nonetheless, sweet equity is subject to a high risk, as the loan notes in the institutional strip rank ahead of the equity i.e. if the company does not do so well, there is more risk that management won’t get anything at all. [7]

·      Employee stock options (“ESO”): instead of giving shares to the management of Company Y directly, X can grant derivative options on Y’s stock instead. This which shall be documented in the stock options agreement.[8]

·    Management warranties: as Company Y’s management will be running the operations until the sale is concluded, and Company X has limited information about Company Y’s future growth potential, Company X shall ask Y’s management to warrant certain information prior to the acquisition.[9] Such warranties are divided into forward and backward looking warranties. Forward looking warranties are those focusing on the preparation, by management, of Y’s business plan and projections. While the backward looking warranty focused more on all aspects of business until the acquisition is complete.[10] The main purpose of this warranty is to enhance disclosure on the part of the Y’s management.

For financial leverage, Company X shall manage the associated cost of debt which can be done using the following techniques:[11]

·   Structural and/or contractual subordination: this is achieved by putting in place an inter-creditor agreement. The terms of which can determine the ranking of security between debt and equity providers.

·   Asset seizure: Company X shall provide security and cross-guarantees from Company Y’s assets post-acquisition. The security granted will usually include fixed and floating charges over all of the assets and undertakings.

Exit strategies on the other hand can take different forms with different characteristics of each, such as:[12]

·        Initial public offering (“IPO”): Company X could sell Company Y to the public, which historically results in the highest exit value when compared to other exit routes.

·        Trade sale: Company X could sell Company Y to a direct competitor. This holds many benefits for X, as it is an immediate and complete exit and a relatively straightforward process.

·         Secondary Buyout: Company X could sell Company Y to another PE firm. 

·         Asset sale: Company Y could sell the jewel assets of Y. However, such a sale is mainly tax driven.

It is worth mentioning here that such exit strategies usually are combined with management support i.e. Company Y’s management, along with drag provisions to make sure the minorities i.e. management sweet equity, is dragged into the transaction.[13]

Another indirect way to turn around Company Y, can be done by Company X who has full control over Company Y in certain circumstances. This can be done by composing Company Y’s board to Company X’s favour, incorporate positive and negative covenants and build proper information rights in to the investment agreements.[14]

2.      Financing the Deal: Marketing, governance documents and the purpose of each

We shall assume that the new fund will be structured as a Limited Liability Company.

In terms of marketing documents, the following are required: 

·         Private Placement Memorandum (the “PPM”): the PPM is a principal formal marketing document which has become an industry standard.[15] A PPM is a legal document provided to prospective investors when selling stock or another security in a business. It is sometimes referred to as an offering memorandum or offering document. It is used in “private” transactions when the securities are not registered under applicable federal or state law, but rather sold using one of the exemptions from registration. The document describes the company selling the securities, the terms of their offering, and the risks of the investment, amongst other things. The disclosures included in the PPM vary depending on which exemption from registration is being used, the target investors, and the complexity of the terms of the offering.[16]

The importance of the PPM stems from its purposes. It provides a description of the new fund investment strategy, policies, investment restrictions i.e. prohibition on the offering and sale of interest under the regulator, and market commentary. Going back to our previous example, it contains the profile of Company X and its senior team members along with their track records. Additionally, it provides a summary of the Limited Partnership Agreement (the “LPM”), along with relevant major risks. Moreover, it contains details of the fund size i.e. €150m, plus any limitations on the amount to be raised.[17]

·    Subscription Booklet: this contains a subscription agreement and an investor questionnaire.[18] The subscription agreement consists of a formal offer, which shall be binding once executed, from the new fund to the potential investors to acquire a Limited Partnership interest and the mechanics of such. While the investor questionnaire is mainly made to extract information to ensure the new fund complies with the regulator(s) requirements.[19]

For governing documents on the other hand, the following are essential:

·        Limited Partnership Agreement (“LPA”). The terms that govern the relationship between the partners are listed in the LPA, which includes lengthy details about the financial arrangements between the partners, investment objectives; constraints; closing date; term; indemnity; early termination provisions;[20] management fees; and the distribution waterfall provisions.

·        Side Letters. It is a bilateral agreement between the GP and LP that set out bespoke arrangements not included in the LPA, i.e. rights of co-investment; terms of extent of transfer; and withdrawal or excuse rights. It is worth highlighting that there has been a proliferation/increase of side letters especially as key investors insist on 'Most Favoured Nation' (the “MFN”) clauses in side letters. This ensures that if any special treatment is given to certain investors that it will also be extended to others with the same benefit.[21]

  ·      Investment Management Agreement: this agreement regulates the terms between the manager and the fund,setting out the terms on which the manager agrees to act, and the powers and rights which have been delegated to it.[22]

·         Advisory Agreement: this is in the case that some advisory responsibility will be delegated to third party. Back to our example, instead of Company X permanently bringing a new team on-board, X can delegate to them advisory responsibilities specifically for the new fund. Thus, Company X shall prepare an agreement to regulate the relationship with them.[23]

·         Co-investment Agreement: this is used in a situation where some regulatory and/or tax difficulties for a certain investor(s), where investors are offered the option to invest alongside the new fund.[24]

3.      Cornerstone investor: preferential rights and negotiation power

As a cornerstone investor, they could negotiate getting a seat in the new fund advisory committee, or push for engaging a side letter (as discussed above) to grant them additional rights and variations to the obligations in the LPA. In this side letter, such investors might insist a sliding MFN clause, however, the new fund management might counter MFN clause by including ‘pay-to-play’ clauses. This will encourage them to fully participate in any future financing that might occur in the new fund.^[25] This is along with early bird incentives to reduce management fees; co-investment rights; waterfall with escrow structure; and interim claw back guarantees from senior managers.

Bibliography

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Statutes:

1.      Alternative Investment Fund Managers Directive 2011