Contributed By Simpson Thacher & Bartlett LLP
This chapter provides an overview of the key trends and features of a “private equity transaction” in the United Kingdom, which means an acquisition (or disposal) where either the buyer (or the seller) is a special purpose vehicle owned and controlled by a private equity fund.
After a period of competitive auctions and pre-emptive bids in the private equity space in the UK, activity at the start of 2020 was heavily focussed on difficult carve-outs and finding value in listed companies with depressed share prices. This steady private equity dealmaking during the first quarter gave way to the challenges posed by the COVID-19 pandemic.
The value and volume of transactions closing during Q2 fell and has continued during Q3. Leveraged buyouts declined due to the tightening of the debt markets tightened and alternative strategies such as joint ventures and distressed debt grew in popularity. Despite market conditions, some mega deals have still been done, such as Advent’s GBP4bn takeover of Cobham, a leading global defence and aerospace company, KKR’s GBP4.2 acquisition of Viridor, the waste business of Pennon plc.
Technology, media and telecoms and manufacturing remained a sharp focus this year across Europe, with increased deal volume in these sectors. Online businesses have been attractive as has healthcare, with CD&R’s acquisition of Huntsworth Services, a leading provider of services to biotech companies looking to commercialise new therapies.
The hospitality sector is in decline, with deal activity being focussed on restructurings, such as the restructuring of Hony Capital owned Pizza Express and the distressed sales of private owned businesses such as Bistrot Pierre, Byron Burger and Casual Dining Group.
The continued uncertainty regarding Brexit has resulted in some lack of confidence in the UK as a place of investment. Consequently, there has been a decreased focus on the UK as an attractive jurisdiction for private equity fund buyers and this has in turn affected dealflow. Additionally, a major legal development for the private equity community was the introduction of a national security regime.
Transactions and National Security
In June 2018, the UK government adopted new powers to review certain transactions on national security grounds, extending the scope of its existing controls by amending the share of supply threshold and turnover test in three key areas of the economy: military and dual-use, computing hardware, and quantum technology. The government has consulted on options for long-term reform and published a White Paper to significantly expand the national security regime, which means that certain acquisitions can be “called in” and reviewed by the Minister.
While nuclear, defence, communications, energy and transport sectors are the core areas that will receive the most focus, the regime can examine any sector of the economy on any trigger event, which includes M&A transactions but also acquisitions of assets with national security implications (such as intellectual property or land), new projects and some loans, regardless of market share or revenues. Furthermore, this will apply to all entities, not just “foreign” or non-UK parties. It appears that a mandatory notification regime will not be pursued but, given the widespread potential remedies (including ultimately divestment), most private equity buyers will seek clearance as a condition precedent where there is a risk of a deal being subject to review under the national security regime. In June 2020, the Enterprise Act was further amended to block acquisitions of a company that would threaten the UK’s ability to combat a public health emergency. There is no clear definition of “public health emergency” and thus this has increased uncertainty for investors in the UK.
The Regime in Practice
Unlike an antitrust regime, it will be difficult for the government to give clear guidance on the sorts of investor that will be problematic from a national security perspective, and this will ultimately be a political decision. This trend reflects the wider global trend of jurisdictions introducing or increasing the scope of the foreign investment regime. Other European countries such as Spain, France and Germany introduced similar additional restrictions in the wake of the COVID-19 crisis.
These measures are likely to give some pause for thought, as private equity funds will need to grapple with the uncertainty of a new regime and are likely to be reluctant to incur significant at risk costs while there is this execution risk, at least while market participants gain experience of the approach to be taken by the Minister.
Generally speaking, the acquisition and sale of private limited companies is not regulated in the UK. The City Code of Takeovers and Mergers regulates the acquisition of listed and public companies in the UK, which is administered through the Panel on Takeovers and Mergers, a body with statutory powers of enforcement.
For most private equity transactions involving unlisted companies, there is no mandatory consultation with any bodies unless the business is regulated, in which case the regulator of such business may need to approve a change of control, or at least be notified of it. There are specialist regulators covering certain regulated industries – for example, Ofcom regulates telecommunications, media and post; Ofgem regulates gas and electricity; Ofwat regulates the water and waste industry; the Office of Rail and Road (ORR) regulates the rail industry; the Civil Aviation Authority regulates air traffic and airport operations; Monitor governs healthcare; and the Financial Conduct Authority (FCA) regulates financial services. Typically, a financial services business that is regulated by the FCA may require the approval of the FCA when there is a change of control (or at least a notification), and companies that hold licences may require the approval of the licensor on a change of control – eg, the ORR in the case of a rail business with a rail licence.
The Enterprise Act 2002
UK merger control is governed by the Enterprise Act 2002, as amended by the Enterprise and Regulatory Reform Act 2013. The Competition and Markets Authority (CMA) is the principal regulatory body tasked with ensuring that the markets are competitive, and examines mergers and acquisitions. The UK has a voluntary regime, which means there is no obligation to refer deals to the CMA. However, if the transaction meets the relevant thresholds and the parties do not notify, the CMA may launch its own investigation. The CMA will conduct a “phase 1” investigation and the deal will be cleared if the CMA does not have serious competition concerns about the acquisition. If the CMA does have competition concerns about a deal after a phase 1 investigation, it may then be referred to a “phase 2” investigation.
The CMA can make an interim order (to hold the businesses separate) during its investigation and, following a “phase 2” investigation, may require the disposal of the acquired businesses or assets (or part of them). Therefore, where material substantive competition issues arise on an acquisition meeting the relevant jurisdictional thresholds, most private equity buyers will require CMA approval as a condition precedent to closing.
Detailed due diligence is typically carried out by private equity bidders, covering financial, tax, commercial, insurance, environmental, tax, compliance and legal due diligence. This is carried out on behalf of the private equity buyer by its advisers, who work closely with the private equity deal team in reviewing the findings. Those findings are then addressed through valuation adjustments, contractual protection or perhaps remedies to be adopted following the acquisition.
Legal due diligence usually focuses on the key legal aspects of the business, including:
Litigation and Investigations
Litigation and investigations involving the target company are reviewed to check for significant liability exposures, including legal costs. The compliance policies are reviewed to ensure they are adequate. Accounting firms may also conduct an audit of the compliance function to confirm it has been adequately adopted and complied with.
Employment, pensions and other benefits terms are reviewed to ensure they comply with legal requirements and to obtain an understanding of the cost profile going forward, including whether there are particular bonus or other incentive payments triggered by the transaction and the specifics of the employment contracts of the senior management team. A review of the property portfolio of the business varies in scope from the procuring of a "certificate of title" of each material property to a high-level confirmation of a property schedule – this is dependent on the significance of real estate to the business of the target and whether it forms part of the security package of the debt financiers of the transaction. A review of the planning arrangements, IP rights and licences and other licensing arrangements is also typically carried out by the lawyers.
Other material contracts or arrangements such as outsourcing, IT contracts, franchise agreements, acquisitions and disposals and joint venture or partnership agreements are usually also reviewed for ongoing liabilities, onerous terms or impediments to the transaction, or to check various assumptions in the valuation model or business plan.
As most private equity transactions are financed by leveraged loans, the due diligence exercise also needs to be satisfactory to the lending banks. It is shared with them and they typically rely on the reports.
In sales that are structured by way of a competitive auction, sellers (particularly private equity sellers who tend to run very well-organised sale processes) often prepare legal vendor due diligence (VDD) reports, which provide a narrative description of the business and an overview of consents required or other potential impediments to the transaction. It is common for reliance on these vendor due diligence reports to be provided to the buyer. The purpose of vendor due diligence is to expedite the diligence process of all the bidders, by minimising the amount of work bidders need to do to understand the business. It also gives the vendor the opportunity to present the business in a positive light and to ensure all bidders have similar access to information about the business to maximise the value of their respective bids.
Even where vendor due diligence is provided by the seller, it is common for private equity buyers to conduct their own buyside diligence as well, to interrogate the VDD and also to analyse how best to deal with any impediments or liabilities identified. A wholesale verification of the VDD is not typical, but the buyside advisers will conduct a qualitative review of the VDD.
Most private equity acquisitions are effected by way of a private sale and purchase agreement, pursuant to which the buyer acquires the entire issued share capital of the company that is the holding company of the group. Asset sales are less common, although occasionally businesses comprise multiple companies not owned by a single holding company, in which case they are usually acquired pursuant to the same sale and purchase agreement.
A seller will often conduct a pre-sale reorganisation in order to ensure all the assets (including companies in the group that own the assets) are housed in a single corporate structure. Where this is done, it is customary for a buyer to obtain an indemnity in relation to any tax or other losses arising as a result of the pre-sale reorganisation. It is also usual for the sale and purchase agreement to include “wrong pockets” provisions so that if any asset core to the business is not transferred, or if an asset not required by the target business that should have been retained by the vendor is mistakenly transferred, both parties are obliged to effect a transfer back of such asset to rectify the situation.
Private equity funds often comprise multiple parallel partnerships that together constitute the fund. Typically, the fund making the acquisition will usually set up a special purpose vehicle as the buyer entity (the “Bidco”). Representatives of the private equity fund shareholder will be appointed to the board of the Bidco and control it.
The Bidco (as a newly incorporated “clean” special purpose company without other obligations or assets) is the entity that contracts with the seller. The private equity fund partnerships typically do not enter into any transaction documentation directly with the seller, other than an equity commitment letter agreeing to fund the Bidco (see below).
Private equity buyers normally finance their acquisitions using a mixture of equity funding provided by the private equity fund (which has the benefit of commitments from its underlying investors) and third party debt funding provided by banks and other lenders.
Equity commitment letters are commonplace to support the Bidco, which typically has a balance sheet comprising only its paid-up share capital (often a de minimis amount) at the time of entering into the sale and purchase agreement. Pursuant to the terms of the equity commitment letter, the private equity fund will provide warranties that it has sufficient cash commitments from investors available to it to fund the Bidco with the equity portion of the purchase price. The private equity fund commits to provide the necessary equity funding to the Bidco under the equity commitment letter, and this commitment is usually in favour only of the Bidco.
Usually, the seller also has a right to rely on the equity funding commitment and enforce this right through the Contracts (Rights of Third Parties) Act 1999, which enables the seller to enforce the right of the buyer to enforce the commitment provided by the private equity fund, giving the seller comfort that there is an entity of substance standing behind the Bidco’s obligations under the sale and purchase agreement.
Typically, the private equity fund owns a significant majority of the equity in Bidco. The management team will own a small proportion of the ordinary equity (often between 5% and 10%), but this ordinary equity represents a very small portion of the total equity funding required for the transaction. A significant portion of the equity funding is provided by way of a preferred equity instrument (rather than ordinary equity), which has a preferred return.
Private Equity Fund Buyers
The private equity fund buyer may invite investors in its fund to co-invest alongside it (indeed, many investors in private equity funds insist on having such co-investment rights). Very often, this equity syndication is done after the transaction has signed but prior to the transaction being funded and closed, as co-investors will not wish to spend time and resources considering a transaction before there is certainty it is going ahead, and also because their involvement may impede the progress of the private equity buyer. Sometimes syndication takes place after the transaction has closed (at a premium).
Such limited partner investors co-invest alongside the main private equity fund high up in the structure – several levels above the Bidco and above the level in the structure in which the management team invests. These are typically passive investments, managed entirely by the private equity fund manager; their purpose is to increase the financial exposure of the relevant investor to that particular investment.
Sometimes, one or more co-investors may participate alongside the private equity fund at the same level as the management team. This is typically for a larger stake, and the co-investor will have some minority protection, information rights and possibly even a board seat or right to appoint an observer to the board. For such larger equity investments, the co-investor will take part in due diligence and have some oversight of the transaction documents.
Occasionally, private equity funds form consortia when making very large acquisitions (for example, the consortia that made an offer for Inmarsat and Merlin). In such consortia, the governance arrangements are relatively equal, with each private equity fund having significant governance over the underlying portfolio company.
In the UK, locked-box transactions are generally favoured, particularly by private equity sellers. This structure involves fixing a value as at the locked-box date, based on the balance sheet as at the locked-box date. Ideally, the locked-box balance sheet is audited, although sometimes it is not and the risk (and reward) of the business passes to the buyer from the locked-box date.
The seller covenants not to pay or agree to pay any value to the seller from that point (such value transfer being known as “leakage”), so that no dividends or distributions may be made to the seller from that point and no transfers of value may take place from the target group to the seller (eg, transfers at an undervalue or arrangements not on arm’s length terms that would be beneficial for the seller). If there is any leakage, the seller must repay it to the buyer on a pound-for-pound basis by way of indemnity. Occasionally, interest is paid on the leakage. Where a business is a carve out of a business from a larger business and does not have its own standalone balance sheet or audited accounts, it is more likely that completion accounts will be used as the consideration mechanism.
Vendor participation is not a common feature of private equity transactions in the UK generally, other than reinvestment by management on a secondary buyout (see 8.2 Management Participation for details of reinvestment by management and the equity terms). Occasionally, vendor participation in the form of a vendor loan or equity stake is used where a buyer cannot raise external debt, or to bridge a valuation gap. This ongoing participation from the seller can provide comfort as to the seller’s confidence in the future performance of the business.
For a locked-box structure, the seller provides an indemnity in respect of leakage. This is rarely backed by a guarantee or an escrow, even where the seller is a special purpose holding company without any assets other than the target being sold. Buyers rely instead on the reputation of the private equity seller.
It is not unusual for the seller to undertake not to be wound up until the limitation period for claims for leakage to be brought expires; this period is usually three to 12 months. Under a locked-box mechanism, the consideration is capped (at the fixed equity value plus interest). For a private equity buyer, this whole amount is covered by the equity commitment letter.
In the case of completion accounts, a seller will again normally not have any escrow to back its obligations, although a corporate seller with insufficient covenant strength might be supported by a parent guarantee. A private equity seller might occasionally agree to a retention to back a completion accounts mechanism. A private equity-backed buyer will usually agree to the equity commitment letter covering any additional amounts payable under the completion accounts mechanism.
Where completion accounts or other deferred consideration mechanisms are used, amounts payable (particularly by the buyer) should be capped in the sale and purchase agreement to give the buyer certainty, and in the equity commitment letter to ensure the fund is not exposed to an unlimited funding undertaking.
This is a point for negotiation in the event of a consideration mechanism that includes an earn-out or element of deferred consideration that is outstanding for a long period of time. If this period is long, a private equity buyer may be reluctant for this contingent liability to be backed by an equity commitment letter, particularly in the case of an earn-out, which has an anti-embarrassment element to it that is not expected to be paid out. Depending on the bargaining position of the parties, a buyer may need to escrow a portion of the deferred consideration so that the seller has comfort that the buyer will have the funds. This is more common where there is a two-way adjustment.
Historically, interest was charged on leakage, on the basis that the seller who has received the leakage should have to treat it as a loan from the buyer. However, increasingly, the trend has been that interest on leakage is not charged on private equity deals, mainly due to the seller-friendly environment.
It is rare to have any dispute resolution mechanism specially imported for a locked-box consideration structure. In the event of a dispute, the usual dispute resolution applicable to the whole agreement would be adopted, which is normally determination by the courts.
Where a completion accounts structure is used, it is common to include a specific “expert determination” procedure, which provides for an expert (usually an independent accountant) to determine the elements of the completion accounts adjustment at dispute, in a process that is concluded over a matter of weeks or months and at costs that would be much less than a full court process. This process would often be adopted for earn-outs or deferred consideration mechanisms as well.
On the whole, private equity transactions in the UK have minimal conditionality. Deal certainty is a fundamental principle of UK M&A transactions, particularly in deals involving private equity-backed buyers or sellers. Typically, the only conditions that are acceptable are those that are mandatory and suspensory, such as an EUMR filing or a suspensory foreign investment filing.
As the UK regime is voluntary, CMA approval is not typically a condition to UK transactions. Material adverse change provisions (entitling a buyer to termination the transaction) are unusual, unless the transaction has a significant US element (where such clauses are common) or the business has significant revenues or presence in the emerging markets (again, where such clauses are common). It is unusual to have a third-party consent as a condition to a transaction, unless this is a regulatory approval.
Despite the uncertainty posed by Brexit, conditions or termination rights linked to Brexit have not typically been agreed.
One of the most hotly negotiated provisions in a sale and purchase agreement is the so-called “hell or high water” provision, which requires a buyer to take whatever steps are required to be taken – including divestments or the agreement of undertakings – in order for the transaction to be cleared or approved by the regulatory authority. In a private equity context, it is difficult for a private equity fund to agree to divest other businesses in its portfolio, as to do so would be in breach of its fiduciary obligations towards its investors. This is particularly acute in the case of a fund agreeing to such undertakings across other related funds’ portfolios. Therefore, this provision is heavily resisted by private equity buyers.
Where there is a known substantive issue in the portfolio that has been considered by the parties, then a heavily negotiated hell or high water provision might be included to address such specific issues. However, in a very competitive auction, private equity buyers may accept a hell or high water undertaking where the fund has no overlapping business and on the basis of advice from their antitrust counsel that there is no prospect of any substantive competition issue.
Break fees are unusual in private equity transactions, and indeed in acquisitions of private companies in the UK more generally. Private equity buyers will strongly resist the requirement to pay any costs in the event that the transaction does not close.
On public takeovers, break fees are no longer permitted by the Code. Where private equity sellers are selling to a buyer hat has an external condition such as shareholder approval or an unusual condition (eg, foreign exchange approval) that is subject to the suitability of the buyer (eg, FCA change of control approval for a regulated financial services business), then they may seek a break fee. As they are unusual, there is no “norm” for break fees, but the historic guidance of a 1% cap (which used to apply on public takeovers) is often where such break fees would end up.
On public takeovers, break fees or other deal inducements are generally prohibited under the Code.
Private equity buyers and sellers are focused on deal certainty and, as such, termination rights are heavily resisted, particularly on the buy side. As described, acceptable conditionality is normally limited to mandatory and suspensory conditions only in a sale and purchase agreement. The sale and purchase agreement terminates if those conditions are not satisfied by a long-stop date that is agreed by the parties, and usually at the outer end of when the conditions might reasonably be satisfied, allowing a significant buffer, but taking account of when a buyer’s debt financing commitments might expire.
If various completion obligations (such as payment of the purchase price, delivery of executed documents such as stock transfer forms or other material items) are not complied with at the planned time for completion, then the non-breaching party can usually elect to postpone completion. Termination is rarely automatic, and there is usually a requirement to defer completion to allow the breaching party to comply with its obligation.
Private equity sellers will always seek to minimise their ongoing liability on the sale of a portfolio business. This is because they aim to return all proceeds to investors as soon as possible, in order to maximise their investors' return. Holding back funds to satisfy contingent liabilities following the sale of a portfolio company would be a drag on the returns and therefore affect the fund’s performance. As a consequence, private equity sellers assume very little liability under the terms of a sale and purchase agreement. Where liability is assumed by a private equity seller, this is normally in relation to matters that the private equity seller can be sure will not give rise to any liability.
As such, their limited undertakings and covenants are limited to the following:
Overall, a private equity seller will seek to limit its total liability to the equity value only – ie, the amount of consideration received in respect of the shares and not the amount of debt the purchaser repays – and such liability falls away after a period of 18 or 24 months.
Private equity buyers will expect customary commercial warranties (in addition to title and capacity) from sellers, except private equity sellers, where the position above is generally accepted.
Private equity sellers typically only provide warranties in relation to legal title to the shares of the target (and not ownership of the rest of the target group), capacity to enter into the transaction documents, and insolvency. Occasionally, additional comfort may be given on certain compliance and anti-corruption matters.
Management who hold shares in the target on a secondary buyout normally provide commercial warranties relating to the business. These warranties provide comfort on all aspects of the business, such as accounts, books and records, material contracts, condition and sufficiency assets, real property, insurance, employment and pensions, litigation, compliance with law, anti-bribery and corruption, and solvency. However, the cap on liability for breaches of these warranties is generally low, limited to a percentage of the net returns to the manager shareholders. As such, their function is more to elicit disclosure than to allocate risk between buyer and sellers.
If management are not shareholders, and therefore not sellers under the sale and purchase agreement, but are investing in “sweet equity” (see 8.2 Management Participation) alongside the private equity fund, then the management will usually provide warranties in the shareholders' agreement. Typically, managers warrant that the due diligence reports are not materially inaccurate, that the business plan is based on reasonable assumptions, and that factual statements are not materially misleading. Managers also complete a management questionnaire, providing details in relation to prior convictions, other directorships, disputes and occasionally net worth. This is warranted as true and correct.
The liability of a manager under these warranties is typically capped at one or two times the annual basic salary of the relevant manager. They are limited in time to between 12 and 24 months.
A tax covenant is occasionally provided by management. It is unusual for a private equity seller to provide specific indemnities, for the reasons already explained: the proceeds of a sale are swiftly distributed to the investors in the fund. If there is a specific known issue the quantum of which is unknown or relates to a potential liability, then a specific indemnity is occasionally provided. This might be backed by an escrow to give the buyer comfort that the seller is able to meet any liability under the indemnity. This is important given the practice of private equity sellers to distribute funds quickly. Usually, the specific holding vehicle that held the shares in the company being sold is wound up following completion.
For title and capacity warranties, the limit is typically the amount of the consideration, and the time period is one to two years, or sufficient time to allow for one complete audit cycle. For commercial warranties given by management, the time period is often one year, occasionally two years and longer for tax warranties.
Warranty and Indemnity Insurance
It is increasingly common for warranty and indemnity insurance to be procured on transactions involving private equity sellers. Insurance is used to increase the protection provided by business warranties, from the low level of protection management sellers can provide (typically limited to a small fraction of the total consideration, as explained in 6.9 Warranty Protection) to 10% or 20% of the total consideration. Certain private equity funds favour this, while others rely on the management team’s disclosure and prefer not to incur the cost of insurance. It is unusual to insure “known” problems (such as the outcome of a particular investigation or piece of litigation), as the cost is prohibitive.
Tax covenants, pursuant to which the seller agrees to indemnify the buyer for all unpaid taxes up to completion, are commonly provided by corporate sellers. Private equity sellers do not give tax covenants, but the management team may do so, subject to the usual limitations. This limit can also be topped up by insurance. It is also possible to construct a purely synthetic insurance policy to cover tax liabilities up to completion.
Corporate sellers will normally give "restrictive covenants", such as a non-compete undertaking, an undertaking not to solicit senior employees and occasionally a non-disparagement undertaking. In line with the general approach of limiting their post-sale obligations and liabilities, and the fact that it is problematic to limit the business of a private equity fund which is to buy and sell other companies, frequently in sectors in which it has experience, it is unusual for private equity sellers to provide these covenants, although they will occasionally agree not to solicit key employees for a restricted period, provided that such obligation extends only to the actual fund that owns the selling entities, and not to related funds.
As mentioned, if there is a gap between the signing of the transaction and closing, the seller normally covenants to run the business in the ordinary course and to obtain buyer consent for significant actions relating to the business.
Litigation is not common in relation to private equity transactions. The potential for disputes is limited where private equity sellers are involved, given the limited nature of their contractual obligations. Warranty claims are also relatively infrequent, especially where the warrantors are the management team. Private equity funds are usually slow to claim against the management team, who are seen as partners in the business, other than in extreme situations such as fraud.
Claims for leakage under the locked-box indemnity are usually agreed or settled relatively quickly rather than litigated. Completion accounts often end up being determined by the expert, although this avoids the need for full-blown dispute resolution.
Public to private transactions have been on the increase, particularly in the past year, as outlined. Such transactions are regarded as being more difficult than transactions involving private companies, due to the rules that apply to public transactions. Public to privates can be transacted by a bidder making an offer for the listed company (usually under the Code).
An alternative commonly used in the UK is a scheme of arrangement, which is a statutory procedure under the UK Companies Act 2006 (CA 2006) whereby a company can make a compromise or arrangement with its members (or any class of them). Changes to the Code in 2011 introduced a requirement that target companies should name all potential bidders with whom they are in discussions (save in limited circumstances) when announcing any possible offer. This has led to many potential suitors being named at a much earlier stage than was customarily the case before the new rules took effect, and many market participants consider that this has resulted in fewer private equity bids taking place.
In practice, based on current experience, the effect of those changes is that bidders are ever more sensitive to the need for secrecy before a bid is formally announced, including restricting the number of individuals (including within the bidder and target deal teams) who know about a possible bid and maintaining the use of codenames in all communications.
Under UK rules, a person must notify the issuer of the percentage of voting rights he holds as shareholder (or holds or is deemed to hold through his direct or indirect holding of financial instruments) if, as a result of an acquisition or disposal of shares or financial instruments, the percentage of those voting rights reaches, exceeds or falls below 3%, and each 1% threshold above such 3% threshold. For non-UK issuers the thresholds are 5%, 10%, 15%, 20%, 25%, 30%, 50% and 75%. If the issuer is traded on a regulated market for UK purposes, a notification to the UK regulator (the Financial Conduct Authority) must also be made.
There is a mandatory offer regime under the Code. Where a person is interested in shares carrying 30% or more of the voting rights, that person must make a mandatory offer in cash (or including a cash alternative) at no less than the highest price paid by that person during the 12 months prior to the announcement of the offer.
Generally speaking, an offer does not have to be in cash (except in the case of a mandatory offer or certain other limited exceptions), but any securities offered as consideration must, at the date of announcement of the offer, have a value equal to or higher than the highest relevant purchase price. Cash offers are more common than offers of shares as consideration.
Aside from the acceptance condition, an offer must not normally be subject to conditions or pre-conditions that depend solely on subjective judgements by the bidder or the target company, or where the satisfaction of which is within their control. Financing conditions are generally not permissible (other than the passing of a resolution to raise cash by the issue of shares, which would not typically apply to a private equity-backed offeror). A condition that the transaction has not been referred to phase 2 antitrust proceedings is acceptable.
A bidder has a legal right to buy out the minority – the “squeeze-out right”, which is triggered on satisfaction of a dual test: a bidder needs to have acquired, or to have unconditionally contracted to acquire, both 90% of the shares to which the offer relates and 90% of the voting rights in the company to which the offer relates. In addition, minority shareholders have a right to be bought out (the “sell-out right”), which is also triggered on the satisfaction of a dual test: any minority holder has the right to require the bidder to buy their shares at the offer price if the bidder has obtained 90% of both the issued shares and the voting rights in the company.
As mentioned earlier, many private equity-backed bidders choose to use a “scheme of arrangement” rather than an offer for listed targets in the UK. One of the principal advantages of this is that, once the scheme has been approved by 75% of each class of shareholder to which the scheme relates, the scheme is approved by the court and the bidder can acquire 100% of the shares to which the scheme relates.
It is common for private equity-backed buyers to seek irrevocable undertakings to accept the offer from major shareholders and from any shareholding target directors, particularly in the case of a recommended offer. The undertakings will generally require shareholders to accept the offer within a certain timescale, and will usually also prohibit any action that could prejudice the outcome of the offer. Similarly, in a scheme, a bidder will obtain irrevocable commitments to vote in favour of a resolution to approve or give effect to a scheme.
Hostile takeover offers are unusual, and many private equity funds have an investment mandate that excludes them. The high-profile takeover of GKN by Melrose was a successful hostile takeover but other examples are rare, particularly by private equity buyers, where target co-operation is usually part of the investment thesis and where the private equity bidder will normally want the management team to execute the next phase of development under private ownership.
The Code applies the automatic imposition of a “put up or shut up” deadline of 28 days, which means that it is quite rare to see unsolicited/semi-hostile virtual bids by potential bidders, attempting to put a target board under pressure to open up discussions and/or grant access to target due diligence. That being said, the Panel has granted extensions to the “put up or shut up” deadlines.
Equity incentivisation of the management team is a fundamental principle of alignment on UK private equity transactions, and is therefore a feature of most private equity investments.
The management team normally subscribes for ordinary shares in the holding company of the target. Due to the funding structure of the deal, which includes a combination of external debt funding and preference equity (which carries a preferential return of about 10% to 14%), a very small portion of the equity funding is funded through the subscription monies for the ordinary shares. As the preferred equity has a fixed return, the upside from the investment flows through to the ordinary shares held by management, enhancing their returns. As a result, this equity is known as “sweet equity”.
On a secondary buyout, where management are sellers of a business, having benefited from an equity incentive scheme during the first buyout, management are normally required to reinvest some of the proceeds of sale into the equity funding of the second buyout. In the UK market, anything from 20% to 50% of proceeds net of tax and costs is typical.
In management incentive schemes on UK transactions (where the majority of senior managers are UK based and/or UK tax payers), shares are usually acquired by the managers at the same time as the private equity fund – ie, when the private equity fund equity funds and closes the transaction. However, “value vesting” of this sweet equity is quite common. This means that if a manager leaves the business prior to the private equity fund’s exit, the value they receive for such equity “vests” over a period of time, such that the value obtained for such sweet equity increases over time.
This is usually structured through a compulsory acquisition mechanism, whereby the private equity fund has the right (but not the obligation) to acquire the sweet equity when the manager leaves, and the manager obtains market value for a proportion of the sweet equity that increases over time. This increase can be on a straight line basis (eg, from 0–100% over a five-year period), or with cliffs (eg, every year another 20% is acquired for market value). For the balance of the “unvested” sweet equity, the cost or market value is paid for that equity, whichever is lower. It is also typical to have a “vesting holiday” such that no value vests for an initial period of between 12 and 24 months.
Categorising Good Leavers and Bad Leavers
For the purpose of vesting, most management equity schemes provide for a different treatment of “good leavers" and “bad leavers”. Generally, “good leavers” obtain market value for the vested portion of their sweet equity and “bad leavers” obtain either cost or market value for all their sweet equity, whichever is lower. The categorisation of good leavers and bad leavers is a matter of negotiation between the managers and the private equity fund. Where only two categories of leaver (good and bad) are identified, typically the “good” leaver definition is very narrow, often limited to death, permanent disability, redundancy on the sale of a division and “wrongful” dismissal (ie, dismissal in breach of the employee’s employment terms). Unfair dismissal is sometimes also included as a good leaver category. A “bad” leaver is any leaver who is not a good leaver.
Occasionally, the narrow definition applies to the bad leaver – ie, where a leaver leaves to join a competitor or is dismissed for cause. There is an increasing trend to have a third category of “intermediate” leaver. Where three categories are adopted, "good leaver" is defined narrowly, "bad leaver" is defined narrowly and all other leavers are “intermediate” leavers. Good leavers are fully vested, and there is usually a vesting schedule so that intermediate leavers get market value for an increasing portion of their equity stake over time.
On about 50% of deals, compulsory transfer provisions do not apply to the “institutional strip”. Therefore, the manager is entitled to retain this equity and sell it on exit on the same terms as the other selling shareholders. On other transactions, the equity is swapped for “frozen loan notes”, which crystallise the value of the equity at the time of the exit by the issue of loan notes, which may have no coupon or a risk-free coupon rate. Such loan notes may only be redeemed on an exit such that if the company becomes insolvent or there is not value in the ordinary equity, the exited manager does not benefit from any equity upside.
It is typical for managers to be subject to various restrictive covenants, such as a non-compete, non-solicit and occasionally a non-disparagement undertaking.
On new equity issues, management normally have a pre-emption right to subscribe for such equity on the same terms. Typically, they do not have evergreen anti-dilution protection in relation to the sweet equity proportion, however, and therefore they can be diluted if significant additional equity funding is provided. Where additional equity funding is expected, the shareholders' agreement will often prescribe how this is to be funded, and may afford management protection by prescribing that this is funded using preferred equity instruments in the same ratio as the initial equity funding.
The main principle of private equity governance is that the management team has day-to-day control over the target’s business. Oversight by the private equity house is achieved through the appointment of directors on the board of the holding companies. In addition, the private equity house has vetoes over strategic matters, so that the consent of the private equity fund (either through shareholder approval or via the nominated director as conduit) is required before the business is permitted to proceed with such action. Such matters would include amendments to the capital structure, constitutional documents, entering into, amending or terminating material contracts, changing the nature of the business or entering into new business lines, and commencing or settling litigation.
In general, the fundamental principle of company law is that shareholders are not liable for the actions of a limited liability company in which they hold shares, and, as such, shareholders can only be liable to the extent of the amount invested in the company. There are exceptional circumstances under the laws of England and Wales in which there can be shareholder liability – eg, under the Bribery Act, antitrust laws, shareholders of companies with UK-defined benefit pension schemes, environmental liability and decommissioning liability.
Sometimes these liabilities are strict in nature; at other times there needs to be an element of wrongdoing or involvement in such activities by the shareholder. The governance regime implemented by private equity funds in their portfolio companies seeks to minimise exposure in this regard, by imposing “best practice” compliance and risk management procedures in their portfolio companies.
The private equity fund shareholder typically seeks to impose various environmental, social and governance (ESG) and compliance policies on the portfolio company. It also has extensive information rights to ensure it has oversight of activities. This is combined with its governance rights, being the rights to appoint directors to the board of companies within the portfolio group, and various vetoes over material strategic matters.
Normally, the private equity fund shareholder has freedom to transfer its shares and full flexibility to achieve its exit. Occasionally, there is specific provision made for syndication, provided the private equity fund retains a controlling majority (ie, more than 50%). Private equity funds are typically closed end funds and therefore investments must be realised within the timeframe of the fund (ten years, with an extension of up to two years). Therefore, the usual investment horizon is between two and seven years, with the precise timing being a function of the business cycle, mode of exit and general market conditions, as well as, importantly, the completion of business plan milestones for the portfolio company’s business.
The most common form of exit is by way of an auction sale to strategic trade buyers, other private equity funds or longer-term institutional investors, such as pension funds. In addition, IPOs are common where the IPO market conditions are good. It is relatively unusual for private equity funds to reinvest or stay invested alongside the buyer, due to their fixed life fund structure. However, occasionally they will reinvest for a period, and funds with longer fund lives have more flexibility to do so.
Most equity arrangements have “drag” rights, whereby the private equity fund majority shareholder can force the minority shareholders to sell to a buyer of a majority of the issued shares, provided it is on the same terms. It is relatively unusual for management to be dragged, as they are closely aligned with the private fund seller, and hence the vast majority of deals are done on a consensual basis. Where the equity is widely spread amongst a large management team (eg, more than 50), then the drag mechanism may be used to sell the equity held by such majority shareholders so as to avoid a sale and purchase agreement with multiple sellers.
The dragged sellers either adhere to the main sale and purchase agreement or sell pursuant to a short-form sale and purchase agreement, which is substantially on the same terms as the main sale and purchase agreement, such as the price, conditionality and timing.
The quid pro quo for a drag right is a tag-along right to the sale by the majority shareholder. This means that if the private equity majority shareholder sells a majority stake to a third-party buyer, the minority shareholders are entitled to sell to the same buyer on the same terms.
Exits by IPO are common but very dependent on market conditions. 2020 started with the February listing of KKR-owned Calisen plc but market volatility followed even prior to the impact of the Covid pandemic which saw a number of planned IPOs pulled. IPOs in certain sectors will increase, see the recently announced planned IPO of the Hut Group (owned by a number of institutional investors including KKR) due to be the largest since 2013.
Often a private equity fund will run a “dual track” exit process, where the company undergoes both an auction sale process and an IPO exit process and ultimately the sellers proceed with whichever option achieves the best valuation (balanced with execution risk).
Where a company is listed, it is common in the UK market for the private equity sponsor selling shareholder to be "locked up" for six months, with management sellers locked up for a longer period, usually 12 months. Relationship agreements are usually put in place between the private equity sponsor seller and the listed company.