The Private Equity guide provides expert legal commentary on the key issues for businesses involved in that sector. The guide covers the important developments in the most significant jurisdictions.
Last Updated: September 12, 2019
Private equity is a significant part of the M&A market globally, and the popularity of private equity as an investment is clear. Global fund-raising numbers in the first half of this year were an improvement over a relatively soft 2018 (although they failed to match the boom years of 2016 and 2017). Slowing economic growth, political uncertainty, escalating trade tensions and volatile stock markets have created adverse conditions for deal activity in 2019, with most markets reporting a decline in private equity activity. Preqin notes that the second quarter of 2019 seems to have been a worrying period of decline – fund-raising has well and truly withdrawn from the heights reached in 2017 and much of 2018, while both the buyout and venture capital deals markets have recorded fewer transactions and lower values in the first half of the year. That being the case, there is still a relatively steady flow of private equity transactions from which our authors can provide insights into market practice in their respective jurisdictions and give guidance on the common features of private equity deals in their markets.
The sectors dominating private equity transactions vary from jurisdiction to jurisdiction, but most jurisdictions have observed significant activity in the technology sector. Healthcare, infrastructure and consumer goods all appear to be active sectors across the globe. One of the legal changes that seems to have taken hold globally and is affecting private equity transactions has been an increase in protectionism, which has translated into more regulation of foreign investment or investment generally in critical sectors (such as infrastructure and technology). While China has simplified governmental approval and filing procedures, enhancing the competitiveness of foreign private equity funds, most other jurisdictions (including most European countries through both domestic and EU-wide measures) have expanded foreign investment regulation and increased the scrutiny of investors in certain critical industries.
There are many common features of private equity transactions across the globe. Market terms vary depending on the maturity and sophistication of the relevant market. Less developed markets have greater variability in terms. Most deals are concluded by a negotiated sale and purchase agreement, with the buyer and seller allocating risk through warranty and indemnity protection.
The absence of customary or “market standard” provisions is notable in public to private deals, where the lack of precedent usually perpetuates the rarity of this form of deal activity, as it is a more risky venture for private equity firms. Public to privates represent a small portion of private equity deals, although they are increasing in popularity in the UK, the US and Germany. There are legal barriers to doing take privates in certain countries, such as PRC. There are some common features across the different legal systems, however. Generally speaking, hostile takeovers are rare. Most takeover regimes have mandatory offer thresholds and a disclosure regime for significant shareholdings.
One of the striking differences in practice from one market to the next in private equity transactions is the approach to consideration mechanisms. While Western European jurisdictions such as the UK, Germany, France and Spain favour locked box consideration mechanisms, which fix the price based on the locked box balance sheet, therefore giving the seller almost complete protection on price, jurisdictions such as the US and China generally use completion accounts mechanisms (with the associated adjustments). In some European and many Asian jurisdictions, the practice is more mixed, with consideration mechanisms varying from one deal to the next. Where the bargaining position favours the seller, locked box mechanisms are increasingly used. Of course, there are situations where completion accounts mechanisms are more appropriate regardless of the market standard – ie, in complex carve-outs or other circumstances where there are no standalone accounts for the target.
The appetite of sellers to accept conditionality varies from one jurisdiction to the next. Private equity sellers usually seek to limit the conditionality of transactions so that they enjoy deal certainty, but market practice generally dictates what conditions are acceptable. All jurisdictions permit regulatory/antitrust conditions. Financing conditions are rare across most jurisdictions, although not wholly unusual in the US. Indeed, the US market permits a much higher level of conditionality than is usual in Europe or Asia. US private equity deals will often include the repetition of representations and warranties and the absence of litigation as conditions, third party consents will be conditions, and “no material adverse effect” conditions are often included as well.
Whatever the approach to conditionality, break fees are rare in almost all jurisdictions. The notable exception to this is the US, where a buyer is typically required to pay a reverse break fee if it exercises a termination right. This reverse break fee is often linked to a failure to secure debt financing. They are also common in some Asian jurisdictions, such as Vietnam.
In general, the allocation of risk favours private equity funds, which are very unwilling to accept liabilities on exit. Typically, therefore, they do not provide commercial warranties or indemnities. In all markets, warranty protection is subject to a raft of limitations, such as caps, thresholds, and de minimis provisions. Indemnity protection has more bespoke limitations. Another recent trend is the increasing use of W&I insurance in private equity transactions, with many private equity buyers using it to bridge the gap between the low limitation on liability for warranties often offered by sellers and the coverage provided by insurance, for modest additional cost. Where private equity funds are sellers, W&I insurance can be used effectively to limit their exposure, achieving their aim of a “clean break” post exit.
Generally speaking, litigation is rare in private equity transactions across all markets due to concerns about the reputational impact of litigation. Where disputes arise, private arbitration is usually favoured. Common areas for dispute are earn-outs and certain warranties or indemnities. Many consideration mechanisms have dispute determination mechanisms involving experts, rather than having disputes decided by the courts. In addition, where closing accounts mechanisms are used, an escrow is often used to secure payment of the top-up payment or refund.
Private equity buyers across all markets generally conduct a thorough buyside due diligence exercise covering the usual areas of risk, such as corporate structure, employment, impediments to the transaction, regulatory, compliance risk and litigation. The precise scope varies from one deal to the next, and depends on the nature of the target. Vendor due diligence is not common in all markets. Even in jurisdictions where vendor due diligence reports are typically prepared, in some markets providers do not afford reliance to bidders, with some offering merely a legal fact book that a buyer cannot rely on. For obvious reasons, where it is not market practice for vendor advisers to offer reliance to bidders, it is less widespread. Generally speaking, private equity buyers will do top-up due diligence rather than relying solely on sellside due diligence, even where reliance is granted.
Liabilities of Private Equity Funds as Shareholders
The general principle under most legal regimes is that private equity fund shareholders are not liable for the liabilities of their portfolio companies. Circumstances in which the corporate veil can be pierced are generally very limited, and structures used by private equity funds aim to ensure these risks are managed, both by good governance and by the adoption of compliance policies by their portfolio companies. There are some exceptions whereby the corporate veil can be pierced, which should be analysed carefully, usually when the shareholder is the de facto manager of the company.
The alignment of management and the private equity fund shareholder (whether majority or minority) is an important part of the private equity strategy globally. However, the approach to management equity incentivisation varies from jurisdiction to jurisdiction. How such equity incentivisation is ultimately structured is often tax driven. In many countries, options and profit participation schemes are also common. Generally, any management incentive schemes have “leaver” arrangements, so that the incentive is linked to the manager continuing his employment. Equity or other incentives are usually forfeited by a leaver, with the economic consequences varying according to the nature of the leaver: a “good” leaver will receive more than a “bad” leaver.
In almost all markets, managers are subject to restrictive covenants, such as non-compete provisions and non-solicitation. These can often be set out separately in employment arrangements rather than forming part of the equity package. The terms, duration and enforceability of such covenants vary from one country to the next.
Limited minority protections are offered to managers who hold equity in the business. These protections include pre-emption rights as anti-dilution protection. Most management equity holders enjoy tag rights as one of the few minority protections afforded.
A common feature in all private equity deals is that the private equity fund has liquidity and freedom to achieve an exit on its own terms, without restrictions from management shareholders or co-investors. That being the case, drag rights – whereby the majority shareholder can force minority shareholders to sell on the same terms – are common in private equity transactions globally. Very often, these include a minimum floor protection to the minority shareholders. The enforceability of drag mechanisms is not guaranteed; certain jurisdictions have specific conditions that must be satisfied in order for a drag to be enforceable. Management usually assists on an exit. It is unusual for members of management to provide warranties in most jurisdictions, unless they are themselves shareholders.
Auction processes are common for attractive assets. The popularity of exits by initial public offering varies from one market to the next, depending on the position of the capital markets more generally. IPOs on European stock markets have declined. Dual track exits (ie, where a sale and an IPO are pursued in tandem) are not that common, with most commentators noting that the high costs outweigh the perceived benefits of that exit strategy.