The COVID-19 pandemic has severely affected private equity M&A activity in the USA. Significant economic uncertainty arising from shutdowns of non-essential businesses, decreased demand, high unemployment, diminished access to credit and the unknown duration of the crisis has caused private equity sponsors generally to dramatically curtail or even cease, at least temporarily, new platform acquisition activity. Instead, firms are more focused on ensuring the stability of existing investments and preparing for longer holding periods than previously anticipated. These stabilisation efforts are expected to result in, among other things, an increased number of add-on acquisitions, which give sponsors opportunities to spend available capital, typically without the levels of debt financing required for a new platform investment.
The effects of COVID-19 appear to have interrupted the long-lasting sellers’ market, during which healthy levels of credit, low interest rates and record amounts of private equity capital resulted in highly competitive deal processes that increased valuations of private targets. Without clarity on when consumers and businesses will resume pre-COVID-19 levels of economic activity, traditional valuation methods – including historical earnings or revenue – may be less reliable measures of future performance. Consequently, valuations are expected to fall generally and sellers may be forced either to accept a lower multiple on their businesses or to share the risks of an uncertain future through earn-outs, substantial rollover equity or other valuation-bridging mechanisms (see 5.4 Multiple Investors and 6.1 Types of Consideration Mechanisms).
Despite the abrupt shift in market dynamics, the use of representation and warranty (R&W) insurance in private equity deals is not expected to slow. M&A participants’ increased familiarity with, and confidence in, R&W policies means quality targets will likely continue to push for R&W insurance as part of a buyer’s bid to allocate risk away from sellers. Sponsors and sellers should, however, prepare for more rigorous due diligence from underwriters, which will likely include an increased focus on legal compliance in light of a wave of emergency federal legislation relating to labour and employment, lending and public health and safety programmes (see 2.1 Impact on Private Equity).
Most sectors have suffered, and are expected to continue to suffer, a significant decline in private M&A activity in 2020. Deal activity has persisted, albeit at a slower pace than before the pandemic, in sectors such as healthcare and technology, where demand for products and services has continued and, in some cases, increased in the new “working from home economy”.
The US federal government enacted emergency COVID-19 relief legislation for businesses and employees, including the Families First Coronavirus Relief Act (FFCRA) and the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). Among other things, the FFCRA expanded employee paid leave protections for COVID-19-related reasons, creating compliance issues for sponsors, their portfolio companies and targets. The CARES Act authorised two new lending programmes, including the Paycheck Protection Program (PPP), which provides small businesses with low-interest rate loans that may be entirely forgiven if used for payroll and other specified uses, and the Main Street Lending Program (MSLP). Loans under the MSLP are not forgivable, but are available at attractive rates to a broader range of borrowers and may be used for general operating purposes.
While most private equity-owned businesses are not eligible for PPP loans, potential buyers of any business that has received a PPP loan should carefully review the target’s compliance with programme rules since all PPP loans, especially those over USD2 million, are subject to potential audit by the Small Business Administration. Far more portfolio companies are eligible to receive MSLP loans, but potential borrowers should weigh the benefits of inexpensive debt financing against MSLP-imposed covenants including, among other things, restrictions on leverage, dividends and stock repurchases.
The 2017 Tax Cuts and Jobs Act continues to influence private equity acquisition deal structures. Factors included in structuring decisions now include the option to expense 100% of tangible assets of a target in the same tax year as the acquisition, net operating loss deductions and interest expense limitations. The reduced corporate tax rate, elimination of corporate AMT and several favourable tax characteristics of corporations have expanded the options in entity choice in a market previously dominated by pass-through structures such as limited liability companies.
The Foreign Investment Review Risk Modernization Act of 2018 and the final regulations issued thereunder in 2020 (FIRRMA) expanded the scope of CFIUS (discussed in 3.1 Primary Regulators and Regulatory Issues) in the context of transactions involving US real property interests, certain critical infrastructures and technologies and personal data.
Recent privacy law developments (including the EU’s General Data Protection Regulation and California’s Consumer Privacy Act of 2018) continue to have a global impact on companies with significant operations involving personal data. And while the markets await more certainty in interpretation and enforcement of these new laws, private equity funds continue to grapple with the new requirements and tailoring pre-acquisition due diligence and post-acquisition compliance monitoring practices to identify and manage the potential exposure under a legal paradigm with continued momentum toward enhanced personal privacy rights and substantial penalties for non-compliance.
Several lawsuits regarding deals terminated prior to closing by the buyer because of COVID-19-related impacts are currently pending in Delaware (the most important US jurisdiction for corporate transactions). At issue in several of these cases is a buyer’s right to terminate an acquisition agreement for an alleged material adverse effect (MAE) or the seller’s alleged failure to operate the target in the ordinary course of business between signing and closing.
Decisions in these cases may provide a more particular and nuanced MAE analysis than previously provided by Delaware courts, which to date have found only one MAE (a case in which a host of legal compliance failures resulted in an estimated 21% reduction in the target’s value). Such decisions may also provide guidance as to whether actions taken in response to the pandemic that are reasonable (or even government-mandated) in the unique pandemic environment, and yet extraordinary based on historical practices, constitute a breach of a seller’s covenants to operate in the ordinary course of business.
US federal regulation of private equity M&A transactions is typically focused on three areas: (i) oversight of the offering and sale of securities in an M&A transaction, (ii) clearance of transactions for antitrust compliance and (iii) review of transactions involving foreign investment for national security concerns.
State law may affect M&A transactions, including with respect to fiduciary duties, shareholder rights and the transaction’s structural requirements. Transactions involving targets in regulated industries or operations may have additional regulatory oversight.
Oversight of Offering and Sale of Securities in M&A Transactions
The US Securities Exchange Commission (SEC) and various states regulate the sale of securities. Oversight is limited in M&A transactions between sophisticated, accredited investors, except in public acquisitions or where securities are offered to a large group of sellers as part of the acquisition consideration.
Clearance of Transactions for Antitrust Compliance
Under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (the HSR Act) and other applicable federal statutes, antitrust oversight is the domain of the US Department of Justice (DOJ) and the Federal Trade Commission (FTC). The primary regulatory burden in M&A transactions exceeding relatively low thresholds for transaction value and size of transaction participants is providing prior notice of the transaction to the DOJ and FTC. The parties may not close the transaction until the expiration or termination of post-notice waiting periods, during which regulators may request additional information or challenge the transaction. While rare, expiration of the waiting period does not foreclose a governmental challenge post-closing.
Review of Transactions Involving Foreign Investment for National Security Concerns
Under FIRRMA, the Committee on Foreign Investment in the US (CFIUS) has broad authority to review certain transactions that involve foreign investment. While notifying CFIUS of most transactions is voluntary – because CFIUS has the power to recommend changes or rescission of completed transactions – customary practice is to notify CFIUS in advance in transactions involving foreign investment in sensitive US real estate or companies that own or operate critical infrastructure or maintain and collect sensitive personal data of US citizens.
Mandatory filings are required for certain investments in any company that produces or develops enumerated critical technologies and any transaction resulting in the acquisition by a foreign government-controlled entity of 25% or more of a direct or indirect voting interest in a covered US business.
Legal advisors representing private equity acquirers generally conduct a thorough due diligence investigation of target companies. These investigations involve reviewing materials provided by the target or an investment banker who facilitates information and document requests.
The scope of legal due diligence review is broad and typically includes detailed examinations of the target’s equity ownership, organisational documents, equity holder arrangements, material contracts, financial statements, and records related to tax, real property, intellectual property, environmental investigations, legal compliance, litigation, employees and employee benefits.
For the foreseeable future, advisors should carefully review and counsel buyers on the target’s responses to COVID-19, including historical actions taken to address the pandemic and plans for future business disruptions, suspension or termination rights under material contracts and compliance with changing laws and government relief programmes.
In addition, advisors typically search publicly available lien, litigation and bankruptcy filings in jurisdictions relevant to the target’s operations and interview target management for clarification of key issues. Among other important matters, legal advisors seek to identify obstacles to completing a transaction, including required consents or notices and restrictions that may impact the private equity sponsor’s valuation, such as non-competition, most-favoured nation pricing, exclusivity or non-solicitation provisions. Increasingly, legal due diligence investigations focus on matters receiving heightened governmental and media scrutiny, such as anti-corruption compliance, data privacy and sexual misconduct.
The increasing use of R&W insurance in private equity-sponsored acquisitions has resulted in the production of more formal due diligence work product authored by advisors and heightened focus on conducting a comprehensive due diligence investigation. Prior to issuing a policy, the R&W insurance underwriter conducts its own independent legal due diligence investigation, reviews the due diligence reports prepared by the buyer’s legal and other advisors and conducts interviews with those advisors on the content of their reports and the scope of their investigation. Underwriters are likely to focus significant attention on the target’s response to COVID-19 and its effects on pre-closing operations.
Historically, private equity buyers have not relied on vendor (sell-side) due diligence reports. Increasingly, sellers engage advisors to conduct a quality of earnings analysis and due diligence on select matters and provide those reports to bidders to control the messaging on valuation and any potential concerns. However, buyers generally rely on their own review of those matters, and definitive transaction agreements typically eliminate the buyers’ legal recourse for materials not expressly included in the agreement’s representations and warranties.
Most US private equity-sponsored buyout acquisitions are structured as privately negotiated agreements, taking the form of a purchase and sale of equity or assets, or a merger.
Purchase and sale transactions are used where the seller is a single owner or a small, controlled group of equity holders. Transactions are customarily structured as mergers (which typically require approval from less than all equity holders) where broader groups of equity holders exist or where the potential recalcitrance of minority equity holders might delay or block a traditional purchase and sale transaction.
Merger structures are occasionally employed to limit post-closing seller liability in the transaction, with the target company being the sole non-buyer party to the merger agreement and recourse to equity holders of the target limited or non-existent.
Courts rarely participate in acquisition transactions, other than in US federal bankruptcy cases. In those cases, private equity buyers (often specialised distressed asset funds) may acquire the equity or assets of a bankrupt debtor following a court-supervised marketing process, with the transaction agreements privately negotiated by the debtor (or a trustee) and the buyer and approved by the bankruptcy court following one or more hearings.
In "take-private transactions" (see 7.1 Public-to-Privates), private equity-sponsored acquisitions may also utilise public tender offers, typically followed by mergers.
Quality targets pursuing an exit in the current recession are expected to engage in the same broadly marketed auction processes heavily utilised in the recent seller-friendly market. Auctions tend to result in more favourable seller outcomes in both economics and legal terms, but the uncertainty caused by COVID-19 may create substantial gaps in valuation for many businesses (see 6.1 Types of Consideration Mechanisms). Auctions also require dedication of target management resources over a lengthy marketing and auction period, which may be scarce in the current environment.
In the near term, private equity buyers are expected increasingly to devote resources to identifying so-called "proprietary" targets for potential platform and existing portfolio investments, where buyer and seller negotiate the transaction without a competitive process. While proprietary transactions typically involve smaller targets or those with limited potential buyers based on industry, regulatory or other considerations, the current recession may motivate sponsors to take advantage of falling asset prices by approaching desirable targets outside of a process.
Private equity-sponsored buy-out transactions for platform investments typically involve a special purpose buyer entity formed and funded by the private equity fund shortly before the acquisition. Co-investor, employee and seller-reinvested equity financing is usually invested in this buyer entity rather than directly in the target.
Frequently, unaffiliated co-investors invest in the buyer indirectly through additional upstream special purpose entities controlled by the private equity fund. This structure is intended to limit the private equity fund’s contractual exposure in the acquisition, both under the primary acquisition agreements (where upstream fund-level guarantees are generally non-existent or limited to narrow, specific areas, such as reverse termination fees) and the debt-financing arrangements (where lenders customarily require guarantees from the buyer entity but not the fund).
The structure enhances flexibility in exit options where co-investor or employee investments exist, allowing the private equity fund to control seller conduct directly without having to enforce contractual remedies under drag-along agreements. Minority investments by private equity funds typically employ a similar special purpose entity.
Private equity acquisitions are almost universally financed with a mix of equity and debt. While debt financing levels typical of the leveraged buyout eras of the 1980s and 2000s have not been prevalent in the market to any comparable extent since the 2008 credit crisis, most private equity-sponsored buyouts are financed with significant levels of debt, with some form of borrowed money often representing half or more of the acquisition financing.
Private equity sponsors typically employ senior secured term debt as a primary source of debt financing, but mezzanine debt may be used where sufficient senior credit is not available. Banks remain the preferred lenders in private equity-sponsored acquisitions, but increasingly debt funds and other non-traditional lenders provide primary senior debt financing rather than only mezzanine and other subordinated lending. These non-traditional lenders are expected to play a significant role in the leveraged buyout market during the current recession as banks become reluctant to underwrite loans in an uncertain economic environment.
The majority of the equity in a private equity buyout is typically provided by the private equity sponsor. Minority equity investments by private equity funds are less common but may increase during the recession as sponsors face pressure to deploy their record amounts of capital amidst a declining number of quality investment opportunities. The private equity sponsor typically provides an equity commitment letter in transactions structured with a separate signing and closing.
"Club deals", where multiple private equity funds form a consortium to bid jointly for a target, have fallen out of popularity over the last two decades, a trend driven by anti-competition concerns from regulators and sellers seeking more robust auctions. Despite challenges posed by the negotiation of deal terms and post-acquisition governance issues, club deals may re-emerge during the recession as private equity funds look for broader opportunities to deploy high levels of available capital and sellers have less leverage to thwart consortium bids.
Co-investors are frequently included in private equity-sponsored transactions, providing sponsors with flexibility in obtaining equity financing without overly concentrating a portfolio and investors with the ability to employ funds without customary fees and carried interest allocations.
Co-investments arise from a variety of sources, including "rollover" equity reinvested in the restructured target by existing selling equity holders and direct investments by the sponsor’s limited partners, the target’s management and lenders of acquisition financing. Increased rollover equity is one potential solution to bridge valuation gaps, allowing sellers to share more substantially in an upside exit scenario.
The purchase price in a typical US private equity-sponsored acquisition is generally a base purchase price (typically reflecting the enterprise value of the target), reduced by certain amounts at closing – including indebtedness of and transaction expenses incurred by the target (often paid in full by the buyer at closing) – and adjusted for variations in working capital or other accounts at closing from a negotiated target amount.
Closing account adjustments are typically estimated shortly before closing and finalised an agreed period of time after closing based on actual closing account values reflected in financial reports prepared by the buyer. Disputes over working capital adjustments are customarily resolved by an agreed-upon neutral third party.
Sellers’ payment obligations in connection with closing account adjustments are frequently secured by a portion of the purchase price held in escrow pending resolution of the closing account values. By contrast, buyers’ closing account adjustment payment obligations are rarely secured by escrowed amounts. Well-positioned sellers negotiate for the adjustment escrow to be a buyer’s exclusive recourse for negative purchase price adjustments, often in exchange for a matching collar on positive adjustments.
A portion of the purchase price is sometimes contingent upon satisfaction of certain specified post-closing revenue or profit targets. The terms of these so-called "earn-out" payments are typically used to bridge valuation gaps and are heavily negotiated, particularly with respect to the conditions, standards used to measure their satisfaction, and conduct of the business post-closing to the extent it may affect achievement of the earn-out conditions.
Earn-out payments are more common in transactions with private equity buyers than with private equity sellers, but the valuation gaps expected to result from the COVID-19 pandemic may lead to their increased use. Earn-out payments are frequently the subject of post-closing disputes that are typically required to be resolved by a neutral third party similar to disputes over closing account adjustments.
Locked-box consideration mechanisms are rare in US private equity-sponsored acquisitions, other than in the context of cross-border transactions with sellers in jurisdictions where such mechanisms are more prevalent, or in limited circumstances where sellers enjoy a relatively strong bargaining position and buyers seek to enhance their bid values for competitive targets.
Disputes between the parties regarding the closing account purchase price adjustments are typically submitted for binding resolution to a neutral third party, often a financial accounting or audit firm. This generally follows a specified period of negotiation among the parties.
While conditions to the buyer’s obligation to close an acquisition are often negotiated based on specific characteristics of the transaction and the target, some variants of the following key closing conditions are customary:
Private equity buyers often negotiate for a condition that no "material adverse effect" has occurred between signing and closing. Other transaction-specific conditions are frequently negotiated, including delivery of new restrictive covenant or employment agreements, effectiveness of ancillary transactions occurring simultaneously and satisfactory remediation of material matters uncovered in due diligence. Financing and due diligence conditions are rare except in very buyer-favourable circumstances.
Private equity buyers traditionally resist so-called "hell or high water" covenants, which require the buyer to take all actions necessary to obtain applicable regulatory approval of the transaction, including – in the case of clearance under the HSR Act – commencing litigation, divesting assets or agreeing to restrict other business operations. This is particularly sensitive to private equity funds with diverse holdings where anti-trust scrutiny of the transaction could trigger obligations under these covenants that would adversely affect the fund’s other portfolio investments. While the recent seller-friendly M&A market saw private equity buyers soften their opposition to some forms of hell or high water covenants, the recent shift in market dynamics may reverse that trend.
In transactions where the acquisition agreement provides a private equity buyer the right to terminate the acquisition agreement for its failure to obtain debt financing (see 6.7 Termination Rights in Acquisition Documentation), upon the buyer’s exercise of the termination right, the buyer is typically required to pay a reverse termination fee (customarily between 2% and 7% of the base purchase price, depending on the transaction size) as the target’s and the seller’s exclusive remedy for the buyer’s failure to close. Otherwise, termination fees are uncommon in private equity-sponsored acquisitions, except in transactions with public company targets.
A typical acquisition agreement may be terminated before closing by a private equity seller or buyer under limited circumstances, including where the closing has not occurred before a specified outside date, or the counterparty fails to cure its material breach of the agreement.
In transactions funded by significant acquisition debt financing, private equity buyers often negotiate the right to terminate the acquisition agreement if adequate debt financing is not secured by a specified date in exchange for payment of a reverse termination fee (see 6.6 Break Fees). Under this approach, the buyer customarily makes representations regarding debt financing commitments obtained at signing and is typically bound by covenants to use reasonable efforts to secure the financing.
Allocation of risk is primarily governed by a negotiated package of indemnities provided by the seller. General indemnities typically cover losses suffered by the buyer as a result of any inaccuracy or breach of the representations and warranties made by the seller or the target in the acquisition agreement. In addition, narrowly tailored specific indemnities may cover known concerns identified in due diligence.
Bolstered by the availability of R&W insurance policies, sellers, particularly private equity sellers, increasingly seek to minimise post-closing liabilities by negotiating for limited post-closing liability. This "public company style" allocation of liability results in structures with minimal or no significant post-closing seller liability that rely almost exclusively on R&W insurance to manage buyer risk.
In a traditional private equity transaction, the seller is responsible for the representations and warranties related to the target (whether made by the seller or the target and backstopped by the seller through indemnity). While the target’s management is usually involved in reviewing the representations and warranties and preparing disclosure schedules, management is rarely a party to or contractually liable under the acquisition agreement, other than to the extent of management’s equity holdings.
Limitations on a seller’s liability for representations and warranties depend on both the nature of the representations and warranties and whether the transaction involves R&W insurance or another recourse-limiting feature. Generally, representations and warranties are classified (for liability limitation purposes) as either "fundamental" or "non-fundamental" based on their subject matter and the extent to which they are critical to the essence and validity of the transaction.
Seller liability for the handful of fundamental representations and warranties survives closing for a relatively long time (often 20 years or more, where permitted by applicable state law) and is often capped at the purchase price. By contrast, seller liability for non-fundamental representations and warranties typically survives for only 12 to 24 months and is capped at a small percentage of the purchase price (usually 10% or less, and as little as 0% to 1% in R&W insurance transactions).
Indemnification for non-fundamental representations and warranties is ordinarily subject to a deductible (of up to 1% of the purchase price) borne by the buyer which often excludes losses below a small threshold. Some representations and warranties defy the broad fundamental/non-fundamental classification. For example, representations and warranties related to taxes often feature an intermediate survival period tied to the tax statute of limitations and liability capped at the purchase price. Those related to environmental or employee benefit matters may have longer survival periods or not be subject to deductibles and other indemnification limits.
The custom in US private target transactions is to limit legal reliance of all parties to the four corners of the acquisition agreement. Accordingly, the acquisition agreement precludes reliance by the buyer on representations and warranties outside of those expressly included in the agreement, and similarly limits exceptions to those representations and warranties to matters identified in disclosure schedules to the acquisition agreement. Materials made available in data rooms or otherwise may not be relied on by either party in connection with liability issues, except to the extent expressly incorporated into the acquisition agreement.
A portion of the purchase price in a private equity transaction is typically deposited in escrow to backstop the seller’s indemnity obligations. While traditionally a buyer would have direct recourse to the seller for at least a portion of the indemnity obligations in excess of the indemnity escrow, it has become increasingly common for the indemnity escrow to serve as the exclusive source of a buyer’s recovery, with limited exceptions for breaches of fundamental representations and warranties, taxes, breaches of covenants and perhaps an indemnity unique to the transaction. Escrow holding periods usually match the general survival period for a seller’s liability for non-fundamental representations and warranties.
The use of R&W insurance in private M&A transactions involving private equity funds has increased dramatically in recent years, enhancing the viability of transactions that significantly limit seller liability for representations and warranties. Indemnity escrows that previously ranged between 5% to 10% of purchase price typically drop to between 0.5% to 1% in R&W insurance transactions, and occasionally buyers agree to eliminate the indemnity escrow in aggressively seller-favourable transactions with R&W insurance.
Seller liability in R&W insurance transactions varies widely as available insurance products allow buyers to customise risk allocation to deal-specific demands and the competitive contours of the auction process. Despite the rapid rise in popularity of R&W insurance in private M&A transactions, experience on the claim resolution process under those policies remains limited.
Though the use of R&W insurance is not expected to slow in the current environment, underwriters are responding by adding COVID-19-specific exclusions into policies and focusing due diligence efforts on COVID-19-related impacts to the target. Insurers’ unwillingness to underwrite losses resulting from the continued pandemic adds further uncertainty to the current deal market, as buyers and sellers struggle to allocate that risk in the face of continued economic uncertainty.
Litigation over post-closing disputes in private equity transactions is rare, in part because private equity funds often resist litigation due to reputational risk. Accordingly, private arbitration is popular among private equity participants in M&A transactions. Post-closing disputes commonly arise in connection with closing account adjustments. These disputes are ordinarily resolved by private negotiation or by a neutral third party.
Earn-out payments are another area of frequent dispute, as they often call for a closing-account type of reconciliation for determining earn-out payments on a frequent, repeated basis, potentially over several years. Tax and environmental liability are additional areas of common seller liability, but these issues are usually identified before closing through careful due diligence and are the subjects of specific indemnities (often with special escrows), minimising dispute over coverage post-closing.
Public-to-private or "take-private" transactions represent a modest portion of the overall volume of US private equity-funded transactions. The overall number of public-to-private acquisitions has been relatively flat in recent years, but that may change as private equity firms assess less traditional avenues to deploy capital in the current economic recession.
Shareholding disclosure thresholds and filing requirements are defined in the Securities Exchange Act of 1934, which provides as follows.
First, any party (or parties acting together) acquiring more than 5% of a class of voting equity securities of a US public company must file a publicly available Schedule 13D or 13G with the Securities and Exchange Commission (SEC). Schedule 13D, the document required of potential acquirers, is due within ten calendar days of crossing the 5% threshold and must be promptly amended following certain changes. Among other things, Schedule 13D discloses the acquirer’s identity, purpose for the investment, securities beneficially owned and consideration paid for the securities.
Second, a party engaging in a take-private transaction of a public company that is an "affiliate" of such company must file a Schedule 13E-3 prior to undertaking a tender or exchange offer or merger. Schedule 13E-3 requires, among other things, disclosure of the purpose and effects of the transaction and why the filing party believes the transaction is fair to the shareholders of the public company. Determination of whether a party is an affiliate of a public company depends on the specific facts and circumstances, although a general rule of thumb is that an owner of 10% of the company who has the right to appoint one or more directors to the company’s board is presumed to be an affiliate for this purpose.
In addition, the HSR Act generally requires that any acquisition of voting securities, non-corporate interests or assets in excess of certain thresholds (USD94 million as of 2020) be reported to the DOJ and the FTC prior to any such acquisition. Thereafter, the acquisition cannot be completed before the applicable waiting period (30 calendar days for most transactions) either expires or is terminated earlier, upon request by the filing parties granted at the discretion of the regulatory agencies. The agencies may also extend the review period by requesting that additional information and materials be submitted.
US federal securities laws do not require bidders acquiring a significant portion of a public company’s shares to make mandatory offers to acquire additional shares from the company’s other shareholders. However, the laws of three US states (Maine, Pennsylvania and South Dakota) include "control share cash-out" provisions permitting shareholders of corporations incorporated in such states to demand that bidders acquiring more than a specified percentage of shares (as low as 20% in Pennsylvania) purchase their shares at a specified price (for example, the highest price paid per share by the bidder in recent share acquisitions).
Cash is the primary form of consideration to acquire US target companies. Issuance of shares may require registration of the offering with the SEC, an expensive and time-consuming process. However, if structured in accordance with applicable provisions of the US Internal Revenue Code of 1986, as amended, a transaction involving the exchange of target company stock for acquirer stock may qualify, in whole or in part, as a tax-free reorganisation under which the receipt of the acquirer stock by the target company’s shareholders would not be taxable.
Acquisitions of US public companies are typically effected pursuant to merger agreements, under which either (i) the public company’s board of directors and shareholders approve a one-step merger under applicable state law or (ii) the acquirer first makes a public tender or exchange offer soliciting shareholders to sell their shares for the proposed consideration (cash in the case of a tender offer or securities, alone or in addition to cash in the case of an exchange offer), and second acquires the remainder of the target company’s shares through a statutory second-step or "squeeze-out" merger.
Bidders may make takeover offers subject to the satisfaction of specified conditions, which typically include the following.
Transactions may be conditioned on the acquirer obtaining adequate equity and/or debt financing. When such a condition is accepted, target companies typically require that the acquirer has binding commitments from its financing sources at the time the merger agreement is signed and also require a "reverse termination fee" payable by the acquirer. That fee is typically the target company’s sole recourse if such financing is not funded.
The target company often agrees to pay a termination or "break-up" fee to the acquirer if the merger agreement is terminated in certain circumstances, such as:
The merger agreement typically governs the target company’s ability to solicit or support competing offers and must accommodate the directors’ fiduciary duties to the target company’s shareholders under applicable state laws. Provisions may range from permissive ("go shop") to restrictive ("no shop"). The merger agreement may provide the acquirer "matching rights" or a "last look" allowing it to match superior third-party bids received by the target company. Although less common recently, the acquirer may seek a "force the vote" provision requiring the target company’s board to present the transaction to a shareholder vote, even if the board withdraws its support of the transaction.
If a bidder has acquired the requisite shares to approve a statutory merger under applicable state law and the target’s organisational documents, the bidder can effect a second-step or "squeeze-out" merger to acquire the target company’s remaining shares.
State laws typically require that mergers be approved at a meeting of the company’s shareholders, unless (i) the target’s organisational documents permit mergers to be approved by written consent of the shareholders, or (ii) the bidder has acquired the statutorily required number of shares to effect a short-form merger, which permits an expedited process without a shareholders meeting.
Most state laws require that the bidder hold 90% of the outstanding shares to effect a short-form merger. However, some state laws (including Delaware) permit bidders to complete short-form mergers following first-step tender offers in which enough shares are acquired to approve a merger under the target’s organisational documents (which may, for example, be a simple majority of the outstanding shares).
If a bidder does not seek or obtain 100% of the target’s shares, it may nevertheless obtain significant governance control with respect to the target. A bidder acquiring the requisite shares under applicable state law and the target’s organisational documents to elect directors (typically a plurality of the votes cast) may nominate and elect all directors, although for companies with staggered director terms, electing all directors may require several years. Significant share ownership may provide a bidder with blocking rights on matters submitted to shareholders and permit the bidder to seek negotiated rights.
Potential acquirers often seek "lock-up" agreements from principal shareholders of the target company to tender their shares or vote in favour of the merger. Such agreements are typically entered into simultaneously with the signing of the merger agreement.
Under Delaware law, restrictions imposed under such tender or voting agreements, together with the obligations of the company’s directors under the terms of the merger agreement, may not be so broad as to impede the directors’ ability to exercise applicable fiduciary duties and entirely preclude the company from pursuing a better offer from a competing bidder. Depending on circumstances, lock-up agreements also may be subject to restrictions under SEC regulations.
Hostile takeovers are permissible in the USA, although they are far less common than friendly takeovers and face significant hurdles. State statutes permit corporations to implement takeover defences such as shareholder rights plans ("poison pills") and staggered terms for directors to deter potential hostile acquirers.
Poison pills are triggered when an acquirer accumulates a certain percentage of the target’s outstanding shares and threaten substantial dilution to the acquirer and a significantly higher acquisition cost. Under staggered board terms, only a minority of the total number of the company’s directors (typically one-third) are re-elected or replaced in one year.
In addition to the challenges presented by takeover defences, hostile acquisitions typically take longer to complete than negotiated transactions, impose higher acquisition costs that may include litigation, and limit the bidder’s ability to conduct robust due diligence with the co-operation of the target company’s board and management.
Hostile acquisitions may present potential reputational risks to the bidder, especially when the attempted takeover is ultimately unsuccessful or the target engages in a negative publicity campaign against the bidder. Private equity buyers seldom pursue hostile takeovers and often agree with their investors not to make investments other than on a friendly basis.
Private equity sponsors commonly rely on equity to align their incentives with management, and the level of participation varies widely from sponsor to sponsor. Management equity may arise from rollover equity, cash investment in the post-closing company, or incentives issued in connection with or after the transaction closing.
Private equity sponsors often seek to retain, rather than replace, existing management teams and therefore wish to maintain management’s commitment to the post-closing business. Accordingly, private equity buyers often permit a target’s management to make significant investments in the acquiring company (from 10% to as much as 50% of the transaction’s equity financing) through rollover equity or new investment.
The scale of incentive equity in the post-acquisition equity capitalisation is, by contrast, somewhat more uniform in private equity transactions. Historically, incentive equity commonly represented around 10% of a private equity-sponsored company’s fully diluted equity, but more recently incentive equity pools have increased to approach 15% and above, particularly in smaller companies. In step with this trend, private equity sponsors may rely on more aggressive performance thresholds for incentive equity participation.
The breadth of participation in incentive equity programmes varies by industry and investment size. Typically, incentive equity participation is limited to "C-level" management and other key employees. However, in certain industries, such as technology and life sciences, broader incentive equity participation among less-senior employees is more common and is often a necessity to attract and retain skilled employees in tight labour markets.
While rollover equity is more often pari passu with the sponsor’s equity in terms of liquidation preferences, participation rights and other economic terms, sponsors increasingly consider subordinated equity structures for management and rolling equity holders, particularly with respect to investments in oil and gas and other industries hardest hit by COVID-19. Regardless of economic parity, the private equity sponsor typically retains broad, exclusive control over matters such as governance, additional equity financing and liquidity.
Incentive equity in private equity investments takes many forms, including profits interests, stock options, phantom equity, stock appreciation rights and restricted stock. Stock options and profits interests are the most common forms and share similar mechanics, permitting management to participate in equity value above the value at the time of issuance.
The generally employee-favourable tax treatment of profits interests (typically permitting capital gains treatment on liquidity, while proceeds from stock options are taxed at ordinary income rates in most circumstances), together with the increased popularity of limited liability company structures in private equity investments, has led to a marked trend toward profits interests over stock options in recent years. The prevalence of stock options persists in software and other technology sectors.
Restricted stock and similar types of capital equity are less commonly used for incentive equity, and usage is limited to corporations. Unlike stock options or profits interests, the value of restricted stock is taxable to the recipient at issuance. Accordingly, unless the recipient pays fair market value in exchange for the equity, the employee would have an upfront tax obligation without any corresponding liquidity.
To avoid this tax timing dilemma, the issuer company can loan the fair market value of the restricted stock to the employee to finance the employee’s purchase of the stock. The terms of those loans are subject to rules of taxing authorities and must not be entirely non-recourse. They are generally repaid in connection with liquidation of the stock or termination of the employee’s employment relationship.
Vesting of management equity differs based on the type of equity. Generally, rollover equity and cash investments by management are fully vested upon issuance, as is the equity purchased by other investors. Incentive equity, however, is customarily subject to vesting requirements, with vesting commonly occurring incrementally over periods of three to five years.
The frequency of incremental vesting varies, usually annually or monthly, sometimes with "cliff" vesting of a larger portion after the first vesting period, followed by a straight-line vesting schedule of the remainder. Incentive equity may also be subject to performance vesting conditions, commonly tied to a multiple of the private equity sponsor’s return on invested capital.
Vesting determines the treatment of incentive equity upon termination of the employee’s employment. If vested upon termination of an employee’s employment, incentive equity is typically owned by the terminated employee and often subject to repurchase by the company (as described below), while unvested equity is typically cancelled or otherwise surrendered without consideration.
Time-based vesting of incentive equity is often accelerated in connection with certain specified liquidity events, and less commonly in connection with termination of the employee’s employment by the company without cause or by the employee for good reason.
Management equity is typically subject to repurchase by the company following certain events. Repurchase rights are usually broader (and less favourable to the employee) for incentive equity, and narrower (and more favourable to the employee) for rollover equity or cash investments. The repurchase price also typically differs between incentive equity and rollover equity or cash investments.
The repurchase price is often the fair market value of the equity, but if the employee’s employment is terminated by the company with cause or by the employee without good reason, then the repurchase price for incentive equity may be some nominal amount (or no amount). These "good leaver/bad leaver" provisions occasionally apply to management rollover equity or cash investments, but it is more common for that equity to be repurchased at fair market value in all circumstances.
Repurchase rights are typically permissive, rather than mandatory, and management put rights are uncommon in private equity-sponsored companies.
Private equity sponsors typically seek restrictive covenants from management shareholders, either in the definitive acquisition agreement, incentive, rollover or cash investment equity documentation, employment agreement or separate restrictive covenant agreement. Generally, these restrictive covenants include non-competition, non-solicitation (of employees, customers and other business relationships) and no-hire restrictions, as well as non-disparagement, non-interference and confidentiality covenants.
The term and scope of these obligations are subject to negotiation and vary across transactions, but five-year terms that cover the entire world are not uncommon in merger and acquisition transactions involving businesses with a material international presence.
The enforceability of restrictive covenants (including specific, often technical, requirements for enforcement) varies from state to state within the USA and depend on the consideration given for the agreements. While most jurisdictions have historically enforced non-competition and non-solicitation restrictions on selling shareholders in the context of M&A transactions, enforceability is less certain in many US states in ordinary employment relationships (and in some states are unenforceable). Moreover, the US Department of Justice has taken the position that certain restrictions not critical to a separate, legitimate business arrangement may be per se illegal.
In recent years, enforceability may not be certain even in the context of merger and acquisition transactions. States enforce non-competition and non-solicitation restrictions only to the extent that they are reasonably limited in duration and scope and tailored to protect the goodwill and business of the acquired company. Further, the FTC has challenged covenants that unduly eliminate competition (which is more relevant in strategic acquisitions, including add-on transactions) or restrict activity beyond what is necessary to protect the buyer’s investment.
Management equity generally represents a minority position in the post-acquisition equity capitalisation. Incentive equity holders commonly have only economic rights. Holders of equity obtained by purchase (including rollover equity and cash investments) typically have minority protections that fall into four categories: anti-dilution, exit participation, restrictions on sponsor-affiliate transactions and information rights.
Anti-dilution rights of management equity holders typically take the form of participation (or pre-emption) rights to subscribe for additional equity in post-closing issuances to maintain their proportionate equity position. In private equity-sponsored companies, participation rights often apply only to issuances to the private equity sponsor or its affiliates, permitting the sponsor to dilute the management minority equity holders to the same extent that the sponsor dilutes itself through third-party equity financing. Less commonly, participation rights apply to a broader array of equity financing.
Exit participation rights of management equity holders are designed to prevent a private equity sponsor from exiting its investment without providing liquidity to management and other minority investors. The rights commonly are provided as so-called "tag-along" rights, which permit minority holders to sell their equity on a pro rata basis (described in more detail in 10.3 Tag Rights). Additionally, registration rights agreements often provide minority investors the right to participate in registration of public securities for resale, although these agreements have become less relevant in recent years as public offerings of securities in private equity-sponsored companies are less common.
Restrictions on Sponsor-Affiliate Transactions
Minority investors may negotiate restrictions on proposed transactions between the private equity sponsor or its affiliates and the company. These rights are aimed at preventing the sponsor from using its control of the company to extract value that the minority would otherwise be entitled to by virtue of its equity position.
Minority investors typically receive limited information rights, often including periodic financial statements but occasionally broader rights. Because management would typically have access to that information (at least while employed by the company), minority information rights are often of limited value to management equity holders.
Occasionally, management and other minority investors with significant capital equity positions negotiate rights to appoint board members. Private equity sponsors rarely surrender control of the governing board. Likewise, minority investors in a private equity-sponsored company rarely have veto rights over company action. Minority investors usually are subject to a series of restrictive provisions, including the private equity sponsor’s "drag-along" rights (described in 10.2 Drag Rights), strict restrictions on transfer of equity, and rights of first refusal in favour of the company and the sponsor on most transfers of equity. Consequently, the sponsor has nearly absolute control over operations, financing, acquisitions and liquidity.
In most US states, including Delaware, statutory-provided minority rights are limited, and in limited liability companies minority rights are almost entirely left to contract provisions.
Private equity sponsors typically enjoy broad control rights over portfolio investments in which they hold a majority interest, ordinarily controlling appointment of at least a majority (and often all) of the governing board and rarely ceding much if any control to minority holders, except in the context of limited minority protections (described in 8.5 Minority Protection for Manager Shareholders). Accordingly, private equity sponsors commonly have legal control of all operational, capital and liquidity matters, although as a practical matter they frequently defer to a significant extent to existing management in operational matters.
In minority private equity investments, a fund often negotiates for specific veto rights, including with respect to exit transactions, additional equity, material deviations from approved budgets and enhanced information rights. Control rights in these minority investment contexts vary broadly depending on the size of the investment, the parties involved, and the fund’s investment strategy.
Private equity funds that hold controlling equity positions in a portfolio investment may be liable for the company’s conduct in certain circumstances. For example, majority equity holders may be liable for the company’s employee pension obligations under the US Employee Retirement Income Security Act of 1974 (ERISA), the company’s compliance with various environmental regulations, or for the company’s failure to comply with requirements of the Worker Adjustment and Retraining Notification Act of 1988 and state labour regulations. Law enforcement bodies have increasingly brought or threatened action against controlling equity holders for the criminal conduct of operating companies, including under the federal False Claims Act and the Foreign Corrupt Practices Act (FCPA), typically in situations where heightened levels of operational control are exercised.
Civil liability may also pass to controlling private equity funds in scenarios where lack of required corporate formalities and other bad acts can result in limited liability structures being disregarded under corporate veil piercing and other alter ego theories. Sponsors can minimise the risk of exposure to portfolio company liability by observing traditional corporate formalities, installing formal governance bodies at portfolio companies separate from those of the fund, documenting thorough due diligence of potential criminal conduct before the acquisition and regularly exercising diligent oversight of the company’s conduct after the acquisition.
In an effort to insulate private equity funds from control liability (described in 9.2 Shareholder Liability), as well as to enhance exit value and avoid reputational losses, controlling private equity sponsors commonly will insist that their portfolio companies adhere to robust legal compliance policies, including with respect to anti-corruption under the FCPA and state laws, compliance with employee benefits requirements under ERISA and, increasingly, policies addressing sexual misconduct. This oversight often involves regularly auditing policy compliance, but is balanced with a concern that a fund’s exercise of too much control over day-to-day compliance may actually enhance the risk of control liability generally.
Average holding periods for private equity investments have increased over the last decade, replacing the traditional three to five-year period historically characterising those investments with average periods recently exceeding six years. This may be driven in part by a stagnant IPO market and increased popularity of funds with long-term investment horizons focused on minimising transaction costs and other inefficiencies incident to shorter investments. Additionally, the effects of the COVID-19 pandemic are expected to at least temporarily extend holding periods.
The most common exit for a private equity investment is a complete liquidation in a buyout transaction. Only in extraordinary circumstances will private equity funds reinvest in an exit transaction because the terms of the fund generally dictate that the fund be wound up before a reinvested investment is likely to be liquidated.
Private equity sponsors holding a controlling equity position typically enjoy broad rights to compel the sale of minority equity positions in connection with the majority’s exit. These "drag-along" rights usually apply to all minority investors, including institutional co-investors, although the specific terms of the drag rights may be negotiated individually. Drag-along rights are commonly triggered by the sale of a controlling stake in the company, but occasionally apply to smaller transfers, such as sale of a majority of the controlling equity holder’s position. Drag-along rights are seldom exercised.
Buyers are typically sensitive to minority dissent in a transaction and reticent to close an acquisition unless each equity holder is a party to the acquisition agreement. More often, an alternative transaction structure (such as a merger or asset sale) is employed to avoid minority holdup value or refusal to deal. Accordingly, drag-along rights have more value in establishing the expectations of the parties and creating a mostly symbolic threat than in practice.
Management and other minority investors generally have rights to participate (on a basis proportionate to their respective investment positions) in a complete or partial exit led by the majority private equity sponsor. These "tag-along" rights are commonly triggered by any sale of equity (other than specified permitted transfers such as transfers to affiliates and estate planning transfers), but thresholds may be negotiated to permit partial exits without minority participation, as when a sponsor has a plan to sell down equity to co-investors. Tag-along rights usually require the sponsor seller to use some level of reasonable or best efforts to facilitate participation in the transaction by the tag-along investors, and the sponsor may not complete the exit if the prospective buyer refuses tag-along investor participation.
In general, IPOs remain rare in the USA, particularly among private equity-sponsored companies. Lock-up periods applicable to private equity and other pre-IPO equity holders are typically 90-180 days. Relationship agreements are not a common feature of US IPOs.
The first half of 2020 has been dominated by the COVID-19 pandemic. Public markets have been up and down, M&A activity dramatically slowed, and the outlook for new fundraisings is less clear than it has been for many years. Sponsors have also been focused on supporting the liquidity and business requirements of portfolio companies.
During the second half of the year, some innovative refinancing transactions are expected alongside an uptick in restructuring activity. At the same time, many dealmakers have been creative, with take-privates and strategic investments in public companies seeing something of a resurgence in Asia and the United States respectively.
It is not yet certain what the longer-term implications of the crisis will be, but some are already becoming clear. The many episodes of racial violence and injustice over the last few months are a sharp reminder to us all of continuing racial inequalities, while the pandemic itself highlighted many social issues that are often hidden from view. Private equity firms and their portfolio companies have been among those in the business community responding positively to these events. It is anticipated that this focus on business integrity will continue in the years ahead – as policy-makers and asset-owners continue to demand more deliberate attention to the social, environmental and governance agenda from all quarters of the investment community.
Despite considerable disruption caused by the global COVID-19 pandemic, the amount of capital raised globally in the first quarter of 2020 surpassed the same period in 2019. However, the significant decrease in the number of funds closed in the first quarter of 2020 (as compared to the first quarter of 2019) indicates that much of the first quarter growth can be attributed to established sponsors raising megafunds. It is also likely that many of these funds were in the market before the onset of the pandemic and it remains to be seen whether current fundraising levels will continue through the remainder of 2020 and into 2021 or begin to decelerate as new products are marketed in the current economic environment.
Established sponsors and investors across the spectrum have adapted quickly to remote meetings and other investment processes necessitated by the global pandemic. At the same time, for newer fund managers, attracting first-time investors has become uniquely difficult, as most business travel and in-person due diligence remains inadvisable, leading investors to seek out sponsors with established track records. We expect these trends to continue for the remainder of the year.
With respect to new products being marketed, there has been a meaningful increase in credit-focused funds, as well as pooled funds and separate account mandates that can be launched on an expedited basis, which favours sponsors with established track records and relationships with institutional investors able to execute quickly. In addition to fundraising efforts with new strategies, another trend we are seeing is increased sponsor appetite to (i) help existing portfolio companies' weather short-term liquidity issues and (ii) take advantage of market dislocation, much of which is achieved through fund-level financing sources as well as amendments to existing fund documents expanding the ability of a fund to borrow, recycle or make follow-on investments.
The private market space
Finally, we are seeing a notable build-up of dry powder in the private markets space, while at the same time deal volume has declined throughout the first half of 2020 (from the record 2019 pace). This change seems to be particularly impactful in the venture capital market, due to the unprecedented economic uncertainty in the market and difficulty assessing COVID-19’s impact on valuations without reliable market data. As sponsors begin to better understand the economic impact of COVID-19 on valuations, we expect an increasing rate of deal volume in the second half of 2020.
Leveraged Finance and Fund Finance
Until the widespread impact of COVID-19 became clear, activity in the leveraged financing markets started 2020 at a brisk pace. There was a significant uptick in volume, as the outflows of 2019 were replaced by considerable inflows, allowing even lower-quality credits to return to the market. All of this came to an abrupt halt in March. The COVID-19 crisis caused arrangers to hold off on syndicating previously committed deals, funding them from their balance sheets instead, while many M&A deals that had been close to signing were shelved. PE sponsors went into crisis management mode, evaluating the potential impact of the pandemic-related shutdowns on their portfolio companies’ liquidity, performance and ability to continue as going concerns.
An overwhelming number of borrowers drew down on their revolving credit facilities to guarantee available liquidity as lockdown arrived. Revolving draws did not represent the only path to liquidity, as the high-yield market reopened by April, leading to record levels of issuance since then. Notably, similar to the market recovery following the financial crisis, secured notes have been the primary source of new deal volume, as borrowers look to shore up the liquidity on their balance sheets; secured notes have also allowed a limited number of leveraged buyouts to be completed, including CD&R’s acquisition of Radio Systems Corporation. In addition, some borrowers have engaged in liability management transactions either to increase liquidity or to reduce debt load or both, including some that have been judged controversial by creditors, such as the priming transaction for Serta.
Long-term impact of COVID-19
As the negative impact of COVID-19 on some borrowers’ performance continues, increased stress is expected to be reflected in their liquidity position, potential non-compliance with financial covenants, ability to address near-term maturities and possible going concern qualifications in the next audit season. In this context, also expected are disagreements between borrowers and lenders over EBITDA addbacks, requests for covenant relief and/or additional out-of-court and in-court restructurings.
The focus on access to liquidity also extended to fund level financings, as sponsors sought to close ongoing fund-finance transactions quickly and efficiently to minimise any execution risk. Many sponsors raised new liquidity at fund level not only as a defensive move in light of the pandemic but also for the purposes of taking advantage of market dislocation. Although some lenders retrenched and terms shifted somewhat in favour of lenders, the fund finance market remains robust as others have sought to expand their market position.
The fund finance market is also looking to the future in respect of ESG-linked financings. Debevoise recently acted on a EUR2.3 billion (USD2.6 billion) ESG-focused subscription line facility, which was the first of its size and kind in the fund finance market. The search for new sources of liquidity has also led to growth in the market for financings against non-diversified portfolio assets (ie, concentrated net asset value facilities) of buyout funds, providing fund level leverage to sponsors where this was previously not possible.
2020 began with a brisk PE M&A deal market, as the decade-long combination of vast amounts of dry powder and an abundance of debt financing continued to fuel buyout activity. But then, as the first quarter drew to a close, the severity of the coronavirus pandemic transformed all of our lives overnight. Debt markets unsurprisingly seized up and M&A sale processes were put on hold. It seemed as though 2020 was going to be the year that the PE deal market came to a temporary halt.
But the private equity community is nothing if not resilient. As the world adjusted to due diligence sessions conducted via Zoom calls, much of the focus of sponsors in Q2 shifted to PIPE (Private Investment in Public Equity) investments, with at least 27 PE-led PIPE transactions announced since the start of the pandemic. Few of these transactions involved debt financing (other than occasional back-leverage), and many came together in days, not weeks, and competition among sponsors was intense. Not surprisingly, many of the PIPE deals of 2020 featured more issuer-friendly terms (including conversion terms and lock up, standstill and voting obligations) than appeared in PIPES in recent years. In fact, in a number of situations, sponsors agreed to close prior to HSR approval, taking non-voting shares pending filings made post-closing.
Prospects for M&A activity
Prospects for M&A deal activity in the second half of the year feel as uncertain as in recent memory. The recent resurgence of COVID-19 cases in the USA, and the related delays in the reopening of the debt markets – as well as the looming presidential election – are all contributing to the medium-term caution. There has been anecdotal talk of sellers looking to accelerate sale processes in an effort to close prior to potential changes to tax rates following November’s election, but those processes would need to be in full swing relatively quickly and, for now, it seems many sellers are still taking a wait-and-see approach.
In this time of uncertainty, it is expected that the theme of a significant volume of deals that require less, or no, debt financing will continue. For example, minority equity investments in portfolio companies owned by an existing sponsor, allowing the existing sponsor some liquidity. Portfolio company add-ons will continue to be plentiful, particularly to the extent the portfolio company can finance the deal from its balance sheet or additional sponsor equity. And, obviously, the credit and distress arms of PE sponsors will continue to review opportunities, including in so-called “363 sales” out of bankruptcy.
In short, the traditional large-scale LBO may not be as frequent, but we expect that PE M&A lawyers will continue to be quite active as their clients pivot to bespoke opportunities resulting from the current economic disruption.
While the Securities and Exchange Commission (SEC) continues to focus on protecting retail investors and assessing market-wide risks, in January 2020, the SEC’s Office of Compliance Inspections and Examinations (OCIE) identified private funds as an examination priority. OCIE noted that it will focus on private equity advisers that have a greater impact on retail investors, private equity funds with emerging investment strategies (including ESG criteria), the disclosure of conflicts relating to fees and expenses and compensation arrangements, and key compliance risks. OCIE further emphasised these priorities in June 2020 in its risk alert on observed deficiencies by advisers to private funds.
While the June 2020 alert did not identify new risks that have not been previously identified by the SEC, it reinforces the SEC’s focus on private funds and the need by private fund advisers to review and update compliance policies, practices and procedures. Finally, the June 2020 risk alert draws attention to the potential misuse of MNPI, an area which has separately been the subject of recent enforcement cases as will be further discussed.
The SEC also focused on supporting market participants during the COVID-19 pandemic by issuing exemptive relief under the Advisers Act and providing guidance on how to comply with various regulatory obligations. The Division of Investment Management updated its Frequently Asked Questions on completing and amending Form ADV and complying with obligations under the Custody Rule (Rule 206(4)-2) to provide guidance related to, among other things, a firm’s reliance on remote working conditions and inability to access mail and deliveries, maintain physical certificates with qualified custodians and complete surprise examinations. The SEC reminded firms that receive Paycheck Protection Program (PPP) loans that they may have related regulatory reporting obligations to their clients. Finally the SEC also issued extensions for certain Form ADV and Form PF reporting and filing obligations.
OCIE stated that it would not consider an adviser’s reliance on exemptive relief as a risk factor in deciding to begin an examination, it may request further information on the implementation and effectiveness of such adviser’s business continuity plans. OCIE is beginning to incorporate, into its routine examinations, specific requests with respect to private fund advisers’ preparedness and disclosures prior to the pandemic, responses to changing circumstances, disclosures and communications to investors over the course of the pandemic, and overall health and safety. We expect OCIE (and the SEC generally) to continue with this focus in the near to medium term.
Following a 2019 concept release on the harmonisation of exempt offerings, the SEC proposed amendments to the exempt offering framework, which seek to harmonise certain of the offering exemptions and provide increased flexibility and certainty to issuers. Perhaps most notable is a proposal to modify from six months to 30 days the current “cooling off” period found in the existing offering integration safe harbours. Shortening this safe-harbour time period, outside of which other offerings would be considered to be integrated or part of the same offering, would enhance market flexibility in accessing capital.
The SEC also proposed an expansion of the “accredited investor” definition under the Securities Act of 1933. Where the current definition primarily relies on quantitative measures, the proposal includes qualitative categories that would allow a person to qualify as an accredited investor based on such person’s status as a “knowledgeable employee” of a fund or based on a natural person’s possession of certain professional certifications and designations or other credentials issued by an accredited educational institution.
At the same time, the SEC engaged with the industry on its various proposals. Discussions continue on the 2019 proposals to modernise the advertising and cash solicitation rules. In light of the upcoming election and uncertainty of SEC leadership composition in 2021, the SEC is expected to focus on finalising these proposed rule amendments before the end of the year.
Department of Labor roadmap
As widely reported, the Department of Labor issued an informational letter providing a roadmap for including private equity investments as an investment option for participant-directed individual account plans (such as 401(k) plans) in a manner that complies with the Title I of ERISA. The letter notes that, in order to better diversify portfolios or align investment horizons, a fiduciary that follows an objective, thorough, and analytical process can, consistent with its ERISA fiduciary duties, offer 401(k) plan participants the opportunity to invest in private equity. The letter includes a number of considerations for such a process as well as practical solutions on managing the liquidity constraints.
While none of the structures considered would permit plan participants and beneficiaries to invest directly into private equity investments on a stand-alone basis, the letter suggests potential paths for such investments, including through separately managed accounts or fund-of-fund structures.
In a March statement emphasising the importance of market integrity, the SEC’s Division of Enforcement focused on corporate insiders’ access to, use of, and protection of material non-public information (MNPI), noting that holding such MNPI may have greater value now in light of unprecedented market conditions. Shortly thereafter, in Ares Management LLC, the SEC found that the firm failed to implement and enforce its policies and procedures designed to prevent misuse of MNPI while a member of its deal team sat on a portfolio company’s board and while it was subject to confidentiality provisions in a loan agreement with the portfolio company. The SEC found that Ares’ compliance policies were insufficient as they provided compliance staff with wide discretion in implementing policies and did not require them to contact all employees with potential access to MNPI. The SEC also found that Ares failed to sufficiently and consistently document instances where compliance staff inquired with deal teams as to whether anyone had received MNPI.
Conflicts of interest
The Division of Enforcement also continues to focus on the timely and accurate disclosure of conflicts of interest, especially as they relate to firm-specific practices concerning the allocation of fees and expenses. In Monomoy Capital Management, LP, the SEC found that Monomoy charged the portfolio companies owned by a private fund that Monomoy managed for the services of Monomoy’s in-house Operations Group but failed to provide full and fair disclosure of this practice. In particular, Monomoy did not disclose that the Operations Group would provide billable services to the funds’ portfolio companies, or that Monomoy would receive reimbursement from portfolio companies to cover the cost of such services.
Later, Monomoy amended its Form ADV to state that “under specific circumstances, certain Monomoy operating professionals may provide services to portfolio companies that typically would otherwise be performed by third parties”, and that “Monomoy may be reimbursed” for costs related to such services. This disclosure, however, did not accurately describe the practice and was not identified as a material change in the “Summary of Material Changes”.
Monomoy presents yet another example of a “may” disclosure that was found to be inadequate where a practice is in fact occurring. The SEC also expressed concern that the disclosure did not make clear that the manager recouped most of the total cost of maintaining the Operations Group. Monomoy reflects the SEC’s continuing skepticism of private equity managers that charge investors for employee-related expenses outside the management fee in the absence of crisp, detailed disclosures. More generally, it is also an important reminder that fund documentation must clearly and accurately reflect a firm’s practice regarding how expenses (eg, salaries of adviser personnel, compliance, regulatory filings, and office expenses) are allocated.
The compliance issues raised in both Ares and Monomoy are examples of the specific deficiencies that OCIE noted in the June 2020 risk alert already discussed.
Meanwhile, the US Supreme Court restricted the SEC’s power to seek “disgorgement” from firms. In June, the Court held that the SEC has the ability to seek disgorgement as long as the disgorgement award does not exceed a wrongdoer's net profits and is awarded to victims of the violation. While the Court held that a “disgorgement award that does not exceed a wrongdoer’s net profits and is awarded for victims” is equitable relief permissible under the statute, it nevertheless suggested that the SEC may exceed its authority to seek disgorgement if it:
It remains to be seen, however, whether Congress will enact legislation that would overturn this decision. Without legislative change, the SEC’s ability to obtain disgorgement (and the amount of any such awards) in certain types of cases could be substantially affected.
Asset Management Litigation
In PE-related US litigation, 2020 has been the year of the “contractual out.” As lockdown began and the global pandemic disrupted all manner of business expectations, parties questioned whether their contracts were enforceable, or could be modified or set aside. The doctrines that govern those questions are rarely tested. This year, they have drawn an unprecedented level of focus and litigation.
Three doctrines may provide a basis for temporarily or permanently excusing performance of contractual obligations: force majeure clauses, material adverse events/change clauses and frustration of contract. For each of these doctrines, changes in the economy are usually not enough to avoid performance, nor are these doctrines meant to buffer against the normal risks of contracting. The implications of these doctrines for any particular contract or transaction will depend on the applicable law, the specific terms of the agreements and the governing facts.
New York and Delaware courts look to precedent when resolving contract disputes – and there is none to guide them here.
Force majeure clauses in contracts allocate risk by excusing one party’s non-performance when its reasonable expectations have been frustrated due to circumstances beyond its control and, therefore, are applied narrowly. Force majeure clauses that specifically excuse non-performance due to outbreaks, epidemics, pandemics, quarantines, travel restrictions and the like provide a stronger basis to argue that the current coronavirus outbreak constitutes a force majeure event than those that do not.
Typically, a party seeking to avoid performance due to a force majeure event must demonstrate that performance has (i) become objectively impossible, or (ii) occurred as a result of an event that could not have been foreseen, unless such event is specifically enumerated in the clause or is otherwise captured by a catch-all provision. Orders imposed by a government may excuse performance if it would be impossible both to comply with the order and to perform under the contract.
To be a force majeure, an event must have an effect beyond the contract or parties at issue: a party’s duty to perform is not discharged if the event that rendered it unable to perform would not likewise have prevented others from performing. The non-performing party may also have to demonstrate that it made an effort to perform notwithstanding the force majeure, and its performance may only be excused for so long as those conditions persist and prevent performance.
Material Adverse Effect/Material Adverse Change
A Material Adverse Effect (MAE) or Material Adverse Change (MAC) clause contemplates a change in circumstances that significantly reduces the value of an enterprise, transaction or venture, because of which buyers or investors may be able to avoid completing a transaction. MAE clauses are often heavily negotiated and, accordingly, their applicability may depend on the language of the specific MAE clause at issue.
Absent specific controlling language, courts set a high bar when asked to consider whether a circumstance constitutes an MAE. Most courts have imposed two requirements:
Since the inception of the pandemic, multiple parties have filed complaints alleging MAEs due to COVID-19. The ongoing litigation in Forescout Technologies, Inc v Ferrari Group Holdings, LP, may provide the first court decision considering the impact of the COVID-19 pandemic on contracts containing MAE provisions.
In the absence of a contractual provision directly addressing the consequences of unanticipated risks, parties may seek to avoid contractual obligations based on the common law doctrine of frustration of contract (or frustration of purpose). Such frustration can occur when both parties are literally able to perform but, as a result of unforeseeable events, performance by one party would no longer give the other the benefit that induced that party to make the bargain in the first place.
Courts analysing frustration claims typically consider the foreseeability of the allegedly frustrating event’s occurrence, the fault of the non-performing party in causing or not providing protection against the event’s occurrence, the severity of the harm and other circumstances affecting the just allocation of the risk. Frustration of contract is very difficult to invoke and is limited to instances where a virtually cataclysmic, wholly unforeseeable event renders the contract valueless to one party.
The US COVID-19 outbreak in mid-March raised concerns that capital, which had until then been readily available on favourable terms, would dry up. This caused an abrupt second-quarter shift, with an immediate focus on preserving and building liquidity – whether by drawing on revolver facilities, reaching agreements to defer payment of interest and rent, seeking new debt or equity funding, or otherwise – sponsors were able to review their portfolios and assess the company-by-company impact of the pandemic.
As the second half of 2020 comes into focus, with new COVID-19 cases multiplying and states pausing or even reversing their reopenings, the outlook is more challenging. Even borrowers who are not facing near-term maturities and had a once-manageable debt load – those who would not ordinarily have experienced any financial distress – may be forced to address the prospect of covenant defaults caused by revenue shortfalls, and a resulting inability to meet financial thresholds or deliver unqualified going concern audit opinions. Also, short-term liquidity bridges may have been consumed in the first months of COVID, requiring a new, more comprehensive cash flow solution. In short, sponsors and portfolio companies now must refocus their analysis, with potentially more activist solutions required.
Operations in a COVID landscape
In general, it is believed lenders and the capital markets will continue to be accommodating for companies that were previously healthy, whose businesses will allow for a reasonable level of modified operations in a COVID landscape, or who have unencumbered assets that can facilitate new financing on creative and advantageous terms. Indeed, in recent cases such as Revlon and Travelport, portfolio companies have utilised “investment” capacity under their loan agreements to remove existing liens from valuable intellectual property and then borrow new money secured by that same IP. By contrast, for companies that were already stressed or fully leveraged, particularly those that are in heavily impacted industries such as travel, in-person entertainment, education and others, a refinancing or amendment solution appears less likely and sponsors will face the choice of defending their investment through self-help funding initiatives, which may be unpalatable, monetising the value of the business through a sale, or pursuing a holistic capital structure adjustment.
In this context, if sponsors opt to pursue balance sheet alternatives, we see with increasing frequency that they will seek to engage with a select group of lenders who hold a majority of the debt (or certain key tranches of debt). By limiting the number of lenders who participate in a liability management transaction, the sponsors can provide each of those lenders with more attractive recovery as an inducement to transact – thereby achieving a needed amendment or liquidity raise that extends runway to allow the sponsor to shore up operations and improve the business, or ride out the impacts of COVID. By way of example, the currency offered to participating majority lenders can include non-pro rata repayments of loans at par, changes to the payment waterfall that grant priority to the majority lenders, backstop and financing opportunities, and fees.
Serta Simmons Bedding recently pursued this approach, in a transaction where a majority of first- and second-lien secured lenders voted to amend their credit agreement to create three new tranches of debt higher in priority than the existing first-lien loans, allowing the participating lenders to improve their position in the capital structure while exchanging at values below par, thereby reducing the company’s debt load and injecting new financing to provide needed liquidity. Non-participating lenders sought unsuccessfully to block the transaction in court, and were forced to settle for a junior position in the new capital structure, while Serta and its sponsor were able to move forward with new cash and a reduced debt load, to try to weather the COVID storm. A trend toward similar types of transactions is expected as portfolio companies continue to utilise available provisions in finance documents and applicable law to provide needed balance sheet relief.
Other expected outcomes
Not every portfolio company will be able to find a new-liquidity solution, however. Where sponsors are not willing or able to defend their investment, or where lenders are not willing to accommodate new borrowing or other needed amendments, an increased wave of control-change transactions, including an uptick in distressed M&A and debt-for-equity swaps, is expected. These instances are most likely to occur where sponsors conclude that certain investments in companies cannot be salvaged, and their best option is to achieve an outcome that minimises loss to creditors, protects directors and management teams, and enables the sponsors to obtain releases. To that end, a number of pre-arranged or pre-packaged restructurings in Chapter 11 that turn control of troubled companies over to lenders or put operating assets up for auction have been seen, and this trend is anticipated to continue in the next year.
Recent market trends reflect that US-based private equity firms are increasingly interested in analysing Environmental, Social and Governance (ESG) issues. This evolution flows in part from the increasing number of limited partners seeking analyses of such issues. In addition, more sponsors are concluding that a company committed to ESG principles offers additional value, which will benefit the sponsor upon the sale of the business or an exit to public markets. Of course, many sponsors also support ESG principles because they can help a company to avoid various legal and reputational risks.
In particular, an increasing number of US-based private equity firms are relying on counsel and other external advisors to evaluate ESG issues associated with their acquisitions. This review includes assessing a target company’s ESG risks, including in areas such as carbon emissions, worker safety, data privacy and diversity. Such an assessment also typically includes recommending actions to help mitigate ESG risks and identify opportunities to create further value.
COVID-19 and inequality issues
Given recent events, certain issues are receiving greater scrutiny in the ESG assessments being prepared for private equity firms. For example, ESG assessments may now encompass issues associated with COVID-19, such as whether a company is adequately protecting its employees from exposure to the virus. They may also consider whether a company has avoided layoffs, supported flexible working arrangements and repurposed production facilities to manufacture personal protective equipment during the pandemic. Other considerations include assessing data privacy and security concerns resulting from employees working from home.
In addition, the May 2020 killing of George Floyd by a Minneapolis police officer and other racially motivated incidents have highlighted racial inequality issues. Relatedly, ESG assessments may evaluate company efforts to increase racial diversity, including initiatives designed to help promote minority employees to management positions.
Legal advice and privilege considerations
Although the role of ESG consultants is growing, certain critical ESG-related information is often best obtained by a sponsor’s counsel. For example, ESG issues such as bribery and corruption often raise issues for which sponsors need specialised legal advice.
Given the legal intricacies surrounding these issues, sponsors properly benefit from the attorney-client privilege applicable to such advice.
Looking ahead to the November 2020 election, if Joe Biden wins the presidential election and Democrats control both houses of Congress, certain ESG-related initiatives may yield new laws. For example, a Biden administration is expected to impose certain restrictions on emissions of greenhouse gases. Private equity firms will want to evaluate the impact of such laws on the companies they acquire, in addition to monitoring and addressing other evolving ESG risks.