Financial Investors: Bridging the Valuation Gap and Liquidity

Introduction

Persistent global financial headwinds and geopolitical events of the past few years, among other factors, have provided challenging market conditions for financial sponsors looking to deploy dry powder for new investment platforms and/or obtain liquidity for their aging portfolios.

As widely reported, higher interest rates and inflationary forces have resulted in debt financings becoming increasingly expensive, and sellers continue to find it difficult to maintain the valuations of their businesses that the market had seen between 2020-22. This has led to the widening of valuation gaps between buyers and sellers.

The gap in price expectations between buyers and sellers has also made it difficult for financial sponsors to provide liquidity to its limited partners. In fact, we are seeing an increase in the duration of financial sponsors' holding periods of assets, as they look to delay exits until the valuations of their assets recover or for portfolio company revenues and EBITDA to increase to compensate for the current low multiple environment.

In light of growing valuation gaps and delayed exits, financial sponsors are digging deep into their playbook of alternative deal consideration structures to execute transactions and are hyper-sensitive to ensure they have the control and flexibility to obtain liquidity.

Bridging the valuation gap

Deferred consideration

Given the day light on bid and ask valuations for target businesses, acquiring financial sponsors are increasingly looking to defer the payment of deal consideration over time, so that the business case of the target, as presented by the sellers, can be adequately tested in the years immediately following closing. Deferred consideration mechanics enables the acquiring sponsor to, among other potential benefits and depending on the elected structure:

• pay a more accurate valuation for a target business;
• lower the amount of capital a buyer has to deploy at closing;
• pay the deferred consideration through profits of the target business; and
• take additional time to find financing sources that may result in a lower cost capital than if the full purchase price was paid at closing.

Deferred payments are typically structured as earn-outs that are tied to an agreed financial metric of the target business (eg, EBITDA or revenues) and have successive earn-out periods, with each respective period routinely spanning for one year, ranging in the aggregate between two and five years post-closing of the transaction. Sellers will typically look to negotiate earn-out amounts being payable on a sliding scale, in lieu of a payment of the full earn-out amount upon a financial threshold of the target being met or exceeded, and if yearly results fall between the threshold and target figure, a corresponding percentage of the earn-out amount will become payable from the buyer to the seller. Some sellers may even look to obtain a catch-up payment to the extent the agreed financial targets in prior years are not met, but are then exceeded in later earn-out periods. Further, when negotiating the conduct provisions in respect of an earn-out, financial sponsors will seek to:

• limit or restrict the seller's ability to affect the financial sponsor's control of the operations of the target business; and
• accelerate earn-out payments upon a direct or indirect change of control of the target business.

Alternatively, deferred consideration can take the form of instalment payments which, unlike earn-outs, are not contingent on the financial performance of the target business – therefore this form of deal consideration payments are preferred by sellers over earn-outs. Instalment payments are routinely paid annually after the fiscal year-end of the target business, but may also be set at difference cadences, such as monthly or quarterly payments. The instalment payment amounts can also be fixed or can be scaled up or down over the life of the payment schedule.

Rollovers

Another way financial sponsors look to bridge the valuation gap on the buy-side is by offering deal consideration that is a mix of cash and equity interests of the go-forward business. Often financial sponsors may require founders and executive management members who are selling the target business, to continue to hold a share of the target business post-completion. This can be structured in several different ways, but typically in the US, founders and executive management members will roll a portion of their equity interests into the target business post-completion.

Founders, and those members of the management participating in the equity structure, find rollover equity attractive because:

• they not only receive partial liquidity at closing, but are also able to participate in the growth of the target's business post-closing; and
• they are able to defer taxes on the portion of their equity stakes rolled into the post-closing equity structure.

Similarly, rollovers are attractive to financial sponsors for several reasons, such as limiting the amount of equity capital needed by financial sponsors to fund the purchase price, avoid or diminish the amount of debt financing needed to fund the acquisition (which is currently expensive) and, most importantly, keeping the founders and those members of management who participate in the equity structure of the target business fully invested in the future growth and success of the target's business post-closing.

Recently, rollovers have evolved to be a more dynamic valuation-bridge mechanic. Similar to earn-outs, in some cases financial sponsors are making all or certain portions of the rollover amount of a purchase price contingent on the post-closing performance of the target business. In particular, rollovers can be set to a one-way or two-way ratchet. A one way rollover ratchet entails the valuation gap amount (ie, the difference in target valuation between the buyer and the seller) being payable by the buyer to the seller on closing, but with such gap amount being forfeited back to the buyer if certain financial metrics are not met by the target business over a specified period of time. A two-way ratchet includes the features of a one way ratchet, but also offers sellers the ability to increase their rollover if the pertinent financial metrics are met and outperformed.

Rollover ratchets have similar considerations for the parties to work through as the other deferred consideration mechanics in a financial sponsor's tool chest, but unlike deferred consideration routes, rollover ratchets can give both the buyer and seller more comfort that the valuation gap will be bridged, while also directly incentivising rollover sellers to drive the growth of the target business post-closing.

As with all alternative consideration structures, financial sponsors and sellers should seek structuring and tax advice if a rollover ratchet is to be utilised to ensure suitable structuring is in place and appropriate tax treatment is achieved.

Liquidity

Transfers to Continuation Vehicles

Over recent years we have seen an increased number of financial sponsors using continuation funds as a tool to provide liquidity to limited partners in their aging funds, while also enabling financial sponsors to retain beyond the aging fund's term an asset that has not yet achieved its full upside. The financial sponsor sells such asset to the newly formed fund, and limited partners that invested in the legacy fund can either roll all or a portion of their interests into the continuation fund or obtain a full liquidity event. New limited partners may also have the option of participating in the continuation fund.

In order for financial sponsors to have the ability to freely transfer its equity interests in an asset to a continuation fund, it must carefully negotiate the terms of the governance documentation it entered into when the initial platform investment was made. One highly negotiated point in the governance documentation is the financial sponsor's ability to make certain transfers or sell the asset to a third party without the consent of the minority investors (eg, a target business's founders and / or management team) and also have the ability to drag such minority investor into such sale. Given the rise in the use of continuation funds, financial sponsors are seeking to explicitly carve-out such transactions from the tag-along rights of founders, members of the management team in the equity structure of a target business, and other minority investors. This reduces the amount of financing the financial sponsor will need to obtain in order to consummate a transfer of the asset to a continuation fund – which is increasingly important given the current fundraising challenges for financial sponsors and expensive debt markets.

Depending on the capital structure of a target business (eg, co-investment or management incentive schemes), a financial sponsor should pay careful attention to key definitions such as "change of control", "sale", "liquidity event" and similar defined terms, to ensure that a sale to a continuation fund would not trigger vesting or a liquidity event for management. If carve-outs are negotiated, the financial sponsor will have more flexibility as to how to treat outstanding incentive equity in the transaction.

Sale of minority stakes

Financial sponsors are also gaining access to liquidity by selling minority stakes in certain control investments that they would otherwise have sold out entirely in a more buoyant market – such secondary transactions may also be coupled with a smaller equity capital raise to provide fresh capital to the business for continued growth which is attractive for the new minority investor and the existing ones.

Even more important than the consideration financial sponsors should give to the governance documentation of an asset in respect of a transfer of such asset to a continuation fund, financial sponsors should be prepared for a tough negotiation as to governance with the new investor (depending on such new investor's leverage). In some instances, a financial sponsor may capitulate on certain important governance terms in order to obtain a higher valuation for its equity interests from the new investor (eg, increased board seats, material veto rights, preferential ranking and clear exit and drag threshold rights).

NAV loans

In seeking liquidity for their limited partners, financial sponsors are using debt to return capital – often taking out net asset value (NAV) loans. Financial sponsors may use debt financing in lieu of an equity financing (eg, sale of minority stakes) to avoid diluting a fund's equity interests in its portfolio of assets.

NAV loans are a type of debt financing that allow financial sponsors to borrow money secured by all of the assets owned by a fund. NAV loans are often extended by banks, insurance companies, and private lenders and while these have been traditionally more common in Europe, they are becoming an increasingly popular alternative liquidity option for sponsors in the US in light of current market conditions. Financial sponsors are turning to NAV loans because debt financing of a single asset is more expensive and capital call lines, which are collateralised by uncalled capital commitments, are unavailable due to the aging life of the fund. In addition to providing liquidity to a financial sponsor's limited partners, NAV loans provide financial sponsors the ability to support portfolio companies (through, among other things, ensuring payment of related management fees), while strategically delaying exits until the valuations of their assets recover or for portfolio company revenues and EBITDA to increase. NAV loans also give financial sponsors the flexibility of considering investment into new assets or roll-up transactions for its platform investments at later stages of a fund's life.

If a financial sponsor is contemplating securing a NAV loan, it is advisable to carefully consider the limited partnership agreement of the fund. Fund organisational documents often restrict securing financing at the fund-level based on the net asset value of its underlying assets. If any such restrictions exist under the organisational documents of the fund, these should be amended to remove any such restrictions prior to securing NAV financing.

Dragged or tagging shareholders

When financial sponsors acquire a target business and negotiate governance arrangements with minority investors (eg, rolling founders or members of management), the representations and warranties (R&Ws), indemnities and restrictive covenants to be provided by dragged-sellers and tagging-sellers, may affect the drag-sale or other transfer process and / or the valuation on such equity interests.

Dragged-sellers and tagging-sellers will seek to:

• limit R&Ws given by them to only fundamental R&Ws (eg, organisation and authority, title to shares);
• not provide certain covenants to the potential buyer, including but not limited to non-solicit, no-contact and non-compete covenants; and
• only be severally liable for breaches of R&Ws.

Conversely, financial sponsors are keen to require dragged-sellers and tagging-sellers to give the same R&Ws, covenants and indemnities as the financial sponsor, including R&Ws regarding the company and its business, because a sale involving multiple investors in the capital structure is less attractive to a potential buyer when seller liability is several, rather than joint and several, due to the fact that the purchaser may have to pursue claims against multiple sellers to satisfy an indemnification claim in full. The more neutral approach is for dragged-sellers and tagging-sellers to make R&Ws for both itself, the company and its business, with the indemnification several for each investor and indemnity capped at the proceeds received by such investor in the sale or transfer. It is worth noting that some practitioners argue that a tagging-seller should be subject to the construct more favourable to the proposed seller in such tag-sale because the tagging-seller is electively participating, whereas dragged-sellers are forced into a drag-sale.

Notably, dragged-sellers may also seek to negotiate that they cannot be dragged into a drag-sale unless the deal consideration is in the form of cash or cash equivalents or in the same form as that being received by the dragging seller. Financial sponsors push back on this as they want to retain flexibility in deal structuring and economics to seek an efficient exit.

ROFO over ROFR

The transfer provisions in the governance documentation of an asset owned by a financial sponsor are critical to understanding the path to liquidity. In particular, the transfer provisions where there are multiple financial sponsors in a structure often contain a requirement that a transferor first satisfy either a right of first offer (ROFO) or right of first refusal (ROFR) of the other investors prior to consummating a transfer of equity interests to a third party. A ROFO is a contractual right of first offer, typically found in the governance documentation of the target portfolio company, pursuant to which an investor must first offer its shares for sale to the other existing investors before it can offer its shares to any third party purchaser (and it must beat the price if it declines an offer from an existing investor and opts to sell to a third party). On the flip side, a ROFR is a contractual right of first refusal, whereby an investor can engage with third parties and look to agree a sale of its shares in the company, but before closing on such sale it must first extend the other existing company investors the right to match the offer of the sale.

In instances where financial sponsors are invested alongside a number of other equity holders and its ownership percentage is 50% or less, financial sponsors prefer including a ROFO in the governance documentation since they are less restrictive than a ROFR; making access to liquidity more feasible. ROFOs are less restrictive than ROFRs because the financial sponsor does not have to first negotiate a deal with a third party purchaser – who may be reluctant to incur fees and expenses in the knowledge that there is the impediment of a ROFR lingering in the background – prior to offering the equity interests to (or receiving offers from) the other equity holders.

Conversely, to the extent minority shareholders have third party transfer rights (ie, that are not conditioned on the consent of the majority shareholder / financial sponsor), then financial sponsors often include a ROFR in the governance documentation for its control transactions which provides the financial sponsor with the ability to manage the equity holders in the capital structure. The ROFR is routinely solely for the benefit of the financial sponsor; it is not reciprocal for other equity holders because of the resistance by financial sponsors to be subject to provisions that restrict the timing and terms of its exit from the investment – in other words, access to liquidity. Nevertheless, there may be instances where a minority equity holder has substantial leverage and may receive a ROFR over transfers by a financial sponsor. In such instances, financial sponsors can avoid the encumbrance of a ROFR and achieve liquidity by including a carve-out to such ROFR for a drag-sale.

Conclusion

With instability and uncertainty in market conditions expected to persist in the near term, financial sponsors will continue to grapple with the complexity of securing liquidity for their limited partners while also deploying new capital at reasonable valuations. If history is a lens to the future, financial sponsors will continue to find creative solutions to navigate through the constraints.