Private equity in United States: market and regulatory overview
A Q&A guide to private equity law in the United States.
The Q&A gives a high level overview of the key practical issues including the level of activity and recent trends in the market; investment incentives for institutional and private investors; the mechanics involved in establishing a private equity fund; equity and debt finance issues in a private equity transaction; issues surrounding buyouts and the relationship between the portfolio company's managers and the private equity funds; management incentives; and exit routes from investments. Details on national private equity and venture capital associations are also included.
To compare answers across multiple jurisdictions visit the Private Equity Country Q&A Tool.
This Q&A is part of the global guide to private equity. For a full list of jurisdictional Q&As visit www.practicallaw.com/privateequity-guide.
The primary sources of funding for private equity funds in the US are:
Public pension funds.
Funds of funds.
Corporate pension funds.
Banks and other financial institutions.
High net-worth individuals.
Sovereign wealth funds.
As of June 2015, the largest investors were (Dow Jones, Private Equity Analyst, Sources of Capital, June 2015):
Public, corporate and union pension funds, accounting for about 43% of total capital, up from about 39% in 2014. Public pension funds remained the largest single type of investor, providing about 31% of total capital commitments, which was roughly the same as in 2014.
Sovereign wealth funds, with roughly 6% of total capital commitments. This represented a marked decrease from 2014, when sovereign wealth funds represented about 12% of total capital commitments. The decrease may represent a smoothing out of investment activity by certain sovereign wealth funds that ramped up investments over the last five years as sovereign wealth funds represented just 3.7% of total capital commitments in 2010.
Endowments and foundations, providing about 7% of total capital commitments, an increase from 2014, when endowments and foundations provided 5% of total capital commitments.
Funds of funds providing about 3% of total capital commitments, which is lower than 2014 levels, which were at roughly 6%.
Following a record-setting 2014 in terms of distributions, investor appetite for private equity funds was strong. Sponsors came back to the market in 2015, in some instances earlier than expected, and market fundraising was robust. In 2015, 689 private equity investment vehicles raised about US$288 billion in capital commitments (The 2016 Preqin Global Private Equity & Venture Capital Report).
Deployment of private equity capital continued at a moderate pace, held back in part by concerns over the valuation of investment opportunities. The amount of private equity capital overhang as of June 2015 was up 9% from the previous year and stood at about US$755 billion (The 2016 Preqin Global Private Equity & Venture Capital Report).
Private equity funds that held closings in the years leading up to the financial crisis are nearing the end of their initial ten-year terms. Vintage 2006-2008 funds represented US$1.1 trillion of total unrealised assets as of June 2015, nearly 40% of all unrealised private equity fund assets. As these funds approach end of life, sponsors are focused on exits from portfolio companies as well as sponsor-led recapitalisations whereby new buyers are introduced to cash out some or all limited partners who are seeking liquidity (The 2016 Preqin Global Private Equity & Venture Capital Report).
Small funds continue to be popular. Funds with commitments under US$100 million represented the highest percentage of total vehicles raised. Over the course of 2015, 104 of these sub-US$100 million vehicles came to the market. Although this is a slight decline from the total of 126 sub-US$100 million funds raised in 2014, these smaller vehicles are still prevalent in the market (Pitchbook 2015 Annual PE + VC Fundraising & Capital Overhang Report).
Buyout funds accounted for the bulk of funds raised, but a new record was set in 2015 for capital allocated for energy investments. This continues a record-setting trend in energy-targeted fundraising. The 2015 data shows a 55% leap from 2014 in energy related vehicles, as US$35 billion was raised across 18 vehicles. However, deal flow in the energy sector fell to the lowest levels since 2009, reflecting the general uncertainty in the energy market (Pitchbook 2015 Annual Private Equity Breakdown).
In 2015 the aggregate number of deals that were closed decreased by 9%, decreasing from 3,923 transactions in 2014 to 3,602 in 2015 (Pitchbook 2015 Annual Private Equity Breakdown).
Aggregate deal value continued on its upward trajectory since its most recent low point during the financial crisis. In 2015, aggregate deal value was US$411 billion, up 18% from 2014. However, just two deals made up 26% of the 2015 aggregate deal value (The 2016 Preqin Global Private Equity & Venture Capital Report).
Add-ons accounted for 62% of total private equity activity in 2015, and although this represented a minimal year on year decline of just 1.7%, data shows steady growth from around 50% in 2010. Additionally, portfolio companies continued to manage to find accretive add-ons (Pitchbook 2015 Annual Private Equity Breakdown).
The median valuation-to EBITDA multiple documented in 2015 declined from 11.1x in 2014 to 9.1x, reverting back to the levels of 2012. However, some sectors that are experiencing difficulties (for example, the depressed energy space) curbed these deal multiples and it is believed that this trend lends itself to the decline of upper-echelon companies preparing to enter the market (Pitchbook 2015 Annual Private Equity Breakdown).
Lenders must consider regulatory pressures concerning risk-weighted-assets and therefore must make decisions to avoid certain types of deals. At the high end of the deal spectrum, buyers and sellers have been forced to enter into negotiations to lower prices or even restructure signed deals for the sake of the economics of the deal. Debt-to-EBITDA multiples have lowered to around 5.1x which is a decline from 6.4x and 6.6x in 2013 and 2014 respectively. The needle on the median debt percentage moved lower than that in both of the previous two years, reaching only 56% (Pitchbook 2015 Annual Private Equity Breakdown).
Exit activity was strong in 2015, with private equity firms realising over 1,132 investments. This represents a 2.4% year over year decrease in exit volume, but the exit value of these investments actually increased by 10% from 2014, as these exits comprised US$321 billion in capital. Strategic acquisitions continued as the main exit path at upwards of 54% of all PE-backed sales. In 2015, IPOs accounted for the lowest share of exits since 2008, accounting for only 3% of all exits. This was not surprising, due to the wariness of exiting into the public market because of a variety of factors including difficulties for sponsors to estimate public investor interest and trouble pricing the offerings (Pitchbook 2015 Annual Private Equity Breakdown).
Volcker Rule Guidance from Federal Agencies for Non-U.S. Banking Entities and Fund Sponsors Seeking to Rely on the "SOTUS" Covered Fund Exemption
On February 27, 2015, the Board of Governors of the Federal Reserve System (Federal Reserve), the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) (collectively known as the "Agencies"), released guidance on section 13 of the Bank Holding Company Act of 1956 (Volcker Rule).
By way of background, the Volcker Rule, which was finalised in December of 2013, prohibits banking entities from:
Acquiring or retaining any equity, partnership or other ownership interest in any private fund or covered fund as a principal.
Otherwise sponsoring or investing in any private fund, which includes most hedge funds and private equity funds.
The Volcker Rule provides for an exemption for certain covered fund activities if all those activities are conducted completely outside the US, by non-US banking entities holding ownership in, or acting as sponsors to these covered funds (SOTUS Exemption). In particular, one condition for this SOTUS Exemption is that no ownership interest in the private fund is offered for sale or sold to a resident of the US (US Marketing Restriction). The release of the final rules implementing the Volcker Rule sparked apprehension within the industry that the US Marketing Restriction generally applied to activities of third parties selling or offering ownership interests in the covered fund, instead of only applying to marketing activities conducted by non-US banking entities. The concern was that this restriction would force them to start restructurings or setting up transfers of those interests.
However, the Agencies explained that the US Marketing Restriction only constrains the activities of non-US banking entities looking to rely on the SOTUS Exemption and does not apply as a whole to the activities of unaffiliated third parties. The Agencies explained that this clarification is in line with the ultimate goal of limiting the Volcker Rule’s extra territorial application to foreign banking entities while seeking to ensure that the risks of covered fund investments by foreign banking entities occur and remain solely outside of the United States. However, the Agencies reiterated that a non-US banking entity and its affiliates that seek to rely on the SOTUS Exemption are still obliged to adhere to all the conditions of the SOTUS Exemption, including the US Marketing Restriction. Specifically, a non-US banking entity that participates in an offer or sale of covered fund interests to a resident of the US cannot depend on the SOTUS Exemption with respect to that covered fund. Moreover, if a non-US banking entity sponsors or serves directly or indirectly as the investment manager, investment adviser, commodity pool operator or commodity trading advisor to a covered fund, this banking entity will be seen as participating in an offer or sale by the covered fund of ownership interests in the covered fund. This makes the SOTUS Exemption unavailable if it offers or sells to a resident in the US.
However, the Agencies' clarification is decidedly positive for non-US banking entities, and covered fund sponsors who are not banking entities, due to the:
Eradication of the costly administrative burdens and constraints.
Elimination of the expense of creating a parallel fund structure to accommodate non-US banking entity investors.
SEC Sheds Light on "Voting Equity Securities" for the Purposes of the Bad Actor Rules
In 2015 the SEC released guidance on the definition of "voting equity securities" as applied to the bad actor disqualification rules within Rule 506(d) of the Securities Act 1933. The bad actor disqualification rules disqualify securities offerings from exemption under Rule 506, if the offerings involve certain "felons" or other "bad actors". Private fund and hedge fund offerings to US investors normally rely on Rule 506 under Regulation D as the source for their exclusion from registration under the Securities Act.
Rule 506(d) disqualifies a securities offering from depending on a Rule 506 exemption if a covered person (including any beneficial owner of 20% or more of the issuer's outstanding voting equity securities) has had a "disqualifying event". The SEC has defined the term "voting equity securities" as securities that bestow shareholders with the ability to "control or significantly influence the management and policies of the issuer through the exercise of a voting right". The outcome of this definition, as it appeared in the Rule 506(d) adopting release by the SEC, has led private fund sponsors to determine that fund interests held by their investors may be considered to constitute "voting equity securities" for the purposes of Rule 506(d). As a result, fund sponsors needed to recognise and track whether investors had been subject to any "disqualifying events" in order to warrant that the fund did not unintentionally contravene Rule 506(d).
However, in additional guidance, the SEC stated that it has reassessed its original views on the definition of "voting equity securities" definition. The SEC has now adopted a new bright-line standard under which "voting equity securities" are defined as securities that, by their terms, provide the security holders with a current exercisable right to vote for the election of directors. To be sure, the SEC notes that the definition of "voting equity security" must be interpreted notwithstanding the existence of control or substantial influence. Therefore a beneficial owner will not qualify as a covered person under Rule 506(d) as long as it holds less than 20% of the issuer’s outstanding securities that are currently entitled to vote for the election of directors, even if that beneficial owner has control or significant influence over the issuer. Unfortunately, the issued guidance does not openly address the application of the abovementioned bright-line standard to issuers organised as limited partnerships or limited liability companies.
SEC Provides Guidance on Use of "Bad Actor" Waivers
In the summer of 2015, the SEC’s Division of Corporate Finance issued guidance to explain how it processes "Bad Actor" waiver requests, describing four general factors it considers when deciding whether to allow a request for waiver from automatic disqualification under Rule 506 of Regulation D. The following are the four factors considered:
Who is responsible for the misconduct? On this factor, the SEC gives considerable weight to the role of the bad actor with respect to the party seeking the waiver. For example, the SEC will take a more negative view if the party pursuing the waiver was the one responsible for the misconduct or if the individual (for example executive officer, director or other control person) committed the misconduct and that individual continues to influence the operations of the entity seeking the waiver. On the other hand, if the misconduct was committed by one or more individuals and the entity seeking the waiver later removed or terminated its association with such individuals, the SEC would generally view such actions favourably in light of the request.
What was the duration of the misconduct? Isolated incidents will be viewed more favourably than misconduct that occurred repeatedly over an extended period of time.
What remedial steps have been taken? The SEC’s analysis of corrective steps taken emphasises what the requesting entity has done to prevent similar misconduct from happening in the future and to mitigate the possibility of future violations. Specifically, the SEC would look to any changes or improvements made to the requesting entity’s policies, procedures and practices.
The potential impact if a waiver is denied. With this final factor, the SEC contemplates the impact that rejecting the waiver would have on the requestor and third parties such as investors, clients, and customers and whether a disqualification would cause disproportionate hardship in light of the parties involved in, and the nature of, the misconduct.
Additionally, the SEC guidance advised the SEC of the following:
The SEC will take an ad hoc approach.
No single factor is dispositive.
The burden lies with the applicant to show good cause under the circumstances for why the waiver should be granted.
SEC Sets July Compliance Date for New Pay-to-Play Rules
The SEC announced a compliance date of 31 July 2015 for its ban on third party "pay-to-play" solicitations to be expanded to municipal advisers. The "pay-to-play" rules prohibit registered investment advisers from paying a third party to solicit business from government clients, unless the solicitor is regulated by the SEC, including investment advisers, broker-dealers, and now municipal advisors. Under these provisions, advisers are subject to a two-year ban on receiving compensation from a public pension plan or other investment vehicle if a top official makes a political contribution to a candidate who would exert influence with respect to the management of the adviser or the funds it manages.
The SEC allowed time for the Financial Industry Regulatory Authority (FINRA) and the Municipal Securities Rulemaking Board (MSRB) to finalise and adopt their own pay-to-play provisions, regardless of the 31 July 2015 compliance date. In the Frequently Asked Questions the SEC noted that it would not endorse an enforcement action under the pay-to-play rules against an investment adviser or its covered associates under rule 206(4)-5(a)(ii)(i) of the Advisers Act until the later of the effective date of either of the relevant:
FINRA pay-to-play rule.
MSRB pay-to-play rule.
FERC Proposes Regulations for Disclosure of "Connected Entities" of Market Participants
The Federal Energy Regulatory Commission (FERC) proposed to amend its regulations to require supplementary disclosures from market participants in regional transmission organisations (ROTs) and independent system operators (ISOs). The proposal does not expand the definition of the "market participants" required to make a filing with the FERC. However it would replace existing disclosure requirements regarding "affiliates" of market participants with an all-inclusive concept, "Connected Entities", which would include entities having a contractual relationship with such market participants, including asset managers. Market participants would be required to define the nature of their relationship to those Connected Entities as well as to disclose the major provisions of contracts between them (for example, start and end dates, a brief description, and renewal provisions). If this information is not already public, it would not be publicly available in this filing. However, these new requirements may be onerous and inappropriate in relation to the release of information about market participant’s Connected Entities.
Tax incentive schemes
The most commonly used vehicle for private equity funds is the Delaware limited partnership, which gives limited liability to the investors who are limited partners in the limited partnership. The fund's sponsor, or an affiliate, typically acts as the general partner and has unlimited liability for the limited partnership's obligations.
A Delaware limited liability company (LLC) may be used instead of a Delaware limited partnership. However, the LLC is far less popular. There are disadvantages to using an LLC, particularly for funds that invest outside of the US or which have non-US investors. The two primary drawbacks are:
LLCs are not recognised as tax transparent in some jurisdictions.
In some jurisdictions, investors and LLCs may have difficulty accessing the benefits of tax treaties.
Both limited partnerships and LLCs are generally treated as tax transparent for US tax purposes. While every US state can be used as a jurisdiction in which to form a limited partnership or an LLC, Delaware is generally considered the best choice because of its well-thought out and well-developed statutory regime and, partly because so many fund sponsors choose Delaware, its well-developed body of case law.
Some private equity funds, due to the nature of their investors or the focus of the fund's investments, are organised offshore. The Cayman Islands is the most typical offshore jurisdiction for a private equity fund with a broad investment mandate. Funds organised in the Cayman Islands generally provide a similar level of limited liability to investors to that provided by a Delaware vehicle. Funds with a more narrow geographic focus are often organised in other jurisdictions.
Private equity funds in the US (or offshore with a US fund sponsor) are typically treated as partnerships for US tax purposes, regardless of whether they are organised as limited partnerships or LLCs. The fund itself is then not taxed in the US. Instead, the fund's income flows through to each investor and is taxable at the investor level. The character of the income also flows through to the investors so that capital gains realised by the fund maintain that character in the investors' hands. The flow-through tax treatment applies to both US and non-US investors. However, other jurisdictions may impose taxes on investors' income and even on the fund itself.
Almost all non-US entities can elect to be treated as a partnership and to be tax transparent for US tax purposes. In some circumstances, fund sponsors may wish to use a non-tax transparent investment vehicle to allow investors to avoid US filing requirements and tax obligations. If so, the entity itself must make the required US filings and tax payments.
Fund duration and investment objectives
Private equity funds generally seek to achieve significant long-term capital gains by acquiring a controlling interest in a number of private investments and then improving the management and operations of those companies. The typical term of a private equity fund is ten years (often with a right granted to the sponsor to extend for up to two years). Capital is drawn down from investors during an investment period of generally three to six years, with an investment period of five or six years being the most common. The manager uses the remainder of the term to increase the value of the portfolio investments and seek exit opportunities. Additional capital may be called down after the investment period to meet any additional capital needs of existing portfolio companies and to pay expenses of the private equity fund. Difficult exit environments often result in many fund extensions.
Fund regulation and licensing
As a result of the Private Fund Investment Advisers Registration Act of 2010 (Registration Act), which was signed into law as part of the Dodd-Frank Act, an investment adviser to a private equity fund is likely to have to register with the SEC.
Also, if a private equity fund trades even one commodity interest contract or holds itself out as being able to do so, the sponsor of the fund will be deemed a commodity pool operator (CPO), and the adviser to the fund will be deemed a commodity trading adviser (CTA). Without an exemption, any CPO or CTA must register with the CFTC and become a member of the National Futures Association.
Any issuer that is engaged in investing or trading in securities is considered an investment company and, as a result, must register as an investment company under the US Investment Company Act 1940 (Investment Company Act) unless an exception is available.
There are two exceptions to registration as an Investment Company which private equity funds often use:
The fund has outstanding securities that are beneficially owned by fewer than 100 persons (section 3(c)(1), Investment Company Act). Various look-through rules apply in calculating whether a fund has 100 investors.
The fund has outstanding securities which are owned exclusively by persons who are qualified purchasers at the time of acquisition (section 3(c)( 7), Investment Company Act).
Qualified purchasers are:
Natural persons, family-owned companies and trusts with at least US$5 million in investments.
Companies that own and invest at least US$25 million.
If using the 3(c)(7) registration exemption for funds where all the investors are qualified purchasers, there is no limit on the number of investors that a fund can have, although the Exchange Act requires registration for any class of securities held by 2,000 persons in total or 500 persons who are not accredited investors.
In addition, an issuer engaged in a public offering must register the offering.
If the securities are offered by an issuer in a transaction that does not involve any public offering, there is no need to register. In general, to qualify as a non-public offering:
The offering must be private and must not involve a general solicitation.
The issuer must have a substantive relationship with each prospective investor before the offering and must have knowledge of an investor's suitability to purchase interests in the private offering.
There cannot be any advertisement, article or notice, or any communication in any newspaper, magazine or similar media or any radio and television broadcast, that has the purpose or effect of offering or selling the fund.
Issuers must also take precautions regarding their websites. Issuers should restrict internet pages that provide access to private offerings of securities to prospective investors.
The concerns regarding general solicitation do not apply to offerings relying on Rule 506(c) of Regulation D. Under Rule 506(c), a transaction may qualify as a non-public offering even if the issuer engages in "general solicitation" and "general advertising".
An offering can maintain the exemption under Rule 506(c) so long as all of the following conditions are satisfied:
The issuer takes reasonable steps to verify that the purchasers of the securities are accredited investors.
All purchasers of securities are accredited investors, either because they come within one of the enumerated categories of persons that qualify as accredited investors or because the issuer reasonably believes that they do at the time of the sale of securities.
The integration and resale restriction terms of Rules 501, 502(a) and 502(d) are satisfied.
Because of the 2013 "bad actor" amendments to Rule 506 (see Question 4, SEC Provides Guidance On Use of "Bad Actor" Waivers), an offering involving "felons" or "bad actors" cannot rely on Rule 506 for exemption from registration.
There are no statutorily prescribed maximum or minimum investment periods. Depending on the nature of the private equity fund, investment periods generally range from three to six years, with five or six years being by far the most common. Depending on macro-economic situations, funds may have a difficult time deploying capital and, as a result, may seek extensions of investment periods from their investors. This can be accomplished with an investor vote.
Alternatively, funds may deploy capital very quickly and may end the investment period early to begin fundraising for a successor fund.
There are no statutory limits on investment transfer amounts. However, if fund interests are transferred to investors who do not meet statutorily prescribed conditions for a registration exemption, that exemption may be lost. In addition, in certain cases the flow-through tax treatment of the fund vehicle may be lost if, as a result of transfers, the fund is considered a publicly traded partnership. Fund sponsors must be careful to ensure that fund interests are not transferred so as to cause these types of problems. As a result, fund documents usually prohibit transfers without the consent of the fund sponsor and generally require a number of conditions to be met to permit a transfer.
To avoid regulation under the Employee Retirement Income Security Act of 1974, fund sponsors may also need to limit the number of pension plan and similar types of investors in the fund and therefore typically control transfers to these types of investors.
Concerns about credit worthiness and money laundering also generally cause fund sponsors to perform due diligence on each new investor in a fund, similar to the type of diligence performed on the initial investors in the fund.
In the typical private equity fund, the fund sponsor or its affiliate serves as general partner or managing member and, in that capacity, controls almost all activities of the fund. Investors are generally not involved in the operations of the fund. Some of the more common protections investors seek are:
Inclusion of an advisory committee made up of representatives of investors, whose approval is required for certain conflicts of interest, valuation matters and other matters.
Investment parameters which cannot be exceeded without investor (or sometimes advisory committee) approval.
The ability to remove the general partner (or managing member) for cause or sometimes even without cause.
The ability to terminate the fund for cause or without cause.
The ability to terminate the investment period early, if the key persons running the fund are no longer devoting sufficient time to the fund or for other causes.
The investor vote required to remove the general partner or terminate the fund or the investment period without cause may be as high as 80%.
The Institutional Limited Partner Association (ILPA) is a member-driven organisation dedicated to advancing the interests of private equity limited partners. The ILPA has developed best practices in the form of its Private Equity Principals, which focus on alignment, governance and transparency.
Interests in portfolio companies
Private equity funds commonly take an interest in a portfolio company that provides for a threshold financial return that the portfolio company must achieve for the holders of residual interests to obtain any benefit from their interests in the portfolio company. This often takes the form of convertible preferred stock, in which the preferred stock has a set dividend and liquidation preference that must be returned to the holders of the preferred shares before the holders of common shares receive anything. The convertible preferred shares convert into common shares at specified ratios, allowing the holders of the preferred shares to obtain ownership interest in the common shares if they wish to do so.
Variants of this include combinations of two (or more) types of interests, for example:
Notes and warrants to obtain common stock.
Non-convertible preferred stock and common stock issued together.
Non-convertible preferred stock issued with warrants.
There is generally no legal restriction on the transfer of any of these as securities, though typically there are extensive contractual restrictions on the ability to transfer interests in a portfolio company.
Application of withholding taxes or capital gains taxes
Depending on the facts and circumstances of a particular portfolio company investment, US or non-US withholding taxes and/or capital gains taxes may apply. The applicability of such taxes depends on a number of factors, including:
The jurisdiction in which the investment is made.
The manner of exit from the investment.
Whether gains are derived from current income or on sale of the asset.
The use of holding companies.
The availability of tax treaties.
The tax characteristics of the ultimate beneficial owners.
Whether an applicable taxing authority taxes indirect transfers, which is more regularly a concern in the People's Republic of China and in India.
For many investments in portfolio companies, structuring alternatives may be available to partially mitigate the applicability or amount of capital gains tax and/or withholding tax.
Buyouts of private companies commonly take place by auction. A financial adviser is often engaged by the seller to manage the auction process. The financial adviser seeks to narrow the number of potential bidders to a limited number of likely buyers. This group of potential buyers is then asked to submit final bids. The seller may enter into negotiations with one or more of them. There is no legislation that generally governs sales of private companies other than anti-fraud and anti-trust rules.
Buyouts of listed companies (public to private transactions) are common, although as with buyout transactions of all types the number of these transactions has dropped steeply over the past several years.
A public to private transaction requires compliance with a number of Securities Act rules including those governing proxy contests or tender offers (depending on the method used for the acquisition) and disclosure rules. If the target company is established in Delaware (which is common) or in states which follow Delaware common law, the target's directors have a fiduciary duty to obtain the best price for the target company. As a result, targets seek and generally obtain the ability to terminate acquisition agreements if they receive a superior offer (at the cost of paying a break fee).
Care must also be taken to follow process-related requirements, created by both statute and case law (for example, providing the required notice to shareholders and complying with charter and bye-law provisions).
Target companies must also adhere to the rules of the exchanges they are listed on, although these generally do not pose much of a problem if other legal and regulatory requirements are being met.
There are two principal forms an acquisition of a US public company can take:
A one-step transaction, involving a proxy solicitation and a vote of the target's shareholders to approve the merger, which then takes place after the solicitation and vote.
A two-step transaction, involving a tender offer by the buyer, followed by a merger after the buyer acquires voting control of the target's stock directly from its shareholders in the tender offer.
One-step transactions can take a great deal longer than two-step transactions. Until recently, one-step transactions have been private equity sponsors' preferred route, despite the additional amount of time they involve. Recently there has been an increased use of two-step transactions involving a tender offer.
Regardless of whether a public to private acquisition is one-step or two-step, the principal agreement is a merger agreement between the target company and the acquisition entities formed by the private equity sponsor. The merger agreement is necessary because it is almost impossible to locate every single shareholder in a public company, and the merger agreement eliminates the need to do so.
In a private acquisition, the principal agreement is one of the following:
A merger agreement.
An equity purchase agreement.
An asset purchase agreement.
The type of agreement depends on the transaction structure, which depends on numerous factors. In a private acquisition, there may be additional agreements between the seller(s) and the private equity sponsor dealing with ancillary matters such as real estate leases, escrow arrangements, transition of services and so on.
The acquisition entity, the private equity sponsor's fund and/or the management team may, in connection with the agreements for acquisition and funding of the acquisition entity, enter into other agreements, including:
Equity commitment letters.
Debt commitment agreements.
Equity contribution agreements.
Registration rights agreements.
Private equity sponsors generally provide the seller with an equity commitment letter from the relevant fund. The equity commitment letter is the fund's binding commitment to provide the equity capital to the acquisition entity. Alternatively, a seller may insist on a direct guarantee from the private equity fund. If the sponsor has agreed to a no-financing condition transaction (see Question 19), the guarantee also ensures that the seller can collect the reverse break fee in the event of a triggering termination event.
Buyer protections in a private acquisition generally include:
Representations and warranties. Buyers typically obtain representations and warranties from the seller covering both the entity or assets being sold and the ability to sell them.
Interim operating covenants. Buyers typically require covenants from the seller requiring the seller to, between signing and closing:
operate the business as usual;
not enter into certain transactions without the buyer's consent.
Closing conditions. Buyers also typically obtain closing conditions, including:
receipt of required governmental and third-party consents by the seller;
no material adverse change in the target entity;
receipt of buyer's debt financing;
compliance with covenants by the seller;
a bring-down of seller's representations and warranties.
Post-closing indemnification provisions. The seller must usually indemnify the buyer for breaches of the seller's representations, warranties and covenants. This may also include specific indemnities for pre-closing taxes, known environmental issues and other matters. Sellers typically require buyers to agree to a basket cap, so that small amounts are not indemnified, and a cap on potential indemnity claims. There is also typically a reasonable survival period, during which the buyer can bring an indemnification claim post-closing. Indemnification baskets, caps and the corresponding survival periods are usually highly negotiated.
Typically, a private equity sponsor does not seek any special protections from the target's management team. If the target's management team is selling equity in the transaction, members of the team normally share pro rata in any post-closing indemnification obligation and escrow hold-back.
Private equity funds' obligations to close are sometimes not subject to their receipt of debt financing. In exchange, funds negotiate for a cap on the total damages payable to the seller if they fail to close due to a failure to receive their debt financing or for any other reason. The cap typically takes the form of a reverse break fee payable by the fund. These reverse break fees are typically a small percentage (2% to 3.5%) of the total transaction value, or may be slightly more if the sponsor fails to close for any reason other than a failure to obtain debt financing. In these deals it is common to have provisions barring sellers from being able to seek specific performance to force the closing, even if all conditions to the buyer's obligations to close the deal have been satisfied.
In a public to private transaction, there is typically no post-closing indemnification or other post-closing protections, so buyers rely on interim operating covenants and the no-material-adverse-change closing condition as their key protections.
The principal non-contractual duty that portfolio company managers owe the target company is the common law duty of good faith and loyalty. This duty of loyalty prohibits management from disadvantaging the company for their own benefit or pursuing company opportunities for themselves. The duty of loyalty generally requires disclosure to the board of directors once an opportunity involving the target company presents itself. Management representatives on the board of directors usually withdraw from board deliberations concerning these opportunities to avoid conflict of interest.
Beyond typical employment terms such as title, term, compensation (including incentive compensation), benefits, termination and severance, the most important employment terms typically imposed on management by a private equity sponsor are non-competition, non-solicitation and confidentiality terms.
State law governs employment contracts and so the enforceability of non-competition clauses can vary widely from state to state. Most states will enforce a non-competition clause that is reasonable in scope (considering restrictions on types of employment, geography and duration), although some states (such as California) will not enforce non-competition clauses due to them being against public policy.
Non-solicitation clauses typically cover employees, customers and suppliers. The scope of these clauses often does not extend to general solicitations through mass-media that are not targeted at any particular person or group.
In a single sponsor transaction, the private equity sponsor typically controls all of the fully diluted equity of the company other than that owned by management (usually 10% to 20%). As a result, the sponsor has both voting and economic control over the business.
The private equity sponsor and the other equity holders generally enter into a shareholders' agreement that gives the sponsor the right to nominate a majority of the company's directors, and includes a voting provision under which all parties to the agreement agree to vote in favour of the sponsor's board nominees. Shareholders' agreements also usually contain provisions, such as drag-along rights, that give the sponsor control over exit transactions.
In consortium transactions, or in a transaction where there are one or more significant minority investors, the shareholders' agreement may include provisions requiring a super-majority vote that gives the minority a veto over certain fundamental transactions, such as financings, significant add-on acquisitions, sales of significant assets and exit transactions. In consortium transactions there is often also a desire to place such voting provisions and the provisions relating to the nomination and election of directors in the company charter, which is often more difficult to amend than a shareholders' agreement.
The percentage of financing typically provided by debt depends on the size of the transaction and how much debt can be obtained under prevailing market conditions. While the typical level of debt financing fell at the onset of the credit crisis, the level of debt financing now used in a private equity leveraged buyout transaction is similar to levels before the summer of 2007.
The fundamental different types of debt financing used in buyout transactions are:
Senior secured first and/or second lien financings.
Subordinated mezzanine financings.
Senior secured bonds.
Unsecured senior or subordinated bonds.
Convertible and other hybrid debt financings.
A senior secured financing is senior to the borrower's other debt and a significant portion of the borrower's assets serve as collateral. Such financings consist of one or more term loan facilities that are used to finance the acquisition and a revolving credit facility that is used for working capital. The extent to which these types of debt are used depends on:
The size of the overall financing.
The costs of each type of financing.
The fund sponsor's preferences among the types of debt financing available.
Debt providers typically protect their investments by obtaining security interests in the borrower's assets and by obtaining guarantees from the borrower's subsidiaries, secured by the relevant subsidiaries' assets.
There are a number of contractual and structural mechanisms that are also used by debt providers. Debt providers can contract with each other to subordinate one class of creditors to another class. The two groups can agree that one group will not have any rights in an insolvency proceeding until the other class of creditors has been repaid in full.
Debt providers can also obtain structural seniority by extending debt to an operating company subsidiary of a holding company, rather than to the holding company itself. Lenders at the operating level are repaid before creditors with a claim at the holding company level, because the operating company subsidiary must satisfy all of its debt claims in an insolvency proceeding before the holding company receives whatever value is left as a result of its holding equity in the subsidiary.
Contractual and structural mechanisms
Contractual covenants also provide lenders with some protection. Such covenants can include obligations to maintain the financial health of the borrower as well as other negative and affirmative covenants. Lenders can also be protected by keep-well arrangements under which fund sponsors agree to provide the borrower with capital in certain situations.
There is no prohibition on a company giving financial assistance in connection with the purchase of its own shares. Courts can void guarantees and security given by a target company if a fraudulent transfer has occurred (such as a transfer of assets when the transferor is insolvent). Creditors in leveraged buyout transactions often rely on the guarantee provided by the acquiring fund that the borrower and its subsidiaries will be solvent after the buyout transaction, including any debt resulting from the transaction and the provision of any guarantees and security.
Most portfolio companies in need of bankruptcy relief use the provisions of Chapter 11 of the Bankruptcy Code, regardless of whether the goal of the proceedings is the liquidation of the business or the reorganisation of the business as a going concern.
The statutory priorities for repayment are:
Secured claims, to the extent of the value of the underlying collateral.
Administrative claims (generally, claims that arise after a bankruptcy is commenced and before the effective date of the plan of reorganisation).
Priority claims (for example, certain claims for unpaid wages and taxes).
General unsecured claims.
A senior secured creditor with liens on a material portion of a debtor's assets may agree to be effectively subordinated to the payment of a predetermined portion of administrative and priority claims, as the price of liquidating through Chapter 11. This is because a Chapter 11 liquidation can be more advantageous for the senior secured creditor than simply foreclosing on its collateral.
In a bankruptcy proceeding, the rights of any single holder, including rights relating to priorities of distribution, can be waived by an affirmative vote of a majority of holders (that is, two-thirds in amount and one-half in number) within the same class. Inter-creditor and subordination agreements are enforceable in a Chapter 11 proceeding to the same extent as outside of bankruptcy.
A court can also subordinate one creditor's claim to another creditor's claim (or the claims of all other creditors) if it is shown that the creditor has engaged in inequitable conduct (for example, fraud or breach of fiduciary duties) that resulted in an injury or disadvantage to the other creditor(s). If so, the subordinated claim is treated as lower in priority than the claim to which it is subordinated, but the subordination does not affect its treatment in relation to any other claim or to equity.
Additionally, a court will look past the form of debt to determine its substance and may recharacterise debt as equity (and treat it as lower in priority than all claims) if this is determined to be the economic substance of the transaction.
It is possible for a debt holder to participate in the appreciation of equity value through convertible securities such as rights, warrants or options, but it is not very common in US buyout transactions. Debt holders generally do not participate in the equity in large transactions. In small and middle-market transactions, it is common for mezzanine lenders and hedge funds to invest alongside the equity participants in the equity rather than receiving warrants or other convertible securities, although in some transactions, share purchase warrants are a part of the overall financing provided by the debt holders.
Portfolio company management
The most common management incentives used to encourage portfolio company management are:
Other share-based awards.
A combination of these.
In small and middle-market transactions, incentive plans commonly account for 10% to 15% of the fully diluted equity. Incentive plans are relatively smaller in larger transactions and commonly account for between 5% and 10% of the fully diluted equity. Incentive awards are usually subject to both time-based vesting (for at least some portion of the awards) and performance-based vesting. Performance-based vesting is usually based on the sponsor's return on its investment.
Restricted stock is sometimes used to allow the recipient to gain favourable tax treatment by electing to be taxed on the fair market value of the common share grant at the time of grant and to pay income taxes at ordinary income rates, with appreciation generally taxed at capital gain rates on realisation.
Senior managers may also be required to invest in the transaction, either through a direct cash investment or through the rollover of their current equity holdings in the target company. The structure, nature and amount of such required investment depends on individual circumstances. Sponsors generally work with managers to try to design equity rollovers in a tax-efficient manner.
Corporations can offer incentive share options (ISOs). ISOs are taxed at capital gains rates when the shares are sold if certain requirements are met. No tax is due when they are exercised and therefore the issuer is not entitled to a tax deduction. To achieve capital gains treatment, the shares must be held for both:
Two years following the ISO's grant date.
One year after the ISO is exercised by the manager.
Companies are limited in the amount of ISOs they can grant and as a result ISOs are not widely used.
Portfolio companies that are operated in a pass-through form can grant managers profits interests in exchange for performing services for the company. These profits interests generally represent the right to a share of the venture's future profits and are treated as capital gains at the level of the manager, to the extent that the underlying income is a capital gain. This differs from ordinary income from the exercise of non-qualified share options or the vesting of restricted shares without a section 83(b) election. When the portfolio company is sold the gain is typically treated as capital gains at the level of the manager.
Bills have been introduced in congress several times over the last few years that propose to tax the carried interest earned by managers of private equity and hedge funds at ordinary income rates (they currently receive capital gains treatment). No action has been taken on the most recent proposed Bill, and it is likely that no action will be taken in the near future.
So long as the dividend payments are in accordance with the portfolio company's charter and contractual obligations, the payment of dividends by a solvent company is generally unrestricted. State laws generally prohibit the payment of dividends by a company that is a going concern if after giving effect to the distribution, the company would not be able to pay its existing and reasonably foreseeable debts, obligations and liabilities.
Investment documents may include protections regarding the Foreign Corrupt Practices Act (FCPA). The FCPA generally prohibits fund executives from offering or giving bribes to a "foreign official, "foreign political party or party official," or any candidate for foreign political office, to obtain or retain business opportunities. The FCPA generally applies to:
US persons, including US companies, controlled subsidiaries and affiliates of US companies, and citizens, nationals and residents of the US, wherever located.
In certain circumstances, non-US persons, including non-US companies and non-US citizens outside the US.
The US Department of Justice (DOJ) and the SEC both enforce the FCPA. Violators of the FCPA may be subject to both criminal and civil penalties. In criminal cases, firms are subject to a fine of up to US$2 million per violation of the anti-bribery provisions. Individuals are subject to a fine of up to US$100,000 and/or imprisonment for up to five years, per violation. However, under the Alternative Fines Act, the fines imposed on firms and individuals can be much higher: the actual fine can be up to twice the benefit that the defendant sought to obtain by making the corrupt payment. In civil actions, a fine of US$10,000 can be assessed for each act committed in furtherance of the offence, potentially making the total fine greater than US$10,000. Fines imposed on individuals must not be paid by their employer or principal. In addition, persons or firms found in violation of the FCPA can be barred from doing business with the US Government and can be ruled ineligible for export licences.
Investment documents may also include protections from the UK Bribery Act (Bribery Act). The Bribery Act is similar to the FCPA, which criminalises the payment of bribes to foreign officials. However, the Bribery Act is more expansive in three ways:
Most significantly, the Bribery Act imposes a strict liability criminal offence that applies to any company with ties to the UK that fails to prevent an associated person (that is, anyone performing services on the company's behalf) from paying a bribe. The only defence to liability is if the company can prove that it had adequate procedures in place to prevent the bribery from occurring.
The Bribery Act does not contain any exceptions for facilitation payments or relatively insubstantial payments made to facilitate or expedite routine governmental action.
The Bribery Act criminalises purely commercial bribery that is unconnected to any public or governmental official, unlike the FCPA.
Additionally, investment documents may include protections regarding the OECD Convention on Combating Bribery of Foreign Public Officials in International Business Transactions (Convention). The Convention applies to the bribing of foreign public officials. The Convention applies irrespective of, among other things:
The value of the advantage and its results.
Perception of local custom.
Local authorities' tolerance of these payments.
The alleged necessity of the payment in order to obtain or retain business or other improper advantage.
The Convention applies as soon as an offer or promise is made, whether directly or through intermediaries, and applies even in cases of a third party beneficiary. Penalties are specified by each country but are comparable to FCPA penalties. Many countries specify unlimited fines and ten years' imprisonment.
Forms of exit
The three most common forms of exit used to realise a private equity fund's investment in a successful company are the:
Sale to a financial buyer such as another private equity fund.
Sale to a strategic buyer.
Initial public offering (IPO).
Sales to financial buyers or strategic buyers can take the form of either a sale of the company or of assets. It is also possible to have a carve-out sale in which a portion of a successful company is sold or even, on rare occasions, brought public.
Private sales, whether to financial or strategic buyers, are significantly more common than IPOs. The viability of an IPO depends to a great extent on market conditions.
Advantages and disadvantages
The advantage of an IPO is that it is possible to realise significantly greater value in the long term. However, in most IPOs the fund sponsor does not sell most (or any) of its shares. Instead, newly issued shares are sold to the public. As a result, even with a successful IPO, the fund sponsor still has market risk in relation to its shares in the company, as well as the continued business risk of operating the portfolio company.
Although greater value may be realised over the long term from an IPO, the private sale is by far the more common exit strategy. The advantage of a private sale is that the private equity fund sponsor realises all of the value of the sale immediately and no longer has to deal with either business or market risk in relation to its investment.
Sales to other private equity fund sponsors remained a particularly common form of exit in 2012. From a fund investor perspective, a sale to another private equity fund may mean there is no exit at all if the investor is also invested in the acquiring fund.
Forms of exit
The two primary forms of exit used to end a private equity fund's investment in an unsuccessful company are to sell the company (an asset or a stock sale) where the equity holders do not receive anything, or to enter into voluntary bankruptcy.
Advantages and disadvantages
The bankruptcy procedure is preferred because the buyer gets clean title to all of the assets and the seller is assured of having no remaining liabilities. In a sale of the company outside of bankruptcy, no matter how strong the contractual arrangements may be, the seller is always left with the possibility that liabilities may remain its responsibility.
In a voluntary bankruptcy, the portfolio company can sell all or substantially all of its assets with court approval. It is unusual for such sales to result in any proceeds being paid to the equity holders, and some classes of creditor may also receive proceeds equalling only a small percentage of their claims.
*The authors would like to thank Bartholomew C Galvin for his contribution to this article.
Private equity/venture capital association
National Venture Capital Association (NVCA)
Status. The NVCA is a trade association that represents the US venture capital industry.
Membership. The NVCA comprises more than 450 member firms.
Principal activities. The NVCA aims to foster a greater understanding of the importance of venture capital to the US economy and support entrepreneurial activity and innovation. It represents the venture capital community's public policy interests, strives to maintain high professional standards, provides reliable industry data, sponsors professional development, and facilitates interaction among its members.
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Larry Jordan Rowe
Ropes & Gray LLP
Professional qualifications. Massachusetts, US
Areas of practice. Private investment funds; hedge funds; investment management; private equity transactions.
Debra K Lussier
Ropes & Gray LLP
Professional qualifications. Massachusetts, US
Areas of practice. Private investment funds; hedge funds; investment management.