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Fundamentals of Private Equity Deal Structuring Laura O’Neill Partner SJ Berwin LLP 27 February 2009 CP3:804204.1

Fundamentals of Private Equity Deal Structuring

Laura O’Neill Partner SJ Berwin LLP 27 February 2009

Fundamentals of Private Equity Deal Structuring Laura O’Neill Partner SJ Berwin LLP 27 February 2009 CP3:804204.1
Fundamentals of Private Equity Deal Structuring Laura O’Neill Partner SJ Berwin LLP 27 February 2009 CP3:804204.1
Fundamentals of Private Equity Deal Structuring Laura O’Neill Partner SJ Berwin LLP 27 February 2009 CP3:804204.1
Fundamentals of Private Equity Deal Structuring Laura O’Neill Partner SJ Berwin LLP 27 February 2009 CP3:804204.1

CP3:804204.1

Contents

The main players The classic buyout structure Equity finance Debt finance The principal legal documents Equity documents - the main points to consider

Contents The main players The classic buyout structure Equity finance Debt finance The principal legal documents

The main players (1)

Sellers/existing shareholders

The main players (1) Sellers/existing shareholders
The main players (1) Sellers/existing shareholders
The main players (1) Sellers/existing shareholders
The main players (1) Sellers/existing shareholders

The main players (2)

Bank/Debt provider

The main players (2) Bank/Debt provider
The main players (2) Bank/Debt provider

The main players (3)

Private Equity house

The main players (3) Private Equity house
The main players (3) Private Equity house

The main players (4)

Management

The main players (4) Management
The main players (4) Management

The main players (5)

Accountants, financial, tax and other advisers

The main players (5) Accountants, financial, tax and other advisers
The main players (5) Accountants, financial, tax and other advisers

The main players (6)

and finally….the lawyers

The main players (6) and finally….the lawyers
The main players (6) and finally….the lawyers

The classic MBO structure

Management

Investor

eg 85% Ordinary shares

Topco Ltd (Investment vehicle) Shareholder debt Inter-company loan Newco Ltd Banks Senior/ (Purchasing and debt vehicle)
Topco Ltd
(Investment vehicle)
Shareholder
debt
Inter-company
loan
Newco Ltd
Banks
Senior/
(Purchasing and debt vehicle)
mezzanine
debt
Target

eg 15%

Ordinary shares (“sweet equity”)

Vendor
Vendor

£ Price

The classic MBO structure Management Investor Ordinary shares Topco Ltd (Investment vehicle) Shareholder debt Inter-company loan
The classic MBO structure Management Investor Ordinary shares Topco Ltd (Investment vehicle) Shareholder debt Inter-company loan

Shares

The classic MBO structure Management Investor Ordinary shares Topco Ltd (Investment vehicle) Shareholder debt Inter-company loan

Equity finance (1)

subscription for ordinary shares by:

PE house/Investor

Management - incentive to make business succeed (‘sweet equity’) (ranks behind all other debt and equity)

further funds invested:

usually by way of loan notes or preference shares

give Investor a preferred right to income and to capital on a winding up but unsecured and subordinated to bank debt

form the majority of Investor’s equity contribution

interest rolls up or “PIK” notes used

no payments during term of the notes - return back-ended

Equity finance (1) • subscription for ordinary shares by: – PE house/Investor – Management - incentive

Equity finance (2)

What is sweet equity?

say Management cut a deal with Investor whereby Investor will acquire the target for £100 million and Management will have 20% equity in the buy out vehicle

all things being equal Management will have to pay £20 million for their 20% stake

however, with leverage of, say, £60 million, the equity requirement is £40 million, hence Management need to provide £8 million but Management is unlikely to have this sort of money

so Investor provides the majority of the equity requirement in the form of “quasi-equity” (loan notes or preferred shares) - in this example say £39 million with the balance of £800,000 in the form of ordinary shares (the real equity)

Management, therefore, only needs to subscribe £200,000 for 20% of the ordinary shares to entitle it to 20% of any upside

Equity finance (2) • What is sweet equity? – – say Management cut a deal with

Debt finance (1)

Usually forms largest part of required funding

2 sources of this debt: “senior debt” and “junior debt”

Senior debt

so called because it ranks ahead of all other debt of Newco group

often divided into two types of facility being:

(1)

term facility

 

to finance the acquisition and associated costs and expenses

also to refinance existing Target indebtedness

sometimes a capex facility will be put in place to fund large ongoing capital costs

 

(2)

revolving credit facility

 

to fund ongoing working capital needs of the business

larger transactions will be syndicated (i.e. underwriting banks will sell part of commitment to participant banks to reduce balance sheet exposure)

larger transactions will be syndicated (i.e. underwriting banks will sell part of commitment to participant banks

Debt finance (2)

Junior debt

so called because it occupies a position between debt and equity

subordinated (junior) to the senior debt but will usually receive interest

payments (provided no major event of default occurs) generally shares the senior security, but on a second ranking basis

sometimes attaches warrants giving lenders the right to shares in Topco

warrants allow mezz provider to share in increase in value of equity of Target group and provide higher return on investment to compensate for subordinated nature of debt

Debt finance (2) • Junior debt – so called because it occupies a position between debt

Debt finance (3)

How does leverage work?

say a business has an enterprise value (EV) of £100 million - without any leverage it will cost Investor £100 million

if it is then sold a year later for £120 million, a £100 million investment has generated a £20 million profit (i.e. a 20% profit)

if, however, Investor used debt of £80 million to buy the business then business has only cost it £20 million

hence selling the business a year later for £120 million generates a net return of £40 million – a £20 million investment has generated a £40 million profit or a return of 2 x the original £20 million investment (or a 200% profit)

Debt finance (3) • How does leverage work? – say a business has an enterprise value

The principal legal documents (1)

A buyout essentially involves 3 separate processes/transactions:

the acquisition

between Newco and Sellers for acquisition of Target

the equity arrangements

deal between Investor and Management

debt finance

between Newco and banks/providers of finance for acquisition of Target/working capital etc.

The principal legal documents (1) • A buyout essentially involves 3 separate processes/transactions: – the acquisition

The principal legal documents (2)

Acquisition documents

Sale and Purchase Agreement (‘SPA’)

contains the terms of the sale whether it is of shares, assets or a business

Disclosure Letter

will contain disclosures against the warranties in the SPA

Tax Deed trade mark/trade name licences property documents/transfers transitional service agreements

The principal legal documents (2) • Acquisition documents – Sale and Purchase Agreement (‘SPA’) – contains

The principal legal documents (3)

Equity documents

Investment Agreement (aka Subscription and Shareholders Agreement)

governs relationship between Management and Investor, contains equity and shareholder debt subscription mechanics, Investor rights, Management obligations and restrictions and provisions governing operation of business going forward and “exit”

new Topco Articles

provisions controlling the constitution and share capital of Topco, including dividend rights, transfer restrictions and good leaver/bad leaver provisions

shareholder debt instrument

constitutes shareholder debt (loan notes, deep discount bonds, PIK) which forms majority of equity funding

new Service Agreements for Management

The principal legal documents (3) • Equity documents – Investment Agreement (aka Subscription and Shareholders Agreement)

The principal legal documents (4)

Finance Documents

Senior Finance Agreement (‘SFA’)

contains terms on which senior lenders will advance funds and restrictions on operation of Target going forward and ability of Investor to extract cash from the business

Mezzanine Finance Agreement (‘MFA’)

broadly mirrors terms of SFA with minor changes (e.g. increased pricing and weaker financial covenants - 10% extra headroom)

security agreements

details what security is taken over what assets (eg. debentures (incorporating fixed and floating charges) from Newco and guarantees from Target/subsidiaries guaranteeing Newco’s borrowings)

Intercreditor Agreement

details the ranking between lenders (senior and mezz) as well as loan note holders of Investor and any preferred equity

The principal legal documents (4) • Finance Documents – Senior Finance Agreement (‘SFA’) – contains terms

Equity documents – main points to consider

Warranties

Board representation

Default/swamping rights

Vetoes/consent matters

Information rights

Drag-along/tag along

Restrictive covenants

Leaver provisions

Share transfers

Ratchets

Equity documents – main points to consider • Warranties • Board representation • Default/swamping rights •

Warranties (1)

Warranties (1)
Warranties (1)
Warranties (1)
Warranties (1)

Warranties (2)

Contractual statements by Management, confirming accuracy of position/events Primarily to focus Management’s mind and force disclosure Management can be sued if inaccurate Covers matters such as:

business plan properly and diligently prepared/reasonableness of assumptions accuracy of due diligence reports personal information, including other business activities, financial background, no criminal record, no pending litigation etc. no breach of the SPA (in particular Seller warranties)

Contentious issues include scope, financial thresholds and caps, and whether joint and several or several and proportionate liability

Warranties (2) • • • • • Contractual statements by Man agement, confirming accuracy of position/events

Board representation (1)

Board representation (1)
Board representation (1)

Board representation (2)

Investor director(s)

entrenched rights with “fast-track” appointment/removal procedures

Observer(s)

Notice of meetings, quorum, blocking vote

Committees: Remuneration, Audit, Nominations, others

Boards of subsidiaries

Directors’ fee

Chairman

Board representation (2) • Investor director(s) – entrenched rights with “fast-track” appointment/removal procedures • Observer(s) •

Default/Swamping rights (1)

Default/Swamping rights (1)
Default/Swamping rights (1)
Default/Swamping rights (1)

Default/swamping rights (2)

Enables Investor to ‘step in’ and take voting control if Topco underperforms

Board and/or shareholder level

Triggered by defaults, e.g. banking covenants about to be breached, failure to pay loan stoc k interest, failure to hit budget, bad behaviour etc.

Contentious issues include materiality, remedy period, duration, and whether and when they lapse

Default/swamping rights (2) • Enables Investor to ‘step in’ and take voting control if Topco underperforms

Vetoes/consent matters (1)

Vetoes/consent matters (1)
Vetoes/consent matters (1)
Vetoes/consent matters (1)

Vetoes/consent matters (2)

Management essentially have day-to-day control of Target but important decisions require “Investor consents”

Cover trading matters such as:

entering into material contracts pursuing litigation major capex

Cover structural matters such as:

issuing shares

raising finance

paying dividends

exit

hiring/firing major leases

disposing of business/major assets

buying-back shares

reconstructions share transfers

Vetoes/consent matters (2) • Management essentially have day-to-day control of Target but important decisions requi re

Information rights (1)

Information rights (1)
Information rights (1)
Information rights (1)
Information rights (1)

Information rights (2)

Monthly Management accounts

Minutes of each board meeting held

Projected cashflows & P&L

Testing against banking covenants

Audited accounts

Annual business plan & budget

Rights of inspection/audit

Information rights (2) • Monthly Management accounts • Minutes of each board meeting held • Projected

Drag-along/tag along (1)

Drag-along/tag along (1)
Drag-along/tag along (1)
Drag-along/tag along (1)

Drag-along/tag along (2)

Drag-along:

 
 

ability for Investor to enforce sale of whole

all other shareholders have to sell at same time

usually on same terms and at same price unless there are different classes of shares with different orders of priority on an exit

often a moratorium for initial period, say two years

sometimes a right for Management to match any offer received by Investor

Tag-along:

 

right for minority shareholders to block a transfer unless they are also given an opportunity to exit on the same terms

should not catch permitted transfers (e.g. syndication and intra-group)

Should not catch permitted transfers (e.g. syndication and intra- group)

• Should not catch permitted transfers (e.g. syndication and intra- group)

Restrictive covenants (1)

Restrictive covenants (1)
Restrictive covenants (1)

Restrictive covenants (2)

Protective undertakings covering:

 

non-compete

 

no poaching of staff, customers, suppliers confidentiality

no ‘bad mouthing’

use of business names

Contentious issues include duration, territories, scope and carve outs for existing interests

Restrictive covenants (2) • Protective undertakings covering: – non-compete no poaching of staff, customers, suppliers –

Good leaver provisions (1)

Good leaver provisions (1)
Good leaver provisions (1)
Good leaver provisions (1)
Good leaver provisions (1)

Good leaver provisions (2)

Where a manager ceases to be employee/director – what happens to his/her shares?

Usually bought back/sold – if “good leaver” then typically get higher of price paid/fair market value

“Good Leaver” = death, permanent illness/disability, if Investor agrees

Others may include – unlawful termination, resignation after ‘x’ years service

Vesting of shares as time passes, e.g.

after year 1, after year 2, rest after year 3 once vested, shares not subject to good leaver/bad leaver provisions

Good leaver provisions (2) • Where a manager ceases to be employee/director – what happens to

Bad leaver provisions (1)

Bad leaver provisions (1)
Bad leaver provisions (1)

Bad leaver provisions (2)

“Bad leaver” = typically “if not a Good Leaver” or gross misconduct, voluntary resignation, breach of restrictive covenants

Price would be lower of subscription price paid or fair market value

Bad leaver provisions (2) • “Bad leaver” = typically “if not a Good Leaver” or gr

Share transfers

General prohibition unless it triggers drag-along/tag-along rights

Investor’s right to syndicate and/or transfer to other funds

Permitted transfers, i.e. to family trusts, privileged relations or other funds or with Investor’s consent

Otherwise pre-emption rights apply

Deed of adherence to investment agreement

Share transfers • General prohibition unless it tr iggers drag-along/tag-along rights • Investor’s right to syndicate

Ratchet

Increases Management’s equity if certain performance criteria are met

Performance criteria usually based on a realisation (target IRR/minimum multiple based return eg. 2.5 times) but can follow targets such as EBIT

Part of Investor’s preferred shareholding converts into worthless deferred shares

Means of bridging the commercial gap between Management optimism and Investor conservatism

Ratchet • Increases Management’s equity if certain performance criteria are met • Performance criteria usually based