Fundamentals of Private Equity Deal StructuringLaura O’NeillPartnerSJ Berwin LLP27 February 2009

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

The main players (1)

Sellers/existing shareholders

The main players (2)

Bank/Debt provider

The main players (3)

Private Equity house

The main players (4)

Management

The main players (5)

Accountants, financial, tax and other advisers

The main players (6)

and finally….the lawyers

The classic MBO structure

InvestorManagement

Banks

Target

eg 85% eg 15%

Senior/mezzanine

debt

Ordinary shares

Vendor£ Price

Shares

Inter-company loan

Topco Ltd(Investment vehicle)

Newco Ltd(Purchasing and debt vehicle)

Ordinary shares (“sweet equity”)

Shareholder debt

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 (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

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)

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

• 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)

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 (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 (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 governingoperation 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 (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

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

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

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

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 stock interest, failure to hit budget, bad behaviour etc.

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

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

– hiring/firing

– major leases

– disposing of business/major assets

• Cover structural matters such as:

– issuing shares

– raising finance

– paying dividends

– exit

– buying-back shares

– reconstructions

– share transfers

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

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)

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

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.

– ⅓ after year 1, ⅔ after year 2, rest after year 3

– once vested, shares not subject to good leaver/bad leaver provisions

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

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

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