Fundamentals of Private Equity Deal Structuring

Laura ONeill Partner SJ Berwin LLP 27 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

Investor
Management
eg 85% Ordinary shares Shareholder debt eg 15%

Topco Ltd
(Investment vehicle)

Ordinary shares (sweet equity)

Inter-company loan Price

Banks

Newco Ltd
Senior/ mezzanine debt
(Purchasing and debt vehicle)

Vendor

Shares

Target

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 Investors 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 to fund ongoing working capital needs of the business

(2) revolving credit facility

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

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)

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 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 (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 Newcos 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 Managements 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 intragroup)

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.
after year 1, 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 Investors right to syndicate and/or transfer to other funds Permitted transfers, i.e. to family trusts, privileged relations or other funds or with Investors consent Otherwise pre-emption rights apply Deed of adherence to investment agreement

Ratchet

Increases Managements 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 Investors preferred shareholding converts into worthless deferred shares Means of bridging the commercial gap between Management optimism and Investor conservatism