Private Equity Law Review : New York Private Equity Lawyer & Attorney : Geoffrey Parnass : Corporate & Business Law

Returns for private equity investors suffered their worst decline on record in 2008, according to a study issued by London-based research firm Preqin. Limited partners ended up paying more money into buyout funds than they took out. The Financial Times reported that general partners made $148 billion in capital calls from limited partners, but only distributed $63 billion in returns. Concerned about their ability to meet future capital calls in the face of diminished expectations for distributions, institutional investors appear wary of increasing their exposure to private equity.  

Hampered by the decline in markets, private equity general partners continue to scramble to find profitable exits. A recent Dealogic analysis reviewed by The New York Times reveals that exits from portfolio company investments by private equity funds generated only $20.8 billion in the first half of 2009, down from $115 billion in the first half of 2008. General partners have also achieved little success in finding attractive acquisition targets. Even when private equity firms have identified valuable buyout opportunities, tight credit markets have hindered them from financing the deals.   CNNMoney.com writes that only three loans were given to leveraged buyout funds in the first half of 2009. Lenders’ reluctance to finance leveraged buyouts have forced private equity GPs to adjust their deal structures, relying more heavily on equity investments (and corresponding capital calls from their LPs). Apax Partners LLP, for example, recently bought the personal financial information provider Bankrate, Inc. for around $571 million in cash.    

An increase in capital calls, decrease in distributions, and the scarcity of debt financing for deals have made it difficult for firms to raise financing for new funds. The Dow Jones Private Equity Analyst found that during the first half of 2009 general partners only raised 50% of the capital that they raised during the first half of last year. For those investors that have decided to commit to new funds, however, at least one study suggests that limited partners increasingly have been able to negotiate more investor-friendly terms in the funds’ limited partnership agreements. Last year’s large discrepancy between the amount of capital calls and distributions seems to have emboldened institutional investors to seek greater contractual rights and better financial terms from general partners. 

Evidence from a research report issued by Preqin in July suggests that limited partners have successfully negotiated more favorable terms in fund partnership documents in at least some cases. Preqin discovered that there has been a reduction in the average management fee demanded by general partners to 1.8% (compared to an average of 2% which had held steady for the past several years). Limited partners have also been able to win some concessions on restrictive covenants. Preqin indicates that there has been an increased prevalence of both “key-man” and “no-fault divorce” clauses in limited partnership agreements. 

A key-many provision allows limited partners to suspend their obligations to make further capital contributions for new investments if certain key personnel at the general partner leave the fund or otherwise neglect to spend sufficient time and effort managing the fund’s investments. (When Steven Rattner left the Quadrangle Group in February to head Obama’s auto industry task force, his departure triggered a key-man clause in a fund’s limited partnership agreement.) No-fault divorce clauses permit a specified majority (often 75%) of a fund’s limited partners to vote to suspend their obligations to make capital calls, remove the general partner, or even terminate the partnership, if they determine that the general partner is no longer acting in the interests of the fund.  

Although there is a growing secondary market for private equity fund interests, private equity as an asset class remains more or less illiquid. Limited partnership agreements typically bind investors to a 10-year commitment, often with an option to extend their commitment for up to 3 years until all portfolio investments have been exited. Moreover, investments in private equity funds take between two to seven years to generate returns for their limited partners.  While it’s likely that institutional investors are leveraging what they see as an increase in negotiating power to extract concessions from general partners, it’s also possible that investors are reassessing the risks that buyout funds pose for them as an asset class. After a year of continual capital calls from general partners, institutional investors may have a renewed appreciation for contractual mechanisms that permit them to halt capital calls – and thus stanch the bleeding – during tough economic times.

Related Post:  Private Equity LPs Seek to Impose "Best Practices" on Sponsor Community

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Following our post earlier today in which we reviewed KKR's break-up fees and the "go shop" and "no shop" provisions in the KKR-Sum Total merger agreement, we now examine the absence of a “financing out” in the agreement.

No Financing Out

In private equity buyouts, the acquisition vehicle tends to be a shell holding company with no assets. At the closing of highly leveraged cash-for-stock mergers, the holding company is funded by an equity investment from the funds participating in the merger and by senior and mezzanine, or “bridge,” loans from a syndicate of banks. Upon receipt, the holding company immediately transfers these funds to the target company for distribution to the target’s shareholders to complete the merger.   (The movement of these funds as they’re wired from entity to entity is mapped out in painstaking detail beforehand by the accounting firms in a chart dubbed the “funds flow.”) 

Although private equity firms usually have obtained signed letters from the banks committing their funds to the transaction before they enter into a merger agreement, firms always face the danger that, at some point between signing the merger agreement and closing, their lenders renege on their financing commitments or increase the costs of borrowing. To protect themselves against the possible loss of debt financing on acceptable terms, private equity funds in years past have negotiated a “financing out” in merger agreements by setting the continued availability of financing from their bank syndicates as a condition to closing the deal. 

The merger agreement does not have a “financing out” for KKR because the firm is financing the Sum Total merger solely with an equity investment from Accel-KKR Fund III, L.P., a fund dedicated to investing in mid-market technology companies. With no fear of a third-party’s failure to make good on its loan promises, KKR faces very little risk that it will not be able to come up with the cash to complete the transaction. 

Guarantee from KKR Fund

In fact, it is Sum Total who bears some risk that the KKR fund may fail to contribute cash to the shell holding company serving as KKR’s merger vehicle. The merger agreement gives Sum Total additional comfort by having the right to force the merger vehicle to compel the KKR fund to finance the purchase price. Sum Total also has a direct guarantee from Accel-KKR Fund III, L.P. for the holding company’s (and its subsidiary’s) obligations under the merger agreement. In effect, Sum Total’s contractual right to force the KKR fund to finance the transaction serves as an alternative, extra-judicial means of enforcing its right to specific performance under the agreement.

Sum Total’s right to specific performance will be the subject of our third and final post on the deal protection terms in the KKR-Sum Total merger agreement.

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Fortress Investment Group LLC, one of the first private equity funds to go public, manages private equity funds with more than $17.5 billion in committed capital. The stock was priced at $18.50 on February 8, 2007 but quickly began trading at $31 per share on the first trading day. It has since tracked a steady decline and currently trades at $25 and change.

One of the private equity funds that Fortress manages provides debt and equity funding to other sponsors of private equity transactions. This fund finances small to mid-market transactions, deals with $5 million and more of EBITDA. Fortress provides “one stop financing” for these deals, lending all of the debt needed to finance the transaction and even part of the equity when necessary and attractive. The company likes to see a capital structure consisting of at least 40% of equity before it will finance the other 60%.

At a recent private equity conference, a representative of Fortress admitted that it was getting to be a struggle to find quality deals in the mid-market arena. One-stop financing has become the norm, and the field is seeing a good deal of competition on the lending side from hedge funds, mezzanine lenders and others. Sponsors are looking for and getting friendlier covenant and deal terms in order to maintain control of the company if a downturn in the economy should occur. The absence of good quality deals gives sponsors the ability to drive down interest rates and covenant protections.  At the same time, the amount of debt financing provided to sponsors is at peak multiples.

The pressure to continue putting funds to work is sure to lead to poor credit decisions by lenders.  Whether the gurus at Fortress will also fall to these temptations remains to be seen.

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A private placement is a process, not a source of funding. A private placement simply means that the stock is sold in the private market, and cannot be resold in any public stock markets. As a practical matter, no private placement can occur without a placement agent, underwriter or direct source of capital, such as a venture capitalist. Although a private placement is not itself a source of capital, the phrase has become a shorthand way of referring to capital that is provided by private investors, rather than the public stock market.

Private placements must be structured to comply with State and federal securities laws. These laws, dating back to the 1930s, say that a stock offering must be registered with or approved by a government agency, unless it meets a specific exemption. An offering or sale of the securities that is conducted privately, without a public offering, will generally be exempt, as long as the offering is made only to sophisticated and wealthy investors. The safe harbor most often relied on for private sales of securities is Regulation D adopted by the Securities and Exchange Commission under the Securities Act of 1933. Many States also incorporate the thinking behind Regulation D in their own regulatory scheme.

"Accredited Investors" under Regulation D

Regulation D includes a number of exemptions from registration, depending on the size of the issuer, the number of investors and the manner in which the offering is conducted. One popular exemption under Regulation D allows a company to offer and sell its securities to an unlimited number of "accredited investors” and up to 35 unaccredited investors. Specific classes of information and financial statements must be furnished to unaccredited investors and no general advertising or solicitation is allowed.

An “accredited investor” includes:

• Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer or general partner of a general partner of that issuer.

• Any natural person whose individual net worth, or joint net worth with that person's spouse, at the time of his purchase exceeds $1,000,000.

• Any natural person who had individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.

• Any trust with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase of the securities is directed by a person who has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.

• Any organization that was not formed for the purpose of acquiring the securities being sold, with total assets in excess of $5,000,000.

• Any entity in which all of the equity owners are Accredited Investors.

The scope of State securities laws has been cut back in recent years. Now, a securities offering under Regulation D that is made only to accredited investors is automatically exempt from State securities laws, as long as notice filings are made with the SEC and the State regulators within prescribed time frames.

In practice, most private placements are offered or sold only to accredited investors. A private placement made only to accredited investors has no specific information requirements. For most purposes, there is no limit on the number of accredited investors that can be involved in the offering. The issuer usually prepares and hands out a private placement memorandum that outlines all of the risks of the offering and the material information about the company. Assuming willing investors are found, the private placement mechanism is a popular way to raise equity capital and one that follows a tried and true procedure and legal requirements.

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Companies that have burned through what cash friends and family have been willing to provide, and still can’t get a bank loan, turn to strangers for money. These strangers go by many names, one being “venture capitalists”. 

Venture capitalists provide money when other sources are not available. Most venture capital financing goes to companies in a narrow band of industries:  technology, information services, life science and telecommunications. Because so many start-up ventures fail, venture capital tends to adopt a collective mentality, flocking toward those deals and industries that are perceived to have the greatest chance of a quick and profitable exit.

A common requirement for venture capital is a founder or CEO who has had previous successful experience with venture capital money. Also, venture capital tends to favor companies that are already far along in the development process and need funding to get a product to market.  Finally, venture capital needs to see that projected revenues will accelerate very quickly, like a hockey stick, once product development and launch are complete. New ventures in mature industries with slower growth prospects, no matter the brilliant the business plan, are not a target of venture capital investors.                                  

Once a decision is made to provide venture capital financing, the venture capitalist typically prepares a term sheet for the investment, setting out the principal terms of the transaction. The term sheet is later reflected in formal legal documents. Whatever negotiations transpire between the company and the venture capitalist occur as the term sheet is circulated. 

Venture Capital Term Sheets

The following provisions are typically covered in venture capital term sheets:

1. Fixing the “pre-money” value of the company in order to determine how much equity the new investors will receive. For example, if the company has a pre-money value of $3 million and the venture capitalist provides $1 million of capital, the company will be worth $4 million after the investment, and the venture capital will receive shares equal to 25% of the outstanding stock.

2. Defining the terms of the security the venture capitalist will receive—generally preferred stock. The term sheet will spell out the rights and preferences of the preferred stock, such as dividends (often payable in more shares of preferred stock), liquidation preference, conversion rights (how the preferred stock is converted into common stock), and anti-dilution protection (in case the common stock is split or additional shares of common stock are issued at a price that is less than the conversion price of the preferred stock).

3. Actions that require the consent of the preferred stock voting separately as a class, such as a merger or sale of the company, amending the terms of the preferred and the issuing securities with rights senior to those of the preferred. Generally, the approval of the venture capitalist will be required in order to undertake any significant event.

4. A right to demand that the company file a registration statement with the Securities and Exchange Commission covering the stock so that it can be sold in the public markets. Also, the right to participate in any registration statements filed by the company on behalf of other investors.

5. The right to elect one or more members to the board of directors.

6. Who will serve as CEO and chief technology officer of the company.

7. How much stock management will own, generally through incentive stock options, including lock up provisions prohibiting the sale or transfer of such stock except in connection with a transaction in which all shareholders participate.

8. Rights of first refusal and preemptive rights with respect to new shares offered by the company.

9. The right of the investors to participate in any sale of stock by the original founders of the company.

Venture capital generally comes in stages. Each round of capital is designed to get the company to the next stage of development. As the stages proceed, different venture capitalists may become involved, as the industry has firms that specialize in different stages of development.

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LBO deals are typically done through limited liability companies, while venture capital deals are typically done through corporations. The difference is governed by tax considerations and the expected exit strategy.

Leveraged Buyout (LBO) Deals

In LBO deals, the acquired company is typically generating taxable income—the same taxable income used to repay the debt incurred to buy the company in the first place. In venture capital deals, the company is typically not generating taxable income, as it is spending money on people and technology at least as fast as it is generating revenues. When revenues do catch up, it can shelter the income awhile longer as it burns through the accumulated net operating losses. As a result, LBO deals typically favor a legal structure that minimizes tax liability (such as the limited liability company), while venture capital deals typically don’t care about taxes, and therefore use a taxable corporation.

Venture Capital Deals

Venture capital deals, and other companies that expect to be publicly traded, are typically organized as corporations.  Corporate shares are designed to be liquid and easily traded on national stock exchanges. For this reason, most venture capital deals are made through corporations with multiple classes of preferred stock, each convertible into common shares, as hope springs eternal that the company will one day go public and mint money for the original investors.

At the present time, corporate law is more thoroughly developed than LLC law and is therefore more predictable from a legal standpoint, although this difference is quickly fading away.

Another reason that corporations are favored in venture capital deals is that they better accommodate stock options. It is difficult to grant traditional stock options to key management of an LLC. The tax code does not permit LLCs to issue incentive stock options, which are treated as capital assets rather than ordinary income, and therefore provide a significant advantage in recruiting management. Also, the exercise of the options in the LLC context can raise tricky tax issues, as capital accounts must be rearranged.  

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