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

In debates over public policy, the first battle often involves a contest over narrative. If others adopt your story, you can gain an early advantage by having lawmakers solve the problems you define for them. In this month’s hearings on “Enhancing Oversight of Private Pools of Capital” before the House Financial Services Committee, Douglas Lowenstein, President of the Private Equity Council (PEC), told a familiar tale: Twin brothers, both productive and contributive to the common good, unjustly subjected to different standards. Why should Abel’s gifts be accepted, while Cain’s gifts are rejected? Mr. Lowenstein did not invoke our shared concept of justice, but instead turned to the pragmatist’s supreme value: practicability. In his criticism of Congressman Paul Kanjorski’s (D-PA) draft amendments to the Investment Advisers Act of 1940 (IAA), Mr. Lowenstein claimed the bill’s venture capital exemption may “prove impossible to implement” because private equity and venture capital funds “have virtually the same business model, skill set, and compensation structure.” But how accurate is this statement?         

Private Equity vs. Venture Capital

In his own testimony before the Committee, Terry McGuire of the National Association of Venture Capitalists drew a distinction between venture capital’s investments in young enterprises and private equity’s buyouts of mature companies:

Importantly, the capital supplied to a venture capital fund consists entirely of equity commitments provided as cash from investors in installments on an as-needed basis. Venture capital funds do not use debt to make investments in excess of the partner’s capital commitments or “lever up” the fund in a manner that would expose the fund to losses in excess of the committed capital or that would result in losses to counter parties requiring a rescue infusion from the government.

Venture capital’s “straightforward equity investment,” Mr. McGuire concluded, meant that venture capital “risk is contained and measured,” thereby distinguishing it from the systemic risk Rep. Kanjorski’s draft legislation seeks to monitor.

When describing private equity investments, however, Mr. Lowenstein spoke only of “adding managerial expertise, making capital and R&D expenditures, expanding into new markets and developing new products, and making strategic acquisitions to create the scale required to compete and become market leaders.” Nowhere did he discuss the centrality of restructuring the balance sheet, or leverage recapitalization, to PEC members’ strategy for increasing the rate of return on their investments. On the contrary, most of Mr. Lowenstein’s discussion of private equity practices focused on the limited partnerships at the fund level rather than delving into an explanation of how such funds finance their portfolio company acquisitions. When he touched upon borrowings by portfolio companies, he did so only to note that such loans constituted “a small portion of the overall credit market.” 

In spite of the striking similarity between the PEC’s remarks on October 7 with those delivered to the same Committee on July 17, the PEC tellingly dropped any reference to the 3:1 to 4:1 Debt/Equity ratio carried by private equity fund investments. Back in July, the PEC cited the ratio to compare it to the 32:1 Debt/Equity ratio of failed investment bank Lehman Brothers, a favorable foil, to be sure. Even then, the PEC stressed that Lehman’s parent company carried the debt, thus exposing “the entire bank to collateral calls.” Limited partners in private equity funds, on the other hand, have no such exposure because their organizational documents preclude follow-on equity infusions into existing investments. 

By concentrating on the risks to LPs of any single portfolio company capsizing, the PEC may have lost the forest for the trees. After all, the Obama administration, the Federal Reserve, and Congress have made it clear that the impetus behind regulatory reform is “to monitor and identify emerging risks to financial stability across the entire financial system.” In this context, any assessment of private equity funds must take into account all stakeholders in their portfolio company investments, including banks and bondholders.   

Leveraged Recapitalization (or Restructuring the Balance Sheet)

To begin with, “private equity” is somewhat of a misnomer; a more apt name would be “private levered equity,” a term that would at least acknowledge the critical role of leveraged buyouts (LBOs) in private equity’s investment strategy. Until the credit markets dried up over the last 12 months, equity investments by LBO funds have always been supplemented by a healthy dose of debt financing. Historically, private equity buyouts have been largely funded by acquisition debt, usually comprising senior term and revolving loan facilities paired with a post-acquisition high-yield bond offering, which was occasionally backstopped by mezzanine financing. (In addition to high interest rates, mezzanine loans usually require warrants attached, allowing lenders to roll over into a shareholder’s position upon the occurrence of certain adverse events.) 

What’s the advantage of using relatively small amounts of equity in an investment? Part of the answer may be found in the implications of what is known in modern portfolio theory as the Modigliani-Miller theorem. Nobel Laureates Franco Modigliani and Merton Miller showed that – at least in “perfect capital markets” – the composition of a firm’s securities does not change the total value of a firm’s assets. That is, a firm may divide its cash flows into dividends to shareholders and interest payments to creditors without decreasing the value of its underlying business operations. Without getting into the way in which real-world market imperfections affect the implementation of the Modigliani-Miller theorem, we’ll summarize its influence on the structure of LBOs.    

The expected rate of return on an investment increases in proportion to a company’s Debt/Equity ratio.  (The basic principle is the same as mortgaging the purchase of a house.) In practice, the portion of a portfolio company’s cash flows available for dividend payments to the LBO fund actually is decreased for several reasons. An increased Debt/Equity ratio results in a commensurate increase in the risk that a company will go bankrupt because it fails to make timely interest payments on its debt obligations. For deeply subordinated high-yield debt, for example, some of this risk is borne by bondholders, who accordingly demand higher interest rates, thus siphoning off some of the company’s cash flows that would otherwise go to shareholders. But the cost of servicing debt in turn is reduced by an important provision of the U.S. corporate tax code: interest payments by a company on its debt are tax-deductible (whereas dividend payments are not). So every dollar paid to the company’s senior lenders and bondholders in fact only costs the company a fraction of that amount; the benefits of this tax shield ultimately accrue to the LBO fund that owns the company. (It should be noted that the Wall Street Journal reported this week that a presidential tax-policy panel headed by Paul Volcker is currently examining whether to eliminate the “tax code’s bias toward raising money from tax-deductible debt issues rather than from stock sales.”)

Leveraged Buyouts & the 2006-2007 Credit Bubble

In arguing against the need to disclose information to the SEC, Mr. Lowenstein insisted that “third parties that privately negotiate with PE funds,” including creditors, “are all highly-sophisticated market participants with the leverage to bargain with the fund at the time that the counterparty or creditor relationship is first established.” Yet, the experience of the past four years has demonstrated that even sophisticated lenders are subject to market forces and may sacrifice their negotiating leverage in order to capture fees in a highly competitive environment. As Professors Colin Blaydon and Fred Wainwright of Dartmouth’s Tuck School of Business described the situation in a 2006 article, “The Balance Between Debt and Added Value,” before the credit bubble burst:

Banks and other lenders are aggressively competing with each other for deals to generate fees and interest income in the midst of a relatively low interest rate environment. The result has been a steady expansion of the amount of debt available for leveraged acquisitions and a relaxation of lenders’ terms and conditions. This expansion of debt availability has permitted investors to quickly recapitalize their acquired companies and make large dividend payments to themselves and other equity owners.

In previous posts, we’ve covered the advent of so-called “covenant lite” senior loan agreements (which eliminated or reduced maintenance covenants requiring companies to meet certain financial ratios) and “payment-in-kind,” or PIK notes, to bondholders (which permit a company to issue additional notes to bondholders in lieu of cash interest payments). Declining interest rates over the course of 2006 and 2007 coupled with banks’ eagerness to generate underwriting fees from bond issues enabled private equity funds to generate immediate returns for their investors through financial engineering.

According to a New York Times story on the bankruptcy filing of the Simmons Bedding Company, the company’s private equity owners Thomas H. Lee Partners paid itself and its limited partners a $375 million dividend with the proceeds of post-acquisition debt issuances, allowing it to recover all of its initial equity investment. This sort of recapitalization through additional borrowing serves two purposes: it puts cash directly in the hands of an LBO fund’s LPs and GP and it decreases the fund’s exposure to the portfolio company’s risk profile. Even though portfolio companies generally were able to lock in their debt obligations at low interest rates, these highly leveraged companies were vulnerable to a general economic turndown. Ironically, many of the institutional investors who as limited partners in private equity funds benefited from leverage recapitalization also suffered as portfolio company bondholders when they were only able to recover cents on the dollar, if anything at all.

Private Equity Firms & the Banks

Although senior term and revolver loans for acquisitions are initially funded by a consortium of lead banks, the banks seek to syndicate interests in the loans to other counterparties in an attempt to decrease their risk exposure to any single portfolio company’s financial performance. Similarly, banks underwriting post-acquisition high-yield offerings privately place the bonds with a large number of institutional investors, many of whom later sell interests in these notes to other qualified institutional buyers in the secondary market. A single LBO investment, in other words, has many stakeholders other than the private equity fund itself. 

What happens when the market for LBO senior loan syndication or private placements of high-yield bonds suddenly dries up? Usually, the banks are left holding the debt. Foretelling things to come, Bloomberg reported in July 2007 that “banks have had to dig into their own pockets to finance parts of at least five leveraged buyouts over the past month because of the worst bear market in high-yield debt in more than two years.”   

In late 2006, when private equity funds eyed larger prey, both on their own and in concert with others in “club deals,” banks began to offer buyout firms “equity bridge loans” for the first time since the late 1980s. When banks issued equity bridge loans, they intended them to serve as temporary advances of credit to a private equity fund to facilitate the acquisition of a company. After the deal closed, the banks would then seek to find buyers for the equity stake they had taken in the portfolio company. Although such loans carried a high degree of risk, the competition among banks during the years 2006 and 2007 for the high fees they earned from LBOs provided them with sufficient incentive. After all, according to Dealogic, private equity firms generated 22% of investment banking fees during the period from mid-2006 through mid-2007. In August 2007, BusinessWeek reported that banks were “on the hook for billions of dollars,” although none of the banks would reveal their exposure.

Leveraged Buyouts & Systemic Risk Regulation

As far back as May 2007, Federal Reserve Chairman Ben Bernanke warned that the LBO model resulted in banks’ sharing a significant amount of risk in private equity investments:

There are some significant risks associated with the financing of private equity including bridge loans. ... We are looking at that….. I urge banks to closely evaluate the risk that they’re taking not only in the context of a highly liquid, benign financial environment, but in one that might conceivably be less liquid and benign.

As Chairman Bernanke recognized over two years ago, the institutional investors constituting private equity funds’ limited partners are not the only stakeholders in LBOs. 

None of this should be misconstrued as a call to arms for the regulation of all private equity funds. But unless Congress takes into account the nature of private equity’s leveraged buyouts – especially ones conducted by billion-dollar mega funds like those managed by the PEC’s members – regulatory reform will most likely fail.      

In closing, it’s worth reading the Wall Street Journal’s coverage of Terry McGuire’s interview with founder and chairman of global private equity firm Advent International, Peter Brooke: 

The people that over-leveraged their companies, the people that did these dividend recapitalizations and the things of that nature, have done no one any good…We have to face the fact that there is going to be some form of restrictive legislation on private equity managers…The bad guys deserve it, the good guys don’t deserve it, but I’ll tell you, they’re all tarred with the same brush.

 Related Post: House Hearing on Private Equity and Venture Capital Regulation - Part 1: The Private Equity Council

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Everybody likes a fight. So it came as no surprise that the media dredged up some hackneyed headlines to describe the House Financial Services Committee’s hearings on regulating hedge funds, venture capital, and private equity earlier this month. Whether they dodged bullets at a “Showdown at the VC Corral” or witnessed bloodlust as “PE lobbyists throw VCs under the bus,” journalists let us know that – surprise! – the private equity community trashed the venture capital exemption in Congressman Paul Kanjorski’s (D-PA) draft bill on amendments to the Investment Advisers Act of 1940 (IAA). Even so, it was somewhat disappointing that nobody offered any details about the testimony of Douglas Lowenstein of the Private Equity Council (PEC). True, details don’t always make for compelling news copy, but the PEC’s testimony seems to warrant a second look. Part 1 of this post first asks the questions: “On behalf of whom does the PEC speak?” and “What weight should Congress give to their opinions?” We then review some of the PEC’s specific complaints about Rep. Kanjorski’s draft bill. In Part 2, we’ll analyze the PEC’s arguments for eliminating the bill’s venture capital exemption, especially its facile equation of private equity acquisitions with venture capital financing.    

How Representative is the Private Equity Council?

What is the Private Equity Council? It’s a D.C.-based trade group formed in February 2007 to lobby public policy makers on behalf of some of the largest private equity firms in the U.S., including Blackstone, KKR, Carlyle, Bain, Apollo, Apax, and Madison Dearborn, each of which has over $10 billion in assets under management. By its own admission, the PEC represents only a dozen large private equity firms, even though it estimates that there are over 2,000 private equity firms based in the U.S. By comparison, the National Venture Capital Association (NVCA) has over 450 members, more than half of the approximately 740 U.S. venture capital companies, representing more than 90% of the venture capital industry’s assets under management. The PEC’s presence at the Committee’s hearing on “Enhancing Oversight of Private Pools of Capital” probably speaks more to its members’ influence on Wall Street and K Street than it does to its suitability as an advocate for the private equity industry as a whole. 

To be sure, the PEC’s members will be among those most affected by any regulation of alternative investment vehicles and consequently deserve to have their voices heard by Congressional lawmakers. They are also most likely to be scrutinized by any governmental body charged with the duties of a “systemic risk regulator.” At the same time, the Committee should not take the opinions of Mr. Lowenstein on Rep. Kanjorski’s bill as representative of the some 1,900 other private equity firms, who apparently don’t merit a seat at the bargaining table. It should be borne in mind that some of the PEC’s members either already are, or soon will be, subject to SEC registration and reporting requirements. The Blackstone Group LP (BX) currently trades on the New York Stock Exchange (NYSE), while KKR’s recently completed reverse merger with its Euronext Amsterdam-listed affiliate KKR Private Equity Investors positions it for a planned NYSE listing in the spring of 2010. Meanwhile, the PEC’s other members tend to target acquisitions of relatively mature companies, many of whose securities are publicly traded. In the process of taking such companies private, private equity funds must comply with various SEC requirements, including the Securities Exchange Act’s Rule 13e-3 “going private” disclosures for affiliates of equity issuers, the Williams Act’s regulations governing tender offers, Regulation 13D filings on beneficial ownership, and Section 16’s insider trading rules.

In his prepared testimony, Mr. Lowenstein tacitly acknowledged that many of the investment and fundraising activities of the PEC’s members already fall within the purview of governmental authorities. He seemed resigned that more stringent regulation was inevitable when he gave his lukewarm endorsement: “we are generally supportive of requiring registration of advisers to private pools of capital.” As expected, Mr. Lowenstein’s criticisms of specific provisions in the Kanjorski bill relate the objections of the PEC’s members. It would be foolish to ignore the obvious fact that small- to midsized private equity firms have no trade association that the Committee could have summoned to the Hill. Aside from these firms’ limited resources, the “lone wolf” investment style of private equity firms discourages the formation of a nationwide trade association. After all, the PEC itself was formed only after its members began to club together in mega deals for large corporations. But it would be even more foolish for Congress to disregard how the Kanjorski bills regulatory reforms will impact the vast majority of private equity firms.         

Big Private Equity’s Need for a Competitive Advantage

A close reading of Mr. Lowenstein’s October 6 testimony before the Committee indicates that the PEC’s members are most concerned with the prospect that the draft legislation’s “broad disclosures to third parties” would put its constituents at a “serious competitive disadvantage.” By contrast, the testimony of Terry McGuire of the NVCA focused on how the onerous regulatory burdens of the IAA would interfere with venture capital firms’ ability to “start and grow new companies.” Mr. McGuire pointed out that even relatively large venture capital firms – such as his own Polaris Venture Partners – run on skeleton crews ill-equipped to shoulder heavy administrative burdens. Compliance with the requirements imposed on IAA registered advisers would not only hamper the investment activities of big VC firms, but venture capital firms of all types and sizes.   

Mr. Lowenstein took particular issue with Section 204(b)(7) of the discussion draft, which would grant the SEC broad rulemaking authority to require IAA registrants to provide reports, records, and other information to “investors, prospective investors, counterparties, and creditors” of private funds. For private equity firms to comply with these requirements, Mr. Lowenstein contended, “is potentially destructive of normal commercial relationships and could expose proprietary information and trade secrets to those with whom we compete.” The PEC’s members appear to fear a scenario in which they are compelled by the SEC to disclose certain information to one of their senior lenders, such as JPMorgan or Goldman Sachs, which could then pass on such information to the banks’ respective private equity affiliates, like JPMorgan Partners or Goldman Sachs Private Equity Group. Averring that keeping such information confidential is crucial to retaining a private equity fund’s competitive advantage, Mr. Lowenstein exhorted the Committee to eliminate the provision from any final legislation. Such concerns more likely represent those of the PEC’s membership than of the typical private equity fund, which is unlikely to be able to convince banking behemoths like JPMorgan or Goldman Sachs to provide debt financing on a $50-$150 million leveraged buyout of a midmarket company. 

Moreover, for reasons we’ll explore in more detail in Part 2, Mr. Lowenstein’s argument that creditors and investors that negotiate with private equity funds “are all highly-sophisticated market participants with the leverage to bargain with the fund at the time that the . . . relationship is first established” rings hollow. Does anyone who witnessed the lending frenzy of 2006 – 2007 honestly believe that banks in such a competitive landscape would “simply refuse to lend to the fund if the lender is not satisfied that it has received sufficient upfront information about that fund and its investments?”

Assets under Management Threshold

It’s true that elsewhere in his testimony Mr. Lowenstein championed the concept of “calibrated reporting requirements for different types of funds,” an argument that on its face promotes the interests of smaller private equity funds. A good argument could – and should – be made that the IAA’s $30 million threshold is too low for advisers to private funds, many of whose deals, whether structured as leveraged buyouts or pure equity buyouts, could not arguably pose a systemic risk to the financial system. But even here, where Mr. Lowenstein appears to stand up for most private equity firms, he subsequently undermines this position by demanding that “the language [of the bill] base calibration not just on the type and size of the fund, but on their potential to cause systemic risk.” The problem with this argument is that nowhere does Mr. Lowenstein propose another way for Congress to devise a metric for determining systemic risk.   

Once again, this proposition only serves the interests of the PEC’s members. As Part 2 will show, Mr. Lowenstein’s insistence that the size and type of fund bears no relation to whether or not its investment activities pose a systemic risk relies on his attempt to equate venture capital financing with private equity LBOs. According to the PEC, the two are merely different species of the same genus. But the history of large LBOs over the past three years tells another story. Remember, as recently as this past April French banks seriously considered quarantining their LBO debt in a “bad bank” lest their liabilities metastasize.   

Related Post: House Hearing on Private Equity and Venture Capital Regulation - Part 2: Leveraged Buyouts

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At the end of last week, the House Financial Services Committee focused on regulatory reform measures designed to mitigate systemic risk to the financial system and to regulate hedge funds and private equity. Federal Reserve Chairman Ben Bernanke offered his advice on what steps Congress should take to reform U.S. financial regulation. Congressman Paul Kanjorski introduced draft legislation that would require all private equity and hedge funds that manage assets in excess of $30 million to register with the Securities Exchange Commission, but would exempt venture capital funds from SEC registration. This week, the Committee expects to be just as busy. Tomorrow, October 6, the Financial Services Committee plans to hear testimony from representatives of the venture capital, hedge fund, and private equity industries. In today’s post, we’ll summarize Mr. Bernanke’s recommendations for managing systemic risk, dissect Rep. Kanjorski’s draft bill, and provide you a brief preview of tomorrow’s hearing.

Bernanke’s Testimony on the Oversight of Systemic Risk

The Chairman of the Federal Reserve, Ben Bernanke, journeyed to Capitol Hill last Thursday to offer the House Financial Services Committee his perspective on proposed financial regulatory reforms. Like Treasury Secretary Timothy Geithner, who appeared before the same Committee back in March, Mr. Bernanke emphasized the current regime’s deficiencies in managing systemic risks to U.S. financial markets. Single agencies may be well suited to oversee a single firm or financial sector, Mr. Bernanke pointed out, but have neither the resources nor the expertise to oversee divers types of market players, let alone to anticipate the ways in which their dealings with one another may threaten the financial system as a whole. 

As a remedy to this regulatory malady, Mr. Bernanke highlighted two areas for reform. First, he advised Congress to establish an “oversight council” empowered “to monitor and identify emerging risks to financial stability across the entire financial system, to identify regulatory gaps, and to coordinate the agencies’ response to potential systemic risks.” As conceived by Mr. Bernanke, the oversight council would comprise representatives from governmental agencies tasked with supervising the financial sector. In order to fulfill its mandate, the oversight council would need to have access to a wide range of information from various agencies regarding the institutions and markets they supervise as well as the authority to collect information on its own.

Second, Mr. Bernanke recommended the “reorientation of individual agency mandates to include . . . the responsibility to try to identify and respond to the risks” posed by the firms and markets within each agency’s purview. While Mr. Bernanke acknowledged that each agency individually could take on this challenge, he suggested that they would be aided or advised by the oversight council as well. Although individual agencies could adapt their responses to systemic threats arising in the areas over which they have authority, Mr. Bernanke considered it probable that many systemic risks would cross traditional regulatory boundaries. In such situations, the oversight council would be best positioned to intervene. 

Mr. Bernanke’s proposed “oversight council” fleshed out the bare bones of Mr. Geithner’s “systemic risk regulator.” The Board of the Federal Reserve, it appears, lined up behind President Obama’s prescriptions for regulatory reform. It therefore was not surprising when Congressman Paul Kanjorski (D-PA), Chairman of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises released draft legislation mirroring a model bill issued by the Obama administration in July. 

Private Fund Investment Advisers Registration Act of 2009

Late in the day on October 1, Rep. Kanjorski circulated a “discussion draft” of the Private Fund Investment Advisers Registration Act of 2009, which would eliminate the Investment Advisers Act of 1940's “private fund adviser” exemption. Under the draft bill, all hedge funds and private equity funds with assets under management in excess of $30 million would be required to register with the SEC. The text of the bill introduces a definition of the term “private fund” into the Advisers Act. In its proposed formulation, a private fund would mean an investment fund that would qualify as an investment company under the Investment Company Act of 1940 were it not for the exceptions provided by §3(c)(1) or §3(c)(7) of the Company Act and that either (i) is organized under the laws of the United States or (ii) has 10% or more of its outstanding securities by value owned by United States persons. Under the Company Act, Section 3(c)(1) excludes funds beneficially owned by 100 persons or less and Section 3(c)(7) excludes funds whose securities are owned by certain “qualified purchasers” from the definition of an investment fund.  

The proposed bill would also eliminate the “private fund adviser” exemption under §203(b) of the Advisers Act, which presently is available to any adviser that has fewer than 15 clients and does not generally hold itself out to the public as an investment adviser. As we explained in an earlier post, the SEC historically has interpreted the term “client” in §203(b)(3) to refer to the limited partnerships advised by hedge fund managers and private equity firms rather than to the investors constituting their limited partners. Rep. Kanjorski’s draft legislation vests the SEC with broad rulemaking authority, including the power to change the definition of the term “client” under the Advisers Act. This provision pointedly overturns the 2006 ruling by the D.C. Circuit Court of Appeals in Phillip Goldstein v. SEC that vacated the SEC’s “Hedge Fund Rule,” which allowed the agency to “look through” a limited partnership’s legal structure to count each limited partner as a client.  

The Private Fund Investment Advisers Registration Act would require all SEC-registered hedge fund managers and private equity firms to maintain records or file reports disclosing:

• the amount of assets under management;
• the use of leverage (including off-balance sheet leverage);
• counterparty credit risk exposures;
• trading and investment positions;
• trading practices; and
• such other information as the SEC (in consultation with the Federal Reserve) determines necessary or appropriate for the assessment of systemic risk.

The draft bill also empowers the SEC to share information about hedge funds and private equity firms with either the Federal Reserve or any other government agency tasked with monitoring systemic risk to the financial system. 

Rep. Kanjorski’s proposed legislation exempts advisers to venture capital funds from registering with the SEC. In its current draft, the bill vests the power to identify and define the term “venture capital fund” with the Commission. This exemption has been heralded by many as a victory for the venture capital community, which has contended that its investments do not pose any viable threat to the financial system. Prior to the release of Rep. Kanjorski’s draft legislation, Barney Frank (D-MA), Chairman of the House Financial Services Committee, explained: “We are supportive of the role of venture capital, we are working in consultation with venture capital, and I don’t think there will be anything in there for venture-capital firms.” 

Aside from the discussion draft’s close tracking of the Treasury Department’s own proposal for the regulation of hedge funds and private equity, the House Financial Services Committee’s alignment with the Obama Administration on this issue is perhaps best exemplified by Rep. Kanjorski’s adoption of one of Mr. Geithner’s favorite metaphors for hedge funds and private equity firms. In his press release accompanying the distribution of the bill, Rep. Kanjorski observed: “[W]e need to ensure that everyone who swims in our capital markets has an annual pool pass.”

Capital Markets Regulatory Reform Hearing

Last Wednesday, representatives of the hedge fund industry’s main lobbying group, the Managed Funds Association, met with Mr. Geithner, Mr. Bernanke, and Mary L. Schapiro, chairwoman of the SEC, to voice their opinions on President Obama’s plans for overhauling the financial regulatory system. We expect to hear more from representatives of the hedge fund and private equity community at tomorrow’s Financial Services Committee’s hearing on “Capital Markets Regulatory Reform.” The following individuals are scheduled to testify before the full committee:

• The Honorable Richard H. Baker, President, Managed Funds Association
• Mr. Douglas Lowenstein, President, Private Equity Council
• Mr. James S. Chanos, Chairman, Coalition of Private Investment Companies
• Mr. Terry McGuire, Co-Founder and General Partner, Polaris Venture Partners, and Chairman, National Venture Capital Association

You can watch a live webcast of the hearing on the House Financial Services Committee’s website.

Hedge Fund and Private Equity Regulation Series

For other posts in our series on U.S. regulatory proposals for private equity and hedge funds, see:

Regulation of Private Funds: Senator Reed and the Congressional Hearings

• Senator Jack Reed's (D-RI) bill, the Private Fund Transparency Act of 2009 (S.1276), was referred to the Senate Committee on Banking, Housing, and Urban Affairs on June 16, 2009.

Geithner Calls for a Lifeguard to Monitor “Private Pools of Capital”

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As we previously noted, the ILPA (International Limited Partners Association) recently published a wide-ranging set of “best practices” that it hopes will shape the practices of the private equity sponsor community. In this piece, we’d like to focus on ILPA’s recommended changes to the fiduciary duty provisions of investment partnership agreements. First, we’ll summarize ILPA’s wish list in the area of fiduciary duties. Then, we’ll examine the investor documents of a well-known sponsor (KKR) to see how far apart current practice is from ILPA's wish list.

First, a little background. A fiduciary duty is a relationship of confidence or trust between two parties. A fiduciary must be loyal to the person to whom he owes the duty. He must not put his personal interests before that duty, and must not profit from his position as a fiduciary, unless the principal consents. Under common law rules, the general partner of an investment partnership owes a fiduciary duty to the limited partners. 

In Delaware, where most investment partnerships are formed, the fiduciary duty include an obligation to act in good faith and with due care and loyalty. The duty of care requires a general partner to act for the partnership in the same manner as a prudent person would act on his own behalf.  The duty of loyalty prohibits a general partner from taking any action or engaging in any transaction that is not in the best interests of the partnership where a conflict of interest is present. However, Delaware law also says say that these duties can be “restricted or eliminated” in the partnership agreement. Most sponsors take advantage of the opportunity to both restrict and eliminate fiduciary duties.

ILPA hopes to push back against the erosion of fiduciary duties and “reinforce” the fiduciary duties of the sponsor community. Specifically, it wants to delete:

• Provisions that reduce fiduciary duties “to the fullest extent allowed by law”.
• Provisions that allow general partner to use its sole discretion and weigh its own self-interest against the interest of the fund.
• Provisions where limited partners waive broad categories of conflicts or affiliated transactions.
• Provisions that allow general partner and its affiliates to be exculpated or indemnified for conduct constituting a material breach of the partnership agreement, breach of fiduciary duties, or other “for cause” events.

So, how far back do LPs have to push on fiduciary duties? To answer that, we looked at the prospectus filed by KKR & Co. LP last year when it tried to go public. The prospectus summarizes the lengths to which KKR has gone to restrict or eliminate any fiduciary duty to investors. In short, KKR has fully eliminated the core fiduciary obligation to put the interests of investors ahead of its own interests, and to act solely in the best interests of investors where a conflict is present. In making any discretionary decision, the KKR general partner is allowed to take into account whatever factors it wishes, including its own interests, and does not have any duty or obligation to consider any factors affecting investors.

Moreover, the KKR general partner cannot be liable to investors for any act unless there has been a final and non-appealable judgment by a court determining that it has acted in bad faith or engaged in fraud or willful misconduct. That's a pretty high hurdle.

As the prospectus itself informs us, in language only a lawyer could love: “These modifications are detrimental to our unitholders because they restrict the remedies available to our unitholders for actions that without those limitations might constitute breaches of duty, including a fiduciary duty, and they permit our Managing Partner to take into account the interests of third parties in addition to our interests when resolving conflicts of interest.”

It looks like ILPA and its members have a ways to go.

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Waterfall Structure

• The LP’s capital contribution plus preferred return should be paid first, before any distributions are made to the GP’s carried interest
• Establish GP carry escrow accounts with reserves of 30% or more to cover potential claw back liabilities
• Carry on recapitalizations should be paid only when the full amount of LP capital is returned on the recapitalized investment

Calculation of Carried Interest

• Carried interest should be calculated on net profits, not gross profits
• Carry should not be paid on current income
• Carried interest should be calculated only on an after-tax basis

Claw back

•  Claw back liabilities should be determined and reported periodically
•  Claw back liabilities should be paid within 2 years and should be gross of taxes paid
•  Effective joint and several claw backs should be implemented to make sure that full claw back liabilities are met

Management Fee Structure

• Management fees should be based on reasonable operating expenses and reasonable salaries, so that fees are not excessive.
• Management fees should reduce upon formation of follow-on fund and at the end of the investment period
• The management fee should be used to pay all normal operating costs of the GP, including interactions with the LPs. The LPs should have the power to review the partnership expenses annually
• Placement agent fees should be paid by the GP
• All transaction, monitoring, directory, advisory and exit fees should accrue 100% to the benefit of the fund.     

The Principles also include detailed suggested changes to the fiduciary duty requirements of the GP. For example, provisions of fund documents that disclaim or reduce fiduciary duties should be eliminated.  We will discuss these recommendations in more detail in a later post.

The Association is currently gathering formal endorsement of the Principles from its members and promises to publish a list of the endorsing institutions on its website.

How will the Principles be received by the sponsor community? That awaits to be seen. Institutional investors would love to establish a set of best practices across the sponsor community in order to make their investments in the asset class more uniform, and more favorable. They would like to reign in the variations in how sponsors define and enforce rules governing distributions, claw backs, and fees.  The sponsors will certainly resist any uniform treatment, and look for advantages at the margins, whether in the area of distributions or discretion in the application of fees.  Assuming a large number of institutional investors formally endorse the Principles, it may become difficult, if not impossible, for the GP community to ignore the recommendations.  The LP community has taken to heart the motto: United We Stand, Divided We Fall.         

Related Post:  Increased Capital Calls and Diminished Distributions for Private Equity LPs

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We recently discussed the FDIC's adoption of a final policy statement governing private equity investments in failed banks.  As we and other commentators have noted, the final policy continues to put private equity investors at a disadvantage when compared to strategic investors such as existing regulated bank institutions.  Most importantly, the policy imposes a substantially higher capital requirement for private equity firms (10% of Tier 1 capital vs. 5%) which must be maintained for at least 3 years.

The final policy statement reflects the FDIC's earnest desire not to turn over bank deposits -- that amazing funding source guaranteed by the full faith and credit of the United States -- to unschooled and possibly unscrupulous owners.  That mistake was made during the last banking crisis, and one thing that people in large bureaucracies learn well is not to repeat the mistakes of the recent past.  Accordingly, the FDIC must do what it can to ensure that the private capital which comes to the rescue of failed banks is provided this time by firms and management teams that respect the sanctity of bank deposits, and the FDIC's guarantee.

The policy statement is just that -- a statement of policy.  In many important areas, there are no detailed regulations, defined terms, or clear rules to guide deal making.  Sooner or later, any private equity firm looking at purchasing a troubled bank must contact the FDIC to get its opinion on the meaning of key provisions of the policy.  One may justly conclude that this is exactly what the FDIC wants to have happen.  By compelling firms to get critical interpretive clearance on key deal terms, the FDIC has the ability to screen firms and their management teams and sift the wheat from the chaff, so to speak.

The final policy statement is an important road map for well-regarded and experienced private equity firms to invest in troubled banks.  Other players, without deep experience and respected management teams to run the banks, may as well sit out this round.  Of course, things can change.  The crisis may escalate and the need for fresh capital may become acute.  Also, given the large number of troubled banks on the horizon, there may be opportunities to purchase the assets of institutions that must be liquidated because they fail to find buyers deemed worthy by the FDIC.

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The FDIC made some compromises, but will continue to hold private investors in failed banks to a higher standard than strategic buyers. The FDIC’s board approved a final policy on private equity investment in troubled financial institutions by a 4-1 vote; Director John Bowman stood alone in opposition to the measure. Even so, the FDIC expressed a commitment to review the policy in six months. The chair of the FDIC Board, Sheila Bair, said that the 61 private comment letters “gave us a lot to think about.” In today’s post, we’ll summarize public comments and the final rules for the policy’s capitalization, source of strength, and cross guarantee requirements.

Capitalization.   The majority of comments opposed the FDIC’s proposed rule that private equity investors maintain a 15% Tier 1 leverage ratio in failed banks. Some pointed out – as we did over a month ago – that the suggested ratio was three times that currently imposed on healthy banks. The heightened capitalization requirements, many argued, would place private equity investors at a competitive disadvantage to strategic buyers. Others predicted that private equity firms would be less likely to invest in failed banks and more likely to offer less competitive bids to the FDIC.       

Final Rule. Banks owned by private equity investors are required to maintain a 10% Tier 1 leverage ratio for the first three years. The FDIC reserves the right, however, to impose a higher leverage ratio on a particular investor if it determines that the situation warrants special treatment. After three years, private equity-owned banks must remain “well capitalized” (or maintain certain financial ratios specified in FDIC regulations). The FDIC justified the increased capital requirements as a necessary protection against the “higher risk profile” of private investments in troubled financial institutions.

Source of Strength. The controversial source of strength requirement would have required private equity funds to infuse ailing banks with additional capital. Comment letters overwhelmingly objected to this rule, claiming it could create unlimited liability for private investors. Even more to the point, a number of commentators observed that the rule would bar private equity firms from investing in failed banks altogether. By the terms of their organizational documents, private equity funds are prohibited from providing capital support to or making subsequent investments in their portfolio companies. 

Final Rule. It’s gone. The FDIC deleted the source of strength provision, noting that it would not be possible for private equity firms “as a practical matter.” (It’s not clear why the FDIC did not take practical matters into account when drafting its initial proposal.)    

Cross Guarantee. Commentators complained that the cross-guarantee requirement would place the other investments of private equity investors at risk. They emphasized that different funds – even those managed by the same private equity firm – have different investors and accordingly should be treated separately. Several commentators claimed the rule would impede a private equity manager from investing in two different banks through two different funds with two distinct groups of investors. As we wrote earlier, the rule would also inhibit club deals in failed banks.   

Final Rule. The FDIC raised the threshold for the cross guarantee rule to apply. Under the revised rule, if investors own 80% or more of two or more banks, the stock of the banks commonly owned by those investors must be pledged to the FDIC. If one of the banks fails, the FDIC may exercise its pledge to the extent necessary to recoup any losses it incurs. 

It looks like the FDIC will have a lot of inventory on hand in the coming months. Every week we witness more and more bank failures. The forecast doesn’t bode well either. According to the Financial Times, Dick Bove of Rochdale Securities predicts that another 150-200 banks will likely fail in the next several months. So far, the FDIC has not been able to get rid of all of the failed banks already on its books.  The New York Times reported that of the 77 banks that have failed this year, the FDIC has found buyers for only 69 of them.

We suspect the FDIC hasn’t gone far enough to make investments in failed banks attractive to private equity firms. If banks continue to fail, the FDIC will most likely have no choice but to open the market to as many potential buyers as possible. In six months’ time, it wouldn’t be surprising if we see the FDIC Board revisiting these issues once again.

Related Posts: 

Revised FDIC Policy Clears Way for Experienced PE Firms

Flawed FDIC Guidelines May Block Funding for Failed Banks

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When shopping for law firms, private equity firms may head straight to Tesco. Tesco, one of Britain’s grocery retail giants, has become synonymous with one-stop shopping. Known for its bargains, the ubiquity of its stores, and its relentless advertising campaigns, Tesco seems to have little in common with private equity or law firms. Now, thanks to the British tabloids’ obsession with catchy headlines, “Tesco Law” stands for a set of new regulations that will allow law firms to issue shares to non-lawyer investors, merge with companies, and list shares on the London Stock Exchange.   Though these new rules don’t become effective until 2011, Bloomberg reports that several private equity firms have already scouted the market by holding quiet talks with law firms.   

Reform of the Legal Profession

The Legal Services Act of 2007 sets the stage for the legal profession in England and Wales to become arguably the most liberal in the world. According to the Ministry of Justice, the government designed the reforms to “encourage more effective competition and [to allow firms] to provide a range of legal services to consumers, increasing access to justice.” The government began rolling out the reforms this past March. By forming “legal disciplinary practices” under the Legal Services Act, law firms can be owned by different types of lawyers and can sell up to a 25% stake to non-lawyers. The only requirement is that the firm continue to limit its business to providing legal services. In the next stage, expected to be implemented in 2011, firms will be allowed to reorganize as alternative business structures, providing them even greater flexibility in raising capital. Once reorganized, law firms will be able to offer shares in their firms to non-lawyers, merge their firms with companies that offer other services, and list their shares on the London Stock Exchange.   

So far, according to The Law Society’s Gazette, the legal disciplinary practice option has not attracted many keen investors. But private equity firms don’t seem to have cold feet merely because others have been afraid to dip their toes in the water. Bloomberg reports that small and mid-sized private equity funds may be willing to invest millions of pounds in law firms. Fleming Family & Partners Ltd., Phoenix Equity Partners Ltd. and Lyceum Capital Partners LLP are all said to be considering investments. In interviews with Bloomberg, representatives from private equity firms indicated that they are also evaluating investments in other legal service providers.        

Non-lawyer Investors and the Future of the Legal Profession

From initial news reports, it appears that the Legal Services Act will have the greatest influence on mid-sized firms. Law firms that historically have been limited by liquidity constraints will be able to raise capital through equity offerings. With more money on hand to expand their services, entrepreneurial mid-sized firms may acquire greater market shares. As of now, the UK’s prestigious “Magic Circle” firms scoffed at the idea of allowing non-lawyers into the fold, but they may have to reassess their stance once a radically new legal regime has altered the competitive landscape.  

It’s tempting to see the changes in England and Wales in the light of whispers about possible changes to the legal profession in India. Currently, foreign lawyers cannot practice in India and foreign law firms cannot open offices there either. Undeterred by resistance, British law firms have been pressing the Indian government for changes to India’s protectionist policies. If India were to loosen restrictions on the practice of law by foreigners, we could witness a Copernican turn in the management of law firms. Companies already outsource routine legal tasks, such as prior art searches in patent applications, to captive or third-party legal process outsourcing companies. Non-lawyer investors in British law firms would be less likely to heed traditional conceptions about the legal profession. It may take a non-lawyer to recognize and take advantage of the cost benefits achievable through vertical integration in the legal industry by consolidating traditional law firms with other legal services providers, including outsourcing companies.     

What about the chances of a successful law firm IPO? Unfortunately, the May 2007 initial public offering of Australian class action law firm Slater & Gordon is the only case study we have of a law firm’s stock listing. Slater & Gordon’s stock has declined by around 33% from its high price in September 2007. Yet, Deloitte & Touche notes that Slater & Gordon’s stock price has tracked the overall market and concludes the correlation suggests that the market values law firms just as any other business.

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Before you let your team of due diligence advisers loose in the data room, it’s crucial to reach an agreement about each adviser’s role and responsibilities. Accountants, banks, and other M&A advisers recognize their success depends on their ability to deliver reliable, incisive analysis of a target’s business operations and future prospects. On the other hand, advisers also have an interest in limiting their liability for the advice they give to their clients. When negotiating engagement letters for M&A due diligence services, private equity firms and other buyers should pay careful attention to provisions that restrict their right to seek compensation for losses brought on by bad advice. In today’s post, we review several customary ways in which advisers try to decrease their risk exposure in engagements for M&A due diligence.       

Scope of the Engagement

An M&A adviser will often try to limit its liability by narrowly defining its area of expertise. To some extent this makes sense. Understandably, accountants don’t want to be held liable for having given legal advice, even if their financial review may have legal consequences, such as a modification to the deal’s structure. But private equity firms should ensure that the scope of the adviser’s engagement is not so narrowly construed that it effectively eliminates the firm’s recourse against the adviser. In M&A transactions, this issue is usually resolved by limiting the scope of the adviser’s liability to the contents of a final due diligence report. Anchoring the adviser’s liability to a specific, written deliverable eliminates ambiguity about which statements the private equity firm may rely upon. 

In practice, an adviser issues preliminary drafts of its reports to the firm and other advisers at periodic intervals throughout the due diligence process. The private equity firm, after all, wants to know immediately about any previously unknown risks or “deal killers.” An effective due diligence program helps the firm understand a potential target’s strengths and weaknesses and identify issues that need to be addressed in negotiations with the seller. Periodic due diligence updates enable private equity firms to keep abreast of what its advisers have learned about the target in real time. Without receiving some comfort in the engagement letter that they will only be liable for their final deliverables, M&A advisers may not be as willing to provide potential buyers with provisional reports.

Limitations on Liability

Engagement letters contain a number of provisions that specify the circumstances under which advisers may be taken to court and restrict the amount for which they may be sued. In New York, a court will not infer that an adviser’s liability has been limited unless clearly and unambiguously expressed in the engagement letter. Except for certain exclusions held to be against public policy, however, New York courts will uphold liability limitations in contracts between sophisticated commercial parties.       

There are several mechanisms an M&A adviser may use to limit its liability:

Causation Requirement. Advisers often seek to restrict their liability to losses that are “finally judicially determined to have resulted primarily from” a misstatement or omission. The purpose of this clause is to fix the adviser’s liability to losses directly attributable to errors in its final report. Unfortunately, the phrase “resulted primarily” has no settled sense and raises the specter of Jarndyce and Jarndyce in future litigation. A better drafting choice for a potential buyer is to make the adviser liable for all losses “directly arising from or related to” the firm’s reliance on the adviser’s final due diligence report.  

Restriction on Damages. Engagement letters generally exclude liability for any “indirect or consequential damages.” Consequential damages are losses that do not arise directly or immediately from a contractual breach, but indirectly result from the breach. They can include such claims as loss of revenue and may be recovered if a court concludes that the indirect losses were foreseeable. This provision is often heavily negotiated. Private equity firms argue it’s foreseeable that they may suffer indirect damages as a result of misstatements or omissions in an adviser’s report. Advisers in turn contend that the ultimate investment decision lies with the firm and their risk in the engagement should be commensurate with their fees. In the end, these discussions become relatively less important compared with negotiations over the adviser’s liability cap.   

Cap on Liability. One of the most important provisions in an engagement letter deals with the amount for which an adviser may be held liable. Advisers will typically seek to put a ceiling on their exposure by capping their liability at a fixed amount, at the amount of fees they receive under the engagement, or at some multiple of their fees. The amount of an adviser’s liability cap ultimately turns on a number of deal-specific factors, including the deal’s size and complexity, the importance of an adviser’s findings in the negotiation of essential deal terms, such as price, and the adviser’s transaction fee.        

Definition of Misconduct. The adviser will generally include a provision stating that it will only be liable for losses resulting from its “gross negligence or willful misconduct.” In New York, courts have described gross negligence as acts or omissions that exhibit a reckless indifference to the rights of others or “smack of intentional wrongdoing.” Though not precisely defined by the courts, gross negligence can be thought of as unintentional acts so careless that they ignore the rights of others or appear as though they were intentionally designed to do so. Willful misconduct occurs when a person commits an intentional act with knowledge that the act is likely to result in injury or damage or otherwise exhibits a reckless disregard for its consequences. Advisers’ acceptance of liability for gross negligence and willful misconduct comports with New York common law. New York courts have refused to enforce contractual provisions precluding liability for willful misconduct or grossly negligent acts, finding them to be against public policy.   

Related Posts:   Reviewing a Confidentiality Agreement: What a Potential Buyer Wants

                          Growing the Company through Strategic Acquisitions

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Are earnouts in today’s M&A market still primarily serving to bridge the valuation gap between buyers and sellers? Or do we need a different explanation for the prevalence of earnouts in recent, large M&A deals? Buyers and sellers are negotiating in what is arguably the most uncertain economic climate of the past decade. Whereas in the past, the caricature of a cautious, risk averse buyer bargaining with an optimistic seller may have served as a useful – if crude – illustration of the buyer-seller valuation gap, it’s unlikely there are many Panglossian sellers out in today’s market. What is more, the idea that the valuation gap arises from a buyer’s superior knowledge about market and industry conditions doesn’t seem as plausible when applied to large deals between sophisticated players. 

Earnouts have been a common term in acquisition agreements for high-growth businesses and small companies. By making part of the purchase price contingent on a target’s ability to meet future earnings targets or reach designated milestones, a buyer can reduce its exposure to the risk that the target doesn’t fulfill the seller’s rosy predictions. At the same time, a buyer can promise to reward the seller if the target’s post-sale performance equals the seller's projections of its pre-sale prospects. An earnout, the theory goes, enables wary buyers and eager sellers to bridge the gap between their respective valuations of the target’s future profitability. 

What accounts for this disparity in valuations? Professor Brian Quinn quotes the abstract of a recent paper by Roberto Ragozzino and Jeffrey Reuer concluding that the use of earnouts “increases with information asymmetries surrounding mergers and acquisitions.” In their article, the authors argue that earnouts appear more often in acquisitions where the target is a new company or for other reasons doesn’t have access to the buyer’s superior market and industry knowledge. For acquisitions of small, private companies by buyout firms and strategic buyers like public corporations, Ragozzino’s and Reuer’s empirical findings make sense. But for this M&A season’s rash of earnouts, especially those appearing in large transactions, we may need to abandon our reliance on the explanatory power of a presumed valuation gap. 

The cost of capital for buyout firms and other acquirers has risen considerably. On top of that, buyers are operating with an informational deficit. Even if they feel they may have a strong grasp of a target’s industry and confidence in its business model, the outlook for the general economy over the next 12 to 18 months is foggy at best. More important, unlike the M&A boom period of a few years ago, buyers do not have to push past as many elbows to bring a potential seller to the bargaining table.   Buyers, that is, appear to have a negotiating advantage in today’s market. Earnouts help buyers negotiating with poor information under current economic conditions in two ways. First, it allows them to limit their financial exposure to new investments in the event the economy doesn’t revive in the short- to mid-term. Second, it allows them to defer a significant portion of the purchase price to a time when the cost of capital should be cheaper. 

It’s true that earnouts in private equity deals have always served as a risk management tool. Yet, in the past earnouts generally served to protect buyers from a target’s failure to compete successfully in its industry, not from a continued or worsening recession. Now, however, private equity firms and other buyers are not merely hedging against business and industry-specific variables. They’re signing up for a broader insurance policy against future market conditions. The prevalence of earnouts in today’s market cannot be entirely attributable to a valuation gap; it would be wise to take a close look at the negotiation gap as well.  

Related Posts:  

Valuation of a Private Company

Growing the Company through Strategic Acquisitions

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Yet another draft confidentiality agreement sitting in your Inbox? Private equity firms, investors, and businesses looking for growth opportunities always seem to be signing a new non-disclosure agreement with another potential business seller. Many times, a seller’s first draft of the agreement will be aggressively one-sided. What sorts of issues does a potential buyer care about in a confidentiality agreement? In today’s post, we’ll highlight some of the terms buyers typically negotiate when marking up a confidentiality agreement received from a potential seller. While some of the discussion focuses on the special situation of private equity firms, much of it applies to any confidentiality agreement related to the purchase or sale of a company. (If you’d prefer to follow the discussion below with a first draft of a non-disclosure agreement in front of you, click here.)

Definition of “Confidential Information.”  The definition of “confidential information” generally comprises all oral and written information furnished to the buyer as well as any derivative products, such as the buyer’s analyses of the seller’s underlying financial statements.   There are, however, several customary exceptions to the definition of confidential information that may be absent from a seller’s first draft. A buyer will generally seek to have the following types of information deemed non-confidential: information that (1) comes into the public domain (other than due to a breach by the buyer), (2) the buyer can demonstrate was already in its possession prior to the seller’s disclosure, (3) is given to the buyer by a third-party that is not itself bound by a duty to keep the seller’s information secret, or (4) is developed by the buyer independently, without any use of the information supplied by the seller.      

Return of Confidential Information.  Most sellers require a potential buyer to return all confidential information if negotiations end without a deal. Buyers in turn often ask that they at least be given the option to destroy the information and usually agree to a seller’s request that the destruction be certified in writing by the buyer. In a time when data rooms are often online and vendor due diligence reports are distributed by email, the physical return of confidential information may be impracticable. 

Permitted Disclosures. If the buyer is going to share confidential information with its financial, accounting, legal, or other advisers, the buyer will identify them in the agreement’s definition of permitted recipients. Of course, distributing confidential information to people not directly under the buyer’s control creates additional risks, but the buyer’s exposure can be diminished by taking some additional precautions.   

Limit Liability for Third-Party Breaches. If the buyer’s advisers have been included among the permitted recipients, then the buyer usually takes measures to limit its liability for any non-permissible disclosures by its advisers. For example, a buyer may insert language stating that the buyer will not be held liable for the disclosure of confidential information by any adviser that signs a non-disclosure agreement directly with the seller. The buyer may try to persuade the seller that the advisers are best positioned to police their respective employees’ use of the confidential information. Moreover, if advisers are contractually bound to the seller to keep the information private, they may have a greater incentive to abide by the agreement’s terms. Alternatively, a buyer may sign “back-to-back” confidentiality agreements with each of its advisers. These back-to-back agreements substantially reflect the terms and conditions of the buyer’s underlying confidentiality agreement with the seller. In the event that the buyer is sued by the seller because of a disclosure by one of the buyer’s advisers, the buyer will have a contractual cause of action against the breaching adviser.

Establishing Breach and Liability for Damages. A confidentiality agreement typically makes the buyer liable for any claims or losses resulting from the buyer’s disclosure of confidential information. It is therefore in the interest of the buyer to limit the types of losses for which it can be held liable. A buyer usually negotiates to eliminate all consequential damages (that is, damages suffered by the seller but only indirectly caused by the buyer’s breach), such as lost profits, from its liability. Another concern of the buyer is how the parties will determine whether a breach causing damage to the seller has occurred.   To protect its right to appeal a lower court’s ruling, a buyer may want to include a stipulation that a breach by the buyer must be “established by a final, non-appealable order issued by a court of competent jurisdiction.” This provision can save the buyer from the unlikely – but infuriating – situation in which it has already been forced to pay damages to the seller, even though an appellate court later rules in its favor.       

Sunset Clause. It may come as a surprise, but many first drafts of confidentiality agreements don’t include a sunset clause specifying when the buyer’s obligations under the agreement end. Given that if the deal doesn’t go through all written and electronic information will be destroyed, a reasonable term ranges from 1 to 3 years.

Non-Solicitation of Employees. When certain key employees are essential to a seller’s business, the confidentiality agreement may include clauses prohibiting the buyer from soliciting or employing the seller’s employees.   Buyers generally tailor their comments on this section to fit their specific needs. If the buyer is a company trying to grow its business by acquiring a competitor, for example, considerable care is taken to ensure the non-solicitation and non-employment provisions don’t unduly interfere with the buyer’s efforts to recruit top talent. If, on the other hand, the buyer is a private equity firm investigating a new business, then the firm generally seeks more limited exceptions. Customarily, the non-employment provision does not apply to any job offer that results from a general advertisement (such as in a newspaper or on the Internet) or occurs after a person has left the seller’s employ (without encouragement from the buyer) and a specified period of time has elapsed.

No Additional Obligations. In order to emphasize the limited nature of the buyer’s and seller’s respective obligations under the confidentiality agreement, a potential buyer often inserts a clause emphasizing that until the buyer and seller have executed a definitive agreement regarding the acquisition, the buyer doesn’t have any obligation to the seller regarding the transaction.

Novation to Acquisition Vehicle. When the potential buyer is a private equity fund, more often than not an advisory entity associated with the fund, rather than the fund itself, signs the confidentiality agreement with the seller. If the deal closes successfully, it’s in the interest of the advisory entity to be released from its obligations under the confidentiality agreement.   For this reason, private equity firms try to include a novation clause under which the advisory arm will be released, and the fund’s acquisition vehicle will assume, all of the buyer’s obligations under the confidentiality agreement upon the transaction’s closing.

Related Post: Negotiating Liability with Your Due Diligence Advisers: M&A Engagement Letters

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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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Today, the British government revived its review of the European Union’s proposal to regulate private equity firms and hedge funds. The controversial draft of the European Commission’s alternative investment fund managers (AIFM) directive would prescribe leverage restrictions and disclosure requirements for all advisers managing funds over €100 million. The Financial Times quoted British Member of European Parliament, Sharon Bowles, now head of the European Parliament’s economic and monetary affairs committee, as predicting that implementation of the AIFM directive would result in the “excommunication” of European pension funds and institutional investors from global capital markets. For the time being, it appears that the chorus of objections from members of the British government, ministers of the City of London, industry groups, and U.S. authorities, has found a sympathetic ear. Earlier this week, the Guardian reported that Sweden, which holds the EU’s six-month rotating presidency, announced its intention to “remove unnecessary burdens on alternative investment funds” in the current draft. 

As the debate over how to regulate AIFM in Europe has progressed, a striking ideological standoff has begun to take place. Generally speaking, British government officials have acknowledged a need for more comprehensive regulation of AIFMs, but are wary of straitjacketing the U.K. hedge fund or private equity industry. For good reasons too. UK-based private equity firms raised more than half of the €76 billion in funds raised in Europe in 2007. The government’s coffers have benefited generously from associated tax revenues. 

London’s Conservative mayor, Boris Johnson, aired his frustration over the directive on BBC Radio 4’s Today program:  “I mean it’s a weird thing that under the fog of confusion and war the [European] Commission seems to be proceeding to attack something in which London simply excels and was not responsible for the recent catastrophes.” Johnson denied that he was speaking “in any spirit of – you know - narrow nationalism” but warned that London risked an exodus of private equity and hedge funds should the EC’s AIFM directive become law. (Boris Johnson’s arguments sound similar to those expressed by the Private Equity Council in hearings held on Capitol Hill last week: private equity does not pose a systemic risk to the world’s financial markets. In fact, the European Commission agreed, finding that private equity funds “did not contribute to increase macro-prudential risk.”)

But some socialist politicians on the Continent see private equity regulation through a different lens. For them, the question is not whether private equity creates macroeconomic risks, but whether private equity takeovers benefit all stakeholders (including employees) in the acquired companies and not just shareholders. Over the past several years, certain socialist politicians and labor unions have cast private equity in the role of foreign interlopers in national economies.  

The Chairman of Germany’s Social Democrat Party, Franz Müntefering, famously denigrated private equity firms as “locusts” who stripped bare their portfolio companies’ assets in order to gorge on large profits. Back in 2005, The Independent reported that the Social Democrats accused private equity firms of being a threat to German democracy because leveraged takeovers often resulted in significant personnel reductions.   As an example, the Social Democrats cited KKR’s buyout of German telecommunications company Telenovis, in which half of the company’s 8,000 employees were made redundant, even though a 12.5% wage reduction had been agreed to by workers. But no one is viewed as a greater threat to private equity in Europe than Poul Nyrup Rasmussen, President of the Party of European Socialists and former Danish Prime Minister. In a scathing 2008 article, “Taming the Private Equity Locusts,” Rasmussen described a leveraged buyout as a transaction in which a “once profitable and healthy company is milked for short-term profits, benefiting neither workers nor the real economy.”

The influence of the socialists on the European Commission’s AIFM directive appears in a section addressing the acquisition of “controlling stakes” by buyout firms. Article 26 of the directive provides that if a private equity fund acquires, whether alone or in concert with others, 30% or more of the voting rights of a public or private company domiciled in the European Community, then the acquiring funds would have to comply with regulations and reporting requirements related to:

• disclosing information to other shareholders and to representatives of employees or to the employees themselves, at the time of acquisition;
• the annual disclosure of investment strategies and decisions; and
• general disclosure about the performance of the portfolio companies.

In explaining the purposes behind these provisions, the European Commission expressed a need to disclose information about companies that have a “wider public interest.” But it also emphasized a concern that in private equity buyouts “employees do not enjoy the same protection and rights as is the case when a transfer of undertaking occurs.” (Under the EC Transfer of Undertaking Directive, employees are protected by a set of rights when their employers are merged with or purchased by another business entity.) 

The European Commission’s “Impact Assessment” of the proposed AIFM directive cites several recent studies of private equity buyouts in Europe for evidence that leveraged buyouts harm employees. In the EC’s opinion, one study suggested that private equity buyouts resulted in, among other things, little change in union recognition, union member density or management attitudes to unions, little change in issues over which managers negotiate with and consult unions, and a shift from pension to defined contribution schemes based on investment performance. For these and other reasons, the Commission argued “greater transparency and public accountability of private equity activities would help to ensure that the interests of all relevant stakeholders are taken into account in the governance of the portfolio companies.”

We’ll learn more about the outcome of these and other negotiations once the AIFM conference is held in Luxembourg this September. But what is evident at this point, at least, is that some members of the European Parliament hold radically divergent views on what form regulation of private equity should take. Whereas in the United States, discussions have generally centered around systemic risk and greater transparency for investors, in Europe an influential minority has focused on labor protections. With such divergent points of departure, it’s difficult to see how the Anglo-American and Continental European visions for reform will be easily reconciled.  

Related Post:  European Regulators Eye Private Equity

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Judge Sotomayor’s Senate confirmation hearings may have overshadowed other proceedings on Capitol Hill last week, but members of the private equity community kept a watchful eye on what could turn out to have been landmark hearings on government regulation of private equity and hedge funds. Representatives from the private investment advisory community and institutional investors gathered to testify before the Subcommittee on Securities, Insurance, and Investment of the U.S. Senate Committee on Banking, Housing, and Urban Development. The hearing was convened about a month after the Subcommittee’s chairman Senator Jack Reed (D – RI) introduced his own bill in the Senate, “The Private Fund Transparency Act of 2009.” Senator Reed’s proposed legislation would amend the Investment Advisers Act of 1940 to require investment advisers to private funds who manage assets in excess of $30 million to register with the Securities Exchange Commission. The SEC could in turn require registered investment advisers to submit records and reports to a federal systemic risk regulator.

Private Funds and the Investment Advisers Act

Before taking a look at last week’s hearings and Senator Reed’s bill, it’s instructive to place them in their historical context. The Supreme Court identified one of the fundamental purposes behind Congress’s passage of the Investment Advisers Act of 1940 as the substitution of “a philosophy of full disclosure for the philosophy of caveat emptor” in the securities industry. Under the Advisers Act and its implementing regulations, non-exempt investment advisers are required to register with the Securities Exchange Commission, and all advisers – registered and unregistered alike – are forbidden to engage in fraudulent or deceptive practices. 

Hedge funds (and private equity funds) are typically structured as limited partnerships, with the general partner managing the fund for a fixed fee and a percentage of the fund’s gross profits. Although hedge fund general partners meet the statutory definition of “investment advisor,” they generally qualify for the “private adviser” exemption from SEC registration under §203(b)(3) of the Advisers Act. The private adviser exemption is available to any adviser that has fewer than 15 clients and does not generally hold itself out to the public as an investment adviser. With respect to hedge funds organized as limited partnerships, the SEC historically interpreted the term “client” in §203(b)(3) to refer to the limited partnership itself rather than to the investors constituting its limited partners. 

In 1998, Long-Term Capital Management, a Connecticut-based hedge fund that managed over $125 billion in assets during its heyday, imploded. With many of the country’s major financial institutions at risk because of their credit exposure to Long-Term, the Federal Reserve Bank of New York stepped in to orchestrate the fund’s financial resurrection to avert a national financial crisis. Shortly thereafter, a joint working group of the country’s leading financial regulators embarked on a comprehensive study of the U.S. hedge fund industry. 

Prompted by the working group’s findings, the Securities Exchange Commission adopted the so-called “Hedge Fund Rule” in 2004. The Hedge Fund Rule required most hedge fund advisers to register with the SEC if the funds they managed had more than 15 “shareholders, limited partners, members, or beneficiaries.” In other words, the SEC reinterpreted the definition of “client” under the Advisers Act so that general partners of hedge funds had to “pierce the veil” of their fund to reach its beneficial owners in order to determine how many clients they advised. The D.C. Circuit Court of Appeals vacated the “Hedge Fund Rule” in 2006, dismissing it as “arbitrary.” Consequently, many general partners of hedge funds (and other private funds) still rely on §203(b)(3) to claim an exemption from registration under the Advisers Act.

Senator Reed’s Proposal for Regulating Private Funds

The Private Fund Transparency Act of 2009 (S. 1276), introduced by Senator Reed in June, would amend the Advisers Act to require investment advisers to private funds who manage assets in excess of $30 million to register with the SEC. The text of the bill restricts the private adviser exemption under §203(b)(3) to apply only to a narrowly defined group of “foreign private advisers.” Under Senator Reed’s proposal, all registered private fund advisers – including advisers to hedge funds, private equity funds, and venture capital firms – would be subject to the Advisers Act’s existing regulations regarding disclosures to the SEC, maintenance of books and records, custody of fund assets, compliance policies and procedures, advertising, and the examination of financial and other records by the SEC. (Last week, the Obama administration proposed parallel legislation that would create a new class of “private funds” subject to registration under the Investment Company Act of 1940 and require advisers to private funds to register with the SEC under the Advisers Act). 

In a recent interview with the Wall Street Journal, Senator Reed emphasized the need for transparency and government oversight to ensure what he called “fair dealing with customers.” Andrew J. Donohue, Director of Investment Management for the SEC, advised the Senate Subcommittee that registration of investment advisers with the SEC was essential to giving teeth to the Advisers Act’s anti-fraud provisions by providing the SEC “an opportunity to determine facts that most investors in private funds cannot discern for themselves,” and speculated that registration might deter unscrupulous advisers from committing fraud.  Mr. Donohue also called for (and Senator Reed’s proposed legislation contemplates) granting additional rulemaking authority to the SEC to enforce its broadened jurisdiction under the Advisers Act. 

In addition to protecting investors, Senator Reed described the other goal of his bill as devising a regulatory regime capable of aggregating information about various financial industries “in a meaningful way so that systemic regulators could get a sense if there is a possibility of risk in a particular market.” Back in April, we wrote about Treasury Secretary Geithner’s outline for a reporting system in which the SEC would work in tandem with a systemic risk regulator to ferret out privately managed funds deemed to pose a systemic risk to U.S. financial markets. The Private Fund Transparency Act specifically authorizes the SEC to require any registered investment advisor to “maintain such records and submit such reports as are necessary or appropriate in the public interest of the supervision of a systemic risk by any Federal department or agency.” In a press release posted on the Treasury Department’s website today, Mr. Geithner announced: “There exists today a national mandate, not seen in years, to reform our outdated and ineffective regulatory system.”   

Private Equity’s Response

Lobbyists and representatives from the private equity industry have been clamoring that the private equity industry is not too big to fail, yet have been conciliatory with regard to oversight. Perhaps this is not surprising. A number of private equity’s largest players, including the Carlyle Group, the Blackstone Group, and Kohlberg, Kravis, Roberts & Company, are already registered with the SEC. Mark Tresnowski, general counsel of private equity firm Madison Dearborn Partners, who spoke on behalf of the Private Equity Council, warned the Senate Subcommittee that although the private equity community supported registration of advisers in principle, any reporting and other requirements should be tailored to the type and size of the firm so as to reduce the inevitable increased administrative costs for funds. He concluded: “Private equity contains none of these systemic risk factors and thus should pose little concern for policy makers seeking to develop a new regime to guard against catastrophic, cascading financial shocks.” Private Equity Council President Douglas Lowenstein echoed Tresnowski’s opinions in testimony before the House’s Financial Services Committee two days later. 

This week, the Obama administration followed up last week’s hearings by sending a plan for a systemic risk regulator to Congress. The proposal would establish a Financial Services Oversight Council comprising bank and securities regulators that would be tasked with collecting information on systemic risk and would give the Federal Reserve authority to act as a systemic risk regulator. Both Senator Reed’s and the Obama administration’s proposals for registering private investment funds and/or their advisers would grant widespread authority to the SEC to determine what information should be shared with a systemic risk regulator.

One has to wonder whether the private equity industry’s tactic of conceding on SEC oversight while trying to persuade federal legislators that its business model does not pose a systemic threat to the U.S. financial markets will undermine its longer term strategic interests. Once a substantial portion of the private equity industry falls under the umbrella of the SEC’s regulatory authority, there may be little lobbyists and other industry representatives can do to persuade the systemic risk regulator – be it the Federal Reserve or another government agency – that private equity funds do not pose system-wide financial risks. At that point, leveraged buyout firms may have lost their negotiating leverage.

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House Financial Services Committee Proposes Hedge Fund & Private Equity Regulation

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In our previous post, we discussed some of the customary agreements and covenants in interim investor agreements for private equity consortia. Today, we’ll describe the types of pre-closing equity syndication procedures commonly found in interim investor agreements. For large buyouts requiring significant capital investment, the initial members of a private equity consortium may want to be able to seek out other private equity investors in order to diversify some of their risk. An interim investor agreement often details how members of the private equity consortium may use the period between signing the share or asset purchase agreement and closing the transaction to solicit other investors.   

The interim investment agreement sets forth the equity investment of each of the private equity funds and their corresponding ownership percentages in Newco. This section of the agreement also outlines a mechanism for adjusting equity commitments, typically done on a pro rata basis, to prepare for possible changes in the purchase price of the transaction or the availability or cost of debt financing.   

Equity Syndication

Depending on the number of private equity firms initially involved in the consortium, the interim investor agreement may want to detail an equity syndication procedure. Although the private equity firms covenant to coordinate an equity syndication strategy, they each may also be given limited rights to syndicate on their own.     

Some of the syndication rights that may be granted to the consortium’s members include:

Direct Equity Syndication

The private equity firms may be entitled to directly syndicate a specified portion of their equity investment in Newco without the consent of the other investors. The syndicating investor may possess “drag-along rights” enabling it to compel the non-syndicating investors to sell their respective ownership interests in Newco to the new investor on a pro rata basis. The non-syndicating investors may be granted corresponding “tag-along rights” permitting them to participate in any sale of ownership interests in Newco on a pro rata basis with the syndicating investor. Each new investor is required to become a party to the interim investor agreement and execute an equity commitment letter on the same terms as the initial investors. 

“Silent” Equity Syndication

Each private equity fund may also be entitled to what are called “silent” equity syndication rights. In a silent equity syndication, a private equity firm syndicates economic or beneficial interests in an entity entirely controlled by or affiliated with the firm. This provision allows each of the sponsors to syndicate equity interests in the private equity funds investing in Newco rather than ownership interests in Newco itself. In other words, silent equity syndicatees purchase an ownership interest at the shareholder level. Since silent syndicatees are indirect owners of Newco, the interim agreement explicitly denies them governance, liquidation, or other rights to be offered to the direct owners of Newco in the definitive shareholders agreement.        

The right of consortium members to syndicate their direct equity interests in Newco is usually subject to an anti-dilution provision requiring them to maintain a minimum percentage ownership interest or dollar amount invested in Newco.

Related Post: Private Equity Club Deals: Pre-Closing Investor Agreements and Covenants

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Leveraged buyouts of companies by private equity consortia – also known as private equity club deals – often capture the headlines and the imagination of the business press. Buyouts that demand substantial equity investments, such as the $900 million injected into the failed Florida lender BankUnited Financial by a private equity group that included WL Ross & Co., the Carlyle Group, and Blackstone, often require several private equity firms to club together to come up with enough capital. Besides the large equity investment required, what distinguishes club deals from garden-variety leveraged buyouts is the need for multiple firms to agree on how the transaction will be managed. In this post, we’ll take a look at some of the chief terms of interim investor agreements among members of a private equity consortium.      

Interim investor agreements for private equity consortia are by their nature temporary: the agreement terminates either upon the successful closing of the transaction or the deal’s termination in accordance with the share or asset purchase agreement. If the transaction proceeds as planned, an interim agreement details the steps that need to be taken to complete the deal and lays down the groundwork for how the business will be operated after closing. On the other hand, an interim agreement specifies how the consortium’s members will allocate responsibility for transaction costs and other liabilities, such as reverse break-up fees, should the deal founder. The agreement is signed on the same day the private equity funds sign their respective equity commitment letters, the banks issue their debt financing commitment letters, and the consortium’s shell acquisition vehicle, or “Newco,” enters into the purchase agreement with the target company.   

A few of the principal matters typically covered in an interim investor agreement include:

Pre-Closing Agreements and Covenants

The members of the private equity consortium agree to cooperate with one another to resolve any outstanding issues with the target company, negotiate definitive loan agreements with the consortium’s lenders, execute employment agreements with the future management of Newco, and nail down any other final terms and conditions. In addition to approving the purchase agreement and other transaction documents, the private equity firms memorialize their consent to the proposed transaction structure, usually by reference to the pre- and post-closing organizational charts of Newco and its subsidiaries prepared by the consortium’s accountants. If the target is a public company, the members promise to comply with all applicable securities laws and to file all necessary documents with governmental authorities, such as filings under the Securities Exchange Act’s Regulation 13D disclosing beneficial ownership interests. 

Finally, the private equity firms confirm how Newco will be managed during the period between the signing of the purchase agreement and closing.   The interim investor agreement identifies the number of representatives from each of the consortium’s members appointed to Newco’s interim board of directors, usually in proportion to their respective equity investments. Each of the private equity funds indemnifies (on a pro rata basis) and holds harmless Newco’s interim board of directors from any claims or other liabilities arising from any error or omission by a director.   Directors appointed to Newco’s interim board are likely to become named defendants in any future lawsuit regarding the transaction, whether the plaintiff is a consortium member, one or more of the financing banks, or the target company or its shareholders.       

Definitive Investors’ Agreement

The private equity sponsors agree to negotiate a definitive shareholders’ agreement promptly after the transaction closes and may identify any special tax or ERISA matters (in the case of a public company) that need to be addressed in the definitive agreement. Most important, this section of the interim agreement incorporates by reference the private equity consortium’s investor term sheet, which summarizes the principal terms of the future definitive shareholders’ agreement. 

Advisers’ Fees and Transaction Costs

The interim investment agreement also handles the allocation of transaction fees among the private equity firms’ advisory arms and how transaction costs (including liabilities from potential lawsuits) will be handled both in the event the deal closes and in the event the deal is terminated. Upon completion of the deal, the advisory arms of the private equity firms that sourced the deal receive a transaction fee that usually reflects their proportionate ownership interests in Newco. 

The agreement also specifies how the consortium’s financial, accounting, legal, and other advisers will be paid. If the deal closes successfully, the interim agreement provides that Newco picks up the private equity consortium’s advisers’ fees and expenses. The way advisers are paid in the event of a failed deal turns on whether or not the consortium is entitled to a break-up fee from the target. If there is no break-up fee in the purchase agreement, the private equity firms will share costs on a pro rata basis. If there is a break-up fee under the purchase agreement, then the amounts received will be applied first to pay the advisers’ fees and expenses and other transaction costs, with the remainder being distributed among the private equity firms. If the deal is terminated because one of the private equity funds fails to finance its equity commitment, the defaulting private equity firm will indemnify the non-defaulting firms and be liable for all transaction fees, expenses, and other liabilities.     

A private equity consortium’s interim agreement typically also requires confidentiality and specifies whether disputes will be resolved through arbitration or judicial process. In our next post, we’ll explain how interim investor agreements address the consortium members’ equity syndication procedures.

Related Post: Private Equity Club Deals: Equity Syndication

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The proposed guidelines published by the Federal Deposit Insurance Corporation for private equity investments in failed banks were in line with what was expected, though they did not fail to displease private equity firms. The guidelines require that investors maintain a 15% Tier 1 leverage ratio in the failed bank for three years. This compares with the 5% Tier 1 leverage ratio required for healthy banks.  The obligation to “maintain” this capital ratio means the private equity firm would have to ante up more capital if the numbers slip. And the fuse would be running – the guidelines say the sponsor must “immediately facilitate restoring” the capital.

The private equity sponsor must also act as a “source of strength” to the bank, suggesting they would have to inject additional capital if trouble arises. At a minimum this would require a commitment to raise new capital if necessary.

Also, there is a significant expansion in the cross guarantee requirement. Under the proposed guidelines, a sponsor would have to pledge its investment in each institution in which it “individually or collectively” has a majority interest to cover the FDIC against potential losses. The guidelines would sweep up each participant in a club deal, whether or not it owns a majority stake. For example, a firm that had a 10% club investments in 2 failed banks would somehow have to pledge its investment in both deals to the FDIC. That requirement alone will likely rule out club deals for failed banks. The requirement raises big practical concerns, as each participant in the club would have to cross pledge its interest in different banks to other club-owned banks, all to make the FDIC more secure.  

And there are other problems, such as the 3 year holding requirement. All in all, the guidelines are not friendly toward private equity sponsors, and will go a long way toward dissuading them from investing in failed banks. This may come under political fire, as the FDIC will sooner or later be pressed to support new capital for failed banks, if faced with the prospect of nationalization.

The FDIC’s approach is similar to the one adopted by federal regulators in Blackstone’s failed acquisition of Alliance Data System. That deal broke up when the Office of the Comptroller of the Currency insisted that Blackstone backstop the credit card unit of ADS, which Blackstone was not contractually obligated to do. The banking regulators do not seem to have learned their lesson from that – private equity may walk away again.

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We were recently quoted in the online version of the Wall Street Journal in a piece about Merck's pending merger with Schering-Plough.  You can read the article here.  Thanks to reporter Peter Loftus for the mention!

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Shareholders of closely held, privately owned companies often worry that their voting and economic rights may be diluted if the company were to issue new securities. An issuance of new securities could diminish a shareholder’s proportionate share of profits, dividends, and other distributions. These concerns may be especially acute when a company is just starting up and its owners anticipate future rounds of equity or debt financing. To prevent these undesirable consequences, shareholders may seek preemptive rights in offerings of new securities.  

Some states provide shareholders preemptive rights as a matter of law, while others require that preemptive rights be expressly granted in a company’s state filings or its organizational documents. Delaware’s general corporation law, for example, requires that preemptive rights be granted to shareholders in a company’s certificate of incorporation. Although there is some variance among state corporation laws, a company usually spells out the terms and conditions of any preemptive rights in its shareholders’ agreement.

Preemptive Rights: Determining a Shareholder’s Ownership Percentage

Preemptive rights entitle shareholders of a company to maintain their proportionate beneficial ownership interests by allowing them to participate in offerings of new securities on a pro rata basis. When a company issues new securities, each shareholder has a right to purchase a percentage of the new securities equal to the shareholder’s ownership percentage of the company’s outstanding stock prior to the offering. Each shareholder’s ownership percentage is calculated by dividing the number of the shareholder’s shares by the total outstanding shares of the company. One of the key differences among preemptive rights provisions is the way that the amount of total outstanding stock is determined. 

Preemptive rights may be offered either on an “as converted” or “as converted, fully diluted” basis. If the preemptive rights are offered on an “as converted” basis, then a company’s total outstanding stock prior to a new securities issuance includes both the total outstanding stock of the company and the outstanding stock there would be if its convertible preferred stock and convertible debt were to convert. If the preemptive rights are offered on an “as converted, fully diluted” basis, then a company’s total outstanding stock prior to a new securities issuance includes the company’s total outstanding stock on an “as converted basis,” plus the outstanding stock there would be if all options and warrants were exercised.

When a company plans to issue new securities that are subject to shareholders’ preemptive rights, the company commonly sends each shareholder a subscription warrant notifying him of the number of shares he is entitled to purchase.

Limitations on Preemptive Rights

Whether preemptive rights are offered on an “as converted” or “as converted, fully diluted” basis, they are customarily subject to certain limitations. Shareholder agreements restrict preemptive rights by excluding, or carving out, specific securities offerings from the definition of “new securities.” Securities offerings that may be carved out from the definition of new securities include those related to:

Equity Incentive Plans. Shareholders generally do not have preemptive rights in any new securities issued as part of a board approved employee equity incentive plan or other benefit program where the primary purpose is not to raise additional capital for the company. This exception allows the company’s board to incentivize management by offering them stock options and other interests in securities, while at the same time shielding the company from the prospect of a management buyout.  

Strategic Acquisitions. Where new securities are issued as consideration for the acquisition of another business entity, shareholders’ preemptive rights typically don’t apply. This exception enables the company to enter into transactions like stock-for-stock exchange mergers, or B reorganizations, in which an acquiring company issues new securities to the target company’s shareholders in return for a controlling interest in the target, and asset-for-stock exchange mergers, or C reorganizations, in which a company issues new securities to a target company’s shareholders in exchange for substantially all of the assets of the target. By affording the company an opportunity to grow through strategic acquisitions, this exception allows the company’s business operations to benefit from synergies and economies of scale and scope. 

Equity Kickers. So-called “equity kickers,” or equity interests attached to corporate debt, issued in connection with arm’s-length debt financing transactions are often excluded from a shareholder agreement’s definition of new securities. Banks may want to couple their rights as senior lenders with an equity position in the borrowing company and purchasers of corporate debt securities may prefer bonds issued with convertible features like options and warrants. In return, the issuing company receives lower interest rates on its senior and subordinated financing.

Stock Splits and Dividends. Another exception to the definition of new securities is the issuance of common stock resulting from a share dividend, share split, or similar event that is made on a pro rata basis. In shareholder agreements involving venture capitalists, this exception is generally not included. As primary capital contributors to a business, venture capitalists have considerable bargaining power and negotiate for additional anti-dilution protections by having their respective ownership percentages preserved after stock splits.

Public Offerings. Often, there is an exception for an initial public offering or listing of the company’s shares on a nationally or internationally recognized stock exchange. Usually, the exception only pertains to certain public offerings in which the new securities represent a specified percentage of the company’s total outstanding stock or raise proceeds above a defined threshold. The qualified public offering exception is commonly included in shareholder agreements among private equity firms when the sponsors anticipate a partial or total exit from their investment by means of an initial public offering.  

In practice, shareholder preemptive rights only benefit those shareholders with enough capital to participate in new securities offerings on a pro rata basis with their fellow investors. Shareholders with limited cash reserves may find themselves unable to exercise their preemptive rights in qualified offerings of new securities and consequently discover that their voting and economic rights have been diluted. 

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Before jetting off to the G-20 meeting in London, Treasury Secretary Geithner warned House members that investors should no longer be allowed to swim in large “private pools of capital” at their own risk. Mr. Geithner’s message to the House Financial Services Committee was clear: the nation’s deep private investment pools need a lifeguard on duty. What the duties of this lifeguard would be remain somewhat murky. Mr. Geithner sketched the outlines of a regulatory regime in which an independent “systemic risk regulator” would work in tandem with the SEC to oversee hedge funds, private equity funds, and venture capital funds with assets under management above an – as of yet – unspecified threshold. Such large, privately managed funds would have to submit confidential reports to the SEC, which in turn would funnel the information to the systemic risk regulator. It would then be up to the systemic risk regulator to determine whether a fund is “so large or highly leveraged that it poses a threat to financial stability” and should be subject to stringent regulatory controls designed to mitigate risks to the financial system.  

The new oversight and reporting requirements proposed by Geithner would substantially alter the regulatory world in which private equity funds operate; they would also inaugurate some of the most sweeping reforms in the regulation of financial markets since the 1930s.  Congress passed the Securities Act and the Securities Exchange Act largely based on the sunshine principle. Financial markets would work efficiently, it was thought, if investors had access to reliable, timely information about companies that issued publicly traded securities. The SEC would act as the market’s “sunshine sheriff” by monitoring disclosure and regulatory compliance and taking enforcement actions against the insubordinate. By contrast, Geithner’s newly conceived systemic risk regulator would act as a “shadow sheriff” – making decisions based on non-public information behind closed doors.   

If implemented, Geithner’s plan for regulating large private investment funds would create a two-tiered private equity community, with large funds subject to quasi-public company reporting requirements and small to midsized funds continuing to operate largely outside of the government’s regulatory reach. Funds subject to SEC reporting requirements - especially those subject to the more conservative standards imposed on financial institutions deemed “too big to fail” by the systemic risk regulator – may find their investment and management activities significantly curtailed. There will likely be fewer (if any) opportunities for large, highly leveraged deals, higher transaction costs for M&A activity, and increased costs related to the management of portfolio companies. For private equity funds registered with the SEC, the LBO buyout model that defined private equity for the past several decades may no longer be viable. 

Small and midsized private equity funds, on the other hand, may find themselves more agile and better positioned to seize investment opportunities as they arise. When credit markets return to health, midsized funds may have greater access to both senior bank financing and subordinated financing from investors in high-yield and other corporate debt. Indeed, if the management and investment activities of the big private equity players become straitjacketed by so-called “prudential” regulatory requirements, small and midsized private equity firms may become our only barometer for telling whether or not private equity’s LBO acquisition model can continue to generate high enough returns to ensure its survival.  

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House Financial Services Committee Proposes Hedge Fund & Private Equity Regulation

Regulation of Private Funds: Senator Reed and the Congressional Hearings

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The joint statement issued in London by the leaders of the Group of 20 last week expressed a commitment to bring “all systemically important financial institutions” within the purview of their respective financial regulatory and oversight regimes. Notably, the statement singled out hedge funds for additional regulation, but made no mention of whether private equity funds would also be subject to greater scrutiny by financial authorities. A week after the breakup of the G-20 meeting, it appears that elected officials and members of the investment community in Europe remain divided as to whether private equity funds warrant increased regulation.

The Financial Times reported that the European Commission announced a one-week delay in the issuance of its highly anticipated proposals for new regulations governing hedge funds and private equity funds. (The proposals are now scheduled to be released on April 29.) Although European Commission representatives attributed the postponement to a bureaucratic bottleneck, the Financial Times suggested rumors were afoot that leaked drafts of the Commission’s proposed legislation provoked disapproval by some European government ministers and members of the private equity community. Jim Brundsen of the European Voice, which reviewed a draft of the proposal, writes that the legislation would require private equity funds with assets under management in excess of €250 million to maintain a minimum capital requirement of €125,000, plus 0.02% of the amount by which the funds’ portfolios exceed €250 million. Funds whose assets remain below the €250 million threshold would be excluded from the new regulatory requirements.   

Across the Channel, the Wall Street Journal reports that both the U.K.’s financial regulator, the Financial Services Authority (FSA), and the British Treasury Ministry have expressed less interest in tightening regulation of private equity funds than their Continental counterparts. British officials’ more laissez-faire attitude towards private equity seems to stem from their conclusion that private equity funds are not “too big to fail.” 

The FSA’s Turner Review, a report issued in March that recommended regulatory responses to the financial crisis, argued that since “hedge fund activity in aggregate can have an important procyclical systemic impact,” many such funds should be subject to capital, liquidity, and other restrictions. The Turner Review’s policy proposals, however, did not identify private equity funds as financial institutions that pose system-wide risks. In this respect, at least, the Turner Review seems to agree in principle with The European Private Equity and Venture Capital Association’s (EVCA) assertion that neither private equity funding models nor the portfolio companies in which private equity typically invests pose systemic risks to financial markets. (The EVCA’s 300-page submission to the European Commission and the European Parliament can be found here).

Of course, it’s still too early to tell how these legislative proposals will shake out in the end. But at this stage, one thing seems clear: the decision whether private equity funds should be more strictly regulated will most likely turn on public officials’ assessment of the likelihood that the collapse of a large private equity fund or the insolvencies of multiple portfolio companies would result in unacceptable externalities.

Update: EU Private Fund Regulation: The Anglo-Continental Divide on Private Equity

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The most recent issue of the Debevoise & Plimpton Private Equity Report notes that, at the current time, there are more than 50 private equity transactions in North America with an aggregate transaction value of more than $60 billion waiting to get done. Each of these deals was signed up prior to the current credit crunch.  It remains to be seen how or whether these transactions will get done, and it so on what terms. Separately, it remains open how the current macro economic conditions will impact private equity deals going forward.

The issue also contains an interesting discussion of the Forthright Negotiator doctrine, which this blog has discussed before.  Ambiguity can often be found, or manufactured, during the course of litigation.  The United Rentals case stands for the proposition that what is communicated in negotiating sessions, sidebars and email exchanges, whether involving lawyers, bankers or clients, can carry great weight in shaping a court’s understanding of a disputed contract.  Look for more emails reiterating the parties' intentions, even in the face of contract language that is clear.

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As this website predicted on November 24th, the Delaware Court of Chancery on December 21, 2007 found that the sole and exclusive remedy of United Rental was the $100 million break up fee specifically provided for in the Merger Agreement with entities controlled by Cerberus Capital.

The exchange of drafts and the meetings between the parties indicated that the breakup fee was intended to preclude any other remedies, including specific performance..  United Rental’s case was based on the fact that the contract continued to have language providing for equitable remedies like specific performance, even though other sections said that this remedy was superseded by the breakup fee. In deposition, the Cerberus attorney conceded that it would have been “clearer” to delete the specific performance section altogether.

Given the relatively clear cap on exposure in the Merger Agreement, one would expect that the opinion of the Delaware court would stick closely to the express contract language and the law of summary judgment. In fact, most of the opinion does that. But the court ultimately relied on an interesting though obscure principle of contract interpretation called the “forthright negotiator principle.”

According to the court, under the forthright negotiator principle, “the subjective understanding of one party to a contract may bind the other party when the other party knows or has reason to know of that understanding. Because the evidence in this case shows that defendants [Cerberus] understood this Agreement to preclude the remedy of specific performance and that plaintiff [United Rental] knew or should have known of this understanding, I conclude that plaintiff has failed to meet its burden and find in favor of defendants.”

“The forthright negotiator principle provides that, in cases where the extrinsic evidence does not lead to a single, commonly held understanding of a contract’s meaning, a court may consider the subjective understanding of one party that has been objectively manifested and is known or should be known by the other party.”

The only support for this principle cited by the court was a section of the Restatement of Contracts. 

The very interesting history of these contract negotiations indicates that the parties never explicitly resolved the issue of whether the $100 million breakup fee was the sole and exclusive remedy. The court found that because the parties never clearly drafted any agreement on the termination fee, it would award judgment to the side that most clearly and consistently articulated its subjective understanding of the agreement to the other side. In this, the court found that the Cerberus attorney was more consistent in his statements that the termination fee was intended to preclude specific performance. The attorney for United Rental, the court found, implicitly agreed with the Cerberus position during oral contract negotiations.

The case came down to this fact: “Though URI, through [its lead attorney], had many opportunities throughout the negotiation process to clearly vocalize its understanding of its rights for specific performance under the Merger Agreement, URI consistently failed to communicate this to Cerberus representatives.”

The very interesting implications of this decision for the manner in which merger negotiations are conducted will be the subject of future postings here.

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Does Cerberus have the unilateral right to walk away from its deal with United Rental and limit its exposure to a break up fee of $100 million?  Or does United Rentals have the right to specifically enforce the merger agreement?  That's the issue at the heart of lawsuits currently pending in Delaware and New York arising out of this failed acquisition. 

Cerberus had this to say about United Rental's Delaware action for specific performance in a press release issued November 19th:

"We believe that United Rentals has been less than forthright in its legal filings and its communications concerning those filings.  The fact is that RAM negotiated for and obtained the right to withdraw from the Merger Agreement of July 22, 2007 and instead make a one-time payment in the aggregate amount of US $100 million.  This ability to walk away from the transaction with this limited exposure was specifically bargained for, is clearly and unambiguously stated in the Merger Agreement and related documentation, and is not in any way conditional on the occurrence of a material adverse change, the termination of the Merger Agreement by United Rentals or any other event."

Also, according to Bloomberg, Cerberus started its own lawsuit in New York Supreme Court seeking a declaration that its maximum exposure to United Rentals is $100 million. In the suit, Cerberus says United Rentals has no remedy other than the right to pursue the $100 million brake up fee, which serves as a cap for any or all losses or damages relating to or arising out of the merger agreement.

Let's see where that clear and unambiguous statement appears in the merger agreement.  Section 8.2(c) of the agreement says:

"In the event that this Agreement is terminated by [United Rentals] pursuant to Section 8.1(d)(i) or Section 8.1(d)(ii), then [Cerberus] shall pay $100,000,000 to [United Rentals] as promptly as reasonably practicable (and, in any event, within two business days following such termination), payable by wire transfer of same day funds."

OK then.  Section 8.1(d)(i) says that United Rental can terminate the agreement upon certain breaches by Cerberus of the merger agreement, and Section 8.1(d)(ii) says that United Rental can terminate the agreement if the merger isn't completed by a certain date.  Neither of these things has happened, and United Rentals isn't seeking the fee. 

Later on, in Section 8.2(e), there is a clause limiting liability for termination events to $100 million.  It says that United Rental's right to terminate the merger agreement under Sections 8.1(d)(i) or (ii) and receive the $100 million fee under Section 8.2(c) is the "sole and exclusive remedy" of United Rentals against Cerberus for "any and all loss or damage suffered as a result thereof" and Cerberus shall not have "any further liability or obligation of any kind or nature relating to or arising out of this Agreement or the transactions contemplated by this Agreement as a result of such termination."  This fee is "the sole and exclusive remedy for recovery" in the event of "the termination of this Agreement by [United Rentals] in compliance with the provisions of Section 8.1(d)(i) or (ii)."  

So far, it looks as though United Rentals has the winning position, as this language pretty clearly says that the $100 million payment is the sole remedy only in the situation where United Rentals has terminated the merger agreement due to a misrepresentation or failed deadline.  Up until now, there isn't any absolute cap on liability if Cerberus breaches the agreement and walks away.

But keep reading.  At the very end of Section 8.2(e), comes the provision that finally supports Cerberus:

"In no event, whether or not this Agreement has been terminated pursuant to any provision hereof, shall [Cerberus], either individually or in the aggregate, be subject to any liability in excess of [$100 million] for any or all losses or damages relating to or arising out of this Agreement or the transactions contemplated by this Agreement, including breaches by [Cerberus] of any representations, warranties, covenants or agreements contained in this Agreement, and in no event shall [United Rentals] seek equitable relief or seek to recover any money damages in excess of such amount from [Cerberus].

That's pretty clear.  Although there is plenty of language in the agreement that appears to support United Rentals' position, this one sentence appearing at the end of Section 8.2(e) seems to cap Cerberus' exposure at $100 million.   The stock market seems to agree as well.

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United Rentals Inc. recently sued the shell companies formed by Cerberus Capital Management to acquire the company after Cerberus informed it that it was not prepared to proceed with the $7 billion deal. Cerberus wants to cancel the deal because of trouble with financing. United Rentals is doing fine, having just reported a great quarter. The lawsuit raises an interesting issue on the interplay between the specific performance remedy and a liquidated damages provision providing for a $100 million payment in the event the merger agreement is canceled.

Cerberus and United Rental agreed to the deal in July 2007. The merger agreement has detailed provisions regarding financing. For example, it provides that if the Cerberus entities are not able to obtain financing from syndicated sources, it will draw down on a $4 billion of bridge financing commitments given by a group of lenders including Banc of America, Credit Suisse, Morgan Stanley and Lehman Brothers. As everyone knows, the syndication market for these deals has dried up, so people are looking at the bridge financing package.

Cerberus went along through the fall and the United Rental shareholder vote as though everything were fine. Several days ago, apparently reacting to pressure from the bridge lenders, it notified United Rental that it was not prepared to impair its relationship with the bridge lenders by forcing them to fund, even though the merger agreement required them to do so. Instead, it notified United Rental that it “elected not to consummate the transaction” and would pay a break-up fee of $100 million.

Cerberus or its advisers also leaked news of the potential breakup to the press and the stock dropped fast, erasing more than $1.2 billion of market cap.

The lawsuit is a study in the remedy of specific enforcement. United Rental wants to force the Cerberus entities to go through with the deal, and wants the Delaware Chancery Court to order Cerberus to draw down the bridge financing. Cerberus on the other hand acts as though it holds an option to buy the company which can be canceled by paying the $100 million break up fee. 

The break up fee section says the fee is due only if the merger agreement is terminated. Cerberus doesn’t seem to have the right to terminate the agreement. Cerberus is counting on the fact that specific performance is not a favorite judicial remedy, especially where the parties have contemplated a specific financial damages remedy, like a break up fee. But this agreement has all the makings of a good specific performance action. 

Right now, the market doesn’t think the chances of United Rentals are so good, as the stock price is substantially below the merger price.

 

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Deep within Blackstone's recent 10Q, in the MD&A section, the company discusses the negative impact that the "considerable turbulence" in the housing and sub-prime mortgage markets has had on other fixed income markets. 

"Deteriorating conditions in fixed income markets prevented lenders from syndicating senior loans and high yield debt."

Translation:  when the music stopped the the banks got stuck holding our last deals.

"[T]he backlog resulting from pending private equity-led transactions reached record levels."

Translation:  the banks can't get rid of the paper.

"This backlog resulted in lenders becoming less willing to fund new, large-sized acquisitions and as a consequence, the volume of new private equity acquisitions declined significantly in the quarter."

Translation:  until the pipeline gets opened we can't get the big dogs closed.

"Recently announced private equity-led acquisitions have mostly been smaller in size, with less leverage and less favorable terms for the debt provided, including more onerous loan covenants."

Translation:  looks like it's back to Plan A.

"The duration of current conditions in the credit markets is unknown."

No translation needed.

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Knowing how to get out of a deal is often as important as knowing how to get in.  When a company blows up, it's easy to find a representation that went awry.  But when things turn sour because of legislation or macro economic issues, you've got to look at the MAC clause.

The MAC, or material adverse change, clause sets the conditions under which a deal may be terminated without penalty. MAC exceptions, which are often appended to such clauses, outline specific circumstances under which the MAC doesn't apply, meaning the deal must proceed even if there is a material change.

During the deal frenzy of the past several years, sellers have had the upper hand in negotiating deal terms, a trend that has extended to the MAC clause. To win deals, buyers have agreed to loose MAC clauses with lots of exceptions, or in some cases have foregone MACs altogether.

The litigation currently pending in Delaware between SLM (Sallie Mae) and J.C. Flowers & Co. will, if it goes that far, shape the understanding of MAC clauses for the next few years.  J.C. Flowers and its partners have sought to walk away from the deal, in part on the basis that new Federal legislation will decrease the earning of the company.  SLM has of course insisted that the deal must go through, and issued a press release saying that "core earnings" at the company will be negatively impacted by only 1.8 to 2.1 percent annually over the next 5 years.  The issue is whether the MAC clause is triggered by the adverse impact of the new Federal legislation.  The clause reads as follows:

"Material Adverse Effect" means a material adverse effect on the financial condition, business, or results of operations of the Company and its Subsidiaries, taken as a whole, except to the extent any such effect results from: ... (b) changes in Applicable Law provided that, for purposes of this definition, "changes in Applicable Law" shall not include any changes in Applicable Law relating specifically to the education finance industry that are in the aggregate more adverse to the Company and its Subsidiaries, taken as a whole, than the legislative and budget proposals described under the heading "Recent Developments" in the Company 10-K, in each case in the form proposed publicly as of the date of the Company 10-K) or interpretations thereof by any Governmental Authority..."

As the highlighted language shows, SLM and JC Flowers were acutely aware of the potential impact of the new Federal legislation on the earnings of Sallie Mae.  This was not a thunderbolt from out of the blue.

SLM's position is that the "core earnings" of the company will only be reduced by 1.8 to 2.1 percent  MORE than what was already presented in the 10-K.  This sets the bar well under the 10% figure which most lawyers and judges would agree is "material".  As the M&A Law Prof Blog points out, the Delaware courts set a high bar for proving a MAC.  Under these cases the party asserting a MAC has the burden of proving that the adverse change will have long-term effects and must be materially significant.

Of course the issue may be settled before any trial.  Justine Strine has been pressing the sides to settle.  A renegotiated price is the likely outcome, as SLM will not likely want to remain in the public eye after this battle.

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What do you call a guy who gives you a non-binding letter of intent to buy your company for $15.5 million, waits a few months before giving you another non-binding letter, and then sues you when you sign a binding contract to sell your company for $30.5 million?  In Nebraska, he’s called Kelly Conolly.

Conolly worked as a terminal manager for Clark Brothers Transfer, a trucking company based in Nebraska.  James Clark was the company's president and majority shareholder.  In early 2003, Conolly began talking with Clark about buying the company.  After months of negotiating, they executed a confidentiality agreement on October 17, 2003, which gave Conolly financial information about the company.  Clark asked Conolly to give him a written purchase offer in 2 weeks.  Conolly sent another non-binding letter of intent without a purchase offer.  The letter also left the purchase price open.

Clark and Conolly met the next day, orally agreed on a purchase price of $15.5 million, shook hands and left all the other terms open. Clark asked for a firm purchase offer within two weeks.  Six weeks later, Conolly's attorney sent a letter saying Conolly was interested in purchasing the company "pursuant to the terms contained in this non-binding letter of intent."  The letter named a price but reiterated that it was not a binding commitment by either party.  Conolly sent Clark an email stating, "of course this is just preliminary and a formal proposal will be forthcoming once we reach an agreement."  Six weeks later, Clark sold the company to another buyer for $30.5 million.

Conolly argued that the parties had a contract when they agreed on the price and shook hands.  The United States Court of Appeals for the Eighth Circuit held that that the terms of the oral agreement were not “sufficiently definite to demonstrate an objective intent to be bound” at the time the parties shook hands.  The parties were still negotiating many basic terms. 

Wikipedia says that chutzpa is the quality of audacity, for good or for bad.  That may be the right word.

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The recent tax proposal submitted by the two top lawmakers on the Senate Finance Committee "closes a loophole" in the treatment of publicly traded partnerships. 

Years ago, 1987 to be exact, Congress passed legislation treating publicly traded partnerships as corporations.  It excluded however partnerships that derived at least 90% of their income from interest, dividends, and gains from the disposition of a capital asset.  Blackstone and other private equity firms that are flocking to go public have relied on this exemption since most of their income qualifies for the exclusion.  The exemption is huge -- corporations pay up to 35% of their income to Uncle Sam.

The new bill provides that the exception from corporate treatment for a publicly traded partnership, 90 percent or more of whose gross income is qualifying income, does not apply in the case of a partnership that derives income from investment adviser services or related asset management services.  Such a partnership is treated as a corporation for Federal tax purposes and is subject to the corporate income tax.

This strikes at the heart of the private equity firm, which receives fees and carried interests from investment adviser services.  As such, the legislation is pointed directly at firms such as Blackstone that hoped to be publicly traded partnerships without paying a corporate tax.

Reflecting, however, the strong connections that Blackstone must have in Washington, the new bill contains a 5-year exception for any private equity firm that is already public or that has an IPO registration statement already on file with the SEC.  As my tax colleague Stephen Foley notes, Blackstone may have successfully lobbied for the ability to be one of the few private equity firms that can ever go public.

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It's hard to ignore the growth of covenant-lite lending in private equity deals, when even famous investment gurus like  Anthony Bolton remark on it, and at his farewell dinner no less.  Here is what Mr. Bolton had to say on the topic:

“I think the phrase is ‘covenant-lite’, but in many cases it appears to mean no covenant at all,” Mr Bolton said. He added: “Covenant-lite borrowing ... will come back at some stage to haunt the banks,” he said.

Quotes about covenant-lite lending are usually paired with a dire prediction, such as the premonition of another financial bubble.  But will covenant-lite lending really come back to haunt the banks?   

In a typical covenant-lite deal, the lenders give up what are called "maintenance" covenants.  As the name suggests, these are requirements that the borrower maintain certain financial standards at regular intervals.  For example, a borrower might be required to certify that at the end of each quarter, it has maintained a certain ratio of EBITDA to total debt.  These covenants are designed to be an early warning system that the borrower's earnings are deteriorating, and it might become unable to meet debt service requirements at some time in the future.  With these maintenance covenants gone, the lenders rely solely on what are called "incurrence" covenants.  These require that a borrower meet defined financial standards not on a regular basis, but only when there is a specific event, such as an acquisition.  For example, if the borrower wants to make an acquisition, it must certify that it will meet a specific EDITDA coverage test after the acquisition is taken into account.   

Finally, in covenant-lite deals, the other covenants are less restrictive, for example allowing for more extensive dividend payments or larger capital expenditures.

How bad are covenant-lite loans?  Despite the publicity these deals receive, they appear to be limited to large private equity deals involving companies with earnings cycles that are relatively well known or at least fairly predictable.  With companies like these, perhaps the function of maintenance covenants -- to provide an early warning system -- isn't necessary.  What good is a warning when the funds have already been loaned?  Perhaps maintenance covenants aren't really needed, and their elimination is simply a matter of efficiency.

Perhaps the traditional way of lending, where a borrower is required to certify periodically that it remains healthy enough to maintain its debt, is out of date.  Then again, if it is merely out of fashion, we may see it come round again.  Time will tell.

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Freescale Semiconductor  was acquired by Blackstone Group, Carlyle Group, Permira Advisers LLC, and TPG Capital LLC in late 2006.  A recent article by Henny Sender in the Wall Street Journal discussed how this consortium convinced its banks and other lenders to accept an especially lenient package of covenants and interest payment options.  A review of Freescale's public filings since the deal closed reveals just how lenient the package is.

Believe it or not, due to the way the deal is structured, the trade creditors in 72% of Freescale's business are functionally senior to all of the $9.5 billion that was borrowed to finance the acquisition.  The $9.5 billion is "structurally subordinated" to these trade creditors, because the borrower of these funds is the parent company and the trade creditors deal with subsidiaries that did not guarantee the parent's debt.  Pretty neat trick.

Here is one of the Risk Factors in Freescale's Form S-4, filed on March 8, 2007 in connection with a bond exchange offer:

Claims of holders of the Exchange Notes will be structurally subordinated to the claims of creditors of our subsidiaries that do not guarantee the Exchange Notes, including trade creditors. All obligations of these subsidiaries will have to be satisfied before any of the assets of such subsidiaries would be available for distribution, upon a liquidation or otherwise, to us or creditors of us, including the holders of the Exchange Notes.

In a separate section of the S-4 we learn who these lucky trade creditors are and the magnitude of the structural subordination:

Our non-guarantor subsidiaries accounted for approximately $4,594 million, or 72% of our net sales, and approximately $635 million of our EBITDA for the year ended December 31, 2006.

There's more.  Not only is the unsecured high-yield debt in this boat, but the secured debt is too!  Information about the secured debt is a little hard to find in the filing, which is an exchange offer for the unsecured notes.  But here it is:

As of the issue date, none of our subsidiaries will guarantee the Exchange Notes or the new senior secured credit facilities.

In other words, all $9.5 billion of the debt, secured and unsecured, sits at the parent company with 28% of the revenues.  The other 72% of the revenues run through various subsidiaries, none of which has guaranteed even the senior debt.  On top of that, the filing discloses that Freescale is allowed to incur an additional $1 billion of new debt, draw on a $750 million revolved and pay some of the bonds in PIK notes.  With the bulk of its trade creditors protected and plenty of excess capital, it's hard to imaging how this boat could ever go down.

Apologies to Polonius, but what a great time it is a borrower to be.

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This is from an article in the Boston Globe quoting Scott Sperling and Kevin Landry of TA Associates:

"The reality is the markets are willing to provide extraordinary amounts of debt, almost indiscriminately," says Scott Sperling , copresident of Thomas H. Lee Partners, the big Boston private equity firm. "It's hard to put these companies into default. I can't think of the last time we had a real covenant in one of our deals."

Landry told me about the terms TA Associates secured recently to fund the purchase of a company. In particular, the interest rate was set at 2.25 percent over the floating London Interbank Offered Rate, or LIBOR. But TA Associates doesn't have to make all its payments in cash if the acquired company runs into trouble. It can make something known as a toggle payment, or "payment in kind," essentially borrowing more to make the regularly scheduled loan payment. The only penalty: an interest rate that rises 0.5 percent."

Covenants are a thing of the past.  The toggle payment, payment-in-kind and similar default-avoidance provisions, make even failures to pay interest a non-event. 

You could argue that what the lenders are doing is pre-agreeing to terms of a default work-out program.  They are saying, "we like the horse we rode in on, and are willing to give them time to get back on track when problems arise."  It is a show of faith in the ability of the PE sponsors to work out any problems or ride out short term economic issues.

Is it a bad idea for lenders to be handing over traditional lending rights to PE sponsors?  Maybe.  But is the cost and outcome of bankruptcy any better?

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Several recent deals illustrate the extent to which financial covenants have all but disappeared from senior loan agreements in private equity transactions. The following transactions were chosen at random.

• In the October 2005 acquisition of Neiman Marcus by Texas Pacific Group and Warburg Pincus, the $2 billion senior loan facility provided by Credit Suisse and Deutsche Bank Securities had no financial covenants. The agreement did have the usual negative covenants, but even these were significantly weakened. For example, the restriction on incurring other indebtedness had 23 exceptions.

• In the November 2005 acquisition of the Vitamin Shoppe by Bear Stearns Merchant Banking, the senior revolving loan facility provided by Wachovia Bank had one financial covenant. It said that if the availability on the revolver was nearly tapped out (less than 10% remaining) then during the four preceding quarters the Fixed Charge Coverage Ratio had to be at least 1.1 to 1.0, or barely enough to cover the charges.

• Finally, in the January 2006 acquisition of AMC Entertainment by J.P. Morgan Partners and Apollo Management from Bain Capital Partners, the $850 million senior credit facility provided by Citicorp had one financial covenant. This covenant provided that as long as the revolver remained outstanding, the company had to maintain a ratio of Senior Debt to EBITDA, on a pro forma basis (!), of at least 3.25 to 1.0.

These random selections from the credit agreements of large and mid-market deals illustrates the extent to which lenders have turned over the risk of defaults to the ultimate purchasers of the debt, namely, the CLO pools.

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The ratio of total debt to EBITDA in mid-market private equity transactions is now as high as it was in 1997 – 4.7 times for companies with less than $50 million in EBITDA and 5.4 times for companies with more than $50 million of EBITDA (Source: Standard and Poors). The ratio of EBITDA less CapEx to Cash Interest in highly leveraged loans is also falling – in the 4^th quarter of 2006 the ratio fell to 2.2 times (Source: Standard and Poors).

At the same time, the covenants being written for leveraged loans are becoming more “lite”: several years ago, loan covenants were written at a 15% discount to model; now they are being written at a 25% discount.

“Covenant-lite” transactions come in many forms. In their most direct form, the covenants that require the borrower to “maintain” certain financial ratios are eliminated altogether, and the lenders are left to rely only on covenants that restrict a company from “incurring” or actively engaging in certain action. For example, a covenant that requires a company to maintain a ratio of debt to EBITDA can be breached if the financial condition of the company deteriorates, as the covenant is measured periodically, usually quarterly. But a covenant that only restricts a company from incurring new debt cannot be violated simply by a deteriorating financial condition, the company has to take affirmative action to breach it. 

Less direct forms of “covenant-lite” include carve-outs in traditional maintenance covenants that forgive in advance a certain measure of deviation from the standard. It is sometime more palatable to embed these carve-outs in a traditional loan covenant than discard the covenant altogether.

In addition to covenant-lite structures, private-equity sponsored deals have started to include a greater number of “equity cure” provisions. These enable a borrower to cure a covenant deficiency by adding more equity into a deal to count as EBITDA, thereby curing the breach. The additional equity does not have to be used to pay down debt and can be used for different purposes such as capital expenditures. In effect, the private equity sponsor is pre-negotiating an equity infusion without having to get lender approval.

This trend is of course a function of the amazing amounts of liquidity available in the credit markets to fund acquisitions.  The impact of these covenant-lite transactions will be to retard the speed with which lenders will be able to take control over troubled deals.  That may not be such a bad thing.  Lenders are not equipped to own a business and typically sell too quickly when forced to take over a company.  The next downturn may provide less opportunity for distressed debt investors than previous business investment cycles, as fewer private equity sponsors may be handing over the keys to their lenders.  

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In a recent case from Delaware’s chancery court, the clear language in a merger agreement, controlling dispute resolution matters, was enforced by the court even where the method specified wasn’t the best way to resolve the dispute. The case underscores the importance of thinking carefully about the implications of arbitration clauses, and especially how two or more arbitration schemes relate to each other.

Matria Healthcare entered into an agreement to acquire CorSolutions Medical for $445 million. Both companies were engaged in the disease management business. Nearly 5% of the purchase price ($20.3 million) was set aside in an escrow account to satisfy claims that the closing net working capital of CorSolutions fell short of a minimum target. The escrow account was also available to satisfy claims under the indemnification provisions, including breaches of representations and warranties.

Whether a claim fell under the working capital adjustment or the indemnification claim was critically important, as indemnification claims were subject to a threshold of $4.45 million, while claims for a working capital adjustment were not subject to any threshold. There was an important procedural difference as well. Claims concerning the closing net working capital were to be resolved solely by a specific accounting firm. Indemnification claims were to be resolved in accordance with the Commercial Arbitration Rules of the American Arbitration Association, which give the parties the ability to challenge and investigate claims.  

The parties saw ahead of time that disputes involving, for example, misrepresentations could fit within both arbitration schemes. They decided that any matter relating to the closing working capital had to be resolved by the accounting firm mechanism, even though the matter could also be raised as a misrepresentation under the AAA procedure.

Shortly after the closing, a messy dispute arose involving a customer of CorSolutions. The customer instituted an audit of a CorSolutions disease management program. Matria dealt with the matter after the closing by negotiating a resolution with the client that involved, among other things, a cash payment of $1.5 million and amendments to the customer contract. Matria applied the $1.5 million payment as a debit to the closing working capital and asserted a claim against the escrow account.

The dispute could have been raised as both a working capital adjustment and a claim for indemnification. CorSolutions thought the working capital arbitration was too narrow a context to allow a full airing of the issues, and it asserted that the AAA was the only proper place to hear the dispute. It also, of course, wanted the claim to be subject to the $4.45 million threshold for indemnification claims.

The court agreed in substance with CorSolutions, but ruled in favor of Matria, on the strength of the clear hierarchy of arbitration contained in the merger agreement. Even though the dispute was one that typically would be subject to an indemnification threshold, the clear hierarchy of arbitration procedures forced the claim into the working capital adjustment, for which there was no threshold. Clever drafting by Matria’s attorneys.

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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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Credit continues to be readily available for buyouts of all sizes at attractive terms.  One notable features of leveraged acquisition financing in the past few years has been the growth of “second lien” debt financing in place of traditional “high yield” debt financing.

As the name suggests, the providers of second-lien financing get a security interest in the underlying collateral, but it is ranked second to the senior debt. Specifically, the second-lien lender agrees to subordinate its security interest to the rights of the senior lender. Over time, as the senor term debt is repaid, the second-lien financing achieves a higher position in the capital structure, as it remains senior to trade and other unsecured debt. Under the Bankruptcy Code, holders of second-lien debt will have priority over unsecured creditors, the right to adequate protection, the right to post-petition interest, and the right to object to sales of collateral unless they are paid in full from the proceeds of sale.

The growth and popularity of second-lien financing has nearly eclipsed traditional high yield financing, especially in large transactions. But even in the mid-tier arena, second-lien financing is making rapid inroads on traditional high yield financing. The difference in pricing between second-lien and high yield financing can be 200 to 300 basis points. Whether the second-lien position is adequate compensation for this reduced interest will be discovered when the next round of defaults and workouts hits the private equity markets.  

In many ways, second lien financing is a product of the collateralized loan obligation market. CLOs are pools of capital that invest in collateralized loan obligations. The vast amount of cash that has poured into CLOs in recent years has increased the availability of financing structured as second-lien debt.

 

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The purpose of having the financial and affirmative and negative covenants in senior loan agreement becomes clear in the Defaults section of the agreement. It’s here that they get their teeth. 

Defaults

The first events of default are non-payment of principal or interest. There is generally no grace period for principal payments. Interest payments are usually given a short grace period of five days. After that, nonpayment results in immediate default of the entire loan.

Another category of defaults occur if any representation made by borrower proves to have been incorrect in any material respect at the time it was made. This is a static test, looking only at the representation on the date it was made and asking if it was true or false in all material respects on that date. The limitation to material issues is intended to rule out minor inaccuracies as a cause of loan defaults.  What constitutes materiality is not usually defined in much detail.

After nonpayment, the most important defaults are those involving covenants. These are not static events. Covenants apply to the activities of the borrower throughout the life of the loan. Failure to comply with a covenant can result in the default of the entire loan agreement, even if the borrower is current in its payment obligations. A covenant default is therefore a powerful tool in the hands of the lender, and lenders frequently use covenant defaults to impose additional restrictions on a borrower or even to accelerate repayment of the loan.

Covenant defaults usually have a cure period. The borrower is given a chance to correct the default before it becomes a reason to accelerate the loan. Covenant defaults are sometimes classified in two groups: those that have short cure periods, such as five days of less, and those that have longer cure periods, usually thirty days. The shorter cure periods are reserved for those important covenants that can’t be readily corrected, such as the delivery of an incorrect financial statement. The longer periods are reserved for the things that can be corrected with proper diligence, such as compliance with laws, removing liens from properties and delivering compliance certificates.

A special class of defaults is reserved for bankruptcy and insolvency. These generally trigger immediate default of the credit agreements.

Remedies

Once a default has occurred and the borrower has run out of time to correct it (if such a right exists) the lender has the ability to accelerate the loan and demand that all amounts due under the loan be repaid immediately. Any obligation of the lender to continue extending credit under a revolving credit facility is canceled. If the borrower fails to immediately prepay the loan, as is generally the case once a default occurs, the lender is then free to exercise the security instruments and liens it carefully acquired when the loan was made. Also at this time the defaulted loan begins to bear a higher, default interest rate.  

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Affirmative covenants are those things the borrower must affirmatively do during the term of the loan agreement. Most of these requirements are things the borrower would do in any case without being instructed by a lender, such as pay its taxes, comply with laws, and meet its financial obligations. Other covenants are matters that work to conserve the borrower’s cash flow, focus borrower on a specific line of business and generally keep its nose to the grindstone.

Negative covenants are the things the senior lender says that a borrower may not do. Most of these are things the borrower wouldn’t do anyway. The rest are designed to keep the borrower focused on running its business in the ordinary course and repaying the senior lender’s debt.

Here is a list of certain affirmative and negative covenants that are often negotiated in the credit agreement of a private equity transaction:

Affirmative Covenants:

• Ordinary Course Conduct of Business. Conduct its business in the ordinary course and use its reasonable efforts, in the ordinary course, to preserve its business and the goodwill and the business of its customers, advertisers, suppliers and others having business relations with it.

• Payment of Taxes. Pay and discharge before the same shall become delinquent, all lawful material governmental claims and all material federal and material state, local and foreign income, franchise and other taxes, assessments, charges and levies.

• Maintain Insurance. Maintain insurance with responsible and reputable insurance companies or associations in such amounts and covering such risks that are sufficient, appropriate and prudent in the conduct of the business of the kind conducted by the borrower.

• Access to Information. Let the lender have access to books and records, visit properties of the borrower, meet with management and meet with auditors.

• Books and Records. Keep proper books of record and account, in which full and correct entries shall be made in conformity with GAAP.

• Maintain Condition of Assets. Maintain its properties in good working order and condition and preserve its permits and intellectual property.

• Additional Collateral. Deliver any supplements or amendments to the collateral documents as may be necessary to reflect and fully protect the lender’s security interest in the collateral.

• Deposit Accounts. Where collateral includes cash, deposit all cash in controlled collateral accounts.

• Real Estate. Comply with all obligations under lease agreements, and deliver mortgages on any real estate acquired subsequent to the loan.

Negative Covenants:

• Indebtedness. Borrower will not create, incur, assume or otherwise become or remain directly or indirectly liable with respect to any Indebtedness except for expressly permitted items that are typically subject to caps and refunding limitations.

• Liens. Borrower will not create or suffer to exist, any lien upon or with respect to any of its properties or assets, whether now owned or hereafter acquired, or assign any right to receive income, except for items expressly permitted such as those arising in the ordinary course of business or by operation of law.

• Investments. Borrower will not make any investments in any other party except as specifically permitted or as may be necessary in connection with the borrower’s ordinary course of business.

• Sale of Assets. Borrower will not sell, convey, transfer, lease or otherwise dispose of, any of its assets or any interest therein except as specifically permitted or as may arise in the ordinary course of business (subject to caps and permitted baskets).

• Restricted Payments. Borrower will not pay any dividends on stock or redeem and stock subject to permitted exceptions.

• Prepayment and Cancellation of Debt. Borrower will not prepay or cancel any debt subject to compliance with defined restrictions such as leverage ratios.

• No Mergers. Borrower will not merge with another party or enter into any fundamental transaction that changes the identity of borrower.

• Change in Nature of Business. Borrower will not make any material change in the nature or conduct of its business, except for businesses reasonably related to the business already carried on or ancillary or complementary thereto.

• Modification of Subordinated Debt Documents. Borrower will not change or amend the terms of any subordinated debt if the effect of such amendment is to (i) increase the cash pay portion of the interest rate on such debt, (ii) change the dates upon which payments of principal or interest are due, (iii) change any default or event of default, or change any covenant with respect to such debt in any manner materially adverse to borrower, (iv) change the subordination provisions of such debt, (v) change the redemption or prepayment provisions of such debt or (vi) change or amend any other term if such change or amendment would be materially adverse to borrower.

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Financial covenants are specific financial benchmarks that the borrower must satisfy during the term of the loan. The covenants generally change over the course of the loan, reflecting improvements in growth and financial condition that are expected to occur. The following are typical financial covenants in senior loans made in connection with private equity transactions:

• Leverage Ratio. Compares the borrower’s total debt from all sources to its EBITDA (earnings before interest, taxes, depreciation and amortization).

• Interest Coverage Ratio.  Compares the borrower’s EBITDA to its cash interest payment obligations.

• Fixed Charge Coverage Ratio. Compares the borrower’s EBITDA minus capital expenditures to its fixed obligations for interest, principal on debt, cash dividends of preferred stock and income tax liabilities.

• Capital Expenditures. The amount the borrower can spend on capital expenditures.

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The closing conditions in a senior loan agreement spell out what hoops the borrower must jump through before it is able to draw down the loan proceeds. The first condition is that borrower must sign all the contracts diligently prepared by the bank’s lawyers to document and secure the transaction. In addition to the main credit agreement, the bank’s lawyers prepare the following documents:

• Promissory Notes. Different promissory notes reflect the different term loans and revolving credit facilities provided by the senior lender.

• Intercreditor Agreement. Where there are two or more lenders, as is usually the case in private equity transactions, the intercreditor agreement spells out the relative rights of the creditors with regard to the borrower’s assets in the event of a default.

• Guaranty Agreements. Each subsidiary of the borrower typically guarantees the credit facility, thus giving the lender a direct security interest in the assets of the subsidiary.

• Security Agreement. Borrower and its subsidiaries pledge and grant security interests in all of their assets to secure the loan. In the event of default, the lender can repossess this collateral under Article Nine of the Uniform Commercial Code.

• UCC Filings. As part of getting security interests in the borrower’s assets, the lender must file UCC instruments in the borrower’s state of incorporation.

• Mortgages. If real estate forms part of the collateral package, the borrower will sign real estate mortgage documents, giving the lender a first mortgage on the land. These are especially important where real estate forms the principal asset of the borrower, as with resource or agricultural companies.

• Pledge of Certificates and Accounts. Certain assets, such as stock certificates and bank accounts, are not covered by the UCC and separate arrangements have to be made to perfect security interests in these assets, usually by taking direct possession. Any other assets that are not covered by standard UCC security documents, such as ships, require their own forms of pledge agreements.

• Landlord Waivers. Where a borrower, such as a retailer, has significant leased premises, lender will require waivers from landlords that give the lender priority over collateral located at the premises.

• Opinion of Counsel. Borrower’s counsel will be asked to give legal opinions as to the validity and authorization of the credit documents and certain conditions of borrower such as good standing and litigation.

• Certificates of Insurance. Certificates from insurance companies certifying that the borrower maintains the prescribed levels of insurance, and naming the lender as an additional insured under the policies.

• Solvency Opinion. Lenders sometimes require an opinion from a valuation expert that borrower is technically solvent after incurring the debt, in order to address possible risks under bankruptcy law.

          Finally, anything that borrower has specifically promised to do, such as deliver an audited financial statement, is a condition to closing.

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Senior credit facilities in private equity deals generally include one of more term loans and a revolving credit facility. The term loan is a fixed amount that is loaned for a defined term. The loan is usually repaid in fixed installments of principal and interest so that the loan balance decreases with each payment.  

The revolving credit facility is a commitment to loan funds from time to time based on the borrower’s inventory and accounts receivable. The facility will have an upper limit of availability, but the actual amount that can be borrowed will vary from month to month based on the amount of inventory and receivables. Each month the borrower has to pay interest on the outstanding balance and, if the loan balance exceeds the borrowing base, and amount of principal equal to the excess. When the facility matures, usually in a year, the entire amount becomes due and payable. If conditions are good, the facility is generally renewed. 

A portion of the credit facility may be dedicated to providing letters of credit, if the borrower uses these instruments in its business. Senior credit facilities can be prepaid, thought there are often penalties associated with prepayments that occur other than at stated intervals. The facilities must be prepaid with the proceeds of assets sales, public offerings and other extraordinary transactions.

Interest rates may be computed on the basis of bank prime rates or LIBOR, with certain rights to switch back and forth between the two forms of loans as financial conditions may determine. Senior lenders also charge a number of fees on the initial borrowings and on the specific commitments that are made to provide ongoing financing.

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The indemnification provisions of a purchase agreement function like an insurance policy. Each party (buyer and seller) stands behind its warranties and agrees to make the other party whole if there is a loss that is attributable to or covered by the misstatement or broken promise. 

In some cases, the indemnification may take the form of protection against the claim of a third party. For example, if the seller warrants that the business may be conducted without infringing the intellectual property of any third party, and that proves not to be true, then the seller must hold the buyer harmless against the claim made by the third party. In other cases, the indemnified matter may be a direct loss suffered because the quality of the assets transferred is not as represented. For example, if the seller’s receivables are warranted to be collectible in full, and there is a shortfall in collection, the buyer can recover the shortfall from the seller.

Like an insurance policy, the first question is how long the coverage lasts. The indemnification sections will say how long the representations and promises will remain in effect. This is generally a year or two after the closing, although certain representations, such as those covering taxes, employee benefits and environmental laws, will last longer as the laws they cover carry exposures that may last many years.

Next, like an insurance policy, the indemnification clause will usually have a threshold or deductible for making any claims at all, on the theory that small or minor claims do not warrant invoking the indemnification process. The size of the deductible will generally vary according to what is considered material in the transaction. A small deal may have a deductible of $10,000 while large deals can have deductibles of $100,000 and more. This issue is usually negotiated in the term sheet. Finally, an indemnification clause may have a cap on the total value of claims that can be made for indemnification, usually expressed as a percentage of the purchase price.

In an asset purchase transaction, the indemnification protection that a buyer gets will cover three events: a misrepresentation or breach of a warranty made by seller; a breach of any covenant or agreement made by the seller; and any liability that seller agreed to retain. For the seller, the indemnification covers the first two items and any liability that buyer agreed to assume but was nonetheless imposed on seller. Indemnification extends to any costs or expenses (including reasonable attorneys fees) that the protected party incurs as a result of the claim or loss, such as the costs of defending against a third party claim and the cost of asserting a claim against the other party to the deal. In fact, the only legal liability added by the indemnification clause is this obligation to pick up costs and expenses, since in the absence of the clause, the aggrieved party would still have a claim for breach of contract in case the other party breaches a warranty or covenant.

The procedures for exercising indemnification claims involve giving the other party notice of the claim and the opportunity to take over the defense of the claim, in the case of a third party liability. The party providing the indemnification generally has the right to settle the matter and both parties must assist in the defense of third party claims.

Related Posts:  What is Indemnification? Part 1 and Part 2

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In private equity transactions, the most important thing that needs to happen before a closing occurs is the buyer needs to raise the financing needed to pay the seller the cash portion of the purchase price. Sometimes this is stated as an express condition, meaning that if financing cannot be obtained, the private equity firm will not be in breach of the agreement. If it is not an express condition, then the private equity firm will be in breach of contract if the financing cannot be raised. But because the private equity firm generally forms a special purpose entity for the sole purpose of completing the acquisition, there isn’t a company against which seller can assert a claim. For this reason, even where financing is not stated as an express condition, as a practical matter there is a financing condition in most private equity transactions.

Smart sellers sometimes require that a buyer provide firm financing commitments from equity and debt sources before a binding purchase agreement is signed. Alternately, sellers may demand that the buyer place cash in escrow that becomes forfeit in case financing is not raised by a stipulated date.

Buyer’s obligation to complete the purchase of the business is subject to the fulfillment of a number of standard conditions. These conditions may include further due diligence in case certain matters are left for review after the contract is signed. The more conditions loaded into the contract, the less the contract is a firmly binding agreement. Some contracts can have so many conditions and due diligence requirements that they amount to no more than an option to purchase the company. 

The standard closing conditions are as follows:

Continued Truth of Warranties.  The representations and warranties of seller in the purchase agreement must continue to be true and correct in all material respects. In essence, seller must reiterate the representations at the time of the closing.

Performance of Covenants. Seller must perform in all material respects all covenants and obligations and comply with all conditions required by the purchase agreement to be performed or complied with prior to the closing date.

Material Adverse Effect. No event, occurrence or circumstance shall have happened that has had or could reasonably be expected to have a material adverse effect on the business or prospects of the business. This section gives buyer one last chance to cancel the transaction if something material and unexpected happens to the seller between signing the purchase agreement and the closing.

Permits and Consents. Seller must obtain all of the consents, approvals and clearances that it’s required to get before the closing, such as third party consents under contracts that require such consents in order to be assigned.

No Litigation. There must not be any litigation or proceeding pending or threatened to restrain or invalidate the sale and purchase of the business. Such proceedings might include a governmental antitrust action or securities law matter.

Authorization. All corporate action necessary to authorize the execution, delivery and performance by seller of the purchase agreement, and the consummation of the transactions contemplated thereby, must have been duly and validly taken by seller. This is generally performed even before the agreement is signed, although sometimes shareholder approvals are not obtained until after the agreement is signed.

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The first covenant given by seller is the promise that it will operate its business only in the “ordinary course” and “consistent with past practice” between signing the purchase agreement and closing. The covenant goes on at length about specific things that seller will and will not do during this period without the permission of buyer. The purpose of these sections is to make sure that no significant or unusual transactions are undertaken without buyer’s knowledge and consent.

Seller agrees to give the private equity firm and its representatives access to its books, records, facilities and employees between signing the purchase agreement and closing. This is often necessary to bring in lenders for the transaction and let them complete their due diligence and investigation of seller and its business. 

Seller and its affiliates, including principal shareholders of seller, typically agree not to engage in the same business for up to three to five years, sometimes longer. This non-compete restriction will include owning any equity interest in any entity that is engaged in the same business being sold and otherwise participating in, managing, controlling, operating or financing any entity that is engaged in this business. The geographic territory of the restriction is generally limited to the area in which seller conducts the business as of the closing date. Also, seller and its affiliates are not allowed to solicit or hire employees of the business to work for them or solicit customers or suppliers to the business. Seller and its affiliates also agree not to use confidential information, such as trade secrets and customer list, of seller after the closing.

These non-compete and confidentiality covenants are very important to a private equity buyer, as seller and its affiliates would otherwise have the ability to set up an effective competing business immediately after the closing. Buyer is given rights to specifically enforce these provisions against any party that breaches them. It is also important to make these covenants assignable to any person the private equity firm may later sell the business.

Often, special covenants regarding trademarks and trade names are included in the purchase agreement, as seller may need to change its name or take other actions to ensure that buyer has the exclusive right to use the purchased trademarks and goodwill. Other times, special covenants regarding the employment of seller’s management team and work force will be included in the agreement.

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Representations and warranties serve two functions. They are part of the due diligence process where the private equity buyer looks at all material information about the target’s business; representations and warranties reflect the results of this investigation. They are also the insurance policy that the seller gives the private equity buyer about the truth and accuracy of the business information. The “representations” are assertions that the information furnished is correct and the “warranties” are legal obligations to stand behind the statements financially.

The subject matters of the representations and warranties cover all major facets of a business. Although the representations are worded in absolute terms, in practice the seller creates a schedule of exceptions and attaches them to the purchase agreement. These exceptions contain information about the company’s business and assets that deviate from the standard representations. Accordingly, these exceptions are important to the private equity buyer and their disclosure often provokes further negotiations.

Many representations overlap one another. For example, a representation that the seller has no liabilities other than those disclosed in its financial statements overlaps with the representation that there is no litigation pending against it, since the litigation may be treated as a liability required to be disclosed in the financial statements. Also, some representations are more important than others, such as those involving the seller’s financial statements. Finally, special attention will be devoted to representations in areas of special importance to a seller. For example, a seller with extensive real estate holdings will give representations on these matters that are far more detailed than sellers whose only real estate is rented office space. In the end, the seller must give detailed representations in every area remotely relevant to its business, with special focus on those areas where the seller generates its revenues.

Sometimes, a representation is qualified “to the knowledge” of the seller, meaning that seller is only responsible for a breach if it knew that the representation was false. Because it is difficult to prove whether a company knew a fact or not, the “knowledge” qualification is granted sparingly.

The following outlines the principal representations made by a corporate seller of business assets, the subject matters covered by the representation and a comment on why the representation is included in the purchase agreement.

2.1 Valid and Binding. 

The purchase agreement is a valid and binding agreement of seller, enforceable in accordance with its terms.

This confirms that all internal approvals (board of directors and shareholders) have been given for the deal. Seller has no legal defenses to enforceability of the contracts. This representation is typically confirmed through a legal opinion from seller’s attorneys.

2.2 No Consents. 

No consent or approval is required to be obtained by seller in connection with its execution or performance of the purchase agreement.

This identifies any third party consents that may be necessary to complete the deal.

2.3 Financial Statements. 

The financial statements of seller identified and furnished to buyer are accurate and complete in all material respects, are consistent with the books and records of seller (which have been maintained in all material respects in accordance with good business practices), have been prepared in accordance with generally accepted accounting principles consistently applied and fairly present in all respects the financial condition and results of operations of seller as of the dates thereof and for the periods covered thereby.

This is the most important representation, as financial statements are the lynch pin of private equity transactions.

2.4 No Undisclosed Liabilities. 

Seller has no liabilities or obligations except as identified in a schedule, disclosed or reserved against in its latest balance sheet, or incurred in the ordinary course of business consistent with past practice since the date of the latest balance sheet.

This is an important catch-all representation on liabilities. It forces seller to specifically identify any liabilities not properly reflected in its financial statements.

2.5 Taxes. 

Seller has filed all tax returns required to be filed and has paid all amounts required to be paid on such returns.

This provides specific verification that taxes have been reported and paid.

2.6 Title to Assets. 

Seller has good, valid and marketable title to its assets; seller owns its real property free and clear of liens; and the assets being conveyed to buyer constitute all of the assets (tangible and intangible) used in connection with the operation of the business as presently operated by seller.

The last part of the representation confirms that seller is transferring all of the assets used in its business, and there are not other assets held by other parties that are used in the business.

2.7 Intellectual Property. 

Seller owns or has the right to use all of its intellectual property; the transfer of this property will not alter or impair any such rights or require any consent or approval; the intellectual property is subsisting, in full force and effect, has not been canceled, expired, or abandoned, and is valid and enforceable; and seller’s business does not infringe upon, misappropriate or otherwise violate any intellectual property rights owned or controlled by any third party.

Intellectual property is a unique class of assets that gets its own set of representations. Buyer can independently verify the validity of patents and trademarks, but not even seller may know whether its business infringes the intellectual property of others.

2.8 Contracts. 

None of seller’s contracts are in default and the transactions contemplated by the purchase agreement will not require the consent or approval of any other party to the contracts.

This identifies all of seller’s contracts and certifies that the contracts are enforceable and no consents are required to transfer them. Consents can be time-consuming and expensive to obtain.

2.9 Employee Plans. 

Seller’s employee benefit, savings, welfare and pension plans comply with law and there are no unfunded pension liabilities.

Benefits have their own federal laws and regulations and it’s customary to break benefit plans out into their own section.

2.10 Labor Relations. 

Representations about seller’s relations with labor unions and the existence of organized labor activities at seller.

This is the place for seller to identify any union activities at its plants, even if no union has been formally recognized.

2.11 Litigation. 

There is no litigation pending or, to the best knowledge of seller, threatened against seller or any of its properties.

Pending litigation is easy to identify and has usually been reserved against on the balance sheet. A buyer is interested in learning if any litigation has been threatened, which may not be reflected in the balance sheet.

2.12 Compliance with Laws. 

Seller has complied with all laws applicable to its business.

The representation is generally easy for the seller to give. Issues can arise where the business operates in a heavily regulated area.

2.13 Absence of Changes. 

Since the date of the last balance sheet, the business has been conducted in the ordinary course consistent with past practices and there has not been any unusual transaction.

This brings disclosure about the business current since the last balance sheet date and requires the seller to identify any transactions outside the ordinary course since that date.

2.14 Inventory. 

Seller’s inventory consists of merchandise of a quality and quantity usable and saleable in the ordinary course of business consistent with past practice, except to the extent of normal obsolescence or to the extent written down or reserved against in accordance with GAAP, and is fit for its intended purpose.

This ensures that the quantity and quality of seller’s inventory is acceptable. The representation implies many subjective determinations about obsolescence and GAAP reserve policies that are more art than science.

2.15 Suppliers. 

Identifies the top suppliers to the business and represents that none of them changed its method of doing business with seller nor indicated that it intends to do so.

Buyer wants to know that it will continue to have a stable source of supply from the key suppliers to the business.

2.16  Accounts Receivable. 

Seller’s accounts receivable arose in the ordinary course of business, are legal, valid and binding obligations of the respective debtors enforceable in accordance with their terms, are not subject to any counterclaim, set-off or defense and have been accurately and fairly reflected in the latest balance sheet.

This representation is a statement that the receivables are collectible in full at their stated amount subject to any reserves established in the most recent balance sheet.

2.17 Related Party Transactions. 

No affiliate of seller is, or in the past has been, a party to any transaction or contract with seller or the owner of an interest in any person which is a competitor or supplier of the business.

An important representation that identifies any transactions or relationships that may not be at arm’s-length.

2.18 Environmental Matters. 

Seller has complied with all environmental laws and has not treated, stored, disposed of, arranged for or permitted the disposal of, transported, handled, released, or exposed any person to, any hazardous substance.

Environmental law compliance is typically treated in a separate section, even though it is covered under the representation that seller has complied with all laws.

2.19 Disclosure. 

All information furnished by seller has been true and correct in all material respects.

This is a catch-all representation saying that the materials and disclosures furnished by seller during due diligence have been accurate in all material respects.

 

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