private equity

Acquisitions - Private EquitySTAGE 1 - IntroductionHello and welcome to this i-Tutorial on private equity.Acquisitions of businesses and the development of new and existing businesses all require financing. The question facing a company is how does it raise that finance, and what are the implications for the company and its stakeholders of doing so?There are various forms of financing which a company may consider. For example, the company may have existing financial resources it can use, it may borrow the money from a bank, or if it is a listed company with substantial borrowing requirements, it may raise money through the capital markets.There is however another form of financing that can be used by private companies that wish to raise money. This is known as private equity funding.By the end of this i-Tutorial you should be able to :•Explain what we mean by the term private equity.•Explain the role of the private equity funds and their advisers, and their main concerns when financing a private equity transaction.•Identify the types of transactions which fall within the generic term “buy-outs” and outline the basic structure of a leveraged buy-out.•Identify the main legal documents used in a private equity transaction, and finally, •Explain the rationale behind some of the main terms negotiated in a private equity transaction.STAGE 2 - The Meaning of Private EquityWhen a company needs to raise capital from external sources, it can do so broadly in three ways. In no particular order these are,For the company to borrow money under a contractual arrangement with an investor or lender. This is known as “debt finance”.For the company to raise money on the capital markets. This is more suited to listed companies with substantial borrowing requirements.And finally, for the company to issue shares giving ownership rights over the company in return for an investment in the company, this is known as “equity finance”.Private equity is a form of equity finance which does not differ in principle from any other type of equity finance provided to a company. However, in a private equity transaction, the source of the finance behind the equity investment is usually funds which have been established specifically to invest in unquoted securities, that is private companies. The fund is normally set up as a Limited Partnership.The private equity provider is usually a team of investment managers who manage and advise funds which come from a variety of sources, including institutions; such as pension funds, banks and insurance companies; companies, individuals and government agencies. The pension funds, companies and other investors in the fund will be the limited partners.As we move through this i-Tutorial and consider the concerns of private equity funds and their advisors, it’s worth bearing the following points in mind:First, a private equity house is in the business of advising funds sourced by third parties and it makes its profits from the successful investment of those funds.Secondly, these funds are invested in businesses owned by private limited companies which by their very nature carry a relatively high level of risk. That risk is further enhanced because the private equity funds rely on the managers of the business to run the business and ultimately make their investment grow.If investments made by the private equity funds do not generate acceptable returns for the fund participants, those participants are unlikely to invest in the same fund in the future. Consequently the private equity house will lose business.Therefore it’s fundamental to the success of a fund that the private equity house reduces the risk inherent in private equity investments. If it can accomplish this, it is more able to protect and grow its own business interests and reputation.STAGE 3 - Activity 1 – Reduction of Risk for ProviderHow do you think a private equity provider makes sure that it reduces the risk of a private equity investment and thereby protects and grows its own business and reputation?Let’s think of it in terms of a simple example. Say that you were responsible for investing ten thousand pounds of your friends’ money in a small business venture. What questions would you be asking about the investment, in order to protect your friends’ money and make it grow? Type in the boxes provided four questions that you might ask. Click ‘Done’ when you are ready to receive feedback.PAUSE AND STOPIn simple terms you would probably want to know the following:•What return am I going to see on the investment?•How long do I have to wait before I get that return on the investment?•If the investment isn’t doing well, what can I do about it?These questions are no different to those considered by a private equity house before it recommends an investment decision. In the next stage, we’ll look at the answers to these questions in the context of the key assumptions a private equity fund will make about a private equity transaction before it invests. If these assumptions are not met when the private equity house evaluates the investment and negotiates its terms, then generally it will consider the risk to be too high and will not recommend the investment.STAGE 4 - Key Assumptions made by the Private Equity ProviderOn your screen now are the four key assumptions that underpin a private equity house’s recommendation to invest. You should see that these assumptions cover the same areas that anyone investing in anything would want to ask themselves, namely, what return will I get on the investment, how long do I have to wait for that return, how will I know the investment is being looked after, and if the investment isn’t being looked after, what can I do about it? Let’s take a look at each in more detail.In order to attract investors into private equity funds, private equity houses must show they have made good returns on the funds which they advise. This return is gauged by what is known as an internal rate of return. In basic terms, this is a compound rate of interest, worked out over the life of the fund, which takes into account when money was paid in by investors and when they receive their return. Because an investment in private equity is a relatively high risk investment, the returns expected by investors in a fund are high. Private equity houses therefore generally expect an internal rate of return in excess of thirty per cent per annum and a multiple of at least two and a half times the money invested.As we have just seen, the objective of the funds is to realise a positive return on their investment. They will want to realise such investment at some point, known as an ‘exit’. Most private equity houses expect to achieve an exit within three to five years after the original investment date. This means that within this timeframe, they will need to release the monies tied up in the fund to investors. In broad terms there are three ways of achieving this. The first is a sale to a trade purchaser of the company in which it has invested. Secondly it might make an initial public offering on a recognised stock exchange, or IPO as it is otherwise known. Thirdly, it might arrange what is called a secondary buy-out. A secondary buy-out is where the managers find a new private equity fund that replaces the existing fund and acquires the company.Private equity houses usually reserve a right to appoint a director or representatives to attend board meetings of the company in which they have invested. The private equity houses will usually hold a majority at board level, but in a non executive capacity. Whilst they have this right they don’t always use it from day one. Generally, they won’t become involved in the day to day running of the business in which they have invested unless the business is not performing well. To make sure it is performing well, and that their investment is being protected, they will insist on certain powers to intervene in or even to veto management decisions from the outset. The managers of the business will have no option but to comply. These reserved powers will certainly extend to major decisions affecting the structure, future or activities of the company, for example, in relation to any major acquisition or disposal of assets.Ultimately, the private equity house’s main objective is to make sure that the funds achieve a successful exit. This generally means that the investment realises an acceptable internal rate of return and multiple of investment within three to five years. If this looks to be jeopardised because the company is underperforming, the private equity house will want the power to take control and, if necessary, appoint new management to turn the investment around and achieve a successful exit.STAGE 5 - Internal Process for Private Equity ProvidersBefore we move on to look at some typical private equity transactions, let’s look at how a private equity house typically advises the funds and manages the investments internally. It’s important to have a general understanding of a private equity house’s internal procedures as these will affect the terms and timing of any transaction you undertake for them when you are in practice. For example, if you don’t appreciate that final approval is required from an investment committee, you may inadvertently compromise your client’s position by committing it to an unrealistic timetable for completion.Take a look at the flow chart on your screen now. This summarises the general procedure for obtaining investment approval within a private equity house. The procedure is generally set out in the investment management agreement entered into with the funds it manages. However, because procedures vary from one private equity house to another, it’s essential to understand each private equity house’s particular requirements.Typically, a private equity house will investigate a potential investment and prepare an investment paper on the investment. This generally evaluates the viability of the investment for the funds and takes into account those key assumptions that I mentioned earlier.This investment paper will then be considered by an investment committee, comprising senior members of the fund management team, who will analyse the investment’s likely pitfalls and returns. The investment committee will test the terms of the investment against its own criteria and the “what ifs” to ensure that it stacks up. The proposal can’t be pursued unless the investment committee approve it.Once the investment committee has given its approval ‘in principle’, an offer can be made to the investment target. If this is accepted, the parties and their advisers will begin negotiations to agree the terms of the investment.The investment committee often needs to confirm its initial approval prior to the completion of any investment. By now, the terms of the transaction will have been negotiated and the legal documentation agreed in principle. The investment committee will want to make sure that the deal as negotiated still supports the initial assumptions that were made. So for example, it would expect to see provisions enabling the private equity funds to remove underperforming members of the management from the Board, who might jeopardise the success of the business. This is known as the “Final Investment Committee approval”.Assuming our transaction requires this approval, and gets it, the investment documentation will be completed.STAGE 6 - Categories of TransactionsNow you understand what private equity is and the role of a private equity provider, the next question is what types of investments do the funds make?Private equity transactions cover a variety of arrangements but these all fall into three broad categories which you can see on your screen now.Businesses that are starting from scratch may need funding at the outset for example, for set up costs and purchase of assets such as land and equipment. Private equity funds may be willing to provide start up capital at this stage in the business’s life cycle.Once the business is up and running, it may then need further funding in order to expand, for example into new product and geographic markets. This is known as development capital and typically will be provided only to companies where the funds have already invested on a start up business. Start up and development capital private equity investments are usually referred to as ‘venture capital’ investment. In a venture capital investment, the private equity house will generally take a stake by subscribing for shares in the existing company. It won’t take over the company lock stock & barrel. There will generally be no debt financing as there is no acquisition of a business or company to finance.Buy-outs are probably the area of funding that many people think of when talking about private equity. In its simplest form a buy-out is where the private equity provider funds the management team of a company to enable it to buy its business. This is usually through an acquisition of the shares of the company which owns the business or even by way of a takeover bid.The term “buy-out” is a generic term used in the industry for a number of different variations on a theme. We’ve just considered the simplest form, where the existing management team buys out the business it manages. Take a look on your screen now at the other types of transaction which fall under ‘buy-outs’. You may hear these spoken about in practice so you should have a basic understanding of what they mean.A management buy-in is where a team of managers, who have not previously run the business, are assembled for the purpose of making the acquisition.A BIMBO is short hand for a buy-in/management buy-out. This is a form of hybrid between a buy-out and a buy-in. In this situation, the assembled management team will include existing managers and an external management team who have been brought in for the purpose.Finally, an institutional buy-out is where the private equity fund sets up a company to acquire a business and gives management a small stake either at the time of the buy-out or after its completion.All these types of ‘buy-out’ have one common thread, namely that an existing business is being acquired, typically through a share purchase. Buy-outs are also often referred to as‘leveraged buy-outs’ because, as we will see, the acquisition of the existing business involves equity financing from the funds as well as a significant element of bank finance.When we are talking about the provision of equity finance in a buy-out, a corporate group structure will be set up to buy the business, or the company which owns the business, whichever it is. The private equity funds will invest in one of the companies in the group in return for ownership rights in that company. We’ll look at the structure of a leveraged buy-out a bit more closely in a moment, but before we do, bear in mind that many of the components of a private equity transaction, whether it’s a start up, development capital, or a ‘buy-out’, are the same. So, the process, your clients’ worries and advice you give them will be similar although the approach of the private equity house will obviously depend on whether it is taking a majority stake or a minority stake in the business.In this i-Tutorial we’ll focus on leveraged buy-outs where, unlike in a venture capital investment, the private equity funds will generally take a majority stake.STAGE 7 - Leveraged Buy-outsA buy-out is the process whereby a private equity fund, together with perhaps the existing management team, or one assembled specifically for the purpose, acquires a business from its current owners. It’ll typically do this either by a share purchase of the company which owns the business, or even by way of a takeover bid.If the buy-out does involve a takeover bid for the target, it is often referred to as a ‘public to private’ management buy-out or a ‘P2P’ transaction. Originally, all leveraged buy-outs were management buy-outs, with management of the target business initiating and leading the transaction, and seeking backing from private equity houses and banks. Today, all but the smallest leveraged buy-outs are usually initiated by the private equity houses, with the management team remaining involved and being incentivised. The private equity provider will also seek to fund some of the acquisition by debt finance from a bank, which will look to secure against the target business.To achieve the equity finance element of the funding, a group of new companies will be established, so that the equity provider, namely the private equity funds, can take equity in return for the investment. At its most straightforward, this will consist of a top company, which will act as an investment vehicle for the private equity funds and management, and a wholly owned subsidiary which will act as the purchasing and bank debt vehicle.If you look at your screen now, you will see a chart which illustrates the main parties to a leveraged buy-out and the funds flow that has just been covered.As you can see both management and the private equity funds will invest in Newco, number one which is the investment vehicle. You’ll remember from earlier, that funds are usually set up as Limited Partnerships. But, the private equity funds don’t usually invest directly in the target company through the Limited Partnership they have set up to hold the Fund. Instead, they will invest via a limited company that has been set up for the purpose of the investment in Newco number one. In return for their subscription monies the funds and management will both receive ordinary shares in Newco number one. The ordinary shares held by management are often referred to as ‘sweet equity’. The fund’s shares are however likely to have different class rights attaching to them and which rank above the rights attaching to management shares. These will be as the right to dividends and to the return of capital on winding up. This is because the private equity funds will require an acceptable balance between the investment risk they are willing to assume, and the return they receive.In addition, the funds might also take a mixture of shares in Newco number one and debt in the form of ‘payment in kind’ notes, known as pick notes for short, in Newco number two. These may provide tax benefits to the funds. The funds may also take preference shares in Newco number two. These may or may not be secured against Target’s assets, but if they are secured they will be secured after the Bank’s debt, which takes priority.A bank is typically asked to provide acquisition finance for the buy-out and working capital to the purchasing vehicle, Newco number two. The purpose of this working capital facility will be to help the business function after acquisition. In return, the bank is likely to take security over Newco number two, Target and Target’s subsidiaries.The debt is also used by the funds to generate higher returns on their investments if the buy-out is successful, but this may seem difficult to understand so let’s consider two scenarios to show how this can happen.In our first scenario, let’s assume Newco two buys Target for one hundred million pounds all of which is financed by way of equity finance by the private equity funds and management.Suppose that the value of Target increases to one hundred and ten million pounds on exit, then the equity value in Newco number one will have increased by ten per cent.In our second scenario, the acquisition price, one hundred million pounds is exactly the same but this time it’s financed by fifty million pounds of equity finance and fifty million pounds from a bank.Now, a ten per cent increase in the value of target will result in a twenty per cent increase in the value of the equity, from fifty million to sixty million, thus providing a higher return on the fund’s investment.The principal source of bank debt is generally referred to as ‘senior debt’ and there will often be a secondary source of debt finance known as ‘junior debt’ or ‘Mezzanine’. It’s called Mezzanine because it earns a higher rate of interest than the senior debt but potentially a lower return than equity finance. It’s also unsecured and ranks behind the senior debt, which means that if the Newco group is ever wound up, the senior debt gets repaid first. Finally, once Newco one and two have received the necessary funding and all the legal documentation is in place, Seller Limited will transfer to Newco two the target shares, in exchange for payment.The acquisition of the shares, or very occasionally assets, from Seller Limited will follow the same procedure as a standard acquisition. Extensive due diligence will be undertaken on Target, there will be either a share purchase or an asset purchase agreement, unless this is a public to private buyout, when instead there will be an offer document, and a disclosure letter. However, there are differences from a standard acquisition, since the purchaser’s group structure needs to be created. Further, additional documentation is required to regulate the investment made by the private equity fund and management team to fund the purchase and also the debt funding required.STAGE 8 Equity Finance Documentation – the Investment AgreementLet’s now look in a bit more detail at how the private equity funds manage the risks and assumptions they have made on their investment. They do this through the legal documentation, which the private equity house will negotiate on their behalf. The funds will only make their investment once they have approved the terms of the legal documentation.The equity finance documentation which is used in all private equity transactions includes;an investment agreement; articles of association of the investment company, which in our case would be newco number one, managers’ service agreements, and in many cases, PIK notes and a warrant instrument. Warrant instruments are used to give the providers of Mezzanine or junior debt options to subscribe for shares.However, the equity finance documentation may well tell only part of the story. It’ll often complement additional transactional documentation, dependent on the structure of the deal. So for example, there’ll typically be banking documentation for debt finance and a share purchase agreement or offer document, and associated acquisition documents. It’s important to make sure that all the documents inter-relate well and, in particular, that none become unconditional unless all others do.In this stage we’ll look at the investment agreement, and then after completing a short activity we’ll consider the other key equity finance document - the Articles of Association.In practice, you might hear people talking not only about investment agreements, but also subscription and shareholders’ agreements. These names are used interchangeably for the same agreement, which basically governs the terms of the provision of the equity finance, the ongoing relationship between the private equity funds and the management and the corporate governance of, in our example, the Newco group.On screen you’ll see a diagram which sets out the main provisions to be included in an investment agreement.The terms of the investment are exactly that, so you will expect to see clauses such as how much money is being invested by the private equity funds and management and the number and class of shares they will subscribe for.The other provisions may not be so obvious so let’s briefly consider these.Conditions precedent in their simplest form set out the events that need to happen before the private equity funds are willing to invest in Newco one. If you think about it practically, the private equity funds will have agreed to invest in Newco one on the basis of a number of matters. These will be things such as the management but also subscribing for shares and the bank providing finance for the acquisition and working capital purposes. It’ll also provide for the business to be transferred to the investment group of companies, typically through a share acquisition or through a takeover bid. If the fund has based its investment on any of these matters, then you should expect to see them set out in the conditions precedent to the investment agreement.Let’s now consider the management warranties. As you know the function of a warranty is generally twofold. The first is to provide a remedy to a contracting party if statements it has relied upon are incorrect, particularly, in order to determine the price it is wiling to pay for the shares of the target, or, sometimes its assets. The second purpose is to flush out information and encourage disclosure of potential problems in the business.In a share or asset purchase, the warranties are usually given by the seller of the target business or company to the buyer.Their purpose is to give the buyer comfort about various aspects of the company or business that is being sold. In terms of the acquisition of the target, the seller will give warranties to Newco two, the buyer, in the normal way. In a private equity transaction, warranties will also be given by the management to the funds, but their purpose is slightly different from those you will see in a share or asset purchase agreement.The management warranties in an investment agreement are more focused, shorter and concentrate on the managers’ business plan and projections, the due diligence reports that may have been prepared in the buy-out and a number of other such areas. The private equity funds’ primary motive for requiring these warranties is to ensure that the management is properly motivated to prepare accurate and often forward looking information, such as the business plan. Remember that whilst the private equity adviser has evaluated the investment opportunity and obtained approval from the investment committee, it has done so on information and facts prepared and produced by the management team.Just as with the warranties given in a share or asset purchase agreement, the funds have the ability to bring a claim for breach of warranty if the management warranties are not true. However, this isn’t the main purpose for the warranties in the investment agreement and it is more to do with encouraging the management to make full disclosure. Because the funds and the management are in effect joint owners of the business, it is in fact extremely rare for a fund to pursue management for a breach of warranty unless it thinks it has been deliberately misled. And in any case, management’s liability for breach of the warranties is likely to be capped at a certain amount.The funds will want to control key decisions in order to safeguard their investment.One way that the funds can achieve this is by reserving certain matters which cannot be passed without their consent. The matters for which consent will be required should be considered carefully, with de minimis thresholds where appropriate, to ensure that they do not unduly fetter the running of the business going forward. A balance needs to be struck between the needs of management to run the business and the need for the funds to protect their investment. Clearly, however, fundamental matters such as altering share rights by changing the constitutional documents,that is the Memorandum and Articles of Association and winding up the company would require the funds’ consent.Depending on the size of the transaction, the board should comprise one or two of the private equity provider’s executives (known as Investor Directors), the key management (usually the CEO, CFO and one, possibly two others), an independent non-executive chairman and probably one other independent non-executive director.。