21 Private equity with copy.qxp by lanyuehua

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									Private equity
The new world

John M Reiss, Daniel M Latham and David A Goldstein of White & Case LLP
survey the private equity landscape.


                                                                                                                       Artist: Satoshi Kambayashi
While fundraising in the first half of
2008 by private equity funds remained
robust and fairly consistent with the first
half of 2007 levels, deal making dropped
off significantly both in terms of deal
volume and transaction size following
the onset of the credit crisis in the sum-
mer of 2007.

This has triggered a number of changes in
market practice. While some of these
changes represent no more than short-
term adjustments, it is now clear that the
days of the mega-buyout are a thing of the
past and the credit crisis of 2007 has had a
lasting impact on the US private equity
landscape.

Against that background, this article
looks at:

• The market.

• Fund formation.

• Buyouts.

• Portfolio company management.

• Strategies and issues.

THE MARKET
The slow down in private equity deals in
the second half of 2007 continued
through the first half of 2008. For in-

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stance, in Q2 of 2008, US buyout volume          parent the purchase price they were pay-                In the first half of 2008, there were a fair
dropped 89% from the same period last            ing was too much or they simply lost inter-             number of deals in the $1-3 billion range
year (The Wall Street Journal, “M&A              est in the deal.                                        (Carlyle’s majority stake in Booz Allen
World Continues to Spin but at a Slower                                                                  Hamilton; the Blackstone/Wellspring ac-
Pace”, 1 July 2008).                             While it is not expected that this trend                quisition of Performance Food Group;
                                                 will continue far into the future (prima-               Blackstone’s acquisition of Apria Health-
All of the biggest deals fell outside of the     rily because most mega-deals have                       care) and the largest US private equity
top 20 range from 2007 and the two               closed or been terminated), in future                   deal through the first half of 2008 was less
largest deals of 2008 came in at less than       deal making there will be robust negoti-                than $6 billion.
$6 billion (Lone Star’s acquisition of the       ations around deal protections in acqui-
home lending business of CIT and the             sition agreements for both sellers and                  Given the recent history in the lending
Nordic Capital/Avista Capital acquisi-           sponsors.                                               markets, it is not uncommon to see equity
tion of the ConvaTec business unit of                                                                    cheques in the range of 50% of the total
Bristol-Myers Squibb).                           Unsyndicated financings. One side effect                acquisition price. This trend is also likely
                                                 of the onset of the credit crunch that ham-             to continue until the lending markets
Deals change shape                               pered deal making in the last half of 2007              warm up to private equity again.
One change directly attributable to the          and continued to hamper deal making in
pace of deal making and the mega-size of         2008 is the build up of unsyndicated fi-                Fundraising
US private equity deals in 2006 through          nancings on the balance sheets of the                   In 2007 US-based private equity funds
the summer of 2007 is the unprecedented          large financial institutions that have been             raised a total of 415 funds with aggregate
number of renegotiated and terminated            traditional sources of debt financing for               funds raised through year-end totalling a
deals, several of which wound up in court        US private equity.                                      record $313 billion (Private Equity Wire, 8
before they were resolved.                                                                               July 2008 and Deal Journal, 8 January
                                                 For example, in July 2007 there were $245               2008).
In several instances, sponsors claimed a         billion of unsold loans on the balance
material adverse change had occurred in          sheets of the major private equity financ-              On the whole, US private equity fundrais-
the target company (the Bain Capital,            ing institutions, while by the end of                   ing through Q2 of 2008 has remained
Carlyle, CD&R acquisition of Home De-            March 2008, the backlog amounted to $95                 strong, totalling an aggregate of $132.7
pot Supply; Lone Star Fund’s acquisition         billion (Bloomberg, “Carlyle, Deutsche                  billion by 185 funds, only 3% short of the
of Accredited Home Lenders; the KKR/             Bank Seek to Raise $500 Million CLO                     $137.2 billion raised by 199 funds during
Goldman Sachs acquisition of Harman              (Update3)”, 21 April 2008).                             first half of 2007 (Private Equity Wire, 8
International), which lead to a renegotia-                                                               July 2008), even though leveraged buyout
tion of the purchase price (Home Depot,          In many instances, such financings were                 fundraising suffered a 20% decline
Accredited Home) or a restructuring of           syndicated at a discount notwithstanding                through Q2 of 2008 with a total of 75
the deal (Harman).                               that the underlying portfolio companies                 funds raising $85.5 billion, down from
                                                 were performing reasonably well. While it               $107.6 billion raised by 91 funds during
There were also instances where lenders          is not expected that this trend will con-               the same period in 2007.
attempted to back out of binding financ-         tinue, as most pre-credit crisis financings
ing commitments (Providence Capital’s            have been syndicated, the current reluc-                The slow down in buyout fundraising has
acquisition of Clear Channel Communi-            tance for private equity lending by those               been offset by steady fundraising by mez-
cations and Centerbridge Partners and            institutions is attributable in part to the             zanine and venture capital funds. During
Fortress Investment Group’s purchase of          gridlock that occurred in the syndication               the first half of 2008, seven mezzanine
Penn National Gaming) and instances              markets and the write-downs lenders                     funds raised a new first half record of $24
where sponsors terminated signed deals           took to as they sold loans at unprece-                  billion. In Q2 of 2008, 71 venture capital
based solely on the terms of the acquisi-        dented discounts.                                       funds raised $9.1 billion, a 3% increase in
tion agreement (Cerberus’s proposed ac-                                                                  dollar value but a 14% decrease in number
quisition of United Rentals; Goldman             Smaller deals. Two recent trends that are               of funds from Q2 of 2007.
Sachs proposed acquisition of Myers In-          expected to continue into the future is that
dustries).                                       the size of private equity deals will tend to           FUND FORMATION
                                                 be relatively modest (that is, less than $5             The legal structure private equity funds
In all of these cases, the sponsors took un-     billion) and the size of equity cheques                 most commonly use as a vehicle is the
precedented steps to reshape or walk away        sponsors will be asked to write will con-               Delaware limited partnership. The lim-
from signed deals because it became ap-          tinue to increase.                                      ited partnership affords investors limited
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liability for the fund’s obligations while               In some instances, a private equity fund                 definition of an investment company and
the fund sponsor, or an affiliate, acts as               may actually desire to use a vehicle that is             are therefore not required to register:
the general partner and has unlimited lia-               not tax transparent (for example, to avoid
bility for the fund’s obligations.                       investors having certain US tax filing and               • Section 3(c)(1) of the Investment Com-
                                                         tax paying obligations). In those cases,                   pany Act exempts any issuer whose
An alternative to the limited partnership                fund sponsors may similarly elect to en-                   outstanding securities are beneficially
is the Delaware limited liability company                sure that their fund vehicles are not tax                  owned by not more than 100 persons.
(LLC). However, an LLC is not generally                  transparent for US tax purposes.
appropriate for funds that either have                                                                            • Section 3(c)(7) of the Investment
non-US investors or that invest outside                  SEC registration                                           Company Act exempts any issuer the
the US, as the tax treatment of LLCs in                  A promoter or sponsor of a private fund                    outstanding securities of which are
some jurisdictions is not favourable                     is not required to register with the Securi-               owned exclusively by persons who, at
(LLCs are not residents of the US for tax                ties and Exchange Commission (SEC) or                      the time of acquisition of such securi-
treaty purposes and, in some cases, LLCs                 otherwise be licensed merely to conduct                    ties, are qualified purchasers (that is,
are not recognised as a flow-through en-                 its activities. However, the promoter or                   natural persons, family-owned com-
tity under the tax rules of some jurisdic-               an affiliate is likely acting as an “invest-               panies and trusts who own at least $5
tions).                                                  ment adviser” to the fund and implica-                     million in investments and any com-
                                                         tions of the US Investment Advisers Act                    pany that owns and invests at least $25
Some private equity funds, due to their in-              of 1940 (Advisers Act) must be consid-                     million.
vestor mix or investor focus, are organised              ered.
offshore, typically in the Cayman Islands                                                                         In each case, if the issuer does not make a
or the British Virgin Islands. These struc-              The Advisers Act requires certain invest-                public offering of those securities.
tures generally provide a similar level of               ment advisers, including private fund
limited liability to investors as that pro-              managers, to register with the SEC. An in-               The Securities Act of 1933 provides that
vided by a Delaware vehicle.                             vestment adviser essentially is any person               securities need not be registered with the
                                                         who is paid to advise others regarding se-               SEC if the securities are offered and sold
Tax transparency                                         curities investments.                                    by an issuer in a transaction not involving
Regardless of the legal structure, nearly                                                                         any public offering. The offering must be
all private equity funds with a US connec-               The Advisers Act provides a number of                    private and not involve a general solicita-
tion are tax transparent, as they are taxed              exemptions from its registration require-                tion. In addition:
as partnerships for US tax purposes.                     ments, including the private investment
                                                         adviser exemption. This exemption ap-                    • Issuers must have a substantive rela-
This means that the fund itself is not sub-              plies to any adviser who:                                  tionship with a prospective investor
ject to US tax; instead, the income of the                                                                          before the offering of interests (com-
fund flows through to each investor and is               • Does not hold itself out to the public as                monly referred to as a pre-existing rela-
taxable in the investor’s hands. The char-                 an investment adviser.                                   tionship) and must have knowledge of
acter of the income also flows through so                                                                           an investor’s suitability to purchase in-
that capital gains realised by the fund                  • Does not act as an investment adviser                    terests in a private offering.
maintain their character when taxed to                     for any registered investment company.
the investors. The same result applies to                                                                         • The SEC prohibits any advertisement,
US and non-US investors, although other                  • Has had fewer than 15 clients in the                     article or notice, or any communica-
jurisdictions may impose tax on the fund                   most recent 12-month period.                             tion in any newspaper, magazine or
or on the income of an investor domiciled                                                                           similar media as well as radio and tel-
in those jurisdictions.                                  Registration as an investment company                      evision broadcast, that has the pur-
                                                         Any issuer, such as a private equity fund,                 pose or effect of offering or selling the
US tax laws provide for an election under                which is engaged in the business of invest-                fund.
which most non-US entities may elect to                  ing or trading in securities must be regis-
be tax transparent for US tax purposes                   tered as an investment company under the                 • Issuers must take precautions when de-
(see Article, “US corporate taxation: an                 US Investment Company Act of 1940 (In-                     termining the content for their web-
introduction”, page 225). This means that                vestment Company Act).                                     sites. The SEC is particularly con-
tax transparency is rarely an issue for pri-                                                                        cerned about a general solicitation via
vate equity funds using a non-US struc-                  However, most private equity funds meet                    the internet. Issuers should restrict in-
ture.                                                    one of the following exemptions from the                   ternet pages that provide access to pri-

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    vate offerings of securities to prospec-      For example, interests cannot be trans-                 holders of the common stock. Valuations
    tive investors through password pro-          ferred to an investor who is not an accred-             may be scrutinised closely by US taxing
    tection after the issuer or affiliate has     ited investor or qualified purchaser. In ad-            authorities, particularly where there are
    determined that the investor is suit-         dition, fund sponsors must comply with                  substantial upward revaluations shortly
    able.                                         anti-money laundering regulations and,                  after formation.
                                                  accordingly, must perform due diligence
Fund governance                                   on each new investor in a fund. Sponsors                Convertible preferred stock is more typi-
A fund is generally governed by a limited         may also need to limit the number of pen-               cally used in early-stage investments,
partnership agreement, an LLC or a                sion plan and other similar investors to                such as venture capital transactions, and
shareholders’ agreement, depending on             avoid legislation under the Employee Re-                in minority investment transactions be-
the nature of the fund.                           tirement Income Security Act of 1974.                   cause it provides the investor a preferred
                                                                                                          return ahead of the common stockhold-
Investor protection. Typical terms that           Investment term. The average term of a                  ers and also permits the seed or minority
provide investor protection include the           private equity fund is ten years (often with            investor to share in equity appreciation
following:                                        a right granted to the sponsor to extend                on conversion to common stock. Certain
                                                  for up to two years). Capital is drawn                  aggressive structures, or aggressive valua-
• A capital commitment of the sponsor             down from investors during an investment                tions, could cause US tax authorities to
  that represents some percentage of to-          period which is generally three to six                  challenge the intended tax analysis or val-
  tal committed capital.                          years. The manager uses the remainder of                uations.
                                                  the term to increase the value of the port-
• Investment restrictions imposed on the          folio investments and seek profitable exit              BUYOUTS
  manager.                                        opportunities.                                          Buyouts of private companies usually
                                                                                                          take place by auction.
• Limits on borrowing on behalf of the            Investors can expect an internal rate of re-
  fund.                                           turn of 20% to 25% overall in a successful              A seller usually engages a financial ad-
                                                  fund.                                                   viser to manage the auction process. The
• Forced distributions under certain cir-                                                                 financial adviser establishes the proce-
  cumstances.                                     Typical investment structure                            dures for the auction with a goal of reduc-
                                                  A private equity sponsor typically forms a              ing the field of potential bidders to a lim-
• Clawback of the profits interest of the         new entity (either a corporation, LLC or                ited number of viable purchasers of the
  sponsor in the case of excess carry dis-        limited partnership) to effect the acquisi-             business who are asked to submit final
  tributions.                                     tion of a portfolio company.                            bids and with whom the seller may enter
                                                                                                          into negotiations with.
• Restrictions on the sponsor’s ability to        Tax and other considerations are taken
  create a competing fund.                        into account when choosing which form                   If the seller is a public company selling a
                                                  of acquisition entity to use. A sponsor’s               significant division or subsidiary, the fi-
• Removal of the sponsor by a specified           equity contribution to the acquisition en-              nancial adviser may be asked to provide
  percentage of the investors.                    tity is either in the form of common stock              the seller with a fairness opinion in rela-
                                                  or a combination of common stock and                    tion to the winning bid.
• Advisory committees made up of in-              preferred stock. On rare occasions a spon-
  vestors that have some approval or              sor funds an acquisition entity with debt.              There is generally no legislation that gov-
  oversight role regarding conflicts of in-                                                               erns sales of private companies other than
  terest and valuation issues.                    If a combination of common and re-                      certain securities laws (that is, anti-fraud)
                                                  deemable preferred stock is issued, at the              and anti-trust rules.
• Modifications to fiduciary duties that          closing, a substantial amount of the ini-
  exist under law.                                tial equity value of the portfolio company              Listed company buyouts
                                                  will be in redeemable preferred stock,                  As the size of US private equity funds has
Transfers. While there are no statutory           which will earn a modest return (6% to                  grown over the last few years, there has
limits on amounts or transfers of invest-         8%) per year.                                           been a steady rise in the number of private
ments, sponsors must ensure that fund in-                                                                 equity sponsors (or consortiums of pri-
terests are not transferred to investors          Any equity appreciation in the business in              vate equity sponsors) acquiring public
who would cause the fund to lose its appli-       excess of the fixed return on the re-                   companies. However, consistent with the
cable exemptions or tax status.                   deemable preferred stock accrues to the                 overall slowdown in US private equity ac-
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tivity, the last half of 2007 and the first              • A two-step transaction involving a ten-                action is structured (itself dependant on
half of 2008 saw a dramatic decrease in                    der offer by the buyer followed by a                   numerous factors) but is one of the fol-
take-private transactions. According to                    back-end merger after the buyer ac-                    lowing:
mergermarket:                                              quires voting control of the target’s
                                                           stock directly from its stockholders in                • A merger agreement.
• In 2006, there were 65 announced                         the tender offer.
  transactions.                                                                                                   • A stock or equity purchase agreement.
                                                         Although a one-step transaction can take
• In Q1 and Q2 2007, there were 84 an-                   twice as long (or longer) as a two-step                  • An asset purchase agreement.
  nounced transactions.                                  transaction to complete (a two-step trans-
                                                         action can be completed in as little as 20               In addition, in a private acquisition, there
• In Q3 and Q4 2007, there were 27 an-                   business days), the one-step transaction                 may be additional agreements between
  nounced transactions.                                  has traditionally been the favoured form                 the sellers and the private equity sponsor,
                                                         by private equity sponsors because:                      such as:
• Through Q2 of 2008, there were 19 an-
  nounced transactions.                                  • Margin rules may limit the amount of                   • Escrow agreements.
                                                           debt that can be used to acquire public
The time and expense of complying with                     company stock.                                         • Transition services agreements (usu-
enhanced record-keeping and disclosure                                                                              ally where the seller is a trade seller
requirements due to securities laws                      • Until recently, private equity sponsors                  who is selling a division or carve-out
changes over the last few years (including                 were concerned that offers of employ-                    business).
the Sarbanes-Oxley Act of 2002 (Sar-                       ment agreements and equity partici-
banes-Oxley)) also created new incentives                  pation to incumbent management                         • Non-compete agreements.
for smaller public companies to go pri-                    could be seen as additional considera-
vate.                                                      tion for management’s stock, which                     • Real estate leases.
                                                           could trigger the best price rule re-
Directors are fiduciaries of the company                   quirement to pay such additional con-                  Equity funding agreements. In connec-
and its stockholders. Under Delaware                       sideration to all stockholders in the                  tion with the funding of the acquisition
common law (which many states follow),                     tender offer. In late 2006, the SEC                    entity, the acquisition entity, the private
once directors have decided to sell control                amended the best price rule to clarify                 equity sponsor’s fund and/or the incum-
of a company, they are no longer charged                   that such arrangements are not subject                 bent management team may enter into the
with protecting the corporate enterprise                   to the rule as long as certain condi-                  following:
but rather become auctioneers charged                      tions are satisfied.
with seeking the best price for the enter-                                                                        • A subscription agreement.
prise.                                                   There are a number of detailed SEC dis-
                                                         closure and other requirements in a going-               • An equity contribution agreement.
This fundamental tenet of takeover law is                private transaction in which the target’s
reflected in the terms of almost every pub-              incumbent management team partici-                       • A stockholders’ agreement.
lic company acquisition agreement,                       pates that need to be taken into account
which, generally speaking, allows the tar-               by private equity sponsors. Going-private                • An employment agreement.
get company to terminate a definitive ac-                transactions may also be subject to en-
quisition agreement if it receives a supe-               hanced judicial scrutiny if challenged by a              • A non-competition agreement.
rior offer. A break-up fee will be payable               stockholder.
by the target if it exercises its “fiduciary                                                                      Equity commitment letters. Private eq-
out” and accepts the superior offer.                     Principal buyout documents                               uity sponsors are usually required to pro-
                                                         In a public-to-private acquisition, the                  vide the seller with an equity commit-
Acquisitions of US public companies take                 principal agreement is a merger agree-                   ment letter from its fund. This represents
the form of either:                                      ment between the target company and ac-                  the fund’s binding commitment to pro-
                                                         quisition entities formed by the private                 vide the equity capital to the acquisition
• A one-step transaction involving a                     equity sponsor.                                          entity.
  merger after a proxy solicitation and
  vote of the target’s stockholders to ap-               In a private acquisition, the principal                  In most instances, the condition to fund-
  prove the merger.                                      agreement will depend on how the trans-                  ing under the equity commitment letter is

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the satisfaction or waiver of the acquisi-         The seller’s post-closing indemnification               In a public-to-private transaction, there is
tion entity’s closing conditions under the         covenant usually requires the seller to in-             typically no post-closing indemnification
acquisition agreement.                             demnify the buyer for breaches of the                   or other post-closing protections, so buy-
                                                   seller’s representations and warranties and             ers rely on interim operating covenants
Sellers typically insist on third-party ben-       covenants, and may also include specific in-            and the no material adverse change clos-
eficiary status under the equity commit-           demnities for pre-closing taxes, known en-              ing condition as their key protections.
ment letter, which gives the seller the right      vironmental matters, and other matters.
to enforce the private equity fund’s obliga-                                                               Management control
tion to provide the equity capital at the          Sellers typically require buyers to agree to            In a typical, single sponsor transaction,
closing directly against the private equity        a cap on the potential losses they can                  the private equity sponsor controls
fund.                                              claim through the indemnity and a rea-                  roughly 80% to 90% of the fully diluted
                                                   sonable survival period during which the                equity of the company with management
Alternatively, a seller may insist on a direct     buyer can bring an indemnification claim                owning the balance through direct share
guarantee from the private equity fund. In         post-closing. Indemnification caps and                  ownership and/or stock options or other
situations where the sponsor has agreed to         the corresponding survival periods are                  incentive securities. Thus, sponsors typi-
a no-financing condition transaction               usually highly negotiated.                              cally enjoy voting control as well as eco-
(that is, where the sponsor has agreed that                                                                nomic control over the business.
its obligation to proceed with the transac-        Typically, a private equity sponsor does
tion will not be subject to the receipt of its     not seek any special or incremental pro-                It is common for the private equity spon-
debt financing), the guarantee also en-            tections from the management team of                    sor and the other equity holders to enter
sures that the seller can collect the reverse      the target. If the target’s management                  into a stockholders agreement which pro-
break-up fee in the event of a triggering          team is selling equity in the transaction,              vides the sponsor with the right to nomi-
termination event.                                 they would typically share pro rata in any              nate a majority of the directors of the
                                                   post-closing indemnification obligation                 company and include a voting provision
Buyer protections                                  and escrow hold-back.                                   whereby all parties to the agreement agree
The most common forms of buyer protec-                                                                     to vote their stock in favour of the spon-
tions in a private acquisition are interim         Reverse break fees. In recent (that is, post-           sor’s board nominees. Stockholders
operating covenants, closing conditions            2004) multi-billion dollar acquisitions,                agreements also contain provisions, such
and post-closing indemnification provi-            private equity sponsors have agreed to                  as drag-along rights, that provide the
sions.                                             transactions where their obligation to                  sponsor with control over exit transac-
                                                   close was not subject to their receipt of               tions.
Buyers typically insist on interim operat-         debt financing. In exchange, sponsors
ing covenants requiring the seller to oper-        have insisted on a cap on the aggregate                 In consortium transactions or in a trans-
ate the business in the ordinary course and        damages that may be payable if they fail to             action where the lead sponsor invites a
not enter into enumerated transactions             close due to a failure to receive their debt            significant minority investor to partici-
without the consent of the buyer between           financing or for any other reason.                      pate in the transaction, the stockholders’
signing and closing.                                                                                       agreement may include supermajority
                                                   The cap typically takes the form of a re-               voting provisions that give the minority a
Buyers usually require certain conditions          verse break-up fee payable by the sponsor.              veto over certain fundamental transac-
to closing, including:                             Such reverse break-up fees are typically a              tions, such as financings, add-on acquisi-
                                                   small percentage (2% to 3.5%) of the ag-                tions and exit transactions.
• Receipt of required governmental and             gregate transaction value for a termina-
  third party consents by the seller.              tion due to a financing failure and in cer-             Debt financing
                                                   tain transactions the fee may be slightly               The level of debt financing used to effect a
• No material adverse change in the tar-           more if the sponsor fails to close for any              typical private equity leveraged buyout
  get entity.                                      other reason.                                           transaction has fallen dramatically since
                                                                                                           the summer of 2007 and there has been a
• Receipt of buyer’s debt financing.               In many recent deals, it is common to see               corresponding increase in the size of eq-
                                                   provisions barring sellers from being able              uity contributions.
• Compliance with covenants by seller.             to seek specific performance to force the
                                                   closing, even if all conditions to buyer’s              New issuances of loans for Q2 of 2008 de-
• A bring-down of seller’s representa-             obligations to close the deal have been sat-            creased 86% to $7.9 billion, compared
  tions and warranties.                            isfied.                                                 with $57.7 billion for Q2 of 2007 (Invest-
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ment Dealers Digest, 7 July 2008).                       sidiaries whose obligations are, in turn,                Priority. Although chapter 7 of the US
Through April of 2008, the average equity                secured by the subsidiaries’ assets.                     Bankruptcy Code is generally recognised
contribution for leveraged buyouts was                                                                            as applying to liquidations and chapter 11
up to over 45% compared to 30% in 2007                   Contractual subordination. Two separate                  of the Bankruptcy Code (chapter 11) is
(Mergers and Acquisitions Journal, 1                     classes of creditors contractually agree                 generally recognised as applying to reor-
May 2008).                                               that the subordinated class of creditors                 ganisations, most businesses in need of
                                                         will not have any right to any payment                   bankruptcy relief use the provisions of
There are many different types of debt fi-               with respect to any extensions of credit                 chapter 11.
nancing that may be provided in buyout                   they make to the relevant borrower until
transactions, for instance:                              all extensions of credit made to that bor-               This is regardless of whether the initial
                                                         rower by the senior class of creditors have              goal or ultimate outcome of the proceed-
• Senior secured first and/or second lien                been satisfied in full.                                  ings is the liquidation of the business or
  financings.                                                                                                     the reorganisation of the business as a go-
                                                         Structural seniority. This can be accom-                 ing concern.
• Subordinated mezzanine financings.                     plished by a class of creditors extending
                                                         debt to an operating company subsidiary                  Under either a liquidating or stand-alone
• Senior or subordinated bonds.                          of a holding company instead of extend-                  plan of reorganisation, the statutory pri-
                                                         ing the credit to the holding company. By                orities with respect to repayment of
• Convertible and other hybrid debt fi-                  structuring the debt in this fashion, the                amounts owing are as follows in descend-
  nancings.                                              creditors are repaid before creditors with               ing order:
                                                         a debt claim only at the parent company,
Senior secured financings are typically                  since in an insolvency proceeding the op-                • Secured claims to the extent of the
senior or pari passu in right of payment                 erating company subsidiary must satisfy                    value of the underlying collateral.
to all of the borrower’s other debt, se-                 all of its debt claims before the parent
cured by all or a significant portion of the             company receives any residual value                      • Administrative claims (generally,
borrower’s assets and comprised of one or                through its equity claim in such sub-                      claims that arise after a bankruptcy is
more facilities of term loans which pro-                 sidiary.                                                   commenced and before the effective
vide financing for the buyout and a revolv-                                                                         date of the plan of reorganisation).
ing credit facility which provides liquidity             Financial assistance. Though there are a
for the borrower’s working capital and                   number of laws and regulations that can                  • Priority claims (for example, certain
other general corporate needs.                           have the effect of restricting loans made to               claims for unpaid wages and taxes).
                                                         finance acquisitions, US laws do not pro-
The mix of these various forms of debt in                hibit a target from giving financial assis-              • General unsecured claims.
any particular transaction depends on                    tance for the purchase of its own shares.
the aggregate size of the debt financing                                                                          • Equity.
and the relevant private equity fund’s                   However, fraudulent conveyance laws in
goals as to the aggregate costs of funds for             the US can have the effect of voiding                    Nevertheless, because section 1129 of the
the financing and its preferences as to                  guarantees and security where the courts                 Bankruptcy Code requires administrative
the various forms of debt available.                     find that a fraudulent transfer has oc-                  claims and certain priority claims to be
                                                         curred. This has an impact on the ability                paid in cash in full as a condition of con-
Debt providers protect their investments                 of a target company and its subsidiaries                 firmation of a plan of reorganisation, a
by taking security and guarantees, using                 to give security, and, in the case of its sub-           senior secured creditor with liens on a ma-
contractual subordination, structural                    sidiaries, provide guarantees in support                 terial portion of a debtor’s assets is often
seniority and through financial mainte-                  of a target company’s repayment obliga-                  effectively subordinated to the payment
nance covenants as well as other negative                tions to lenders.                                        of administrative and priority claims as
and affirmative covenants.                                                                                        the price of liquidating through chapter
                                                         The primary exception that lenders rely                  11, which can be advantageous for the sen-
Security. Security and guarantees are the                on in leveraged buyout transactions in the               ior secured creditor.
primary sources of protection that debt                  US is solvency (that is, after giving effect
providers use. Senior secured financings                 to the buyout transaction, including the                 In addition, the rights of any single
are customarily secured by the assets                    incurrence of all debt and the provision of              holder, including rights relating to prior-
owned by the borrower and are guaran-                    any guarantees and security, the borrower                ities of distribution, may be compro-
teed by all or certain designated sub-                   and its subsidiaries are solvent).                       mised by an affirmative vote of a major-

This article first appeared in PLC’s US Special Report and is reproduced with the kind permission of the publishers.                                          7
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Private equity



ity of holders (that is, two-thirds in           Management investment. Private equity                   its of the venture. They may be structured
amount and one-half in number) classi-           sponsors may also require senior man-                   with performance and vesting hurdles
fied within the same class as such holder.       agers to invest in the transaction, either              similar to stock options or restricted
Inter-creditor and subordination agree-          through a direct cash investment or                     stock, but generally result in capital gains
ments are enforceable in a chapter 11            through the use of their current equity                 to the manager to the extent that the un-
to the same extent enforceable outside           holdings in the target company. The use of              derlying income is in the nature of capital
of bankruptcy. Although distribution             current equity could involve as much as                 gains, rather than ordinary income that
schemes in plans of reorganisation often         50% of a manager’s pre- or post-tax cur-                generally results from the exercise of
take into account the enforcement of             rent holdings in the target company. Spon-              non-qualified stock options.
contractual subordination agreements,            sors typically work with managers to de-
there is no requirement that these agree-        sign equity rollovers in a tax-efficient                In addition, when the portfolio company
ments in fact be enforced through a plan         manner.                                                 is ultimately sold, the manager typically
of reorganisation.                                                                                       recognises gain and receives cash equal to
                                                 It is important to note that, when a private            the value of the profits interest at the time
PORTFOLIO COMPANY MANAGE-                        equity sponsor exits a portfolio invest-                of sale and is taxed at capital gains, rather
MENT                                             ment through a private sale, it should en-              than ordinary income, rates on the gain.
Incentive plans may account for 10% to           sure in the definitive transaction agree-
15% of the fully diluted equity in small         ment that:                                              Section 409A of the Internal Revenue
and middle-market transactions and 5%                                                                    Code codifies the federal income taxation
to 10% in larger transactions. Sponsors          • Any tax deductions relating to incen-                 of nonqualified deferred compensation,
may offer stock options, restricted stock,         tive securities should be for the account             and can affect the structuring of many
incentive stock options, or a combination          of the selling sponsor.                               private equity compensation arrange-
of these.                                                                                                ments. There continues to be a good deal
                                                 • Any attending tax benefits, including                 of significant legislative activity poten-
Incentive securities are usually subject in        potential refund claims for taxes paid                tially affecting private equity compensa-
part to:                                           in previous years and potential post-                 tion.
                                                   sale tax deductions in respect of such
• Time-based vesting (upwards of 50%               incentive securities, should pass to the              For example, Congress is considering leg-
  of the aggregate pool).                          selling sponsor.                                      islation that would tax certain carried in-
                                                                                                         terest at ordinary-income rates, add tax
• Performance-based vesting (perform-            Corporations can offer incentive stock                  penalties on deferred compensation in ex-
  ance metrics may be based on earnings,         options (ISO). ISOs are taxed at capital                cess of $1 million, and accelerate the taxa-
  the internal rate of return realised by        gains rates when the shares are sold. There             tion of deferred compensation from cer-
  the sponsor at the exit and so on), with,      is no tax on ISOs when they are exercised.              tain off-shore entities.
  in some instances, a sub-portion of the        Accordingly, the issuer is not entitled to a
  performance-based pool subject to the          tax deduction for ISOs. ISOs are not                    STRATEGIES AND ISSUES
  attainment of stretch performance              widely used because the manager must                    Trade sales, IPOs and secondary buyouts
  goals.                                         hold shares for at least one year after an              are all typical forms of exits. In addition,
                                                 ISO is exercised to achieve capital gains               up until mid-2007 when there was a robust
Restricted stock may be used where the           treatment. In addition, companies are                   debt financing market, many sponsors
acquisition entity is funded by the spon-        limited on the amount of ISOs they can                  bolstered their overall returns by execut-
sor with both common and redeemable              grant.                                                  ing dividend recapitalisations of recently
preferred stock due to potential                                                                         acquired portfolio companies.
favourable tax treatment afforded low-           Another tax-efficient structure is unique
value restricted stock in cases where the        to portfolio companies operated in flow-                Through July 2007 portfolio companies
recipient makes an appropriate tax elec-         through form (that is, those taxed as part-             of sponsors completed 129 dividend re-
tion to take the fair market value of the        nerships). These companies may grant                    capitalisations for a total value of $47 bil-
common stock grant into taxable income           managers profits interests in exchange for              lion. The second half of 2007 showed a
at the time of the grant and pay income          performing services for the company or                  marked decrease with only seven recaps
taxes at ordinary income rates, with the         an affiliate.                                           completed for a total of $2 billion.
corresponding appreciation generally
taxed at capital gain rates on a realisation     These profits interests generally repre-                Financial sponsors brought approxi-
event.                                           sent the right to a share of the future prof-           mately 47% of all new companies to mar-
8                                         This article first appeared in PLC’s US Special Report and is reproduced with the kind permission of the publishers
                                                                                   Legal & Commercial Publishing Ltd. Subscriptions +44 (0)20 7202 1200
                                                                                                                                                Private equity



ket through Q2 of 2007 and raised 58% of                 than an IPO (although a private sale can                 usually being declared the winner in the
all proceeds during this period, up from                 also be time-consuming). In addition, the                auction. These sales do not typically re-
about 29% and 15%, respectively,                         natural buyer of the portfolio company                   sult in any proceeds being paid to the eq-
through Q2 of 2006 (PricewaterhouseC-                    may be a competitor, so there are sensitivi-             uity holders and often certain classes of
oopers US IPO Watch, 7 August and 3 Oc-                  ties from a business and anti-trust per-                 creditors, such as unsecured creditors,
tober 2007).                                             spective that need to be considered care-                may only receive a few pennies on the dol-
                                                         fully. Through May 2008, there had been                  lar for their claims.
Financial sponsor-backed IPOs for Q3 of                  88 secondary buyouts worth $13.1 billion,
2007 were as high as the rest of the year,               less than one fifth of what it was for the               Section 363 sales are beneficial to buyers
reaching 52% of all transactions and rais-               same period in 2007.                                     because they generally cleanse the
ing 38% of all proceeds. In Q4 of 2007,                                                                           debtor’s assets of all pre-bankruptcy
following the trend, financial sponsors                  Unsuccessful investments. Circumstances                  claims, including liens of secured credi-
were responsible for 68.3% of the total                  normally dictate how and when a sponsor                  tors, which enable a buyer to perform less
IPOs and 31.86% of all proceeds (Price-                  exits from an unsuccessful portfolio com-                due diligence than in a normal acquisition
waterhouseCoopers US IPO Watch, 2007                     pany. In most cases this means that the un-              transaction. Secured lenders favour such
Analysis and Trends).                                    successful portfolio company is in finan-                transactions because they often lead to a
                                                         cial trouble and is forced to seek bank-                 much quicker recovery than under a nor-
IPOs are attractive because the sponsor is               ruptcy protection.                                       mal reorganisation process.
often required to hold a portion of its
original investment post-offering, there-                With court approval a debtor can sell all
fore providing an opportunity to realise a               or substantially all of its assets (§ 363,
greater return on its total investment if the            chapter 11, Bankruptcy Code). Section                    John M Reiss, Daniel M Latham and
offering is a success. IPOs, however, are                363 sales usually take place by auction un-              David A Goldstein are partners in
expensive, very time-consuming, and                      der the control of the bankruptcy court. A               White & Case LLP’s private equity group.
cause the portfolio company to become                    debtor typically enters into a purchase
subject to burdensome securities regula-                 agreement with a stalking horse, which                   The authors would like to thank Joseph H
tions including Sarbanes-Oxley.                          agreement is binding on the stalking                     Brazil, Andrew Oringer and Gerard H
                                                         horse but is only binding on the debtor                                                      ,
                                                                                                                  Uzzi, partners at White & Case LLP and
Private sales are more common exit sce-                  once approved by the bankruptcy court.                   Nicholas V Marchica, Eduardo Lasmar,
narios. These have the benefit of provid-                                                                         Nicola Rosenstock and Jeremy Naylor,
ing for a complete exit from the portfolio               Other bidders are invited to bid against                                                ,
                                                                                                                  associates at White & Case LLP for their
company, and they typically take less time               the stalking horse, with the highest bidder              assistance with this article.




This article first appeared in PLC’s US Special Report and is reproduced with the kind permission of the publishers.                                        9
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