In our third article we discuss the drivers of PE transactions, namely the PE firm and the management of the organisation, the typical documents and the key provisions within the documents and the exit of the PE firm from the organisation.
Definitions:
- Management of the organisation refers to Shareholder Directors and Shareholder Executives of the target organisation.
- PE firm refers to the Private Equity investor company making the investment in the target organisation.
- The shareholders/investment agreement is the legal document that covers the relationships between the PE firm and the founder and/or owners and the directors of the target organisation. .
Drivers of the PE transactions
The PE firms drivers are:
- To protect their investment.
- To enable their investment to grow in an extremely controlled manner. A controlled manner may or may not include incentivising the management of their investment to work to grow the value of the organisation.
- To profit from their investment.
- To control their exit process.
- To ensure a100% exit at a future point in time.
- To ensure that the exit is done in the most tax efficient manner possible.
The target organisations management drivers are:
- To run the organisation with undue restriction.
- To be adequately compensated and incentivised to work hard and to grow the value of the organisation.
- To ensure that as equity holders, their interests are adequately protected for.
- To ensure that any gain in value of equity and thereafter distributions are achieved in the most tax efficient manner.
Typical documentation and key provisions
Key documents are the shareholders agreements. Key provisions found in the shareholders agreement can be categorised under three main headings:
- Those relating to the PE firm controlling its investment.
- Those relating to the owners of the target organisations equity holdings.
- Those relating to the PE firms ability to exit its investment.
Board control
Usually, the day to day running of the organisation will remain with its management. The PE firm will however require the ability to control some aspects of the day to day running of the organisation. They may do this through the appointment of individuals into key positions such as the CEO and the CFO etc. The PE firm will also retain the right to appoint one to three representative non-executive directors. They will also retain the right to appoint additional directors.
Governance structures
The PE firm will put in place corporate governance structures similar to that of a listed company (for example, using a finance and strategy committee, an audit committee and a human resources and remuneration committee etc) as best practice. The management generally recognises the PE firms requirement to ultimately control the board if it feels it needs to. The shareholders agreement will provide for rights of both the PE firm and the target organisation.
Legal control
The PE firms intention is not to get involved in the day to day operation of the organisation, but certain operational decisions will require permission in advance from the PE firm. These permissions would for example include:
- Any changes to the articles and the memorandum of the organisation.
- Entering into major contracts with customers and suppliers.
- Major capital expenditure decisions.
- Disposals of assets.
- Appointment of senior employees or directors.
- Set up Employee Share Options Schemes (ESOP).
- Dividends and distribution.
The shareholders agreement will also have a set of veto rights in favour of the PE firm in the events of deadlocks.
Management warranties
Warranties are aimed at obtaining disclosure from management of all possible issues relating to the organisation that might not otherwise have been disclosed to the PE firm through its financial, commercial, technical and the legal due diligence process. These warranties would typically be given in relation to amongst many items such as:
- The accuracy of the due diligence process.
- The organisation plan, budgets and forecasts going forward.
- The personal position of the management team.
- Tax compliance and tax position issues.
- The validity of contracts currently in place.
Warranties are one of the most touchy issues for management. They can result in much negotiation. From the PE firms perspective, these warranties are not about financial damages if the organisation turns out not to be what the PE firm thought it had acquired but about recourse of the same.
Restrictive covenants
More often than not, the PE firm will require non-compete, non-disclosure and non-solicitation of employees, customers/clients and information about the PE deal as well as about the organisation itself. These restrictions from the management team will be imposed on them for a period after they have left employment with the organisation. The usual negotiating point here is the duration of these covenants. Typical periods range between one to three years. Management might seek to argue that their service agreements contain restrictive covenants and so they need not be in the shareholders agreement.
From the PE firms perspective, however, the covenants are more enforceable if they are included in the shareholders agreement and so the PE firm will require the covenants to be included.
Positive covenants
The shareholders agreement will hold management responsible for providing financial and other information relating to the organisation on a regular basis (for example, monthly management accounts, quarterly board reports, annual budgets and annual accounts etc) so that the PE firm is able to monitor its investment. Management will also be obliged to implement the corporate governance structure required by the PE firm and put in place all appropriate insurances (including directors’ and officers’ liability insurance). All of these provisions are usually acceptable to the management team, provided they are given enough time to prepare information for delivery to the PE firm.
Minority protection for management
One of the PE’s and/or management’s drivers is to protect any minority equity interest in organisation. The most common area of contention is the anti-dilution protection. As majority shareholder and (ultimately) in control of the board, the PE firm or the management might otherwise be able to issue new shares in the organisation thus diluting either the management’s or PE firms equity stake depending on who is the majority. In the shareholders agreement either the PE firm or the management will not want to agree any restrictions on the ability to raise further equity capital. Generally pre-emptive rights on new issues of shares (that is, on a put up or shut up basis) will be agreed upon. Some shareholders agreement may grant either the PE firm or the management a small number of veto rights.
Management equity
A large part of the rationale behind the PE deal is that the PE firm provides financial support and some strategic guidance to the organisation without getting involved in the day to day operations. The day to day running is left to the management team that the PE firm has chosen to run the organisation. In order to get the maximum out of the management team it must be properly incentivised to work to grow the organisation and create value. It is widely considered that giving management or top employees an ownership interest or equity stake in the organisation for which they work is one of the most effective ways of incentivising them to work smart.
In accordance with this model, management will, in addition to the terms of their employment set out in their respective service agreements, be offered ordinary equity in the organisation at the outset of the transaction. This equity will, however, be subject to certain specific restrictions.
Management shares
In order to make this incentivisation tool as effective as possible, the PE firm would want to keep the equity in the target organisation in the right hands, that is, those of its current management team. Accordingly, the shareholders agreement will prevent management from transferring those shares without the consent of the PE firm. Management will seek to negotiate certain exceptions to this blanket transfer restriction and commonly the PE firm will allow management to transfer to immediate family members and family trusts, provided that such persons agree to comply with the relevant compulsory transfer provisions of the agreement. Management might also request the ability to transfer its shares within the management team. This is usually unacceptable to the PE firm as it could result in a mismatch of individual managers’ holdings and prejudice the incentivisation rationale behind the original allocation of the management’s equity.
The shareholders agreement will also include compulsory transfer or leaver provisions if any manager ceases to be employed by the organisation. Again, this is to ensure that the equity remains in the hands of those who are able to work to enhance the value of the organisation. Accordingly, the leaver provisions will provide that the PE firm (or, sometimes, the board or the remuneration committee of the board) might require a leaving manager to transfer his shares, usually to a replacement employee, another member or members of management or to an employee trust instrument that will look after those shares pending allocation to another manager in the future. The concept of the leaver provisions as being a necessary feature of the PE deal model is generally recognised by management. The central concern of management when negotiating these provisions is how much they will be paid for their shares when required to transfer them.
Good leaver/bad leaver provisions
This is another emotive area for management when negotiating the shareholders agreement document. Potentially, a manager could be sacked having worked hard for the organisation for a period and nonetheless be entitled to none of the increase in value of his shares in the target organisation over that period. From the PE firm’s perspective it sees itself and the management as being bound together in the investment for the life of the investment and only those who are there at the end should benefit from any increase in value in the organisation other than in limited circumstances.
A good leaver category includes death, retirement at usual retirement age and permanent disability. A bad leaver category would be dismissal for gross misconduct, fraud, stealing and forgery. The contentious area is causes of cessation of employment that fall between the two obvious categories. From an PE firm’s perspective if a manager resigns voluntarily then this should be a bad leaver event. Management tends to want circumstances constituting constructive or unfair dismissal to be in the good leaver category, but the PE firm usually resists this, given the potential width of these concepts. Ultimately, this is a matter for negotiation and can result in there being a third intermediate leaver category.
The most common position is that if managers are categorised as good leavers they will be paid the market value for their shares at the time of leaving, if required to sell them pursuant to the leaver provisions. If they are categorised as bad leavers they will be paid the lower of either the market value of their shares, or what they paid for them when they originally acquired them. Market value will either be agreed by the parties or referred to the auditors or another independent valuer, for expert determination.
The exit
One of the crucial drivers for the PE firm in the transaction is that it has the ability to exit its investment in the organisation. Linked to this is the importance for the PE firm to be able to force the sale of 100% of the share capital of the target organisation. If it is not able to deliver 100%, this will impact adversely on the amount a third party purchaser would be willing to pay for the PE firms stake. Purchasers usually do not want to purchase organisations which have minority interests. Accordingly the shareholders agreements contain provisions that enable the PE firm to achieve its aims in relation to exit.
Setting the ground rules
The shareholders agreements will usually contain provisions requiring the co-operation generally of the management team if the PE firm sees a potential exit option, whether this is a sale or an initial public offering (IPO) of the organisation. In addition, in the current climate PE firms are keen to ensure the documentation extends these cooperation obligations to circumstances in which the PE firm requires the organisation to be refinanced with additional and cheaper debt, enabling the PE firm to take out some of its investment before a full exit. In addition, the shareholders agreements will make it clear that no warranties will be given by the PE firm at exit in relation to its stake other than as to title to the shares. The main contentious provision in this area is that the PE firm will often require a provision that management will give customary warranties relating to the organisation on an exit. Management generally does not like committing to this obligation so far in advance of the eventual exit.
Forcing an exit
To ensure that the PE firm can deliver 100% of the share capital of the target organisation, the shareholder agreement will have some rights in relation to the shares owned by management. If the PE firm finds a buyer for its shares, it can force the management to sell its shares to the third party purchaser on the same terms. Management will generally accept this provision but will, if well advised, require that the sale to third parties be on genuinely arms-length basis and that the management will be paid the same amount (as the PE firm) per share. If the PE firm agrees to receive share-for-share (or other non-cash) consideration for its shares in the target organisation, it is unlikely to give management a cash-only option for its shares, because this would probably prejudice negotiations with the purchaser and/or the return the PE firm would obtain on its investment.
The shareholders agreements will also usually state that the PE firm cannot sell its shares to a third party purchaser without also requiring the purchaser to acquire management’s shareholding on the same terms. The PE firm will always agree to grant the management tag-along rights in these situations as it is only fair that if the PE firm is exiting its investment, management is also allowed to take the benefit of its hard work over the life of the investment and participate in the exit.
Principles remain despite increased complexity
Private Equity as a concept is not rocket science by any means. It is relatively simple and the overall transaction as well as the provisions of the documentation tend to be heavily negotiated.
The CFOO Centre can be your strategic advisory partner.
We have been part of core PE deals with international investors including the International Finance Corporation (IFC), Proparco, DEG and more recently the PE investor firm Africinvest. We will offer you first hand advice and work with you on the process, due diligence, pre-equity and post-equity valuations, the multiple, the pro’s and con’s, the do’s and the don’ts, the costs vs. the benefits and what you should and shouldn’t expect from such a deal.