THE DEBEVOISE & PLIMPTON PRIVATE REPORT

Volume 1, Number 3 Spring 2001 What’s Inside

Without Pooling, Are Recaps Doomed? A Brave New World: Revised Article 9 to Hit July 1, 2001 page 3 Everyone in the “deal business” knows the extent of any asset impairment of that after June 30, pooling transactions the goodwill in subsequent periods. (The Guest Column: The Advantage of Identity may be only of historical interest, but few existing rule requires all goodwill to be page 4 have focused on what the new proposed amortized on a straight line basis over 40 accounting rules relating to the elimina- years.) This change would allow one of SEC Staff Loosens Standards for tion of pooling and the amortization of the principal benefits historically associ- No-Action Relief for Broad-Based goodwill mean for recapitalizations. ated with pooling – eliminating the charge Option Plans page 5 Recapitalizations have traditionally been to earnings associated with amortizing Termination Fees, Expense one of the ’s most goodwill – to thereafter be realizable in Reimbursement and LBO Funds valuable tools in competing for deals deals accounted for as a purchase, at page 6 against strategic buyers who could utilize least to the extent of no subsequent asset pooling in stock for stock transactions. impairment. Based largely on the view Key Issues in Reviewing When the Financial Accounting that the new rules governing the impair- Confidentiality Agreements Standards Board announced in December ment of goodwill would allow strategic page 8 of 2000 that it was proposing to eliminate buyers to avoid recurring amortization Investing in a Foreign Portfolio the pooling of interest method of of goodwill without having to navigate Company: Call 1-800 Tax Lawyer accounting and to simultaneously revise through the treacherous qualifying require- page 10 the way goodwill would be amortizable ments under the pooling rules, strategic under GAAP, most of the M&A commu- buyers and their advisors have generally Trendwatch: nity, particularly strategic buyers and their expressed support for the FASB proposal, Run-off Management Fees advisors, breathed a sigh of relief. including its elimination of pooling, page 12

True, the bad news was that the although they have expressed concern Alert: Funds and proposal would give effect to the FASB’s over the implementation of the impair- Financial Holding Companies long stated goal of eliminating pooling – ment model. page 16 an accounting technique favored by But what do the impending rule strategic buyers because it allowed them, changes mean for recapitalizations, subject to satisfying a somewhat the financial sponsor’s Byzantine set of rules, to combine their answer to poolings? balance sheet with a target’s balance (Recapitalizations are sheet and to thereby avoid any asset write similar to poolings in up or goodwill on the opening balance that they allow a financial sheet (and any need to amortize those sponsor, subject to a assets in subsequent P&L’s). different set of qualifying But the good news was that the FASB conditions, to acquire also proposed, quite surprisingly, to a controlling interest effectively revise purchase accounting to in a business without provide that any goodwill created in a having to restate any deal (i.e., the excess of the purchase price of the target’s assets over the fair value of the target’s assets) or to recognize any would thereafter be amortizable only to continued on page 14 © The New Yorker Collection 1995 Robert Mankoff from cartoonbank.com. All Rights Reserved. © from cartoonbank.com. Collection 1995 Robert Mankoff Yorker The New “What’s your exit strategy?” letter from the editor As we publish the third issue of the Debevoise & Plimpton Private Equity Report, a publication for our clients and friends in the private equity world, the private equity environment is far less robust than it has been in many years. Although the private equity fundraising environment remains challenging and the performance of many private equity firms’ portfolio companies reflects the uncertainty of our current economic times (as highlighted in this month’s cartoon), we hope to focus private equity firms and their advisors on some good news for private equity firms and their portfolio companies. Our guest columnist for this issue is David Webb, head of Merrill Lynch & Co.’s Financial Sponsors Group and a member of its Operating Committee. David’s article reminds private equity firms of the “Advantages of Identity.” David has been a leader in providing investment banking services to private equity firms for many years and shares some of his thoughtful guidance on how private equity firms can distinguish themselves in today’s competitive environment. The FASB’s anticipated elimination of pooling and its changes in accounting for goodwill are the result of significant input from the business community. In this issue, we analyze the impact that those proposed changes will have on recapitalizations as a deal structuring tool for financial sponsors. Because today’s uncertain equity markets may result in LBO firms re-engaging in going private transactions, we offer some thoughts on how termination fees in public transactions affect LBO funds. In light of the more robust investment climate for private equity firms abroad, Gary Friedman, one of our Tax partners, helps to simplify the Byzantine rules that U.S. private equity firms investing in foreign portfolio companies can face. Also in this issue, Bill Beekman, a partner in our Finance practice, reports on the simplification of UCC filings required to perfect securities interests in leveraged acquisitions as a result of revisions to Article 9 of the UCC. In addition, in this issue we explain how private equity portfolio companies can create broad-based stock option plans without subjecting themselves to SEC registration. In this issue’s “Trendwatch,” we follow up on our recent analysis of fund management fees by focusing on run-off management fees. As always, we welcome your comments on this issue and any thoughts you might have on ways we can offer practical guidance on matters of interest to private equity firms and their investors.

Franci J. Blassberg Editor-in-Chief

Private Equity Partner/ Counsel Practice Group Members

The Debevoise & Plimpton Franci. J. Blassberg All contents © 2001 Debevoise & The Private Equity Mergers & Acquisitions/ Private Equity Report is a Editor-in-Chief Plimpton. All rights reserved. Practice Group Venture Capital publication of E. Raman Bet Mansour Ann Heilman Murphy The articles appearing in this Debevoise & Plimpton All lawyers based in New York Paul S. Bird Managing Editor publication provide summary except where noted. 875 Third Avenue Richard D. Bohm information only and are not New York, New York 10022 Please address inquiries regarding Franci J. Blassberg intended as legal advice. Readers Private Equity Funds (212) 909-6000 topics covered in this publication to Margaret A. Davenport should seek specific legal advice Ann G. Baker – Paris the authors or the members Michael J. Gillespie www.debevoise.com before taking any action with Woodrow W. Campbell, Jr. of the Practice Group. Sherri G. Caplan Gregory V. Gooding Washington, D.C. respect to the matters discussed All other inquiries may be directed Michael P. Harrell Stephen R. Hertz Paris herein. to Deborah Brightman Farone at David J. Schwartz David F. Hickok – Paris London (212) 909-6859. Andrew M. Ostrognai James A. Kiernan, III – London Hong Kong – Hong Kong Antoine Kirry – Paris Moscow Marc A. Kushner Robert F. Quaintance Andrew L. Sommer – London The Debevoise & Plimpton Private Equity Report l Spring 2001 l page 2 A Brave New World: Revised Article 9 Due to Hit July 1, 2001

If you’ve participated as a purchaser in today, provides a system for filing introducing the concept of “authen- the closing of a leveraged acquisition, notice of a non-possessory security tication” in lieu of signature. you probably remember that after interest in personal property on a Revised Article 9 is in fact quite signing multiple copies of multiple simple form in one or more state filing different from the version currently in security documents, some haggard offices, whereupon the security interest effect (last up-dated in 1994 to bring young lawyer presented you with a is “perfected.” (Article 9 also codified “investment property” in as a new mountain of forms with little boxes on the old practice of possessory liens.) class of collateral). Perhaps the most them (maybe even with carbon-paper Thereafter, a competing creditor can widely noted (and potentially problem- multiples, like from the fifties) to keep search the record for notice of the lien atic) change is in the place where UCC signing. Those forms are called UCC- (and if it fails to search, it will nonethe- filings are to be made in multi-state 1’s, and under Article 9 of the Uniform less be deemed to have constructive transactions. Under the old law, the Commercial Code as currently in effect notice, provided that the filing was general rule was that for tangible prop- they need to be filed in specified loca- correctly made). Upon compliance erty, you filed where the property was tions as a notice of the lender’s lien with Article 9, a secured creditor will located, while for intangible property on personal property. Now, a revised have a “valid” and “perfected” security you filed where the debtor was located. version of Article 9 of the Uniform interest, the priority of which is governed Thus, for a sales business with inven- Commercial Code, due to become by the time of filing of the UCC form. tory in 49 states, you filed in 49 states effective nationally on July 1, promises Article 9 has been amended from (and, in some states, maybe in county to make your life as a signer (and time to time, but Revised Article 9, offices as well). the haggard young lawyer’s life as a slated to become effective July 1, is a But where was such a company preparer) of UCC-1 forms much easier. thorough overhaul that was ten years “located?” The UCC said it was located Article 9 of the UCC governs secu- in the making. The stated purpose of at the location of its chief executive rity interests in personal property, and the drafters of Revised Article 9 was office. Assuming that your borrower it is a key underpinning of any secured to address problems that had evolved had its inventory in all states but loan transaction. As the name implies, due to a lack of clarity in the old statute, Hawaii and its chief executive office in the UCC is promulgated to be enacted leading to confusion among lawyers Hawaii, you had to file in the other 49 in each state as a uniform statute, and (more importantly) judges in states to perfect a security interest in though the drafters may provide a interpreting the law. This confusion all of its tangible personal property, menu of options for certain key provi- resulted in clients having to sign piles and you had to file in Hawaii to perfect sions. The original version of Article 9, of additional UCC-1’s because the a security interest in all of its intangible introduced approximately 50 years ago lender’s lawyers wanted to ensure that personal property. For a borrower with in much the same form as it survives the lender would be protected in all less than a national presence, failing to events where the facts or the law were file a UCC-1 in a particular place could even slightly ambiguous. The drafters mean that the lender was unperfected also sought to up-date the statute to in some of the physical collateral James C. Swank – Paris Adele M. Karig John M. Vasily David H. Schnabel help cover transactions (e.g., sales of located in that place or, if the lender Acquisition/High Peter F. G. Schuur financial assets other than customer chose the wrong place as the “chief Yield Financing – London accounts receivable) and types of executive office,” in all of the intangible William B. Beekman collateral (e.g., deposit accounts) that collateral. Lawyers being cautious (and Craig A. Bowman Employee – London Compensation did not exist or had previously been UCC filings being relatively cheap and David A. Brittenham & Benefits carved out of the scope of Article 9. easy to make), UCC-1 filings multiplied. Paul D. Brusiloff Lawrence K. Cagney A. David Reynolds David P. Mason Finally, the revision was intended Hence, the proliferation of UCC-1 forms Elizabeth Pagel to modernize the statute, such as by to be prepared and signed at, or prior Tax Serebransky Andrew N. Berg to, closing. Estate & Robert J. Cubitto continued on page 9 Gary M. Friedman Trust Planning Jonathan J. Rikoon The Debevoise & Plimpton Private Equity Report l Spring 2001 l page 3 guest column The Advantage of Identity

The private equity industry is now fically asked that I bring a comprehen- At my firm, we are fortunate to have well-established, which is quite an sive list of the private equity firms that an extensive franchise with private equity accomplishment in an industry not would be comfortable investing the firms and over a number of years have much more than 25 years of age. Just $100 million he required. developed a clear sense of how many ten years ago, there were only two He told me that he wanted to meet of them are distinctive. As investment private equity firms with as much as with potential partners and make a bankers, we can then knowledgeably $1 billion of capital. Five years ago the decision within three weeks. Well, the introduce those investment opportuni- number of $1 billion firms had grown list of private equity firms with the ties – and many of these opportunities to eleven. Today there are upwards wherewithal to make such an invest- of necessity may only be discussed of 75 private equity firms with over $1 ment extended to over 50 firms, an with a limited number of private equity billion of capital; a third of that number impossible number for him to consider. firms – which would be most inter- with $2.5 billion or more. There are He looked down the list and said, “I esting to a particular firm. Armed with nearly 100 additional firms with $250 haven’t even heard of most of these this knowledge, we are also better able million to $1 billion of capital. In short, firms, David, how does one decide to direct investors to the private equity we now have a large number of well- even whom to interview?” firm that best suits their objectives. capitalized firms competing for A second example which illustrates But it is here in this issue of identity attractive investments and funding. the competitive environment that where I believe that private equity The implications of this to two private equity firms now face comes firms, themselves, can take the lead in important constituencies of private from my partner, Kevin Albert, who communicating their specific identity; equity firms – potential investors and runs our firm’s equity private place- take the lead in establishing a strong corporate managers – are profound. ment department. Early each year, awareness of the individuality of their Recently, I met with the CEO of one many of our largest institutional private firm. Corporate executives and institu- of my firm’s corporate clients who equity investors ask to get together tional investors will ultimately select was considering an acquisition that with Kevin to discuss their private a private equity firm based upon he believed would transform his com- equity investment allocations for the personal chemistry, performance and pany. He needed a financial partner year, and which private equity firms other factors. But they need a place to accomplish this, and wanted our are coming to market and in what size. to start. A strong identity is an advan- advice. This type of request has And this year more than ever, there are tage in what has become a large, become almost commonplace when more demands than the institutions well-established and perhaps even public capital markets are unsettled can possibly fulfill. One important crowded industry. as they are now. The CEO had speci- investor told Kevin recently, “not only David Webb is head of Merrill Lynch can I not satisfy all the requests I have & Co.’s Financial Sponsors Group and received for ‘re-ups’, I don’t even have a member of its Investment Banking the time to monitor the results of the Operating Committee. Private equity firms, 58 firms in which I have invested… I’ve got to cut back.” These institutional themselves, [should] take investors are faced with the same dilemma, how does one decide? the lead in communicating This decision will be significantly their specific identity; influenced by how each private equity firm defines itself. take the lead in establishing a strong awareness of the individuality of their firm.

The Debevoise & Plimpton Private Equity Report l Spring 2001 l page 4 SEC Staff Loosens Standards for No-Action Relief for Broad-Based Stock Option Plans

Incentivizing employees of private that they will now consider granting • the company must distribute to companies with options has just no-action relief to private companies holders of options on a continuing become easier. The SEC staff recently with more than 500 option holders basis materials similar to that which loosened the standards under which it under far less onerous conditions. would be provided if the company will permit private companies to grant Any relief granted will apply only were registered, including annual and options to more than 500 employees to stock options. Once a company quarterly financial statements and without registration. This will permit has 500 holders of record of any other such other information as is provided financial sponsors’ private portfolio security (such as common stock, generally to all of the Company’s unit companies to issue stock options including stock received on exercise of holders. In addition, the company without having to register their equity options), it would be required to register. must make its books and records securities under Section 12(g) of The conditions for relief are as follows: available on request and, where the Securities Exchange Act of 1934 options terminate upon termination • the options may be granted solely (the “Exchange Act”) and become of employment, distribute, prior to to employees of issuer or its wholly- reporting companies. such termination, all relevant infor- owned subsidiaries and consultants Because companies that have mation with respect to the options who meet the requirements under a class of outstanding securities that is material to the decision Rule 701;1 (including options) held by more whether to terminate employment • options may only be issued without than 500 security holders and more and forfeit the options. consideration, for purposes of incen- than $10 million in assets at the end Any options or stock incentives tivizing employees (and consultants); of any fiscal year are required to granted under the company’s other • options must be non-transferable, register their securities, it has been equity incentive plans must be suffi- except in the case of death or disability; difficult for private issuers to grant ciently different in terms of eligibility, stock options to more than 500 • grantees must be under no obligation exercisability, vesting, transferability, employees, absent an exemption. to acquire the stock underlying the repurchase provisions and other Although the SEC staff has been options; features that they will not be part of the willing to grant no-action relief • vesting may not be subject to same class of securities as options for exempting private companies from individual performance objectives, which no-action relief is requested. the registration and reporting require- only company-wide performance The no-action relief will not be ments for options granted to more objectives; granted for an indefinite period of than 500 employees, the onerous • holders of options may not be time. Accordingly, companies seeking conditions imposed by the SEC made entitled to vote or to receive any divi- no-action relief will need to commit to adopting plans that met those dends with respect to the options; register the options (or cash them out) conditions too burdensome for many by a specified date in the future (gener- • options may be exercised, but shares companies. In a recent update to ally seven or eight years after grant). received on exercise may not be the SEC’s Division of Corporation The SEC’s new policy for granting transferred, except back to the issuer, Finance Current Issues and Rulemaking no-action letters to private companies’ or on death or disability; Projects Outline, the staff indicated option plans will permit financial • holders must have no right to receive sponsors to offer equity based incen- compensation in respect of their 1 Consultants are natural persons, provide bona fide serv- tives to a broader group of employees ices to the company that are not in connection with the options or exercise shares, other than without having to register with the SEC offer or sale of securities in a capital-raising transaction, in a change in control or on death and do not directly or indirectly promote or maintain a or agree to burdensome conditions. market for the issuer’s securities. or disability; — Elizabeth Pagel Serebransky

The Debevoise & Plimpton Private Equity Report l Spring 2001 l page 5 Termination Fees, Expense Reimbursement and the LBO Fund

The termination (or “breakup”) fee, and what triggers its payment, are often some of the more highly negotiated provisions in a public company merger agreement. The buyer’s desire to protect the deal must be balanced against the seller’s need to protect its directors from breaching their fiduciary duties. On the other hand, buyers must be mindful that courts may not enforce overly generous termination fees, and sellers must recognize that a generous fee may sometimes be necessary to convince a reliable buyer to sign a merger agreement.

When a private equity fund sponsor funds in our database that also free up a corresponding portion negotiates a termination fee, the rele- have closed since 1997, suggests that of the fund’s capital for investments. vant questions are not significantly the situation is far more complex. Broken-deal expenses are typically different than those that a strategic Termination fees received by the fund considered fund expenses that are buyer would consider: How badly manager are typically “shared” with borne by the limited partners (although does it want to protect its deal? What the limited partners through a reduction in some instances they are borne by the is reasonable compensation for the in management fees. The fee-sharing manager instead). However, even if the time, effort and costs (including, for percentage is typically 50%, but can be manager does not have to pay these instance, financing commitment fees) as high as 100%. Based on a sampling expenses, amounts paid by the limited expended in the structuring and negoti- from the Debevoise & Plimpton propri- partners for broken-deal expenses ation of the deal? How much “idiot” etary database, approximately 32% of ultimately have an impact on the fund insurance does it want in the event its the funds require an equal sharing of sponsor. All capital contributions, publicly announced deal is displaced termination fees, 28% call for the including amounts contributed as by a superior offer? management fee to be reduced by the expenses, have to be returned before In some cases, this insurance may entire amount of the termination fee, the fund sponsor is entitled to its 20% be marginally more important to a and only 8% allow the manager to keep carried interest (which means that private fund than a strategic buyer, the entire fee. The remaining 32% the fund sponsor effectively bears 20 since it is a fund’s business to close its provide for some other type of sharing. cents of every dollar of broken-deal deals. On the other hand, acquisitions The fact that termination fees are expenses). However, if broken-deal by private funds are often significantly shared reveals only a small piece of the expenses are paid by the proposed more conditional than strategic acquisi- puzzle. Even managers who share all target rather than by capital contribu- tions, principally due to the financing or a large portion of termination fees tions from the limited partners, it is contingency. A target may argue that with their limited partners can be highly better for the fund’s IRR. Also, fund its board’s fiduciary duties are unduly motivated to negotiate an aggressive sponsors generally do not like to be in strained when a high termination termination fee. Not only does the the position of reminding their limited fee could ward off bidders who may manager have a positive obligation to partners through a capital call for promise not only a better price but also look out for the best interests of the broken-deal expenses that their efforts greater certainty of completion. (On the fund and protect the deal, but there are to bring in an investment has failed. other hand, a financial buyer probably also sensitive investor relations issues Thus, if a fund is asked to trade raises fewer antitrust impediments to be considered. To the extent manage- termination fees for reimbursement than a strategic buyer.) ment fees are “paid” by third parties of expenses in negotiating a merger The conventional wisdom is that through this reduction mechanism agreement, the sponsors may want fund sponsors are more concerned rather than by capital contributions to analyze not only which approach about expense reimbursement than from the limited partners, it can boost will result in more cash flow to the termination fees because they are the fund’s IRR. In addition, reducing manager, but also which approach required to share termination fees and management fees generates goodwill will have the least negative impact not expense reimbursements with among the limited partners, especially on the fund’s IRR and the best impact limited partners. Our analysis, based when a publicized deal has been lost. on investor relations. Fund sponsors on a sample of the 297 leveraged A reduction in the management fee will

The Debevoise & Plimpton Private Equity Report l Spring 2001 l page 6 should also determine the impact For the purpose of this article, we undertook an unscientific study of termination in situations where there is only an fees in public deals struck in 2000. The following chart summarizes the results: expense reimbursement provision Value of Transaction ($ millions) and not a termination fee. In situations $25-$100 $100-$500 $500-$1,000 > $1,000 where there is both, but the expense Average Fee 4.4% 3.3% 3.0% 2.7% reimbursement is capped, the termina- Range of Fees 1.0% -10.3% 0.1% -7.0% 1.2%-4.4% 0.3%-5.3% tion fee provision will probably provide Number of Transactions 75 108 31 93 for any unrecovered expenses to be Average Fee for Fund Acquirors 9.0% (1 deal) 3.9% (8 deals) — 1.7% (2 deals) deducted from amounts attributable Source: Securities Data Corporation to the termination fee before the termi- nation fee sharing is implemented. As the results suggest, it is generally A Generally, these would be paid thought that higher termination fees to the disappointed buyer. However, Below are a number of frequently (as a percentage of deal value) are more when the buyer is a private equity fund, asked questions about termination defensible the lower the value of the receipt of these payments by the fund fees and expense reimbursement. The transaction. The theory is that 3 or 4% itself could generate an unrelated busi- answers should be taken with a grain of a small deal is unlikely to deter ness taxable income problem for some of salt, because courts have not – and competing bidders in the way 3 or 4% limited partners. The payments are cannot – set firm rules regarding termi- of a large deal might. therefore generally directed to the fund nation fees, which are only part of Of the more than 300 public trans- manager, but in most cases are shared the fiduciary story. In determining the actions covered in the chart, only 11 with the limited partners through a propriety of the amount and the trig- involved private equity funds (including management fee reduction. gers of a termination fee, courts will venture capital funds). Termination often ask a variety of related questions: Q Is a termination fee or an expense fees in those transactions varied signi- Was the target in “Revlon mode?” Was reimbursement provision more likely to ficantly, and it is difficult to draw any it trying to defend against an unsolicited be upheld by a Delaware court? meaningful conclusions. offer? Was there a market check? An A Generally, although courts have auction? Are there are other bidders? Q What is a termination fee calculated not addressed this directly, the more a What other “defensive” provisions are as a percentage of? payment to a disappointed buyer can there? Did the termination fee enhance A Generally, the courts think of a be viewed as compensation or reim- stockholder value by encouraging the termination fee as a percentage of bursement of expenses rather than as original bidder, or did it impermissibly aggregate purchase price, not enterprise a defensive or protective measure, the hinder a fair and spirited bidding process value. It is probably appropriate to easier it will be to defend in court. In to the detriment of stockholders? These consider fully diluted equity to the a 1996 case, a Delaware court noted and other factors will color a court’s extent options, convertible securities that a termination fee together with decision as to the enforceability of a and the like will be converted into continued on page 11 challenged termination fee. merger consideration in the transaction, Q What do the Delaware courts deem although again the courts have not to be an enforceable termination fee? spoken definitively to this point. Please note that in a leveraged transaction, the The conventional wisdom A Delaware courts generally uphold termination fee will be a much higher termination fees up to 3%. One court is that fund sponsors are percentage of the sponsor’s equity has recently upheld a 3.5% termination commitment. This explains why lending fee, stating only that it was at the high more concerned about sources often feel entitled to “share” end of what Delaware courts have in the sponsor’s termination fee. expense reimbursement approved. On the other hand, the Court of Chancery recently found that a 6.3% Q To whom should a termination fee than termination fees.... termination fee “seems to stretch the and expense reimbursement be paid? definition of… reasonableness… beyond [o]ur analysis... suggests its breaking point.” that the situation is far more complex.

The Debevoise & Plimpton Private Equity Report l Spring 2001 l page 7 Key Issues in Reviewing Confidentiality Agreements

A private equity firm will be asked to you should try to avoid being liable for (ii) exclude non-targeted, general solici- sign a confidentiality agreement (“CA”) your representatives’ breaches, but that tations (e.g., newspaper advertisements) for each “blue book” it receives. As a may not be realistic. As a compromise, and (iii) apply only to executives, officers result, financial sponsors with robust you might offer to use commercially and/or technically trained employees deal flows may need to review several reasonable efforts to assure that your first met during the sale process. such agreements a week. Often, the representatives will comply or agree Standstills. Public companies usually most efficient process will be to review to be responsible for any breach by a seek to preclude bidders and their the agreement in-house, produce a representative. affiliates from making unsolicited bids limited mark-up, initial the changes Apart from the auction context, you (including public pressure on target and return the signed agreement to the may be able to negotiate for the confi- management) and open market seller or its banker. Here is a checklist dentiality provisions to apply to both purchases of the target company’s of key issues that may facilitate such parties. This may prevent the seller securities. Although many financial a review. from using the bidder as a “stalking sponsors view standstill provisions as horse” to attract other bidders. What’s Covered. The CA will prohibit acceptable since their business prac- disclosure of “Evaluation Material,” Return of Information. If the sale tices do not include either of these except to the bidder’s employees and process is terminated, sellers will want activities, other sponsors, especially representatives and except for legally all the Evaluation Material returned. those affiliated with investment banks required disclosures. When reviewing You should ask instead for the ability to or hedge funds, may have significant a CA, be sure that “Representatives” destroy rather than return documents, issues with these provisions. In any includes financing sources and their since this requirement will be easier to event, it is advisable, and usually counsel and co-investors, if applicable. fulfill and you may not want other expected, for the standstill to expire In the exception for legally required parties to obtain the notes, analyses or after a fixed time period. disclosures, delete any obligation to projections that you have prepared Auction Process. CAs often prohibit obtain written advice from counsel. based on the Evaluation Material. As a the bidder from contacting the target The standard exceptions from the compromise, you could offer to certify company or any of its employees definition of Evaluation Material include the destruction of Evaluation Material without the written consent of the information that (i) is publicly available, in writing or limit the right to destroy seller or its investment banker. (ii) the bidder already possesses or Evaluation Material to what you devel- However, since financial sponsors will obtains from sources other than the oped internally. often want to negotiate employment target or (iii) the bidder develops inde- Non-Solicitation. Sellers want to restrict and equity terms directly with manage- pendently. The CA will also usually limit bidders, particularly competitors, from ment, it is a good idea to liberalize this these exceptions so that they will not using the sale process to identify and requirement by providing that consent apply to information that is subject to poach key employees of the target. can be obtained orally from either the another confidentiality obligation. You Although a financial sponsor is unlikely investment banker or the seller. should insert that it is only information to solicit or hire a target company’s that the bidder does not know to be Termination. CAs should terminate employees, that may not be true of its the subject of another confidentiality after two or three years, thereby portfolio companies. Because many obligation, or you risk inadvertently limiting the need to monitor use of the financial sponsors would find it breaching this provision. Evaluation Material, particularly if you impractical to enforce such a restric- are likely to make future acquisitions Who’s Covered. You will need to advise tion on their portfolio companies, in the target’s industry. your representatives of the confidentiality the mark-up of the non-solicitation restrictions, but, absent special circum- provisions should explicitly exclude Antitrust. If you have a portfolio stances, you should resist a requirement affiliates and portfolio companies. company that operates in a similar to obtain written acknowledgements Other customary limitations on the business to the target company, partic- from all of your representatives since non-solicitation provisions are that ularly in a concentrated industry, you that is generally impractical. Obviously, they (i) expire after one or two years, should agree to follow the special

The Debevoise & Plimpton Private Equity Report l Spring 2001 l page 8 procedures proposed by the seller to consult outside antitrust counsel for above should facilitate an in-house avoid any appearance of using the sale guidance on typical procedures. review of a plain vanilla agreement. In process to share sensitive information Although most CAs are relatively other circumstances, it is advisable to (e.g., product prices) and to create a “plain vanilla,” they can present consult with experienced counsel. record of compliance from the time of onerous obligations on a financial — Timothy S. T. Bass early contacts. Generally, you should sponsor. The key issues discussed

A Brave New World: Revised Article 9 Due to Hit July 1, 2001 (continued)

The filing rules change drastically office is located in Delaware and the counsel) may want to refile in the juris- under Revised Article 9. After July 1, in physical collateral is located in California, diction of the borrower’s incorporation, the case of a borrower that is a statu- both of which have enacted a version even though the transition rules for tory entity such as a corporation or a of revised Article 9? Under 9-103 of the Revised Article 9 generally provide that limited partnership, the place to file for New York UCC, we look to the UCC of the original filings remain good for up almost all types of UCC collateral is in Delaware and California. What do they to five years after July 1. The good news the state office of the state where the say? Section 9-307 of Revised Article 9 is that it should be easy enough for entity is organized. For a Delaware tells you to look to the law of the place borrowers to indulge such lenders by corporation, that is Delaware. Under where the borrower is incorporated. making these extra filings (and in any Revised Article 9, there is no guessing The borrower is a Delaware corpora- event, borrowers are most likely obliged (or multiple filing) to deal with the tion? That will work. The borrower is to do so under a “further assurances” uncertainty of location (whether of chief a New York corporation? Revised Article or similar type of clause in the existing executive office or physical collateral). 9 sends us back to New York, which security documents). But there’s a catch that could prove sends us back to California and But the best news for clients is that troublesome. As we go to press, Delaware, which sends us back to the first acquisition closing you attend Revised Article 9 is currently enacted New York… Lawyers call this problem after July 1, 2001 should require fewer (and due to become effective July 1) in “renvoi”, and it can be ugly. If renvoi UCC-1’s to be signed. Maybe you can 36 states and the District of Columbia, should arise because Revised Article 9 get some real work done that day. and has been introduced in all the has not been timely enacted in a rele- — William B. Beekman remaining states (including New York). vant jurisdiction, borrowers should Sounds like we’re in pretty good shape? expect to continue signing multiple Not necessarily. If Revised Article 9 is UCC’s as a precautionary measure until not timely enacted everywhere, chaos Revised Article 9 has been adopted. The filing rules change could ensue for those lenders and In addition to worrying about renvoi, borrowers having contacts with the the finance attorneys are all fretting drastically under Revised tardy states. about how to re-write the forms of their Article 9… [I]n the case of a Suppose Revised Article 9 is not security documents and legal opinions timely enacted in New York. Section 9- to accommodate Revised Article 9, and borrower that is a statutory 103 of the current New York UCC would what (if anything) they might need to still provide the old rule for whose law do for the billions of dollars worth of entity such as a corporation governs perfection of a security interest deals that were done under current or a limited partnership, the in a multi-state transaction, i.e. the Article 9. For lawyers who spend all place where the tangible collateral is of their time representing secured place to file for almost all located and the location of the lenders, these problems make Y2K look borrower’s chief executive office with like a picnic in the park. Our prediction types of UCC collateral is in respect to intangible collateral. But is that certain lenders (including of what if the borrower’s chief executive course the ones with the most cautious the state office of the state where the entity is organized.

The Debevoise & Plimpton Private Equity Report l Spring 2001 l page 9 Investing in a Foreign Portfolio Company: Call 1-800 Tax Lawyer

Secretary of the Treasury Paul O’Neill recently called the U.S. Tax Code an “abomination” and “not worthy of an advanced society.” Although Mr. O’Neill obviously chose his words for political effect, when it comes to the provisions of the Code dealing with invest- ment in foreign companies, his descriptions seem almost appropriate. The U.S. tax rules dealing with U.S. investment abroad are among the most counter-intuitive, and in many ways arbitrary, rules in the U.S. tax system.

Example 1 million profit and reinvests the The results in Example 1 through 3 A U. S. private equity fund (“PEF”) proceeds in a new manufacturing above arise because the portfolio buys 100% of a German manufac- plant. Result: Each U.S. investor in company is a controlled foreign corpora- turing company. The German company PEF must include a pro-rata share of tion (a “CFC”). The result in Example 4 sees an opportunity to expand into $20 million in income even though arises because the portfolio company is the U.S. and invests $20 million of its neither they nor PEF receives any cash. a foreign personal holding company (an retained earnings in the stock of a U.S. Example 4 “FPHC”), and the result in Example 5 distributor. Result: Each U.S. investor arises because the portfolio company The partners of PEF are all corpora- in PEF must include a pro-rata share is a passive foreign investment tions, except for one individual, who of $20 million in income even though company (a “PFIC”). owns 1% of PEF. PEF forms a Swedish neither they nor PEF receives any cash. Each of these regimes was enacted start-up company, which temporarily by Congress with good intentions, Example 2 invests the cash received from PEF in namely to avoid giving U.S. taxpayers PEF buys 100% of the stock of a French U.S. Treasury securities. The Swedish an incentive to invest abroad rather manufacturing company. Over the company has no significant earnings than in the U.S. Because profits real- next two years, the French company for the year other than interest on the ized in the U.S. are subject to current earns $20 million, which it reinvests Treasury securities. Result: Each U.S. U.S. tax, Congress feared that U.S. in the business. At the end of the two investor must include in income a pro- taxpayers would favor offshore invest- years, PEF sells the French company, rata share of the Swedish company’s ments because of the opportunity they realizing a $50 million profit. Result: earnings even though neither they nor present to defer U.S. tax. To place U.S. Only $30 million of the profit qualifies PEF receives any cash. and foreign investment opportunities for long-term capital gains treatment. Example 5 on a level playing field, Congress The remaining $20 million is taxable PEF is organized outside of the U.S. sought to end the ability of U.S. tax- as ordinary income to PEF’s partners. On January 1, PEF invests in a Swedish payers to defer tax on foreign investment Example 3 start-up company organized one in most cases. As the above examples PEF buys 100% of a Dutch manufac- month earlier. The start-up invests the illustrate, however, the rules are written turing company. The Dutch company proceeds received from PEF in U.S. so broadly that they sweep up a variety sells its Italian subsidiary at a $20 Treasury securities. On July 1, the of legitimate transactions that are not Treasury securities are sold and the motivated by a desire to escape or proceeds are used to buy machinery. defer U.S. taxation. Two years later, PEF sells the Swedish Despite the breadth of the CFC, The U.S. tax rules dealing company at a $20 million profit. FPHC and PFIC rules, it is generally Result: The entire profit will be treated possible to avoid them, or at least with U.S. investment as ordinary income (not long-term minimize their effect, in most transac- abroad are among the capital gain), and each U.S. investor tions. In Examples 1 through 3 above, in PEF will owe a substantial interest forming PEF as a non-U.S. partnership most counter-intuitive, charge to the IRS on its share of the (for example, as a Cayman partnership) resulting tax. would generally make it possible to and in many ways, arbitrary, rules in the U.S. tax system.

The Debevoise & Plimpton Private Equity Report l Spring 2001 l page 10 ...[W]ith a bit of advance avoid the CFC provisions. A CFC is a owned) by the other partners of PEF. foreign corporation owned more than The solution here is to require any planning, the worst of the 50% by 10% or greater U.S. share- individual desiring to invest in PEF to CFC, FPHC and PFIC rules holders. If PEF is a U.S. partnership, do so through an entity, such as an any majority investment it makes in a S corporation. Only an individual is can be avoided. foreign corporation will cause the CFC deemed to own stock owned by his rules to apply, because PEF is a U.S. partner, so the attribution will not shareholder. If PEF is instead a foreign occur if PEF has no direct individual partnership with no U.S. partners with partners. good that the election will be painless a 10% or greater interest, the CFC rules In Example 5, the portfolio company because the company will have no generally can be avoided. is a PFIC, which is a foreign corpora- positive net income at the early stages. In Example 4, the portfolio tion 50% or more of whose assets for In later years, when the portfolio company is a FPHC, which is defined the year are held for the production company is profitable, it will be unlikely as a foreign corporation that (a) earns of passive income. The solution here to have the same high proportion of mostly passive income for the year and is to cause the portfolio company to passive assets, and hence it will no (b) is owned more than 50% by five buy the machinery June 30, rather than longer be a PFIC. or fewer U.S. individuals. For purposes on July 1, so that the assets for the So with a bit of advance planning, of the stock ownership test, an indi- year, on average, are mostly machinery, the worst of the CFC, FPHC and PFIC vidual is deemed to own all the stock not passive investment securities. rules can be avoided. Alternatively, owned directly or indirectly by his Alternatively, the solution is for the PEF fund managers can write to Congress partner. Under this rule, the individual partners to file an election to include and Secretary O’Neill urging repeal of who directly owns a 1% interest in PEF the portfolio company’s net income the anti-deferral rules. We think that is deemed to own 100% of the port- currently in any year in which the working with tax lawyers is easier than folio company because he is attributed company is a PFIC. If the portfolio working with politicians. all of the stock owned (or treated as company is a start-up, chances are — Gary M. Friedman

Termination Fees, Expense Reimbursement and LBO Funds (continued) reimbursement of expenses would triggers that could be viewed as fair) and pragmatism (requiring a fee be “only” 4.8% of the offer value; the coercing the target’s stockholders into upon a material adverse change may termination fee alone was 2.8%. The voting in favor of the buyer’s merger not be practical). implication is that courts are likely proposal. For instance, requiring the Private equity firms contemplating to be more willing to uphold higher payment of a fee if the stockholders going private transactions should payments to disappointed buyers simply voted down the deal without recognize that the way termination if a portion clearly reflects the reim- another offer on the table is often fees and expense reimbursements are bursement of quantifiable expenses. rejected as being coercive (though at handled in their partnership agree- least one court seems to have upheld Q What types of triggers are ments and in deal negotiations are an this type of trigger). Often, the deter- permissible or impermissible? important part of the risk calculus of mination of appropriate triggers is such deals. A Merger agreements can and do based on considerations of fairness — Andrew L. Bab and Sherri G. Caplan contain a broad variety of termination (requiring a fee upon an unintentional fee triggers. Courts have been wary of breach of representation may not be

The Debevoise & Plimpton Private Equity Report l Spring 2001 l page 11 Without Pooling, Are Recaps Doomed? (continued)

goodwill.) Put another way, if the new 2. Preservation of Treatment. holders of target – usually enables a rules have effectively allowed strategic Another likely continuing advantage financial buyer to achieve independent buyers to view poolings as dispensable, of the recap structure is that the commercial objectives as well as to will they also eliminate or significantly avoidance of goodwill in a qualifying realize the accounting benefits associ- blunt the advantages to a financial recapitalization is permanent, whereas ated with a recapitalization. For example, sponsor of structuring a transaction the continued avoidance of goodwill the retention of enough stub equity by as a recapitalization? under the new FASB rules will be a corporate divester, a private seller or We believe the answer to that ques- dependent on the absence of any by a target’s management to qualify tion is a qualified no, for the following impairment to that goodwill in subse- for a recap, may also provide extra insur- reasons: quent periods. While FASB has yet to ance to the financial buyer about the 1. Avoids Write-up of Identified specify what standards will apply under condition of the business it is buying Intangibles and Fixed Assets. the new rules to determining whether since the former owners are retaining some “skin in the game.” This alignment While the proposed new rules would any impairment to goodwill has of underlying commercial objectives require buyers to amortize goodwill only occurred, an acquiror in a transaction with the preferred accounting result to the extent of any impairment, the accounted for as a purchase will run inherent in a recapitalization likely rules keep in place the existing require- the risk that it might have to record ensures the continued utility of the ment that all fixed assets and identified substantial and possibly recurring recap structure. It also contrasts sharply intangible assets of a target must be amortization charges in subsequent with poolings, where the conditions written up to fair value on the opening P&L’s if and when the target’s goodwill that needed to be satisfied to achieve balance sheet. As a result, buyers declines in value. For example, if these a qualifying pooling often defeat impor- utilizing purchase accounting will still rules were in effect 12 months ago, tant commercial objectives of the have to take an incremental charge many companies which acquired high parties. This may explain why strategic against earnings in periods subsequent tech or Internet businesses 24 months buyers now seem prepared to accept to the acquisition to reflect the amortiza- ago would presumably have seen the the elimination of pooling in favor of tion and depreciation relating to the goodwill associated with those busi- the new rules governing the amortiza- write up of these assets. Conversely, in nesses impaired in light of the market tion of goodwill. a deal structured as a recapitalization, turmoil in the technology sector. To the extent the same transaction is these types of charges would not flow Because recaps, unlike deals structured and accounted for as a through any subsequent P&L since accounted for as a purchase, will afford recapitalization, however, the acquiring there is no restatement for financial the benefits described above, we believe party would run no such risk because accounting purposes of any of the they will continue to be attractive to under recapitalization accounting target’s assets (and hence no subse- financial buyers even after the new no goodwill is recorded on the target’s quent amortization or depreciation of FASB rules take effect. We should note, balance sheet to begin with (it is all these assets). This difference will obvi- however, that the FASB, which has previ- retained at a level above the target) ously preserve a significant advantage ously indicated its interest in reviewing and hence there is no possible impair- of the recap structure, particularly in recap accounting, may be pressured to ment charge relating to that goodwill deals where there would be a significant do so sooner rather than later by in the future. write-up of the target’s fixed assets strategic buyers who have no option to (such as property, plant and equipment) 3. Alignment of Incentives. avoid the write-up of identified intangi- or identified intangibles (such as specific A final reason why recapitalizations are bles and fixed assets or to be faced with patents) under purchase accounting. We likely to remain attractive to financial potential goodwill impairment. However, understand that accountants are finding buyers is that the principal condition the gap between the accounting benefits it virtually impossible to advise clients that needs to be satisfied to achieve a associated with a recap under the new on the appropriate amortization period qualifying recap – the retention of equity rules, on the one hand, and purchase for many identifiable intangibles such by one or more of the existing stock accounting, on the other, will be as routes, customer lists and the like.

The Debevoise & Plimpton Private Equity Report l Spring 2001 l page 14 narrowed significantly. As a result, we in circumstances where the incremental tion costs associated with achieving believe that financial sponsors will use benefits of the structure in a given deal a successful recapitalization. recapitalizations more selectively than from a P&L and overall deal perspective — Franci J. Blassberg and has been the case historically and only are likely to outweigh the added transac- Stephen R. Hertz

Ten Issues to Keep in Mind in Structuring a Recapitalization

Structuring a recapitalization can which holders of the same class of available even if there is no continuing be tricky. Here is a brief overview of securities of a company (e.g., Common common stock ownership. This struc- some key issues to keep in mind. Stock) receive differing forms of con- ture usually has little practical benefit • The sine qua non of a recap is the sideration for their shares. It can be for financial buyers, however, because retention by some or all of the used to ensure that a certain percen- the terms of the target’s public debt target’s existing stockholders of at tage of target’s shares are retained normally preclude the leverage needed least 5% of the equity in the recapi- by management, whereas all other to implement the recapitalization. In talized company. Generally, stock shares are converted to cash. Some addition, the moment the public debt options, warrants and similar securi- states do not permit “disparate treat- is retired – often at the time of an IPO ties are ignored in determining the ment” mergers. Delaware generally – the target’s assets and liabilities need percentage of ownership by the new allows disparate treatment mergers, to be restated, and goodwill relating and continuing stockholders. but subjects them to an “entire fair- to the original investment needs to be ness” test. recognized. • A recap can be structured as a purchase of primary shares by an • If a “disparate treatment” merger • A typical sponsor’s form of stock- investor, coupled with the simulta- isn’t available, a cash-election merger holders agreement should be modified neous repurchase or redemption is another viable alternative. But in to comply with recapitalization rules. of a portion of target’s outstanding deals involving the recapitalization of Specifically, the retained equity should shares. This will generally be the a public company, this structure may generally not be subject to transfer preferred structure in deals involving result in public stockholders contin- restrictions (other than rights of first private targets with a manageable uing to hold a small equity interest (or refusal or rights of first offers) or calls number of stockholders. stub) in the target. This may result in upon termination of employment. the target continuing to be subject to Drag-along rights are acceptable. • Recapitalizations involving private public reporting obligations and may companies with a large number of • Because the target’s assets are not force some financial sponsors to stockholders or public companies written-up in a recapitalization and “mark to market” their investment can be structured as a merger, so no goodwill is created, a leveraged in the recapitalized company. long as the “merger subsidiary” recapitalization can often result in is transitory and has no business • A recap cannot be structured as a the target having substantial negative operations other than signing the third-party because of the equity on a GAAP basis. This can merger agreement and consum- requirement that the merger vehicle have important collateral conse- mating the merger. The merger be as transitory as possible. In theory quences for the target, particularly subsidiary should not be a party to it could be structured as a self-tender, if it operates in a sector where a any of the financing arrangements. but this structure is not attractive due strong balance sheet is critical to to the application of “illegal dividend” commercial success. • Some states permit “disparate treat- and similar statutes to the target’s ment” mergers, which facilitate a • Finally, early and continuing coordi- purchase of shares in the self-tender. financial sponsor’s ability to ensure nation between legal counsel and that the requisite continuing equity • If the target has publicly traded debt accountants is critical in order to avoid in a recapitalization is retained only securities that will remain outstanding inadvertent “trip-ups” over the rules. by existing management. A disparate after the consummation of the acquisi- — Franci J. Blassberg, Stephen R. Hertz treatment merger is a merger in tion, recapitalization treatment may be and Joshua L. Targoff

The Debevoise & Plimpton Private Equity Report l Spring 2001 l page 15 alert Private Equity Funds and Financial Holding Companies

What do financial holding companies (“FHCs”), investors addition, an FHC and its controlled funds can also invest in the private equity funds they sponsor and fund sponsors any amount in equity of a portfolio company (even more hoping to attract investment from FHCs have in common? than 50%) and control it. However, neither an FHC nor a They should all be aware of the merchant banking rules fund controlled by an FHC can routinely manage or recently issued by the Federal Reserve Board and the operate the portfolio company. Treasury Department. The new rules provide guidance and some clarity on FHCs, which were created by the Gramm-Leach-Bliley what constitutes control of a fund by an FHC and how Act of 1999 (“GLB Act”), are basically bank holding FHCs and their controlled funds can participate in the companies whose depository institution subsidiaries are governance and management of portfolio companies. well-managed and well-capitalized and who elect to be In general, board representation and similar supervisory an FHC under the GLB Act, thereby avoiding the restric- authority (including approval rights over actions outside tions on merchant banking activities and provision of the ordinary course of business), and provision of financial non-banking financial services and products applicable and advisory services are permissible control of a portfolio to bank holding companies. company. Involvement in day-to-day operations, such as The GLB Act opened the door to FHCs becoming full the FHC’s personnel acting as officers or employees and participants in the private equity business by eliminating approval rights over routine business decisions, constitute the restrictions on their equity ownership of nonfinancial routine management activities and are generally prohib- companies, i.e., portfolio companies. Instead of the prior ited. Investors should note, however, that if the portfolio approach of limiting the percentage interests of portfolio company needs new management, the FHC can have its companies that can be held by FHCs, the GLB Act personnel manage the company only on an interim basis. distinguishes between permissible and impermissible In addition, the new rules set limits on the percentage investments by FHCs based on the concepts of “control” of an FHC’s Tier 1 capital that can be invested in private and “routine management or operation.” equity funds and require the implementation of certain Under the GLB Act, an FHC can control and routinely policies, procedures and systems to manage risks assoc- manage and operate a qualified private equity fund. In iated with merchant banking activities.

Upcoming Speaking Engagements

May 7 Andrew N. Berg Getting Out of a Deal – Creative Exit Strategies New York, NY

June 4-5 Raman Bet-Mansour Special Issues in Acquiring Divisions or Subsidiaries of Large Corporations New York, NY

June 11 Sherri G. Caplan Negotiating Key Issues: Real Estate Opportunity Funds Santa Fe, NM

June 25-26 Adele M. Karig Examining the Critical Tax and Accounting Issues Surrounding the Private Equity Market New York, NY

For additional details on speaking engagements, contact Deborah Brightman Farone, Director of Client and Public Relations, at 212.909.6859.

The Debevoise & Plimpton Private Equity Report l Spring 2001 l page 16