Private Equity Transactions Provides a Return to the Managers on an Exit If the Across the United States, Sponsor Realizes a Minimum Return on Its Investment
Total Page:16
File Type:pdf, Size:1020Kb
Q32015 GLOBAL PrivateUPDATE Equity A Comparison of subscription price for the sweet equity is often set at a low amount, with some form of performance ratchet or Management Incentive hurdle, such that there is little or no value in the sweet Equity Arrangements in equity on subscription. The sweet equity then only Private Equity Transactions provides a return to the managers on an exit if the Across the United States, sponsor realizes a minimum return on its investment. Europe and Asia This often allows the managers to minimize income By Timothy Gardner, James Harvey, Michael Nissan, tax costs on acquisitions while ensuring that exit Sumit Ram and Amanda Rosenblum proceeds are taxed at the prevailing capital gain rate rather than as ordinary income. Introduction United States: In the United States the nature of the securities or interests held by managers is A key feature of private equity transactions is ensuring more varied, with managers typically holding either that management, who will be asked to deliver on options exercisable into ordinary equity, profits the company’s business plan, are appropriately interests or, occasionally, leveraged common equity incentivized and aligned with the sponsor to share (common equity subordinated to preferred equity in the future growth of the company. This is typically so as to depress entry value), with vesting of these achieved with incentive equity arrangements put in interests subject to continued service and the overall place at the time of the sponsor’s acquisition of, or performance of the business or investment. The investment in, the company. In this article we look at choice between these different interests is driven by the approaches taken to management incentive equity tax considerations and the negotiating strength of arrangements for sponsor-backed transactions in the management: options giving rise to ordinary income United States, Europe and Asia. treatment but a compensation deduction benefit in the hands of the company, and profits interests and equity Observations giving rise to capital gains treatment for the managers, Europe: The common position across the vast but no compensation deduction for the company. majority of European jurisdictions is for managers to Asia: The position across Asia is also more varied, be issued ordinary (sweet) equity, sitting alongside and in general there is no settled market standard for the sponsor’s interest held across a mix of securities, management equity incentive arrangements, although including for example ordinary and preferred equity it is more common for management in transactions in and shareholder loans (the institutional strip). The 2015 Private Equity Weil, Gotshal & Manges LLP UPDATES Global Private Equity Update China to be given equity incentive awards that vest Transferability purely over time with no performance requirements, Ensuring that management incentive interests are held whereas in the Hong Kong market managers are only for the benefit of management is also important commonly issued with a mix of ordinary equity as well and, therefore, general prohibitions on transfers by as options exercisable into ordinary equity and which a manager of equity or other incentive interests are are linked to future business performance. In other an almost universal feature in arrangements across markets we see features similar to both Europe and the United States, Europe and Asia. Similarly, if a the United States. manager ceases to be employed by the company Pooling Vehicles (i.e., becomes a “leaver”), that manager may no longer be allowed to retain some or all of his/her The use of a pooling vehicle controlled by the incentive interests. Across Europe it is typical for the company (and ultimately the sponsor) to hold at least leaving manager to be required to transfer equity (for more junior managers’ equity interests is becoming example to a new incoming manager, or perhaps a increasingly common in European transactions. This warehouse vehicle to be recycled later). In the United allows for greater control of management’s incentive States, unvested options or equity will typically lapse, equity as well as easing the administrative burden, with any vested equity being subject to a repurchase since the company will only have one management right by the company. The price paid for equity being shareholder entity to deal with, as opposed to many transferred or repurchased is determined by the individual management shareholders. Use of such circumstances of the manager’s leaving, with a “good vehicles is not common in the United States with leaver” typically being entitled to receive a higher managers typically holding their interests directly with, amount than a “bad leaver” on vested equity. less frequently, junior managers holding phantom equity through a profits interest structure. Across Asia While each transaction is different, there are a transactions, pooling vehicles are sometimes used in number of areas where it is possible to find a larger transactions but (in some markets, like China) generally settled position and, accordingly, we set are often controlled by the company’s founders rather out below a summary of certain of the key terms and than the company itself. some of the more common positions adopted. Right Europe United States Asia Type of Interests Held Class of Security ■■ Rollover of existing equity: ■■ Rollover of existing equity: ■■ Rollover of existing equity: ordinary equity or into a strip of same mix of securities as typically ordinary equity or ordinary equity and preferred sponsor (pari passu save equity-linked securities equity and/or shareholder for company’s call right over ■■ loans alongside sponsor manager held equity on Incentive equity: varies, but, becoming a leaver) e.g.: (i) in Hong Kong, options ■■ Incentive equity: ordinary linked to future performance or equity, sometimes with a ■■ Incentive equity: non-qualified equity with a hurdle linked to ratchet or hurdle, or similar, stock options (exercisable a minimum sponsor return on such that the sweet equity into common stock), profits exit; or (ii) in China, shares and only provides a return once interests or, occasionally, not options a minimum return has been leveraged common stock achieved by the sponsor on (common stock subordinated exit to preferred stock to depress value) Weil, Gotshal & Manges LLP Q3 2015 2 Global Private Equity Update Right Europe United States Asia Vesting for Incentive Equity ■■ Time vesting over e.g. a four or ■■ Combination of both time ■■ Combination of both time five year period, annually or on vesting and performance vesting and performance a straight line basis (see also vesting for both options and vesting: leaver price below) other incentive equity: ■■ Time vesting over e.g. a ■■ Time-vesting component: four or five year period four to five years ■■ Performance vesting: ■■ Performance vesting return-based and/or component: return-based operating based (e.g. (multiple of investment EBITDA) performance and/or IRR) and/or metrics operating based (e.g. EBITDA) performance metrics Voting Rights ■■ Varies but often voting ■■ Varies but often voting ■■ Usually voting Anti-Dilution Rights ■■ None (although see pre- ■■ None (although see pre- ■■ None (although see pre- emption rights below) emption rights below) emption rights below) Pre-emption on New Issues of ■■ Pro rata pre-emption rights, ■■ Usually for rollover equity only ■■ Usually for rollover equity only Securities with exceptions for: ■■ Sometimes for vested incentive ■■ Acquisition issues equity ■■ Emergency issues (for example to avoid imminent default under the company’s financing arrangements) with managers having a subsequent catch-up ■■ Issues under a management incentive plan up to a certain percentage of equity Terms of Loan Notes / ■■ Varies, but between 10% ■■ N/A ■■ N/A in most cases Preference Shares / and12% interest, PIK often Shareholder Debt seen Management Rollover ■■ Often about 50% of post-tax ■■ Determined on a case-by-case ■■ Determined on a case-by-case Percentage proceeds basis (50% post-tax proceeds basis would not be unusual) Use of a Pooling Vehicle to ■■ Senior managers hold directly, ■■ Use of pooling vehicles not ■■ For larger transactions Hold Management Interests with more junior managers common. Senior managers management’s equity is holding through a pooling usually hold equity interests sometimes held through a vehicle/co controlled by the directly; junior managers hold pooling vehicle controlled company either directly or, occasionally, either by the founder (if may have phantom equity applicable) or the company interest instead Weil, Gotshal & Manges LLP Q3 2015 3 Global Private Equity Update Right Europe United States Asia Leaver Provisions Which Securities are Subject ■■ Incentive equity only ■■ Incentive equity and typically ■■ Varies, but incentive and to Leaver Repurchase rollover equity rollover equity often subject to Provisions? leaver provisions Types of / Reasons for ■■ Good leaver – manager who ■■ “Cause” or when “cause” exists ■■ No fixed position–both United Becoming a Leaver leaves due to: States and European positions ■■ Resignation without Good seen in recent deals ■■ Death or incapacity Reason ■■ Redundancy or retirement ■■ Death ■■ Wrongful dismissal ■■ Disability ■■ Sale of that manager’s ■■ Termination without Cause part of the business ■■ Resignation with Good Reason ■■ Designated by the board ■■ as a good leaver Retirement (not as typical) ■■ Bad leaver - a manager who leaves due to any