Private Equity Report What’s Inside Volume 3 Number 2 Winter 2003 Questions to Ask Before You Join a Club Shark Repellants That Can Bite page 3

Despite the recent flurry of large transactions in which a consortium of firms have Private Equity and the teamed up to make joint bids and acquisitions, “club deals” themselves are not breaking news. Proposal to Exclude Dividends In fact, they have been a staple of small- and middle-sized private equity M&A transactions for From Income page 4

years. Recently, however, there has been a growing trend toward large club deals with enterprise How to Ensure that Your 1 values over $1 billion. Due to their size, complexity and, often, international dimension, these Special Committee is Special transactions have generated considerable attention in the business press and have prompted much page 5 discussion among private equity professionals and the limited partners whose money they manage. A Comparison of U.S. and UK Private Equity Funds page 6 The increased number of very large club increase its chances of acquiring an interest transactions arises from a number of in a “prized property” that it would otherwise Guest Column: factors, including the tremendous growth not have sufficient equity to obtain. In What’s Good for the Goose… in the availability of private equity capital addition, sharing judgments about valuation Turning the Due Diligence and the popularity of auctions in the sales and limiting the other number of compe- Spotlight on Sponsor process. Even more importantly, perhaps, titors are added benefits of being part of Infrastructure page 8

because of difficulties in the debt markets, a club bid. Minority Equity Investments the percentage of equity needed to complete Diversification and Risk-sharing. Club in German Companies page 10 transactions has increased to such a degree transactions are also a way of spreading You’re Not in Delaware: that in the largest transactions even large investment risk by permitting firms to use Directors’ Liabilities in Major private equity firms cannot complete a their available equity to participate in a larger European Countries page 12 transaction without running afoul of the number of transactions and to spread the diversification limitations in their limited risk of a single transaction among similarly Update: Removal of the UK partnership (fund) agreements. (Most situated private equity firms. 20-Partner Rule Limit page 17 funds limit the amount that can be Greater Leverage with Financing Sources. invested in any portfolio company to 20% Alert: Goodbye to Lockups? Teaming up with another private equity or 25% of the fund’s committed capital.) page 24 firm may well make it easier for club Therefore, a may be the only way members to get the best financing terms to raise the required equity to finance a available. Financing sources would gener- very large transaction. ally find club deals attractive, Club deals offer private equity firms: especially since they will be The Chance to be a Winner, Especially in able to serve more than one Very Large Transactions. By participating client in a single transaction. in a club deal, a private equity firm may Running on the “Inside Track” and Breaking New Ground. 1 Notable recent examples include: the acquisition by Texas Pacific Group, Inc. (the lead investor), , Inc. and Club deals might also permit Partners, LP of Burger King Corporation from a private equity firm to benefit its British parent, Diageo plc for $1.5 billion in December 2002; the acquisition by , LP (50% equity) and from the industry (e.g., telecom) Welsh, Carson, Anderson & Stowe (50% equity) of QwestDex, expertise or prior relationships a subsidiary of Qwest Communications International, Inc. for $7.05 billion in August 2002; and the acquisition by funds (e.g., with management or the managed by Partners Inc. (49% equity and seller) of its co-bidders. lead investor), Soros Private Equity Partners, LP and Goldman Sachs of Eircom plc for $2.5 billion in June 2001. continued on page 14

© Nobleman / www.mtncartoons.com Tyler 2003 Marc “I never said it was the world’s most exclusive club.” letter from the editor In this, the first issue of the Debevoise & Plimpton simpler U.S. fund model that uses parallel vehicles Private Equity Report for 2003, we focus on new and less frequently and relies on a single, integrated proposed legal developments that impact the partnership agreement for both U.S. and non-U.S. private equity industry – from tax laws to takeover investors. In our private funds formation practice defenses. We also highlight several key respects in in both London and New York, we are pleased to which U.S. private equity firms operating in Europe be participating in this transition. need to get accustomed to different ground rules. In that connection, we are happy to announce In our cover story, we outline the issues that the arrival of our newest partner in London, Marwan private equity firms participating in club deals ought Al-Turki, a leading English fund formation and finan- to consider – both vis-à-vis the private equity firms cial services regulatory lawyer. The addition of Marwan with whom they partner as well as their own limited to our international practice further strengthens the partners. We also report on a recent Delaware firm’s commitment to European private equity clients Supreme Court case that may potentially limit private and U.S. funds seeking to organize and invest abroad. equity investors’ exit opportunities from public In our Guest Column, Steven Millner, a managing transactions. On the tax front, we describe how the director at DML, a specialist in accounting, admin- most recent version of President Bush’s tax proposals istrative and advisory services for the private equity to eliminate taxes on corporate dividends may impact industry, cautions that institutional investors are private equity. focusing the due diligence spotlight on private equity Jim Kiernan, who heads our European practice, fund managers and proposes guidelines to help fund explains how serving on the boards of a fund’s managers develop the infrastructure, processes and European portfolio companies can expose a spon- controls that investors expect. sor’s employees to civil and criminal liabilities that The Trendwatch column is taking a brief hiatus would be unlikely in the U.S. and suggests how to this issue as we update our database in order to protect against that liability. provide you with the most current analysis of trends Also from the European perspective, Geoff Kittredge in the financial terms of private equity funds. describes the basic differences between private We continue to strive to make the Debevoise & equity funds organized as English versus Delaware Plimpton Private Equity Report a useful and informa- limited partnerships – most of which relate to form tive resource for our private equity clients and friends rather than substance. We believe that the elimina- and welcome any suggestions you might have on tion of the 20-partner limit for English partnerships topics of interest to you and your colleagues. should allow UK private equity funds and their Franci J. Blassberg sponsors to move closer to the administratively Editor-in-Chief

Private Equity Partner/ Counsel Practice Group Members

The Debevoise & Plimpton Franci J. Blassberg The articles appearing in this Kenneth J. Berman – Washington D.C. Colin Bogie – London Private Equity Report is a Editor-in-Chief publication provide summary Jennifer J. Burleigh Richard D. Bohm publication of information only and are not Woodrow W. Campbell, Jr. Geoffrey P. Burgess – London Ann Heilman Murphy Debevoise & Plimpton intended as legal advice. Sherri G. Caplan Margaret A. Davenport Managing Editor 919 Third Avenue Readers should seek specific Michael P. Harrell Michael J. Gillespie New York, New York 10022 Please address inquiries regarding legal advice before taking any Marcia L. MacHarg – Frankfurt Gregory V. Gooding (212) 909-6000 topics covered in this publication action with respect to the Andrew M. Ostrognai – Hong Kong Stephen R. Hertz to the authors or the members www.debevoise.com matters discussed herein. David J. Schwartz David F. Hickok – Frankfurt of the Practice Group. Rebecca F. Silberstein James A. Kiernan, III – London The Private Equity Washington, D.C. Antoine Kirry – Paris All other inquiries may be Practice Group / London Marc A. Kushner directed to Deborah Brightman All lawyers based in New Paris Robert F. Quaintance Farone at (212) 909-6859. York except where noted. Andrew L. Bab Frankfurt Kevin M. Schmidt Hans Bertram-Nothnagel – Frankfurt Moscow All contents © 2003 Debevoise Private Equity Funds Thomas Schürrle – Frankfurt E. Raman Bet Mansour Hong Kong & Plimpton. All rights reserved. Marwan Al-Turki – London Andrew L. Sommer – London Paul S. Bird Shanghai Ann G. Baker – Paris James C. Swank – Paris Franci J. Blassberg

The Debevoise & Plimpton Private Equity Report l Winter 2003 l page 2 Shark Repellents That Can Bite

When private equity firms use IPOs as shareholders. Second, for whatever rights other than those held by the exit strategies (as they sometimes reason, IPO investors just don’t seem bidder become exercisable to buy stock have, and might again, in better market to be bothered by them. That’s odd, in the target company at half price. At conditions), the portfolio company because institutional investors tend to the same time, the bidder’s pill rights going public often includes a full disfavor antitakeover devices – to the become void – thereby causing massive complement of “shark repellents”– extent that it is often impossible to economic and voting dilution. A poison that is, charter and by-law provisions obtain shareholder approval for meas- pill is stronger than a business combi- intended to guard against unwanted ures such as a staggered board after a nation statute because a pill punishes or abusive takeover attempts. Private company has gone public. But under- any unauthorized crossing of the equity sponsors should review these writers have frequently advised that threshold, not just one followed by provisions carefully, because some including a normal set of shark repel- a business combination. of them can limit a fund’s flexibility lents – including a poison pill – will not Private equity sponsors should to cause a sale of the public portfolio harm the marketability of the IPO shares. seriously consider having a portfolio company or, under the right circum- The private equity sponsor that company opt out of Section 203 at stances, obtain a control premium that will continue as a major shareholder the time of its IPO. Even if Section 203 is not shared with other stockholders. of a public company should think twice wouldn’t directly apply to the private The array of shark repellents imple- about whether some shark repellents equity sponsor – either because it has mented for a new public company are really in its best interests – specifi- owned its shares for at least three might include, among other things, cally, business combination statutes, years or because it has received board a staggered board, elimination of such as Delaware’s Section 203, and approval – it would apply to any person shareholders’ ability to act by written poison pills. to whom the sponsor wants to transfer consent or call special meetings, Section 203 imposes a three-year its shares. That means that the private adoption of a shareholder rights plan moratorium on business combinations equity sponsor’s decision to sell its (a “poison pill”), and advance notice with any 15% or greater stockholder shares becomes, in part, a board deci- requirements for shareholder pro- unless the business combination or sion – and the board will be looking posals and director nominations. the crossing of the 15% threshold after the interests of all shareholders, There are two reasons these provi- receives prior board approval, the not just the sponsor. The same is true sions often are added at the time of bidder reaches the 85% threshold in if the company has a poison pill, which the IPO. First, they have proven effec- the same transaction as it crosses the is why private equity firms should also tive in improving the board’s leverage 15% threshold, or the combination is consider whether they want the IPO in the event of an unsolicited takeover approved by the board and by holders company to adopt one. attempt, strengthening the company’s of two-thirds of the shares not owned Here’s an example of how Section 203 ability to do the best possible job for the by the bidder. A Delaware company or a pill can chill dealmaking: can opt out of applicability of Section A private equity sponsor takes Port- 203 by so providing in its charter, but folioCo public and, after some secondary that’s really a one-shot opportunity for John M. Vasily Adele M. Karig sales, is left with a 35% interest. Two Philipp von Holst David H. Schnabel the private equity sponsor to decide – Frankfurt Peter F. G. Schuur years later, BuyerCo would like to acquire whether or not Section 203 will apply. Acquisition/High – London PortfolioCo, but will go forward only if A poison pill works in a similar Yield Financing Employee it is sure that PortfolioCo’s biggest share- William B. Beekman Compensation manner by making it prohibitively Craig A. Bowman & Benefits holder – the private equity sponsor – expensive for a bidder to cross a speci- – London Lawrence K. Cagney is committed to the deal. If PortfolioCo David A. Brittenham David P. Mason fied ownership threshold – often 15% Paul D. Brusiloff Elizabeth Pagel has a poison pill or is subject to Section – without prior board approval. If a A. David Reynolds Serebransky 203, any lock-up agreement between Tax Estate & Trust bidder crosses the threshold without the sponsor and BuyerCo will require Andrew N. Berg Planning prior board approval, all poison pill Robert J. Cubitto Jonathan J. Rikoon continued on page 16 Gary M. Friedman Friedrich Hey – Frankfurt

The Debevoise & Plimpton Private Equity Report l Winter 2003 l page 3 Private Equity and the Proposal to Exclude Dividends from Income

In early January, the Bush Administration proposed to exclude corporate dividends from the taxable income of individual share- holders. Although it appears unlikely that the 100% exclusion proposed by the President will survive as the proposal wends its way through Congress, even a lesser exclusion (say at the 70% or 80% level) would significantly alter the tax strategies employed by private equity funds.

Under current law, most exits are struc- The Administration’s proposal dends is foreign investors. The tured as sales so as to permit individual would also cause leverage recapitaliza- Administration’s proposal does not investors, including the partners of the tions prior to final exit to become a call for an elimination of the 30% sponsor, to enjoy the benefits of long- more popular method of delivering withholding tax on dividends paid to term capital gains taxation (currently at value to investors. This is of particular foreigners. Accordingly, foreigners a maximum tax of 20%). In addition, importance in today’s market where will continue to favor receiving value foreign investors in a fund are generally many private funds are holding equity through sales transactions. Unlike the exempt in the U.S. with respect to investments that have appreciated in current state of affairs where the tax capital gains (except for those involving value but that are not in a position to interests of U.S. individuals and foreign real estate companies). Since dividends be sold in light of the general state of investors are aligned, the Administra- are taxed to individuals at a rate of the market and the absence of strategic tion’s proposal would cause those 38.6% and foreigners are potentially buyers. To deliver value to investors interests to diverge. subject to a 30% U. S. tax on dividends, prior to final exit, a fund could cause a If the Administration’s proposal payment of dividends is not currently portfolio company to borrow and use is watered down in Congress – for a desirable method of delivering value the proceeds to declare substantial example, if Congress enacts a capped to shareholders upon exit. Under the dividend to the fund. Whereas under exclusion (similar to the $100 per year Administration’s proposal, however, today’s law the tax rate for individual dividend exclusion that existed prior to the incentives will be reversed, at least investors would be 38.6%, the tax rate 1987) – the effect on private equity will in connection with U. S. investors. If, on a dividend paid under an 80% exclu- be unimportant. Any sort of substantial for example, Congress were to enact an sion regime would be the 7.72% rate exclusion, however, will cause private 80% dividend exclusion, the tax on indi- discussed above. Indeed, even a 50% equity funds to rethink in fundamental vidual investors (including partners of exclusion regime would make this exit ways their tax planning strategies. the sponsor) upon receipt of a dividend strategy desirable; under a 50% regime, — Gary M. Friedman would be only 7.72% (20% of 38.6%) the tax rate would be just under 20%. [email protected] as opposed to 20% with respect to a One group of investors that will not capital gain. be enthusiastic about receiving divi-

Upcoming Speaking Engagements

March 6-7 Franci J. Blassberg, Program Chair and Panelist ALI-ABA Conference on Corporate Mergers and Acquisitions Special Problems When Acquiring Divisions and Subsidiaries and Negotiating the Acquisition of a Private Company San Francisco, CA

April 1-3 Adele M. Karig Annual Private Equity and Venture Capital Markets Summit 2003 Mastering Effective Tax Practices for Venture Capital and Private Equity Funds New York, NY

The Debevoise & Plimpton Private Equity Report l Winter 2003 l page 4 How to Ensure That Your Special Committee is Special

Companies that are controlled by continued employment and compen- the context of a proposed going-private private equity funds often find it useful sation arrangements are ultimately transaction, that it was not a breach of to establish “special committees” to within the discretion of the directors the fiduciary duty of the board not to approve transactions between the appointed by the fund. give the special committee the power company and the fund. In some cases, In general, the special committee to block the transaction by adopting a this is because the company has debt should not include any director who poison pill, and that the independent instruments, such as high-yield bonds, could be viewed as being beholden to directors of the board did not have any that require that transactions between the fund or its affiliates or as having a duty to seek such a power. the borrower and its affiliates be similar interest as that of the fund in Even if this instance, though, where approved by non-affiliated directors. the transaction that is being negotiated. a proposed transaction is structured In other cases, particularly where there Number of Members in a manner that does not require any are minority shareholders whose inter- action by or approval of the company – It is possible for a special committee ests may be different from that of the for example, a tender offer by a control- to have only one member. However, fund, the use of a committee of inde- ling shareholder, which is made directly committees with two or more members pendent directors can limit the risk to the shareholders – Delaware law are to be preferred. Courts may give a of liability for breach of fiduciary duty may mandate the use of a special transaction particularly careful scrutiny under the laws of the state in which committee to assist the shareholders where there is only one member of the the company is incorporated. in evaluating their options. Again in Committee. (See, for example, Kahn v. However, the benefits to be gained the case of In Re Pure Resources, the Dairy Mart Convenience Stores, Inc. through the use of a special committee Delaware Chancery Court has held (Del. Ch. Mar. 29, 1996).) in these circumstances can be realized that a controlling shareholder who only if the members of the committee The Committee’s Charter proposes to make a going-private are truly independent, and the com- The resolutions that are adopted tender offer to the public shareholders mittee is given the freedom to do its by the full board in establishing the owes a duty to those shareholders to job without interference from the special committee should clearly permit the independent directors of controlling shareholder. This article set forth the responsibilities of the the board of the target company “free briefly outlines the basic requirements committee. Ideally, these should be rein and adequate time” to evaluate of a properly organized and functioning as broad as possible. For example, the proposal (including with the assis- special committee of independent it is better if the special committee is tance of independent financial and directors, in the context of a public specifically authorized to negotiate, legal advisors), make a recommend- company that is controlled by a private rather than merely to approve or dis- ation to the shareholders as to such equity fund. approve the initial proposal of the offer, and provide the shareholders controlling shareholder. Likewise, Independence of Committee with adequate information with which it is better for the Committee to be to make an informed judgment. The members of the special committee authorized to explore alternatives, must be truly independent. Naturally, Selection of and assuming that an alternative trans- this means that any affiliates of the Independence of Advisors action is a realistic possibility. fund, such as employees of the fund’s The special committee should be given On the other hand, the special management company, cannot be on the power to hire advisers, the costs of committee need not be given the the committee. It also means that which would be borne by the company. power to block the proposed transac- directors who are employees of finan- For a complicated matter, such as a tion (e.g., to prevent the fund from cial organizations or other companies going-private transaction, these would going “over the heads” of the committee that have commercial relationships typically include both independent and taking its proposal directly to the with the fund should be excluded. legal counsel and a financial advisor. public shareholders). In the recent Likewise, the committee should not The committee should hire its case of In Re Pure Resources (Del. Ch. include officers or employees of the advisors without interference from October 1, 2002), the court held, in company, such as the CEO, since their continued on page 17

The Debevoise & Plimpton Private Equity Report l Winter 2003 l page 5 A Comparison of U.S. and UK Private Equity Funds

In this article, we review the basic differences between private equity funds organized as Delaware and English limited partnerships and find that most are differences in form, not substance. The notable exception is an economic one – U.S. sponsors generally receive distributions before their UK counterparts.

Delaware and English Limited Partnerships Typical U.S. Structure The Delaware is the fund vehicle of choice Figure 1 (below) presents a typical but simplified U.S. among U.S.-based private equity fund sponsors. Of the more private equity fund structure and Figure 2 (below) presents than 700 hundred U.S. private equity funds listed in Debevoise a typical but simplified European private equity fund struc- & Plimpton’s proprietary database, more than 80% are ture based on an English limited partnership. Delaware limited partnerships. The Cayman Islands exempted limited partnership is also a popular investment fund vehicle Figure 1. Standard U.S. Private Equity Fund Structure among U.S.-based private equity sponsors, but is still less commonly used than the Delaware limited partnership. Principals (or Institutional Sponsor) As popular as they are with U.S.-based sponsors, neither Delaware nor the Cayman Islands has succeeded in becom- General Partner of ing the preferred jurisdiction for organizing private equity General Partner Principals funds sponsored by European firms. In Europe, the English (Delaware LLC)

limited partnership has emerged as the European coun- GP LPs Carried terpart to the Delaware limited partnership and the favored Interest fund vehicle of the UK’s, and to some extent Europe’s, Manager General Partner (Delaware LLC) (Delaware LP) private equity industry. Of the approximately 70 private Adviser Carried interest Investors equity funds in our database that are focusing on European Agreement (20% profits)

investment, about half take the form of English limited part- GP LPs Capital & nerships. Other popular jurisdictions include Jersey and (~2% Commitments) 80% Profits Fund Guernsey in the Channel Islands. (Delaware LP) At first glance, U.S. private equity funds organized as Delaware partnerships and UK private equity funds organ- Portfolio ized as English partnerships look rather similar. But there Companies are certain differences between the two that sponsors and investors should be aware of, including (1) the use of loan Limited Partners (Investors) commitments instead of capital commitments in an English In Figure 1, the private equity fund itself is a Delaware partnership, (2) the market practice of distributing the carried limited partnership that invests in one or more portfolio interest later in a UK fund than in a U.S. fund, (3) tax-driven companies. The fund’s investors are limited partners that structuring of UK management fees and (4) the legacy of make capital commitments to the partnership and agree England’s old 20-partner rule – numerous parallel partnerships. to meet those commitments by making cash contributions For the most part these are differences in form, not to the fund as and when the general partner determines that substance (although from a legal and tax perspective they such contributions are needed for the fund to make port- are critical to a properly documented UK fund). The timing folio investments or pay partnership expenses. As Figure 1 of the carried interest distributions is a notable exception indicates, limited partner investors receive a return of their and economically impacts fund sponsors, but represents a capital contributions, plus 80% of the profits thereon, as commercial difference between the U.S. and UK private equity cash and other proceeds from the fund’s investments become markets. We do not expect either the U.S. or UK market on available for distribution after payment of expenses. carried interest distributions to change significantly in the near future. We do expect U.S. and UK funds to move closer General Partner (Sponsor Affiliate) together on structure, as UK fund sponsors going forward The general partner of the fund is also a Delaware limited reduce the number of parallel partnerships they manage. partnership (other forms or jurisdictions are possible) and makes a capital commitment to the fund equal to about 1%

The Debevoise & Plimpton Private Equity Report l Winter 2003 l page 6 of the fund’s total commitments, although the precise percentage may vary for tax reasons or based on commer- Figure 2. Standard European (U.K.) cial negotiations between the sponsor and investors. (In Private Equity Fund Structure

Figure 1 we ignore the general partner’s capital contribu- Principals (or Institutional Sponsor) tion.) In addition to receiving a return of its own capital contributions and any profits thereon, the general partner receives a carried interest equal to 20% of the profits gen- erated by the fund’s investments (frequently subject to Management a hurdle or preferred return). The sponsor’s investment Agreement Carried Interest Partner Manager General Partner professionals (in Figure 1, the “Principals”), if they share Annual (“Founder Partner”) Costs in the carried interest and/or help fund the general partner’s Special LP Investors Annual Profit Share (~2% capital commitment to the fund (as is typically the case), Commitments) are limited partners of the general partner and receive cash LPs GP Carried Interest Repayment of (20% Profits) interest-free loan distributions from the general partner. Participation in the & 80% Profits Fund carried interest by the Principals can also be structured one (English LP)* level up, through the general partner of the fund’s general Portfolio partner, or may involve additional entities and more complex Companies structuring to accommodate sophisticated personal tax and estate planning. * One or more additional parallel partnerships may be, and until most recently almost always have been, required. Manager (Sponsor or its Affiliate) In a standard U.S. private fund structure the manager of are entitled to 80% of the profits from their investments, the fund is neither a general nor limited partner of the fund. (2) a 20% carried interest on the profits generated from Instead, the manager usually is a separate but affiliated the limited partners’ investments is distributed to a special entity that is organized as a limited liability company instead purpose vehicle under the control of the fund’s sponsor of a partnership. Although the management company may (although in this case it is not the general partner of the also be organized as a Delaware entity, and many are, it fund) and is eventually distributed to the sponsor’s Principals is also common for a U.S. fund sponsor to organize the man- and (3) a fixed annual amount is paid out by the fund, which agement company in the state where its principal offices covers the actual costs of providing investment advice and are located and business activities take place. managerial services. Nevertheless, there are certain differences If the manager is a private equity “boutique,” it is con- in the way that the commitments, carried interest distribu- trolled by one or more of the Principals and is referred to tions and management fee work together in an English as the sponsor. Alternatively, if the manager is a subsidiary limited partnership. of a large financial institution, such as a bank or Commitments: Capital and Loans company, then the financial institution is generally viewed One difference between UK and U.S. private funds is that as the sponsor and in most cases maintains ultimate control investors in English limited partnerships are required to make of both the fund manager and the general partner. In capital (equity) commitments and loan (debt) commitments either situation the manager acts as an adviser to the fund, to the fund, whereas investors in Delaware limited partner- providing investment advice and administrative manage- ships make only capital commitments to the fund. Why? ment services to the fund pursuant to a services contract Under Section 4(3) of the English Limited Partnership that is approved by the general partner and the fund’s Act of 1907, no part of a limited partner’s capital contribution limited partners. In exchange for the services that it provides can be irrevocably returned to the limited partner prior to the fund, the manager earns an annual management fee the dissolution of the partnership. If capital contributions are that is paid by the fund as a routine operating expense. returned to the limited partner earlier, the limited partner Typical UK Structure loses its limited liability status to the extent of the capital Figure 2 represents a generic UK private equity fund organ- returned and any capital contributions distributed to a ized as an English limited partnership. limited partner prior to the fund’s dissolution may, as a The structure is generally similar to the U.S. model in matter of English partnership law, be required to be re- Figure 1: (1) investors are limited partners in the fund and continued on page 18

The Debevoise & Plimpton Private Equity Report l Winter 2003 l page 7 guest column What’s Good for the Goose… Turning the Due Diligence Spotlight on Sponsor Infrastructure

Private equity sponsors are obviously familiar with the importance of appropriate due diligence into management and business conti- nuity systems at potential targets when they make their own investment decisions. What may not be so obvious is that institutional investors are increasingly shining the due diligence spotlight on the private equity fund sponsors themselves before committing capital. Interestingly, many sponsors are challenged when faced with formulating their responses to these inquiries.

The turmoil created by Enron, asset base). The private equity busi- continuity plans for their own opera- WorldCom and Tyco coupled with ness has grown from a cottage tions, progress has been slow. This the terrorist attacks of September 11, industry to a mainstream asset class. progress has been impacted by concerns 2001, have dramatically demonstrated This growth and the renewed focus about costs, trepidation regarding the that businesses must reexamine their on governance and quality of financial ability to close future funds and the financial reporting, governance and reporting has led to increased scrutiny need to justify an appropriate return business continuity plans. Private and expectations on the part of institu- on investment, the current economic equity firms are not exempt. Restive tional investors. There is also a concern climate(including softer market con- LPs and increased media attention of increased regulation. Harvey Pitt, ditions for new fundraising), more time almost certainly guarantee that the the outgoing Chairman of the Securities spent tending to the needs of portfolio market will demand major changes. and Exchange Commission, revealed companies, reduced carried interest There is simply too much capital in a recent speech that the private distributions to sponsors and LP pres- exposed in the private equity asset investment arena was under review sure on management fees. class and growing, though not neces- by the Commission. In our capacity as private equity sarily accurate, perceptions of While certain aspects of private fund administrators, we have noted “murky valuation standards,” “port- equity, like deal structuring and a substantial increase in the number of folio company melt downs,” “fund financing, are highly complex, the inquiries from the downsizing,” “lack of transparency” operations of a private equity fund are community regarding processes, and sponsors with “mom-and-pop” actually fairly straightforward. It is procedures and business continuity back offices. easy to understand why private equity planning. Not surprisingly, requests Our experience in dealing with a managers seem to associate their busi- on behalf of our new fund clients large number of U.S. and European ness more closely with the operations to complete gatekeeper checklists private equity firms reveals that many of a small business, than with a multi- addressing reporting policies, pro- senior executives at private equity million/billion dollar investment asset cedures and infrastructure are on firms today are, in fact, concerned manager. Most firms have traditionally the rise. about the quality of their firm’s internal been highly entrepreneurial organiza- Identifying, assessing and imple- infrastructure. This should come as tions driven by the vision and skills of menting change to a sponsor’s no surprise given the dramatic growth their founders. However, the signifi- infrastructure is not unlike those in private equity. From 1999 to 2001 cant fiduciary responsibility associated processes a sponsor employs when alone, there were a record 528 new with investing substantial amounts of vetting a potential acquisition. In fact, funds closed that raised $214 billion third-party capital creates a difference many of the resources necessary to of capital. between the private equity fund improve a sponsor’s infrastructure As in many other growth industries, sponsor today and a small business. substantially are often readily available investment in infrastructure oftentimes While sponsors are increasingly within its organization. lags revenue growth (in the case of recognizing the need to institutionalize The key to moving forward is to private equity – the “build-out” of the their organizations, including re-exam- accept the fact that infrastructure ining the infrastructure and business

The Debevoise & Plimpton Private Equity Report l Winter 2003 l page 8 As private equity fund issues and business continuity plan- • Is there a formal escalation policy? administrators, we have ning should be a key concern of senior • Is compliance being maintained with private fund management. At an your policies and procedures? noted a substantial increase implementation level, it is important • Is the technology system you are to identify an individual or team of using well supported and backed in the number of inquiries individuals with the proper level of up at a secure location? authority who, while not involved in from the institutional investor • Do you have the most up-to-date day-to-day operations, have significant community regarding operating experience. The individual version of the technology being used? or team must be empowered to make • Is knowledge of the technology and processes, procedures and an assessment of business operations. access to key information limited to The following simple set of guide- only one employee? business continuity planning. lines will help ensure that a fund • Make an honest assessment of sponsor’s infrastructure has the requi- your team. site fundamental processes and • Benchmark financial and investor administration. Now, there are readily controls in place to meet the core reporting with other funds. available software packages designed needs of institutional investors. specifically for private equity fund admin- Reach out for accessible help: Identify critical processes: istration. The expanded pool of advisors • Meet with your auditors. Inquire specializing in the private equity arena, • Fund raising of them as to their views on your including executive search firms as well • Investor relations internal controls and financial as legal, accounting, communications reporting. • Investment identification, and fund administration providers can monitoring and harvesting • Speak to your professional team. be tremendous resources. Increasingly, • Financial and investor reporting Legal counsel and placement agents outsourcing is being embraced as a can be insightful. • Risk management best-practice solution for private equity • Borrow professionals from your fund administration. • Technology portfolio companies. By way of Now Is the Ideal Time to Act Take inventory of what you currently example, we know of a fund sponsor This is the time of year that funds close have in place. You should have: that enlisted the help of a portfolio out their year-end accounts and the • An organization chart company’s risk manager to develop independent auditors commence their the fund’s business continuity plan. • A well-documented policy and work. That makes it an ideal time for procedures manual • Consider outsourcing private equity sponsors to assess their • Documentation regarding your • Speak to colleagues internal infrastructure. The investment community is demanding action on technology platform Utilize the Multiple Resources these issues to ensure that sponsors • Business continuity plan There has been a concomitant growth and their portfolio companies are • Job descriptions in the number of available resources prepared for a range of formerly to serve private equity fund sponsors • Market-standard financial reporting unthinkable scenarios. Firms with as the industry has grown. Industry processes and practices an institutional vision, will exercise groups are cropping up to enable Assess what you currently have: leadership and heed their call. private equity managers to have a — Steven Millner, Managing Director of • Is the organizational structure appro- forum to share ideas and experiences. New York-based DML, a BISYS company. priate for your business model? When I started in private equity, • Do your policies and procedures Lotus 123 was the industry standard for adequately address high-risk areas? private equity fund accounting and

The Debevoise & Plimpton Private Equity Report l Winter 2003 l page 9 Minority Equity Investments in German Companies

2002 was a tough year for private equity investors in Germany, as in almost every other jurisdiction. “Total write-off” was the leading exit channel by volume for members of the German Venture Capital Association during the first half of the year, according to its managing director. The reasons for this result include the typical litany – differences in valuation expectations of buyers and sellers and difficult debt financing conditions made it harder to close deals, deteriorating economic conditions led to a number of restruc- turings and insolvencies of German portfolio companies backed by private equity funds and the capital markets remained essentially closed to IPO activity (six IPOs in 2002, as compared to 150 in each of 1999 and 2000).

But the mood among private equity equity (and particularly venture capital voting and other shareholder rights professionals and their advisors in funds) in German companies. attaching to any equity interest or class Germany is not sullen. As one might Investment structures and Instruments of equity interests very much as the expect, investment bankers are even parties desire, whereas the rules gov- Minority investments in German com- more optimistic1. Ninety-four percent of erning an AG are more restrictive. panies by private equity/venture capital German investment bankers surveyed Equity investments in either an AG funds involve investment structures are confident that cheaper assets rep- or a GmbH can take the form of either and investor rights very similar to those resent an opportunity for private equity ordinary or preferred shares. Non-voting in the U.S. Typically, the fund will seek firms. There is also a dramatic rise in preferred shares are often used, but limited shareholder rights to protect its the expectation of increased going- non-voting preferred shares may not investment, such as supervisory board private transactions. constitute more than one half of the representation and information rights, For many private equity firms, the share capital of an AG. Minority invest- assurance of equal economic treatment main issue at the moment, however, ments in a GmbH & Co. KG typically through such mechanisms as a tag- is how to ensure an exit from current take the form of non-voting limited along right (a right to participate pro or new investments. The general view partnership interests with such economic rata in any sale of securities by the in Germany is that the IPO market is rights as are provided in the partnership controlling shareholder), pre-emptive unlikely to warm up again before 2004. agreement; the majority investor or rights to subscribe for new shares, and But even then, European markets may sponsor then holds 100% of the GmbH less commonly, rights of first refusal in not be as vibrant as some are hoping. acting as general partner, which often respect of sales of shares by the control- Strategic buyers are showing lukewarm only has nominal economic rights. ling shareholder or shareholders. interest – they often have their own In Germany, important features of However, in continental Europe, issues to sort out. securities that are standard and self- company laws and contractual rights, Nevertheless, there is deal activity executing in the U.S., such as conversion are quite different from those in the in Germany. In our own practice we or redemption rights, can only be imple- U.S., so that a number of typical U.S. have seen an increasing number of mented by means of shareholder voting private equity/venture capital invest- private equity firms effecting partial agreements. While shareholder voting ment structures or investor rights need exits or restructurings by selling agreements are enforceable in Germany, to be adapted to local law or, in some minority participations in portfolio there may often be a substantial delay in cases, simply do not work. companies. We expect this trend to obtaining a judicial remedy in the event continue – at least until strategic German Structures of breach and the need to hold a share- buyers and the public markets show By way of background, the most holders’ meeting is in itself cumbersome. more interest in the investments common company forms in Germany For example, in order to provide issuance currently held by private equity firms. are the limited liability company of options or warrants to minority stock- This article outlines some of the issues (Gesellschaft mit beschränkter Haftung, holders or to provide them with the that have arisen in a number of recent “GmbH”), the stock corporation benefit of conversion or subscription of minority investments by private (Aktiengesellschaft, “AG”) and a form rights, a shareholders agreement must of limited partnership with a GmbH provide that the controlling shareholder 1 In a survey (the Index) published in December 2002, as general partner (GmbH & Co. KG). will vote in favor of the required corpo- nearly four out of five (78%) bankers expect private equity participation in the overall M&A market to increase across In the case of a GmbH or a GmbH & rate action, which requires a 75% vote of Europe (Germany 65% versus UK 89% and France 80%). Co. KG, it is possible to tailor financial,

The Debevoise & Plimpton Private Equity Report l Winter 2003 l page 10 shareholders present at a shareholders’ amendment to the articles in the form the drag-along as a contractual penalty. meeting at the time of issuance. of a notarial deed. However, this solution is less secure, The role of pre-emptive rights in Trade Sales to Minority Investors. In the since the sale would be delayed until Germany, as in many continental juris- absence of access to capital markets, the dispute is resolved and a contrac- dictions, is far more problematic than tag-along rights – whereby minority tual penalty may be set aside or in the U.S. Depending on the terms investors are granted the right to par- reduced by a court. of the company’s Articles, existing ticipate pro rata in trade sales by the Redemption. One common means to shareholders may have compulsory controlling shareholders – currently seek to provide exit from an investment pre-emptive rights or pre-emptive rights constitute the principal means of in the U.S. is the use of redeemable that can only be eliminated by super- ensuring an exit for minority share- preferred stock. Unfortunately, German majority vote. The articles of association holders. The clause is typically enforced company laws place extensive limita- of an AG may provide for a greater or by an irrevocable power of attorney tions on redemption. Although in some a lesser lower majority vote to issue authorizing the controlling shareholder cases it may be possible to negotiate common shares and, within certain to transfer legal title to shares of the the equivalent of a redemption right limits, the management may issue other shareholders. In a number of through complex shareholder agree- shares in amounts and on conditions recent transactions on which we have ments, in most cases such contractual set forth in a shareholder resolution. worked the minority investors have rights provide little real assurance of Convertible preferred stock does sought (without success) the right to an exit by way of redemption and may not exist in Germany. Conversion of sell all of their shares before the con- also be subject to enforcement delays. preferred shares into common shares trolling shareholders can make a sale. In Germany, redemption can take also requires 75% shareholders’ approval Controlling shareholders often seek the form of a repurchase of shares and a separate 75% majority vote of a prohibition on sales by the minority (essentially a put option), or a reduction the holders of the preferred shares, investor for a specified period. While in stated capital (the aggregate nominal which could also be provided for in prohibitions on transfer for extended value of all shares issued) or a com- a shareholder’s agreement. periods are not permitted under bination of the two. (There are other Only an AG can issue convertible German law, prohibitions of reasonable possibilities for withdrawing shares that bonds. Otherwise conversion of a loan duration (one to three years) should are not relevant to this discussion). into equity can only take the form of be enforceable. It is more common, Unless shares are to be cancelled a contribution in kind of the loan to the however, for controlling shareholders following repurchase, an AG may only capital of the AG/ GmbH. A contribu- to permit minority investors to make purchase its own shares pursuant tion in kind requires a valuation of the sales to third parties, but to retain rights to a specific shareholders’ resolution loan by a qualified auditor to ensure of first refusal over such sales. Less passed no more than 18 months prior the loan is worth at least the nominal frequently, minority investors seek first to purchase. A put option with a longer value of the shares issued as well as refusal rights in respected sales by exercise period would require a share- a shareholder vote. Again, as in most other minority or controlling investors. continued on page 20 cases, the only enforceable mechanism Drag-along clauses – whereby for providing for such a contribution minority investors can be obligated upon request of an investor would be to participate pro rata in sales by the In Germany, important a shareholder’s agreement to vote in controlling shareholders – are also favor of a capital increase. standard in Germany. The clause is features of securities that are Corporate action to give effect to also typically enforced by an irrevocable changes approved by shareholders also power of attorney authorizing the standard and self-executing does not occur as swiftly in Germany controlling shareholder to transfer in the U.S., such as conver- as in the U.S. The issuance of new legal title to shares of the other share- securities often takes up to four to six holders. As an alternative, some sion or redemption rights, weeks (and occasionally even longer in investment agreements in Germany Germany) because of the need to file have required a shareholder resisting can only be implemented with the local commercial register an a drag-along to surrender some or all by means of shareholder shares to the investor benefiting from voting agreements.

The Debevoise & Plimpton Private Equity Report l Winter 2003 l page 11 You’re Not in Delaware: Directors’ Liabilities in Major European Countries

You are a principal of a U.S. private liability in situations where liability A director’s statutory duties are prin- equity firm, and you have been asked to would be unlikely in the U.S., including cipally contained in the Companies Act sit on the boards of directors of several violations of certain provisions of cor- 1985 and the Insolvency Act 1986, both of its European portfolio companies. porate law, such as unlawful dividend of which can impose personal as well Before you make up your mind, you distributions and “financial assistance.”1 as criminal liability in certain cases. should know how companies in these In view of these differences, we For example, violations of the finan- jurisdictions are governed, as well as would recommend that, in France and cial assistance rules in the Companies the extent of your duties and liabilities Germany, where two-tier board struc- Act 1985 can result in criminal liability, in these jurisdictions. tures are possible, they should usually but, so long as certain “whitewash” You are probably familiar with be chosen and that representatives procedures are followed, financial Delaware corporate law on these of private equity firms should generally assistance can often be given in lever- matters. You understand that a director serve on the supervisory board. Of aged acquisitions. In addition, the of a Delaware corporation is subject course, if, through provisions of the Companies Act 1985 contains detailed to both civil and criminal liability for articles of incorporation or a share- provisions concerning fair dealing by breaches of his/her duty of care or duty holders agreement, all or many of the directors that supplement and overlap of loyalty, as well as for failing to comply ordinary course of business decisions with the common law rules. with other applicable legal requirements, generally made by members of the In practice, the provisions of the such as the federal securities laws. management board are in fact made Insolvency Act 1986 are likely to be Nevertheless, you are comfortable that by members of the supervisory board, of greater concern as they can impose your personal liability is relatively limited there is a risk that the members of personal liability on a director (or in practice, through the application of the supervisory board may be found former director) to contribute to a the business judgment rule and the use to have assumed the responsibilities company’s assets upon liquidation of indemnification agreements and (and, accordingly, the liabilities) of the where the director has been involved insurance policies. management board. in wrongful or fraudulent trading. It would be incorrect, however, to England “Wrongful trading” is broadly inter- assume that company law in Europe preted and essentially means allowing is similar to Delaware law or even How are English Companies Governed? a company to continue to do business that a uniform approach exists among As in Delaware, the management of when there is no reasonable prospect European countries. Although the rules English companies is vested in a single of avoiding an insolvent liquidation. in England may generally be similar board of directors. The board of direc- A director’s duty of skill and care, (though not identical) to those in the tors of an English company usually has set forth in case law, is owed to the U.S., the rules in France and Germany extensive rights and responsibilities. company as opposed to its individual are quite different. Directors in a one- Although the British government has shareholders. Whether a director is tier board structure (a single board of expressed a commitment to reforming meeting his or her duty of skill and directors), or members of the manage- company law as a whole, including care is determined by the higher of an ment board in a two-tier structure the law with respect to governance, this objective standard (that of a reasonably (management board and supervisory is still at the discussion stage. As in diligent person having the knowledge, board), face civil and even criminal the U.S., English law is a composite skills and experience that may reason- of statutory and case law. ably be expected of a person carrying 1 Under an EU directive, it is illegal for the assets of an issuer What are the Sources of out the same functions) and a subjec- to be used to provide financial assistance (directly or indirectly through loans or guarantees) in support of the purchase of Directors’ Liabilities? tive standard (that of the actual general shares of that issuer. There are exceptions to the rules on financial assistance in some EU countries, particularly in Directors’ liabilities in England can arise knowledge, skill and experience of the England, but it should be borne in mind that financial assis- from breaches of three categories of director involved). tance issues almost always arise in leveraged acquisitions by private equity funds. duties: (1) statutory duties, (2) the duty of skill and care and (3) fiduciary duties.

The Debevoise & Plimpton Private Equity Report l Winter 2003 l page 12 In France and Germany, It is not common for a company to France where two-tier board struc- sue its directors for breach of the duty How are French Companies Governed? of skill and care, and there are fewer Significant French companies, including tures are possible, they should lawsuits brought against directors in portfolio companies of private equity England than in the U.S. The lower funds, are usually organized as stock usually be chosen, and… volume of litigation may also be the corporations (SAs). A majority of these representatives of private result of a lack of a clear form of deriv- corporations have a single board of direc- ative action. A law commission report tors similar to the unitary board structure equity firms should generally on company law reforms in England of a Delaware or English company. recommended the establishment of French company law also permits serve on the supervisory board. a new and clearer form of derivative French companies to have a two-tier action, but that recommendation has board structure, consisting of a superv- not yet been acted upon. isory board and a management board. various circumstances (including not The fiduciary duties of directors In this case, the supervisory board over- only what U.S. lawyers would view as in England are also derived from case sees the activities of the management breaches of fiduciary duty, for example, law. Except in limited circumstances, board and the management board is using corporate funds or assets in a fiduciary duties are owed to the responsible for the ordinary course manner known to be contrary to the company as opposed to its individual business of the company. interests of the corporation, but also shareholders. However, as a company In our experience, private equity for violations of certain provisions of approaches financial difficulties the firms are increasingly adopting two-tier corporate law, such as unlawful divi- interests of creditors become increas- board structures for their French port- dend distributions, financial assistance ingly important. Examples of fiduciary folio companies and appointing their and the requirements with respect to duties include: (1) a duty of loyalty representatives to the supervisory the issuance of shares). (to act in the best interests of the com- board. We generally recommend this In the early 1990s, Nasa Electronique pany), (2) a duty of independence (to alternative because it means that the S.A., a French company whose investors exercise independent judgment in private equity firm principals (and included a well-known English private the best interests of the company) and others) are less exposed to potential equity fund, was involved in a leading (3) a duty of fairness (to act fairly as civil and criminal liability (because their French case concerning directors’ liabil- among shareholders). If a director responsibility is limited to supervising ities. The French court found that the breaches his fiduciary duty, the director the management board), while still board of directors (Nasa had a one-tier may be liable to the company for any allowing the private equity firm’s repre- board structure) was aware of question- loss incurred and will be accountable to sentatives to exercise an oversight role. able management decisions and did the company for any benefit received. What are the Sources of nothing to prevent them. Subsequently, How can a Director be Directors’ Liabilities? Nasa and its subsidiaries declared bank- ruptcy. The French court held all the Protected from Liability? Members of the board of directors of directors jointly and severally liable for In general, an English company may a French corporation (in the case of a an amount in excess of FF 400 million indemnify and insure its directors one-tier board structure) or the manage- (approximately $53 million), but did not against liability. Liability insurance poli- ment board (in the case of a two-tier find criminal liability on the part of the cies may cover the director’s “neglect, board structure) are subject to both board members. The English private omission or error,”but only to the extent civil and criminal liability. Directors are equity fund had only a 5% shareholding any loss incurred is not a result of the subject to civil liability in connection in Nasa and had appointed only one of director’s fraud or criminal act. Directors’ with acts or omissions: (1) committed its seven directors. liability insurance is increasingly in violation of statutory or regulatory In contrast to members of a man- common in England, and we would provisions, (2) violating any provision agement board, members of a French recommend its purchase for private of the corporation’s articles of incorp- supervisory board are only subject to equity firm principals (and others) oration or bylaws or (3) attributable civil liability for acts or omissions serving on any boards in England. to “errors” in management. Directors continued on page 22 are also subject to criminal liability in

The Debevoise & Plimpton Private Equity Report l Winter 2003 l page 13 Questions to Ask Before You Join a Club (continued)

Ability to Penetrate Foreign Markets. • Role of management. What opportuni- Determining the overall financing Joining a local firm in a transaction ties and incentives are the bidders structure, including the debt sources, based in a foreign market might provide willing to offer to management to work is something the club members should a good introduction to that market for with them in the selection process? carefully review. Are the co-bidders in a private equity firm that has not previ- • Negotiating control. Who will control agreement on the degree of financing ously (or regularly) invested in that the bidding process? Should there be certainty that is acceptable for their bid? market. Collaborating with a local private a “lead” investor? Should it neces- Are club members willing to pay for equity firm could reduce the risk of sarily be the firm that will contribute commitments from financing sources, investing in a new geographic area. the most equity or that initiated the or can they rely on historical relation- Before participating in a joint bid or transaction, or perhaps another club ships to obtain the requested joining a “club,” private equity investors member with a strong relationship with commitment letters? should understand the complications management? Private equity firms tend Allocation of expenses. If the transaction involved – both at the bidding stage to operate by consensus. Should one is not successful, how will the club and if the bid is ultimately successful. individual at each firm be responsible members allocate the “dead deal” costs? Preliminary Deal Matters. Before joining for making decisions for that firm so Allocation of any break-up fees. If the trans- a bidding process, each party should that the process works smoothly? action is not successful, how will the club consider the following issues: Relationships with advisors, including members share in any break-up fees? • Exclusivity. What holds the bidding the investment banker (if any), the Participants in a joint bid also need group together? Will they be exclu- accountants, outside counsel, etc. How to have tackled a number of other issues sively tied to each other? Until the will advisors be selected? Often each before submitting their bid in order to auction is over, or only until a certain member of the group selects one of its feel confident that they will have a good date, or until they disagree on fund- traditional advisors, such as account- working relationship with the co-investors amental terms or strategy? Can they ants or counsel, although sometimes if the bid is successful. switch partners mid-stream? Who “neutral advisors” are chosen so that Governance Rights. Among the most decides to admit a new member? each member of the group has the important issues to be addressed are • Bidding strategy. How should the same degree of relationship with the governance rights. The allocation of bidding be handled? Should the indica- advisors. In choosing outside counsel, governance rights among the club tion of interest range include a stretch we have found that the club is best members will be a function of, among price, dependent on due diligence served by selecting counsel not only other factors, their relative equity stakes findings? Do the club members agree with private equity M&A experience, in the company, their relative bargaining on the highest price that they are but also with an understanding of the positions, their expertise in the business willing to pay? special requirements of the private or some combination thereof. Matters equity funds (e.g., tax, ERISA, partner- to be covered in allocating governance ship agreement investment restrictions) rights among club members include: and their investors, which will be • Board representation and committee Before participating in a providing the equity in the transaction. membership, including chair positions, joint bid or joining a “club,” Financing structure. While determining replacement procedures and adjust- the amount of equity that each club ments to board representation when private equity investors member commits to should be fairly investors’ equity stakes change. Jointly easy, other aspects of the financing should understand the selected independent directors should structure can be more problematic. be considered to round out the Board. complications involved – For example, some club members may If the company is going to issue public be prepared to “bridge” some of the debt, care should be taken to have both at the bidding stage purchase price from their funds, while directors that will meet Sarbanes-Oxley others may not be permitted to do requirements. Investors that are and if the bid is ultimately so or may prefer other alternatives. successful. The Debevoise & Plimpton Private Equity Report l Winter 2003 l page 14 private equity funds may be required to tion may have different abilities to plans and the appropriate strategy for obtain rights to board seats to satisfy provide additional capital and/or achieving such goals. Among the items the venture capital operating company may require limited partner approval to be considered are: (VCOC) exemption from the plan asset for follow-on investments, these • The company’s strategic plan. regulations under ERISA. constraints should be analyzed when • The management team. The club the transaction is structured initially. • Supermajority voting rights and veto members should focus on the man- rights. The club members should first • Information and observation rights. agement team: Is it strong? Does decide the matters, if any, that will A minority investor that is unable to it need supplementing, especially if require a supermajority vote of the secure board membership should the transaction is a divestituture? Board. Items for consideration might insist upon having information rights • The optimal management incentive include new equity issuances, payment – the right to inspect the company’s mechanisms. The club members of dividends or other distributions, books and records and the right to should agree on the various incen- sales or purchases of significant assets, receive financial reports and other tivization approaches (stock purchase, extraordinary corporate transactions periodic disclosures, for example – options, warrants, bonuses, etc.) such as mergers or joint ventures, CEO and/or observation rights for purposes that most closely align managers’ hiring and firing, transactions with affil- of satisfying VCOC requirements. incentives with the club members’ iates (including deal and management • Allocation of deal and management fees financial objectives. fees), and exits from the investment. among the club members. This issue is • The courses of action to follow if the Veto rights may also be appropriate in close to the hearts of private equity company starts performing poorly. For some transaction but, particularly in investors and should be resolved early example, is there someone at one of a club with three or more members, in the process. Many private equity the participants’ firms who could run might tend to create logjams. In 50/50 firms charge investing banking, origi- the business on an interim basis if a club deals, the club members should nation, directors and monitoring fees management change is required? devise mechanisms for dealing with to their portfolio companies. If the Exit strategy. deadlock, perhaps by having indepen- transaction is successful, which firms • The club members should dent directors on the Board. may charge which fees? When? How determine whether they have roughly similar time horizons and target rates • Anti-dilution protection: preemptive much? Because different investors rights, warrants and convertible stock. will hold different percentages of the of return on the investment. In order to provide dilution protec- equity post-closing (and thus affec- Limited Partner Reaction. In deciding tion, private equity firms typically tively bear different percentages of whether to participate in a club deal, a consider preemptive rights, convert- fees charged), and because some private equity firm should consider the ible securities and/or veto rights private equity firms share larger per- potential reactions of the limited part- over new security issuances by the centages of fee income than others ners in its funds. Limited partners that company. In some instances, partic- (and thus may be less anxious to are investors in funds that jointly acquire ipants will not know if they will be charge transaction fees, for example) a business may take issue with the way able to provide additional capital to this can be a contentious issue. the transaction impacts them, regard- maintain their pro rata interests when Portfolio Company Management, Exit less of the merits of the transaction. new equity infusions are required Strategy, etc. Once a transaction is • Anti-diversifying effect. For limited because they are close to completing completed, participants in a club deal partners, club deals may have an anti- the investment of a fund’s capital or may face challenges because of the diversifying effect by increasing their risk are in jeopardy of running up against nature of joint ownership. To enhance exposure when multiple private equity diversification limits. In those circum- the likelihood of a smooth working rela- firms in which they are investors stances, the private equity firm might tionship, club members should discuss invest in a single portfolio company. want to put the investment in a operating philosophies at the outset Limited partners may find themselves new fund (subject to limited partner of the deal. That means, for example, “over-invested” in a transaction in approval) or permit its prior fund’s sharing a common understanding of which several of their private equity limited partners to participate directly. the company’s business and growth managers have jointly participated. Because participants in a club transac- continued on page 16

The Debevoise & Plimpton Private Equity Report l Winter 2003 l page 15 Questions to Ask Before You Join a Club (continued)

• Control investing. Some limited part- • Management fees. Limited partners ments are much less typical in club ners expect (by agreement or may feel that private equity firms that deals solely among private equity firms. otherwise) the private equity firms in participate primarily in club deals —— which they invest to participate prima- should receive a lower management Large club deals appear to be a rily in control investments. If a private fee because such limited partners permanent part of the private equity equity firm engages in more than an may view participation in club deals landscape. Private equity firms that occasional club deal in which it is a as devaluing what the “deal finders” anticipate participating in such transac- minority player or 50/50 investor, it bring to the table. tions should do some careful planning might fail to satisfy the expectations Put and Call Rights. If a strategic in order to structure those investments of its limited partners who anticipate investor is participating with private in a way that avoids surprises and that it will engage mostly in control equity firm(s) in a club deal, the parties conflict between both club members transactions. should consider whether to include and their limited partners. • Cross-ownership problems. Limited put and call rights in the shareholders’ — Paul S. Bird partners that are invested in a single agreement. Such rights could be [email protected] transaction through multiple private structured to enable the private equity — Franci J. Blassberg equity firms may be subject to unan- firm(s) to require the strategic partner [email protected] ticipated tax treatment in certain exit to buy out the private equity firm(s) at — Michael P. Harrell transactions unless sponsors carefully an agreed upon multiple or to permit [email protected] monitor the situation. In addition, the strategic investor to acquire a larger — Laura N. Beny such cross-ownership issues may stake (through exercise of a call right) [email protected] limit exit alternatives. at an agreed-upon IRR. Such arrange-

Shark Repellents That Can Bite (continued)

PortfolioCo board approval, because a tender offer for all of PortfolioCo’s May 1996 to January 2003. Of that otherwise either BuyerCo will trigger the shares – without any involvement by Port- group, at the time of the IPO, eight pill or be forbidden from completing an folioCo’s board other than its need to companies (or 38%) opted out of acquisition of PortfolioCo for three years. make a recommendation about the offer. Section 203 and did not adopt a pill. The board approval requirement is Foregoing a poison pill and appli- Another eight companies were subject not just ministerial. Based on recent cability of Section 203 should not to Section 203 but did not adopt pills, case law (see “Goodbye to Lock-Ups?” seriously compromise the ability of a and five companies were subject to in this issue), the board of a Delaware company to defend against a coercive Section 203 and adopted pills – company will likely be unable, on fidu- takeover attempt. The board could meaning that 62% were subject either ciary grounds, to approve the lock-up always decide to adopt a poison pill to a pill, to Section 203 or both. Down agreement if it would, as a practical down the road, once a specific threat the road, it is possible that at least matter, preclude a higher bid by a third materializes – and if a company has a some of those firms will wish their com- party. But if PortfolioCo has no pill and pill, it shouldn’t also need Section 203. panies did not have those particular is not subject to Section 203, BuyerCo We looked at a selected group of 21 shark repellents. could freely enter into a lock-up agree- IPOs by U.S. portfolio companies of — William D. Regner ment with the sponsor and then launch private equity sponsors over the period [email protected]

The Debevoise & Plimpton Private Equity Report l Winter 2003 l page 16 How to Ensure That Your Special Committee is Special (continued) the company or the controlling share- be part of a multi-function financial concludes that the committee did not holder. In one case, Kahn v. Tremont services organization, in which case do its job properly. For example, in Corp., 694 A.2d 422, 426 (Del. 1997), the special committee should consider Kahn v. Tremont Corp., 694 A.2d 422, the Delaware Supreme Court concluded ties and business relationships of 429-30 (Del. 1997), the Delaware that even though the going-private affiliates of the financial adviser (for Supreme Court noted the lack of atten- transaction was approved by an example, banking relations, underwrit- dance and diligence by some committee independent committee, the control- ings or other advisory relationships). members as part of the basis for its ling shareholder still had the burden Past or even present business rela- conclusion that the defendants retained of proving that the transaction was tionships between the advisor or its the burden of showing the entire fair- “entirely fair,” in part because the affiliates and the controlling share- ness of the transaction, despite the use committee member with the closest holder need not necessarily disqualify of a special committee. ties to the controlling shareholder the advisor, but such relationships There are many benefits to be chose the advisers, and the target should be carefully scrutinized by the gained to negotiating a transaction with company’s general counsel, who was special committee and, if the transac- a special committee of independent also general counsel to the controlling tion is subject to shareholder approval, directors: It can serve to shift the burden shareholder, suggested the committee’s will need to be disclosed. of proof on the question of “entire fair- legal advisors. In another case, the Recordkeeping ness” under Delaware law. It can help Delaware court characterized as “not convince shareholders to vote in favor To establish that the special committee helpful” the fact that the special of the transaction or to tender their has done its work carefully, a careful committee’s investment banker was shares. It can be used to deflect public record of the meetings of the Com- recommended by the controlling criticism that the transaction is coer- mittee, including telephonic meetings, stockholder’s counsel. cive or unfair. However, these benefits should be kept, with appropriate Similarly, the advisors to the special can be obtained only if the special minutes reflecting the members’ committee should be independent committee is established and func- knowledge of Target’s business and of the company and the controlling tions appropriately, including by giving their careful consideration of the shareholder. In selecting its advisors, proper attention to the matters issues. The courts will consider the special committee should inquire outlined above. whether the members of the special into whether a prospective adviser — Gregory V. Gooding committee were diligent in reviewing has done business for, or is otherwise [email protected] and negotiating the transaction and beholden to, the controlling share- may give little weight to the determin- holder. Often the financial adviser will ation of the special committee if it

UPDATE: Removal of the UK 20-Partner Limit

As a follow-up to the Alert in our Winter effective December 21, 2002. This no more than 20 partners. This should 2002 issue, the UK government, acting amendment, which came sooner considerably reduce the administrative through the Department of Trade and than anticipated, removes the need complexity and cost of establishing and Industry, abolished the 20-partner limit to establish and operate a series of operating English partnerships for on general and limited partnerships parallel partnerships, each containing investment purposes.

The Debevoise & Plimpton Private Equity Report l Winter 2003 l page 17 A Comparison of U.S. and UK Private Equity Funds (continued)

contributed to the partnership to satisfy the partnership’s advances, are made to the fund on an interest-free basis and liabilities and obligations. For example, capital contributions all distributions of investment proceeds made by the fund to returned to an investor in the fourth year of a fund’s 10-year its investors are treated as a repayment of the principal term are subject to recall for six more years, or longer if the amounts of the loans advanced or as a distribution of profits fund’s term is extended for one or two additional years, as realized from gains on the sale of portfolio investments. partnership agreements commonly allow. (Note that it is the If an investor making a loan commitment to an English amount of the limited partner’s returned capital contribu- private equity fund is a U.S. taxpayer, the investor must tion, plus any capital commitments still uncontributed, that treat the loans to the fund as equity for U.S. tax purposes. the limited partner is liable for prior to the dissolution of the Sponsors of such UK private equity funds are advised to partnership, not the amount of any gains or profits received include a covenant in the partnership agreement requiring in connection with the returned capital.) U.S. investors to report the loans as equity for U.S. tax As a commercial matter, U.S. and European private purposes. equity funds have traditionally negotiated limits on the Carried Interest Distributions: Where and When amount of distributions to investors that may be redrawn Another difference between UK and U.S. funds is where the by the fund to satisfy the fund’s liabilities (the so-called “LP carried interest is distributed. The standard practice in the clawback”). LP clawbacks are relatively common in U.S. U.S. is for the general partner to receive the carried interest private equity funds, subject at times to limitations on the (see Figure 1). In an English limited partnership structure duration of the provision and/or the amount or percentage the carried interest vehicle is a limited partner, often called of distributions that may be recalled or clawed back. LP the “founder partner” (see Figure 2). clawbacks are relatively uncommon in UK and other When the English partnership is first established, and European private equity funds. then at each closing with the fund’s investors, the founder If investor commitments to English limited partnership partner contributes to the partnership 20% of the capital funds were structured as they are in the U.S. (i.e., as capital commitments of the fund (i.e., 20% of the 0.001% equity), commitments), English limited partnership law would frus- but not 20% of the loan commitments. In exchange for trate the commercial agreement negotiated between the contributing 20% of the “equity,” the founder partner receives sponsor and the investors – namely that distributions to 20% of the profits (the carried interest). For example, if the limited partners are not subject to recall or being clawed back fund’s total commitments are £500 million (£499,995,000 except as specifically provided in the partnership agreement. loan commitments and £5,000 capital commitments), the European private equity funds organized as English founder partner contributes £1,000 (20% of £5,000). If limited partnerships solve this problem by splitting an the fund’s cumulative profits equal £400 million, then the investor’s fund commitment into two components: a large founder partner receives carried interest equal to £80 million loan commitment coupled with a small capital commit- on an investment of £1,000. ment. Loan commitments make up more than 99% (often Note that the timing of the distribution of the carried 99.999%) of an investor’s total commitment to a private interest tends to be different in UK and U.S. funds. In the equity fund. The remaining 0.001% of the investor’s UK and elsewhere in Europe, private equity funds usually commitment is in the form of a capital commitment make distributions by returning all contributions made by contributed at or soon after closing. In accordance with the investors (plus the hurdle/preferred return) before making terms of the partnership agreement, this nominal capital any carried interest distributions. In the specific context contribution is not returned to the investor until the fund’s of an English limited partnership, amounts returned first final, liquidating distribution and dissolution. Therefore, at include the return of all loan advances, but not the small no time during the life of the fund is the investor liable for capital contribution that is returned at dissolution. returning even this nominal capital contribution because it In the U.S., LBO funds and, to a lesser extent, venture has not yet been distributed by the partnership. capital funds, often make distributions to investors on a net Loan commitments are drawn down from time to time in “deal-by-deal” basis. Net deal-by-deal distribution arrange- accordance with the terms of the fund’s partnership agree- ments allow for the possibility of distributing carried interest ment in the same way that capital commitments are drawn earlier in a fund’s term because distributions of carried in a U.S. fund. These contributions, in the form of loan

The Debevoise & Plimpton Private Equity Report l Winter 2003 l page 18 interest with respect to gain on the disposition of a particular manager (see Figure 1), the UK manager charges the general portfolio investment may be made at the time that such port- partner a fee for providing managerial, advisory and adminis- folio investment is realized, provided that realization trative services. The general partner’s payments to the proceeds are sufficient to return to investors the cost basis of manager are not generally subject to VAT because the general such investment, plus related expenses and the hurdle thereon, partner and the manager are part of the same VAT group. plus any prior shortfall not already returned to investors. Parallel Partnerships and Elimination of the 20-Partner Limit The timing of carried interest distributions is the prin- One of the cumbersome aspects of UK funds and the English cipal economic difference between UK and U.S. private limited partnership structure has been the long-standing equity funds; however, this difference between the two prohibition (dating back to 1856) against having more than markets is purely commercial and is not related to any 20 partners in an investment partnership. Although the limi- inherent legal differences between Delaware and English tation was recently removed (see the “Update” elsewhere limited partnerships. in this Report), many UK funds and their sponsors have not General Partner Profit Share (Management Fee) yet taken advantage of the removed ceiling and continue to The form of the management fee also distinguishes UK operate their funds as a series of parallel partnerships, each private funds from their U.S. cousins. In a U.S. fund, the with no more than 20 partners. U.S. fund sponsors also fund pays the management fee to the manager pursuant structure their funds using parallel vehicles on occasion, but to a management contract. In a UK private equity fund, the only when necessary to address tax, regulatory or other issues equivalent of the annual management fee is structured as related to specific investors or portfolio investments. an annual guaranteed profit share (in addition to the carried UK fund sponsors traditionally used the parallel partner- interest) drawn periodically by the general partner. Even in ship structure not only to comply with the 20-partner rule, the early years of the fund’s term, when there may not be but also to channel certain categories of investors into the any profits, the general partner’s profit share is distributed same partnership vehicle and then customize the relevant and recorded as a charge against the fund’s future profits. partnership agreement to accommodate the unique require- The reason is tax-related: structuring the distribution to the ments of the particular investor group. For example, UK general partner as a guaranteed share of the fund’s profits funds organized as a series of parallel English partnerships reduces the risk that UK value-added-tax (VAT) of 17.5% is often establish a single partnership dedicated to U.S. imposed on this annual amount distributed by the fund. investors with a partnership agreement that includes special- Because private equity funds do not engage in any business ized terms (e.g., VCOC covenants and ERISA withdrawal other than investing, they do not provide services to anyone rights for U.S. pension plans; transfer clauses tailored to U.S. and therefore cannot charge VAT to offset any VAT that they tax rules on publicly traded partnerships; limitations on UBTI must pay out. Given the amount of the general partner’s profit for U.S. tax-exempt investors). share over the life of a fund – somewhere between 10% Documenting and administering multiple parallel partner- and 20% of commitments – it is important to minimize the ships adds unwelcome complexity to managing a fund: (1) amount of unrecoverable VAT. The absence of a VAT regime in a co-investment agreement among the various parallel part- the U.S. makes it unnecessary for U.S. private equity funds nerships to ensure pro rata participation in investments is managed from within the U.S. to adopt a similar structure with needed, (2) “true ups” within each partnership and between respect to amounts paid by the fund as management fees. partnerships to take into account expenses and portfolio Although the general partner of a UK private fund receives investment dilution related to subsequent closings with fund the annual profit share, it does not generally retain such investors can be complicated and (3) going forward, the profits. The cash from the profit share is used for the same fund is burdened with a more difficult drawdown and port- purposes as the management fee received by the manager folio acquisition process. of a U.S. fund – to pay the overhead and other expenses of Elimination of the 20-partner limit for English part- the fund sponsor or manager, including rent and salaries of nerships should allow UK private equity funds and their the firm’s investment professionals. Those salary and other sponsors to move closer to the administratively simpler overhead costs and expenses are incurred largely by the UK U.S. fund model that uses parallel vehicles less frequently manager, which is appointed by the general partner as the and relies more on a single, integrated partnership agree- fund’s manager. Pursuant to a services agreement between ment for both U.S. and non-U.S. investors. the general partner and the manager (see Figure 2), which is — Geoffrey Kittredge similar to the services agreement between a U.S. fund and its [email protected]

The Debevoise & Plimpton Private Equity Report l Winter 2003 l page 19 Minority Equity Investments in German Companies (continued)

holders’ agreement to periodically vote However, an ordinary reduction which dividend withholding tax applies. upon a new resolution approving repur- of share capital of an AG or GmbH In the absence of a tax treaty, the with- chasing. The shares acquired and any from nominal capital (as opposed to holding rate would be a little above 21%. other shares already acquired and still profits and free capital reserves) is Tax gross-up clauses in investment held by an AG also may not exceed 10% quite cumbersome and generally takes agreements may provide relief, but are of AG’s company’s share capital. (There more than six months. obviously not tax efficient. It is prefer- is no such limitation if an AG acquires Shareholder Agreements able to avoid the issue altogether its own shares on the basis of a share- through careful drafting of shareholder As noted above, in many cases minority holders’ resolution in connection with a and investment agreements. rights which would normally be subsequent redemption of such shares embedded in the organizational docu- Management Rights Agreements through a reduction of share capital, ments of a U.S. portfolio company An AG has a two-tier management but a reduction of share capital can be a must, in the case of German compa- structure, with a management board burdensome, time-consuming process nies, be set forth in a shareholder or that is responsible for the operations and is not always practicable.) investment agreement. However, and a supervisory board that oversees In the case of a GmbH, a repurchase care must be taken to structure these the activities of the management board. at above market value pursuant to a put agreements to avoid having them The supervisory board elects the option may possibly be deemed to be characterized as partnership agreements. members of the management board. an illegal dividend that must be repaid In such a case, each shareholder would A GmbH is only required to have a by the shareholder. have the right to terminate the partner- supervisory board if it has more than In the case of both a GmbH and an ship without notice unless the agreement 500 employees or if provided for in AG, a share repurchase or a reduction in is entered into for a fixed period of time. the articles of association. capital out of accrued profits and free It is therefore preferable to avoid a Private equity funds that receive a capital reserves may only be made to the mutual undertaking by all shareholders significant portion of their capital from extent that there is shareholders’ equity to cooperate to achieve a specified U.S. pension plans typically seek to which exceeds stated capital (the aggre- exit or other goal, which might suggest operate as a venture capital operating gate nominal or par value of outstanding that a partnership exists. company (VCOC) in order to qualify for shares) and legal reserves–in other words A different tax concern in this exemption from certain requirements only to the extent there are accrued profits context has arisen in connection with of the U.S. Employee Retirement and premiums on share issuance on the the recent German tax reforms: the Income Security Act of 1974 (ERISA). company’s books. In the case of a start- non-deductibility of interest under the One of the requirements for funds to up or a loss-making company, there very amended anti-thin-capitalization rules qualify as VCOCs is that at least 50% often will be insufficient shareholders’ pursuant to Section 8a Para. 3 sentence (by cost) of their investments include equity to satisfy this requirement, so that 3 KStG (Corporate Tax Act). Those the right to participate substantially in a “put option” has little real practical rules apply to shareholder-lender loans the management activities of the port- value as a means of ensuring exit. provided that the shareholder holds folio company, which is often most A redemption of shares of either a directly or indirectly more than 25% easily satisfied by the fund obtaining GmbH or AG by way of reduction of of capital. Separate minority investors the contractual right to appoint a share capital also requires a resolution bound by mutual shareholder obligations member of the company’s Board of of the shareholders’ meeting. The under a shareholder or investment Directors. In the case of German shareholders can commit themselves agreement may possibly be viewed as companies, the appropriate board in a shareholders’ agreement to pass a single, greater then 25% investor, would be the Supervisory Board a resolution on the cancellation of an for this purpose. rather than the Management Board. investor’s shares upon request by the In addition, dividend withholding Management Board members are investor or upon occurrence of certain taxes may be created because German responsible for day-to-day operations objective events, such as specific law treats disallowed interest under the and face significant risks of personal revenue targets being met. new rules as “constructive dividends” to liability for a number of corporate

The Debevoise & Plimpton Private Equity Report l Winter 2003 l page 20 actions, such as delay in declaring an entire class of shares (common or is unlikely. Most existing Neuer Markt bankruptcy upon an insolvency or preferred, for example) are simply listed companies will be listed in the Prime over-indebtedness or making interest, by application to the relevant exchange Standard Segment and private equity/ royalty or other payments to share- accompanied by an approved prospec- venture capital sponsors seeking holders that are later found to be tus. Minority investors therefore do maximum returns are also likely to disguised dividends. not require registration rights unless an apply for the Prime Standard segment. Under the German worker co- offering on the U.S. is contemplated. Whereas the current regulations relating determination law and the works Most observers expect the German to the specific market segments of the constitution laws, respectively, half capital markets to return to life some- Frankfurt Stock Exchange are contained of the members of supervisory board time in 2004. However, one permanent in the civil law statutes of the FSE, must be workers’ representatives casualty of the current downturn has future regulations will be promulgated if a company has more than 2,000 been the once glamorous Neuer Markt, by the federal government which is employees, and a third if the company which had served as the platform for expected to reassure investors and has less than 2,000 but more than 500 the initial public offerings of numerous ensure a better and more effective employees. In such cases, controlling telecommunication, media and tech- enforcement of such rules by public law. shareholders are usually unwilling to nology companies, among others in 1999 As in the U.S., in the wake of the give a board seat to minority investors. and 2000. On November 19, 2002, the recent accounting scandals, the German However, contractual rights to partici- Exchange Council of the Frankfurt Stock government plans to significantly revise pate as observers in Board meetings, to Exchange (FSE) approved the merger German securities laws, in particular to obtain information on the company’s of the Neuer Markt into the FWB and a fight balance-sheet fraud. More detailed business and to meet and consult with new segmentation of the FWB equity plans are expected to be presented in management should usually be suffi- market of the FSE. As of January 1, 2003, a joint press conference of the Federal cient to qualify for VCOC status. the FSE is divided into established two Departments of Finance, Justice, IPOs new market segments, the Prime Stan- Economics and Labor in the first quarter dard and the General Standard. The of 2003. Thus, investors should expect Only securities (shares or bonds) Neuer Markt and Small cap (SMAX) some tightening of the regulatory issued by an AG may be listed on a segments will be discontinued by the framework and greater scrutiny of German stock exchange. Thus, if an end of 2003. transactions by regulators. is planned, an The Prime Standard includes Although Germany may provide investment vehicle organized as a companies that wish to target interna- some attractive opportunities for private GmbH or a GmbH & Co. KG must be tional investors. Companies listed in equity investors to make minority converted into an AG prior to the the Prime Standard must meet high investments in German companies, offering. In the case of a GmbH, this international transparency criteria, over those investors accustomed to requires a 75% majority vote of the and above those set out by the General investing in the U.S. should carefully shareholders present at the share- Standard, such as quarterly reporting, structure investments that will provide holders’ meeting. It is not possible to application of international accounting them with the legal protections and evade the 75% voting majority require- standards or U.S. GAAP, analyst confer- economic rights that they expect. In ment by delegating the decision to ences and English language for current general, through contractual agree- convert into an AG to the directors or reporting and ad hoc disclosures. The ments, many of the features of the U.S.- by providing for a contingent automatic General Standard segment is aimed style securities and investments can future transformation. However, share- at smaller and mid-sized companies be replicated, but there may well be holder agreements to vote in favor of a that predominantly attract domestic additional delays and risks that need transformation proposed by one of the investors and are interested in an inex- to be accommodated. shareholders are enforceable (although, pensive way of being and staying listed. — David F. Hickok as previously noted, judicial enforce- In general, this change in market [email protected] ment can involve substantial delay). structure will have little impact on the — Dr. Thomas Schuerrle In Germany (and Europe generally), ability of private equity funds to exit by [email protected] there is no “registration” of shares initial public offering, although a return with the securities authorities. Instead, to the heady heyday of the Neuer Markt

The Debevoise & Plimpton Private Equity Report l Winter 2003 l page 21 You’re Not in Delaware: Directors’ Liabilities in Major European Countries (continued)

committed in the exercise of their duty Unlike German stock corporations, or omissions in the management of the to supervise the management board German limited liability companies are corporation itself). Members of the (but not for acts or omissions in the not required to have a two-tier board management board also face civil and management of the company itself). In structure unless they have more than criminal liability for their acts or omis- certain limited circumstances, supervi- 500 employees. The shareholders of sions, including violations of certain sory board members may face criminal limited liability companies, however, provisions of corporate law, such as liability. Criminal liability may be found may choose to have a “voluntary” unlawful dividend distributions, financial in the case of acting in complicity with supervisory board and may elect to assistance and the failure to make a the management board (for example, limit the liability of the “voluntary” timely filing for insolvency. not disclosing irregularities in the finan- supervisory board to damages resulting One of the largest German cases cial statements of which the supervisory from intentional acts or gross negli- concerning director liability in Germany board had become aware). gence. Unless the shareholders have in the 1990s was the bankruptcy of limited the duties and liabilities of a Balsam Aktiengesellschaft. In the Balsam How can a Director be Protected limited liability company’s “voluntary” case, not only were the members of from Liability? supervisory board, the provisions of the management board of Balsam sen- French companies may take out German law applicable to stock corp- tenced to jail for two to ten years, but a insurance to protect their directors (or orations apply to them as well. member of the supervisory board was supervisory or management board German limited liability companies held civilly liable for failing adequately members) against civil liability only. The may also have an advisory board to supervise the actions of the manage- insurance may not cover liabilities relating (Beirat). (Advisory boards are not as ment board. Although the supervisory to personal benefits received by a director common for stock corporations board member in question had heard to which he was not entitled, his inten- because advisory boards would be in rumors about a fraudulent transaction tional or willful wrongful acts or addition to the required supervisory involving the company and the wors- omissions, or claims of which he was boards.) The role and function of the ening financial situation of Balsam, he aware prior to the issuance of the insur- advisory board is not governed by did not investigate these stories. The ance policy. Liability insurance for statute and is determined by the share- German courts held the supervisory directors and members of supervisory holders. In our experience, private board member liable for the damages boards is increasingly common in France, equity firms tend to appoint their repre- of approximately DM 5 million (approx- and we would recommend its purchase sentatives either as members of the imately $2.2 million). for private equity firm principals (and supervisory boards (or advisory boards) As shown in the Balsam case, a others) serving on any boards in France. of their German portfolio companies. member of the supervisory board is Germany We generally recommend this alterna- liable for negligently or intentionally How are German Companies Governed? tive because the supervisory board’s failing to exercise: (1) the duty of care German stock corporations (AGs) have role (and usually the advisory board’s (in supervising the management board a two-tier board structure that consists role) is limited to overseeing the man- and acting in the best interests of the of a supervisory board and a manage- agement board, and thus there is less corporation) and (2) the duty of loyalty ment board. The supervisory board potential civil and criminal liability (putting the corporation’s interests oversees the activities of the manage- for private equity firm principals (and first). The members of a supervisory ment board. The management board others) serving as members of supervi- board are also criminally liable in a is responsible for the ordinary course sory (or advisory) boards in Germany. limited number of circumstances (for example, aiding and abetting fraud), business of the corporation and repre- What are the Sources of but generally not for the acts or omis- sents the corporation in its dealings Directors’ Liabilities? sions of the members of the manage- with third parties. Members of a supervisory board are only ment board. Most German private companies, liable for acts or omissions committed The extent of potential liability of the including German portfolio companies in the exercise of their duty to supervise members of the advisory board may of private equity funds, are organized the management board (but not for acts as limited liability companies (GmbHs). differ depending on the structure of

The Debevoise & Plimpton Private Equity Report l Winter 2003 l page 22 Comparative Points Under Delaware, English, French and German Law

Delaware English private French German corporations limited companies corporations (SAs) corporations (AGs)

What is the corporate governing body? Board of directors Board of directors Either board of Supervisory board and directors or super- management board visory board and management board

What are the sources of liability? Breaches of the duty Breaches of statutory Failure to supervise Breaches of the duty of care or the duty of duties, the duty of skill the management of care and the duty of loyalty and failing to and care and fiduciary board (for supervisory loyalty (for supervisory follow applicable legal duties board members) board members) requirements

May criminal liability be incurred? Yes Yes Yes, but in limited Yes, but in limited circumstances for circumstances for supervisory board supervisory board members members

Do companies take out directors’ insurance? Yes Yes Yes Yes

the advisory board and its duties, both Subject to certain limitations, a substantially different from Delaware of which are determined essentially by German corporation may agree (1) to law and there is no pan-European the shareholders. If the advisory board indemnify the members of the supervisory approach. Company law in Europe is in of a German company assumes the board or (2) to waive or compromise a varying stages of reform or modification. functions of a supervisory board, the claim of damages against the members of Despite the fact that the Sarbanes- potential liability of a member of the the supervisory board (though in respect Oxley wave of corporate governance advisory board will be similar to that of of a statutorily required supervisory board reforms may not apply to those serving a member of the supervisory board. this may be done only after the passage on the boards of European portfolio of three years). German companies may companies (although they may if high- How can a Director be Protected take out insurance to protect their man- yield bonds or other securities are from Liability? agement board and supervisory board publicly offered in the U.S.), private In Germany, lawsuits against supervi- members against civil liability and, in equity firm principals serving as direc- sory board members for breach of their certain circumstances, even against tors or members of supervisory boards duties are extremely rare outside of criminal liability. Liability insurance for need to make certain that they are insolvency because of the difficulty in directors and members of supervisory aware of the applicable rules of, and proving breaches of such duties. boards is increasingly common in are following best practices in, the Procedural and practical limitations Germany and we would recommend country in question. Moreover, as the include the following: (1) shareholders its purchase for private equity firm rules and practices are evolving, private may assert claims against the supervi- principals (and others) serving on any equity firm principals should make sory board only if their losses differ boards in Germany. (There is some certain that a system is in place so that from those suffered by the corporation question as to whether payment of the they are notified by the portfolio and (2) the difficulty in proving the premiums by the company constitutes company and its counsel of important supervisory board’s malfeasance leads taxable income in Germany to the changes in the rules and practices. to a reluctance in bringing a case director or other board member.) — James A. Kiernan against it because the losing parties [email protected] bear the entire cost of the litigation. A Final Word of Warning (with assistance from Dale Gabbert, The law and practices in Europe as Elisabeth Huber-Sorge and Julie Perchenet) to directors’ duties and liabilities are

The Debevoise & Plimpton Private Equity Report l Winter 2003 l page 23 alert Goodbye to Lock-Ups?

A recent Delaware Supreme Court reluctant to take on the completion Section 251(c) provision, coupled with order may have a big impact on private risk caused by the delay. the support agreements, ensured that equity firms that own large stakes in To facilitate deals, M&A practi- the first deal would be approved. public companies. tioners have sought to reduce the The Chancery Court had held that, Private equity funds increasingly risk through a variety of deal protec- under the circumstances, the NCS find themselves with public company tion devices, including termination board did not breach its fiduciary stakes – as a result of making signifi- fees, no-shop clauses and lock-up duties by agreeing to the locked up cant minority investments in PIPE agreements with major shareholders. deal. The court’s conclusion appears transactions, receiving public stock The ability to grant a lock-up has to have been strongly influenced by the as acquisition currency when selling given private equity funds – parti- fact that NCS had been shopped exten- portfolio companies, or using IPOs cularly those owning a majority or sively to over 50 potential acquirers. as a partial exit strategy. Private equity near-majority of the target’s stock – Moreover, Omnicare, the competing firms that don’t usually like to be a significant amount of control, bidder, had offered less than Genesis, passive investors are sometimes will- and leverage, over the sale process. and had insisted on a due diligence ing to accept these kinds of stakes That may now change. condition in its previous proposal. if they can have a significant degree In November 2002, the Delaware On appeal, a divided Delaware of control over their exit strategy. Chancery Court rejected a challenge to Supreme Court said in its preliminary The Delaware case, which casts a fully locked-up merger transaction. order that, even if NCS’s board had doubt on whether there are any circum- (In re NCS Healthcare, Inc. Shareholders sought a transaction that would yield stances in which directors of a public Litigation) On appeal, the Delaware the highest value reasonably available, company can agree to a fully locked Supreme Court reversed. While the “the deal protection measures must up deal, appears likely to erode that Supreme Court has not yet released its be reasonable in relation to the threat control. It’s an important decision full opinion, the ruling seems likely to and neither preclusive nor coercive.” for private equity sponsors, because make it much tougher – and perhaps The Supreme Court held that the inability to control the sale process impossible – for the board of directors NCS/Genesis arrangements violated may have a real impact on how a pri- of a public company to approve a deal this standard by irrevocably locking vate equity firm would value having that is fully locked up, even when there up the merger. According to the court, a large interest in a public company. have been substantial prior efforts to without a fiduciary out, “this mech- When it’s time for the public com- shop the company. anism precluded the directors from pany to be sold, the private equity The merger agreement challenged in exercising their continuing fiduciary fund will see very quickly one of the NCS included a requirement, permitted obligation to negotiate a sale of main differences between private and under Delaware General Corporation the company in the interest of the public company M&A: in a public Law Section 251(c), that the proposed shareholders.” company deal, it really ain’t over ’til it’s stock-for-stock merger between NCS The Supreme Court’s full reasoning over. That’s because, unlike a private and Genesis Health Ventures be put – and the scope lock-ups can play in company, a public company can’t get to a stockholder vote, even if the NCS future transactions – will not be clear all of its shareholders into a room to board no longer recommended until a formal written opinion is issued, vote for the deal at the same time a approval of the transaction. In addi- which had not been done by press sale agreement is signed. So the buyer tion, stockholders with a majority time. We will report on that opinion of a public company won’t know for of the voting power committed to vote in a future issue. sure that the deal will close until the in favor of the deal. When rival bidder — William D. Regner target’s shareholders have voted on a Omnicare offered a higher price, the [email protected] merger or have tendered their shares NCS board withdrew its recommen- — Jonathan Levitsky into a tender offer. Some buyers are dation of the Genesis deal – but the [email protected]

The Debevoise & Plimpton Private Equity Report l Winter 2003 l page 24