Adding to the Club: Co-Investments by Fund Limited Partners

Debevoise & Plimpton Private Equity Report Summer 2007 Volume 7 Number 4 Adding to the Club: WHAT’S INSIDE 3 Look Out Co-Investments by for Double Indemnity: Director Proctections Fund Limited Partners Take a Hit in Delaware The bigger equity checks required for many their decision to invest in a fund. For the Guest Column: private equity M&A deals in recent years has fund sponsor, co-investment eliminates or 5 The Human Side not only increased the number of club deals reduces the dilution of control over but also the number of co-investments, in governance and exit decisions that are part of of the Deal – Evaluating which private equity sponsors turn to their club deals. This article discusses a number of and Motivating the Senior limited partners and others to fill an equity threshold issues a sponsor should consider Management Team to gap. when planning to raise equity for a Maximize Returns This can be a win-win proposition. For transaction from co-investors. limited partners, co-investment offers the The Equity Bridge opportunity to put additional capital to work Applying Revlon to Private In most circumstances, sponsors are not 7 behind a fund sponsor with a proven track Equity Transactions: Lessons obligated in their fund documents to offer record, often on better financial terms than co-investment opportunities pro rata to all of from Recent Delaware those applicable to the primary fund. Some their limited partners, and therefore they may Chancery Court Decisions limited partners view potential co-investment limit the co-investment opportunity to a opportunities favorably in connection with CONTINUED ON PAGE 17 9 Alert: Antitrust Class Action Against Private Equity Firms Dismissed © Cartoonbank.com 11 Section 363 Sales: How to Play the Game 13 What’s Old Is New: The Re-emergence of Stub Equity in Going Private Transactions “We used to be an investment club. Now we’re a support group.” Letter from the Editor The private equity scene never ceases to amaze us. This year Gary Kubek reports on the dismissal of the recent class action alone has witnessed several IPOs of private equity managers, a antitrust suit against several leading private equity firms. record number of deals and record-breaking deal sizes, an In our guest column, David Astorino, a Managing Director of increasingly challenging tax environment, hostility towards RHR International, a firm of management psychologists who private equity from unions, increased antitrust scrutiny, as well as advise private equity sponsors on their human capital assets, financing markets ranging from boom to bust. Never has being outlines how sponsors should evaluate and motivate a target’s nimble and creative, as well as knowledgeable of the legal and senior management team in order to maximize returns. regulatory environment, been so important for private equity Also, My Chi To and Jasmine Powers remind private equity professionals. This issue of the Private Equity Report attempts to investors of the process under Section 363 of the Bankruptcy help you to be both. First, on our cover, we look at the issues Code for purchasing the assets of a distressed business. sponsors need to keep in mind when structuring co-investments As the market for private equity investment continues to from among their limited partners. evolve, the Debevoise private equity team and the Private Equity Elsewhere in this issue, we review several recent legal decisions Report remain dedicated to providing you with the guidance and affecting private equity firms. First, we report on the recent spate analysis you need in this increasingly challenging environment. of Delaware cases interpreting the duties of boards reviewing As always, we welcome your inquiries and suggestions as to how acquisition offers from private equity sponsors. We also explain the we can be of most help to you and how we can make the Private surprisingly increased risk that private equity funds will not be able Equity Report more useful reading. Enjoy the rest of your to recover indemnification costs they advance to corporate summer! directors and how to modify existing indemnification agreements Franci J. Blassberg to solve this problem in light of a recent Delaware case. Finally, Editor-in-Chief Private Equity Partner/ Counsel Practice Group Members The Debevoise & Plimpton Frankfurt Franci J. Blassberg Michael P. Harrell Antoine F. Kirry – Paris Private Equity Report is a 49 69 2097 5000 Editor-in-Chief Geoffrey Kittredge – London Marc A. Kushner publication of Marcia L. MacHarg – Frankfurt Jonathan E. Levitsky Moscow Stephen R. Hertz Andrew M. Ostrognai – Hong Kong Li Li – Shanghai Debevoise & Plimpton LLP 7 495 956 3858 Andrew L. Sommer David J. Schwartz Christopher Mullen – London Associate Editors 919 Third Avenue Hong Kong Rebecca F. Silberstein Dmitri V. Nikiforov – Moscow New York, New York 10022 852 2160 9800 Ann Heilman Murphy Robert F. Quaintance, Jr. Hedge Funds 1 212 909 6000 Managing Editor William D. Regner Shanghai Byungkwon Lim Jeffrey J. Rosen www.debevoise.com 86 21 5047 1800 The Private Equity Mergers & Acquisitions Kevin M. Schmidt Practice Group Washington, D.C. Please address inquiries Andrew L. Bab Thomas Schürrle – Frankfurt 1 202 383 8000 regarding topics covered in this All lawyers based in New Timothy Bass Wendy A. Semel – London publication to the authors or York, except where noted. E. Raman Bet-Mansour – Paris Andrew L. Sommer London the members of the Practice Paul S. Bird James C. Swank – Paris 44 20 7786 9000 Private Equity Funds Group. Franci J. Blassberg John M. Vasily Marwan Al-Turki – London Paris Richard D. Bohm All contents ©2007 Debevoise Ann G. Baker – Paris Leveraged Finance 33 1 40 73 12 12 Thomas M. Britt III – Hong Kong & Plimpton LLP. All rights Kenneth J. Berman – Washington, D.C. Katherine Ashton – London Geoffrey P. Burgess – London reserved. Jennifer J. Burleigh William B. Beekman Marc Castagnède – Paris Woodrow W. Campbell, Jr. David A. Brittenham Margaret A. Davenport Sherri G. Caplan Paul D. Brusiloff Gregory V. Gooding Jane Engelhardt Pierre Clermontel – Paris Stephen R. Hertz Alan J. Davies – London David F. Hickok – Frankfurt Peter Hockless – London page 2 l Debevoise & Plimpton Private Equity Report l Summer 2007 James A. Kiernan, III – London Look Out for Double Indemnity: Director Protections Take a Hit in Delaware In a decision that has implications for all case when preparing fund and portfolio Fund, and not the Directors, paid the directors, but is of particular interest to company agreements and should consider $4.8 million settlement. private equity firms, the Delaware Court of carefully the consequences of funding Delaware law does not permit HLI to Chancery recently decided that a director’s indemnification obligations that are shared bear the expenses of the Directors’ expenses incurred in an unsuccessful effort with a portfolio company. unsuccessful suit. to enforce a corporation’s indemnification Background obligations must be paid by the director, The Directors are obligated to reimburse A private equity fund (the “Fund”) owned notwithstanding the corporation’s prior HLI for the expenses that it had approximately 34% of HLI Operating unconditional agreement to bear such advanced. Company, Inc. (“HLI”). Four principals of expenses. Levy et al. v. HLI Operating the Fund’s sponsor served as HLI directors Although the Directors are not entitled Company, Inc., 2007 WL 1500032 (the “Directors”). to maintain their indemnification claim (Del.Ch., May 16, 2007). The holding The Directors were beneficiaries of for the benefit of the Fund, the Fund increases the risk that any director of a relatively standard indemnification by HLI can bring a contribution claim against Delaware corporation could have to bear and by the Fund. The HLI indemnification HLI, seeking reimbursement for HLI’s the cost of a suit for indemnification agreements provided that HLI would equitable share of the $4.8 million personally. advance expenses of any suit brought by the payment. (The Fund will have to bear Another aspect of the case is particularly Directors to enforce their rights to the expenses of prosecuting that claim.) noteworthy for private equity firms. The indemnification and that the Directors plaintiff directors were associated with a The Vice Chancellor’s decision may have would not be obligated to reimburse HLI private equity fund that had a significant been colored by the apparent failure of the regardless of the outcome of the suit. stake in the corporation. The private equity plaintiff directors to disclose that the loss HLI restated its financials, and securities fund paid the loss that the directors might for which they were seeking indemnification fraud litigation followed. As part of the otherwise have been entitled to recover had already been satisfied by the Fund, but settlement of the securities litigation, the from the corporation, and it is unlikely that the breadth of the holding nevertheless Directors agreed to pay $4.8 million. The the fund will be able to recover from the raises a number of concerns. Directors sought indemnification from corporation the whole amount paid. HLI. When HLI refused to indemnify, the What to Do Private equity firms should reflect on this Directors sued HLI. Private equity firms should consider how to For 16 months, HLI advanced design relevant fund and portfolio company to the Directors the costs of the agreements to enhance the fund’s chances of Alan V. Kartashkin – Moscow Trust & Estate Planning Directors’ litigation against HLI, recovering fully from a portfolio company A. David Reynolds Jonathan J. Rikoon as was required by the HLI for payments by the fund of losses that both Philipp von Holst – Frankfurt Cristine M. Sapers Gregory H. Woods III indemnification agreements. HLI the fund and the portfolio company have The articles appearing in this Tax publication provide summary then learned, in discovery, that the indemnified.

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