Private Equity Strategies for Exiting a Leveraged Buyout Rashida K

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Private Equity Strategies for Exiting a Leveraged Buyout Rashida K. La Lande, Gibson, Dunn & Crutcher LLP This Practice Note is published by Practical Law Company on its PLCCorporate & Securities web service at http://us.practicallaw.com/2-501-0347.

This Note explains the main exit equity sponsor can plan for a fund’s exit from the time of the investment. strategies for private equity sponsors The most common exit routes include: making control investments in portfolio Initial public offerings (IPOs) (see Initial Public Offering). companies through leveraged buyouts, Selling shares after the IPO through either: Rule 144 sales under the Securities Act of 1933, as including initial public offerings, Rule amended (Securities Act) (see Sales after the IPO under 144 resales, secondary registered Rule 144); or registered secondary offerings (see Secondary Registered offerings, sales to a third party, Offerings). leveraged and non-leveraged dividend Sales to a third party, typically through the exercise of drag- along rights (see Sale to a Third Party). recapitalizations, redemptions rights Dividend recapitalizations (see Dividends and and tag-along rights, and discusses the Recapitalizations). main advantages and disadvantages of Redemptions (see Redemption Rights). Tag-along rights (see Tag-along Rights). each strategy. For more information on LBOs generally, see Practice Note, Buyouts: Overview (http://us.practicallaw.com/4-381-1368). When a private equity fund makes a control investment in a portfolio company through a leveraged buyout (LBO), the majority of the purchase price for the portfolio company’s equity is usually financed PREPARING FOR EXIT through debt. The remaining portion of the purchase price comes Private equity funds typically have fixed life spans of about ten from the fund’s own capital, given by the investors, and represents years. At the end of its life span, the fund is closed and the the fund’s at-risk investment in the portfolio company. Private remaining principal plus any profits made during the fund’s life equity funds typically enter these transactions with the view toward are paid out to its investors and the fund sponsor. To maximize the increasing the portfolio company’s value and realizing a positive return to itself and its investors, a sponsor plans for two five-year return when the fund exits its investment. Exits usually occur investment periods during the fund’s ten-year life. In each five- somewhere between three to seven years after the initial investment. year investment period, the fund invests in a portfolio company’s This Note focuses on the most common exit strategies, including equity (such as in an LBO) and then at the end of the period, the advantages and disadvantages of each, and how a private exits its investment and recovers its capital (and a return on its

investment, if any). Often that recovery coincides with the period in management team to operate the business. That management team which a sponsor is trying to raise capital for new funds. Therefore, will also need to oversee the sponsor’s exit and effectively market the sponsor has every incentive to control the timing and nature the portfolio company to potential buyers or investors. Therefore, it is of its exit and to begin planning for the exit as early as the initial important for management to support the transaction. investment stage. Early exit planning can help the fund protect its During the initial investment, sponsors typically enact equity investment and maximize its return. Sponsors must also remain incentive plans to provide incentives and compensate a portfolio vigilant throughout the life of an investment to ensure that they can company’s new or existing management, or both. Any equity make a successful exit. awarded is usually subject to a prohibition on the transfer for either a period of time following the buyout or until an IPO by INVESTMENT STAGE EXIT PLANNING the company. In addition, there are other transfer restrictions The sponsor should plan for the fund’s exit during the initial (such as rights of first offer or rights of first refusal and forfeiture investment stage as the sponsor negotiates its buyout of the and call rights if the executive leaves the portfolio company). portfolio company. That way, the fund can ensure to exit its Typically, these plans are designed in a way that closely aligns the investment at the time and in the manner the sponsor deems best. value of management’s awards to the success and value of the portfolio company and the return that the sponsor receives on its Control and Liquidity investment (for instance, through subjecting equity awards to time or performance vesting, or both). The sponsor must ensure that it has sufficient control and liquidity from the beginning of the investment. This may involve amending In addition, if structured properly, these plans create incentives for the portfolio company’s existing charter documents, stockholders management to stay with the portfolio company after the sponsor agreements and registration rights agreements. More typically, liquidates its investment in the company. Having the existing however, this may involve entering into new agreements to ensure management remain with the portfolio company after the fund’s the fund’s investment is protected. Common rights that sponsors exit can be critical to maximizing the amount the fund realizes negotiate at this stage include: when it exits. In an IPO or sale to another financial buyer, the Board control or veto rights. Sponsors making a control ability to retain current management to run the portfolio company investment typically do not manage the portfolio company’s daily will be factored into the price that buyers or investors are willing to operations. However, having designees on the board or veto rights pay for the company. over extraordinary actions help protect the sponsor’s investment. For example, the sponsor can set up an equity incentive program Registration rights. Sponsors should ensure they have the with awards that have either a: power to trigger or participate in registered public offerings Single trigger. The awards only vest if the employee stays of the portfolio company’s equity through board control or with the portfolio company for a set period of time after the registration rights (see Practice Note, What are Registration transaction. Rights Agreements? (http://us.practicallaw.com/3-386-4395)). Double trigger. The awards only vest following both the change Redemption rights. In some cases, sponsors may negotiate the of control and the termination of the employee within a period right to cash out their investment under certain circumstances of time after the transaction. by requiring the portfolio company to acquire its equity (see Redemption Rights). However, in the case of a sale to a strategic buyer, which typically has its own management team, rewarding the Drag-along rights. Drag-along rights provide sponsors with greater liquidity by allowing them to force minority investors to participate management team for remaining with the business until the in the sale of the portfolio company (or the parent holding closing may be the optimal solution. In this case, the awards company, as applicable) (see Planning at Investment Stage). would vest on the change of control.

Tag-along rights. In the case of club deals or co-investments For more information on management incentive plans and with other private equity sponsors, tag-along rights provide the transfer restrictions in private equity transactions, see Practice ability to participate pro rata in sales by other co-investors (see Notes, Management Equity Incentives in Buyouts (http:// Tag-along Rights). us.practicallaw.com/2-500-2291) and Management Equity Incentives: Rights and Restrictions (http://us.practicallaw. For more information these provisions, see Practice Notes, com/2-500-6213). For a discussion of practical limitations on Stockholder Protections (http://us.practicallaw.com/6-382-7132) and a sponsor’s ability to structure management equity incentives Key Corporate Governance and Exit Considerations for the Sponsor- for senior management in a going private transaction due to the backed IPO Candidate (http://us.practicallaw.com/1-503-0874). potential heightened disclosure requirements under Rule 13e-3 of the Securities Exchange Act of 1934, as amended (Exchange Management Incentives Act), see Practice Note, Going Private Transactions: Overview: When a sponsor executes a buyout, it does not intend to control Disclosure Obligations in a Going Private Transaction (http:// the portfolio company’s daily operations and needs a qualified us.practicallaw.com/8-502-2842).

Copyright © 2011 Practical Law Publishing Limited and Practical Law Company, Inc. All Rights Reserved. 2 POST-INVESTMENT EXIT PLANNING offerings after the IPO so it can, if it chooses, use these offerings to complete its exit after the IPO (see Secondary Registered Offerings). After the LBO is complete, but before making the decision to exit, there are several steps the sponsor can take to ensure a smooth When a fund exits its investment through an IPO, it does so and more profitable exit. These steps include: through an offering of shares to the public of either:

Addressing known issues. The portfolio company.

Enacting value-building strategies. The parent holding company that wholly owns the portfolio

Maintaining proper governance and administrative practices. company and through which the fund made its investment and owns equity. Addressing Known Issues For a discussion of the typical structure of an LBO, see Practice The sponsor should prepare the portfolio company to make it Note, Buyouts: Overview: Buyout Vehicle (http://us.practicallaw. more attractive to potential buyers or a better candidate for an com/4-381-1368). IPO. Often the best place to start is by correcting any issues that the sponsor uncovered during its due diligence process. ADVANTAGES OF AN IPO EXIT Enacting Value-building Strategies Sponsors consider exiting through an IPO owing to the advantages of this form of exit. Despite any issues that it uncovered, the sponsor completed the LBO because the sponsor believed that it could increase Higher Exit Valuation the portfolio company’s value through better management, streamlining operations or acquiring other companies to create Sponsors often prefer an IPO because IPOs typically result in synergies and economies of scale. Enacting these strategies higher valuations for portfolio companies than other possible efficiently and successfully will be key factors in determining when exits. In addition, although IPOs typically do not result in a a sponsor can exit a portfolio company investment successfully. full exit for the fund, the fund benefits from any post-IPO increases in a portfolio company’s value. An IPO also gives Maintaining Proper Governance and Administrative Practices the sponsor a readily ascertainable valuation so it can better time a future exit, compared to relying solely on theoretical The professionalization of administrative and operational functions private valuation techniques. will not only help the portfolio company run more efficiently but it will also make the portfolio company a more attractive target when Increased Liquidity the sponsor exits the investment. The sponsor should review and ensure there are proper practices of: Unlike other partial exits (for example, partial dividend recapitalizations (see Dividends and Recapitalizations) or Record keeping and document management. partial secondary purchases (see Sale to a Third Party), Internal and external controls. an IPO provides a sponsor increased future liquidity. Once Human resources and payroll. public, a portfolio company’s equity has an established public Finance and accounting functions. float and the company must produce public disclosure on a regular basis, giving the sponsor a market for its securities The fund should also ensure the portfolio company (and any (see Ongoing Disclosure and Reporting Obligations). As a parent holding company) is following appropriate corporate result, the sponsor may find it easier to achieve a full exit governance practices, particularly if it anticipates an IPO. from its investment in a relatively short time and for an easily For more on maintaining proper governance and administrative demonstrated price. practices ahead of an IPO, see Practice Note, Preparing a Company for an Initial Public Offering: Corporate Structure (http:// Management Support us.practicallaw.com/2-380-8512). A supportive management team is crucial for a successful IPO and makes it easier for a sponsor to achieve an exit. Unlike a sale to a third party (particularly to a strategic buyer), the INITIAL PUBLIC OFFERING management team is more likely to support an exit through As discussed (see Control and Liquidity), when completing an an IPO. On the advice of underwriters, members of the LBO, the sponsor should ensure that it has the board control and management team often do not participate in the IPO by selling contractual registration rights to trigger and participate in an IPO, equity themselves. There is a view that significant management and to veto an IPO proposed by the portfolio company. Negotiating participation may affect negatively the equity’s price. these rights at the time of the initial investment gives the sponsor Nonetheless, management often feels a sense of increased the right to control if and when the portfolio company goes public. wealth due to future liquidity for its shares and additional equity In addition, the sponsor should ensure it has the contractual compensation on an IPO. In addition, the management team registration rights to trigger and participate in registered secondary often views as a positive the heightened prestige and publicity

for the portfolio company. For an overview of the importance shares over particular periods of time. Therefore, a full exit in of the role of management in the IPO process, see Timeline connection with an IPO is a lengthy process because post-IPO and Responsibility Chart: Initial Public Offerings (http:// follow-on offerings can take up to an additional two to four us.practicallaw.com/9-380-8542). months for each offering.

For more on lock-up agreements in connection with an IPO, see DISADVANTAGES OF AN IPO EXIT Standard document, Lock-up Agreement (http://us.practicallaw. Sponsors considering exiting through an IPO must also consider com/0-386-6174) and Practice Note, What’s Market: Lock-up the disadvantages of this method of exit. Agreements (http://us.practicallaw.com/5-501-8196).

Lack of Complete Exit Cost and Distraction of Management’s Attention A fund typically does not fully liquidate its investment through the An IPO can be costly and can distract management from their portfolio company’s IPO for several reasons, including: main job of running the portfolio company’s business. The IPO The fund’s investment, with the shares the company sells in process demands significant amounts of senior management’s the IPO, is typically too large to be sold into the market at one and other key employees’ time and attention, including: time at a desirable price. Deciding the size and timing of the IPO.

The underwriters’ concern that an exit of the fund in the IPO Participating in the road show to market the offering to tells investors that the company has limited upside, which is potential investors. the wrong message to send. Overseeing the Securities and Exchange Commission (SEC) The underwriters’ concern about negative investor response registration process. to the IPO if a substantial portion of the proceeds of the offering go to the fund instead of the portfolio company. Public Significant costs of an IPO include underwriters’ compensation, investors often want to see the offering proceeds used to pay the fees of accounting and legal professionals, financial printing down the company’s debt given the high leverage of sponsor- costs and filing and listing fees. backed portfolio companies. For an overview of the importance of the role of management in Instead, the IPO is the first step to a full exit for the fund. the IPO process, see Timeline and Responsibility Chart: Initial Following the company’s IPO, the fund can sell its remaining Public Offerings (http://us.practicallaw.com/9-380-8542). investment:

In unregistered sales that comply with Rule 144 under the Ongoing Disclosure and Reporting Obligations Securities Act (see Sales after the IPO under Rule 144). Both during and after the IPO process, the company will be In one or more registered secondary offerings (see Secondary subject to extensive rules and regulations under the Exchange Registered Offerings). Act, including: The SEC’s periodic reporting and proxy requirements. For more information on the IPO process generally, see Practice Notes, Preparing a Company for an Initial Public Offering (http:// The requirements of Regulation FD. us.practicallaw.com/2-380-8512) and Registration Process: The certification and other requirements of the Sarbanes-Oxley Overview (http://us.practicallaw.com/7-380-8736). Act of 2002.

Timing Preparing the required reports and other documents, and the design, setup and maintenance of the internal controls, procedures The IPO process can be a lengthy process and taking four to six and systems necessary to do so, will be costly and require a months is common (see Timeline and Responsibility Chart: Initial significant amount of the portfolio company personnel’s time. Public Offerings (http://us.practicallaw.com/9-380-8542)). In addition, IPO underwriters typically require in the underwriting In addition, company insiders and major stockholders, including agreement or lock-up agreement that funds not sell any shares in the fund while it continues to meet certain ownership thresholds, the portfolio company for up to 180 days following the IPO (known will become subject to the reporting requirements of Sections 13 as the lock-up period). and 16(a) of the Exchange Act. This will require the fund to file reports with the SEC concerning its ownership of the company’s The fund’s continued ownership of a significant portion of the securities. These filings are normally prepared with the assistance company’s equity following the IPO puts downward pressure of counsel. on the company’s stock price. This is because the market understands that the fund wants to exit and is likely to sell For an overview of the reporting requirements of public those shares into the market (known as market overhang). To companies and their major stockholders, see Practice Note, limit this downward pressure on the company’s stock price, Periodic Reporting and Disclosure Obligations: Overview (http:// the underwriters may insist the fund sell a limited amount of us.practicallaw.com/7-381-0961).

Copyright © 2011 Practical Law Publishing Limited and Practical Law Company, Inc. All Rights Reserved. 4 Insider Short-Swing Profit Recovery and Insider Trading Keeping certain control protections which require the sponsor’s Concerns consent (for example, veto rights on material corporate transactions such as issuing new classes of stock, incurring As stockholders of a public company, the fund and its sponsor significant debt and undergoing a change of control). Although, have potential liability for actions that they may have taken in the in IPOs of sponsor-backed companies, it is common practice ordinary course as stockholders in a private company. to give up these rights and only in some cases can sponsors The fund will be subject to Section 16(b) of the Exchange Act if negotiate narrow veto rights. the fund owns 10% or more of the company’s public stock after For more information on governance planning after the IPO, see the IPO (or in some cases if it owns 10% or less but has the right Practice Note, Key Corporate Governance and Exit Considerations to board representation). Under Section 16(b), the fund can be for the Sponsor-backed IPO Candidate (http://us.practicallaw. required to disgorge to the issuer all profits realized from purchases com/1-503-0874). and sales of any equity securities of the issuer within a six-month or less period of a purchase or a sale (known as short-swing profits). Execution Risk For detailed information on Section 16(b), see Practice Note, Section 16(b) Short-swing Profit Liability: The Perils of Turning a External and internal market factors may prevent the company from Quick Profit (http://us.practicallaw.com/8-503-3911). getting the IPO pricing or level of investor interest that it predicted. In that case, the IPO typically fails and the time and money involved In addition, if the sponsor continues to have access to material is lost. An IPO’s failure can create the perception that: nonpublic information (known as inside information) about the portfolio company after the IPO (for example, through board representation), The company was overvalued. the sponsor can be subject to liability under Rules 10b-5 and 10b5-1 There is a material problem with the company. for insider trading if it trades in the portfolio company’s securities while If the sponsor needs to pursue another exit strategy after a failed it is aware of that information (see Practice Note, Periodic Reporting IPO, the sponsor will have to seek an alternative in a market that and Disclosure Obligations: Overview: Insider Trading Issues (http:// is aware of the failure. us.practicallaw.com/7-381-0961)). Loss of Control SELLING SHARES AFTER THE IPO Even if a sponsor retains a significant interest in the company A sponsor typically cannot liquidate fully the fund’s investment after the IPO, the sponsor may lose control of the company’s in a portfolio company in the company’s IPO. To complete a full board of directors or the stockholder voting process. exit after the IPO, a fund can sell shares in unregistered sales After the IPO, to satisfy SEC requirements relating to audit that comply with Rule 144 of the Securities Act or in one or more committees, the company will need to have at least three registered secondary offerings. independent directors (and new independence rules under the Dodd-Frank Wall Street Reform and Consumer Protection Act SALES AFTER THE IPO UNDER RULE 144 of 2010 (Dodd-Frank Act), which the SEC expects to adopt by When a fund purchases shares of a private company in an LBO, August, 2011, may impose similar requirements on compensation those shares are restricted securities under the Securities Act. committees) (see Practice Note, Summary of the Dodd-Frank Restricted securities can only be resold in transactions registered Act: Corporate Governance (http://us.practicallaw.com/9-502- with the SEC or in transactions exempt from registration. Resales 8358)). If the company is going to be listed on an exchange, the of restricted securities made under Rule 144 of the Securities Act company will also need to comply with the director independence are considered exempt from registration. Sponsors often use Rule requirements of that exchange, unless the company can qualify 144 to resell shares in portfolio companies that have gone public. as a “controlled company.” Compliance with these requirements will make it more difficult for the sponsor to control the company The requirements of Rule 144 differ depending on whether: and continue implementing its strategy for improving the company’s value. For more on these requirements, see Practice The seller is, or in the last three months has been, an “affiliate” Note, Corporate Governance Standards: Board of Directors (http:// of the company. us.practicallaw.com/0-381-5330). The company has been a reporting company under the Exchange Act for at least 90 days, and is current in its reporting obligations. In addition, stockholders agreements typically, but not always, terminate or are terminated on the IPO. This means that any Affiliate is broadly defined in the Securities Act to include any control protections like veto rights also terminate. person that has the power to control or direct management and policies of the company. Generally, any stockholder that owns Sponsors can attempt to counteract this loss of control by: 10% or more of the company’s stock is considered an affiliate. A Maintaining the contractual right to nominate a majority of the stockholder that owns less than 10% of a company’s stock can company’s board seats (through voting agreements among also be considered an affiliate, particularly if that stockholder has significant pre-IPO stockholders). contractual rights to representation on the company’s board.

The portfolio company (or the parent holding company, as the lock-up period, the fund is prohibited from selling any shares applicable) will become a reporting company under the Exchange in the portfolio company. This can make an unregistered public Act as soon as it goes public, so assuming it remains current resale an inflexible and unattractive method for making a full on its reporting requirements, the company will satisfy this exit from an investment in a portfolio company, and may make requirement 90 days after the IPO. unregistered sales more suitable for small, partial exits intended to capitalize on favorable, temporary market conditions. Under Rule 144, a fund that is not an affiliate of the portfolio company and has not been an affiliate for the last three months can sell shares in the portfolio company at the expiration of the SECONDARY REGISTERED OFFERINGS IPO lock-up period or 90 days after the IPO, whichever comes A second way that a sponsor can exit its investment after an first, assuming it has held those shares for at least six months and IPO is through one or more secondary registered offerings. A the company stays current in its Exchange Act reporting. Even if secondary registered offering is a public resale of the company’s the company is not current in its Exchange Act reporting, a non- shares held by its stockholders instead of a primary offering of affiliate can resell restricted shares under Rule 144 as long as it shares by the company itself. has held them for one year or more. For a sponsor to sell its shares in a secondary offering, the A fund that is an affiliate of the company must comply with portfolio company (or the parent holding company, as applicable) the same timing restrictions as a non-affiliate and also with the must first file a registration statement registering the sale with following requirements: the SEC. The registration process in a secondary offering is less time consuming and expensive than in an IPO. But a company Volume restrictions. During any three-month period, the fund still incurs the costs associated with preparing the registration may not sell shares representing more than the greater of: statement. Therefore, a company may be reluctant to register 1% of the company’s outstanding shares of the same class; or the fund’s shares unless obligated to do so under a registration

the average weekly reported trading volume of the class of rights agreement (see Practice Note, What are Registration Rights shares for the previous four calendar weeks, if the class of Agreements? (http://us.practicallaw.com/3-386-4395)). shares is listed on a US securities exchange. It is important that the sponsor negotiate registration rights at the time it Manner of sale. The sales must be broker transactions, makes its initial investment in the company because the sponsor may transactions with a market maker or riskless principal no longer control the company after the IPO (see Investment Stage Exit transactions, each as defined in Rule 144. Planning). Registration rights require a company to register securities Notice of sale. If the amount of sales exceeds 5,000 shares or held by the stockholder exercising the rights. Typically, a registration $50,000 in any three-month period, the seller must file a notice rights agreement provides that the holder of registration rights has of the proposed sale on Form 144 with the SEC. The sales will a certain number of demand registrations and unlimited piggyback also probably trigger reporting obligations under Section 13 registrations. Importantly, demand registration rights permit a sponsor or Section 16(a) (see Practice Note, Periodic Reporting and (under certain limitations) to force the company to register its shares Disclosure Obligations: Overview (http://us.practicallaw.com/7- with the SEC. For a form of registration rights agreement, see Standard 381-0961)). Document, Registration Rights Agreement (Section 4(2) Private Placement Form) (http://us.practicallaw.com/8-500-6936). In addition, the fund must not solicit or arrange for the solicitation of orders to buy the shares in connection with the sales or pay Secondary registered offerings are a preferred method for sponsor anyone for the offer or sale of the shares, other than the broker- exits because of the comparative flexibility and speed. The timing, dealer that executes the order to sell the shares. volume and manner of sale restrictions that apply to sales by affiliates under Rule 144 do not apply in a secondary offering For more information on Rule 144 resales, see Practice Note, (see Sales after the IPO under Rule 144). Therefore, a registered Resales Under Rule 144 (http://us.practicallaw.com/4-382-8769). offering, if demand for the company’s equity is sufficient, may Unlike a registered sale, an unregistered sale is quicker, less provide a sponsor with an immediate, complete exit. expensive and does not require a broad marketing campaign On the other hand, secondary registered offerings are subject to to ensure the offering is fully subscribed. An unregistered sale some of the same shortcomings as IPOs (see Disadvantages of an may also be more likely to succeed than a secondary registered IPO Exit). These offerings are likely to provide sponsors with only offering during market downturns for registered offerings. a partial exit to their investment unless there is a high demand for the company’s stock. In addition, depending on the size of the However, the timing, volume and manner of sale restrictions that public float, the fund’s investment could still be too large to be Rule 144 places on resales by a fund considered an affiliate of a sold in the market at one time at a desirable price. Furthermore, portfolio company can make unregistered resales a slow exit strategy. the registration process itself, though usually less extensive In addition to the timing and volume requirements imposed by than the initial registration, can still take up a large amount of the SEC, a fund typically agrees to a contractual lock-up period of management’s time, attention and other company resources, up to 180 days with the IPO’s underwriters (see Timing). During especially if the company does not qualify to use the shorter Form

Copyright © 2011 Practical Law Publishing Limited and Practical Law Company, Inc. All Rights Reserved. 6 S-3 registration statement. In addition, the sponsor’s ability to sell by setting the timetable for negotiating and completing the sale, through a secondary offering is subject to its ability to compel the and drafting the transaction documents, the process can take company to file a registration statement covering the fund’s stock. longer than a single buyer negotiation. However, an auction with multiple bidders can result in a higher sale price for the portfolio For more information on secondary registered offerings, see company than in a single buyer process or other exit method. Practice Note, Follow-on and Secondary Registered Offerings: The process forces bidders to bid against each other and offer Overview (http://us.practicallaw.com/5-381-0957). terms more favorable to the seller than they would in a single buyer process. For more on auctions, see Auction Timeline (http:// SALE TO A THIRD PARTY us.practicallaw.com/9-381-0700) and Practice Notes, Auctions: From the Seller’s Perspective (http://us.practicallaw.com/6- The most common exit alternative for a sponsor of an LBO is a 383-1087) and Auctions: From the Bidder’s Perspective (http:// sale of the portfolio company to a third party. Sales can be made us.practicallaw.com/5-503-3724). to either a: Strategic buyer (such as a competitor, customer or supplier of Clean Break the portfolio company). In the sale, the sponsor will want to obtain a clean break from Financial buyer (such as another private equity fund or other the portfolio company and distribute the proceeds to investors. financial purchaser) in a secondary purchase. Therefore, in purchase agreement negotiations, sponsors typically are concerned with: SPECIAL CONSIDERATIONS FOR PRIVATE EQUITY SELLERS Survival. It is important to ensure the representations, warranties The sale of a portfolio company follows a similar process to any and covenants survive for a finite period of time. This includes private sale transaction. However, what will drive certain aspects representations and warranties relating to fundamental matters, of the sale is the sponsor’s goal to exit its investment and return like due authority, capitalization and taxes, which buyers capital to its investors. sometimes want to survive in perpetuity. For more on negotiating survival periods from the seller’s perspective, see Standard Planning at Investment Stage Document, Stock Purchase Agreement (Auction Form) (http:// us.practicallaw.com/3-502-5305). The sponsor must begin planning for the sale at the time of its Cap on indemnification. Sponsors will also want to be able to initial investment. To realize the greatest return on its investment, distribute as much of the proceeds from the sale to their limited a sponsor must be able to deliver the entire business to the partners as possible. They cannot do so if the purchase price buyer, including all of the portfolio company’s outstanding shares. continues to be at risk because of potential indemnity claims To ensure it has this ability, the sponsor should negotiate drag- by the buyer. The sponsor should structure the agreement to along rights in its stockholders agreement at the time of its initial limit its exposure for breaches of representations and warranties investment. Drag-along rights allow the fund to force any minority to a percentage of the purchase price and for all other matters stockholders (including management) to join in the sale of the to no more than the amount of the purchase price. For more company under the same price, terms and conditions as the on negotiating indemnification provisions from the seller’s fund is receiving. For more on drag-along rights in stockholders perspective, see Standard Document, Stock Purchase Agreement agreements, see Practice Note, Stockholder Protections: Drag- (Auction Form) (http://us.practicallaw.com/3-502-5305). along and Tag-along Rights (http://us.practicallaw.com/6-382- Limited escrow. The sponsor should attempt to limit the buyer’s 7132) and Standard Clause, Stockholders Agreement: Drag-along recourse if there is a breach to an amount placed in escrow at Rights (http://us.practicallaw.com/6-383-5245). the closing of the sale. The sponsor should try to have any escrow The sponsor should also consider the type of buyer to whom period be as short as possible because the sponsor cannot the portfolio company may be sold. If the portfolio company distribute the amount in escrow until it has been released. For is sold to a financial buyer, the sponsor will want to have a more on escrow agreements, see Standard Document, Escrow management retention plan in place to allow the sponsor to Agreement (http://us.practicallaw.com/1-386-3603). deliver the retained company’s management to the buyer. This Consideration. Sponsors should also negotiate for the consideration will increase the value of the company to the buyer, and increase to be cash or other liquid assets. Earn-outs and other deferred the purchase price and the amount the fund realizes on its consideration as well as illiquid forms of consideration should be investment (see Management Incentives). avoided if possible. For more on earn-outs, see Practice Notes, Earn-outs (http://us.practicallaw.com/0-500-1650). Auction Process or Single Bidder In selling the portfolio company, the sponsor can choose to Dual Track Process negotiate with a single buyer or shop the portfolio company in an The financial uncertainty during the last few years has sometimes auction process and receive offers from multiple bidders. In an made it difficult for sponsors to exit successfully their portfolio auction, though the seller is typically in control of the sale process companies. As a result, it has become increasingly common for

sponsors to prepare simultaneously for both an IPO and a sale Nondisclosure Agreements (http://us.practicallaw.com/7- process (known as a dual track). With a dual track, there is a 501-7068) and Standard Document, Confidentiality greater likelihood that some transaction will occur and the sponsor Agreement: General (Unilateral, Pro-discloser) (http:// increases its chances of an exit. The sponsor ultimately chooses us.practicallaw.com/9-501-6497). to pursue to closing the exit that seems most likely to succeed Regulatory delays. Sales to strategic buyers may be delayed and to generate the greatest return. For more on dual track exits, by antitrust review. For an overview of the main US antitrust see Practice Note, Managing a Dual-track Exit Strategy (http:// statutory provisions and regulatory structure, see Practice us.practicallaw.com/2-503-9911). Note, US Antitrust Laws: Overview (http://us.practicallaw. com/9-204-0472). ADVANTAGES OF A SALE PROCESS Risk from financial buyers. Financial buyers may not be able There are several reasons why a sponsor may find a sale to be to pay as much as strategic buyers because financial buyers more advantageous than an IPO. It offers: cannot factor synergies into their cost. Financial sponsors also finance their deals with debt, which adds risk that the A complete exit. Unlike an IPO, sales typically allow a fund deal may not close if they are not able to obtain financing (see to make an immediate and complete exit. At the closing of Practice Note, Buyouts: Overview: Financing a Buyout (http:// the sale, the fund usually transfers its entire interest in the us.practicallaw.com/4-381-1368)). Many financial buyers portfolio company to the buyer and ends its investment in counter this risk by providing a reverse break-up fee in the the company. purchase agreement, particularly in a going private transaction. More control. In a sale of the portfolio company, the fund has However, that may not be a sufficient remedy for a seller that more control over the sale process than in an IPO, where many wants more certainty to close the deal. For a discussion of of the terms are controlled by securities laws, exchange rules these issues, see Practice Note, Reverse Break-up Fees and or the underwriter. Specific Performance (http://us.practicallaw.com/8-386-5095)). Speed. The seller and potential buyers often simultaneously complete due diligence and negotiate the terms of the acquisition document. Once the diligence and negotiations PARTIAL EXITS are complete, the seller and the buyer execute the definitive agreement. Once the definitive agreement is signed, the deal DIVIDENDS AND RECAPITALIZATIONS can be closed as soon as any applicable regulatory approvals Sponsors may achieve a partial exit from their investment in a are obtained and, if applicable, the buyer obtains financing. portfolio company through a special dividend issued by either the In a sale process with a single bidder, the process can take as portfolio company to its parent holding company or by the parent little as two to three months. holding company itself (for an overview of the typical structure of an LBO and the use of buyout vehicles, see Practice Note, DISADVANTAGES OF A SALE PROCESS Buyouts: Overview: Buyout Vehicle (http://us.practicallaw.com/4- 381-1368)). The type of dividend is defined by the source the Sales also pose potential downsides for sponsors, such as: company (or the parent holding company) uses to finance it:

Resistance from management. The portfolio company’s A non-leveraged dividend recapitalization is financed by the existing management may be resistant to a sale involving a company by using cash that it already has on hand. strategic buyer because buyers often replace the portfolio A leveraged dividend recapitalization is financed by the company’s managers with their own team. As a result, company by incurring additional debt. in a strategic sale, the sponsor cannot always count on management to assist the transaction from the start. Non-leveraged Dividend Recapitalization Risk from competitors. The sales process can expose a Typically, a non-leveraged dividend recapitalization is smaller portfolio company to risks from competitors that enter bids than a leveraged dividend recapitalization because a non- only to determine the portfolio company’s value or gain leveraged dividend recapitalization relies on cash already on the access to the portfolio company’s confidential information. portfolio company’s balance sheet. Therefore, non-leveraged Sponsors must verify the genuineness of a competitor’s dividend recapitalizations rarely result in a full exit from the interest in purchasing a portfolio company before granting investment for the fund. the competitor this access. Sponsors should also consider limiting access to sensitive contracts and information until However, if a non-leveraged dividend reduces the amount of the the later stages of the process when it is easier to determine fund’s at-risk capital invested in the portfolio company, a non- a competitor’s motive. Also, if competitors are involved in leveraged dividend does reduce the level of the fund’s downside a sale process, the terms of the confidentiality agreement risk. Non-leveraged dividends, unlike a leveraged dividend and having strong company protections becomes even recapitalization, do not substantially increase the portfolio more important. For more on confidentiality agreements company’s risk profile or increase the size of its debt service in this context, see Practice Note, Confidentiality and payments, and do not usually lead to bad press for the sponsor.

Copyright © 2011 Practical Law Publishing Limited and Practical Law Company, Inc. All Rights Reserved. 8 Leveraged Dividend Recapitalization REDEMPTION RIGHTS Leveraged dividend recapitalizations are often funded by having Sponsors may also achieve at least partial liquidity (and the parent holding company of the portfolio company take out possibly complete liquidity) by forcing the portfolio company to debt secured by its shares in the portfolio company. Lenders redeem their stock for cash. At the time of the LBO, sponsors typically prefer this structure over issuing debt to the portfolio can negotiate for redemption rights that allow the fund, at its company itself, especially if the portfolio company has already discretion, to return their shares to the portfolio company in return incurred a significant amount of debt in the LBO. for an immediate payout of cash or some other consideration. Redemption rights are typically built into either the charter A leveraged dividend recapitalization has certain advantages as an provisions or stockholders agreements. exit strategy:

Larger size and possible full exit. A leveraged dividend often Charter provisions can provide for the company to issue the can be larger than a non-leveraged dividend and often can fund redeemable preferred stock with a liquidation preference. provide the fund a full return of the dollar value of its invested This gives the fund the right to redeem its stock as well as to be capital. If so, the fund and its investors will have no further the first stockholder paid back if the portfolio company enters downside risk in the portfolio company investment. liquidation. For an overview of the rights of preferred stock, including redemption rights and priority liquidation rights, see Ability to maintain control. Unlike in an IPO (see Loss of Practice Note, Preferred Stock: Overview (http://us.practicallaw. Control), a leveraged dividend recapitalization does not require com/2-504-1419). the fund to give up any control to realize its partial exit. A stockholders agreement can give the fund put rights However, sponsors considering a leveraged dividend recapitalization allowing the fund to sell its shares to the portfolio must consider the disadvantages of this exit strategy: company at an agreed price. For a further discussion Typically not a full exit. Leveraged dividends usually do not of redemptions and put rights, see Practice Notes, provide the fund with a full exit of its investment and make the Stockholder Protections: Protections Relating to Stock fund’s remaining investment in the portfolio company riskier. Ownership (http://us.practicallaw.com/6-382-7132) and This is because the portfolio company and its business and Stockholders Agreement Commentary: Overview of Transfer assets will be the sole source of servicing the debt (even if the Provisions (http://us.practicallaw.com/7-381-0517). debt is placed at the parent holding company level), and, as a result, the portfolio company will have higher leverage and an Redemption rights give sponsors the ability to get an immediate increased debt load. return of at least a portion of the fund’s at-risk capital. In addition, redemption rights typically are priced at a premium providing a Bad press for the sponsor. Leveraged dividend return for the sponsor even in a transaction where the fair market recapitalizations can also result in bad press for the sponsor, value of the equity at the time of redemption is about the same and make the sponsor appear to be raiding the portfolio price the fund paid for its initial investment. company for its own benefit.

Market limitations. In a tight credit market, parent holding However, exercising redemption rights is still an exit of last companies and portfolio companies may be unable to resort for a sponsor that is typically only used in unsuccessful secure financing (or financing with desirable pricing) for a investments because: dividend recapitalization forcing sponsors to pursue a different Unless all of the stockholders are redeemed pro rata (and, transaction to gain liquidity. as a result, the fund’s relative equity ownership in the State corporate law limitations. As a matter of corporate law, portfolio company does not change), the sponsor loses some a company can only make dividends out of available cash. of its upside potential in the investment because the fund For example, under Section 170 of the Delaware General gives up its stock (and reduces its ownership percentage) in Corporation Law, a company may only pay dividends out of a redemption. available surplus. The price at which a sponsor can redeem its stock typically State and federal fraudulent conveyance limitations. In provides the fund with far lower returns than what were addition, federal and state bankruptcy laws provides that if originally expected by the sponsor and promised to the a company is already insolvent or is rendered insolvent by fund’s investors. paying a dividend, then the dividend may be voided as a A sponsor’s ability to exercise redemption rights is limited fraudulent conveyance. In that case, the fund would have by how much cash the portfolio company has on hand, to repay all or a portion of the dividend it received. For a how much additional debt it can borrow and its ability discussion of fraudulent conveyance issues for sponsors, to pay for the redeemed shares. As a practical matter, if see Practice Note, Fraudulent Conveyances: Issues and a portfolio company has insufficient cash or borrowing Strategies for Lenders and Private Equity Sponsors (http:// capacity to pay the redemption, the sponsor will be unable us.practicallaw.com/8-382-2478). to exercise its rights.

TAG-ALONG RIGHTS In multi-sponsor or club deals where several sponsors own Practical Law Company provides practical legal equity in the same portfolio company, tag-along rights can help know-how for law firms, law departments and law a sponsor protect its investment and maximize its return. The schools. Our online resources help lawyers practice sponsor should provide for tag-along rights in a stockholders efficiently, get up to speed quickly and spend more agreement at the initial investment stage. Tag-along rights give time on the work that matters most. This Checklist their holder the right to force another stockholder that is selling its is just one example of the many resources Practical shares to include the other holder’s shares in the sale, on a pro Law Company offers. Discover for yourself what the rata basis. A tag-along holder has the right to sell its shares for the same price and on the same terms as the selling stockholder. world’s leading law firms and law departments use to enhance their practices. The advantage to tag-along rights is that it ensures a fund can participate in a sale by another equity holder for a price and on terms the sponsor deems to be advantageous. However, tag- along rights rarely provide a fund with a complete exit from its Contact Us investment in a portfolio company. Because tag-along rights only Practical Law Company allow their holder to participate in a sale on a pro-rata basis, the 747 Third Avenue, 36th Floor extent to which a fund will be able to gain liquidity through tag- New York, NY 10017 along rights will be limited by both: 646.562.3405 How many shares the purchaser wishes to acquire. [email protected] The fund’s proportional ownership in comparison with the other http://us.practicallaw.com selling stockholders.

In addition, the benefit of tag-along rights to a sponsor owning a controlling equity interest in a portfolio company is limited because, in those situations, tag-along rights mostly serve as a disincentive to the company’s other stockholders. Other stockholders may be reluctant to spend the time and resources searching for a third- party buyer and negotiating a sale of their stock if the sponsor, by exercising its tag-along rights, can reap the majority of the benefits of the selling stockholders efforts (due to its ability to sell more shares on a pro rata basis in the transaction).

For an example of a tag-along provision, see Standard Clause, Stockholders Agreement: Tag-along Rights (http://us.practicallaw. com/8-383-5254).

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