The Report Quarterly Spring 2021 | Volume 21, Issue 1

From the Editors Over the past year, the private equity industry has responded to the upheaval of the COVID-19 pandemic with tremendous resiliency and innovation. Private equity sponsors have acquired new long-term sources of capital through investments, accessed the IPO market through SPACs and protected exit strategies from volatility in the debt financing market through the use of portability provisions. While these strategies were already part of the private equity playbook, the pandemic has intensified their use. The pandemic has also highlighted the importance of nonfinancial factors in investing—not just climate change, but other environmental issues like biodiversity, and social issues, such as racial justice and economic inequality. The EU’s ESG directives are thus one point in an arc tracing the evolving Spring 2021 Issue Editors expectations of regulators and investors. In this issue of the Debevoise Private Equity Report, we explore these developments, what they mean for private equity sponsors and the caveats to keep in mind. We hope that you will find this to be a useful guide in developing your own strategies to flourish during times of great change. We look forward to the opportunity to assist you in that journey. Paul S. Bird Patricia Volhard [email protected] [email protected]

SPOTLIGHT VIDEO INTERVIEW Editorial Board Sally Bergmann Paul S. Bird Jennifer L. Chu Editor-in-Chief • Spotlight Interview: KKR’s Susanna Berger Rafael Kariyev To mark its twentieth anniversary, we have added a new video section Franci J. Blassberg Scott B. Selinger Founding Editor to the Debevoise Private Equity Report: Spotlight Interviews, featuring Patricia Volhard leading private equity figures from around the world in conversation Jin-Hyuk Jang with Debevoise partners on important industry topics of the day. In our inaugural segment, Susanna Berger, London-based Managing Director and General Counsel for KKR in Europe, speaks with Patricia Volhard, a partner in Debevoise's Frankfurt and London offices. We invite you to: WATCH HERE (~15 minutes).

• SPACs: Key Regulatory Considerations for Private Equity Sponsors SPACs provide sponsors with a permanent capital vehicle, access to different targets than might otherwise be available due to restrictive fund covenants, and greater access to capital through retail investors and liquidity options that are not always available to a traditional private equity portfolio company and private equity funds, allowing for the pursuit of larger targets. Despite these attractions, SPAC sponsors should proceed with some caution. continued on page 2 From the Editors

• SPAC Trends in the Europe Market–Are SPACs the New Entrance and Exit? With the popularity of SPACs in the reaching fever pitch, we share our thoughts on why the strategy is so attractive for private equity, what sponsors should be wary of and whether they expect a similar uptake in Europe.

• Locked Boxes in U.S. Practice: An Underused Tool? The locked box in U.S. private M&A is a relatively foreign concept—relegated to special situations and often looked upon with suspicion by wary buyers. Is this reputation justified? Should U.S. practitioners embrace the locked box as a value and efficiency creating mechanism. • Insurance Investments: Key Considerations for Investors in the U.S., Europe and Asia Financial sponsors have long been important providers of capital to the insurance industry, but in recent years, private equity acquisitions of insurance businesses have become more common. While this trend has been most noticeable in the United States and Europe, it is beginning to take hold in Asia as well. Private equity sponsors considering insurance investments in Asia and in emerging markets can look to lessons learned from deal experience in the United States and Europe—but need to keep in mind the quirks across different jurisdictions regarding capital, structure and reporting.

• Portability in Debt Financing Agreements: A Helpful Tool for Private Equity Sponsors Portability provisions, allowing a buyer to step into the shoes of a seller upon a change of control and leave the target’s financing intact, have become a useful tool to mitigate the impact of market risk on a potential exit transaction. However, sellers need to think through the required conditions at the time they incur the debt to ensure that closing risks have been

appropriately mitigated. © 2021 CNCARTOONS

• The End of Leveraged As We Know Them? Hardly. On Dec. 4, 2020, Judge Jed S. Rakoff, of the U.S. District Court for the Southern District of , in a decision applying Pennsylvania law, declined to dismiss breach of fiduciary duty claims against the board of directors of the Jones Group Inc. in connection with the April 2014 take-private acquisition of the company by . While the decision—In re LBO “It’s been awhile. I thought I’d stop by and Securities Litigation—was only a preliminary ruling and not a decision on the see how you all were doing.” merits, it has been described as a potential “game stopper for the private equity business” and a “sobering punctuation mark to a sobering year.”

• ESG Outlook for Private Equity Sponsors While ESG concepts have been gaining momentum for almost two decades, the pandemic, coupled with growing concerns around climate change, has elevated This report is a publication of its importance. This article discusses the evolution of ESG investing, provides Debevoise & Plimpton LLP an overview of the current regulatory landscape in Europe and the United The articles appearing in this publication provide Kingdom, and examines the potential effects of ESG developments on private summary information only and are not intended equity sponsors in the short, medium and long term. as legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed in these articles.

Private Equity Report Quarterly 2 Spring 2021 SPACs: Key Regulatory Considerations for Private Equity Sponsors In 2020, special purpose acquisition companies went from a niche capital markets Private fund SPAC maneuver to being in the mainstream of popular culture, garnering the attention of sponsors have particular the media, retail investors, celebrities and regulators—while raising approximately considerations arising from $75 billion through nearly 250 initial public offerings. The pace has increased obligations to their clients. rapidly in 2021, with about 300 IPOs raising $90 billion in the first quarter. Given the benefits they provide to private equity sponsors, there are good reasons for SPACs’ sudden popularity. In comparison to traditional IPOs, SPACs offer a more streamlined and faster IPO process, lower financial transaction costs, greater control over deal terms, the management expertise of the sponsors and less uncertainty in pricing due to their simplified process. SPACs also provide sponsors with a permanent capital vehicle, access to different Christopher Anthony Morgan J. Hayes targets than might otherwise be available due to restrictive fund covenants and Partner Partner greater access to capital through retail investors and liquidity options that are not always available to a traditional private equity portfolio company and private equity funds, allowing for the pursuit of larger targets. Finally, SPACs generally require fewer disclosures to investors at the time of the IPO as compared to the typical disclosure package required in case of a listing of existing operating

Robert B. Kaplan Marc Ponchione companies (and pre-commitment disclosure for private equity fund offerings). Partner Partner Despite these attractions, SPAC sponsors should proceed with some caution. Here is a list of key considerations for any private equity sponsor evaluating a SPAC:

SEC Scrutiny In the face of the vehicle’s proliferation, the SEC has begun to provide formal Julie M. Riewe Shannon Rose Selden and informal direction on the potential regulatory risks of SPAC offerings and Partner Partner transactions, some of which raise acute issues for private equity fund managers looking to sponsor a SPAC. The SEC, for example, has: (i) provided educational materials to investors looking to invest in SPACs; (ii) cautioned investors against making investment decisions with respect to SPACs solely based on celebrity involvement; (iii) provided guidance for sponsors relating to disclosure

Steven J. Slutzky Norma Angelica obligations; (iv) hosted meetings and spoken publicly on SPACs, raising Partner Freeland awareness of issues and inviting further feedback, especially as to how to further Associate investor protections; (v) questioned whether the statutory safe harbor for forward-looking statements would apply to projections used in proxy statements for de-SPAC transactions; and (vi) explicitly cautioned SPAC sponsors on conflicts of interest and disclosure issues, stating its view that such warrants should be accounted for as liabilities, not equity. Adrian St. Francis Associate

Private Equity Report Quarterly 3 Spring 2021 SPACs: Key Regulatory Considerations for Private Equity Sponsors

In addition, the SEC has explicitly There have been attempts to solve For example, SPACs may be subject cautioned SPAC sponsors on conflicts this problem by using a more tailored to different levels of fees and costs, of interest and disclosure issues structure. For example, in July 2020, some of which may not be known and, in early April, the SEC brought Pershing Square decided not to with precision at the time of the IPO the SPAC market to a standstill by take the typical 20 percent sponsor (such as costs relating to potential publicly challenging the accepted promote and instead to “keep skin in redemptions and PIPE financing). accounting treatment for certain the game” by investing in warrants In addition to the foregoing concerns, types of warrants issued by SPACs. at market value that included which apply to all SPAC sponsors, Further slowing the SPAC market, the significant transferability and exercise private fund SPAC sponsors have SEC orally advised SPAC issuers that limitations. In addition, many recent particular considerations arising from it will apply its procedural policies acquisitions involve the restructuring obligations to private fund clients and rigidly in the registration statement of some or all sponsor-promote any other investment advisory clients: review process. With the recent shares to vest only if the post-closing change in leadership at the SEC, company’s performs above Allocation. A SPAC target company further scrutiny may be ahead. certain levels. may be an appropriate investment for a manager’s existing funds, Conflicts of Interest. SPAC sponsors Disclosures. The participation by retail creating potential allocation conflicts. may have divergent financial investors presents particular risks, For example, a fund’s governing incentives from public shareholders as retail investors may not appreciate documents may require that the of the SPAC. These conflicts can the implications and the risks of manager (who is affiliated with the arise in numerous places, including the SPAC structure and sponsor SPAC sponsor) offer the deal with the target company to its fund as a SPACs provide sponsors with a permanent capital vehicle, access portfolio company acquisition. to different targets than might otherwise be available due to Conflicted transactions. Similarly, restrictive fund covenants, and greater access to capital through conflicted transactions may occur retail investors and liquidity options that are not always available where the SPAC sponsor seeks to a traditional private equity portfolio company and private equity to have the SPAC acquire a target funds, allowing for the pursuit of larger targets. company in which one of the fund manager’s funds has an interest. The precise degree of conflict this capital and payment structures in the economics. Sponsors therefore poses is determined by the fund’s SPAC itself, timing commitments to should avoid recycling generic SPAC organizing documents, as are the close a deal within the contractual disclosures and instead ensure that protocols to be followed in instances investment window or repay disclosures are tailored to their specific where conflicted transactions are investors, and competing fiduciary SPAC and are consistent with SEC contemplated. obligations where the sponsor has guidance. Another area where tailored Successor fund restrictions. A SPAC positions in other financial vehicles disclosure is appropriate is the level may be considered a “successor fund” or separate business dealings and of future expense and financing needs under fund organizational documents, interests in the target company. that a particular SPAC will incur. in which case the sponsor may be

Private Equity Report Quarterly 4 Spring 2021 SPACs: Key Regulatory Considerations for Private Equity Sponsors

restricted in raising capital for the and/or conflicts of interest. The eight months after the merger’s SPAC until after a certain amount of exponential increase in SPAC announcement, over stock performance capital from existing funds has been formations, however, is likely to issues only apparent after the merger’s invested or committed. lead to an even steeper exponential completion. increase in related litigation as some Key person time and attention [See “SPAC Plaintiffs Are Filing targets will be weaker candidates, requirements. Fund managers must Early—But Not Too Early” more likely to falter after the de-SPAC be aware of obligations imposed upon BloombergLaw, April 22, 2021 process concludes, drawing increased them by fund documents or firm (“Bloomberg: Filing Early”), scrutiny from both regulators and the policies regarding the time and attention available here.] plaintiffs’ bar. that must be dedicated to managing a The regulatory and litigation certain fund. This issue is particularly SPAC-specific litigation vulnerability. concerns discussed above exist in the acute where these requirements oblige Time-limited contractual investment context of a market that suddenly key persons to devote time to specific obligations leave SPAC sponsors feels less friendly to SPACs than it did funds or strategies, rather than being particularly vulnerable to strike suits earlier in 2021. The pace of new SPAC applicable on a firm-wide or platform- in which plaintiffs seek to enjoin the listings has slackened and existing wide basis. merger, often by way of demanding SPACs are finding deals harder to increased disclosures, in the Local offering restrictions. Depending consummate, thanks in part to a immediate lead-up to a shareholder on where a SPAC is set up and offered drop-off in available PIPE financing. vote on the transaction. Sponsors and how it is organized it may be With hundreds of SPACs in the with SPACs nearing the end of their subject to additional regulatory and market still pursuing transactions, investment windows may be forced marketing restrictions. For example, sponsors have all the more reason to to capitulate or face terminating the if offered to investors in Europe, it exercise caution. SPAC and repaying investors. could in some cases be considered an alternative investment fund within [See “What Do SPAC Federal the meaning of the European AIFM Securities Lawsuits Look Like So Directive triggering a whole set of Far?” Above the Law, April 6, 2021 regulatory requirements. (“Above the Law: Federal Securities Lawsuits”), available here.] Developing Litigation Trends Bi-modal litigation timing trends. Looming upswing in litigation. SPAC-related litigation to date Assuming that historic trends suggests an emerging trend, that the continue, the substantial increase risk of litigation is not equally likely in SPAC-related investment activity over the life of the SPAC, but rather would indicate a commensurate increases at two junctures: (i) close to increase in litigation arising the merger completion date, usually out of alleged SPAC transaction around four months after the merger shortcomings, including purported announcement, often over disclosure incomplete or misleading disclosures or conflicts issues; and (ii) around

Private Equity Report Quarterly 5 Spring 2021 SPAC Trends in the Europe Market—Are SPACs the New Entrance and Exit? This article was originally published in European private equity publication We have not yet seen a Unquote (link here). proliferation of SPACs listed With the popularity of SPACs in the United States reaching a fever pitch, E. Raman on European exchanges, Bet-Mansour and James C. Scoville of Debevoise & Plimpton share their thoughts although they are expected on why the strategy is so attractive for PE, what sponsors should be wary of, and to gain popularity around the whether they expect a similar uptake in Europe. word as demand outstrips the U.S.'s supply. Greg Gille: What makes special-purpose acquisition companies (SPACs) relevant to private equity firms?

E. Raman Bet-Mansour: SPACs were the biggest Wall Street story in 2020, and activity in the first quarter of 2021 already exceeded 2020's record pace. Major PE firms have joined the bandwagon on both ends by sponsoring SPACs, acquiring targets via their sponsored SPACs and exiting investments by merging portfolio companies with SPACs (i.e., de-SPAC transactions). By sponsoring SPACs, PE firms are able to diversify their offerings beyond James C. Scoville E. Raman Bet-Mansour traditional funds, offer shorter exit time horizons and achieve Partner Partner attractive economic returns. GG: To what extent are SPACs becoming a phenomenon outside of the U.S.?

James C. Scoville: An overwhelming majority of SPACs are listed in the US due to its mature legal and financial infrastructure, and a deep investor base

Matt Dickman Laurence Hanesworth familiar with SPACs. However, many SPACs listed in the US are sponsored International Counsel Associate by non-US sponsors or looking at non-US targets. We have not yet seen a proliferation of SPACs listed on European exchanges, although they are expected to gain popularity around the world as demand outstrips the US's supply. Regulators in London, Hong Kong, Singapore and other important non-US financial centres are studying the possibility of reforming their regulations to SPACs more easily accommodate SPAC listings. Notably, the UK sees Brexit as an opportunity to reform its listing rules to make the London Stock Exchange a more attractive listing venue, and on 3 March 2021 new rules were proposed that would reform the current reverse rules that apply to SPAC transactions. Similar regulatory flexibility in Amsterdam is likely to position Amsterdam's Euronext as the core EU listing venue for SPACs on the continent.

Private Equity Report Quarterly 6 Fall 2020 SPAC Trends in the Europe Market: Are SPACs the New Entrance and Exit?

GG: What makes SPACs different Third, the economic entitlement of Second, de-SPAC transactions from traditional PE vehicles? SPACs' sponsors is different from a provide more structural flexibility PE structure. In a PE fund, a PE firm and allow use of M&A tools (for ERB-M: A SPAC's goal is to unlock usually earns an annual management example, earn-outs, governance, value for shareholders in private fee, invests alongside third-party financing) that are not customarily companies under the guidance of a investors to ensure alignment of available in traditional IPOs for team of investment professionals, interests, and receives a carried parties to maximize value and reach which in essence is the same goal interest as a share of profits, if certain compromises on areas they each care as PE historically, and which may hurdles are met. However, for a the most about. allow PE firms' expertise to shine in a different arena. However, SPACs carry a few important distinctions from The market turbulence and historically low interest rate caused traditional PE vehicles. by the Covid-19 pandemic are undoubtedly two major factors First, SPACs are publicly listed behind the rise of SPACs, but some of the benefits inherent in companies. This status provides the SPAC structure will allow them to stay beyond the current SPACs with ready access to public economic and financial cycle, and gain popularity among more debt and equity capital markets, and PE firms. no requirement to seek an investment exit within a fixed period of time. SPAC, the sponsor does not receive Third, de-SPAC transactions are Further, as a publicly listed company, a and its invested more cost-efficient and less time- a SPAC is able to raise capital from a cash is primarily used for expenses consuming than traditional IPOs; broader group of investors. to operate the SPAC until it finds a de-SPAC transactions typically Second, a SPAC is formed with target. However, if an acquisition is take between four to five months the intention that it seeks to acquire completed, a SPAC sponsor receives and involve a lower a single operating company (or a 20% equity interest in the pre- commission, whereas traditional IPOs perhaps a group of related operating acquisition SPAC, which provides typically take six to nine months companies) rather than a traditional sponsors a strong incentive to find a and involve a higher underwriting PE vehicle that acquires, owns deal and complete it quickly. commission. and ultimately sells a portfolio of operating companies. As a result, a GG: What makes de-SPAC GG: What are key issues for SPAC investment is not diversified transactions different from PE firms to consider before across several companies or traditional IPOs? sponsoring a SPAC? management teams or geographies, JCS: First, de-SPAC transactions ERB-M: PE firms should carefully and has increased exposure to provide more certainty in target consider potential conflicts of the risks of the single underlying , because parties may interests relating to a SPAC business, business. In addition, a SPAC has determine target valuation through as well as requirements in its existing a much shorter period to acquire a extensive negotiations that are typical in fund agreements, and securities law target (generally up to two years) PE buyouts and avoid price fluctuations requirements—including dedication while a PE fund can have up to a 10- that may exist in traditional IPOs, which of time and attention, allocation of year investment period. are even more prevalent in the post- investment opportunities, and conflicts Covid equity market.

Private Equity Report Quarterly 7 Spring 2021 SPAC Trends in the Europe Market: Are SPACs the New Entrance and Exit?

arising from a SPAC seeking to acquire although they can be mitigated In addition, to allow a speedy and an existing portfolio company. through a combination of disclosure, efficient de-SPAC process and be PE firms should ensure their key third-party valuations and other attractive to SPAC buyers, PE firms persons are permitted by existing techniques. should ensure that their portfolio fund documents to dedicate time to companies have best practices in GG: Conversely, what should the SPAC without triggering a key place to comply with the rules and PE firms consider before exiting person event or otherwise adversely regulations governing public companies, an investment via a de-SPAC affecting existing funds. have audited financial statements in transaction? In addition, if a target is suitable hand, and can provide adequate public for both an existing fund and the JCS: One of the appeals to investors disclosures in a timely manner. SPAC, PE firms should consider of a SPAC is that they can redeem GG: Are SPACs here to stay? how to allocate such an investment their SPAC shares after they vote in opportunity. Further, the investment favor of a de-SPAC transaction and ERB-M: The market turbulence in the SPAC sponsor (and the related retain the ability to enjoy upside by and historically low interest rate incentive economics) is itself an exercising warrants after the closing caused by the Covid-19 pandemic investment opportunity, which may be of such a de-SPAC transaction. are undoubtedly two major factors suitable for one or more existing funds. Therefore, sponsors should ensure behind the rise of SPACs, but some Finally, it is possible that PE- that their SPAC buyers have of the benefits inherent in the SPAC sponsored SPACs seek to acquire mechanisms in place to provide structure will allow them to stay portfolio companies from existing backup liquidity in the event that beyond the current economic and PE funds. Existing PE firms know there is a redemption spree. financial cycle, and gain popularity their portfolio companies well and For example, a SPAC may enter into among more PE firms. are well positioned to evaluate which a forward purchase agreement with its companies are ready for an IPO. sponsor or anchor investors to obligate However, these situations do raise such sponsors or investors to provide potential conflicts of interest and liquidity in a de-SPAC transaction if therefore difficult valuation issues, needed, or a SPAC may enter into a PIPE transaction to secure liquidity.

Private Equity Report Quarterly 8 Spring 2021 Locked Boxes in U.S. Practice: An Underused Tool? The locked box in U.S. private M&A is a relatively foreign concept – relegated We have seen more to special situations and often looked upon with suspicion by wary buyers. Is discussion this past year of this reputation justified? Should U.S. practitioners embrace the locked box as a locked box constructs given value and efficiency creating mechanism? the difficulties associated with constructing good A Primer on Closing Accounts vs. Locked Boxes working capital targets in Prevailing practice in the U.S. private M&A market is a “closing accounts” light of temporary balance purchase price construct. Under this construct, the equity consideration due sheet disruptions during to sellers in a transaction is derived by defining an in dollars 2020 due to COVID. in the acquisition agreement and then adjusting this amount based upon the cash, indebtedness, net working capital (relative to an agreed target working capital figure or range) and seller transaction expenses as of the closing date. The calculations of these amounts are determined in accordance with definitions and accounting principles negotiated in the acquisition agreement. These figures are “trued up” post-closing through a settlement process, which, for sponsor sellers, is supported by an escrow account. This construct results in the seller benefiting from the earnings, and bearing the burden of losses, of the Jennifer L. Chu Uri Herzberg business through the closing date. Partner Partner By contrast, in a locked box transaction, the equity value due to sellers is defined in the acquisition agreement in dollars and the only potential adjustment to that amount is for any “leakage” that occurred between a recent date (aka the locked box date) and the closing date. Leakage consists of unpermitted payments to or benefiting seller and its affiliated Spencer K. Gilbert entities and is typically expected to be zero—that is, it is meant to be a Associate protective mechanism but not value-shifting. The dollar equity value is derived from buyer’s diligence of the earnings of the business and its balance sheet as of the locked box date. Some locked box structures may include a ticking fee concept, which provides seller incremental compensation the longer it takes to close the transaction. Any leakage is estimated at closing and additional leakage claims may be made for a limited period after closing in a manner similar to the closing accounts construct (including with a supporting escrow in sponsor sales). The locked box construct therefore provides that the upside and risks associated with the target’s performance between the locked box date and the closing date inure to the benefit of (or detriment to) the buyer. As a result, seller may seek to negotiate for a higher purchase price to compensate it for running the business between the locked box date and closing.

Private Equity Report Quarterly 9 Spring 2021 Locked Boxes in U.S. Practice: An Underused Tool?

Although frequently utilized in b. Alternatively, the enterprise- When Do Locked Box European transactions, locked to-equity value bridge includes Transactions Make Sense? box transactions are rare in U.S. the full suite of closing account The following factors might increase transactions. We have seen more adjustments, determined as of the appeal of utilizing a locked box discussion this past year of locked the historical locked box date. structure: box constructs given the difficulties Under this construct, the parties associated with constructing good are accelerating the equity value • Seasonal business where testing working capital targets in light of calculation to the pre-signing closing date net working capital temporary balance sheet disruptions period (and are keeping it out against a target might lead to a during 2020 due to COVID. However of the acquisition agreement), significant equity value swing, those discussions rarely translated but must still engage in a which is inconsistent with a going- into usage of the locked box negotiation concerning the basis concern transfer. construct. of the calculation of the target net • Extraordinary activity in the Locked box transactions are often working capital. historical period that makes touted as a way to avoid protracted Both approaches avoid the risk of a agreeing on a normalized target negotiations over the working capital post-closing dispute relating to the net working capital figure more target and closing net working capital calculations of the closing account challenging (e.g., due to COVID inputs. Whether this is true depends purchase price adjustments, while impacts). on the approach the parties take in the former approach has the added arriving at an agreed equity value. • Businesses with unusually large benefit of meaningfully reducing the There are two basic approaches: intra-week or intra-month swings time and effort spent negotiating a. Buyer conducts due diligence on that make agreeing on a target purchase price adjustment terms and the target’s net working capital challenging where there is a the resulting value changes relative to position as of the locked box date possibility of closing at any day the agreed upon enterprise value. (e.g., relative to a trailing 12-month during a week or month. In the case of either approach average), but in fixing the described above, the buyer and seller • Transactions utilizing a portable enterprise-to-equity value bridge will need to agree upon amounts of debt structure in which the business (and resulting purchase price), the excess cash (and the classification deal is negotiated on the basis of an parties do not assume a specific of any cash as restricted cash) and equity value / per-share value rather normalized level of working capital indebtedness (including debt-like than an enterprise value. (i.e., a peg/target) against which a items such as earn-outs and capital Conversely, the following factors calculation of the NWC position as leases) on the locked box date make the usage of a locked box of the locked box date is compared. balance sheet, as well as anticipated construct more challenging: Rather, only extraordinary working sell-side transaction expenses. On capital issues would be included • Absence of a recent balance sheet occasion, incurrences of debt outside in the bridge (as cash- or debt-like prepared in a manner that gives the ordinary course or in excess of items). That is, the deal is priced buyer comfort as to the accuracy a certain threshold, or transaction similar to how a public company and completeness of the balance expenses above a specified amount, deal is priced based upon a fixed sheet to be used as the locked box are defined as leakage. equity or per-share value. date balance sheet.

Private Equity Report Quarterly 10 Spring 2021 Locked Boxes in U.S. Practice: An Underused Tool?

• A target company business with Pros affiliate transactions that would Seller Buyer make it challenging to cleanly define or police leakage from the Avoids “price chipping” by Removes potential for purchase target company to the seller or its buyer through NWC peg/target price increase through natural negotiation after competitive differences between closing affiliates (e.g., a corporate carve- tension has been reduced working capital and the target out or family run business with (e.g., as a result of a growing numerous day-to-day transactions Shifts risks of GAAP-based liabilities business) with family members or affiliated that arise between signing and closing to buyer Avoids potential for unexpected companies). purchase price increases through Avoids unexpected purchase price • Long sign-to-close period with the closing estimate adjustment reductions through the closing process uncertain projections that makes estimate adjustment process or pricing in seller’s compensation for post-closing true-up Potential to underpay seller for operating the business during the actual profitability between sign interim period challenging. Ability to lock in seller and close based on mechanism compensation for expected agreed at signing • Where the seller is a sponsor, profitability between sign and buyer’s discomfort on relying on a close based on mechanism or Reduces likelihood of costs small escrow as the sole recourse for value agreed at signing associated with post-closing purchase price disputes any leakage discovered post-closing Reduces likelihood of costs (i.e., where a buyer views leakage associated with post-closing risks differently from typical closing purchase price disputes estimate risks). A fund guaranty or similar support beyond an escrow Cons for leakage claims could be offered Seller Buyer by the private equity seller, but most U.S. sponsors are unwilling to Loss of potential for purchase price Requirement to commit to equity increase through natural differences value purchase price (including any offer a fund guaranty in connection between closing working capital debt-like reductions and NWC with an exit transaction as a matter and the target (e.g., as a result of adjustment components) at an of policy. a growing business) earlier phase with potentially more competitive tension and/or less Advantages and Disadvantages Risk of being undercompensated for access to the management team actual profitability between sign of the Locked Box Construct and close based on mechanism Risk of overcompensating seller There are a number of advantages agreed at signing for actual business performance between sign and close based and disadvantages to the locked box Loss of potential for unexpected on mechanism agreed at signing construct, both value and process- (i.e., windfall) purchase price related. The chart below compares increases through the closing Removes potential ability to potential value-related pros and cons estimate adjustment process allocate certain liabilities to seller that may be discovered after of the locked box construct from signing / after closing the perspective of each of the buyer and seller. Assume risks of GAAP-based liabilities that arise between signing and closing

Private Equity Report Quarterly 11 Spring 2021 Locked Boxes in U.S. Practice: An Underused Tool?

Whereas economic advantages of the competitive process where other accuracy early in the process and locked box construct to one party bidders are unwilling to do so. there is the potential that seeking generally correspond to disadvantages bids on a locked box basis may These process-related benefits must to the other party, the process-related complicate comparison of multiple be weighed against the following benefits of the locked box construct bids if some, but not all, bidders disadvantages of utilizing a locked accrue to both parties. These include: submit proposals accepting the box structure: locked box construct. • Avoiding protracted negotiation • Accelerates the need for sufficient over balance sheet definitions, On balance, locked boxes are often balance sheet diligence (and accounting principles, sample thought of as seller-friendly given the potentially full historical NWC balance sheet and certain other greater value certainty they deliver analysis) in advance of reaching an closing account terms. (although sellers risk losing the agreement on price (or forces bidders benefit of the anticipated growth of • In public-company style locked to make offers on price that may the business through closing unless box deals, avoiding the need for be difficult to modify in advance of they capture it in the headline price protracted negotiation relating to a completing due diligence). target net working determination. • Reducing likelihood of costs and There are a number of advantages and disadvantages to the distraction associated with closing locked box construct, both value and process-related. estimates and post-closing true-up process. • Potential need to negotiate a • Reducing likelihood of distractions or otherwise). While there is some mechanism for compensating seller and adversarial discussions truth to that idea, the full picture is for the profitability or operation of associated with post-closing more complex and use of a locked box the company between signing and purchase price disputes. construct may be beneficial to both closing. buyer and seller, given the right set • For sellers, there is the potential • Lack of familiarity with the of facts and circumstances. U.S. M&A to simplify the comparison of construct may create a learning practitioners should add the locked multiple bids (rather than needing curve for parties and their counsel, box mechanism to their tool-kit to understand enterprise-to-equity and may potentially lead to buyer and seriously consider its utilization value bridges based upon contract suspicion in negotiations. where warranted based on the nature markups). of the deal. • For sellers, there is additional • For buyers, a willingness to accept pressure on the locked box date or propose a locked box construct balance sheet presentation and can be a distinguishing factor in a

Private Equity Report Quarterly 12 Spring 2021 Insurance Investments: Key Considerations for Investors in the United States, Europe and Asia Financial sponsors have long been important providers of capital to the For private equity firms, insurance industry, but in recent years, private equity acquisitions of insurance acquiring an insurance businesses have become more common. While this trend has been most company brings both the noticeable in the United States and Europe, it is beginning to take hold in Asia opportunity of reliable as well. Private equity sponsors considering insurance investments in Asia returns on investment and and in emerging markets can look to lessons learned from deal experience in ongoing access to capital. United States and Europe—but need to keep in mind the quirks across different jurisdictions regarding capital, structure and reporting. This article reviews recent trends and compares key considerations for private equity players in insurance investments in the United States, Europe and the APAC region. We consider how recent developments may evolve in Asia present opportunities for PE sponsors looking to extend their asset management expertise to insurance investments in these markets.

Alexander R. Cochran Eric R. Dinallo Insurance Deal Activity and Drivers Partner Partner United States Deal activity by private equity sponsors in the United States insurance market has accelerated significantly over the past five years and financial sponsors and pension funds now appear poised to play a permanent role as active M&A

E. Drew Dutton David Grosgold participants and controllers in the sector. Partner Partner Recent examples of growing private equity involvement in the U.S. insurance sector include Blackstone’s pending acquisition of Allstate Life Insurance Company for $2.8 billion, KKR’s acquisition of Global Atlantic for $4.4 billion, Jackson National’s strategic transaction with Athene Holding Ltd to reinsure $27.6 billion of fixed and fixed index annuity liabilities, ThirdPoint Re’s $788 million merger with Sirius

Eric T. Juergens Marilyn A. Lion Group in Bermuda, and Carlyle Group’s partnership with T&D Holdings to acquire Partner Partner 76 percent of Fortitude Group Holdings from AIG for $1.8 billion. In addition, we’re seeing signs of consolidation in the mutual insurance space with the recently announced sponsored demutualization of Ohio National Mutual Holdings, Inc. by Constellation, an insurance acquisition platform backed by Caisse de dépôt et placement du Québec and Ontario Teachers’ Pension Plan Board.

Edwin Northover Nicholas F. Potter These transactions illustrate how private equity-backed investments and Partner Partner acquisitions in the insurance space can bring experienced investment management capabilities to insurance companies confronted with the challenges of an ongoing low interest rate environment. For private equity investors, these transactions, Private Equity Report Quarterly 13 Spring 2021 Insurance Investments: Key Considerations for Investors in the United States, Europe and Asia

expand their reach across the full solvency regimes come into effect, breadth of the industry—including capital-intensive back books P&C and life insurers. become increasingly difficult to Recent deals include GreyCastle’s service in the low-interest rate sale to Monument Re (which is backed environment and insurers continue Clare Swirski Allison A. Lee International Consultant International Counsel by , among others), Bain to seek ways to move risk off their Capital Credit’s deal to invest in Beat balance sheets. Recent transactions Capital and their acquisition of LV=, include JC Partners’ acquisition of and Lovell Minnick Partners’ take- a controlling stake in KDB Life, the private of Charles Taylor. Additionally, strategic co-insurance partnership last year’s bumper crop of start-ups between Carlyle and Korean Re, Benjamin Lyon Andrew G. Jamieson looking to take advantage of hardening and Resolution Life’s AU $3 billion International Counsel Counsel rates, the “Class of 2020”, saw support acquisition of the Australian and New from private equity players on the Zealand wealth protection and mature equity side and in the form of debt; businesses of AMP Limited. this year’s cohort is expected to Expected Regulatory Control continue the trend. Lloyd’s of London and Disclosure Considerations remains fertile ground for private Sarah Hale Matthew B. Parelman for PE Buyers Associate Associate equity sponsors, and ongoing and planned expense cutting in the market United States particularly in the life insurance space, can only increase Lloyd’s appeal. Insurance M&A transactions bring both the opportunity for a reliable Inigo is being backed by JC Flowers, involving the acquisition of control return on invested capital and access to StonePoint, CDPQ and others; (generally 10 percent or more of the permanent capital provided by an Blackstone and Fairfax took part in Ki’s an insurance company’s voting insurance company with a significant capital raise to support its expansion. securities) will be subject to approval base of assets backing reserves. Asia from the state insurance regulator of the target’s domiciliary state. UK & Europe In contrast to the United States, in Because of increased deal activity, Just as in the United States, the UK the UK and Europe, private equity state insurance regulators have and Europe have seen a noticeable investment in insurers in the Asia become increasingly experienced with increase in the involvement of private Pacific region has been relatively private equity buyers and the complex equity investors in the insurance space limited to date. Some Asian markets structures that they typically present. in recent years. Any auction process present limited opportunity because Regulators are thus examining private involving an insurance company now the industry is still in its early stages, equity structures more thoroughly, typically includes a number of private while other markets are further digging into how control is exercised equity participants as a matter of course. along but still lack the run-off, (including information concerning Private equity sponsors in the consolidation and targets that make ultimate controlling persons), UK and Europe often begin their for scale possibilities and a vibrant proposed affiliate arrangements involvement in the sector with deal environment. Structuring and their impact on the underlying investments in insurance service considerations and uncertain insurance businesses. To fully companies and intermediaries; as regulatory environments can also understand the proposed deal and the industry experience, credentials and hamper activity. business going forward, regulators the relationships with insurance However, the area seems ripe now sometimes seek information regulators deepen, buyers then for change as new region-wide that private equity sponsors have

Private Equity Report Quarterly 14 Spring 2021 Insurance Investments: Key Considerations for Investors in the United States, Europe and Asia

traditionally been reluctant to will generally need regulatory documentation along with detailed provide, including review of limited approval if the transaction involves information and supporting partnership agreements and other the direct or indirect acquisition of 10 documents for the relevant entities. fund documentation, as well as all percent or more of capital or voting Regulators will focus on the buyer’s aspects of investment management or rights (20 percent for intermediaries plans for the target business, including other affiliate arrangements. generally). Therefore, unlike in the proposed changes to In addition, regulators have United States, it is not possible to and dividend plans, management, placed a priority on ensuring that disclaim control or to use non-voting systems and governance, as well as an acquisition by a private equity shares in the transaction to avoid the the details of the expected integration sponsor will not negatively affect approval requirement. Additionally, into the buyer’s group. In particular, an insurance company’s access to parties which do not individually regulators often require confirmation capital sources to back policyholder liabilities. This concern can lead regulators to impose conditions as Private equity sponsors in the UK and Europe often begin their part of the approval of a change of involvement in the sector with investments in insurance service control, including requirements to companies and intermediaries before expanding across the sector. maintain a minimum RBC ratio after closing, restrictions on dividends that can be paid by insurance reach the relevant thresholds can of the acquirer’s commitment and companies without regulatory trigger a filing if they reach the plans to support the target insurer approval for a certain period of time threshold on a combined basis and going forward. Reassurance on this after closing, and restrictions on can be shown to have an explicit point can be usefully provided where affiliate transactions without regard or implicit agreement to exercise the investor has a proven track record to materiality thresholds that might their rights in the same way. Pre- in the industry. While regulators may otherwise exist under insurance law. approvals are also required to increase impose conditions on their approval Given the significant regulatory an existing holding above specified (e.g., additional capital commitments approval process and the heighted thresholds. or dividend restrictions), in our scrutiny of the more complex Regulators will want to understand experience this usually reflects structures of private equity acquirers, any investor’s ultimate beneficial underlying concerns regarding the obtaining approval can take between owner; for private equity buyers, this target business rather than the buyers. six months to a year. Reinsurance can result in some back and forth as the The regulatory review timeline transactions, however, tend to be regulator seeks to map the decision- in the UK and Europe is clearly approved more quickly given the making structure through the fund. delineated, regardless of the type of narrower scope of a reinsurance Given the prevalence of private equity buyer: 60 working days from receipt transaction compared to the investors in the industry, regulators in of a complete filing (subject to “clock- acquisition of an insurance carrier. the UK and Europe are sophisticated stopping” for an additional 20 or 30 in dealing with this type of buyer; to working days, depending on whether UK & Europe ensure a smooth approval process, it is it is a European or non-European In the UK and Europe, proposed critical to explain the holding structure acquirer). Approval can generally be acquirers of insurance companies, clearly and the legal analysis identifying expected within three to four months insurance brokers or other which entities require approval. of the first filing, even where complex intermediaries, as well as certain As in the United States, regulators fund structures are involved. regulated insurance services firms, will want to see transaction-specific

Private Equity Report Quarterly 15 Spring 2021 Insurance Investments: Key Considerations for Investors in the United States, Europe and Asia

Asia experienced successful completion conditions on one or both parties’ In Asia, controller thresholds upon of private equity investment in expected economic benefits to more which insurance M&A requires insurance companies, regulators in specific conditions around dividend regulatory approval varies in each jurisdictions in Southeast Asia are restrictions or capital maintenance and jurisdiction, but can be triggered still largely untested. As such, the support requirements. upon an acquisition of 5% or 10% of presence of a private equity acquiror In addition to increased focus on the voting securities of an insurer. will likely extend the timing required regulatory covenants and conditions, While the meaning of control varies for receipt of approvals. there has also been growing use of somewhat by jurisdiction, regulators complex deal financing solutions, Structuring Considerations in generally focus on ownership with including equity commitments, Insurance M&A the ability to exercise, or control the debt financing, and combinations exercise of, voting power. United States of traditional stock and merger Regulators will typically require The acquisition of insurance companies transactions with reinsurance and disclosure for all entities “up the chain in the United States can take the reserve financing structures. As part of control” and information on the traditional form of the purchase of of the regulatory approval process, general partner including its controlling stock or, if the private equity sponsor the sources of funding for any person, while seeking limited to no has already acquired a licensed acquisition of an insurance company information regarding insurance company, be effected through are closely scrutinized by regulators partners. Group structure charts and bulk reinsurance of blocks of business and greater complexity of a sponsor’s operating agreements are typically to acquire reserves and a larger pool of financing arrangement could increase requested, although the depth and level assets and cash flows. the time needed for regulatory review. of scrutiny varies by jurisdiction and Given the lengthy regulatory UK & Europe may also depend on the identity, track approval process and additional Share acquisitions are common in UK record and market reputation of the scrutiny of private equity buyers in and European insurance transactions, private equity sponsor. the United States, deal negotiations with locked box pricing mechanisms As part of the approval review focus on the crafting of covenants more likely to be used than and process, regulators will focus on and conditions around the obligations completion accounts. Consistent with issues around capital adequacy and to obtain regulatory approval and the effective transfer of economic risk ongoing support and may impose whether regulatory restrictions at signing, pre-closing termination heightened capital standards, capital imposed on an acquirer by insurance rights, including “burdensome support undertakings or dividend regulators may trigger a right to conditions” clauses in purchase restrictions as conditions of approval. terminate an acquisition agreement. agreements, have traditionally been To help ensure stable and long-term Buyers and sellers typically negotiate less prevalent than in the United management, regulators may also the “burdensome conditions” a States. However, as both strategic and subject private equity sponsors to a regulator could impose that would private equity buyers with familiarity minimum lock-in period, enhanced impede the economic benefits of a with U.S. insurance transactions have operational scrutiny or heightened transaction for private equity sponsors. entered the market, termination disclosure requirements. These may be developed by the parties rights have started to become a The views of regulators toward following discussions with insurance point for negotiation, depending on private equity investors vary regulators to better understand the the overall transaction dynamics. across the region. While regulators areas of regulatory focus for a particular A growing trend in private equity in jurisdictions such as Hong transaction. These conditions can range deals in the UK and Europe is the Kong, Singapore, and Korea have from general material adverse effect

Private Equity Report Quarterly 16 Spring 2021 Insurance Investments: Key Considerations for Investors in the United States, Europe and Asia

use of W&I insurance; as well as the should expect to encounter similar for being a controller in more than obvious benefits, a W&I policy can considerations around the parties’ one insurance company or line of allow the parties to short-circuit obligations to obtain regulatory business, as applicable. In some negotiations regarding the scope of approval and what constitutes jurisdictions, a foreign private equity warranties and specific points of risk “unduly burdensome conditions.” fund cannot itself be the controller of allocation. Provided they are brought Depending on the jurisdiction, an insurer, but rather must establish on board at the right time, W&I portfolio transfers can range from a a local presence. In still some other insurers can therefore speed up the relatively streamlined court process jurisdictions, even where there is pre-signing process, which is valuable where policies are automatically no local presence requirement, in in an auction process with a limited novated to a more burdensome practice a local presence may still exclusivity period. process requiring regulatory approval prove to be quite helpful as part of the In the UK and Europe, the transfer of and policyholder communications regulatory approval process. a particular book of business, including that can be held up due to Conclusion in a carve-out, can be accomplished policyholder objections. through portfolio transfers. This In Asia, as a preliminary matter, Given the global nature of the typically occurs through a court process buyers also need to consider a variety insurance business, it is not which has the effect of automatically of other structuring factors, including surprising that there are a number novating policies and reinsurance from foreign ownership limitations (FOL), of themes that are common across the transferor to the transferee without single presence rules and local jurisdictions. As a result, many requiring the consent of each individual presence requirements. In certain concepts and regulatory questions policyholder. Supporting assets and jurisdictions, foreign private equity will be familiar to investors entering employees can also be transferred at funds are prohibited from investing a new region, and deal teams should the same time. Given the number of directly in a local insurer and instead be able to leverage off much of their safeguards to protect policyholders and must structure the acquisition expertise when facing familiar issues the administrative steps involved to through a private equity invested in unfamiliar markets. However, complete the transfer (which vary from financial institution or insurer. given the highly regulated nature of jurisdiction to jurisdiction), this can be FOL rules are often in flux. China these businesses and the diversity a lengthy process taking 12 months removed its 51 percent foreign of regulatory perspective and or longer. To more quickly achieve ownership limitation for insurance sophistication across the world, the the economic effect of transferring companies as of the beginning of devil will continue to be in the details. the business, it is common for parties 2020, and India recently issued draft To learn more about private to enter into an interim reinsurance guidance raising its FOL from 49 equity’s involvement in the insurance arrangement pending completion of percent to 74 percent. Because of this industry, read our recent piece, Private the portfolio transfer. dynamic regulatory environment, Equity and the Insurance Industry: A anyone doing insurance deals in Asia Close Look at a Natural Partnership. countries with FOL rules (other than As in other regions, insurance M&A To hear a discussion of the topics in insurers grandfathered under old in Asia can also be structured through this article by some of the leaders regimes) will likely need to partner a variety of forms, whether through of our global insurance and private with a local entity. share acquisitions or transfers of equity teams, an on-demand webinar With respect to single presence particular books of business through recording is available here: Global rules, any current holdings must portfolio transfers. Both locked Private Equity Insurance Wave: be reviewed to ensure the investor box and completion accounts are Recent Trends and Outlook. does not run afoul of limitations used in share acquisitions; buyers

Private Equity Report Quarterly 17 Spring 2021 Portability in Debt Financing Agreements: A Helpful Tool for Private Equity Sponsors

Introduction When an active M&A market occurs alongside a sub-par As disruptive as the COVID-19 pandemic has been to the economy, its effects financing market, a company have not been evenly distributed. Financing markets, for example, continued with portability in its debt to flourish. U.S. high-yield issuance had a blockbuster year in 2020, with financing could become a volume increasing 60 percent from 2019 to $435 billion, according to LCD. more attractive target. The M&A market, on the other hand, was slower to rebound. While 2020 deal volumes fell 6 percent to $3.5 trillion, according to Bloomberg, $1.3 trillion of that amount signed in Q4 2020, and Q1 2021’s $1.1 trillion in deals represented the best start to a year since at least 1998. This temporary dislocation between the financing and M&A markets had a particular impact on private equity sponsors that had planned to exit portfolio company investments during 2020 and in some cases led to those plans being delayed. At the same time, however, sponsors and companies took advantage of open Scott B. Selinger Brett M. Novick financing markets to extend maturity profiles. These financings can serve as a Partner Associate bridge to a future exit while re-levering a business and returning capital to equity holders. Despite those immediate benefits, sponsors and companies need to take care that the new financing does not impede a successful exit once M&A markets have fully returned, such as by incurring debt with expensive call protection. Portability provisions play an important role in mitigating that risk.

The Role of Portability An acquisition of a target company may constitute a “change of control” under its financing agreements, which usually either triggers an event of default or gives the lenders a put right for the target company to repurchase this debt. In either case, a buyer would need to allocate funds as of signing (whether in the form of committed financing or available working capital) to backstop or replace this existing debt. Instead, portability provisions allow, under certain conditions, for the buyer to step into the seller’s shoes in the target’s financing agreements, leaving the target company’s debt capital structure intact post-closing. Including portability provisions in debt agreements brings sponsors three main benefits. First, portability features provide a sponsor with the ability to initiate a sale when difficult financing market conditions might impede prospective buyers from raising debt financing. Indeed, when an active M&A market occurs alongside a sub-par financing market, a company that previously obtained debt financing with portability features could become a

Private Equity Report 18 Fall 2019 Portability in Debt Financing Agreements: A Helpful Tool for Private Equity Sponsors

more attractive acquisition target, the seller’s debt in an acquisition. Third, the buyer must meet certain since the buyer will inherit a debt These conditions are designed to individual criteria. Financial sponsors capital structure that is likely better provide comfort to the lenders typically must have a minimum than what the market would provide. regarding both the company’s health amount of committed capital or Second, portability features allow for and the buyer’s reputation as an (usually a sponsor to pursue debt financing equity investor. $1 billion). Similar to the minimum transactions based on strategy and First, the company must satisfy a equity test, this provides lenders opportunity, without having to worry leverage ratio requirement. This is further comfort that the buyer is a about how the buyer’s ability to often a total leverage ratio test; there reputable actor with a track record of replace the debt might affect a future may also be a separate leverage ratio substantial assets under management sale. Third, portability provisions test for secured debt. The leverage which can be provided as future equity can lead to fewer transaction costs ratios tend to be set using the leverage capital to the company if necessary. overall, since a buyer will not have levels as of the financing closing Some debt agreements also allow for to pay commitment and other fees date, although sometimes there is a a strategic company to be the buyer (including the portfolio company of another sponsor), in which case As M&A markets return, portability provisions play an important there may be a requirement for role in mitigating the risk that new financing does not impede a this company to be in the same successful exit. or related business. Additionally, some debt agreements allow for a for the new debt financing (which slight cushion added or a rounding SPAC to be the buyer, so long as any are usually more expensive than upwards. These leverage ratio tests controlling shareholder would have fees for a best efforts refinancing) assure lenders that the amount of the been a permitted if and the sponsor seller will not have company’s debt is in-line with lenders’ acquiring the company directly. to “pay” prepayment penalties or original credit determination. Fourth, the company must provide other breakage costs to refinance Second, the buyer must provide lenders with the identity of the the company’s existing debt (which sufficient equity financing to meet buyer, and subsequently provide any are often allocated as a deduct to a pro forma equity-to-capitalization relevant “KYC” information requested the closing purchase price paid to a test, typically 30 percent. This by the lenders within a certain period sponsor seller). Assuming a buyer demonstrates to the lenders the buyer prior to the closing date. prices in these lower transaction costs has sufficient “skin in the game” Finally, the sale transaction as part of the deal, the sponsor seller so that the incentives of the buyer must occur within a certain period can negotiate to receive the benefit and lenders are aligned. Note if the of time following the financing of these amounts in the form of purchase price paid to the seller is closing, typically two years. This additional purchase price. not enough to satisfy the minimum represents a sufficiently long period equity requirement, the buyer may for the company’s equity owners The Five Customary need to fund additional equity to the to arrange a sale process, while also Portability Conditions company’s balance sheet (which can acknowledging that investment Portability provisions customarily also be used to prepay a portion of the considerations (and company include five conditions that must be company’s debt, to further increase performance) may deviate following satisfied so that the buyer can assume the equity capitalization percentage). that time.

Private Equity Report Quarterly 19 Spring 2021 Portability in Debt Financing Agreements: A Helpful Tool for Private Equity Sponsors

Considerations When to close due to a third party (in this the balance sheet at closing, sponsors Negotiating Portability case, a rating agency providing an should also include a rule that these Provisions adverse rating or ratings indication). calculations made at signing can be Second, make clear that certain prepared based on estimated working There are two considerations conditions can be satisfied at capital and balance sheet items. sponsors should prioritize in signing using the “limited condition negotiating portability provisions to Risk Allocation in transaction” (LCT) technology already help minimize risk factors that can common in debt agreements.1 In Purchase Agreements occur between closing on the debt particular for financial conditions, LCT Another set of considerations for and closing on a deal. technology provides certainty at signing sponsors is how the risk of failing to First, avoid including conditions that the calculations are satisfied based satisfy the portability provisions is that are not fully within the control on the agreed debt and equity inputs, allocated between the buyer and the of a buyer and seller. For example, and ensures that any potential change in seller in the purchase agreement. The some debt agreements include a components of the calculation between following chart summarizes various portability condition that rating signing and closing (such as a decrease risks for each of the five portability agencies confirm that the company’s in EBITDA) would not prevent the conditions and how they might credit ratings meet certain agreed condition from being satisfied at closing. be apportioned. Note that the risk levels (often the rating given at the A related consideration is the role cash allocation may be affected by a buyer’s time of the financing). This type of plays in leverage ratio calculations. planned capital structure. condition introduces incremental risk Given that calculations made at signing that the acquisition may not be able will be based on estimated cash on

Condition Responsibility Notes Leverage Ratio Condition Typically, Seller. Seller may be in a better position to satisfy this condition, since it can If Buyer is contemplating incurring provide both the debt and EBITDA any additional debt, Buyer may be in inputs at signing. a better position to be responsible for the maximum incremental debt If Buyer is incurring additional debt, input. Buyer may be in a better position to be responsible for confirming the pro forma debt levels to be used for any ratio calculations.

If a debt agreement does not provide for this condition to be satisfied at signing using LCT technology, there is additional risk that this condition may not be satisfied at closing if the company’s EBITDA decreases between signing and closing.

1. For further information on limited condition transaction technology, see SunGard 2.0, The Private Equity Report, Winter 2014, Vol. 14, Number 1, https://privateequityreport.debevoise.com/the-private-equity-report-winter-2014-vol-14-number-1/-20.

Private Equity Report Quarterly 20 Spring 2021 Portability in Debt Financing Agreements: A Helpful Tool for Private Equity Sponsors

Condition Responsibility Notes Minimum Equity Seller may be in a better position to Seller may be in a better position to Capitalization Condition be responsible for the debt input. provide the debt component, while Buyer may be in a better position to Buyer may be in a better position provide the equity component. to be responsible for the minimum equity input, and if Buyer is If Buyer is incurring additional debt, contemplating incurring any Buyer may be in a better position to additional debt, the maximum satisfy this condition by confirming incremental debt input. both the pro forma debt and equity metrics.

If a debt agreement does not provide for this condition to be satisfied at signing using LCT technology, Buyer’s equity contribution may be affected if debt levels change between signing and closing. In particular, if debt levels increase between signing and closing (e.g., due to working capital draws under the company’s revolver), Buyer may need to put in additional equity beyond what is required in the acquisition to fund the purchase price in order to satisfy this condition.

Buyer Identity Condition Buyer. (e.g., minimum AUM)

Sanctions/KYC Condition Buyer primarily responsible. Buyer should want cooperation from Seller on KYC requests within its Seller responsible to the extent control (e.g., new beneficial ownership within its control. form is based on Buyer ownership but signed by target). Otherwise, Buyer Seller responsible for providing the may be in a better position to satisfy identity of the buyer. this condition since the sanctions/KYC requirements are specific to Buyer.

Timing Condition Seller.

Conclusion the pandemic ends. To be sure, that portability features will be portability may not be necessary for closely considered in connection with While the turbulence of the past sponsors to include in all financing future dividend or year has lead to a rising number of transactions, such as new LBO refinancing transactions in advance of financings that include portability financings or for investments with the sponsor’s eventual exit. features, we expect the use of longer holding periods. For astute portability to continue even after sponsors, however, we anticipate

Private Equity Report Quarterly 21 Spring 2021 The End of Leveraged Buy Outs As We Know Them? Hardly. Public company directors decide, but federal judges rule, and a federal court While the decision—In re ruling has raised the specter of directors being less willing to sell to private Nine West LBO Securities equity firms because of the risk that they would face personal liability for Litigation—was only a that decision. preliminary ruling and not On Dec. 4, 2020, Judge Jed S. Rakoff, of the U.S. District Court for the Southern a decision on the merits, District of New York, in a decision applying Pennsylvania law, declined to it has been described as a dismiss breach of fiduciary duty claims against the board of directors of the potential “game stopper for Jones Group Inc. in connection with the April 2014 take-private acquisition the private equity business” of the company by Sycamore Partners. and a “sobering punctuation mark to a sobering year.” While the decision—In re Nine West LBO Securities Litigation—was only a preliminary ruling and not a decision on the merits, it has been described as a potential “game stopper for the private equity business” and a “sobering punctuation mark to a sobering year.” For the reasons noted below, I think that significantly overstates the matter. The sky is not falling and LBOs are not dead.

The Transaction Gregory V. Gooding Partner The Nine West transaction involved a leveraged buy-out of Jones Group and the simultaneous spin-out of certain of the company’s business lines to an affiliate of Sycamore in 2014. The merger agreement provided that the following actions would take place “substantially concurrently” at closing: (i) the merger and cash out of the Jones Group public shareholders; (ii) a $395 million equity contribution by Sycamore and the borrowing by the surviving company of any additional $200 million of debt (on top of $1 billion of existing debt that would remain outstanding); and (iii) the transfer of a number of key assets by the surviving company to another Sycamore subsidiary for cash (the carve-out). Between signing and closing, the equity contribution was reduced to $120 million and the new debt was increased to $550 million, apparently without any objection from Jones Group. Although the merger agreement contemplated the new debt and the carve-out, and contained customary provisions requiring Jones Group to assist Sycamore in planning for and effecting those transactions prior to closing, the board’s approval of the merger agreement “purported to exclude the additional debt and the carve-out transactions.”

Private Equity Report Quarterly 22 Spring 2021 The End of Leveraged Buy Outs as We Know Them? Hardly

The Claims the solvency of the company after company’s shareholders, can certainly giving effect to the additional debt be debated. The entity resulting from the merger and the carve-out, since these steps But the real takeaway from the and carve-out (now named Nine were effected after they ceased to be decision is the usual one: Process West) went bankrupt in April 2018, directors (albeit only a moment after matters. The typical steps that we four years following the merger. After and pursuant to the terms of a merger would advise a target company to the bankruptcy, a litigation trust agreement which they had approved). take in this situation—including established for the benefit of certain The court disagreed, treating reviewing and understanding the creditors of Nine West brought breach the “substantially concurrent” terms of the buyer’s financing of fiduciary duty claims against the transactions effected at closing as “a commitments, obtaining a solvency former Jones Group directors. single integrated plan.” representation from the buyer in The director defendants moved to As goes the business judgment the acquisition agreement, and dismiss these claims on the grounds rule, so goes exculpation, at least in confirming with management that that their approval of the 2014 this case. Under Pennsylvania law, a they expect to be able to deliver any transaction was protected by the company cannot exculpate directors solvency certificates required at business judgment rule and that they for “self-dealing, willful misconduct, closing—would likely have protected could not in any case be held liable for or recklessness.” the directors here. That is, had the damages in light of the exculpatory directors not—by taking the position provisions contained in the Jones The Decision that the debt level and carve-out Group by-laws. The District Court declined to terms were not their concern— The Law dismiss the plaintiff’s claim that the arguably put themselves in a position directors were reckless, and thus not where they could not claim reliance Under the Pennsylvania business entitled to exculpation. In doing so, on these steps. judgment rule, a decision made in the the court emphasized the “conscious What didn’t protect the directors context of a merger that is approved disregard” by the directors of whether was taking the position that they need by a majority of disinterested the additional debt and carve-out only consider the merger itself, and directors is protected, “unless it is would render the company insolvent. that they could ignore those elements proven that the disinterested directors The court also noted a variety of of the overall transaction that did not assent to such act in good red flags that “should have alerted were necessary components to the faith after reasonable investigation.” the director defendants [of the need merger, contemplated by the merger The court found that the directors to] investigate the [post-carve-out agreement, and facilitated by actions were disinterested, but that they surviving company’s] insolvency.” the company was required to take, but couldn’t rely on the business that notionally took place a moment judgment rule because they “made The Lesson after (but substantially concurrent no investigation whatsoever” into The directors may ultimately prevail with) the completion of the merger. the additional debt incurrence and on the merits, if the case isn’t settled Directors can rely only on advice the carve-out and, in fact, “expressly before then. And certain elements of that they seek. The business judgment disclaimed any evaluation of whether Judge Rakoff’s opinion, including its rule presupposes that directors have [these] components of the transaction failure to grapple with the potential in fact made a business judgment. would be fair to the Company.” conflict between the duties of the LBOs will survive. The directors asserted that they directors to the company and to the had no obligation to investigate

Private Equity Report Quarterly 23 Spring 2021 ESG Outlook for Private Equity Sponsors

Despite its limitations in I. INTRODUCTION reach, the Non-Financial Reporting Directive The COVID-19 pandemic has put a spotlight on the vulnerability of the modern successfully introduced ESG economic system to non-financial risks. The incorporation of environmental, reporting requirements to social and governance (“ESG”) factors in investment decisions is an important the market. acknowledgment of many of those risks, and in some cases, goes a step further by aiming to achieve certain ESG goals when making investments. While ESG concepts have been gaining momentum for almost two decades, the pandemic, coupled with growing concerns around climate change, has elevated their importance. This article discusses the evolution of ESG investing, provides an overview of the current regulatory landscape in Europe and the UK, and examines the potential effects of ESG developments on private equity sponsors in the short, medium and long term.

Geoffrey Burgess Samantha Rowe The Rise of ESG in Mainstream Private Equity Partner Partner Increased investor appetite is the clearest indication that ESG has now hit the mainstream. In 2006, the United Nations Principles for Responsible Investment (“UN PRI”) was formed, and by the end of 2020, the network had garnered more than 3,000 signatories representing over $110 trillion of assets under management (“AUM”). More UN PRI signatories naturally means more Patricia Volhard Jin-Hyuk Jang AUM reflecting ESG considerations: the past five years have seen a 30 percent Partner International Counsel year-on-year increase in ESG assets and ESG selection strategies, representing 45 percent of total European AUM at the end of 2019. Funds and portfolio companies have embraced ESG as well; Larry Fink, BlackRock’s CEO, noted in his 2021 letter that there has been a systemic shift on this issue, given the evidence that companies with strong ESG profiles

Andrew Burnett outperform those without. Trainee Associate In addition to the growing acceptance of ESG by investors and sponsors, the pandemic has broadened the ESG remit beyond primarily climate-related concerns to fully encompass the broader range of environmental, social and governance matters. This shift is underscored by EU-led regulatory developments.

II. THE DEVELOPMENT OF REGULATORY REQUIREMENTS

The European Union Before 2014, the EU preferred soft-law options for wholesale ESG reporting, such as promoting the UN Global Compact and the UN PRI. That year, however, the EU took a decidedly harder line with the introduction of Directive 2014/95/ EU (the Non-Financial Reporting Directive, or “NFRD”), which amended the Accounting Directive 2013/34/EU. The amendments required certain large

Private Equity Report Quarterly 24 Spring 2021 ESG Outlook for Private Equity Sponsors

undertakings and groups to disclose how its own green finance strategy January 1, 2022. It requires financial information on policies, risks and will depart from the EU’s Action Plan. market participants and financial outcomes regarding environmental In November 2020, Rishi Sunak, the advisers—including most private matters, social responsibility, human Chancellor of the Exchequer, laid equity fund managers in the EU, as rights, anticorruption issues and the out the UK’s roadmap to developing well as non-EU managers marketing diversity of corporate boards. While and implementing environmental in the EU under national private radical in the scope of the disclosures it disclosure standards that are more placement regimes—to disclose how required, the NFRD was conservative robust than the EU’s Disclosure ESG risks are incorporated into their in reach, affecting only around 6,000 Regulation. The UK will require investment decision-making process companies across the EU. Despite that mandatory disclosures in line with the and whether (or, for larger firms, how) limitation, however, the amendments Task Force on Climate related Financial they consider the principal adverse had a significant impact by introducing Disclosures (“TCFD”) by 2025, going impacts of investment decisions on concrete ESG reporting requirements beyond the Disclosure Regulation’s sustainability factors. Products that to the market. The response was “comply or explain” approach. This specifically promote environmental positive—not surprising, given that alignment has already begun its phase or social characteristics and products the global financial crisis, still fresh in, with premium listed commercial with sustainable investments as their in everyone’s mind, had provided a companies now required to provide objective are subject to further special stark reminder of the importance of disclosures in their annual reports pre-contractual and ongoing disclosures non-financial considerations in risk consistent with the TCFD. Sunak also regarding the sustainability indicators management. stated in the announcement that the used to monitor performance against ESG momentum was strengthened UK will review the EU Taxonomy’s their objectives. by the 2015 Paris Agreement and thresholds and metrics and adapt them The Disclosure Regulation will be 2030 Sustainable Development Goals, as needed for the UK market. complemented by the Taxonomy which prompted the announcement Regulation, which will introduce of the EU’s Action Plan on Sustainable III. WHAT DOES THE uniform technical screening criteria Finance. The Action Plan, which was FUTURE ESG REGULATORY to determine whether and to what developed to reorient capital flows LANDSCAPE LOOK LIKE? extent an economic activity qualifies toward a more sustainable economy, as environmentally sustainable. The We expect the ESG regulatory included three headline regulations: the Taxonomy Regulation’s two climate landscape to develop rapidly as we Low Carbon Benchmark Regulation,1 change objectives are scheduled approach the 2030 SDG deadline. the Disclosure Regulation2 and the to become effective on January Below we set out our expectations for Taxonomy Regulation.3 Importantly, 1, 2022, with the remaining four the next twelve months, the next three these regulations cast a wide net, environmental objectives taking years and up to the SDG 2030 deadline. applying to (among others) anyone effect on January 1, 2023. marketing or managing funds in the EU. Short term – twelve months In addition, existing regulations like the AIFMD will be revised to further The United Kingdom • The EU Will Progress the Action Plan incorporate ESG factors. Fund managers With the Brexit transition period Currently, the Disclosure Regulation will soon be required to introduce having ended on January 1, 2021, the is partially in effect, with relevant procedures to address ESG risks; in United Kingdom has begun to define Level II requirements anticipated on

1. Regulation (EU) 2019/2089 2. Regulation (EU) 2019/2088 3. Regulation (EU) 2020/852

Private Equity Report Quarterly 25 Spring 2021 ESG Outlook for Private Equity Sponsors

particular, sustainability risks will need growing consciousness of stakeholder World Bank and OECD all noting to be taken into account in the fund capitalism, we expect further climate that the pandemic has deepened the manager’s risk management policy. commitments from governments and economic divide. With increasing consequently further climate-related investor acceptance of stakeholder • The EU Will Introduce Broader regulations affecting the private sector. capitalism and disclosure obligations Supply Chain Disclosures mandating greater corporate The European Commission has Medium term – three years transparency, corporates and private announced its intention to introduce • Addressing the Biodiversity Crisis equity sponsors alike will be expected far-reaching supply chain due diligence Since the inception of ESG, the “E” to play not just an economic but a legislation by this July; in anticipation, has been synonymous with climate- social role in the global recovery. the European Parliament recently focused investing. However, there is a Of particular importance to this passed a far-reaching Draft Directive growing awareness that this approach dialogue is the social taxonomy on Corporate Due Diligence and needs to be broadened. In September currently being developed by the Corporate Accountability (“Draft 2020, the World Wildlife Federation European Platform on Sustainable CDDCA Directive”). The Draft CDDCA reported that wildlife populations Finance (“EPSF”), which will seek to Directive covers large undertakings have fallen by more than two-thirds foster more equitable employment and high-risk small- and medium-sized in less than half a century; further, and safe working conditions by undertakings, both within and outside $44 trillion of economic activity— promoting investment in education, the EU, that “operate in the internal more than half of global GDP—is at health and housing. However, the market selling goods or providing least moderately dependent on nature. EPSF’s social taxonomy may well services.” Those companies are required The UK Treasury’s Dasgupta Report, engender considerable debate and to consider whether their operations published in February this year, built take longer to come to fruition than and business relationships cause adverse on these conclusions, noting that the its environmental counterpart. sustainability impacts; wherever loss of natural capital lowers crop adverse impacts are found, companies • Public and Private Environmental yields, weakens supply chains and must address them. Companies must Litigation exacerbates natural disasters. The also build such considerations into There are currently 22 cases before revelatory findings of these reports their contractual relationships, codes courts around the globe invoking will likely be discussed at the UN’s of conduct and audits. The Draft obligations under the Paris Agreement, Biodiversity Conference (CDB COP CDDCA Directive is at an early stage of and many more focused on climate 15) taking place in Kunming, China, development, but its breadth and scope change more broadly. The highest- later this year. With the EU and is notable. profile decisions so far have been against UK both considering biodiversity- governments accused of not meeting • COP 26 Will Prompt Further Private related disclosures in the coming their international obligations, most Sector Regulation years, biodiversity will become an notably the Dutch Supreme Court’s The 2015 Paris Agreement committed increasingly important aspect of the 2019 decision in Urgenda Foundation signatory states to limiting global ESG landscape. v Netherlands. In that case, the court temperature increases to “well below” • Social Considerations to Stay held that the Dutch government had 2 degrees Celsius. Since then, the on the Agenda acted negligently when setting a CO2 policies of individual governments The COVID-19 pandemic brought target which did not align with the Paris have fallen short of that goal. Given to the fore the problem of economic Agreement. Such judgments will force that the pandemic has pushed back inequality and elevated its place on governments to address any deficiencies the date of the 2021 UN Climate the regulatory agenda, with the IMF, in regulatory regimes that do not align Change Conference (COP 26), and the

Private Equity Report Quarterly 26 Spring 2021 ESG Outlook for Private Equity Sponsors

with increasingly stringent international climate litigation discussed above, courts the global financial markets, more environmental commitments, affecting will also be faced with the question of attention will be paid to its still- private sector targets and allowances. the extent to which fiduciaries must nascent ESG regulatory environment. More ESG regulation will take ESG considerations into account However, the World Economic Forum invariably increase the number when making investment decisions. As has observed that China is at a tipping of claims brought against private mandatory ESG disclosure obligations point in terms of environmental companies. An early example arose increase, so too will alleged breaches of commitments, noting its ambition in January 2020, when 14 French commitments to align with a particular to reach peak carbon before 2030 and local authorities and five French sustainability benchmark. Courts will carbon neutrality by 2060. NGOs brought a claim against Total under the French Vigilance Law, Governments will be forced to address any deficiencies in claiming that Total had failed to regulatory regimes that do not align with increasingly stringent identify and take appropriate steps international environmental commitments. to mitigate climate risks and that the company’s vigilance plan “does not ensure that the Total group aligns have to decide questions of compliance IV. CONCLUSION with a trajectory compatible with the with, and perhaps more importantly, objectives of the Paris Agreement.” the accuracy of, non-financial reporting, Regulatory developments and whether mandatory or voluntary. international commitments in Long Term – 2030 Courts must also determine the limit Europe, the United States and • The SDG Commitments of corporate separateness and the elsewhere reflect the permanent place Become Reality circumstances in which the “corporate ESG has achieved in the economic Many investors are aligning their veil” can be pierced. landscape. Private equity sponsors portfolios with the UN Sustainable should keep abreast of this fast- • A Global Reach Development Goals, comprising moving regulatory environment. 17 goals and 169 targets addressing While the EU has so far taken the For more Debevoise insights in economic, social and environmental lead in ESG regulation, governments the ESG space, visit the firm’s ESG development. Such alignment is a elsewhere are crafting their own Resource Center here. good indicator of the direction of approaches. In the United States, portfolio risk mitigation. However, the Securities and Exchange given the economic and social impact Commission has made a number of the pandemic, achieving all of the of announcements reflecting the SDGs by 2030 will prove difficult. Fund worldview of the new administration. managers should be conscious of the Most notable is the SEC’s 2021 wording they use when committing to Priorities, which set forth a new align their portfolios with the SDGs, approach to climate change and other being careful not to overcommit to ESG considerations. There is no doubt macroeconomic targets which are the SEC’s ESG disclosure regime will outside of their control. be influential, but it is unlikely to undermine the EU’s current position • Broader ESG Litigation as the global ESG standard setter. ESG litigation is likely to grow on Similarly, as China becomes an multiple fronts. Alongside the general increasingly important player in

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Private Equity Report Quarterly 28 Spring 2021