PE PULSE AUSTRALIAN PRIVATE EQUITY & VENTURE CAPITAL 2018

In this issue 01 W elcome to the PE Pulse

02 A n overview of private equity in 2018

04 VC tech trends in 2018

06 Take-private transactions – Key considerations for a Private Equity bidder

10 L everaged finance

12 P E & VC tax developments

14 W&I insurance

ISSUE 1 SPRING 2018

HERBERT SMITH FREEHILLS PE PULSE: PRIVATE EQUITY & VENTURE CAPITAL 2018 01

Welcome

Welcome to the first edition of the PE Pulse. LAW FIRM OF THE YEAR LAWYERS WEEKLY AUSTRALIAN LAW AWARDS 2018 In this edition we cover: COMMERCIAL TEAM ••Key themes in Private Equity in the year to date OF THE YEAR LAWYERS WEEKLY AUSTRALIAN ••Tech trends LAW AWARDS 2018

••Insights on take-private transactions LAW FIRM OF THE YEAR (>500 EMPLOYEES) AUSTRALASIAN LAW ••Leveraged finance

PRIVATE EQUITY • • Tax developments in Private Equity & Venture Capital LAW FIRM OF THE YEAR – AUSTRALIA – BEST LAWYERS AWARDS 2018 ••Transaction insurance BAND 1, PRIVATE EQUITY – AUSTRALIA – Should you have any questions in relation to the PE Pulse, CHAMBERS ASIA PACIFIC 2012-2018 please contact our Private Equity team.

All the best,

The Herbert Smith Freehills Australian Private Equity Team

Leaders in Private Equity – Market Recognition

2017 AUSTRALIA & NEW ZEALAND 2017 AUSTRALIA & NEW ZEALAND PRIVATE EQUITY ANNOUNCED BY PRIVATE EQUITY ANNOUNCED BY DEAL VALUE DEAL COUNT

HerbertSmithFreehills HerbertSmithFreehills

Allens GilbertTobin

Allen&OveryLLP King&WoodMallesons

Ashurst MinterEllison

GilbertTobin Allens

BakerMcKenzie Ashurst

King&WoodMallesons Allen&OveryLLP

Bowmans ThomsonGeer

MinterEllison TalbotSayerLawyers

SimpsonGrierson SourceMergermarket BellGully SourceMergermarket

           Value(AUD m) Numberofdeals 02 PE PULSE: PRIVATE EQUITY & VENTURE CAPITAL 2018 HERBERT SMITH FREEHILLS

PRIVATE EQUITY: An overview of private equity in 2018

At the end of 2017, the Australian private equity industry was sitting on record levels of dry powder. This, along with positive market conditions for funding, bolstered activity in early 2018, with strong buy-side activity by private equity players across a variety of sectors. The market has trended towards large value deals. Below we explore the state of the private equity market in 2018 in more detail, and set out our predictions for 2019.

Sector overview Deal value and volume From top So far in 2018, sponsor activity has been Published deal values for 2018 so far indicate Clayton James Partner spread across a diverse range of sectors, a continuation of the tendency for larger value Candice Heggelund alongside the continued trend for lower deal deals that are published in the market. The Senior Associate volumes and larger value investments. Preqin sale of I-MED Network Ltd, the sale of data for 2018 reveals that the food and Accolade Wines Limited and the sale of The agriculture sector has attracted the most Real Petfood Company took out the top 3 investment. This is unsurprising given the recorded deal values, proving that healthcare continued growth in demand worldwide for and food & agriculture continue to attract not quality Australian food and produce. only high levels of interest amongst sponsors, but also high value transactions. The number Other sectors attracting sponsor interest this of recorded deals by Preqin for 2018 at this year include consumer products and services, point indicates a lower total deal volume with a particular focus on education, compared to 2016 and 2017, however we healthcare, industrials and information predict that this may change as more deals technology. These sectors have seen fairly are announced and recorded in the final four consistent levels of activity over the past 3 months of 2018. years and their continued prevalence is not surprising. However, the marked lack of activity in the business services sector is surprising. Pegged as a potential growth sector by many commentators, the sector has been remarkably quiet with no deals recorded SECTOR OVERVIEW by Preqin in this sector for 2018. Technology, media and telecommunications was also highlighted as a growth sector to watch for 2018, but so far this has not proved true, with Consumer deal volume remaining fairly constant. This is perhaps a reflection of the blurring of the lines Food/Agriculture between traditional information technology Healthcare sectors and increasing incorporation of Industrials technology into businesses that are more IT often categorised in other sectors. A third notable absence is the lack of investment in Materials the materials, energy and utilities sectors. Clean technology HERBERT SMITH FREEHILLS PE PULSE: PRIVATE EQUITY & VENTURE CAPITAL 2018 03

Public to private sitting across Private Equity and Venture Following on the back of this trend, please Capital funds is estimated to be at least $7 see the article on page 6 which considers One of the more notable trends to have billion. This has created competition for the key considerations for a private equity emerged in 2018 is the significant increase quality assets in the unlisted space. These bidder in a public to private transaction. in public to private transactions. The underlying drivers suggest the increase in acquisition of Pepper Group by KKR in late public to private transactions will continue 2017 started something of a resurgence in as larger domestic and global sponsors this space with Connect 4 reporting 12 look for opportunities in the listed space to public to private transactions being negotiate bilateral deals (and not only announced so far this year. This is almost participate in competitive auctions). triple the amount of announced public to private deals in the 2017 calendar year, and 12 we have only just passed the halfway point NUMBER OF PUBLIC TO 10 of 2018, with the potential for the PRIVATE TRANSACTIONS announcement of additional deals by the 8 end of the year. 6 The factors driving this increase can be traced back to record levels of fundraising 4 in recent years, leading to unprecedented 2 levels of capital becoming available to sponsors. The amount of dry powder 0 2014 2015 2016 2017 2018

PREDICTIONS FOR 2019

••Financial services as a sector to watch

••Public to private transactions will continue to be pursued, along with the use of warranty and indemnity insurance in public deals

••Longer hold periods can be expected as sponsors seek to drive stakeholder value through long term strategies 04 PE PULSE: PRIVATE EQUITY & VENTURE CAPITAL 2018 HERBERT SMITH FREEHILLS

Venture Capital: Tech trends in 2018 HERBERT SMITH FREEHILLS PE PULSE: PRIVATE EQUITY & VENTURE CAPITAL 2018 05

Overview: Increasing fund flows In terms of underlining deal economics, to venture capital market practice is moving towards an investment taking the form of a 1x In June this year, the Economist noted that non-participating preferred instrument, the flow of European venture capital had hit coupled with a weighted anti-dilution its highest level for a decade. According to protection. Essentially, latest money comes the Trade Association InvestEurope of the back first with the investor retaining the ability €6.4 billion in venture investments in 2017, to convert its stake to ordinary shares to sell 45% went to information and communication as part as an exit but maintaining downside start-ups and 23% to biotech and healthcare. protection (the preferred position) in the There are similar stories in America, Asia and event that the proceeds available on a liquidity the emerging markets of Africa and the transaction are not sufficient to pay out all Americas. In Australia, AVCAL has reported equity claims. The anti-dilution protection is that in 2017 venture capital fund raisings designed to adjust the conversion in the event surged to a record level of $1.32 billion. 19 VC that a venture investor invests at a particular funds completed successful fundraisings with valuation, and a subsequent capital raising is superannuation funds increasing their undertaken at a lower valuation. appetite for exposure to the venture market accounting for 32% ($421 million) of the In the circumstance where the venture aggregate funds raised (Australian Private investor does not control the equity (nor the Equity & Venture Capital Association Limited board), board appointment rights are 2017 Yearbook). significant (and it is critical for a venture investor to obtain at least one board seat so It is likely to be the case that capital as to ensure a flow of information and an From top continues to flow to emerging industries, involvement in the board room), coupled with Peter Dunne and to venture investments. In an Australian a detailed list of veto items to ensure that the Partner context the largest share of investments business is conducted in accordance with the Claire Bamford went to the ICT sector including an increase parameters on which the investor invested. Solicitor in funding from overseas based venture As there is no positive control for the venture funds. By way of example Deputy, a cloud investor, composition of the board and due based workforce management tool that diligence on the founder/management team allows users to manage scheduling, assumes a much higher importance. timesheets, tasking and other employee KEY TRANSACTIONS communications closed a $33.2 million While venture governance documents will Series A funding from Boston based include a drag along mechanism consistent Herbert Smith Freehills advised: OpenView Venture Partners in December with that contained in private equity deals, Atlassian on its US$60 million 2017. Healthcare and life science assets the liquidity provisions are triggered by the followed closely behind accounting for 33% Series A fundraising round from shareholder majority (the definition of this is Accel Partners. of all venture investments in the Australian negotiated on a deal by deal basis but it is marketplace (Australian Private Equity rare that this means the venture investor on Campaign Monitor, an Capital Association Limited 2017 Yearbook). its own). For this reason there needs to be a Australian email marketing conversation at the outset around proposed software company on its Venture Capital transactions: exit horizons, coupled with the venture US$400 million Series A Snapshot of deal terms investor having the right to sell its stake (and capital raising. While there are some similarities between the company providing all assistance required An investor in Zoox, a private equity transactions and venture for such sale to occur) in the event that an robotics company pioneering capital investments, traditionally venture exit has not been achieved within a particular autonomous mobility on its capital involves the financial investor time period. A$650 million Series A acquiring a non-controlling stake. As such, capital raising. there are a number of areas to a venture Herbert Smith Freehills has been privileged to Tyro Payments on its A$100 transaction that are different to a more have acted on some of Australia’s largest and million expansion capital raising. most successful technology capital raisings traditional private equity transaction. The Deputy on its US$25 million including Atlassian, Campaign Monitor, main areas that are covered as part of a Series A capital raising from Deputy, Nura, Social Garden, Cognitive venture investment (whether in Series Seed, US based OpenView Venture Platforms, Buckitdream, Docta, Canva, Series A, Series B or beyond) fall under three Partners. main categories: Culture Amp, Instaclustr, Predict HQ, Identitii, Tyro Payments, OzForex, 99designs, SafetyCulture on its A$30 million Series B capital raising. ••Priority of capital; Cloud9, PageUp People, Iron Mountain, Bluestone, BigCommerce, TimeBase, Culture Amp, a software ••Governance arrangements; and Shopsmart, Simple Technology, Elanation, company building a people ••Exit parameters. Unlock’d, SafetyCulture, ArgiSystems, We analytics platform on its Series are Social and Brands on Show. A, B, C and D capital raisings. 06 PE PULSE: PRIVATE EQUITY & VENTURE CAPITAL 2018 HERBERT SMITH FREEHILLS

Take-private transactions – Key considerations for a Private Equity bidder

We are witnessing a welcome renaissance of Private Equity bidders in the Australian public market and we think this trend will continue.

There are some key issues that Private Equity bidders need to keep front of mind.

From top Raji Azzam Partner Kam Jamshidi Senior Associate Jill Davis Senior Associate

Current market trends Participation of target directors participation by insiders, it should establish appropriate protocols. Private equity takeover bids are coming and management in the bid back to the Australian market in a big way. A Private Equity bidder will commonly look Such protocols will involve the to secure the ongoing participation of establishment of an independent board Since the glory days of a decade ago certain target directors or management in committee consisting of non-participating when TPG, KKR, Macquarie and other the running of the target following the directors, who will oversee the takeover sponsors were bidding for Coles, Qantas takeover. This participation is typically response in the interests of target and Alinta, we’ve seen a shortage of achieved by giving equity in the bid vehicle, shareholders. Any directors who are Private Equity bidders participating in or the offer of attractive employment participating in the bid will not be present Australian public M&A. terms, to the directors and management. at any consideration of the bid. However, in the last 18 months, there has When approaching a target, Private Equity Aside from the Panel’s policy, most listed been a welcome renaissance of Private bidders should be conscious of the conflicts companies will have a “conflicts policy” Equity bidders in the Australian public present in this scenario. that directors will be expected to follow and market and we expect that trend to target directors and management will also continue over at least the next 12 months. The Australian Takeovers Panel has a policy need to comply with their legal, fiduciary around the duty of directors to avoid such and statutory duties. So, what should potential Private Equity conflicts. In essence, the Panel’s policy is bidders consider when running their eye that, as soon as the target board becomes Australian listed company directors will not over a listed target? aware of a potential bid in which there is only seek to comply with the Panel’s policy HERBERT SMITH FREEHILLS PE PULSE: PRIVATE EQUITY & VENTURE CAPITAL 2018 07

and their general duties, but also be seen by the beginning of a new era of super funds Issues raised by consortium bids include: target shareholders and the wider participating in bids. ••Premature disclosure: avoiding premature stakeholder community as doing so. disclosure of a potential bid is critical for A Private Equity bidder will often participate success. Under Australian rules, a party in a consortium alongside a strategic bidder Bidding in a consortium that has, either alone or with its with the intention of breaking-up the target A Private Equity bidder will often bid in a “associates”, a relevant interest in control business between the bidders if, say, either consortium, either alongside another over 5% or more of shares in a company party does not want all of the target’s financial investor or a strategic bidder, or a must disclose the holding, and the business or regulatory issues would combination thereof. “association”, to the market. The tests for preclude one of the participants from whether an “association” exists are acquiring the entire business. An interesting trend in the Australian complex and the 5% holding concept can market, which we predict will fuel future capture derivative positions (in addition The successful 2016 consortium break-up Private Equity-led consortium bids, is the to physical holdings). If a potential bid for Asciano by Brookfield and Qube, growing appetite of Australian consortium member has a pre-bid alongside various pension funds, superannuation funds for direct interest, the parties should proceed illustrates the potential to bring together investments. The recent BGH Capital-led carefully to avoid a premature disclosure. financial investor and strategic bidder in A$4 billion bid for Healthscope, alongside one consortium. ••20% ceiling: our rules prohibit an AustralianSuperannuation, may represent acquisition of shares, if the acquisition 08 PE PULSE: PRIVATE EQUITY & VENTURE CAPITAL 2018 HERBERT SMITH FREEHILLS

results in the number of shares controlled KEY TRANSACTIONS by the acquirer and its associates increasing from 20% or less to more than Herbert Smith Freehills advised: 20%. A contravention of this restriction can potentially result in a forced Capilano Honey on A$190 million divestment of the relevant shares (in takeover proposal from Roc addition to being a criminal offence). Partners and Wattle Hill. Again, the parties should proceed carefully to avoid a breach, if one or more has a Pepper Group Limited’s pre-bid interest. Independent Board Committee in relation to the A$750 million ••Insider trading: Australian insider trading acquisition of Pepper by Red Hot rules prohibit the communication of Australia Bidco Pty Limited, an non-public material price sensitive entity indirectly owned by certain information to another person where the funds, clients or accounts communicator knows that the recipient is managed or advised by KKR Credit likely to deal in the relevant shares (the Advisors (US) LLC or its affiliates, “tipping offence”). Any shareholder that is by way of scheme of arrangement. aware of such information is prohibited from trading the relevant securities (the Senior lenders of the Bis Industries “trading offence”). Any approach to a group (including entities managed potential consortium member will need to by The Carlyle Group and affiliates avoid both a breach of the tipping offence of Värde Partners) in connection by the communicator and bringing the with the restructure of A$1.2 recipient “inside” without consent (such billion of Bis Industries group debt that they can’t trade target shares). This is and the transfer of ownership of achieved by the parties following a “wall the Bis Industries group to its crossing” process. lenders through two parallel schemes of arrangement. HERBERT SMITH FREEHILLS PE PULSE: PRIVATE EQUITY & VENTURE CAPITAL 2018 09 10 PE PULSE: PRIVATE EQUITY & VENTURE CAPITAL 2018 HERBERT SMITH FREEHILLS

Leveraged finance

Strong borrower-friendly conditions remain prevalent, driven by high levels of debt liquidity and the entry of new market participants. Traditional bank debt, unitranche and term loan B products compete to provide the best financing solution on a deal by deal basis.

A borrower’s market Traditional lenders have shown tentative signs of interest of being involved in unitranche and The strong borrower-friendly conditions of term loan B markets, generally seeking a 2017 have continued into and developed super senior position in such financings, throughout 2018. Loan volumes have increased although a number of lenders are considering 24% year on year from 1H17. Sponsors have these very much on deal by deal and sponsor continued to benefit from high levels of debt relationship basis. liquidity and strong underwriting appetite to continue to push the envelope on pricing, Trends and predictions leverage and terms. Driven by the competition between the There has been an increase in the use of increased number of market participants and alternative debt products. Unitranche has between the increased number of product become commonplace on Australian offerings, it is anticipated that sponsors will leveraged buyouts. This is across a broader continue to leverage their strong positions to range of the market than its use in the push lenders for more flexible and European markets. We have also seen the borrower-friendly terms and pricing. As the development of an Australian law term loan B ability of borrowers to access alternative debt offering. Archer’s recapitalisation of products continues to increase, we are likely to Craveable Brands via an innovative first- and see further convergence of the terms of second-lien term loan B financing, the first of various financing products. its kind in Australia, broke new ground in Australian debt markets. 40 80

New Zealand & PNG 35 70 Deal volumes in both traditional bank debt Australia Number Number deals of

Volume Volume (USDbn)* Number of deals markets and alternative debt product markets 30 60 are strong. Sponsors are balancing their desired leverage, pricing, need for back-ended 25 50 or low amortisation, financial covenant relief 20 40 and need for operational flexibility, to determine which debt product is the most 15 30 appropriate for any particular asset. While 10 20 lender protections on the unitranche and term loan B products are less than traditional debt 5 10 products, across the products the size of the 0 0 equity cheque has remained relatively 1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 1Q18 2Q18 constant, with few transactions pushing * Includes all major currencies (USD, EUR, JPY, AUD, HKD, SGD, NZD, GBP, CAD, o‰shore CNY) syndicated and club loans based on country of risk. below 40%.

The entry of new market participants and SUMMARY growth in financing options has placed ••Sponsors are continuing to ••It is anticipated that sponsors pressure on traditional lenders to compete receive strong support from both will continue to leverage their with alternative products by accepting more bank and non-bank institutions. strong positions to push lenders borrower-friendly terms. In particular, we have for more flexible and borrower- seen traditional lenders accepting looser terms ••Growth in the unitranche and friendly terms and pricing. around mandatory prepayment requirements term loan B markets has placed This is likely to drive further and back-ended amortisation. There has also pressure on traditional lenders in convergence of the terms of been pressure on pricing (albeit less significant both pricing and terms. various financing products. compression than at other times in the market’s history). HERBERT SMITH FREEHILLS PE PULSE: PRIVATE EQUITY & VENTURE CAPITAL 2018 11

From top Hayley Neilson Partner John Erbacher Senior Associate Marnie Fels Senior Associate

TRANSACTION SPOTLIGHT Herbert Smith Freehills is acting on, or recently acted on, the key ••Archer Capital – on the recapitalisation of Craveable Brands transactions below: involving the Australian dollar, first- and second-lien term ••Adamantem and Liverpool Partners - on their public to loan B financing. private acquisition of Zenitas and associated roll-up ••Riverside Company – on the financing of the acquisition of acquisition of other entities. Energy Exemplar involving a unitranche loan / super senior ••Pacific Equity Partners – on the financing of the acquisition by financing structure. IntelliHUB Holdings Pty Ltd (a joint venture between Pacific ••Bis Industries – on the refinancing of its debt arrangements Equity Partners and Landis + Gyr) of the Acumen electricity following its 2017 restructuring. The transaction included an metering infrastructure business from Origin Energy. innovative senior/super-senior structure. 12 PE PULSE: PRIVATE EQUITY & VENTURE CAPITAL 2018 HERBERT SMITH FREEHILLS

TAX: PE & VC tax developments

Tax continues to be a complex area for navigation for offshore and domestic PE and VC funds, with issues arising from new case law, ATO interpretations and new legislation.

Inbound investment – many hurdles In good news for investors, the Federal Court to jump through in Resource Capital Fund IV LP v FC of T (RCF) largely endorsed the commonly understood The last 12 months has seen a number of position that where the ultimate investors are developments in Australia’s approach to the entitled to treaty benefits, Australian tax on exit taxation of inbound investment, including: from the investment should only arise where the Australian investment is held through an ••Tightening the thin capitalisation provisions Australian permanent establishment, or the and the ability of Australian entities to Australian investment is “land rich” for Australian revalue their assets to increase the amount tax purposes. However, aspects of the decision of deductible debt that can be put into an of RCF were puzzling, such as the suggestion Australian structure. that each limited partner, rather than the limited ••Continued scrutiny of related party funding, partnership itself, could have an obligation to file including requiring that as part of FIRB an Australian tax return. The decision is subject applications, parties self-assess the “risk” of to appeal. these funding arrangements being subject to ATO audit – this is relevant to the quantum Australian structures of, and interest rate that can be charged on, related party debt. There are also a number of open issues for Australian Private Equity and Venture ••Introduction of “anti-hybrid” provisions, which Capitafunds: (for example) can apply to deny Australian interest deductions on a loan from a non- ••MIT structures: One of the key requirements resident, where that non-resident is not for a trust to be classified as a ‘Managed From top subject to tax or is taxed on a different basis on Investment Trust’ and therefore be able to have the interest income. Toby Eggleston its assets taxed under the capital gains tax Director, ••The ATO asserting that non-resident rules is that the trust cannot control, or have Greenwoods & Herbert Smith Freehills companies are more likely to be Australian tax the ability to control, an entity that carries on a Cameron Blackwood resident where the directors make decisions ‘trading business’. The ATO is of the view that Director, in Australia. the phrase ‘control’ can be either by way of Greenwoods & Herbert Smith Freehills having the power to appoint the majority of the ••The extension of the “significant global board of the entity, or by having veto powers entity” provisions, which can trigger an over key decisions affecting the business. The obligation to lodge general purpose financial ATO has for some time been developing a list statements with the ATO and impose of decisions which could be problematic but significant penalties for non-compliance with this process has now stalled. tax return lodgement obligations. ••VC Funds: There are several key issues which have been discussed with the Treasury department including: For Early Stage Venture Capital Limited Partnerships (ESVCLPs): Whether gains on an investment valued at more than $250m is to be taxed as income or capital gain. If the gain is taxed as ‘income’ then non-resident investors may be required to lodge an Australian income tax return. HERBERT SMITH FREEHILLS PE PULSE: PRIVATE EQUITY & VENTURE CAPITAL 2018 13

For Venture Capital Limited Partnership Incentive arrangements companies do not meet the early stage (VCLP): resident investors which are test often because a founder has used There are a number of quirks with incentive super funds are taxed on gains under the an existing company to commence arrangements for private companies: capital gains tax rules whereas resident the new venture rather than starting non-super fund investors are taxed on ••For private equity: there is no simple off with a clean entity. As a result gains as income. Similarly for ESVCLPs, solution for private equity management employees of these entities are not able gains on investments above the $250m incentives, which continue to use to take advantage of the startup tax will be taxed depending on whether they loan plans, converting preference concessions; and are a super fund. Lobbying is continuing shares and premium priced options there is still no easy mechanism to to enable a VCLP and ESVCLP to make as the mechanism for incentivising incentivise founders or adjust equity a capital account election like managed management with equity. stakes between founders. investment trusts to address these issues. ••For venture: While the startup For both ESVCLPs and VCLPs: The concessions have enabled a cost effective exception to the ‘in Australia’ rule for roll-out of equity for most employees eligible venture capital investments applies there are still issues remaining: if at the time of making the investment, the total of the value of the investment and there are a number of technical nuances all other non-Australian investments does with the startup rules which we are not exceed 20% of the funds committed lobbying the ATO and Treasury to fix capital. Lobbying is continuing to have the with the startup concessions; 20% determined by reference to the cost of the investment to the fund as opposed to the market value of the investments .

SUMMARY ••The use of related party debt continues to be an area of focus for the Australian Taxation Office.

••The ATO and Treasury continue to consider how managed investment trusts and Venture Capital funds should be taxed.

••A number of quirks remain with incentive arrangements for private companies. 14 PE PULSE: PRIVATE EQUITY & VENTURE CAPITAL 2018 HERBERT SMITH FREEHILLS

What is W&I and how does Transaction insurance: it work? W&I insurance is transaction insurance W&I Insurance that typically covers a buyer against financial loss arising from a breach of warranty or a claim under a seller indemnity in a share or asset sale agreement. Insofar as it relates to warranties, this kind of insurance typically provides cover for historic risks – that is, unknown breaches of warranty that first become known following the point in time at which the warranty was given, i.e. signing or completion. W&I insurance enables a PE seller to transfer the financial risk of a loss arising from a warranty or indemnity claim to an insurer, providing the PE seller with a ‘clean exit’, avoids the PE seller having to provide a ‘holdback/escrow as security for such claims and, thereby, facilitates a fast and full return of sale proceeds to its investors. For a PE buyer, it enables them to generally deal with the insurer, rather than the seller, in relation to a claim. This provides greater security for claims and also protects any ongoing relationship between the PE buyer and the seller, for example where a founder seller has rolled some of their interest. The process for putting in place a buy-side W&I insurance is generally encountered in one of two ways. The first is where the seller requires, or the parties to the negotiation agree, that the buyer will take AVERAGE out a W&I policy for the deal. The seller PREMIUM RATES may engage the insurance broker and test (% OF THE LIMIT <1% the market for pricing, but nothing further is OF INDEMNITY) done. The broker then ‘flips’ to the preferred bidder when selected. The second is where the seller takes a more active role in the initial steps of implementing the W&I AROUND 1 IN 5 insurance, referred to as a seller-mandated POLICIES HAVE policy. These steps may include: retaining ~29% CLAIMS the broker, reviewing indicative pricing, 2018 selecting a primary insurer, negotiating the base W&I insurance policy and facilitating the insurer and its advisers to undertake their review of the data room materials and any vendor due diligence reports (known AVERAGE LIMIT as ‘sell-side underwriting’). The seller then OF INSURANCE ‘flips’ the engagement of the broker and the $65m PURCHASED insurer, together with the draft policy, to one or more selected preferred bidders. HERBERT SMITH FREEHILLS PE PULSE: PRIVATE EQUITY & VENTURE CAPITAL 2018 15

Current market trends ••Nil recourse is not necessarily sole recourse: Parties to deals are becoming increasingly As an established tool in the Private Equity and sophisticated around their use of W&I insurance. M&A markets and in one of the most developed While ‘clean exist’/nil recourse is still the ideal global markets for this insurance, what are the for PE sellers for the reasons given above, we current trends in W&I insurance in Australia? are seeing some PE sellers taking responsibility ••Seller-mandated policies: With the return for uninsured exposures that are specific to of competitive sale processes to the M&A the business, such as specific indemnities for landscape over the last 1-2 years, there has environmental liabilities or other known business been an increase in seller-mandated W&I risks (rather than having those risks impact price). insurance policies. Front-ending this process For PE buyers, on the other hand, we are seeing allows the seller to control and advance W&I on occasion being used as a first port of call, the W&I process. Undertaking sell-side with secondary recovery to the seller negotiated underwriting can provide the seller with an for the retention, uninsured or excluded warranties early indication of uninsurable risks or areas and claims above limit of the insurance. that require further diligence (allowing the seller ••Insurers are focusing on the robustness of the to address such risks via further information negotiation and diligence process: Insurers disclosures, by notifying bidders that their due will assess the integrity of the sale process by diligence should cover such risks or in the sale carefully scrutinising the deal negotiations, the agreement, before ‘flipping’ the insurance to quality and scope of the buyer’s due diligence the preferred bidder). This minimises the risk of and the seller’s disclosure. Insurers make it gaps in the policy, i.e. risks that are not insured, known that the quality of a party’s professional or the likelihood of the buyer looking to the advisers can make a material difference to the seller to cover any such gaps (which cannot be From top ability for a buyer to obtain the desired insurance closed), and the time taken between the ‘flip’ Ben Landau cover and within the time constraints of the deal and signing of the sale agreement. Executive Counsel environment. Philip Hopley ••Pricing at records lows: It’s a buyer’s market. Our experience Special Counsel Brokers are reporting that average pricing for deals is now less than 1% of the limit ••Herbert Smith Freehills’ market leading insured because greater competitiveness in Private Equity practice is a one-stop shop for the Australian primary insurance market and transactions involving W&I insurance. Our deal “plummeting” excess layer rates have driven teams are supported by specialist M&A and down the cost of programmes. insurance lawyers with extensive W&I insurance experience, who are up-to-date on market trends ••Greater flexibility on retention structures: There and who have long-standing relationships with is a greater willingness by insurers to offer each of the major W&I brokers and primary different retention structures. Tipping retentions insurers in the Australian market, to provide for policies (that is, a retention or excess that comprehensive, seamless and efficient advice. drops down to insure some or all of the retention amount once it is met) of 1% of EV tipping to ••We understand what W&I insurers are looking 0.5% of EV are common. However, on occasion for when they assess deals. For example, there is we are also seeing retentions that tip to nil (so a balance to be struck to ensure that buyer due that recovery is from the first dollar of loss), which diligence is scoped efficiently, but is sufficiently have not been a feature of the Australian market comprehensive to satisfy a W&I insurer. We for the last few years. In addition, insurers are now have insights and experience gained not just commonly offering fixed retentions of 0.5% of from acting on many insured deals, but also EV, whereas previously fixed retentions were not from advising some of the leading primary W&I available below 1% of EV. insurers on their underwriting processes.

SUMMARY ••The Australian market continues to be at the forefront of global W&I insurance trends

••Increased competition between primary insurers in the Australian market is enabling buyers to secure broad cover at historically low premium rates

••Undertaking a ‘seller-mandated’ process before ‘flipping’ the W&I insurance to a preferred buyer can result in a significantly improved sale process and outcome for the seller

••Insurers are increasingly rigorous in their assessment of deals – specifically, there is a focus on the quality of the parties’ professional advisers and the robustness of the negotiation and due diligence processes 16 PE PULSE: PRIVATE EQUITY & VENTURE CAPITAL 2018 HERBERT SMITH FREEHILLS

Our Private Equity & Venture Capital Team

Herbert Smith Freehills Team Members Raji Azzam Baden Furphy Martin MacDonald Partner Partner Partner [email protected] [email protected] [email protected]

Kelvin Choy Damien Hazard Annie Mould Senior Associate Partner Executive Counsel [email protected] [email protected] [email protected]

Andrew Clyne Candice Heggelund Hayley Neilson Partner Senior Associate Partner [email protected] [email protected] [email protected]

Melita Cottrell Tom Hoare Andrew Pike Partner Senior Associate Partner [email protected] [email protected] [email protected]

Jill Davis Clayton James Philip Podzebenko Senior Associate Partner Partner [email protected] [email protected] [email protected]

Stephen Dobbs Kam Jamshidi Melissa Swain-Tonkin Partner Senior Associate Senior Associate [email protected] [email protected] [email protected]

Peter Dunne Francine Kinkade Jayne Walker Partner Senior Associate Senior Associate [email protected] [email protected] [email protected]

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