Debevoise & Plimpton Private Equity Report What’s Inside

Volume 5 Number 4 Summer 2005 3 Proposed Carried Interest Tax Institutional Fund Sponsors’ Rules: Square Peg, Round Hole Consolidation Woes 5 Navigating Conflicts on Boards of Portfolio Companies

Financial institutions that control general New GAAP Rules for Fund General 7 A Tune-Up for Going Privates partners of investment funds are bemoaning Partners — Goodbye to Frivolous recently-approved accounting rules that will Due to the nature of a limited partnership Lawsuits?

generally require them to consolidate their (where only the general partners have the 9 Selected Issues to Consider financial results with the results of the funds power to manage the affairs of the partner- When Taking a Portfolio they manage — unless they share control ship), only the general partners of a limited Company Public of the fund with an independent co- partnership are treated as having voting general partner or provide kick-out or equity interests. Thus, the general partners 11 Guest Column: participating rights to the limited partners. are presumed to control the limited The Challenge of Valuation Guidelines Despite criticism from members of the partnership. Under certain circumstances, investment fund community, the Emerging however, the limited partners may have 13 Are Private Equity and Issues Task Force of the Financial rights that are sufficient to overcome the Strategic Deal Terms Accounting Standards Board reached a presumption of control by the general Converging? consensus position that will require that partners. Until the recent EITF action, which virtually every investment fund limited limited partner rights are sufficient and how 15 Trendwatch: Spinouts of Private Equity Funds partnership agreement be amended if the substantial those rights must be for Fund general partner (or any entity that controls general partners to avoid control for 17 For U.S. Companies, Exiting the general partner) prepares GAAP financial accounting purposes has been with Canadian IDSs Falls financial statements and wishes to avoid unclear. Short of Promise including all of the fund’s assets, liabilities, In June, the EITF reached a final revenues and expenses in its own consensus position on Issue No. 04-5, 19 Alert: Most Private Equity Funds Now Exempt from consolidated financial statements. “Determining Whether a General Partner, German Penalizing Tax Fund sponsors that prepare GAAP or the General Partners as a Group, Regime and Reporting and financials have generally avoided Controls a Limited Partnership or Similar Publication Requirements consolidation of the general partner (and Entity When the Limited Partners Have thus themselves, where they control the Certain Rights.” The FASB approved the 20 Second Lien Financing: general partner) with their investment EITF’s action on June 29. A Ten-Point Primer for the funds by including in each fund’s limited Institutional sponsors of investment Borrower (and its Sponsor) partnership agreement a provision allowing funds (“Funds”) will be the most on Intercreditor Dynamics the limited partners to remove the general affected, since those sponsors generally partner “without cause” upon a super- prepare GAAP financial majority limited partnership vote.1 Fund statements, and the general sponsors have claimed — and their partner is usually a controlled auditors have generally supported their subsidiary of the sponsor and position — that such a supermajority thus included in the sponsor’s removal provision is sufficient to overcome consolidated financial the presumption of general partner control statements. For Funds of the fund that would otherwise require sponsored by private equity the general partner to consolidate with the firms that do not prepare fund for financial accounting purposes.2 GAAP financials for the © 2005 Marc Tyler Nobleman / www.mtncartoons.com © 2005 Marc Tyler Under the new EITF rules, however, general partners of their Funds

supermajority kick-out rights are not continued on page 23 sufficient to block GP control.

“She's affiliated, but we're not consolidating with her.” letter from the editor As all private equity professionals know, tax and Private Equity and Entrepreneurship at Tuck, predict that accounting issues can make or break fund structures as while GPs seem to be adopting valuation guidelines well as deal structures. In this issue, we discuss several tax suggested by PEIGG more broadly in the U.S. than and accounting developments of particular import to the previously thought, recent research indicates that wide- private equity world. Our cover article reports troubling spread adoption of consistent valuation guidelines is news contained in a recent FASB ruling that will require unlikely. most institutional general partners who issue GAAP Elsewhere in this issue, we remind private equity financials to consolidate their financials with those of their sponsors of the dangers of blurring the lines between investment funds and gives some critical steps for GPs to stockholder and director and not being sensitive to the take to avoid consolidation. The last few years have seen conflicts of interest that inevitably arise when controlling numerous spinouts of private equity groups from big stockholders have Board seats, and we give a ten point institutions into their own boutique firms. One could primer on second lien financings. surmise that the FASB ruling may encourage more Last year, we reported on the prospect of income financial institutions to divest their private equity funds deposit securities as a hot new exit strategy for companies rather than face the risk of consolidation. Our Trendwatch without the growth prospects for a traditional IPO. In this column analyzes the legal and commercial issues facing issue, we update you on how the IDS strategy has been all managers contemplating spinning out a private received to date. equity group. Finally, we review recently proposed rules from the U.S. Private equity professionals face a myriad of unfamiliar governing the transfer of partnership interests which if challenges both when taking public companies private adopted will have significant impact on how private equity and when taking portfolio companies public. In our last firms structure carried interests and other common transfers issue, we discussed the first scenario; in this issue we unless safe harbors are found; and from Germany, we report on recent Delaware case law that suggests more announce that most private equity funds will be exempt protection for controlling shareholders from frivolous from the penalizing tax rules and reporting and lawsuits following the announcement of a going private publication requirements of last year’s Investment Tax Act. transaction. Elsewhere, we consider whether deal terms in This fall will mark the five year anniversary of the Private private equity public to private deals are starting to mirror Equity Report. We hope it has provided useful guidance those of strategic deals in the U.S. On the flip-side, on issues facing private equity professionals in a rapidly another article reminds us of the issues sponsor firms changing deal environment. Keep your eye out for our should bear in mind before taking a portfolio company Best of the Debevoise & Plimpton Private Equity Report, public. which we expect to publish before year-end. In our Guest Column, Colin Blaydon and Fred Wainwright, both Professors at the Tuck School of Franci J. Blassberg Business at Dartmouth and principals at the Center for Editor-in-Chief

Private Equity Partner/ Counsel Practice Group Members The Debevoise & Plimpton Frankfurt Franci J. Blassberg The Private Equity Mergers & Acquisitions Private Equity Report is a 49 69 2097 5000 Editor-in-Chief Practice Group Andrew L. Bab publication of All lawyers based in New Hans Bertram-Nothnagel – Frankfurt Moscow Ann Heilman Murphy Debevoise & Plimpton LLP York, except where noted. E. Raman Bet-Mansour – Paris 7 095 956 3858 Managing Editor 919 Third Avenue Paul S. Bird Private Equity Funds New York, New York 10022 Hong Kong William D. Regner Franci J. Blassberg Marwan Al-Turki – London 1 212 909 6000 852 2160 9800 Cartoon Editor Colin W. Bogie – London Ann G. Baker – Paris Richard D. Bohm Shanghai The articles appearing in this Kenneth J. Berman–Washington, D.C. www.debevoise.com Geoffrey P. Burgess – London 86 21 5047 1800 publication provide summary infor- Jennifer J. Burleigh Washington, D.C. Margaret A. Davenport mation only and are not intended Woodrow W. Campbell, Jr. 1 202 383 8000 Michael J. Gillespie Please address inquiries regarding as legal advice. Readers should Sherri G. Caplan Gregory V. Gooding topics covered in this publication seek specific legal advice before Michael P. Harrell London Stephen R. Hertz to the authors or the members taking any action with respect to the Geoffrey Kittredge – London 44 20 7786 9000 David F. Hickok – Frankfurt of the Practice Group. matters discussed herein. Any Marcia L. MacHarg – Frankfurt Paris James A. Kiernan, III – London discussion of U.S. Federal tax law Andrew M. Ostrognai – Hong Kong 33 1 40 73 12 12 All contents ©2005 Debevoise & Antoine F. Kirry – Paris contained in these articles was not David J. Schwartz Plimpton LLP. All rights reserved. Marc A. Kushner intended or written to be used, and Rebecca F. Silberstein it cannot be used by any taxpayer, Li Li – Shanghai for the purpose of avoiding penalties Hedge Funds Christopher Mullen – London that may be imposed on the Byungkwon Lim Holly Nielsen – Moscow taxpayer under U.S. Federal tax law. Gary E. Murphy Robert F. Quaintance, Jr. Jennifer A. Spiegel William D. Regner

The Debevoise & Plimpton Private Equity Report l Summer 2005 l page 2 Proposed Carried Interest Tax Rules: Square Peg, Round Hole

In May 2005, the IRS issued for the first Election. A variety of detailed z In addition, the proposed rules time a comprehensive set of rules requirements must be met in order include a host of other provisions that governing the transfer of partnership to qualify for this election, such as could affect how the members of the interests in connection with the perfor- including certain language in the GP and the Manager are taxed. mance of services. Although not partnership agreements for the fund Application to Existing Arrangements directed at private funds in particular, and the GP. The partnership As proposed, the rules would only the proposed rules will (if finalized) agreement language must be apply to partnership interests trans- apply to a host of transactions commonly enforceable against all of the ferred after the rules are finalized by the undertaken by virtually all private equity partners, including the passive IRS (which is not expected to occur for firms. These include (1) the receipt by limited partners. at least a year, and will probably take the entity serving as the general partner z If an interest in the GP is subject to much longer). Although the new rules (the “GP”) of the 20% carried interest in vesting, the recipient of the interest generally should therefore not apply to the fund, (2) the receipt by the private will generally want to file a so-called the GP’s receipt of the 20% carried equity professionals of interests in the 83(b) election with the IRS within 30 interest in a fund that had already GP, and (3) the receipt by the private days of receiving the interest. closed or that closes before the pro- equity professionals of an interest in the posed rules are finalized, the rules could entity serving as the manager (the z If a new partner recognizes income well apply if such a fund creates a so- “Manager”). upon the receipt of a partnership called “alternative investment vehicle” interest (e.g., where a “capital Overview to hold a particular investment or a interest” is issued), the partnership “parallel fund” for particular investors z In most circumstances, the proposed will generally have a current deduction, after the effective date. One can expect rules would generally permit the same but the deduction cannot be allo- many sponsors to include language in favorable tax treatment relating to cated to the new partner. new fund agreements (and in some the carried interest that is available z If a partner is allocated income or cases to amend existing agreements) to under current practice, such as not gain with respect to a partnership ensure that the carried interest in the including any income upon the receipt interest but forfeits the interest fund (and any AIVs or parallel funds) are of the carried interest and main- before the income or gain is eligible for the safe harbor. Some taining capital gain flow-through. distributed, the partnership will be sponsors have already started to add z In order to ensure this treatment, required to specially allocate these provisions to their agreements. both the fund and the GP will need deductions or losses (to the extent Similarly, the proposed rules gener- to comply with a new Safe Harbor available in the forfeiture year) to that ally should not apply to partnership partner to reverse the interests in the GP or the Manager undistributed income or issued before finalization of the rules. gain. However, if the However, the new rules could well apply Jeffrey J. Rosen Peter A. Furci available deductions or where the interests in an existing GP are Kevin M. Schmidt Friedrich Hey – Frankfurt losses are insufficient, no adjusted after the rules become final- Thomas Schürrle – Frankfurt Adele M. Karig Andrew L. Sommer – London David H. Schnabel further loss will be ized, such as where the terms of the GP Arthur Stewart – London Peter F. G. Schuur– London permitted. require that each member’s share of the James C. Swank – Paris Richard Ward – London John M. Vasily carry be adjusted each year or each z The proposed rules Philipp von Holst – Frankfurt Employee Compensation time a portfolio investment is made. & Benefits apply to both U.S. Leveraged Finance Lawrence K. Cagney Again, we expect that many sponsors William B. Beekman David P. Mason and non-U.S. funds, if will now include language to provide Craig A. Bowman – London Elizabeth Pagel Serebransky a carried recipient is David A. Brittenham for general flexibility to ensure Paul D. Brusiloff Trust & Estate Planning a U.S. taxpayer. compliance with the safe harbor. Alan J. Davies – London Jonathan J. Rikoon However, it appears Peter Hockless – London Background A. David Reynolds that only funds that Gregory H. Woods III file U.S. tax returns Section 83 of the tax law provides that if Tax will be eligible to a person receives property in connection Andrew N. Berg Robert J. Cubitto make the election. continued on page 4 Gary M. Friedman

The Debevoise & Plimpton Private Equity Report l Summer 2005 l page 3 Proposed Carried Interest Tax Rules: Square Peg, Round Hole (cont. from page 3)

with performance of services, the person taxpayers can continue to rely on two available information and under no has income equal to the property’s “fair IRS “revenue procedures” (which are compulsion to buy or sell, but ignoring market value” (less any amount actually somewhat like SEC no-action letters). any vesting provisions). paid for the property). The income is These rulings effectively create a safe Prior to the issuance of the revenue includible and the property is valued at harbor pursuant to which (1) the receipt procedures discussed above, there the time the property is considered of a “profits interest” in a partnership is were a number of court cases dealing “transferred.” If the property is subject generally not treated as a taxable event with how to apply this valuation to vesting, the property is considered if it is received in exchange for services standard to a profits interest in a “transferred” at the time it vests (rather “to or for the benefit of the partnership” partnership. The cases reached than at the time it was actually trans- and (2) such an interest is not treated as conflicting results, with some courts ferred) if a section 83(b) election is not property for purposes of section 83 so (most notably the court in a case called made. If a section 83(b) election is that the recipient does not need to Campbell) concluding that the value of made, the tax treatment follows the make a section 83(b) election. A such an interest was sufficiently form, and the transfer is treated as partnership interest is considered a speculative that it should be valued at occurring when the property is actually profits interest if the holder would not zero and others concluding that transferred. be entitled to any distributions from the valuation was possible. It is not clear partnership under the partnership whether Campbell survives the Square Peg in a Round Hole agreement if, immediately after the proposed rules. Although nothing in section 83 carves interest was transferred, the partnership out partnership interests, the general Valuation Under the Electing Safe sold all of its assets for their fair market rules applicable under section 83 Harbor value and then liquidated. This safe simply do not reflect the common The proposed rules provide that a harbor is not available, however, if the understanding of how someone is partnership can elect for all “Safe recipient of the profits interest transfers taxed upon the receipt of a partnership Harbor Partnership Interests” in the the interest within two years of receipt. interest. Thus, for example, no one (or partnership to be valued based on their The 20% carried interest in the fund virtually no one) who makes partner at a “liquidation value” rather than their issued to the GP is considered a law firm, accounting firm, or other “true” fair market value. A partnership profits interest under these revenue traditional service partnership reports interest’s liquidation value is defined as procedures. An interest in the GP income under section 83 based on the the amount of distributions that would issued to an investment professional is “fair market value” of the partnership be made in respect of the interest if, usually structured so that it qualifies as a interest received. Rather, the under- immediately after transfer, the part- profits interest. standing is that the new partner will be nership sold all of its assets (including taxed on his or her share of the The Proposed Rules any goodwill or other similar intang- partnership’s income as it is realized by The proposed rules would repeal the ibles) for their fair market value and then the partnership. revenue procedures discussed above. liquidated. Under this methodology, the Similarly, when the GP of a fund Instead, under the proposed rules, 20% carried interest issued to the GP at receives the 20% carried interest in the section 83 would expressly apply to any the fund closing would typically have a fund, it has always been the universal transfer of a partnership interest in zero value and an interest in the GP that practice (even before the issuance of connection with the performance of corresponds to a portion of the GP’s the IRS revenue procedures discussed services, including the issuance of the carried interest would typically be below) not to include any amount in 20% carried interest in a fund to the GP structured to have a zero value. income upon the receipt of the interest, and the issuance of interests in the GP Interests Eligible for the Safe Harbor even though the “true” fair market and the manager to the investment Even if all of the requirements for the value is arguably substantial. Rather, the professionals. As a result, unless the safe harbor (discussed below) are GP (and the investment professionals safe harbor discussed below applies, satisfied, the special valuation rule only who own the GP) report income and the recipient of such an interest would applies to so-called “Safe Harbor gain only as they are realized by the generally have income equal to the Partnership Interests” in the partnership. fund and flow through to the partners. “true” fair market value of the interest An interest in a partnership can only be (which is generally the amount that Rules Applicable Until the Proposed considered a “Safe Harbor Partnership would change hands between a willing Regs Become Finalized Interest” if (among other things) it is buyer and a willing seller, each with all Until the proposed rules are finalized, continued on page 8

The Debevoise & Plimpton Private Equity Report l Summer 2005 l page 4 Navigating Conflicts on Boards of Portfolio Companies

When a private equity firm has a control equity and board position in a company, it’s easy for the lines between stockholder and director to blur. The tendency to think of the company as “our company” may be hard to resist. But in light of the current environment of heightened scrutiny of corporate governance and recent Delaware case law addressing directors’ fiduciary duties, private equity firms need to be sensitive to and carefully navigate potential conflicts of interest as they consider and evaluate transactions when serving on the boards of their portfolio companies.

There can be more potential for Further, certain types of transactions, decisions of a board that have the conflicts of interest in serving on the such as exit transactions, may impose effect of benefiting certain classes of board of a portfolio company than additional duties that will place stockholders to the exclusion of others one might think. Conflicts may arise additional requirements on the board’s if there is a strong record supporting involving different classes of stock- deliberation process. why the approved transaction is the holders. Conflicts also could arise Some situations that are ripe for right transaction at the right time. For involving separate portfolio companies conflicts of interests and after-the-fact example, in one case in which the operating in the same industry that are claims against private equity profes- board approved a sale in which the controlled by the same private equity sionals are illustrated below. We will common stockholders would be wiped firm. And, if a portfolio company then offer some tips on how you can out, the court rejected the common ultimately fails, creditors may scrutinize better protect yourself in addressing stockholders’ claims even though the certain types of material transactions these conflicts. board went so far as to take specific involving stockholders, even if they are action to reduce the voting power of Different Classes of Stockholders taken at a time when the company is the common stockholders in connec- Directors are generally obligated to act not insolvent. On top of all of this, tion with the transaction. It appears the in the best interests of the corporation private equity professionals need to be court reached this conclusion because and all of its stockholders. But, if the aware that courts will be reviewing their it was presented with a clear record that portfolio company has different classes decisions closely because the existence the company was struggling and had of stockholders, not all stockholders are of conflicts of interest in transactions searched fruitlessly for other sources of going to benefit equally from certain approved by a board of directors will capital for two years. deals. In fact, certain classes of heighten the level of judicial review. stockholders could potentially be Fighting Over the Same Opportunity. Fiduciary Duties in a Nutshell wiped out entirely upon a sale or other Private equity professionals may find As most private equity professionals exit event. The classes with a lower themselves serving on the boards of serving as directors are undoubtedly priority than the private equity firm may directors of multiple portfolio companies aware, directors owe fiduciary duties to well challenge such a deal (after all, they that have different minority stock- their portfolio companies, including have little to lose) by asking, “Why sell holders but that operate in the same or duties of care and loyalty. Delaware law now?” They will claim that the board similar industries. So, if a new oppor- permits directors to be indemnified for should bypass this deal and “swing for tunity comes up in this industry, should breaches of the duty of care but not the the fences” in operating the business the fund direct it to portfolio company duty of loyalty and not for any actions for the ultimate benefit of all stock- A or portfolio company B? If an oppor- that are not taken in good faith. The holders. Obviously, if the company is tunity is presented to a private equity “good faith” exception to indem- insolvent at the time, these claims by firm’s director designee by a third party nification has recently received a great lower priority stockholders will clash in the context where it is clear that his deal of attention in light of Delaware with those of creditors who will argue connection with one of the two firms is cases that have concluded that that the business needs to be managed leading to the offer, then that firm directors may be personally liable for for their benefit. (For a detailed should be presented with the oppor- breaches of duty of care which are so discussion of fiduciary duties of directors tunity. If an opportunity is presented to egregious that they constitute breaches of insolvent companies, see “Troubling a private equity professional without of good faith. In these recent cases, the Times for Directors of Portfolio clear regard for his affiliation with one of board’s deliberative process and record Companies” in the Winter 2002 issue of the two companies, the firm should be of review were found by the court to be the Debevoise & Plimpton Private able to direct it as it sees fit but (as our so woefully inadequate as to constitute Equity Report.) tips below indicate), the firm should a conscious disregard of its duty and Fortunately, Delaware case law also be sure that the stockholders therefore, were not taken in good faith. suggests that courts will respect the continued on page 6

The Debevoise & Plimpton Private Equity Report l Summer 2005 l page 5 Navigating Conflicts on Boards of Portfolio Companies (cont. from page 5)

agreement governing each of the one year of the sale and filed for informed basis. If a leveraged companies makes clear that its stock- chapter 11 within the following year. In transaction is being approved, the holders have no duties regarding reviewing the board’s decision to information to be reviewed should corporate opportunities or other types approve the sale, the court specifically include projections illustrating how of competition. Also note that if certain cited the board’s failure to review the business will be able to sustain types of recurring conflicts are antici- financial projections prepared by the the additional leverage, including a pated, a company can renounce in buyer that would have shown that the sensitivity analysis if the company advance its interest in specific business projections were not based in reality performs below plan. Sellers in opportunities or specific classes or and left no margin for error. Specifically, leveraged transactions should have categories of business opportunities by the projections assumed immediate some level of comfort based on its adopting an express provision in the savings from an overhaul of the review or its financial advisor’s company’s charter. (Of course, in company’s distribution system which review of buyer’s financing commit- approving a provision renouncing had been ongoing for years with no ment papers and any supplemental certain types of opportunities, directors proven results. materials regarding projections for will remain subject to traditional the business (recognizing that a How to Protect Yourself fiduciary duties, including their duty of buyer will likely be reluctant to So, those are some of the conflicts. loyalty, and should make their decision provide its full operational plans). Here are a few tips to best protect in an informed manner.) yourself against subsequent challenge: 3. Create a Good Record. In addition Leveraged Transactions. Private to exercising applicable fiduciary equity professionals on the boards of 1. Know Your Duties. Directors’ duties and reviewing appropriate portfolio companies may be called fiduciary duties and the consti- materials, it is equally if not more upon to approve various types of tuencies to whom they are owed important to create a record docu- leveraged transactions that will benefit may vary based on the jurisdiction menting the board’s deliberation them in their capacity as stockholders, of incorporation or the circum- process. Board members should be such as a large dividend financed by a stances involved. The board’s record actively and consistently involved in leveraged recapitalization or a sale to should show that it had appropriate the decision-making process. Board another private equity firm that intends counsel explaining their duties — meetings should occur on a regular to leverage up the company immed- e.g., is a sale transaction triggering basis and significant decisions taken iately after the closing. Approving such the duty to get “the best price at a meeting ideally should have a deal when the company is insolvent reasonably available” or is the some predicate discussed at a prior would be a no-no, but directors should company in a state of financial meeting showing how the decisions also be aware that there is Delaware distress such that a duty is owed to are consistent with the plan for the case law which states that directors also creditors — and that consideration business. Board minutes should be have a duty of loyalty to the company of these duties factored into the detailed enough to identify the not to take actions that would leave it decision-making process. topics discussed and show that with “unreasonably small capital” such 2. Review All Material Information. As alternative transactions were consi- that the risk of insolvency is reasonably noted above, directors have a duty dered. We are not suggesting that foreseeable. to inform themselves before taking individual director questions should In one noted case involving a any actions by availing themselves be reflected in the minutes (indeed leveraged buyout, a court sustained a of all material information reasonably that might be counterproductive) claim (although it was subsequently available, such as copies of all but directors should note that in a rejected by a jury) that the board of significant agreements, financial recent Delaware case finding that directors of a selling company breached projections and other relevant directors breached their duty of their fiduciary duties by not informing financial analyses. Although term care, the court specifically criticized themselves of all material information sheets and written summaries can the lack of detailed minutes relating reasonably available to them prior to be extremely helpful for directors, to the approval of a substantial approving the sale which left the recent Delaware cases suggest that compensation package for the company with little to no capital. In that directors who made decisions on company’s president. case, the company defaulted under the basis of term sheets or several of its financing covenants within continued on page 8 summaries did not act on an

The Debevoise & Plimpton Private Equity Report l Summer 2005 l page 6 A Tune-Up for Going Privates — Goodbye to Frivolous Lawsuits?

In our last issue, we explored some of was “unripe and without merit” when frivolous litigation. Because the plaintiff the challenges private equity firms face filed, since, at that time, the proposal will almost always be able to allege that when they take public companies was fully negotiable by the special a transaction was not entirely fair, going private.1 Another challenge is dealing committee. Nevertheless, the court felt private litigation is extremely difficult to with the flurry of lawsuits that seem to bound to order some fee because the have dismissed at the pleading stage — be routinely filed when a going private defendants’ desire to get rid of the which means that it has settlement value. transaction is announced. A recent litigation may have had “some useful As a solution, the court proposes a Delaware case, In re Cox Communi- role” in the price attained. Skeptical new test: if a controlling shareholder cations, Inc. Shareholders Litigation, that the lawsuit had much of an effect makes a merger proposal that from its explores some of these issues and on the ultimate deal price, and finding inception is subject to (1) negotiation proposes to overhaul Delaware going that plaintiffs’ counsel had taken little and approval by a special committee of private law in a way that might provide risk and put in too many hours in independent directors and (2) minority better legal protection to controlling bringing the suit, the court awarded shareholder approval, then the business shareholders and boards that follow an fees of $1.275 million — slightly more judgment rule would presumptively exemplary process, while reducing the than a quarter of the requested fee. apply, so that any plaintiff would need frivolous litigation that dogs these But the real problem, according to to plead particularized facts that the transactions. the court, is that the legal test appli- independent committee lacked inde- The facts of the case are typical of cable to Delaware going private pendence or was ineffective because it going private transactions. The Cox mergers tends to breed strike suits. breached its duties or because of wrong- family, which controlled 77% of the Under Delaware law, all mergers with doing by the controlling stockholder, or voting stock of Cox Communications, controlling stockholders are subject to that the minority approval was tainted proposed to take the company private the test of entire fairness — fairness of by “misdisclosure, or actual or structural at $32 per share, subject to approval by price and fairness of process — even if coercion.” a special committee of independent the merger is approved by a special It’s an interesting proposal, but not directors. On the day the proposal was committee and is made subject to a one that is legally binding: the Chancery announced, before any deal was minority approval condition. However, if Court remains bound by Delaware agreed, six complaints were filed in the merger is negotiated and approved Supreme Court precedent requiring Delaware, including the “entirely by a properly functioning special com- “entire fairness” review of all going boilerplate” one before the court. mittee, the burden shifts to the plaintiff private mergers. But the court hopes The special committee negotiated to prove that the transaction was not that by holding categorically that with the Cox family, which eventually entirely fair. Conditioning the trans- “complaints attacking negotiable pro- agreed to increase its price to $34.75 action on approval by an adequately posals are non-meritorious and do not per share and to condition the informed minority also shifts the burden. give rise to a presumptive claim to a transaction on approval by a majority of As a result, the court says, controlling fee,” the decision may embolden some the publicly held shares. In parallel, the stockholders lack adequate incentives future defendant to challenge, rather Cox family negotiated to settle the to condition their going private trans- than settle, a going private strike suit, plaintiffs’ lawsuit — a process the court actions on approval by the minority which could give the Delaware describes as “A Tale Of Two Nego- holders, which the court believes to be Supreme Court an opportunity to tiation Paths Leading To The Same a “critical” check on the faithfulness consider these suggested reforms. Place At the Same Time.” In the and effectiveness of a special com- Until that happens, however, share- settlement, the Cox family acknowledged mittee. Because they receive only the holder litigation is likely to remain a that the efforts of plaintiffs’ counsel same “modest procedural benefit” standard — though possibly less were “causal factors” that led to the — the shifting of the burden of proof — lucrative — feature of going private increased price and the minority by having a minority approval condition transactions. approval condition. The Cox family later as they would by having a special — Jeffrey J. Rosen agreed not to oppose an attorneys’ fee committee alone, controlling stock- [email protected] request of up to $4.95 million. holders are less likely to accept the — Gary W. Kubek The court found that the litigation added transactional risk imposed by a [email protected] minority approval condition. At the

1 See Dangerous Liaisons: Teaming Up with same time, requiring a test of entire — William D. Regner Management and Significant Stockholders in Going fairness, regardless of the procedural [email protected] Private Transactions, Debevoise & Plimpton Private Equity Report, Spring 2005. protections implemented, encourages

The Debevoise & Plimpton Private Equity Report l Summer 2005 l page 7 Navigating Conflicts on Boards of Portfolio Companies (cont. from page 6)

4. Exercise Negative Veto Provisions equity professionals should also be the board’s decision-making. as a Stockholder Rather Than as a comfortable with the scope of the Directors of companies who are Director. It is customary for portfolio company’s D&O policy considering a significant leveraged stockholders agreements to include and also the scope of their rights of transaction that may potentially “veto” rights that the private equity indemnification at the fund level in create an unreasonable risk of firm can exercise over certain respect of their services as portfolio insolvency are particularly well- corporate actions. If potential company directors.) advised to obtain financial advisors conflicts could arise, it may be who can assist them in determining 6. Limit Stockholder Obligations in the helpful to provide that such rights whether the transaction will leave Stockholders Agreement/LLC will be exercised by the private “unreasonably small capital” in the Operating Agreement. If the private equity firm in its capacity as company. Obtaining a solvency equity firm as a stockholder wants stockholder rather than by the opinion from a valuation firm is also to be free to pursue corporate director who is appointed by the helpful. It is important to note that opportunities in which the portfolio stockholder. As noted above, a directors must still exercise company may have an interest, a director has a duty to all “reasonable care” on behalf of the disclaimer in respect of corporate stockholders. An individual corporation in selecting outside opportunities can be included in the stockholder, by contrast, can usually experts and may only rely in good stockholders agreement. Also note be free to act in its own interest. faith on such experts. that if you are operating in the form 5. Include Protective Provisions in the of an LLC, the managers (who are 8. Require Approval by Independent Company’s Charter. If not already often still referred to as a board) Directors. If the portfolio company provided, private equity firms have a greater ability to limit has independent directors, they should seek to take full advantage fiduciary duties than would exist for could be appointed to a special of the protective charter provisions a corporate entity. committee to separately approve permitted by Delaware law, the transaction and to recommend 7. Consult the Experts. In evaluating a including provisions that limit it to the full board. significant corporate transaction personal liability of directors for and weighing the relevant — Kevin M. Schmidt certain breaches of fiduciary duties alternatives, the board should [email protected] and provisions that relate to consider hiring experts, including — Connie H. Chung renunciation of corporate financial advisors, who can assist in [email protected] opportunities. (Obviously, private

Proposed Carried Interest Tax Rules: Square Peg, Round Hole (cont. from page 4)

issued to a service provider in are undertaken by the manager, with issuing the proposed rules, the IRS connection with the performance of the GP’s actions limited to making final specifically asked for comments about services to that partnership. By contrast, buy/sell decisions. Although it seems how the rules should apply when the the existing revenue procedures apply relatively clear that the individual services are provided to an affiliated to interests in a partnership so long as members of the GP who participate in entity. they are granted in exchange for the buy/sell decisions should be treated In addition, an interest in a services provided to or for the benefit as receiving their GP interests in partnership will not be considered a of that partnership. exchange for services to the GP, this Safe Harbor Partnership Interest if it is In some cases, it is not clear whether may be less clear in the case of the less issued “in anticipation of a subsequent an interest in the GP is being granted in senior members of the GP who do not disposition” by the recipient. If the GP exchange for service to the GP (in which have a say in the decision-making agreement includes a right to call a case the new safe harbor could apply) process. Similar uncertainties may arise member’s interest in the GP if the or in exchange for services provided to in relation to UK-style fund agreements, member stops providing services to the the manager (in which case the new where the carried interest recipient GP, the safe harbor will not apply to safe harbor might not apply). In many typically is a limited partner of the fund, interests granted in the GP unless it can

funds substantially all of the activities rather than the general partner. In continued on page 18

The Debevoise & Plimpton Private Equity Report l Summer 2005 l page 8 Selected Issues to Consider When Taking a Portfolio Company Public

There has been a lot of buzz in the sponsor that is taking a portfolio and choose the proper time to shop the press recently about IPOs backed by company public should consider company for sale. Although private equity sponsors. Even if the IPO whether it is appropriate to adjust or institutional investors generally disfavor market isn’t as frothy as many would terminate these designation rights. anti-takeover defenses, it is possible to like, now is an opportune time to revisit While a sponsor with a majority stake or include some protection for companies issues sponsor firms should bear in close to that in the portfolio company going public without alienating mind before taking a portfolio company post-IPO will generally have the ability institutional investors. public. to elect a number of its nominees, there Anti-takeover provisions that might may be advantages to having that right be considered include: a staggered Will we still get our management fees? as a matter of contract. Contractually board, a poison pill, restricting Private equity sponsors generally mandated nomination rights may be shareholder action by written consent, receive annual fees for the monitoring exercised by the sponsor as a matter of restricting the right to call a special or consulting services they provide to right without implicating the fiduciary shareholder meeting and creation of their portfolio companies and generally duties of the independent directors blank-check preferred stock. The ability have contractual indemnification rights sitting on the nominating committee or to issue blank-check preferred stock will in connection therewith. Although a otherwise considering the nomination generally enable the Board to later private equity firm’s relationship with its process under the NYSE or Nasdaq adopt a poison pill quickly in response portfolio company will change following rules. The contractual nomination rights to an unwanted takeover approach, in an IPO, the consulting agreement may will need to be harmonized with the the event that a poison pill is not or may not terminate at that time. Some NYSE or Nasdaq mandated procedures adopted immediately. Restricting firms will continue to charge a fee (or a for considering nominations and shareholder action by written consent revised fee) for all or a remainder of the disclosed, but should be respected. and limiting the right of stockholders to term of the agreement. Others charge a Such nomination rights will generally be call a special meeting may allow the fee in connection with the IPO, constructed to bear a reasonable Board greater control over the timing of sometimes based on the present value relation between the voting power of stockholder action, while not com- of the fee payable over the remaining the sponsor post-IPO and the number pletely foreclosing the possibility of a term of the agreement, while yet other of nominees that may be designated, successful hostile bid. Provision for a firms charge an exit fee in connection with that right diminishing and then staggered Board increases the Board’s with the IPO which is not based on terminating once the percentage of ability to resist a hostile takeover value to the company of “prepaying” shares held falls below specified levels. combined with a proxy fight, but that the consulting fee for the remaining utility has to be weighed against term. Obviously, such arrangements What anti-takeover provisions should investors’ attitudes towards such pro- need to be disclosed and are depen- the company adopt? visions. The anti-takeover provisions dent on there being no restrictions What are the pros and cons of adopted should be protected against under the fund’s Partnership Agree- adopting anti-takeover provisions? amendment by a simple shareholder ment and may require implementing Management and the private equity majority vote through required super- whatever LP sharing provisions exist. sponsor may have different views as to majority voting provisions. Disclosure may satisfy a private equity the desirability of anti-takeover firm’s lawyers, but any fee that the Should the company opt out of measures. Management may favor market views as oversized may impact Section 203 of the Delaware these measures while the sponsor may the success of the offering. corporation law? prefer to have fewer impediments to a A private equity sponsor of a Delaware Should we still be on the Board? transaction in which it might be able to corporation should consider whether or Most private equity sponsors generally obtain a premium price for its stake. not the company should opt out of have contractual rights to designate However, certain anti-takeover Section 203 of the Delaware corpor- directors contained in a shareholders provisions may benefit the sponsor by ation law before taking the company agreement or similar agreement. The making the company more attractive to public. Section 203 imposes a three- agreement may or may not provide for sophisticated management and year moratorium on business the termination or continuation of these providing the Board with more flexibility combinations with any 15% or greater rights post-IPO. A private equity to resist low-ball takeover approaches continued on page 10

The Debevoise & Plimpton Private Equity Report l Summer 2005 l page 9 Selected Issues to Consider When Taking a Portfolio Company Public (cont. from page 9)

stockholder unless the business com- corporate governance committee and is not yet clear and a recent market bination or the crossing of the 15% a compensation committee must each check on whether having fewer inde- threshold receives prior Board approval, be comprised exclusively of pendent directors and committees will the bidder reaches the 85% threshold independent directors. Under the impact the trading market is advisable. in the same transaction as it crosses the Nasdaq rules, director nominations and Who will qualify as an independent 15% threshold, or the combination is CEO compensation are to be approved director? approved by at least a majority of the by committees comprised exclusively Under the NYSE rules, for a director to Board and by holders of at least two- of independent directors or approved be independent, the Board must thirds of the shares not owned by the by a majority of the independent affirmatively determine that the director bidder. A Delaware corporation can opt directors. (Unlike the NYSE, Nasdaq has no “material relationship” with the out of applicability of Section 203 by so does not require the board to have listed company. Nasdaq requires the providing in its charter. An IPO gives a nominating and compensation Board to make a similar determination. company a one-shot opportunity to committees). In examining relationships between a decide whether or not Section 203 will Private equity firms that will continue director and the listed company, the apply, since it is very unusual to opt out to hold 50% of a company’s voting Board must consider relationships once the company is public and any power after an IPO should consider the between the director and any parent or amendment to the charter to opt out advisability of the “controlled subsidiary in a consolidated group made after the IPO will only become company” exemption to the director with the listed company. Material effective after a one-year waiting independence rules. When at least 50% relationships can include commercial, period. of a company’s voting power is held by industrial, banking, consulting, legal, A private equity sponsor that will an individual, a group or another entity, accounting, charitable and familial retain a greater than 15% stake after an then the company may elect to be relationships, among others. As the IPO may find it desirable to preserve its considered a “controlled company.” A concern is independence from flexibility to sell a meaningful control controlled company is exempt from the management, both the NYSE and block to a potential acquirer who even- requirements to have a board of Nasdaq do not view ownership of even tually wants to acquire the remainder of directors comprised of a majority of a significant amount of stock, by itself, the company without Board approval. independent directors, and a as a bar to a finding of independence. In reviewing any proposed sale by its nominating/corporate governance The rules provide that certain large stockholders, the Board will have committee and a compensation relationships would automatically cause fiduciary duties to all stockholders, committee, each comprised exclusively a director not to be independent. which may limit the ability of the of independent directors. A controlled Among other specified disqualifying sponsor of a portfolio company that company will be exempt from these relationships, a director who is, or has has not opted out of Section 203 to requirements as long as it discloses in been within the last three years, an orchestrate a transaction it favors or to its annual proxy statement that it is a employee of the listed company or its obtain a control premium for its shares. controlled company and the basis for parent or subsidiary, is not inde- that determination. However, a con- Independence requirements and the pendent. A director who has received trolled company still must have an audit controlled company exemption during any twelve-month period within committee comprised exclusively of The role of independent directors on the last three years compensation independent directors. public company boards has been (other than for Board or committee A private equity sponsor that does dramatically increased as a result of service) above a specified threshold not own at least 50% of a company’s Sarbanes-Oxley and the new listing from the listed company is not inde- voting power may wish to consider requirements recently adopted by the pendent (the compensation threshold entering into a voting agreement with NYSE and Nasdaq. Both the NYSE and is $100,000 for the NYSE and $60,000 other investors or with management to Nasdaq require that a majority of for Nasdaq). A director will not be reach the 50% threshold that would directors that serve on the board be independent if he or she is a current enable it to fall under the con-trolled independent and the audit committee employee or executive officer of a company exemption. be comprised exclusively of company that received payments from The market’s receptivity to reliance independent directors. In addition, on the controlled company exemption continued on page 27 under the NYSE rules, a nominating/

The Debevoise & Plimpton Private Equity Report l Summer 2005 l page 10 guest column The Challenge of Valuation Guidelines

Introduction Perspectives on U.S. and International by the Institutional Limited Partners Industry participants are adopting the Guidelines Association (ILPA), which represents valuation guidelines developed by the Respondents to the Tuck survey over 125 LPs. The Tuck survey and Private Equity Industry Guidelines represented a broad cross section of comments made at the conference Group (PEIGG) more broadly in the US GPs with diversity in investment style, indicate that comprehensive adoption than previously thought, according to fund size, and number of funds under will take time, if it happens at all. About an online survey of general partners management. Of the 102 respondents, half of GP survey respondents that recently conducted by The Center for nearly 70% were VCs and 25% were specifically had not adopted PEIGG Private Equity and Entrepreneurship buyout funds. About 50% of respon- indicated that they preferred write-ups at the Tuck School of Business at dents said they relied on well-known only after a new round of financing. The Dartmouth. Nearly 20% of the 102 industry guidelines for their internal National Venture Capital Association respondents indicated they had valuation policies, indicating a general (NVCA), which represents VCs but not formally adopted the PEIGG guide- acceptance of guidelines as a useful buyout firms, chose not to endorse lines, while several more indicated that tool to drive internal policies. The 2005 PEIGG, although it commended the PEIGG had influenced their internal survey followed up on a similar survey group’s efforts. In a 2004 press release valuation policies. by the Center in 2003 and showed that, the NVCA announced that it “encourages The Center hosted a by-invitation despite consistent industry attitudes diligence, prudence, and caution when conference in June to bring together over time about support for valuation implementing the specific elements of GPs, LPs, accountants, advisors, and guidelines (from about 50% of GPs) as any guideline, such as valuation write- representatives of numerous US and well as opposition (from nearly 20% of ups of early-stage companies in the international industry associations to GPs), the influence of PEIGG had absence of market-based financing discuss the issues surrounding valuation taken hold. events.” policies. Both the survey data and The PEIGG valuation guidelines, Despite the situation in the U.S., the comments by participants at the developed 18 months ago (see rest of the private equity world is

conference indicate that there is still a www.peigg.org), have been endorsed continued on page 12 strong discomfort among GPs to Paragraph 30 of PEIGG, which allows non-round write-ups. Respondents and Figure 1: Potential for write-ups participants also expressed skepticism about global convergence of valuation 60% “If you only allow write-ups based on a new guidelines. financing round but you were to apply fair value More importantly, the survey and the 50% principles, then, on average, what percentage of comments by conference participants your portfolio companies would likely be written up suggest that role and influence of 40% which aren’t written up now?” independent auditors is growing. There will continue to be tensions among LPs’ 30% desire for consistency, GPs’ historical Venture preference for privacy, and auditors’ 20% Buyout obligation to apply fair value principles that are not formulaic. As the Financial 10% Accounting Standards Board (FASB) and the International Accounting 0% Standards Board (IASB) further develop

their principles-based guidelines, 50% auditors may ultimately be the force > 11% to 20% 11%

that determines the outcome for the 41% to 50% 21% to 30% Zero to 10% 31% to 40% application of valuation guidelines

in the US and also drives global NA, my fund uses

convergence. “fair value” principles

The Debevoise & Plimpton Private Equity Report l Summer 2005 l page 11 The Challenge of Valuation Guidelines (cont. from page 11)

making meaningful progress toward years, and nearly 40% say it will basis for valuation. While European VCs commonly accepted guidelines. never happen. and buyout funds have broadly agreed Recently, three European industry The Tuck survey also indicated on guidelines, this agreement may associations, the Association Française significant reluctance by U.S. GPs reflect the relatively small portion of des Investisseurs en Capital (AFIC), the to fully apply fair value accounting capital that venture capital represents European Venture Capital Association principles. This was clear in the within the entire European private equity (EVCA), and the British Venture Capital substantial reported impact on industry. Some LPs have expressed Association (BVCA), issued joint portfolio valuations, if GPs were to mark concern over “stale” valuations that do valuation guidelines that were rapidly to market, as shown in Figure 1, page not reflect economic reality and cite adopted by over 25 countries and 11. Pressure to aggressively mark to examples of pre-IPO portfolio com- endorsed by ILPA. market is not present. LPs are generally panies like Google carried “at cost.” The PEIGG board represented a seen by GPs as not giving this a high Some GPs argue that a conservative broad cross-section of U.S. industry priority, and auditors, while more active, philosophy of under-promising and participants. This broad based effort are not insisting on changes (see Figure over-delivering is better for all parties. served to encourage the European 2). Conference discussions showed that Other GPs say that continually adjust- associations to work more collabor- this situation might be substantially ing interim evaluations of early and atively. The international guidelines are inconsistent with what accounting mid-stage growth companies serves no based on fair value principles and aim authorities are intending for fair value purpose. to be consistent with both U.S. generally principles continued on page 25 accepted accounting principles (GAAP), Key Issues as well as IASB principles. Nevertheless, Is there a contradiction? as the Tuck survey of U.S. GPs indicated, Nearly 80% of survey respondents Figure 2: Auditors not convergence of standards may be believe that their current policies insistent on changes difficult to achieve. One quarter of adequately reflect fair value. Yet, the respondents believe convergence of survey results showed that many of the valuation guidelines will occur within 3 “If your valuation policy does not same respondents believe the appli- to 5 years. Another third of respondents allow for non-financing round cation of fair value could lead to material believe convergence will take 5 to 10 write-ups, does your independent write-ups. Accountants seem to indi- cate this means current financial auditor accept this without statements of many private equity firms qualification as GAAP “fair value?” Times are good for many may not be fully GAAP compliant. An overwhelming majority of respondents 80% private equity practi- (75%) said they would change their Venture valuation policy in order to secure an 70% tioners so pressure to do unqualified opinion. However, 60% of Buyout something about GPs report that they believe LPs would 60% be willing to overlook qualified audit valuation guidelines is opinions as long as fund performance is 50% satisfactory. In addition, 25% of GPs not likely to come from provide their investors with “side 40% schedules” that contain up-to-date the industry. Instead, it is valuation estimates that differ from 30% audited financial statements. Ninety likely come from the eight percent of survey respondents 20% accounting standard said their auditors did not issue a qualified opinion to them for fiscal year 2004. 10% setters’ and auditors’ Is this only important to VCs? increasing insistence on Interim valuations are more of a 0% challenge for VCs, since buyout funds No fair value. can rely on operating cash flows as a Yes

The Debevoise & Plimpton Private Equity Report l Summer 2005l page 12 Are Private Equity and Strategic Deal Terms Converging?

As deal professionals know, U.S. private activities); in another such deal, there is of “Material Adverse Effect,” including equity transactions have traditionally no financing condition at all. These with respect to adverse changes in the differed from strategic deals in a number recent deals probably do not signify a seller’s industry or related to the of ways: these transactions have been well-established trend, however - in fact, announcement of the transaction — highly negotiated, almost uniformly our survey of 25 U.S. going-private neither of which, the private equity subject to financing conditions, carefully transactions announced by private buyer might argue, should be borne by structured to maximize financing equity buyers since January 1, 2004 a private equity firm to the same degree efficiencies, focused on cash flows revealed that the vast majority of such as by an existing participant in the rather than synergies and dependent on deals featured relatively customary seller’s industry. a partnership with existing (or some- financing conditions. And if lenders Although the absence of financing times newly hired) management teams. struggle to syndicate their loans in deals conditions and the presence of break- Some have suggested that many of without traditional financing conditions up fees have been limited thus far only those distinctions are blurring in the due to recent instability in the credit to a few deals, more widespread current environment, especially in large markets, this practice may be a short- changes have been seen in the familiar public transactions. Others have noted lived one indeed. definition of “Material Adverse Effect.” that large U.S. public-to-private deals The recent emergence of U.S. private In approximately half of the recent U.S. are beginning to resemble their equity transactions without financing going-private deals that we surveyed, European counterparts more than tra- conditions may result both from the MAE carve-outs (or exceptions to when ditional U.S. private equity transactions. competitive acquisition environment a Material Adverse Effect will be But perhaps recent experience instead currently facing acquirors and because deemed to have occurred) were suggests that, in the competitive U.S. many of the private equity players expanded to some extent beyond the market, public-to-private “mega” deals involved in these transactions are customary “laundry list,” not only to are simply different. veterans of large European public-to- exclude adverse changes in the target private transactions, which have industry that do not disproportionately Financing Conditions historically not featured financing affect the target business or resulting Financing conditions have been conditions and in which definitive from the announcement of the standard practice in U.S. private equity financing documentation may well be transactions for many years. Corporate continued on page 14 completed before a bid can be sellers have traditionally accepted this launched. increased conditionality when strategic acquirors have not been a viable Other Contract Terms; MAE Clauses Although the absence of alternative, comforted in part by the fact Private equity firms have often focused financing conditions and that private equity transactions generally on contract terms to a degree that involve more limited deal completion strategic buyers in frothy markets have the presence of break-up risks related to antitrust or regulatory not. The private equity buyer has approvals. However, a few recent U.S. traditionally demanded more compre- fees have been limited going-private transactions have hensive representations and warranties thus far only to a few garnered attention not only for their from the seller than those typical in large size but also because they are not strategic deals, consistent with the lower deals, more widespread subject to customary financing margin of error for post-closing liabilities conditions. In most of the deals without that may be implicit in the private equity changes have been seen traditional financing conditions, the firm’s pricing model. In divestiture in the familiar definition buyer has a quasifinancing condition transactions, the private equity buyer that is limited very narrowly to the non- may require more extensive post- of “Material Adverse occurrence of certain extreme closing covenants regarding the circumstances of the sort that would be separation of the target business from Effect.” conditions to a firm underwriting of its corporate parent. The private equity securities (such as a banking mora- buyer has traditionally resisted torium or general suspension of trading customary exceptions to the definition

The Debevoise & Plimpton Private Equity Report l Summer 2005 l page 13 Are Private Equity and Strategic Deal Terms Converging (cont. from page 13)

transaction, but also to exclude effects occasionally accepted indemnities company LBOs or other going private of actions required to be taken in order limited to 20-25% of the purchase price. transactions - and that by requiring to consummate the transaction, the The fact that private equity buyers may private equity buyers to compete with target’s failure to meet its earnings be more willing to accept such risks equally “large cap” corporate forecasts or declines in its share price. may again evolve from their acquirors, these deals may require While some of these specific exclusions experiences in European deals, in them to assume a greater degree of may only be applicable to public which MAE conditions (especially in completion risk than that to which they company targets, this development public-to-private transactions) and (and their limited partners) might suggests that certain private equity indemnification provisions have otherwise be accustomed. buyers are willing to assume a greater historically been more narrow than in As private equity firms continue to degree of deal completion risk — and the U.S. — although, in each case, the play an increasingly prominent role in this risk allocation may potentially willingness to accept such risks will high-profile M&A transactions, the U.S. translate into privately-negotiated deals ultimately depend on the parties’ private equity market will no doubt more readily than, for example, the relative negotiating leverage, the continue to evolve. As this process disappearance of the financing nature of the target business itself, the plays out, commentators may speculate condition or the emergence of break- extent of the buyer’s due diligence as to whether the terms of private up fees, depending on the facts and inquiry and other relevant facts and equity and strategic deals are con- circumstances of the relevant circumstances. verging, just as M&A practitioners in transaction. recent years have discussed the Break-up Fees Private equity buyers have also maturation of the European private The few recent transactions in our shown increased willingness to assume equity market and the actual extent of survey that did not include customary post-closing risks by agreeing to more perceived differences between financing conditions also incorporated limited indemnification protection than European and U.S. practices. In the features rarely, if ever, seen in private was traditionally seen in U.S. private ever more competitive U.S. acquisition equity deals — termination or “break- equity deals. Although a private equity environment, the recent surge in up” fees (or expense reimbursements) buyer may have argued in the past that unusually large, public-to-private deals payable by the buyers. In most of these the seller’s indemnification obligations may instead suggest a global deals, the buyers are obligated to pay should be “capped” at the purchase bifurcation of the private equity market. break-up fees equal to approximately price of the transaction, if capped at all, The private equity firms doing “mega” 2.5-3% of the purchase price to the private equity buyers in recent large deals in the U.S. are familiar with public company sellers if the trans- (but not “mega”) deals have prevailing European deal terms and action is terminated due to a breach of may be more willing to accept such the buyers’ representations, warranties terms in the U.S. to land bigger targets or covenants or because the buyers are — but may not necessarily be willing to unable to obtain sufficient debt Private equity buyers have do so in more “normal” deals. In other financing prior to the “drop-dead” words, the most compelling division also shown increased date. But again, virtually none of the may not be between the U.S. and going-private deals in our survey that willingness to assume Europe, or even between private equity included traditional financing firms and corporate acquirors, but conditions also contained break-up post-closing risks by rather simply between mega-deals and fees. This may suggest that the the rest of the deal universe. agreeing to more limited emergence of break-up fees in private — Franci J. Blassberg indemnification protection equity transactions may be a mini-trend limited to “large cap” going-private [email protected] than was traditionally seen deals, which have specific dynamics — Joshua J.G. Berick that involve different considerations [email protected] in U.S. private equity deals. than seen in traditional, private

The Debevoise & Plimpton Private Equity Report l Summer 2005 l page 14 trendwatch Spinouts of Private Equity Funds

In the Winter 2005 issue of this publication we compared the terms and conditions of first-time private equity funds with those of larger, more established successor funds and found that first-time fund managers have generally succeeded in retaining certain standard “market” terms in their fund agreements despite the widespread assumption that as first-time fund managers they are negotiating from positions of relative weakness. One of the factors that explains this unexpected finding is that many new private equity firms are comprised of professionals that are anything but newcomers, having held senior investment and management positions at some of the world’s leading private equity and financial institutions. These private equity groups “spinning out” of larger organizations face a variety of legal and commercial issues before, during and after their transition to independence. We consider some of these below.

Although there have recently been a or an expectation of continuing to be key obligations that should be reviewed number of significant spinouts involved in the parent’s private equity carefully in advance in consultation with announced in the private equity business, but with the intention of counsel: industry, most notably from the large raising a new private equity fund. In the Non-competition. Most employ- investment banks, spinouts have been case of the former, support from the ment agreements in the private equity part of the private equity landscape for parent may take various forms, such as context prohibit employees from many years (see the accompanying engaging the team’s new firm to advise engaging in activity that competes with table for a list of notable spinouts). on the legacy portfolio (or perhaps the employer and provide that the Motivations for a private equity team’s even to manage the parent’s existing employee may not become affiliated as departure often include achieving funds), committing capital to a new employee, partner, service provider, greater investment independence, fund that the spinout group is investor or otherwise with a competing securing a bigger slice of the carried launching, and providing transitional private equity business. The restriction interest, and realizing long-held administrative services and facilities. applies throughout the term of employ- entrepreneurial aspirations to build a From the perspective of the spinout ment and typically extends for a period new firm and culture. Parent institutions team, these negotiated arrangements thereafter, often between three and six also have their reasons for spinning out with the parent essentially put the team months, and sometimes longer in private equity businesses, which may “in business on day 1” and help certain jurisdictions (the so-called include minimizing real or perceived accelerate the process of building the “gardening leave” period). Depending conflicts of interest between the in- new firm from the ground up. For a on how the non-compete clause is house private equity teams and the team that is spinning out without drafted, private equity professionals on investment banking divisions, reducing parental support, there are numerous gardening leave must be cautious balance sheet volatility, managing issues to clarify and resolve before and about certain start-up activities for their compliance with anticipated capital after deciding to leave. We devote new firm, such as forming manage- adequacy requirements under Basel II, most of the remainder of this article to ment or advisory entities to apply for or implementing a broader merger or issues particularly affecting this second regulatory clearances, pre-marketing acquisition initiative. Many of the category of spinouts. future funds to potential investors, and challenges that confront a team maintaining “deal flow” contacts. Restrictive Covenants in Existing spinning out from its parent relate back Non-solicitation. Private equity Agreements to the underlying reasons for leaving professionals may be pinned by two Private equity professionals considering and the support, if any, that the parent prongs of a non-solicitation covenant striking out on their own are likely to is ready to provide going forward. contained in their existing employment find that they are subject to a number Spinouts tend to fall into one of two contracts: one prong prohibits soliciting of restrictive covenants with the parent, basic categories: (1) the parent makes a the parent’s other employees to leave not only in their employment agree- strategic decision to effect a partial or the parent and join the spinout firm; the ments but in the limited partnership complete exit from the private equity other prong restricts an employee’s and other operating agreements sector and is transferring responsibility ability to solicit its employer’s clients related to the parent’s existing carried for managing portfolio assets to the (including fund investors), in effect interest and co-investment programs outgoing team; or (2) a team decides to bolstering the non-competition (e.g., stock options and other employee make a clean break and departs compensation plans). There are three continued on page 16 without the parent’s active cooperation

The Debevoise & Plimpton Private Equity Report l Summer 2005 l page 15 Trendwatch: Spinouts of Private Equity Funds (cont. from page 15}

covenant described above. confidentiality, it is possible to call for a partial or complete loss of Like non-competition covenants, reassemble information on the group’s undistributed carried interest (even if both types of non-solicitation track record through meticulous already vested), including carried restrictions may by their terms continue collection and review of press releases, interest that has been realized but held in effect for a number of months after public information filed with securities back in an escrow or segregated an employee has resigned or been regulators (if public debt or equity has reserve account. There is also the risk terminated and can impinge upon a been issued), semi-public information that the former employer threatens spinout team’s plans to move quickly available to banks in the context of litigation, which may include seeking toward marketing and operating a new debt syndications, and commercial an injunction against the new firm’s fund. In the current fundraising environ- services specializing in providing fundraising activities that disrupts the ment, we are finding that institutional financial information. In addition, process. Other obligations of the investors are paying increased atten- portfolio companies may be willing to departing principals would ordinarily tion to mid-level and junior members provide or confirm certain data, continue, as they would in a departure of a fund management team. The although care should be taken not to that did not involve a contractual expiration date of covenants restricting violate any covenant not to interfere breach, such as the obligation to return a spinout group from “poaching” with existing relations of the former distributed carried interest in the event players away from a former employer employer. In certain jurisdictions, such of a fund-level clawback or indemnity. can directly impact the timing of a new as the United Kingdom, the mandatory Contrast with legacy assets fund. In addition, if the departing public disclosure of company annual spinout. When compared to the professionals are contractually pro- accounts, including for private minefield of restrictions and potential hibited (or, as a gesture of good will companies, can be a particularly useful penalties that these spinout teams toward the former employer, wish to source of information when recreating must steer their way through, the refrain voluntarily) from soliciting clients a track record from public sources. spinout of a private equity team that of the former employer, the pool of Complying with an existing agree- transitions to independence with the targeted investors may shrink. ment not to disclose confidential parent’s active cooperation and Non-disclosure. Standard information (e.g., prior investment support has a clearer path toward employment and other private equity- performance) is separate from the starting a new business and raising a related operating or partnership analysis that any private fund manager new fund. Although a spinout involving agreements proscribe disclosure to must undertake in connection with the ongoing management of legacy another person of confidential infor- satisfying the applicable legal and funds or assets by the new firm will mation obtained during the course of regulatory standards for presenting require substantial negotiation with the employment or association with the and properly attributing an investment parent, the issues at the core of the employer/sponsor. This may encom- track record in offering materials. These parties’ discussions will not be cen- pass information about prior funds, standards vary according to jurisdiction; tered around the former employer’s investors, fund investments, the invest- however, firms that are registered with ability to constrain the development of ment management company and its the U.S. Securities and Exchange the new firm. Instead, spinout nego- affiliates. Reconciling inherent tensions Commission pursuant to the tiations are more likely to focus on between compliance with this confi- Investment Advisers Act of 1940 are structuring a viable alignment of dentiality clause and the need to subject to certain rules and guidelines, economic interests between the new present the spinout team’s investment including the maintenance of detailed firm and its former parent and the track record (including IRRs) when books and records supporting the management of the legacy assets to a raising a new fund requires careful presentation of investment profitable end result. planning and often involves discussion performance. Establishing the New Firm and negotiation with the former Consequences of breach. The Following disengagement from the employer/sponsor to obtain waivers stakes can be high for departing former employer/sponsor and the and access to data. principals if they breach their lapse of gardening leave and any other In some cases, where the spinout obligations not to compete, solicit or applicable restrictions, the spinout group is unable to secure the disclose. These obligations frequently principals will require a new cooperation of the former employer survive beyond the date of their architecture for the governance, and members of the group remain withdrawal or resignation from the firm. continued on page 26 subject to continuing obligations of The consequences for breach routinely

The Debevoise & Plimpton Private Equity Report l Summer 2005 l page 16 For U.S. Companies, Exiting with Canadian IDSs Falls Short of Promise

Last year we reported on the birthplace of the hybrid income While this accomplished the goal of emergence of a new capital markets security, which has a C$100 billion plus making the IDSs eligible for purchase product, Income Deposit Securities income trust market. (Indeed, IDSs by the Canadian retirement accounts, it (IDSs), and their use as a potential exit evolved from income trusts). As a complicated the structuring of the strategy for private equity portfolio result, IDS issuers in Canada found sellers’ retained stake. Most sellers companies.1 IDSs, alert readers may greater market acceptance among want the right to convert their retained recall, are units consisting of common buyers and benefited from a more equity into IDSs in the future in order stock and subordinated debt marketed expedited securities regulatory review. to preserve liquidity upon exit. as a yield-oriented hybrid security. IDSs However, there were still challenges However, under recently enacted U.S. were viewed as potential exit strategies to overcome. First and foremost, since tax rules designed to prevent so-called for companies having stable cash flow U.S. businesses were involved, “inversion” transactions, having such a and modest capital expenditure ensuring that the debt component of right arguably could cause the requirements that may not have been the IDSs would be respected as debt Canadian issuer to be subject to U.S. attractive candidates for traditional (and that the interest on that debt taxation or could subject equity-based IPOs due to their limited growth would be deductible) for U.S. tax compensation of management to prospects. There was considerable purposes was a paramount objective. excise taxes. As a result, in most of the initial excitement about this product This meant that certain requirements IDS issuances done to date, the among investment banks and sponsors that had been developed in the U.S. sponsors lack the right to convert their and by mid-2004, 20 would-be issuers IDS offerings (the so-called “Five retained equity into IDSs, although had filed to do IDS offerings. Commandments”) needed to be some liquidity rights do exist. Ultimately, several IDS transactions satisfied, including the sale of The Possibility of a Brighter Future by U.S. companies were successfully “bachelor bonds” (debt identical to Recent law changes in Canada may completed (B&G Foods in October the IDS debt but sold separately from provide a path for solving the liquidity 2004, Coinmach in November 2004 equity) and the retention by the sellers issue. Specifically, the limitation on and Otelco in December 2004). of an equity stake in the issuer for a Canadian retirement accounts However, the realities of pricing and minimum period of two years. The purchasing non-Canadian securities execution fell far short of the promise, latter requirement of a retained has been removed in the most recent and the large majority of prospective equity stake has proved particularly budgetary amendments, which IDS issuers abandoned their IDS problematic. became law in June. This change offerings for other exits (leveraged One difficulty that arose in would allow U.S. companies to issue recaps, high dividend IPOs or M&A structuring the retained equity portion IDSs in Canada without the need to transactions). While a variety of factors was the fact that a Canadian holding create a new Canadian holding were at work, the suboptimal exe- company issuer was viewed as a company, and, thus, without cution in the U.S. was most likely due necessity for a Canadian IDS offering. implicating the inversion rules. to (1) the lukewarm reception to a Canadian registered retirement The ability to use a U.S. issuer in hybrid product, containing both equity accounts (the equivalent of IRAs in the Canada raises another interesting and debt, by U.S. institutional investors U.S.), which are significant purchasers possibility-the ability to do a dual which have traditionally viewed of income securities, have limitations offering of IDSs in the U.S. and themselves as either equity buyers or on the amount of non-Canadian Canada. A dual offering, likely debt buyers and (2) the lengthy review securities they can purchase. As a weighted more heavily to Canada, of IDS offerings by the SEC which result, U.S. companies seeking to do a presents the potential for larger further challenged actually bringing Canadian IDS would create a new transaction sizes. While the Canadian transactions to completion. Canadian parent to issue the IDSs component would be registered in (sometimes, depending on whether Seeking Greener Pastures Canada and listed on the Toronto the U.S. com-pany was a corporation Several U.S. companies have found Stock Exchange, the U.S. component or an LLC, with different Canadian greater success by completing IDS of the offering could be sold as a issuers for the equity and debt offerings in the Canadian market, the private placement, avoiding an components of the IDSs). extended SEC review process, and at 1 See the Winter 2004 and the Spring 2004 issues of the Private Equity Report. continued on page 18

The Debevoise & Plimpton Private Equity Report l Summer 2005 l page 17 Exiting with Canadian IDSs (cont. from page 17)

the same time giving U.S. purchasers Although to date only six U.S. whether they are destined for the access to liquidity in the Canadian companies have completed Canadian relative obscurity of their U.S. market. Such a structure would enable IDS offerings, anecdotal evidence counterparts. would-be issuers to target U.S. indicates a fair amount of interest — Peter A. Furci investors, such as hedge funds, that among sponsors. Only time will tell [email protected] are more receptive to hybrid securities whether Canadian IDSs for U.S. than mutual funds. companies will really catch on or

Proposed Carried Interest Tax Rules: Square Peg, Round Hole (cont. from page 8)

be established with clear and convincing includes the relevant provisions and carried interest and the continuing evidence that the GP interest was not is legally binding on each partner. application of Campbell to the granted in anticipation of a subsequent valuation of the carried interest. 3) The partnership and each partner disposition. must report the income tax effects What’s Next The Basic Safe Harbor of the Safe Harbor Partnership The IRS has requested comments Requirements. We expect that the Interest consistent with various concerning the proposed rules and a fund and the GP would each want to requirements in the new rules. hearing is scheduled to take place in make the Safe Harbor Election contem- Fall 2005. A variety of groups are plated by the proposed rules. In order 4) The partnership must issue already assembling comments and the for a partnership to make and maintain appropriate information returns application of the proposed regulations a Safe Harbor Election: with respect to each Safe Harbor to private equity funds is certain to be Partnership Interest. 1) The partnership must file a addressed. It is difficult to predict at this document affirmatively electing to Need to File 83(b) Elections. Under point what exactly the final rules will apply the safe harbor. the proposed rules, in general, if an require in order to maintain the favor- interest in the GP is subject to vesting, able tax results available today. As a 2) The partnership agreement must the recipient will want to file an 83(b) result, one can expect sponsors to include provisions legally binding election. If the interest in the GP (or the include language today in fund agree- on all partners (including the LPs) share of the carried interest) is revised ments and GP agreements that will stating that (i) the partnership is after the initial grant date (as is the case give the sponsor sufficient flexibility to authorized and directed to elect the with many GP arrangements), it may be comply with whatever the final safe harbor and (ii) the partnership necessary to file a new 83(b) election. regulations will require in the future. and each partner agree to comply This would be a change from current with all of the requirements of the — Andrew N. Berg practice. We are hopeful that the final safe harbor with respect to all [email protected] regulations will clarify that multiple partnership interests transferred in — Adele M. Karig 83(b) elections with respect to the same connection with the performance of [email protected] partnership are not necessary. services. In the case of a transfer, Non-U.S. funds. The proposed rules — David H. Schnabel the transferee must agree to assume apply to both U.S. and non-U.S. funds, [email protected] the transferring partner’s if a carried recipient is a U.S. taxpayer. — Peter F.G. Schuur obligations. If the partnership However, it appears that only funds that [email protected] agreement does not include the file U.S. tax returns will be eligible to necessary language (or it is not make the election. U.S. carried interest legally enforceable against all recipients in non-U.S. funds that do not partners), the requirement can be file U.S. tax returns will likely want to file satisfied by having each partner an 83(b) election, but will need to sign a separate document that consider carefully the valuation of the

The Debevoise & Plimpton Private Equity Report l Summer 2005 l page 18 alert Most Private Equity Funds Now Exempt from German Penalizing Tax Regime and Reporting and Publication Requirements

There is more good news from the meaning of the Act (i.e. is not itself a continue to be potentially exposed to Germany for private equity players. In partnership), then the mere fact of being the Investment Tax Act. Depending on the Summer and Fall 2004 issues of the owned by a partnership will not cure the the circumstances, incorporated vehicles Private Equity Report we reported on investment fund of its fund status under may nevertheless be able to escape the the possible application of new punitive the Act. By contrast, in a typical fund of ambit of the Act by relying on the tax rules and onerous reporting and funds situation since the fund of funds is guidelines which were used in the past. publication requirements for investment typically organized in partnership form However, these guidelines are not black funds in Germany. In June, after more and holds interest in foreign vehicles and white, and incorporated foreign than a year of intense discussion which again are organized as partner- funds will therefore have to give side and several drafts, the German tax ships, the new safe harbor for foreign letters to investors who will want to be authorities issued a revenue ruling partnerships is applicable to both insured that certain criteria are fulfilled clarifying the new Investment Tax Act vehicles. Hedge funds, on the other in order to avoid the penalizing tax (Investmentsteuergesetz) which hand, even if organized in partnership regime. Even if these assurances are replaced the Foreign Investment Fund form do not enjoy the safe harbor. It is given in a side letter, a German investor Act (Ausland-Investmentgesetz) in not always clear what exactly constitutes will typically demand that a fund January 2004, providing some summer a “hedge activity;” as a rule of thumb it nevertheless comply with the reporting relief for most private equity funds. requires leveraging and taking and publication requirements as an While the Investment Tax Act is really short/long positions. additional safeguard to avoid the directed at mutual funds; because of On a positive note, the Revenue application of the penalizing tax. the broad definition of a “fund” there Ruling also exempts derivative instru- The new safe harbor is effective as of has always been great uncertainty ments which track the performance of the 2004 enactment of the Investment whether foreign private equity funds any type of foreign assets or of a fund Tax Act (i.e. January 2004), and thus is (including LBO and VC funds) fall within from the scope of the Act and foreign also applicable with respect to funds the scope of the Act. If a foreign vehicle funds which issue collateralized debt which were created before 2004 when qualifies as a “fund” within the meaning obligations (CDOs, including CLOs) are, the old law was still in effect. of the Act, an investor is subject to a subject to meeting certain requirements, — Dr. Friedrich E. F. Hey prohibitive tax burden under a penalizing also carved out from its scope. [email protected] tax regime unless the foreign fund Which vehicles remain potentially complies with onerous reporting and subject to the Investment Tax Act and publication requirements, including the its potentially applicable penalizing tax requirement to make public certain and onerous reporting regime? All Which vehicles remain information on the internet, more vehicles which are not classified as specifically in the German Federal “partnerships” under German tax law. potentially subject to the Electronic Gazette (Elektronischer Without going into detail, it is fair to say Investment Tax Act and Bundesanzeiger). that foreign limited partnerships, even if The new Ruling, which is effective they have a corporation as their general its potentially applicable retroactive to January 2004, now partner, are classified as “partnerships” provides a clear safe harbor rule for German purposes. U.S. limited penalizing tax and according to which foreign vehicles liability companies (LLCs) can, depending organized as partnerships never qualify on the individual circumstances, be onerous reporting as a “fund.” Rather an investor will be classified either as a partnership or as a taxed under general principles which corporation. Certainly all incorporated regime? All vehicles prescribe a look-through in respect of entities (a U.S. “Inc.”, an English which are not classified partnerships. Thus, based on this look- “Limited”, an Irish/English “Unlimited through principle, if a foreign partnership Liability Company”, and most notably a as “partnerships” under holds an interest in another vehicle Luxembourg “SICAV”) will not qualify as which does qualify as a “fund” within partnerships and accordingly will German tax law.

The Debevoise & Plimpton Private Equity Report l Summer 2005 l page 19 Second Lien Financing: A Ten-Point Primer for the Borrower (and its Sponsor) on Intercreditor Dynamics

The second lien market has exploded from $3.2 billion in 2003 to $12 billion in 2004, as tracked by Standard & Poor’s. Some expect that figure to reach $20 billion in 2005. While the lenders’ perspective dominates much of the recent second lien financing literature, here are ten intercreditor issues that the borrower should also care about.

Background liquidity or to buy time to improve and cost, especially in the event of a In a second lien financing, a borrower leverage and performance in order to bankruptcy. The problem of dueling grants one or more lenders a junior lien access the traditional debt markets. constituencies may be exacerbated on collateral that is also subject to Today, second lien financing is a routine when a large syndicate of lenders holds another lender’s first priority lien. The part of a borrower’s capital structure, the second lien debt. The terms of the second lien lender believes the value of and second lien financings are used for intercreditor agreement partly deter- the collateral will be sufficient to pay its acquisitions as well as partial exit mine the extent of this additional claim after paying the claims of the first recapitalizations. complexity and cost. lien lenders. For taking the risk that the There are many reasons why The Borrower’s Perspective on collateral will not suffice, the second borrowers may prefer second lien Intercreditor Agreements lien lender receives a higher interest financing to unsecured financing such The intercreditor agreement specifies rate than the first lien lender (currently as mezzanine debt or bonds. Because it the relative rights of the first lien lender around 300 basis points higher). The is secured, a second lien financing and the second lien lender. The borrower first lien lender may have a number of should be priced lower than a com- signs the intercreditor agreement but is reasons to share the collateral; including, parable unsecured financing. There is often precluded from exercising any the second lien lender’s willingness to no equity dilution (which is particularly rights under it. Nonetheless, the subordinate its liens and to waive attractive to sponsors). The docu- borrower still has an interest in nego- certain rights it would otherwise have mentation involved can be quicker, tiating the intercreditor agreement, as a creditor. But unlike traditional debt easier and consequently less expensive because the relative rights of the first subordination (which involves payment than that of mezzanine debt or bonds. lien lender and second lien lender blocks), lien subordination runs only to Call restrictions and prepayment pre- affect the borrower’s relationship with the collateral and the proceeds of the miums in second lien financings are each. The borrower may wish to resist collateral. In other words, the first lien generally less burdensome and less any effort by the lenders —particularly lender is entitled to be paid first only costly than those found in high yield the second lien lenders — to limit the from any proceeds of the collateral. debt. Also, obtaining a covenant waiver borrower’s role in the negotiations. Banks and large institutional from a second lien syndicate does not The borrower’s interests in the investors generally provide most first involve a formal consent solicitation intercreditor arrangements are largely lien financing (and they increasingly process, which may make it less difficult aligned with those of the first lien participate in second lien financing to to obtain than a waiver from a large lender. The first lien lender wants a blend or supercharge their returns). group of bond holders. “silent” second lien (i.e., exclusive Hedge funds, however, have rapidly On the other hand, second lien control of the collateral), both before become important players in the financing may disadvantage the and during a bankruptcy, with extensive second lien market, probably as a result borrower in some important ways. It waivers of rights by the second lien of a surplus of available funds and a may tie up a borrower’s collateral and lender. (Note that, even if an inter- limited ability under their fund increase its leverage, making it difficult creditor agreement says everything the agreements to invest in unsecured or impossible to obtain future financing. first lien lender wants, all of those rights debt. The entry of hedge funds and Second lien covenants, though less may not be enforceable. There are only other non-traditional participants into restrictive than first lien covenants, are a few, inconsistent cases testing such the second lien market is one key usually more restrictive than the cove- terms in a bankruptcy context. Notwith- reason for its rapid growth. nants in high yield bonds. Furthermore, standing some uncertainty, the first lien As this market has grown, borrowers’ when seeking consents or other actions lender often asks for all of these things- motives for borrowing second lien from its lenders, the borrower has two the premise being that, if the first lien financing have changed. At first, classes of secured creditors whose lender can’t ultimately get everything it distressed borrowers often entered interests are not necessarily aligned, a wants, it just might find (as the song second lien financings to secure circumstance that may add complexity goes) that it gets what it needs.) The

The Debevoise & Plimpton Private Equity Report l Summer 2005 l page 20 borrower wants to limit the second lien work out a remedy with the first lien refinancing the first lien debt or the lender’s ability to hold up a future lender and it prevents overlapping or second lien debt more difficult for the waiver, refinancing or reorganization. conflicting enforcement actions against borrower. The borrower’s interest in the Because what the first lien lender wants the shared collateral. outcome of this provision diverges from is consistent with what the borrower the first lien lender’s interest; each 3. Control Over Shared Collateral wants, a borrower may to some extent lender has an interest in restricting The intercreditor agreement generally rely on the first lien lender to lead in changes to the other’s documents, while grants the first lien lender the exclusive negotiating the intercreditor agreement. the borrower’s interest is to eliminate or right to enforce rights, remedies and Whether the borrower is managing minimize such restrictions. make determinations regarding the or merely monitoring the intercreditor release or disposition of the shared 5. Buy Out Option negotiations, here are ten intercreditor collateral, and the second lien lender The intercreditor agreement often points for the borrower (and its equity often waives its right to object to the provides the right of the second lien sponsor) to review. exercise of these rights by the first lien lender to buy out the first lien debt at 1. First Lien Debt Cap lender. To facilitate this, the agreement par following its acceleration. And in The second lien lender, wanting to know provides for the automatic release of negotiations, the second lien lender will with certainty the amount of first lien the second lien lender’s liens. Together, frequently insist on having that right, debt ahead of it, usually insists that the this ensures that the borrower nego- since it allows for the possibility of taking intercreditor agreement cap the amount tiates primarily with the first lien lender control of a reorganization and thereby of outstanding first lien debt. The exis- concerning the exercise of remedies. It getting a better recovery. The first lien tence, scope and size of a cap are key also means that, subject to other terms lender will negotiate for the inclusion of issues for the borrower because the cap of the agreements, the borrower may unpaid interest or any applicable will limit its ability to borrow additional be able to sell collateral in the course of prepayment fees. The buy out option funds or refinance the first lien debt its business with only the first lien may not be worth much; in theory, a first without the consent of the second lien lender’s consent. lien lender should be willing to sell at lender. The cap is often limited to the The second lien lender may par after acceleration, particularly since principal amount of the first lien debt negotiate for consent rights with respect the first lien debt will often trade below plus a cushion. The second lien lender to the exercise of remedies or sales of par at the time. In addition, the exercise may ask that pre-payments and per- collateral, or it may insist on consent period is often so short (sometimes just manent reductions of first lien rights following an event of default 10 to 20 business days or less) it may be commitments reduce the cap. The under the second lien financing agree- impracticable to arrange new financing. parties may also negotiate whether the ment. Alternately, it may seek to restrict Still, the borrower may welcome the cap includes hedging obligations, sales of collateral to those sales per- possibility, though remote, of one interest or fees and the consequences mitted under the second lien financing secured creditor buying out another. of exceeding the cap. agreement, to retain the right to object continued on page 22 to the commercial reasonableness of 2. Standstill such sales, to require notice of such sales The intercreditor agreement usually or to require the proceeds of such sales provides for a “standstill” period (often be used to prepay the first lien debt. The borrower’s interests in around 180 days) during which the first lien lender has the exclusive right to 4. Amendments and Waivers the intercreditor arrange- exercise remedies with respect to the The intercreditor agreement generally shared collateral following an event of permits amendments to the first lien ments are largely aligned default and, frequently, a demand for financing agreement without second with those of the first lien acceleration under the second lien lien lender consent. But changes to key financing agreement. The standstill economic terms — such as the principal lender. The first lien lender period is often extended if the first lien amount of first lien debt or any cap, the lender commences enforcement action interest rate margin or the maturity — wants a “silent” second with respect to all or a substantial part of will often require second lien lender the collateral. Note that the standstill consent. The intercreditor agreement lien, both before and does not apply to other contractual usually places even more limitations during a bankruptcy, with remedies (unrelated to collateral) the on amendments to the second lien second lien lender may have under its financing agreement, including separate extensive waivers of rights financing documents. This standstill restrictions on refinancing of the second period gives the borrower a window to lien debt. Such restrictions make by the second lien lender.

The Debevoise & Plimpton Private Equity Report l Summer 2005 l page 21 Second Lien Financing (cont. from page 21)

6. Use of Cash Collateral in a borrower will often conduct (under 10. Voting on Plan of Reorganization Bankruptcy Section 363 of the Bankruptcy Code) a The borrower might find it nifty to To run its business in bankruptcy, a sale of collateral free and clear of liens support a first lien lender’s request to borrower must normally use cash or other disposition that the first lien restrict the second lien lender’s right to collateral, which includes not only cash, lender supports. To simplify the sale vote on a plan of reorganization. Such a but securities, deposit accounts and process, both the borrower and the restriction, if it were enforceable, would cash equivalents. The second lien first lien lender negotiate in the ease the burden of obtaining votes for lender often waives its right to object to intercreditor agreement to have the confirmation of a plan of reorganization the borrower’s use of cash in bankruptcy, second lien lender waive the right to in a future bankruptcy and serve to if the use is supported by the first lien oppose such sales. The second lien deprive the second lien lender of the lender. This is a key point for the lender often seeks a lien on the sale ability to hold up the reorganization or borrower; if the first lien lender consents proceeds or wants the proceeds to be force a liquidation. (The first lien to the use of cash collateral, the second used to pay down the first lien debt. lender’s request may come in one or lien lender’s waiver in the intercreditor more of the following forms: a blanket 9. Adequate Protection under the agreement would obviate the need for voting restriction; an agreement by the Bankruptcy Code a second lien lender consent. second lien lender not to vote against a A borrower — to preserve cash and plan of reorganization supported by 7. DIP Financing collateral in a future bankruptcy — will the first lien lender (sometimes qualified To successfully reorganize, the support contractual limits on lender’s by material adverse impact on the borrower typically needs a debtor-in- right to seek adequate protection. second lien lender); or a prohibition possession (or “DIP”) financing. The (Adequate protection is designed to against voting for plans that omit second lien lender usually waives its protect a secured creditor from certain conditions (like a condition that right as a secured creditor to object to declines in collateral value and often the first lien lender be paid in full). But a DIP financing supported by the first consists of additional or replacement such restrictions raise particular lien lender. In connection with the collateral.) And a first lien lender — to concerns when it comes to enforce- waiver, the second lien lender also preserve its right to request adequate ability, and, even if the first lien lender typically agrees to subordinate its liens protection or to raise objections based requests them at all, they are all rarely to the liens granted to the lenders on lack thereof — will seek to have the even agreed to in the intercreditor providing the DIP financing (which will second lien lender to waive its right to agreement. normally be super-priority liens, senior contest any such request or objection also to the first lien lender’s liens). The by the first lien lender. The first lien Conclusion second lien lender may negotiate to lender also usually seeks to have the These ten intercreditor agreement condition the waiver on the DIP second lien lender waive its right to points have important ramifications for financing not exceeding the first lien request adequate protection in the borrower. Factors such as the debt cap or a separate DIP financing connection with the use of cash liquidity in the market, the relative size cap that has added cushion. The collateral or DIP financing. Requests to of the first lien compared to the second second lien lender may also ask that have the second lien lender waive its lien, the borrower’s credit rating and any DIP financing be on market terms right to request adequate protection the type of transaction (syndicated or a or that it be given the right to provide under any circumstance can be hotly private “club” loan) will also determine the DIP financing itself. The borrower contested in negotiations. The second where a given intercreditor agreement must often secure a DIP financing if it lien lender has a natural inclination to comes out. While changing market hopes to successfully reorganize, so the try to keep as much as it can of the conditions and evolving case law will absence of a “DIP veto” may be right to request adequate protection continue to shape these provisions, a particularly important. Absent the — or at least the right to request a borrowers who is aware of the potential waiver or given an inadequate cap, the subordinated lien on any additional issues can best protect its interests. second lien lender has considerable collateral the first lien lender receives as — Paul S. Brusiloff leverage to hold up a reorganization or adequate protection. When a second [email protected] force a liquidation. lien lender does retain the right to — Gregory H. Woods request and/or receive adequate 8. Asset Sales under Section 363 of [email protected] protection, the first lien lender typically the Bankruptcy Code gets the right to request a senior lien In a successful reorganization, a on the additional collateral.

The Debevoise & Plimpton Private Equity Report l Summer 2005 l page 22 Institutional Fund Sponsors’ Consolidation Woes (cont. from page 1)

(and where those general partners are Even where a general partner has a z For new limited partnerships: not controlled by an entity that itself significant interest (say, 20%) in the immediately, if formed after June prepares GAAP financials), the new Fund’s economics, consolidation (as 29, 2005 accounting rules are irrelevant.3 opposed to the equity method of z For existing limited partnerships: accounting) can have a fairly extreme Presumption of Control the sooner of (1) immediately after effect on the general partner’s The EITF consensus on Issue No. 04-5 their partnership agreements are consolidated financial statements — confirms that the general partners of a modified, if modification occurs inflating gross assets and gross limited partnership4 will be presumed to after June 29, 2005, or (2) the investment earnings or loss. This is “control” the partnership. Thus, if there beginning of the first reporting particularly true because Funds must is only one general partner of a Fund (or period in fiscal years beginning after use the investment company method of multiple general partners that are under December 15, 2005 accounting — they account for the common control), that general partner, carrying value of their investments at in its own financial statements, must The effect of initially applying these current fair market value, rather than consolidate with the Fund. If there are principles, if they result in a change in cost, and reflect increases or decreases multiple general partners that are not accounting, should be reported in in carrying value as investment earnings under common control, then an overall accordance with new FASB Statement or loss. Thus, general partners forced to facts and circumstances test must be 154 on Accounting Changes. consolidate with Funds under the new applied to determine whether one of accounting rules may face significant What Should GP’s Do? the general partners actually controls The sponsor of every existing and new swings in their net income before the partnership. If so, that general Fund should consult with its financial deduction for minority interests. partner must consolidate with the Fund accounting and legal advisers concerning (and the other general partners account Effective Dates the effect of the EITF action if a Fund for their interests in the Fund under the The EITF consensus on general general partner prepares GAAP equity method). If no single general partner consolidation is effective as partner is in control of the Fund, then all follows: continued on page 24 of the general partners must account for their interests in the Fund under the A GP may control a limited partnership regardless of the GP’s economic equity method. ownership interest in the assets and earnings of the partnership. For example, a The presumption of control (and sole GP having a mere 3% interest in a Fund’s economics would be required thus consolidation) can be overcome to consolidate with the Fund, if the LP’s have neither substantive kick-out only if the limited partners have either rights nor substantive participating rights. The GP’s consolidated financial (1) substantive kick-out rights or (2) sub- statements would appear very different after consolidating with the Fund, stantive participating rights (discussed compared to the equity method of accounting. at greater length below). Control must Example: GP is the 3% sole general partner of a $1 billion Fund that is fully be tested upon the formation of the invested. The carrying value of the Fund’s investments declines to $900 limited partnership and each time that million. the general partner prepares GAAP financials (taking into account changes Consolidation Equity Method in the limited partnership agreement, GP Balance Sheet: GP Balance Sheet: changes in the identity or ownership Assets — Investments $900,000,000 Assets — Investments $27,000,000 interests of or relationships among and between the general partners and Minority interest $873,000,000 Equity $27,000,000 limited partners, and other factors Equity $27,000,000 relevant to determining control). GP Income Statement: GP Income Statement: A general partner may control a Revenues — Investment Revenues — Investment limited partnership regardless of the earnings (loss) $(100,000,000) earnings (loss) $(3,000,000) GP’s economic ownership interest in the Income (loss) before Net Income $(3,000,000) assets and earnings of the partnership minority interest $(100,000,000) — in an extreme case, even a de Less: Minority interest (97,000,000) minimis interest (see sidebar). Net Income $ (3,000,000)

The Debevoise & Plimpton Private Equity Report l Summer 2005 l page 23 Institutional Fund Sponsors’ Consolidation Woes (cont. from page 23)

financials (or is part of a consolidated z Add LP Participation Rights: “act or cause a general partner . . . to group that prepares GAAP financials). If Amend the partnership agreement take or refrain from taking any action” the general partner would be required to provide the LP’s the right to without losing limited liability, so at to consolidate with the Fund under the approve or block the Fund’s making least for Delaware limited partnerships, ruling, and wishes to avoid an investment or divesting all or a ordinary-course participating rights consolidation, there are three areas for portion of an investment. The should not present that problem for consideration: presumption of general partner LP’s. Other states’ limited partnership control can be overcome if the laws are similarly flexible. Fund GP’s z Share Control: Add an independent limited partners have “substantive should consult with their legal advisers general partner that will block participating rights.” on this issue, however, particularly for control by a single GP, that is, so Funds formed outside the United States. that no single GP (or group of GP’s Substantive participating rights are Of course, Fund GP’s will not lightly under common control) will have the ability to “effectively participate in extend ordinary-course participating the power to make ordinary course significant decisions that would be rights to LP’s, and LP’s may see decisions concerning the affairs of expected to be made in the ordinary exercising such rights as a task best the partnership. course of the limited partnership’s avoided, even aside from limited business.” Such rights are contrasted If two or more general partners liability concerns. with “protective rights,” which do not share control, no general partner is overcome the presumption of general z Add LP Kick-out Rights: Amend the required to consolidate. Obviously, partner control. The hallmark of partnership agreement to provide most GP’s will be unwilling to share participating rights is that they relate to the LP’s the right to remove the control of the Fund with a truly inde- financial and operating decisions of the existing GP (without cause) upon pendent co-general partner. Parties limited partnership that are made in the the vote of a simple majority of the under the control of the existing GP or ordinary course of business — that is, interests of the LP’s other than the its affiliates (such as their employees) they allow the limited partners to block GP or parties under common and other parties acting on behalf of (or require them to approve) such control with or acting on behalf of the existing GP or its affiliates (or that ordinary-course business decisions. the GP. The presumption of general they may remove without cause) are The EITF Abstract for Issue No. 04-5 partner control can be overcome unlikely to be considered independent sets out a non-exclusive listing of both if the limited partners have for these purposes, however. participating rights and protective “substantive participating rights.” rights. For example, rights to approve Kick-out rights are the ability to or reject transactions with the general dissolve (liquidate) the limited part- The EITF’s decision that partner involving self-dealing or other nership or otherwise remove the business conflicts are merely protective general partners without cause. Such supermajority without- rights; rights to establish operating and rights are treated as substantive if they capital decisions of the partnership are cause kick-out rights have both of the following charac- participating rights. Since general teristics: (1) The rights “can be partners of Funds make decisions will not override the exercised by a vote of a simple majority whether and when to make particular (or a lower percentage) of the limited presumption of general investments and to divest the Fund of partner voting interests held by parties all or a portion of particular investments other than the general partners, entities partner control is in the ordinary course of the Fund’s under common control with the business, allowing the limited partners probably the most general partners or a general partner, to block such decisions would probably and other parties acting on behalf of be treated as participating rights in significant change in the general partners or a general a Fund. partner”; and (2) “there are no accounting practice for Limited partners will be concerned significant barriers to the exercise of that such ordinary-course participating the rights.” The EITF Abstract for Issue the consolidation of a rights will remove the limited partners’ No. 04-5 sets out a non-exclusive listing limited liability for the obligations of the of such barriers, including “[f]inancial Fund general partner limited partnership. Delaware law penalties or operational barriers with the Fund. specifically allows limited partners to

The Debevoise & Plimpton Private Equity Report l Summer 2005 l page 24 associated with dissolving (liquidating) the kick-out right non-substantive — majority (more than 50%) of the outstanding voting equity interests of an entity. the limited partnership or replacing the and thus not overcome the pre- If the controlling entity does not own all of the equity general partners that would act as a sumption of GP control — Fund interests in the controlled entity, the carrying value of the interests owned by other equityholders (known as minority significant disincentive for dissolution general partners will need to work interests) is accounted for separately between the liability (liquidation) or removal.” closely with their accounting and legal and equity sections of the consolidated group’s balance sheet; and the minority interests in the net income of the The EITF’s decision that super- advisers on the establishment or controlled entity are reflected as a deduction from majority without-cause kick-out rights amendment of kick-out rights. consolidated net income. In contrast, equity investments in entities over which an will not override the presumption of In the final analysis, it may be easiest investor can exert significant influence (but not control) general partner control is probably the simply to provide a bare majority kick- and virtually all noncontrolling interests in limited partnerships and similar entities are accounted for under most significant change in accounting out right without significant limitations the “equity method of accounting” (sometimes known as practice for the consolidation of a Fund — and then for the Fund sponsor to a one-line consolidation). general partner with the Fund. As noted make even greater efforts to maintain 3 Most non-institutional sponsors prepare GAAP above, most Fund GP’s have relied on the goodwill of its limited partner financials for their Funds, but not for themselves, since the sponsors and Fund general partners are generally supermajority kick-out rights to avoid investors. privately held by firms or individuals that do not themselves require GAAP financials. consolidation under current practice. — Robert J. Cubitto Many general partners are wholly [email protected] 4 Including other types of entities having governance unwilling to provide a without-cause provisions that are similar to those of limited kick-out right to limited partners partnerships, such as limited liability companies where only the managing members have the power to manage 1 holding a bare majority of their Fund’s The supermajority has generally been a 66-2/3% the affairs of the LLC. majority in interest of the limited partners. 75% and even LP interests. Others may be willing to 80% supermajority GP removal provisions have also do so only if limitations are imposed on been seen in practice. the right or if there are significant 2 U.S. GAAP requires an entity that “controls” another disincentives to the limited partners’ entity to include all of the controlled entity’s assets, exercising the right. Because such liabilities, revenues and expenses in the controlling entity’s own consolidated financial statements. For consideration limitations and disincentives may make purposes, “control” is generally defined as ownership of a

The Challenge of Valuation Guidelines (cont. from page 12)

Do LPs want judgment calls or do something about valuation guidelines is years of application and incremental they want consistency? not likely to come from the industry. learning. In the interim there will If interim valuations depend heavily on Instead, it is likely come from the continue to be grappling and VC judgment and the application of accounting standard setters’ and discomfort before broad agreement multiple methodologies, it can be auditors’ increasing insistence on fair on best practices emerges. expected that different VCs will value. “Conservatism” is a dirty word to — Colin Blaydon produce different valuation figures. Will accountants - it refers to a willful and William and Josephine Buchanan LPs continue to be comfortable with artificially low valuation of an asset. The Professor of Management, this? The proposed 1989 NVCA result of the accounting industry’s drive Tuck School of Business at Dartmouth guidelines, commonly used by the for fair value will be a tension between — Fred Wainwright industry in previous years, had always judgment and consistency in valuing Adjunct Assistant Professor of been clear about requiring write-downs. portfolio companies. Industry Business Administration, However, LPs’ anxiety over the lack of guidelines or even new accounting Tuck School of Business at Dartmouth discipline by GPs in the timing and regulations are unlikely to eliminate this amount of post-bubble write-downs are tension, because they deal with The authors are principals at the Center exactly what led to pressure for statements of principle. Valuation for Private Equity and Entrepreneurship developing new guidelines. Yet non- guidelines cannot be formulaic and at at Tuck. For more information, go to round write-ups, as allowed by PEIGG, the same time be effective because www.tuck.dartmouth.edu/pecenter. may result in inconsistencies of such prescriptive guidelines will valuation and timing in an era of invariably fail to include all situations or economic growth. become too complicated to be useful. The judgment / consistency issue in Conclusion private equity can only be resolved in Times are good for many private equity the U.S. and internationally through practitioners so pressure to do

The Debevoise & Plimpton Private Equity Report l Summer 2005 l page 25 Trendwatch: Spinouts of Private Equity Funds (cont. from page 16)

employment policies and economic practices that the principals are Governance, carried interest, sharing arrangements that apply to the probably most familiar with) and employment, etc. To some extent, new firm and related entities and will renouncing those practices on the spinout principals must re-orient their need to act on a number of organ- grounds that they are rooted in long- perspectives from their previous roles izational and administrative tasks. One established institutional precedents as employees of a large institutional of the challenges to the spinout and policies that are not well suited to sponsor when the time comes to principals is striking the right balance the new firm’s more closely held propose a fresh set of governance, between perpetuating the former structure. economic and employment arrange- sponsor’s practices (which are the ments for the new firm. In this new context, the spinout will require its own Year Parent Spinouts* set of restrictive covenants against 2005 Marsh & McLennan Stone Point Capital competition, solicitation of colleagues and clients, and disclosure of confi- 2004 3i Exponent dential information, along with a 2004 CSFB Diamond Castle complete set of good-leaver/bad- 2004 Morgan Stanley Metalmark leaver provisions and penalties (i.e., termination with and without “cause”), 2003 Deutsche Bank MidOcean carried interest allocation and vesting 2003 HSBC Montagu schedules, bonus plans, anti-dilution 2002 BNP Paribas PAI Management clauses, investment and other decision- making procedures and dispute 2002 Nomura International Terra Firma resolution mechanisms. Furthermore, 2001 DLJ Phoenix Equity Partners institutional investors in a new private 2001 Foreign & Colonial Graphite Capital/F&C Ventures equity fund expect to be informed of

2000 Mercury Asset Management HgCapital the basic carried interest allocation and vesting arrangements to ensure there 2000 NatWest Bridgepoint Capital are appropriate incentives throughout 1999 Dresdner Kleinwort Benson Indigo Capital the firm. 1998 Hambros Bank Duke Street Capital Carried interest and other economic terms frequently involve intricate tax 1995 British Coal Pension Schemes Cinven and estate-planning analysis, some- 1993 First Chicago Corporation Madison Dearborn Partners times in multiple jurisdictions. All of 1989 Enskilda Industri Kapitalà these are complicated arrangements Altor (2003) for any private equity firm, particularly when terms vary across different levels 1989 Schroders Permira within the organization from junior 1988 Barings Bank BC Partners employees to founding principals, 1985 Lehman Brothers Blackstone Group although in a legacy spinout there is a Evercore Partners (1995) preference for avoiding unnecessary Heartland Industrial Partners (1999) changes to the existing carried interest Silverlake Partners (1999) structure on the legacy assets. Elevation Partners (2004) Practical Necessities. There are a 1978 BancBoston Thomas H Lee myriad of practical things to do as the Berkshire Partners (1986) spinout firm comes “on line”: JW Childs (1995)

1976 Bear Steams KKR z Depending on the jurisdiction, Forstmann Little (1978) regulatory licenses may need to be New Mountain Capital (2000) applied for and obtained (e.g., see Jupiter Partners LLC (1994) Chapter Three of the Debevoise & Kohlberg & Co (1987) Plimpton European Private Equity Fox Paine (1997)

* “ ” indicates a private equity spinout from the prior spinout. continued on page 28

The Debevoise & Plimpton Private Equity Report l Summer 2005 l page 26 Selected Issues to Consider When Taking a Portfolio Company Public (cont. from page 10) the listed company in any of the last other compensatory fee from the must be taken early on to ensure three fiscal years in excess of specified company or any subsidiary of the compliance. amounts. Certain additional inde- company (other than fees for service on Grace period for independent pendence requirements, discussed the board of directors or any board directors below, apply to directors serving on the committees); or (2) be an affiliated Under the NYSE and Nasdaq listing audit committee. person of the company or any sub- rules, companies engaging in an IPO Private equity sponsors will usually sidiary of the company (except as a are allowed a grace period in which to have designees sitting on the boards of result of board or committee member- comply with the requirement to have a portfolio companies when they go ship). The rules prohibit indirect majority of the board and all of the public. It will thus be up to the portfolio payments of compensatory fees, which audit, nominating and compensation company’s Board to determine whether include payments accepted by an entity committees comprised of independent the private equity sponsor nominees in which an audit committee member is directors. Companies listing in con- have any material relationships with the a partner, a member or an officer junction with an IPO would need to portfolio company such as would bar a (except limited partners or non- have one independent director on each finding of independence. Given the managing members who have no active of the audit, nominating and compen- typical structure of private equity role in providing services to the entity) sation committees at the time of listing, sponsors, the nominees may not fall and which provides accounting, a majority of independent directors on within any of the expressly proscribed consulting, legal, investment banking, such committees within 90 days and non-independent relationships financial or other advisory services or fully independent committees and a (depending on the fees paid to the any similar services to the company or majority of independent board sponsor by the portfolio company and any subsidiary of the company. members within one year. who employs the nominees). The Board In addition, a company must disclose will need to consider whether the in its annual report on Form 10-K When should the independent relationships are nonetheless close whether its board of directors has directors join the Board? enough to the proscribed categories determined that the company has at The requirement that companies that the private equity sponsor nom- least one independent audit committee engaging in an IPO have a majority of inees should not be determined by the financial expert and, if it has made such independent directors on the audit, Board to be independent. Apart from determination, identify such financial nominating and compensation com- complying with the NYSE or Nasdaq expert. A company disclosing that it mittees within 90 days can be a stringent listing rules, there are other good does not have an independent audit one, because it may be difficult to reasons to have at least some inde- committee financial expert must explain recruit suitable members that meet the pendent directors not affiliated with why not. An audit committee financial independence requirements. A private either the company or the private equity expert must have an understanding of equity sponsor should, if possible, sponsor because such unaffiliated GAAP, financial statements, internal identify the independent directors well independent directors could deal with control over financial reporting and in advance of a listing. It is preferable to issues that may arise where the private audit committee functions. A private have the independent directors in place equity sponsor and the portfolio equity sponsor should make sure, prior early on so that they can participate in company have differing interests. to taking a company public, that the the review of the IPO registration company has an audit committee statement and get comfortable with What are the major specific rules financial expert at the time of the IPO the corporate governance provisions applicable to the audit committee? because disclosure that the company before they are adopted. If the The NYSE and Nasdaq rules require does not have such expert may raise red independent directors are only that a listed company, including a flags with investors. identified later in the process, they may controlled company, have at least three The audit committee must also pre- not have the time to due diligence members on its audit committee who approve all audit services and all effectively the registration statement are all independent directors, subject to permissible non-audit services to be and may be reluctant to be named as the IPO grace period discussed below. provided by the independent auditors. directors at the time of the IPO, because In addition to the other This pre-approval requirement will apply all directors will have Section 11 liability independence requirements, a member for services rendered in the year the on the registration statement. In that of the audit committee is not allowed portfolio company goes public, so care to: (1) accept any consulting, advisory or continued on page 28

The Debevoise & Plimpton Private Equity Report l Summer 2005 l page 27 Selected Issues to Consider When Taking a Portfolio Company Public (cont. from page 27)

case, independent directors could be and independent Board members they make their initial investment in a appointed immediately after the closing agree. If the auditors are dubious about portfolio company. These should be of the IPO, thus avoiding liability for the the capabilities of the CFO, for example, reviewed in advance of an IPO to make registration statement and yet satisfying the auditing and attestation process sure that they provide the sponsor all the the phase-in requirement that there be could be a rocky road. It may be difficult registration rights it may need in order at least one independent director at the to retain or recruit the required to effectuate possible future exits time of listing. complement of independent directors if through public offerings post-IPO. there are issues about the management Making any changes to the registration Do we have the right management team. Moreover, weaknesses in the rights agreement pre-IPO is preferable, team in place? accounting or disclosure functions could because any adjustment will likely be In light of the more extensive regulation lead to missteps that can be disclosed in the prospectus and be part of public companies under the troublesome in the public arena. of the baseline that public investors Sarbanes-Oxley Act and related listing evaluate. The scrutiny accorded to any requirements, a private equity sponsor Do we need to restructure existing adjustment made after the IPO would needs to be diligent about whether the loans to management? also be greater and directors may be management team of its portfolio The Sarbanes-Oxley Act prohibits a less willing to grant rights to the sponsor company has the right skill set and company from extending or maintaining different from those contained in the experience to lead a public company. In credit or arranging for the extension of registration rights agreement at the time particular, senior management will have credit in the form of a personal loan to of the IPO. to contend with certification as to any director or executive officer. Loans * * * financial statements and disclosure outstanding on July 30, 2002 are not Planning for an IPO far in advance controls, assessment and documentation affected, provided there are no material can help a private equity sponsor ease of internal controls, interaction with the modifications to any term of the loan or the transition into the public arena and investment community in compliance any renewal of the loan in the future. A avoid unpleasant surprises. with Regulation FD, and new, more private equity sponsor should examine demanding SEC reporting requirements, whether any existing loans to — Steven Ostner including the more current reporting management will have to be [email protected] obligations required under Form 8-K restructured prior to the IPO in light of — Xavier P. Grappotte and with respect to Form 4s. this prohibition. [email protected] Even if a private equity sponsor Should we have registration rights? believes that management is up to the Private equity sponsors generally obtain task, it would be wise to make sure that extensive registration rights at the time the company’s independent auditors

Trendwatch: Spinouts of Private Equity Funds (cont. from page 26)

Handbook on establishing a London z Office space must be found and * * * office). fitted, administrative support and Time is probably the scarcest accounting staff must be hired, commodity of private equity pro- z The new firm will need a name that auditors appointed, insurance fessionals planning the commercial does not violate any other firm’s purchased, and public relations terms of a spinout, but attention in rights or otherwise create confusion managed. advance to pre- and post-departure in the marketplace (appropriate obligations under existing agreements trademarks may need to be regis- As is the case with other aspects of can prevent unwelcome delays. tered). disengaging from a former employer, spinouts that are managing legacy — Geoffrey Kittredge z The spinout firm will need to register assets may purchase or receive the [email protected] a domain name and create a website benefits of transitional services and — Mark van Dam that complies with various regulatory support from the former parent sponsor. [email protected] requirements, including U.S. secur- ities laws.

The Debevoise & Plimpton Private Equity Report l Summer 2005 l page 28