Debevoise & Plimpton Private Equity Report
Winter 2009 Volume 9 Number 2
Everything Old Is New Again: WHAT’S INSIDE Guest Column: 3 A Discussion with Barry Gold PIPEs Go Up-Market of the Carlyle Group About Infrastructure Financing Although PIPEs—private investments in included Warburg Pincus’s investment in public equity—have long had a place in the MBIA, TPG Capital’s investment in 5 Limited Partner Defaults: private equity toolkit, the tool had, for most Washington Mutual, Corsair’s investment in The Improbable Becomes Reality PE firms, become rather rusty in the context National City Corp, Carlyle’s investment in of the strong acquisition and financing Boston Private Financial, Berkshire Stimulus Legislation markets of recent years. Indeed, the coercive Hathaway’s investment in Goldman Sachs 7 Provides Some Good News nature of certain “toxic” PIPE structures that and Leonard Green’s investment in Whole for Portfolio Companies were common in the early part of this decade Foods. Even the U.S. government’s had until recently led some investors to investments in AIG, Citigroup, Bank of Deconstructing Equal and 9 Ratable Security Clauses consider the investment structure, as a whole, America and a host of other financial somewhat less than fully respectable. institutions were essentially PIPE transactions. Emerging Markets Shine in a That changed in 2008. Any suggestion The recent resurgence of PIPE deals 11 Difficult Year that PIPEs were somehow “downmarket” was resulted from a number of factors, including belied by last year’s series of multi-billion- unprecedented funding requirements of large 13 Disruptions in the LIBOR dollar deals involving not only leading private financial institutions, a scarcity of other Market: Borrowers Beware When the Boilerplate Is equity firms but some of the country’s largest sources of capital, a desire for greater speed Broken financial institutions and most well-known and certainty than typically available in a public companies. Notable transactions take-private transaction, and regulatory Bridging the Gap: How to CONTINUED ON PAGE 30 15 Get Deals Done in an Unsettled Market
SEC Weighs in on Approval 17 of Stock Mergers by Written Consent
ADS v. Blackstone: 19 Strine Endorses Private Equity Cabins
Final Exon-Florio 21 Regulations: What They Mean for Private Equity © 2009 Marc Tyler Nobleman / www.mtncartoons.com Tyler © 2009 Marc Duties of Directors of 23 Distressed Companies: Avoiding an Intrinsic Fairness Review
Debt Exchange Offerings: 27 A Flash in the Pan? Letter from the Editor
The private equity community is hardly alone in being challenged package, the debate over private funding for public projects has by current economic realities. And, to be truthful, it is probably, as taken center stage. An ad hoc group of private equity professionals, an asset class, among the most able to weather the economic storm. bankers and lawyers has been organized to focus attention on the But no one will argue that the role of private equity in the role to be played by private capital in the development of public business landscape is the same as it was a few short (or long) years infrastructure. In our Guest Column, Barry Gold, Managing ago. In this issue, we highlight some of the techniques that private Director of the infrastructure investment group at Carlyle, is equity can use to invest in the current environment and explain interviewed by another participant in the ad hoc group—our why those investments might just work. On the cover, we remind partner, Ivan Mattei—about “privatizing” public infrastructure. readers (to borrow from Peter Allen) that “Everything Old Is New For those of you who still manage to maintain a “glass half full” Again” and provide a primer on structuring PIPEs transactions. In world view, we do our best to help you with that perspective. We “Bridging the Gap,” we explain that in a world without many provide some updates on recent legislation providing tax relief for financing options, it makes more sense than it once did to use portfolio companies deleveraging or modifying debt and on final earnouts, seller financing and rollover equity to bridge financing regulations providing comfort that the new Exon Florio regime will and valuation gaps between sellers and buyers. not be as stringent for private equity as initially proposed. A few years ago, limited partner defaults were of concern only to While the financing markets are in their current state, we urge compulsive lawyers drafting the technical sections of fund you to remember that the devil is in the details. We provide partnership agreement. Today, the risk of limited partner defaults is guidance in “Deconstructing Equal and Ratable Security Clauses” on everyone’s mind and funds are grateful that their lawyers on how to add new secured debt without refinancing existing anticipated today’s reality. In our article entitled “Limited Partner bonds, while reminding borrowers in “Disruptions in the LIBOR Defaults: The Improbable Becomes Reality” we explore how general Market: The Boilerplate Is Broken” to watch out for changes to partners can sensibly manage defaults and potential defaults by their boilerplate governing standard yield protection and increased cost limited partners to mitigate their impact on the rest of the fund. provisions that may prove to be expensive. On a more positive note, we also report on continued growth in We hope we have managed to update you on some recent 2008 for emerging market funds and on some of the challenges for developments in private equity and have given you some new sponsors structuring those funds. thoughts on how to deal with the current environment. If there is Infrastructure investing has been a part of the private equity something you’d like discussed in a future issue, please let us know. menu for many years, but, with the passage of the federal stimulus Franci J. Blassberg Editor-in-Chief
Private Equity Partner/Counsel Practice Group Members The Debevoise & Plimpton Frankfurt Franci J. Blassberg Geoffrey Kittredge – London Stephen R. Hertz Private Equity Report is a 49 69 2097 5000 Editor-in-Chief Anthony McWhirter – London David F. Hickok – London publication of Jordan C. Murray James A. Kiernan III – London Moscow Stephen R. Hertz Andrew M. Ostrognai – Hong Kong Antoine F. Kirry – Paris Debevoise & Plimpton LLP 7 495 956 3858 Andrew L. Sommer David J. Schwartz Jonathan E. Levitsky Associate Editors 919 Third Avenue Hong Kong Rebecca F. Silberstein Li Li – Shanghai New York, New York 10022 852 2160 9800 Ann Heilman Murphy Christopher Mullen – London Hedge Funds 1 212 909 6000 Managing Editor Dmitri V. Nikiforov – Moscow Shanghai Byungkwon Lim Robert F. Quaintance, Jr. www.debevoise.com 86 21 5047 1800 David H. Schnabel Gary E. Murphy William D. Regner Cartoon Editor Washington, D.C. Please address inquiries Mergers & Acquisitions Kevin A. Rinker 1 202 383 8000 regarding topics covered in this The Private Equity Andrew L. Bab Jeffrey J. Rosen publication to the authors or Practice Group E. Raman Bet-Mansour – Paris Kevin M. Schmidt London any other member of the All lawyers based in New Paul S. Bird Thomas Schürrle – Frankfurt 44 20 7786 9000 Practice Group. York, except where noted. Franci J. Blassberg Wendy A. Semel – London Paris Richard D. Bohm Andrew L. Sommer All contents ©2009 Debevoise Private Equity Funds 33 1 40 73 12 12 Thomas M. Britt III – Hong Kong Stefan P. Stauder & Plimpton LLP. All rights Marwan Al-Turki – London Geoffrey P. Burgess – London James C. Swank – Paris reserved. Kenneth J. Berman – Washington, D.C. Marc Castagnède – Paris John M. Vasily Erica Berthou Neil I. Chang – Hong Kong Peter Wand – Frankfurt Jennifer J. Burleigh Margaret A. Davenport Woodrow W. Campbell, Jr. Leveraged Finance E. Drew Dutton – Paris Sherri G. Caplan Katherine Ashton – London Michael J. Gillespie Jane Engelhardt William B. Beekman Gregory V. Gooding Michael P. Harrell David A. Brittenham Felicia A. Henderson – Paris Paul D. Brusiloff GUEST COLUMN A Discussion with Barry Gold of the Carlyle Group About Infrastructure Financing
The passage of the federal stimulus package leaders of the potential benefits of private billion of total investment. The U.S. has reinvigorated debate over the funding of investment in infrastructure. Why is such an Department of Transportation has public infrastructure projects in the United effort necessary and what are the group’s goals? estimated that every $1 billion of States. An ad hoc group of private equity infrastructure investment will create and The heavy legislative calendar (not just the professionals, bankers and lawyers has been support 34,800 jobs for one year. If you stimulus package, but also the anticipated working to focus attention on the important take the $450 billion of potential private legislation for the creation of a National role to be played by private capital in the investment and deploy it over 10 years, that Infrastructure Bank and, later in the year, development of public infrastructure.1 On implies the creation of over 1.5 million jobs transportation reauthorization)2 creates an February 25, 2009, Barry Gold, Managing each lasting for a decade. If this capital is opportunity for Congress and the Director of the infrastructure investment deployed more quickly, it would pack a Administration to make significant changes group at The Carlyle Group and a leader in correspondingly greater punch in a shorter in the way U.S. infrastructure is funded, the field of private investment in public period. There is concern in many corners maintained, and operated. infrastructure, sat down with Ivan Mattei to of our market that Congress is not At this moment of crisis, there are discuss the activities of the ad hoc group sufficiently focused on the importance of multiple competing and worthy ways to and Carlyle’s views on the opportunities private capital as a source of funding for spend every available dollar of federal and challenges facing infrastructure funds in infrastructure projects. funding. Straight government funding of the current market. Timing is also critical because much of infrastructure procured under the this private capital could be redeployed, Carlyle has been a leading participant in the traditional model will simply not be perhaps to other countries or sectors, if not ad hoc group that has been seeking to promote sufficient to meet the country’s needs. put to work in the U.S. within a reasonable awareness among policy makers and opinion At the same time, there is perhaps $180 period of time. billion of available private capital that can Hence, the limited goal of our “ad hoc” be used to build, maintain, and operate 1 The group includes, among others, Abertis, infrastructure group has been to make sure infrastructure projects and leverage capital Barclays Capital, Carlyle Infrastructure Partners, that policy makers are aware of what the Citi Infrastructure Investors, Credit Suisse, available from government sources. If these private sector has to offer, in hopes that the Debevoise & Plimpton LLP, Deutsche Bank RREEF, private funds are leveraged at a modest current and coming legislation in this area Merrill Lynch, Morgan Stanley, RBC Capital 60:40 debt-to-equity ratio, that’s $450 Markets, Scotia Capital and UBS. will carve out a proper role for private capital.
Previous administrations and various states 2 Federal funds for surface transportation infrastructure have traditionally been allocated have promoted the concept of “privatizing” Pierre Clermontel – Paris Trust & Estate Planning through multi-year authorization bills, public infrastructure. But there remains Alan J. Davies – London Jonathan J. Rikoon reflecting the long lead times necessary to bring much skepticism about outsourcing public Peter Hockless – London Cristine M. Sapers new projects on line. These bills have also Alan V. Kartashkin – Moscow infrastructure in many quarters (heightened, Employee Compensation tended to be the principal legislative vehicle for Pierre Maugüé & Benefits the establishment of U.S. federal transportation perhaps, by the perceived failings of the private Margaret M. O’Neill Lawrence K. Cagney policy, whether by setting spending priorities, A. David Reynolds sector in the current credit crunch). How do Jonathan F. Lewis promulgating safety standards, establishing pilot Philipp von Holst – Frankfurt Alicia C. McCarthy programs or adjusting the regulatory you respond to the skeptics? Gregory H. Woods III Elizabeth Pagel Serebransky framework. The current transportation bill Tax Charles E. Wachsstock covers the five year period 2005-2009 and is The issue is not really whether we should John Forbes Anderson – London due for “reauthorization” by year-end. One The articles appearing in this “outsource” construction of our national Eric Bérengier – Paris publication provide summary specific innovation discussed in recent years, infrastructure. In fact, under the traditional Andrew N. Berg and endorsed by President Obama when he was information only and are not model of infrastructure procurement, much Pierre-Pascal Bruneau – Paris intended as legal advice. Readers a Senator, is the creation of a National Gary M. Friedman should seek specific legal advice Infrastructure Bank that would be capitalized if not most of the design and construction Peter A. Furci before taking any action with and operated by the federal government. Its work is already contracted out to the private Friedrich Hey – Frankfurt respect to the matters discussed mission would be to provide long-term debt Adele M. Karig herein. Any discussion of U.S. financing for U.S. infrastructure projects; most sector, at least on projects of any real Vadim Mahmoudov Federal tax law contained in these likely in combination with private debt or significance. The same is true for major Matthew D. Saronson – London articles was not intended or equity capital. David H. Schnabel written to be used, and it cannot CONTINUED ON PAGE 4 Peter F. G. Schuur be used by any taxpayer, for the Marcus H. Strock purpose of avoiding penalties that Debevoise & Plimpton Private Equity Report l Winter 2009 l page 3 Richard Ward – London may be imposed on the taxpayer under U.S. Federal tax law. Guest Column: A Discussion with Barry Gold (cont. from page 3)
refurbishment and expansions of existing extremely detailed operating standards. The Since there will not be public funds infrastructure. The real issue is how to partnering government agency, in turn, is sufficient to pay for everything on a given partner with the private sector in the most given far reaching power to examine, verify state’s infrastructure “wish list,” bifurcating effective and efficient way possible. compliance, and work together as a partner that list becomes critical. Some Failing to maintain in good repair to find solutions to benefit the project. infrastructure projects may not be attractive existing infrastructure in the U.S. is almost Failure to comply with mandated standards to the private sector even though they offer as big a problem as failing to build new can result in fines and penalties. In a worst a high social rate of return on invested capacity. This is one of the key areas where case scenario, failure to operate the asset to capital. Those projects should be moved to current government practices fall short of world class standards can result in the head of the queue for funding through world class standards. Under the traditional termination of the P3 contract and traditional procurement. At the same time, procurement model, state and local forfeiture by the breaching party of some or projects which are most compatible with governments contract with the private all of its investment in the project. the P3 model should be placed on a fast sector for construction of our public Consider the alternative. What happens track for procurement under that model. infrastructure, but then retain responsibility when a government agency fails to operate In order to be able to follow such a “dual for operation and routine maintenance. and maintain critical infrastructure to a track,” of course, the states must enact a Because the party that builds the world class standard? That happens every viable statutory or regulatory framework for infrastructure does not have to live with the day in virtually every state. There is no P3 procurement. That is where the federal long term consequences of its work (beyond mechanism, short of the relatively blunt government can help with mechanisms to what is typically a relatively short warranty instrument of the ballot box, to hold develop and promote adoption of best period), the results are predictably different anyone accountable in such cases. practices. from what you would get if responsibility One obvious difference between the United Are you optimistic about the prospects for for construction, operation and States and many other countries where public- successful innovation at the state and federal maintenance were not separated. private partnerships have been used to good level and for the future of private capital in Under a well-structured long term effect is the fact that we live in a federal system public infrastructure? public-private partnership, the process of and most infrastructure procurement occurs at negotiating, pricing and awarding the Yes, if only because it is hard to imagine the state and local level, even when it is funded contract forces the parties (both public and how we can meet our enormous and with federal dollars. In such a system, what private) to consider not just the up-front increasing infrastructure needs under the role can the federal government play beyond construction costs, but also the “life-cycle” traditional procurement method. But providing infrastructure funding to the states. costs of the infrastructure in question. This there will be “potholes” along the way. makes it far less likely that infrastructure One of the key things the federal One concern—and this is one of the will be built in a way that saddles future government can do is to promote best reasons why we chose to participate in the administrations and taxpayers with practices at the state level. One good first ad hoc infrastructure working group—is unfunded and unmanageable maintenance step would be to establish an office within that federal spending in this area could obligations. That’s what we have done in the federal government (perhaps at crowd out private capital as opposed to the past and that’s why much of our USDOT) to help promote and coordinate leveraging it. This could happen if federal infrastructure is in such a state of disrepair. public-private partnerships at the state level. funds are used to preempt substantially all The federal government can also help by of the projects that would be most Another frequent criticism or concern is that continuing and expanding initiatives such as attractive to the private sector. Such an public-private partnerships (P3s) have the interstate tolling and the pilot program for outcome could have the effect of “cleaning effect of placing critical infrastructure in the P3s involving airports. out” the pipeline of viable deals for an hands of unaccountable private parties. Certain debt financing mechanisms extended period of time, during which the This is another place where the issue is one dependent on federal law, such as tax- available private capital will be redeployed of structuring P3 contracts wisely, rather exempt private activity bonds and TIFIA to other investment opportunities. That than whether to have P3s at all. A well- funding, should be expanded. is one reason why it is important for states structured P3 transaction is all about to pursue dual track policies of the type I Even if Congress were to act on all these ideas, accountability. The private partner in such mentioned previously. there would most likely still be a government a transaction is obligated to comply with funding deficit. What should states be doing? page 4 l Debevoise & Plimpton Private Equity Report l Winter 2009 Limited Partner Defaults: The Improbable Becomes Reality
Less than a year ago, most private equity option to reduce their commitments by up to committee). Press reports indicate that fund managers thought of defaults on private 40%, with an overall maximum fund level investors took up less than half of the offered equity fund commitments as a theoretical reduction of 35% (at the time, the fund was 10% reduction in commitments. possibility, at best worthy of the attention of about 50% invested). Electing limited In the current environment, it may be their most compulsive professional partners would not be required to fund prudent even for fund managers not acquaintance—their fund lawyer. As a result, future calls for new investments, but would experiencing funding issues or other similar few thought twice about the provisions in still be required to pay management fees and pressures to give some thought as to what their partnership agreement meant to protect expenses as if they had not made the election. actions can be taken in the event of a default the fund against the failure of a limited Reducing limited partners were required to or potential default by its limited partners. partner to contribute its commitments when agree to a forfeiture of 25% of future fund Of course, default terms for each fund called, and rightly so. Current market distributions (the forfeited amounts to be partnership agreement are different, and each conditions have rescued these default shared among the non-reducing limited situation will likely involve unique and provisions from obscurity, however, as the partners) and would not be permitted to complex factual issues, so fund counsel threat of limited partner defaults has become participate in future votes. Significantly then, should be consulted immediately in the event a more realistic concern, capturing the it appears the limited partners who accepted of any funding-related issue.2 attention of fund managers—as well as their this offer were by its terms subject to What Should the General lawyers. essentially the same remedies they would Partner Do If a Limited Partner While the number of publicly reported have faced as defaulting investors, though the Does Not Fund (or indicates significant defaults (or threatened defaults) by offer relieved them of the stigma associated That It Plans Not to Fund) a limited partners in major private equity funds with default. Press reports indicate that Drawdown? has been limited to date, there is reason to elections by 18 investors, representing a 13% While Permira and TPG provide examples of believe that liquidity concerns will continue reduction of fund commitments, were made some of the steps fund managers have taken to challenge fund managers for at least the and that over 90% of the limited partners in anticipation of the impact of limited near future. Indeed, certain of the very approved the amendment to permit the partner liquidity constraints on future capital largest funds have made efforts to reduce reduction. It is not known whether any calls, if there is an actual or potential default their size, with Permira’s and TPG’s probably limited partners agreed to increase their relating to a pending investment, the fund the most widely reported of these recent commitments to make up the reduction. manager must focus first on how to cover the efforts to address strains on limited partner Not long after the Permira offer was missed contribution to close the investment liquidity.1 reported, U.S.-based TPG similarly took and then on how to treat the limited partner In early December 2008, UK-based steps to address the stress of challenging that did not fund. In addition, the fund Permira became the first major private equity market conditions by offering its limited manager will want to think about how (and firm to tackle the issue of potential limited partners the option to reduce their whether) to replace the limited partner’s partner defaults. According to press reports, commitments by up to 10%. In the case of remaining unfunded commitment. a large public fund of funds investor affiliated TPG, management fees would be waived on with Permira was poised to default as a result 10% of commitments for limited partners Covering the Shortfall of over-commitment issues throughout the not electing to reduce their commitments (or Most partnership agreements permit the investor’s portfolio. In an effort to avoid a in the case of a limited partner electing to defaulted amount to be called from the other default on a future capital call, Permira reduce its commitment by less than 10%, on CONTINUED ON PAGE 6 offered all of its limited partners a one-time the portion not reduced). In addition, near- term contribution obligations were clarified, 1 While the Permira and TPG efforts were widely with the general partner undertaking not to 2 This article focuses generally on Delaware limited reported by the press, it is not clear whether all of the call more than 30% of commitments in 2009 partnerships and notes where English law takes a details were reported correctly or whether additional slightly different approach. As a general matter, (the 30% limitation can be waived with the steps have since been taken. Cayman Islands, which has limited case law in this consent of the limited partner advisory area, would likely follow an English law approach.
Debevoise & Plimpton Private Equity Report l Winter 2009 l page 5 Limited Partner Defaults: The Improbable Becomes Reality (cont. from page 5)
limited partners, without increasing their do so by the drawdown date. It may be interested third parties. aggregate capital commitment to the fund. possible to apply overcalled amounts In the event a limited partner does not However, depending on the timing of a from the other limited partners to cover fund, the general partner will have to default, it may be impossible to call the late contribution. Depending on the carefully consider the steps to be taken and additional funds from other limited length of delay, it may be appropriate to whether the limited partner should be partners before the closing of the relevant require the late-funding limited partner declared in default. The general partner of portfolio investment is scheduled to occur. to pay interest on its contribution a Delaware limited partnership owes duties In addition, some funds impose caps on the (similar to investors admitted to a fund of loyalty and care. Although these duties replacement amounts that can be called after the initial closing). If the delay may be limited contractually in the from the non-defaulting limited partners; if persists, the general partner may have to partnership agreement, at a minimum the the amount required would exceed the cap, take more drastic steps. general partner must act in good faith and it will be necessary to raise capital, perhaps deal fairly with the fund. The standard is Offset Distributable Amounts. If the fund either by seeking a waiver to the cap or somewhat higher under English and is set to distribute amounts related to identifying a co-investor to fund the Cayman Island laws, which require the other investments, it may be possible to acquisition. general partner to act in utmost good faith offset amounts distributable to cover the The following are some of the actions a towards its limited partners. These defaulted amount. fund manager will want to consider if it standards may require the general partner to faces, or is concerned that it may face, the Remedies on Default consider a number of factors, including need to cover missed contributions. Most fund partnership agreements provide whether it is in the fund’s best interest to the general partner with a wide range of declare the default, whether the non- Draw Down Early. Consider setting remedies in the event a limited partner is in defaulting limited partners have an interest drawdown dates sufficiently far in default, with the general partner usually in any amounts forfeited by the defaulting advance of a closing to avoid risk of permitted to select among and apply any or limited partner, whether defaulting limited shortfalls due to default; the extra time all of the remedies in its sole discretion. partners must be treated equally, and so can be used to issue a new capital call to These rights typically include a forfeiture by forth. fund the defaulted amount. the defaulting limited partner of 25% to In addition, the general partner must Draw Down More than Required. Some 50% or more of its interests in the fund. consider that any course of action it takes general partners routinely overcall to If a limited partner defaults, the size of against the first defaulting limited partner cover unforeseen contingencies at the fund may be reduced by the amount of may limit its ability to take a different closing, including late limited partner the defaulting limited partner’s unfunded course of action against similarly situated contributions. The overcalled amounts commitment. The reduction may impact later-defaulting limited partners. This can not otherwise used are then returned if the number of investments the fund is be particularly tricky when, as is often the there is no default. ultimately able to complete, as well as case, the fund consists of multiple parallel Borrow the Defaulted Amount. Some reduce the management fee. (The other vehicles in different jurisdictions with fund partnership agreements permit limited partners are in almost all cases not different legal standards. Actions taken in short-term borrowing to bridge the required to fund the defaulting limited one parallel vehicle might affect the defaulted amount, whether from a third partner’s management fee; the defaulting remedies available in other jurisdictions. party or a general partner affiliate. In limited partner might still be required to Also, “most favored nations” rights might the absence of an existing subscription- pay the management fee out of any limit the extent to which defaulting limited backed credit facility, timing forfeited portion of its interest, which partners may be treated differently. It is considerations may make borrowing would likely delay payment until the fund also possible that any disclosure or other from a third party lender impractical. has distributable income.) If permitted communications with the limited partners under the fund partnership agreement, the on this issue may restrict future courses of Late-Funding Limited Partners. In some general partner may want to pursue action; for example, if the general partner cases a limited partner may indicate that replacing the unfunded commitment, either has indicated that it will take a hard line on it plans to fund, but that it is unable to from the existing limited partners or from CONTINUED ON PAGE 18 page 6 l Debevoise & Plimpton Private Equity Report l Winter 2009 Stimulus Legislation Provides Some Good News for Portfolio Companies
Not all tax news coming out of Washington Background deductions may be realized only over the has been unfavorable for private equity. The Retirement at a Discount. If a company retires course of several years, depending on the recently enacted stimulus legislation generally its outstanding debt for an amount less than remaining term of the debt. permits portfolio companies to deleverage (or the issue price of the debt, the company Modifications. If there is a significant modify their publicly traded debt) without generally recognizes COD income equal to modification (e.g., a typical rate increase triggering immediate taxable income. the difference. For example, if a company agreed to in connection with a covenant In recent months, the deep discounts at has $100 of debt outstanding and waiver) of debt that meets the very broad tax which bonds and bank debt have been repurchases the debt for $60, the company definition of “publicly traded” debt (a term of trading and the difficulty of meeting various generally recognizes $40 of COD income at art that can include debt listed on certain financial covenants have caused many the time of the retirement. quotation media), the debt is deemed to have companies to consider repurchasing, or Related Party Purchases. Similarly, if a been satisfied for the trading price and modifying the terms of, their debt. However, company has debt outstanding and a person deemed to have been reissued for the same prior to the stimulus legislation some “related” to the company acquires the debt amount. Thus, if a corporation has $100 companies had been deterred by concerns for less than the issue price of the debt, the face amount of publicly traded debt about creating taxable cancellation of debt company is deemed to have COD income outstanding and a significant modification is (COD) income. For example, although this equal to the difference between the issue made to the debt while it is trading at $60, may seem counter-intuitive, a typical interest price and purchase price, and the debt is (1) the corporation has $40 of COD income rate bump made in connection with a bank deemed to have been reissued for an amount and (2) the debt is treated as having been debt covenant waiver could create COD equal to the purchase price. For example, if a reissued for $60. The same consequences concerns if the debt were to fit the very broad corporation has $100 of debt outstanding discussed above in “Related Party Purchases” tax definition of “publicly traded” debt. and a related person (including, in some apply. Again, the corporation is required to The American Recovery and instances, a private equity fund that controls recognize the $40 of COD income even if Reinvestment Tax Act of 2009 (the Act), the company) purchases the debt for $60, (1) the $40 of OID deductions are disallowed. enacted on February 17, 2009 as part of the the corporation has $40 of COD income and CONTINUED ON PAGE 8 stimulus package, includes provisions which (2) the debt is treated as having been reissued (1) allow companies that recognize COD for $60. Since the $60 issue price of the new income in 2009 and 2010 from the debt is less than its $100 face amount, the repurchase (or modification) of their deemed new debt is treated as having $40 of In recent months, the outstanding debt to include that income over “original issue discount” (OID), which is a five-year period beginning in 2014 and (2) amortized (as interest deductions for the deep discounts at which turn off the so-called “AHYDO” (or issuer and interest income for the holder) bonds and bank debt “applicable high yield debt obligation”) rules over the remaining term of the debt. If the in a narrow but important circumstance. As remaining term of the debt exceeds five years, have been trading and a result, companies are generally permitted to the AHYDO rules may severely limit the deleverage (or modify their outstanding ability of the corporation to deduct the OID. the difficulty of meeting publicly traded debt) without triggering In such a case, the corporation is required to various financial immediate taxable income. Under prior law, recognize the $40 of COD income even this result generally could have been achieved though the $40 of corresponding OID covenants have caused only through filing for bankruptcy or to the deductions are disallowed. If the OID is extent the company was insolvent (or if the deductible, the issuer may still have a timing many companies to underlying modification was not considered disadvantage: the COD income is includible “significant” for tax purposes). in the year of the repurchase and may trigger consider repurchasing, or an immediate tax liability, while the benefit modifying the terms of, of the corresponding amount of OID their debt.
Debevoise & Plimpton Private Equity Report l Winter 2009 l page 7 Stimulus Legislation (cont. from page 7)
COD Income Relief debt issued during the period beginning is required to recognize the COD income. Under the Act, a company that recognizes September 1, 2008 and ending December A practical effect of the Act, from the COD income in connection with the 31, 2009 in exchange for pre-existing debt issuer’s perspective, of a significant “reacquisition” of debt after December 31, (and to debt deemed to have been issued in modification of publicly-traded debt is that 2008, and before January 1, 2011, may exchange for pre-existing debt by reason of the COD income will generally be elect to include the COD income ratably a “significant modification” of that pre- neutralized by offsetting OID deductions, over a five-year period generally beginning existing debt) so long as interest deductions so long as the original debt instrument was in 2014. The term “reacquisition” is on the pre-existing debt are not already not subject to the AHYDO rules and so defined broadly to include any acquisition limited under the AHYDO rules. long as the modification does not reduce of debt by the company or a related person, However, the AHYDO rules would the principal amount of the debt. In including an acquisition of the debt for continue to apply to (1) debt issued for cash contrast, the holder of the modified debt cash, an exchange of the debt for other or other property (including pre-existing will include the OID income as it accrues debt, a deemed exchange of the debt arising debt the interest on which is already subject over the remaining term of the debt even from a significant modification of the debt, to the AHYDO rules), (2) debt deemed to though the issuer is required to defer the an exchange of the debt for equity, a have been issued by reason of a purchase by corresponding OID deductions. a related party, and (3) certain debt contribution of the debt to capital and a Gary M. Friedman providing for contingent interest. forgiveness of debt. Special rules are [email protected] provided for COD income recognized by a As noted above, the acquisition of debt partnership. by a related person or the modification of Vadim Mahmoudov publicly-traded debt can result in both [email protected] AHYDO Turned Off in Narrow COD income to the issuer and the debt Circumstance for One Year David H. Schnabel being treated as reissued with additional The Act also generally turns off the [email protected] OID. Under the Act, the deduction for any AHYDO rules in a narrow but important such additional OID is deferred until the Peter F. G. Schuur circumstance. Specifically, the Act provides five-year period during which the company [email protected] that the AHYDO rules would not apply to
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page 8 l Debevoise & Plimpton Private Equity Report l Winter 2009 Deconstructing Equal and Ratable Security Clauses
Introduction The Equal and Ratable the relative priority of the unsecured Ignorance of the intricacies of “equal and Clause in Context creditors’ claims to the assets of the borrower. ratable” clauses in acquisition candidate’s The “equal and ratable” clause is designed to When a borrower grants the bank the bond indentures was a luxury afforded to provide the borrower with the flexibility to additional collateral required by it to extend private equity players for many years. obtain future secured financing, while the credit and the application of the equal However, as the private equity community protecting a creditor’s relative claim to the and ratable clause is triggered, typically adjusts to working in an environment in borrower’s assets. The clause protects neither the bank nor the debtor wish to which obtaining new debt is—to put it creditors by preventing the borrower from negotiate with the holders of the unsecured mildly—challenging, structuring around granting new creditors a prior lien on its notes. So the structuring of an “equal and restrictive covenants in existing debt assets, thereby removing those assets from the ratable” security package is left to the debtor, instruments is increasingly critical to making pool available to unsecured creditors in the the new creditor and their respective deals work. Negative pledge covenants are event of the borrower’s bankruptcy. counsel—frequently with limited input from among the most common provisions in bond The scope of a negative pledge provision the bond trustee. indentures and restrict a borrower from can vary depending on the nature of the Why Get it Right? pledging collateral, or otherwise securing, transaction and the borrower’s business. The Importance of Structuring future indebtedness. Negative pledge Some negative pledge provisions are absolute an Equal and Ratable Security provisions generally permit the borrower to and flatly prohibit the incurrence of any lien Interest Properly secure future debt issuances, so long as the to secure indebtedness or other obligations. The consequences of breaching a negative 1 existing debt is “equally and ratably” secured. Such provisions are most restrictive of the pledge provision help explain the importance The significance of the “equal and ratable” borrower’s flexibility—both operationally and of properly structuring an equal and ratable clause in negative pledge covenants has been in their ability to obtain future financing. security package. spotlighted in recent restructurings and More commonly, negative pledge provisions The negative pledgee’s only recourse refinancings and as a target of investment contain exceptions that permit the borrower grade investors in last year’s Credit to encumber certain of its assets—“permitted CONTINUED ON PAGE 10 Roundtable White Paper. liens”—subject to limitations outlined in the Although many practitioners have agreement. Sometimes, particularly in older The significance of the grappled with the “equal and ratable” clause indentures, the negative pledge clause will and structured transactions around the clause only limit liens on specified “principal “equal and ratable” in its many guises, there is little written about properties” of the borrower—such as the the meaning of the “equal and ratable” clause equity interests of its significant subsidiaries clause in negative pledge and there is limited case law on the topic. or particular manufacturing facilities or real This article is intended to offer concrete estate. covenants has been guidance on how to effectively deal with The “equal and ratable” clause permits the spotlighted in recent adding new secured financing to the capital borrower to grant liens beyond the scope of structure of a company whose debt contains a the “permitted liens” so long as the security restructurings and negative pledge clause. granted “equally and ratably” secures the debt which benefits from the covenant. The refinancings and as a 1 A typical negative pledge provision reads as follows: clause maintains the creditors’ expectation target of investment grade “The Company will not, and will not permit any of that only a certain amount of secured debt its Restricted Subsidiaries to, directly or indirectly, create, Incur or suffer to exist any Lien (other than will be senior to them. If more than the investors in last year’s Permitted Liens) upon any of its property or assets. . . expected amount of debt will be secured, unless contemporaneously with the Incurrence of such while the liens can be granted to a new Credit Roundtable Liens effective provision is made to secure the creditor, the existing creditors must share an Indebtedness due under the Indenture and the Notes. . . White Paper. equally and ratably with the Indebtedness secured by “equal” interest in the collateral, preserving such Lien for so long as such Indebtedness is so secured.” Debevoise & Plimpton Private Equity Report l Winter 2009 l page 9 Deconstructing Equal and Ratable Security Clauses (cont. from page 9)
against the debtor that has granted a central elements discussed below: the rank capacity to accelerate their debt at the time security interest in violation of the clause is of the security interest, application of that the senior creditors take action against acceleration of the debtor’s debt and a claim proceeds, the nature of the assets pledged the collateral, might not effectively benefit against the debtor for a breach of contract. and control over the collateral. from the lien. The availability of a claim for breach of Rank of Security Interest Assets Pledged: contract is of dubious value because such a To satisfy the “equal and ratable” Shared Pool v. Separate but Equal claim does not affect the validity of the requirement, the lien securing the new and Another issue that debtors confront in security interest granted to the debtor’s new existing debt must be of the same rank. structuring an “equal and ratable” security creditor. The breach of contract action Debt obligations, as well as the liens that package is whether or not the “equal and represents merely an additional unsecured secure them, are often ranked in order of ratable” clause requires that the debtor grant claim of the negative pledgee against the seniority; senior debt ranks higher than the creditors a shared security interest in the debtor, together with its now-accelerated subordinated debt; first lien debt ranks same assets, or whether the debtor can debt. higher than second lien debt. Rank of debt safely provide the creditors with separate Ironically, the new creditor may have a and the lien securing the debt will dictate security interests in different, but equivalent greater incentive to structure properly its treatment in the issuer’s bankruptcy. A assets. around a negative pledge clause than the lien granted to a subsequent creditor cannot In the real world, “equal and ratable” debtor. The creditor who benefits from an be senior in rank to that of the creditor that security packages are structured to provide a improper pledge of collateral is likely to be benefits from the negative pledge covenant. shared security interest in the same pool of the target of litigation by the jilted negative assets for both sets of creditors. When new pledgee. A number of legal theories are Application of Proceeds and existing creditors share a lien over the available to permit the negative pledgee to Proceeds of the shared collateral must be same collateral, however, many issues arise bring action against a new creditor, shared equally and ratably between the new regarding how to structure distributions including tortious interference with secured lender and the negative pledgee from, and the creditors’ control over, the contract and the creation of an equitable following enforcement. Like equality of shared collateral pool. Issues of control lien over the collateral in favor of the legal rank, this principle is clearly at the raised will be discussed below. Grappling negative pledgee. heart of the equal and ratable clause. The with such control issues seems to be an easy negative pledgee must appear in the same Deconstructing the Meaning task when compared with the challenges of level of the distribution waterfall as the new of “Equal and Ratable” structuring an “equal and ratable” pledge secured creditor in the event of a foreclosure Several facets of a security arrangement can over separate pools of collateral. or other realization upon the relevant be impacted by the “equal and ratable” Still, commentators have suggested that collateral. clause. Although the identity of the assets it would be possible to satisfy an “equal and Moreover, many transactions that subject to pledge is the most central feature ratable” covenant by granting a security implement “equal and ratable” security of a security package, any security interest in separate, but equal pools of packages require that proceeds of collateral arrangement must also contain rules for assets. Such an approach would avoid the be distributed ratably between the new making decisions regarding dispositions and intercreditor issues created by shared pools creditors and the existing noteholders in uses of the collateral, distributions of of collateral, but raises other significant proportion to the outstanding principal proceeds in respect of the collateral and issues, principal among them, the valuation amount of their debt, regardless of whether other matters. “Equal and ratable” clauses of the assets pledged to each group of or not that amount is then due and owing. typically do not limit the application of the creditors and a number of impediments To the extent that the principal amount is “equal and ratable” clause to the question of revolving around legal opinion not then due, the proceeds are held in what assets are pledged and are purposely requirements. escrow by a collateral trustee or agent for drafted quite broadly. In structuring an the benefit of those creditors. Such an Control Over Collateral “equal and ratable” security package, it is, escrow mechanism makes it clearer that the The rights of a secured creditor to monitor therefore, essential to examine all of the security interest is truly “equal”—otherwise collateral and to control dispositions of aspects of the security arrangement that can the bondholders, who may not have the be impacted by the clause. There are four CONTINUED ON PAGE 20 page 10 l Debevoise & Plimpton Private Equity Report l Winter 2009 Emerging Markets Shine in a Difficult Year
In recent years private equity activity in emerging markets has been attracting growing attention as industry players look beyond developed markets for investment opportunities. This article examines key differences between private equity fund formation in emerging and more developed markets.
Emerging markets were a relative bright spot the investor base for emerging markets private that invests in developed markets. A fund in a difficult year for private equity, with equity. Previously dominated by multilateral sponsor will take into account the target $66.5 billion raised in 2008 by 210 private development agencies such as the European jurisdiction or jurisdictions where the fund equity funds focused on emerging and Bank for Reconstruction and Development, will invest, the anticipated composition of the transforming markets. Notwithstanding the the International Finance Corporation and investor base, and the sophistication of the generally bleak state of the financial markets, the World Bank, the investor base for legal and administrative service industries in growth in the medium term seems poised to emerging markets funds now looks the jurisdictions under consideration. Tax continue: 74% of investors surveyed in 2008 increasingly like that of other classes of funds considerations are a primary driving force in by the Emerging Markets Private Equity and includes public and private pension plans, the structuring process, as the structure Association (EMPEA), expect to increase foundations and funds of funds. should minimize the incidence of taxation on their allocations to emerging markets during The legal and regulatory issues associated the fund’s portfolio companies and avoid the next three to five years. with organizing an emerging markets fund introducing additional levels of taxation in Several metrics testify to this story of and the contours of negotiations with connection with repatriating proceeds from growth: investors bear many similarities to developed portfolio companies (e.g., withholding taxes markets funds, but nevertheless pose some on distributions from portfolio companies or the number of funds and the volume of distinctive challenges. The remainder of this taxes on intermediate vehicles in the fund or capital raised in emerging markets increased article examines the principal differences in portfolio company acquisition structure). every year from 2003 through 2008; the structures, due diligence process and key Accordingly, sponsors and their advisors the total amount raised by emerging terms applicable to funds in emerging and consider the domestic tax laws and relevant markets funds increased from $3.5 billion developed markets. tax treaties of the fund’s jurisdiction and the in 2003 to $66.5 billion in 2008—an Structure: Jurisdiction jurisdictions where the fund will invest. In increase of 1900%; and emerging markets funds, it is often the case The choice of jurisdiction and legal structure that the fund is organized in a tax-efficient the average size of emerging markets for an emerging markets private equity fund jurisdiction (e.g., the Cayman Islands) and funds increased from approximately depends on a number of factors similar to
$182 million in 2003 to approximately those considered when structuring a fund CONTINUED ON PAGE 12 $400 million in 2008.
What enabled emerging markets funds to defy the gravitational forces that pulled much Emerging Markets of the rest of the private equity market to Investment Incentives Investment Risks ground in 2008? Investor interest has increased in part due to the perception that Superior Risk-Adjusted Returns Investors Inexperienced in Evaluating investment incentives in many emerging Opportunities markets have improved, while investment risks traditionally associated with emerging markets Portfolio Diversification have diminished or become more manageable. Indeed, many investment risks commonly Increase in Quality of Fund Managers Limited Number of High Quality associated with funds in more developed Managers markets, such as strong competition, excess leverage, more sponsor-friendly fund terms, Improving Political and Economic Continued Political and Economic Risks high entry prices and slow economic growth, Conditions are absent or less prominent in emerging Increase in Experienced Management Limited Management Talent markets funds. The changing risk/reward calculus has Increase in Liquidity Concerns About Exit Opportunities resulted in an expansion and diversification of
Debevoise & Plimpton Private Equity Report l Winter 2009 l page 11 Emerging Markets Shine in a Difficult Year (cont. from page 11)
thus much of the tax planning relates to the western investment firms to reduce political where the fund invests, and that the fund’s structure below the fund through which the risk and access valuable country-specific investments will be structured to minimize fund acquires a portfolio company. experience concerning governmental tax. While this process is similar to the Structure: Vehicle policies, local business practices and diligence conducted by investors in operational and employment conditions. developed markets, the analysis can become The majority of emerging markets funds are In addition to the potential benefits, complex for funds investing in multiple organized as limited partnerships, with an however, a fund sponsored by a joint jurisdictions—such as pan-Asia or pan- entity controlled by the sponsor acting as venture presents a number of risks and Africa funds—and in some cases may the general partner and third-party investors potential conflicts of interest that joint involve novel questions of law. subscribing for interests as limited partners. venture partners need to manage. The joint However, alternate structures are used for Terms: Distributions venture partners must agree on key funds investing in certain regions. For The standard distribution waterfall in U.S. economic issues, including the allocation of example, funds investing in India are often fund agreements distributes carried interest carried interest and the sharing of advisory organized under Mauritius law and on a “realized deals to date” basis. In a or management fees between the partners. structured as limited liability companies realized deals waterfall, while investment Venture partners also must agree on key with limited life because neither Mauritius gains and losses are netted across the fund’s governance issues, including the process for nor Indian law recognizes limited portfolio, the fund may distribute carried making decisions involving the fund and partnerships. In addition, India-resident interest in respect of a realized investment the joint venture, such as investments in or investors generally avoid investing directly once the fund has returned to investors all divestments of portfolio companies. In in limited partnership vehicles due to a capital contributions in respect of the addition, the partners will need to address investment, any previously realized concern that an Indian court would treat the possibility that their goals and investments, related fees and expenses, and the limited partnership as a general expectations may diverge, either at the a preferred return. The distribution partnership and treat an Indian investor as outset of the relationship or as the waterfall in the significant majority of liable for the unsatisfied obligations of the relationship develops. emerging markets funds, however limited partnership. (commonly referred to as a “return all Process: Due Diligence Structure: Joint Ventures capital” waterfall), does not permit the fund Investors in private equity funds focused on Many emerging markets funds are to distribute carried interest until the fund any jurisdiction conduct some level of due sponsored by joint ventures established by has returned to investors all capital diligence prior to committing to invest in a two partners. Typically, one joint venture contributions made during the life of the fund. Investors typically, however, conduct partner is a local group with a relationship fund, whether those capital contributions more extensive due diligence when investing network, a track record in the target were made to fund investments that have in emerging markets, often because jurisdiction and access to proprietary deal been realized or investments that continue investors are not as experienced with flow, and the second joint venture partner is to be held by the fund. Some emerging investing in these markets and are therefore an institution with a well-known markets funds have a distribution waterfall less familiar with the relevant legal, international brand and experience that is even more investor-friendly (referred regulatory and tax considerations. Investors to as a “return all commitments” waterfall), operating private equity funds with a solid in emerging markets funds may particularly which requires the fund to return all capital institutional investor base. A joint venture scrutinize the anticipated structures to be commitments during the fund’s investment structure, either at the fund level or the used for the funds’ investments and the period (whether or not actually drawn) portfolio company level, may also be potential legal consequences of an indirect prior to distributing carried interest. This necessary for investments in restricted investment in a jurisdiction, including the difference is due in part to the perception industries in certain jurisdictions. For possibility that a jurisdiction where the fund that emerging markets assets are more example, foreign ownership restrictions on will invest may not respect the limited volatile, and that therefore there is an telecommunications companies in India or liability afforded to fund investors. increased risk that a fund may dispose of natural resources in Russia may mandate Investors often seek comfort with respect one or more portfolio investments at a gain minimum local ownership levels or prohibit to tax issues, including confirmation that, as followed by the realization of a loss, investment by foreign investors without a resulting in an overdistribution of carried a result of investing in the fund, the local partner. A joint venture with a interest to the fund sponsor. investor will not be subject to tax in the reputable local partner may also enable jurisdiction where the fund is organized or CONTINUED ON PAGE 35 page 12 l Debevoise & Plimpton Private Equity Report l Winter 2009 Disruptions in the LIBOR Market: Borrowers Beware When the Boilerplate Is Broken
Most of our readers—even those borrowers deal with this type of market disruption LIBOR loan portfolio as the interest rate who are occasionally involved in negotiating event in the typical U.S. credit agreement changes over time. However, for the more credit agreements—are probably unfamiliar provides relief where a majority of the traditional bank lenders, who are the few with how the standard yield protection and banks are unable to obtain funding at the remaining sources of debt financing in the increased cost provisions operate in bank LIBOR screen rate, the relief is typically current environment, this inability is more credit agreements. In recent years these limited to giving the lenders the right to problematic. This is particularly the case provisions would have occupied possibly switch from LIBOR pricing to “prime rate” where, as is now much more common, the one line in a term sheet and a few pages of pricing. The prime rate is an interest rate lender is expecting to retain a significant boilerplate in the definitive documents, maintained by most U.S. banks which is hold position in the loan for an extended meriting virtually no attention in the supposed to reflect the interest rate they are period of time. negotiation process. then charging on loans to their preferred As a result, a number of lenders, burned Then came the financial meltdown of customers and which can theoretically by their inability to maintain the funding of 2008. As a number of banks and financial fluctuate on a daily basis in accordance with their LIBOR priced loans at rates assumed institutions discovered that they were market conditions. However, this is often to be available to them under existing unable to obtain dollar funds in the inter- not a helpful option for foreign banks who agreements, insisted on reopening the bank market at the LIBOR “screen rate,” typically do not maintain a prime rate for standard boilerplate provisions in borrowers suddenly faced demands to U.S. dollar borrowings. Nor would foreign CONTINUED ON PAGE 14 revisit boilerplate provisions related to the banks necessarily have access to funds from calculation of LIBOR interest rates which the Fed’s discount window (the prime rate have been standard and virtually untouched being most typically linked to the cost of As a number of banks in credit agreements for years. borrowing from the Fed). This problem The screen rate, published daily by was aggravated in late 2008 when decisions and financial institutions Reuters based on information provided to it of the U.S. Federal Reserve Board had the by the British Bankers Association, effect of reducing the prime rate of most discovered that they were represents the average cost of obtaining U.S. banks to a level that was roughly unable to obtain dollar deposits in the inter-bank market by a equivalent to the LIBOR screen rate.1 representative sample of sixteen banks on Their inability to obtain dollar funds in funds in the inter-bank that day as reported by the association and the interbank market at the LIBOR screen is the most common measure of LIBOR rate was not troubling to many of the market at the LIBOR (the London Inter-Bank Offered Rate) used specialized funds and non-traditional “screen rate,” borrowers in credit agreements worldwide. The most lenders who have dominated the syndicated commonly reported explanation for the loan market in recent years because they do suddenly faced demands disconnect between the screen rate and not look to match fund their U.S. dollar available dollar funding was suspected to revisit boilerplate under-reporting by banks in the sample 1 Due to market constraints, in practice U.S. banks provisions related to the group of their cost of funds out of a fear don’t really have much flexibility to manage their that reporting higher costs would betray prime rates in line with short term changes in calculation of LIBOR relative weakness and difficulty in obtaining financial market conditions. As a reflection of this reality, and in order to deal with the fact that LIBOR credit. Non-U.S. banks, having no U.S. has not always kept pace with the recent downward interest rates which have dollar deposit base as an alternative source movement of the federal funds rate, lenders in a of funds, rely heavily for funding of U.S. number of recent transactions have required that the been standard and credit agreement definition of the “prime rate” be dollar loans on the inter-bank loan market adjusted so that it can never be lower than the virtually untouched in and were particularly hard hit. equivalent LIBOR rate plus 100 basis points Although the boilerplate intended to (historically that being the typical spread between credit agreements for LIBOR and prime). years. Debevoise & Plimpton Private Equity Report l Winter 2009 l page 13 Disruptions in the LIBOR Market (cont. from page 13) negotiating new deals. The goal is to high percentage of the floating rate more objective alternative under which rework the relevant provisions to make credit agreement debt swapped to a a specified “disruption” margin is them more like the market disruption fixed rate. added to the LIBOR screen rate upon event provisions common to the European the occurrence of certain recognized A borrower’s degree of comfort with bank market which, when a negotiated signs of distress in the credit markets. broader and more subjective market percentage of the lenders in a bank One approach would trigger the disruption event protections is likely to syndicate are having difficulty funding at addition of this margin if the spread vary in direct proportion to the the LIBOR screen rate, assure virtually between three month LIBOR and the strength of its relationship with the each lender that it will have the right to three month U.S. treasury bill rates particular lender. The more liberal be compensated in full for the cost of (the “TED spread”) exceeds a specified protections of this type could lead to making or maintaining LIBOR priced number of basis points. heightened concern and scrutiny by loans.2 borrowers of proposed secondary Replace the LIBOR base rate entirely This is an unfortunate development for transfers by lenders (and the credit with a base rate tied to the average cost borrowers. Among the consequences for agreement provisions regulating them). of funds for the entire lending borrowers are: syndicate in the loan facility If the need to seek ad hoc LIBOR Long and painful negotiations will be (eliminating, for purposes of pricing adjustments occurs other than common until the market resettles in calculating this average, the highest and on an extraordinary basis, the process this area, because the issues are lowest quotes). of administering these provisions could relatively arcane and the typical deal easily become unmanageable for both Impose as prerequisites to the right to negotiators have little experience the borrower and the lender obtain cost of funds compensation dealing with them. representatives responsible for minimum thresholds in terms of either As the applicable standards will managing the credit agreement. the percentage of the loans held by inevitably require a relatively high lenders seeking compensation and/or The principal device in credit degree of subjectivity, acceptance by the number of basis points by which a agreements designed to protect the borrower requires an element of lender’s actual cost of funds exceeds the borrowers from lenders who abuse trust that is not always there. When applicable LIBOR screen rate. these types of yield protection yield protection provisions were first provisions (the “yank-a-bank” clause) is Where the credit agreement requires a introduced and before they became not likely to work very effectively in certain amount of interest rate hedging, part of the boilerplate, borrowers the current environment. This clause provide covenant relief for any routinely complained about their lack gives the borrower the right to replace interest/debt service coverage test if the of transparency and the possibility that an existing lender exercising these invocation of the market disruption they could be invoked selectively and protective provisions with a new lender provisions (and the resulting unhedged in a discriminatory manner. of the borrower’s choosing if the interest expense) is the cause of the Inasmuch as virtually all fixed-to- replacement lender purchases the loans covenant violation. floating rate swaps are tied to the of the existing lender at par; a right The high degree of liquidity in the credit LIBOR screen rate, the effectiveness of that might not be very meaningful in markets in recent years had made these any interest rate hedging strategy may current depressed market conditions. provisions largely irrelevant. However, as be jeopardized. The importance of this These concerns have led to consideration long as those markets continue to be issue is greatest where the financing of alternatives to full scale cost of funds weak, one is likely to see greater attention needs to be structured with a relatively protections, or measures to mitigate their to potential renegotiation of these kinds of impact. Alternatives that have been boilerplate provisions as more buy and 2 While these kinds of LIBOR market disruption hold investors populate the lender side of fallback provisions have for some time been a considered include: credit agreements. standard feature of European credit agreements, they In lieu of explicitly assuring each bank have almost never been invoked. In the current environment, borrowers fear that this practice of that it will receive its cost of funds if A. David Reynolds forbearance will end. greater than LIBOR, structuring a [email protected] page 14 l Debevoise & Plimpton Private Equity Report l Winter 2009 Bridging the Gap: How to Get Deals Done in an Unsettled Market
The terms “earnouts” and “seller financing” remain involved in the business post-closing, might instead condition payment on achieving were not part of the private equity deal lexicon the buyer may find it unpalatable to share a specified IRR within a specified term after its during the days of ample capital and strong future increases in the value of the company investment. Sellers typically prefer top line equity markets. These days, however, they, with a party that did not actively contribute to metrics because they are less prone to along with rollover equity, have become its growth. manipulation, while buyers prefer bottom line increasingly effective tools for bridging While an earnout can be an effective way measures because they more accurately reflect financing and valuation gaps between sellers to get a deal across the finish line, both buyer value. In any event, the parties will likely need and buyers. For both deal veterans who need and seller will need to make some sacrifices. to agree on parameters to prevent the buyer a refresher course, and for those who are newer The buyer will likely be required to give up (or management, if applicable) from taking to the deal environment, this article will some control over the company post-closing actions to skew results (e.g., inflating expenses discuss how earnouts, seller financing and because the seller will insist on regulating the or deferring revenue). rollover equity can be used, either alone or in operation of the business through restrictive The duration of an earnout is typically one tandem, to get deals done in a less than settled covenants or veto rights to protect its earnout to three years. A buyer might prefer a shorter marketplace. While these tools are more potential. The seller will need to forego a earnout period to avoid long-term constraints frequently used in private company portion of what it may deem to be a fair price on its operation of the business, but will be acquisitions, they can also be adapted to public at closing and settle instead for the wary of the opportunity this creates for company transactions. opportunity to be compensated later if the mischief by the seller in the pre-closing period Earnouts business performs well. Both parties will have (e.g., the seller could postpone receivables until to endure the added complexity and after the closing or buy excess inventory pre- Overview negotiation that inevitably accompanies an closing). Sellers may argue that it will take If a buyer and seller cannot agree on the earnout structure and the potential prospect of several years to achieve their projections and valuation of a target company because their a protracted post-closing dispute over whether thus that a longer period is appropriate, but respective estimates of its future earning and to what extent earnout payments are due. should consider whether they really want to potential differ, an earnout can often bridge The parties should also think ahead to the remain involved with the business over that the gap by making a portion of the purchase likely context in which the ultimate earnout period. The parties will also need to price contingent on the target company’s determination will be made. For instance, if determine the consequences of one or more achievement of defined objectives. If a private management stockholders are retained post- management stockholders leaving the equity buyer intends to retain a company’s closing with the expectation that the earnout company during the earnout term. management stockholders, an earnout will not will be paid, will it make sense for the buyer to If the buyer will integrate the acquired only help address the valuation gap but will risk a fractious dispute with management over company into existing businesses, another also serve as an additional incentive for the whether milestones were achieved? In such a issue to consider is whether sellers should management team to enhance the company’s case, to mollify management and keep them at benefit from such integration (e.g., the value post-acquisition. In addition, earnouts the company beyond the earnout period, the opportunity to bundle products and cross sell, reduce the amount of consideration required buyer may be pressed to pay out some or all of cut costs and take advantage of other at closing and thus minimize and may even the earnout. Indeed, there is an old saying synergies) or whether instead the earnout eliminate the need for third-party financing. that “an earnout is seldom earned but always metric should focus solely on sales of products Not every proposed acquisition with a paid.” and services and related cost structures existing pricing gap is ripe for an earnout. For as of the closing. Buyer will argue that sellers Structuring Considerations example, where a target company has should not benefit from any synergies that If the parties do decide to move forward with stagnated or underperformed prior to the would not have been realized absent the an earnout, threshold structuring issues acquisition and a private equity buyer intends transaction, but post-acquisition it may be include the specific earnout criteria to introduce new management, business difficult to evaluate the acquired company measurement and the time period over which strategies or operational improvements, the independent of the buyer’s other businesses. the measurement will take place. Gross buyer may be disinclined to share the potential For this reason, the negotiation and revenues, net profits and EBITDA are value associated with such changes with the common metrics, but a private equity buyer CONTINUED ON PAGE 16 sellers. More generally, if the seller will not
Debevoise & Plimpton Private Equity Report l Winter 2009 l page 15 Bridging the Gap (cont. from page 15)
administration of an earnout is much easier if payment (aside from an imputed interest employee compensation, must be assigned a the acquired company is managed by the component) will generally be taxed at capital fair value at the time of closing and fully buyer as a stand-alone business after the gains rates rather than as ordinary income. recognized as a liability at that time. closing. Capital gains treatment is generally Subsequently, the value of the earnout must What level of control, if any, should the advantageous to individual sellers, but not to be remeasured at each reporting date, and sellers have over the acquired company after the buyer, who prefers compensation will impact earnings in that period to the the acquisition? Sellers will want to ensure treatment, which could make the entire extent of any fluctuations in the estimated that the business continues to be operated payment deductible by the company. Where value. Similarly, earnings will be impacted to consistent with past practice, while a buyer management sellers will be working for the the extent of any difference between the will not want a seller interfering with the buyer post-acquisition, the sellers will want estimated value and any actual payment operation of its newly acquired business, to ensure that the earnout payments are not ultimately made. In contrast, under the old especially if the buyer wants to integrate the subject to forfeiture for termination of accounting regime, an earnout liability was target into its other businesses or alter the employment in order to avoid ordinary not recognized until the contingency was target’s operations. This is a delicate balance income treatment. Buyers may resist, both resolved, and there were not generally any and there are varying control protections that for business reasons and in order to obtain interim impacts on earnings or liabilities. sellers obtain in earnout structures, ranging the tax deduction arising from treatment as Some buyers may not like these interim from narrow covenants or veto rights to ordinary income. earnout-based adjustments, particularly extensive governance provisions permitting Additionally, for U.S. federal income tax public company buyers or private equity sellers to be involved in the day-to-day purposes, the “installment method” generally firms hoping to recapitalize, sell or IPO the operation of the business. applies to gain attributable to earnout target company before the end of the earnout Buyers considering use of an earnout payments unless a seller elects out of such period, and will want to take these issues into should note that Delaware law’s implied treatment in the year in which the account in deciding whether to include an covenant of good faith and fair dealing may, acquisition closes. Under the installment earnout. Also, the buyer will need to think regardless of whether sellers have any method, a seller generally would not through the implications of the accounting contractual protections, require that a buyer recognize the deferred portion of the treatment under its debt documents. For give the management stockholders “a fair purchase price unless and until it actually example, the additional liability and earnings opportunity to operate the company in such receives the earnout payments. Each seller fluctuations may create issues under the a fashion as to maximize the earn-out should carefully consider the pros and cons financial covenants. consideration available under the of installment sale treatment. For example, a Parties contemplating an earnout [acquisition] agreement.” In Horizon seller that holds an installment obligation in structure should consult with their tax and Holdings, LLC v. Genmar Holdings, Inc. (10th excess of $5 million would be subject to an accounting advisers early in the process. Cir. 2004), the court held that this Delaware annual interest charge on a portion of its Dispute Resolution standard meant that the buyer could not take deferred tax liability. On the other hand, At the time of the acquisition, the parties actions in respect of the acquired company electing out of the installment method would should establish and carefully draft clear that would interfere with sellers’ ability to require the seller to value the contingent guidelines for determining if an earnout achieve the earnout (e.g., changing product payment right and to recognize up-front milestone is achieved. Buyers and sellers names and marketing, shifting production taxable income with respect to an amount should coordinate with their lawyers and priority, discontinuing certain products or that it may never receive (with the potential accountants to ensure that the shutting down a manufacturing facility), capital loss in a subsequent year not being documentation accurately reflects their even though the agreement did not expressly available for carryback to the year of the expectations and can withstand potential provide the sellers with rights with respect to sale). Finally, the installment method may challenges from a dissatisfied party. The such actions post-closing. not be available at all in certain cases. parties should also agree on an appropriate The accounting treatment of earnouts Tax and Accounting Considerations dispute resolution mechanic (e.g., using an was modified at the end of last year to If the earnout is treated as deferred purchase independent accounting firm to arbitrate and require a “fair value” of cash earnouts. Under price—sales proceeds and not compensation settle any disputes). Another way to manage FAS 141R, future earnout payments to be for future employment—the earnout made in cash, other than those treated as CONTINUED ON PAGE 36 page 16 l Debevoise & Plimpton Private Equity Report l Winter 2009 SEC Weighs in on Approval of Stock Mergers by Written Consent
Certainty of closing has always been an even where principal stockholders have The new CDI, however, adds an additional important issue for private equity sponsors signed lock-up agreements. Although the requirement. If the persons entering into involved in public company deals—on the SEC views the signing of the lock-up as an lock-up agreements also deliver written sell side as an aid in extracting maximum investment decision being made without consents approving the business value from an acquiror, and on the buy side the benefit of an effective Form S-4 combination, the SEC staff will not allow as a means of ensuring, to the extent registration statement and final prospectus, the subsequent registration of the securities possible, that the sponsor gets the benefit of recognizing the “legitimate business to be issued in the transaction on Form S-4 its bargain. While the Delaware Supreme reasons” for lock-ups, it has not asserted for any shareholders. The theory is that, in Court’s 2003 Omnicare decision precluded that lock-ups somehow constitute an such a case, offers and sales in connection the use of shareholder lock-ups to create a unregistered public offering, or that they with the business combination transaction fait accompli for a buyer, it left open a are a private offering that precludes have already been made and completed technique, since blessed by the Delaware subsequent registration of the shares to be privately, and, once begun privately, the Chancery Court in a 2008 decision issued to the public in the business transaction must end privately. Because a (Optima Int’l of Miami, Inc. v. WCI Steel), combination transaction—as long as certain good private placement of business combi- whereby controlling shareholders could requirements are met: nation securities to public shareholders is a actually consent to a merger—rather than practical impossibility, the CDI eliminates the lock-up agreements involve only commit to vote for it—shortly after a controlling shareholder consents from the executive officers, directors, affiliates, merger agreement is signed. deal protection arsenal in public company founders and their family members, and A recent Compliance and Disclosure deals in which securities are used as holders of 5% or more of the voting Interpretation (CDI) by the Securities and currency. equity securities of the company being Exchange Commission’s Division of The distinction between a shareholder’s acquired; Corporation Finance, however, indicates commitment to vote and a shareholder that this technique cannot be used for a the persons signing the lock-up consent has never been wholly satisfying, public company if the merger consideration agreement collectively own less than but it is one that the SEC apparently will include stock or other securities instead 100% of the voting equity of the target embraces, as, so far, has Delaware. of only cash. company; and William D. Regner The SEC has a long-standing policy of votes will be solicited from shareholders [email protected] allowing the registration of shares to be of the target who have not signed the issued in business combination transactions agreements and would be ineligible to (such as stock mergers or exchange offers), purchase in a private offering.
Looking A complete article index, along with all past issues of the Debevoise & Plimpton
for a past Private Equity Report, is available in the article? “publications” section of the firm’s website, www.debevoise.com.
Debevoise & Plimpton Private Equity Report l Winter 2009 l page 17 Limited Partner Defaults: The Improbable Becomes Reality (cont. from page 6) defaults, it may be difficult to later apply a entirely clear as to the enforceability of (and the reduction in total fund more flexible approach. default remedies. As a matter of general commitments) on its financial A general partner facing a default may principle, courts in both jurisdictions are statements. In addition, the fund want to take into account the following reluctant to interfere with the freedom to partnership agreement or side letters may options and considerations: contract and will not strike out require material changes to be reported. provisions agreed to by sophisticated Work Through Alternatives. It may not Diversification Limitations. If the parties. However, default provisions, be necessary to declare a default while defaulting limited partner’s unfunded which in the closed-end fund arena the limited partner is cooperating with commitment is not replaced, the provide the primary leverage against the general partner to resolve a liquidity reduced total commitments of the fund default, are subject to particular scrutiny issue or the limited partner is trying to may affect the size of future investments. in many jurisdictions. In determining identify a third party or an existing whether to apply the remedies in the ERISA Considerations under the 25% limited partner to assume its interest in fund partnership agreement, the general Test. If the fund limits benefit plan the fund. partner should consult with counsel investors to less than 25% to satisfy Declare the Limited Partner in Default. concerning applicable case law in the ERISA, a limited partner default may The general partner must usually deliver relevant jurisdictions. require a recalculation to confirm that a default notice before designating the the fund is still in compliance. Other Factors to Consider in limited partner in default. Even then the Event of Default Voting and Representation on Advisory default is not automatic because the There are a number of other possible Committee. In almost all cases, a limited limited partner would typically not be ancillary consequences of a limited partner partner that defaults is no longer entitled considered in default until it has been default that a fund manager will want to to vote on fund matters and can be given a chance to cure. It is possible, weigh in fashioning a response, including removed from the Advisory Committee. however, that undue delay in issuing a the impact of a default on the following: default notice may be considered a Limitations in the Event of Limited waiver and foreclose the general partner Existing Subscription-Backed Credit Partner Bankruptcy. It is possible that from declaring the limited partner in Facilities. A failure to fund by a limited the fund’s remedies may be constrained default. partner usually requires notice to the in the event a limited partner declares, or lender, even if the limited partner is not is about to declare, bankruptcy. Court Enforced Contributions. In theory, declared in default. In addition, a the general partner may be able to * * * default of a certain size may accelerate convince a court to require a limited Limited partner defaults, once seen as a outstanding loans or terminate the partner to honor its capital contribution remote prospect, are now sufficiently on the facility. Lender consent may be required obligations. Barring that, the general radar of many private equity fund managers for certain transfers of limited partner partner should be able to sue for that they are engaged in contingency interests or amendments to the fund damages. However, general partners planning for this eventuality. The above partnership agreement. have traditionally been reluctant to sue suggestions address only some of the issues their investors, concerned primarily Insurance Company Renewals. Most that should be considered in the event of a about the effects any such action might D&O insurance policies are renewed default or potential default of a limited have on future fund raising. It is annually and will require the fund to partner. Each situation will likely have its possible that under certain circumstances identify any limited partner defaults. It own unique facts and all actions should be a general partner may conclude that its is possible that a default may affect carefully considered with the advice of fund duty to the other limited partners underwriting decisions, including counsel. requires it to take action to enforce the pricing. Sherri G. Caplan terms of the partnership agreement. Audited Financials/Other Reporting [email protected] Enforceability of Default Remedies. Obligations. The fund may be required Neither Delaware nor English law is to report the default of a limited partner
page 18 l Debevoise & Plimpton Private Equity Report l Winter 2009 ADS v. Blackstone: Strine Endorses Private Equity Cabins
The Delaware Chancery Court’s recent The Blackstone fund entered into a separate according to the court, spoke only to actions decision in the litigation arising out of limited guarantee, guaranteeing Aladdin to be taken by the merger entities themselves. Blackstone Group’s aborted acquisition of Holdco’s obligation to pay the reverse Most interesting was the court’s firm Alliance Data Systems provides welcome breakup fee but not its other covenants. statements that extrinsic evidence that all affirmation for private equity firms that the ADS claimed that the merger entities that parties considered ADS’s negotiating legal structure of a typical private equity were parties to the merger agreement counterparty truly to be Blackstone rather acquisition will be respected by the breached the agreement by failing to cause than the Aladdin entities could not be Delaware courts. the Blackstone fund to provide the guarantee considered where the text of the agreement As some readers may recall, Blackstone of ADS’ bank subsidiary required by the was clear that Blackstone was not a party and announced on May 17, 2007 that its private OCC as a condition for giving its approval of had no obligations to ADS under the equity fund, Blackstone Capital Partners V, the transaction. ADS pointed to three agreement. In other words, the court L.P., had agreed to acquire ADS, a credit card provisions of the merger agreement to endorsed the validity of the private equity service provider. The deal was conditioned support its claim. First, the buyer entities acquisition structure in which, absent an on, among other things, receipt of approval covenanted to use reasonable best efforts to express contractual provision to the contrary, from the U.S. Office of the Comptroller of obtain regulatory approvals necessary for a private equity fund and its sponsors will not the Currency (the OCC) as the regulator of closing. Second, they covenanted to cause be held responsible for the contractual ADS’s credit card bank subsidiary. As a Blackstone not to take any action that would obligations of acquisition subsidiaries and condition of its approval, the OCC sought a prevent or delay the completion of the deal. portfolio companies. In doing so, the court $400 million guarantee from the acquiring Third, they represented that they had all evidenced its understanding of the necessity Blackstone fund of the obligations of the power and authority necessary to enter into of this structure. As Vice Chancellor Strine regulated bank subsidiary. Blackstone refused and consummate the transaction. In his wrote in his opinion: to provide such a guarantee, and each of decision issued on January 15, 2009, Vice Blackstone’s business model is to operate Blackstone and ADS eventually sent the Chancellor Leo Strine of the Delaware a series of funds, of which [Blackstone other a notice purporting to terminate the Chancery Court rejected all three of ADS’s Capital Partners V, L.P.] is an example. merger agreement. ADS claimed it was arguments and ruled in favor of Blackstone’s These funds make money for their terminating the agreement because Blackstone’s motion to dismiss ADS’s claim. owners by investing in operating breach of the agreement resulted in the failure The court rejected ADS’s argument that businesses that are operated through limited liability entities to prevent the of the conditions to closing to be satisfied, the merger entities’ obligation to use under-performance of any single company while Blackstone claimed that the regulatory reasonable best efforts to obtain approvals from harming a fund’s investment in condition could not be satisfied by the “drop created any similar obligation on the part of other companies. In other words, dead” date as a result of the OCC’s decision. Blackstone, which was not a party to the Blackstone seeks to cabin its risk for any As is typical in a private equity agreement. The court also opined that the portfolio company by restricting its acquisition, the Blackstone fund itself was negative covenant to cause Blackstone not to investment in each company in a disciplined way. not a party to the merger agreement with take any action that would jeopardize the ADS. The parties to the merger agreement closing of the transaction could not be read The ADS decision provides reassurance to were shell entities organized solely for the to imply a positive covenant to cause financial sponsors as to the legal vitality of purpose of entering into the transaction, Blackstone to take actions required for closing. the typical acquisition structure for a private including a holding company called Aladdin Finally, the court did not accept that the acquisition structure, one in which private Holdco, Inc. and its subsidiary, Aladdin representation and warranty that the merger equity funds are responsible only for the Merger Sub, Inc., which was to be merged entities had the requisite power and authority obligations they specifically assume under the into ADS. ADS’s sole remedy under the to consummate the transaction was rendered transaction agreements. merger agreement for a failure of Blackstone inaccurate because they lacked the authority Michael D. Devins to close the deal was a reverse breakup fee of to force Blackstone to take actions required [email protected] $170 million payable by Aladdin Holdco. for closing. The representation and warranty,
Debevoise & Plimpton Private Equity Report l Winter 2009 l page 19 Deconstructing Equal and Ratable Security Clauses (cont. from page 10) collateral should be considered in evaluating bank’s coat tails and the control rights that that the process treats each creditor on compliance with an “equal and ratable” the bank and the debtor determine are equal terms. In practice, however, it should clause. Issues of control arise whenever necessary to satisfy the strictures of the be noted that this approach effectively creditors share a security interest in the equal and ratable clause. disenfranchises the negative pledgee, since same pool of assets. Typically those issues Three basic elements of control are the amount of its debt is frequently less are resolved through intercreditor frequently considered in this context: first, than that of the new secured creditor, who agreements that are customized to the the right of the negative pledgee to will be able to outvote the negative pledgee. circumstances and needs of each of the commence enforcement actions; second, Practitioners intent on satisfying the equal parties—frequently after intense their ability to participate in decision- and ratable clause have focused on the negotiations. While control is not a making regarding enforcement proceedings equality of the decision-making process, not concept that one typically considers in the with respect to collateral; and third, their the equality of the outcome. context of evaluating the legal rank or ability to consent to, or prevent, the release Most “equal and ratable” security priority of a creditor’s claims, the equal and of their shared liens over collateral following packages reserve considerable control to the ratable clause is not so limited; the clause default. Many “equal and ratable” security bank group, however, rather than adopting demands that the security interest granted packages grant the negative pledgee a the pure democratic approach. Before the to the negative pledgee be “equal.” The minimum set of control rights, while occurrence of a default, the bank agent on practitioner should at least ask “how much reserving most decisions regarding the behalf of the bank group typically is control over the collateral must be granted collateral to the bank’s collateral agent—but permitted to maintain sole control to the negative pledgee in order to satisfy treatment of such “control” issues can vary regarding dispositions of collateral and has the negative pledge provision?” widely, as described below. the exclusive right to inspect and oversee This question is addressed in a situation the collateral. In many instances, even Commencement wholly unlike that in most intercreditor following a trigger event, the bank agent of Enforcement Proceedings discussions. The new secured lender will retains sole control over the enforcement The “equal and ratable” requirement want to have as much control as possible proceedings and dispositions of the should be considered with respect to the over all decisions regarding the collateral collateral. trigger for enforcement proceedings. The and leave little or no control over the In other examples, while the collateral trigger events permitting the commence- collateral to the noteholders. The bank will agent for the banks is generally permitted to ment of enforcement proceedings is want to be able to monitor the collateral, to control decisions regarding enforcement, frequently the same for both the bank make decisions regarding releases of the that control can be assumed by the majority lenders and the note-holders. This collateral, and to determine when and how of the creditors, including the bondholders, approach is not universal, however — an to foreclose on the collateral if necessary. if the majority of creditors request. The event of default under the bond indenture The debtor will typically be willing to possibility of such a “democratic override” does not always trigger a right to proceed provide the bank with as much control over of the bank agent’s control arguably against the collateral in the absence of a the collateral as possible in order to induce enhances the likelihood that the control bank default. the bank to participate in the financing. rights granted bondholders are “equal” to The debtor may also believe that the bank Dispositions of Collateral and Method those of the bank lenders. will be more responsive to requests for of Enforcement Alternative structures, in which each releases of collateral and other matters. For In some cases, decisions regarding dispositions secured party is given a single vote or a veto these reasons, the new creditors and the of collateral after commencement of right, would also seem to satisfy the debtor—the parties who are most actively enforcement proceedings are to be made by negative pledge clause’s demand for equality. involved in structuring the “equal and a vote of all of the secured creditors, in Such structures are not seen in practice, ratable” security package—will have a which each creditor receives a vote for every however. The explanation for this fact is strong incentive to limit the negative dollar owed to it. This “democratic likely the simplest one—such structures give pledgee’s control over the collateral. The approach” has been accepted by some the negative pledgee more power and noteholders’ role is generally more passive practitioners as satisfying the negative secured lenders do not want to have to give
—they accept the security interest on the pledge clause’s demand for “equality,” in CONTINUED ON PAGE 34 page 20 l Debevoise & Plimpton Private Equity Report l Winter 2009 Final Exon-Florio Regulations: What They Mean for Private Equity
The private equity community has not been of Presidential interference (subject to foreign national, foreign government or getting much good news from Washington, CFIUS’ ability to reopen a review if any foreign entity. The test of “control” is one but the recently released final Exon-Florio party submitted false or misleading material of facts and circumstances. In general, a regulations provide some comfort for information to it). fund’s general partner and manager should sponsors concerned that the overly-broad When Is a Private Equity Fund be deemed to control the fund, but if proposed regulations might have created “Foreign?” foreign limited partners are entitled to unnecessary impediments to transactions. minority protections (other than those The final regulations provide some relief to In our article, “How the New Exon-Florio specified in a safe-harbor provision of the private equity funds by changing the Rules Affect Private Equity” in the Spring regulations), the fund could be deemed proposed definition of “foreign entity” so 2008 Debevoise & Plimpton Private Equity foreign. One minority protection that is that it now includes only entities organized Report, we noted that the regulations relatively common but which is not on the outside of the United States whose principal proposed by Treasury to implement the safe-harbor list is the right to remove the place of business is outside of the United Foreign Investment and National Security general partner upon a specified vote of States or whose equity securities are Act of 2007 (FINSA), which amended limited partners. However, even where the primarily traded on one or more foreign Exon-Florio, raised a number of questions limited partners have such a right and exchanges.1 Accordingly, even a Cayman and ambiguities for private equity funds that foreign limited partners could control the Islands fund (other than a fund listed are organized offshore or have a significant vote, the final regulations suggest that if abroad) will not be foreign if its principal percentage of foreign limited partners. The limited partner interests are widely place of business is in the United States. final regulations, which became effective on dispersed and foreign limited partners are One potential complication is that the term December 22, 2008, provide some helpful unrelated and have not agreed to act in “principal place of business” is not defined answers, although Exon-Florio will still be on concert, CFIUS would not be likely to find or explained, and this formulation may give the deal checklist for many private equity firms. foreign control. By contrast, veto rights pause to funds that maintain, for tax (other than those specified in the safe- Exon-Florio Recap reasons, that they are not engaged in a trade
Exon-Florio authorizes the President of the or business in the United States. The CONTINUED ON PAGE 22 United States to suspend, prohibit or revised definition also provides that even if require the unwinding of any transaction by a foreign-organized fund is listed or has its or with a foreign person that could result in principal place of business abroad, it In light of FINSA and the foreign control of a U.S. business, if the nevertheless will not be considered foreign President concludes that (1) the foreign if it can demonstrate that a majority of its final regulations, private interest exercising control might take action equity interests are ultimately owned by equity funds will want to that threatens to impair U.S. national U.S. nationals.2 security and (2) other laws do not provide A U.S.-based private equity fund may pay more attention to adequate protection. Parties to a also be “foreign” if it is controlled by a transaction who are concerned that their Exon-Florio. Uncertainty 1 transaction may raise national security Under the proposed rules, a foreign entity would about the applicability of concerns and who do not want to live with have included any fund organized in an offshore jurisdiction by a U.S. private equity sponsor if 50% or the threat that the President could order the more of the fund’s partnership interests were held, the law, as well as the transaction unwound may request a pre- directly or indirectly, by foreign nationals, closing review by the Committee on notwithstanding that the fund’s general partner and current political climate, manager were U.S. persons. Foreign Investment in the United States will likely lead to more (CFIUS). CFIUS also may initiate a review 2 Although the final regulations are very corporation- of a transaction on its own. If CFIUS centric and therefore do not provide much guidance CFIUS filings than in concludes a review without taking further about how partnerships will be treated, we believe that partners will be viewed as holding “equity interests” in action, the parties can proceed without fear proportion to their capital commitments. the past.
Debevoise & Plimpton Private Equity Report l Winter 2009 l page 21 Final Exon-Florio Regulations: What They Mean for Private Equity (cont. from page 21) harbor provision) that can be exercised by decisions likely to be shared by foreign ineligible for the 10% exemption; the individual foreign limited partners could and U.S. investors in a 50/50 club deal investor still may not be considered to be troublesome. will be deemed control by each; and (2) have control, depending on all of the facts The final regulations do not make clear even where a club has three or more and circumstances.) the extent to which CFIUS will look up, members, a foreign minority holder may In light of FINSA and the final or require filers to look up, the chain of be deemed to have control if it can regulations, private equity funds will want control or ownership, although it is clear determine or veto decisions regarding to pay more attention to Exon-Florio. that CFIUS has leeway to do so. important matters (other than those Uncertainty about the applicability of the Accordingly, it will be important when specified in the safe-harbor provision). law, as well as the current political climate, structuring a fund that the sponsor pay Sovereign Wealth Funds will likely lead to more CFIUS filings attention to the nationality of its than in the past. Sponsors of funds in Past investments by sovereign wealth prospective limited partners and their formation who think that they will face funds in private equity sponsors (as ultimate controlling persons as well as to the Exon-Florio filing question—given opposed to funds) often relied on an any relationships among limited partners, their investment strategy and the potential exemption for acquisitions of 10% or less including agreements to vote in concert, make-up of their limited partners—should of a sponsor’s voting securities made solely that may influence the analysis of whether make sure that they have the ability to for the purpose of investment. That the fund is foreign-controlled. elicit from their limited partners the exemption has been preserved, although information required to make Club Deals the final regulations require that to qualify determinations about foreign status. Private equity firms considering for the exemption the investment be solely participation in a club deal with a foreign for the purpose of “passive” investment Jeffrey P. Cunard partner should keep in mind that (1) and make clear that an investment that is [email protected] more than one equity holder can be in accompanied by a right to appoint a Robert F. Quaintance Jr. control at the same time—the influence director is not passive. (Flunking the test [email protected] over investment and management of passivity only renders the investment
Recent and Upcoming Speaking Engagements December 17, 2008 February 27, 2009 March 25, 2009 Mark P. Goodman Jordan Murray Michael P. Harrell Funds in Retreat: The Liability Landscape Maples Investment Funds Forum: Private Equity Negotiating Better Partnership Terms for Directors and Officers Maples and Calder and Conditions Maloy Risk Services Cayman Islands Buyouts East Conference and Debevoise & Plimpton LLP Thomson Reuters/Buyouts Magazine February 27, 2009 CCO University Outreach Program/Webex New York David A. Brittenham, Program Co-Chair January 15, 2009 Private Equity Financing Today April 28, 2009 Steven R. Gross Gregory H. Woods III Andrew M. Ostrognai John S. Kiernan Recent Developments and Trends Broken BRICs? The Future of Private Equity Heidi A. Lawson Private Equity Acquisition Financing Summit in the BRIC Economies Best Planning for the Worst: The Practising Law Institute How the Global Economic Crisis Is Impacting Assuring Coverage for Private Equity Sponsors New York Private Equity in the Largest Emerging and Portfolio Company Directors in a Bankruptcy Economies, and How Investors Can Position March 9, 2009 Debevoise & Plimpton LLP Themselves Well for the Recovery—China Michael P. Harrell, Session Chair New York Emerging Markets Private Equity Association The New Regulatory Environment: Webcast What’s Next? Tenth Annual International Conference on Private Investment Funds International Bar Association London page 22 l Debevoise & Plimpton Private Equity Report l Winter 2009 Duties of Directors of Distressed Companies: Avoiding an Intrinsic Fairness Review
When times are good, the goal of private directors by the “business judgment rule.” corporation or all shareholders generally, equity professionals serving as directors of So long as directors are not “interested” in and (2) substantial enough, based on the portfolio companies is relatively straight- the matter before them, they benefit from director’s individual economic forward—maximization of value for the the presumption that they acted on an circumstances, to make it improbable that corporation’s shareholders. Moreover, the informed basis, in good faith and in the the director could perform his fiduciary interests of the two constituencies that the honest belief that their decision was in the duties without being influenced by the private equity professional serves—his best interest of the corporation. benefit. private equity firm employer and the But the business judgment rule does not To be “independent,” the director’s portfolio company’s shareholders—are apply where it can be shown that the decision must be based on the merits of the typically aligned as the private equity firm directors were either interested in a transaction rather than extraneous factors. is usually the portfolio company’s largest transaction or lacked independence. In This determination is typically based on a shareholder. When a portfolio company these cases, the burden of proof shifts to the fact-specific and subjective analysis of becomes insolvent, however, the private directors to show the “entire fairness” or CONTINUED ON PAGE 24 equity professional serving on its board is “intrinsic fairness” of the transaction— confronted with a significantly more that the actions of the board were both complex situation and the legal standard by procedurally and substantively fair. A which his actions are judged may be court’s determination as to whether to Private equity materially more demanding. Private equity apply the intrinsic fairness test, given the professionals serving as professionals serving as directors of higher standard to which this test subjects portfolio companies during the current a director’s conduct, may dictate the directors of portfolio economic downturn should therefore outcome of a challenge to a board’s understand the duties they owe to the decision and, at the very least, whether the companies during the stakeholders in the corporations they serve challenge will survive a summary judgment current economic and the impact of the corporation’s motion. financial condition on these obligations. When Is a Director Interested downturn should First, a quick recap on the topic from or Not Independent? the last issue of the Debevoise & Plimpton therefore understand the The burden of proving the intrinsic Private Equity Report, “Alert: Duties of fairness of a transaction will only shift to Directors of Distressed Companies—An duties they owe to the the directors if facts can be pleaded that Update and Refresher.” Directors typically show that either a majority of the directors stakeholders in the owe the corporation and its shareholders a were interested in the matter before the duty of care and a duty of loyalty. The board or a third party controlled the board corporations they serve duty of care requires that directors exercise as a whole so as to infect the board’s the degree of care that an ordinary and and the impact of the decision. prudent person would use in similar Courts have found that a director may corporation’s financial circumstances. The duty of loyalty requires be “interested” in a transaction if he stands that directors act in good faith in the best on both sides of the transaction or expects condition on these interests of the corporation and its to derive a financial benefit from the shareholders and that they not engage in obligations. transaction. To render a director self-dealing. Challenges to directors’ interested, a financial benefit must be decisions are generally difficult to sustain (1) personal to the director, rather than a because of the protection afforded to benefit that also devolves upon the
Debevoise & Plimpton Private Equity Report l Winter 2009 l page 23 Duties of Directors of Distressed Companies (cont. from page 23) whether the particular director is likely to What is Intrinsic Fairness? respect to closely held corporations such be dominated by, or otherwise beholden Courts have held that there are two as portfolio companies. to, a controlling shareholder or other third aspects to the intrinsic fairness test: fair When the constituencies to which a party. Courts have held that directors dealing and fair price. Fair dealing focuses director owes duties is expanded, the lacked independence in a variety of on the actual conduct of the directors in range of transactions in which a director different situations, including where the effecting the transaction, including how may be “interested” may also grow. Take, director controlled (or was a director of) a the transaction was initiated, structured for example, transactions involving a party providing financing to the and negotiated. This may include a parent and its wholly-owned subsidiary. It corporation, was an indirect owner of a review of the timing of the transaction is generally settled that a solvent, wholly- party receiving significant fees as part of a and the board approval process, who owned subsidiary is free to serve the transaction, or was a management controlled the structuring and negotiation interests of its shareholder parent. shareholder and would receive financial of the transaction and whether all relevant Consequently, an employee of the parent benefits upon the completion of a information was disclosed to the board. may serve on the board of the subsidiary transaction beyond those received by the Fair price relates to the economic and without fear that its relationship with the shareholders generally (e.g., options, financial terms of the transaction, parent will render him interested. The severance pay). including a review of the value that an interests of the parent and the duties of In order to ensure that a fiduciary does otherwise arm’s-length transaction would the subsidiary’s directors are usually not unfairly benefit himself or a third provide. Courts focus on both elements aligned. However, once the subsidiary is party at the expense of the corporation, of the test as part of an integrated analysis insolvent this alignment may no longer once it is established that a majority of the of all aspects of the transaction since the exist. The director of the subsidiary is directors on the board may be interested question is one of “entire fairness.” legally obligated to serve the interests of or otherwise lack independence, the the subsidiary’s creditors as well as those What Changes When the burden of proof shifts to the directors to of his employer, the parent. As a result, Portfolio Company Is show that the transaction was fair, both in case law suggests that directors of Insolvent? terms of process and price. subsidiaries may breach their duty of When a corporation is solvent, the loyalty if they permit assets—which would directors only owe fiduciary duties to the otherwise be available to satisfy the claims corporation and its shareholders. However, once a of the subsidiary’s creditors—to be Generally, creditors are entitled to only diverted away from the subsidiary for the those contractual rights set forth in their corporation becomes benefit of the parent. financing or other agreements. However, A private equity sponsor and its insolvent, the directors’ once a corporation becomes insolvent, the portfolio company present very nearly the directors’ fiduciary duties run to an fiduciary duties run to an same situation. A private equity sponsor expanded constituency that encompasses employee who sits on the board of a not only the corporation and its expanded constituency solvent portfolio company generally owes shareholders but also the corporation’s fiduciary duties to the sponsor, as the that encompasses not creditors. The assumption underlying controlling shareholder of the subsidiary, this expansion is that once a corporation and may therefore approve transactions only the corporation and is insolvent, the residual value of the that are beneficial to the sponsor without corporation may belong to the its shareholders but also concern that his decisions will be reviewed corporation’s creditors and not its under the intrinsic fairness test, assuming shareholders. This shift can have a the corporation’s that minority shareholders are treated significant impact on the application of fairly. However, once the portfolio creditors. the intrinsic fairness test, particularly with CONTINUED ON PAGE 25
page 24 l Debevoise & Plimpton Private Equity Report l Winter 2009 Duties of Directors of Distressed Companies (cont. from page 24) company is insolvent, the director also What Should Directors Do? legal obligations that are not present in a owes duties to the creditors of the Given that an increasing number of more favorable economic environment. portfolio company, and the director’s corporations are or may be facing Generally, the structure of board relationship with the sponsor may render insolvency, what should directors do? The deliberations should be carefully managed him interested with respect to any primary goal for the directors of any to avert unanticipated challenges to the transaction benefiting the private equity corporation should be the preservation of process and the result. sponsor even in its capacity as a the protection afforded by the business Richard F. Hahn shareholder. judgment rule. To achieve this, a private [email protected] In fact, in a recent case, the equity sponsor should consider ensuring Bankruptcy Court for the District of that at least two independent and Jasmine Powers Delaware found that a Chapter 7 trustee disinterested directors sit on its portfolio [email protected] had sufficiently alleged a breach of the company’s board of directors and, in Jessica Katz duty of loyalty against a private equity certain circumstances, may even wish to [email protected] sponsor, its counsel and the portfolio constitute a special committee of company’s directors to survive a motion to disinterested directors to deliberate on dismiss. In In re The Brown Schools, et al., matters that raise conflict issues for other the trustee successfully argued that a series directors. Where disinterested directors of otherwise unsurprising restructuring serve on the portfolio company’s board, it The primary goal for the transactions that preceded the portfolio is essential that these directors are fully company’s bankruptcy should be informed concerning the transactions directors of any evaluated under the intrinsic fairness test before the board and the private equity because the defendants had engaged in sponsor’s interests in the transactions and corporation should be the self-dealing. The alleged self-dealing participate meaningfully in the decision- included the payment of certain advisory making process. Finally, these actions preservation of the fees to the private equity sponsor and a should be reflected in the records of the grant of junior liens to secure loans the board’s deliberations. protection afforded by the private equity sponsor previously made to If the board does not have independent business judgment rule. the portfolio company. In so holding, the directors, the sponsor and its portfolio Bankruptcy Court turned what appeared company should assume that board To achieve this, a private to be a relatively standard duty of care decisions impacting the sponsor will be case (reviewed under the deferential reviewed under the more demanding equity sponsor should business judgment standard) into a duty intrinsic fairness test and consider how of loyalty case (reviewed under the more best to structure board deliberations in consider ensuring that at rigorous intrinsic fairness standard). It is that light. How frequently and when least two independent important to note that in rendering the should the board meet? What advisors Brown Schools decision, the Bankruptcy should be retained? What input—fairness and disinterested directors Court was required to accept the trustee’s opinions or other independent review and factual allegations as true and was analysis—should be provided by these sit on its portfolio precluded from considering defenses that advisors? What records should be kept of the defendants might assert. However, the board’s deliberations? company’s board of the decision is nonetheless cause for Private equity professionals serving as caution. directors of portfolio companies will want directors... to be mindful that the current downturn may create complexities in fulfilling their
Debevoise & Plimpton Private Equity Report l Winter 2009 l page 25 The
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page 26 l Debevoise & Plimpton Private Equity Report l Winter 2009 Debt Exchange Offerings: A Flash in the Pan?
Last September and October, as high-yield In effect these completed exchanges served fourth-lien debt. In several offerings, the bond prices on the secondary markets as synthetic debt repurchases, pursuant to debt received in the exchanges contained dropped precipitously, several issuers, which an issuer offered to replace, for modified maturity dates, additional cash including a number of private equity example, a $100 note obligation with a $50 payments or preferred equity, as well as portfolio companies, launched exchange secured loan obligation. However, unlike revised interest terms. Most sought to effect offers designed to lower their financing costs more straightforward debt repurchases, the the exchanges without consent from the by capitalizing on the discounted pricing. exchanges generally did not require any existing senior secured lenders, though several The smoke has now cleared on these outlay of cash by the issuer. And unlike used the exchange to simultaneously obtain exchange offers and, though the results are previous traditional note exchanges, most of consents to amend the indentures governing mixed, the challenging economic these exchanges involved the replacement of the notes to be acquired in the exchange. environment combined with recent unsecured notes with secured debt, rather This article examines the common legislation (discussed in the article that begins than new unsecured notes. features and significant differences among the on page 7) easing the tax burden associated While the exchange offers varied flurry of exchange offers late last year in with debt refinancings may lead to an uptick significantly, they each offered unsecured which notes were exchanged for secured debt, in new exchange offers in the coming bondholders the opportunity to exchange as well as their results and discusses certain months. their bonds for first-, second-, third- or even CONTINUED ON PAGE 28
Company Old Debt New Debt Discount of Selected Results New Debt Additional Terms
Realogy Corporation Unsecured Notes 2nd Lien Debt 55%-65% — Withdrawn after (depending on adverse judgment. note series)
Neff Corp. Unsecured Notes 1st Lien Debt 55%-60% Senior revolver Majority subscribed. (subordinated to (depending on capacity reduced, revolver) note series) interest rate increased.
Stripped covenants from unsecured note indenture.
Harrah’s Unsecured Notes 2nd Lien Notes 0%-63% (depending Cash payment Minority of eligible Entertainment, Inc. on note series) option provided on holders of near-term limited portion of maturity notes near-term maturity subscribed; majority notes. of eligible holders of long-term maturity notes subscribed.
Hovnanian Unsecured Notes 3rd Lien Debt 53%-60.5% — Less than 10% of Enterprises, Inc. (depending on note eligible holders series) subscribed.
Finlay Fine Jewelry Unsecured Notes 3rd Lien Notes 0% New notes PIK’ed 70% of eligible Corporation through 2010. holders subscribed.
Exchanging noteholders also purchased additional 2nd lien notes.
Station Casinos, Inc. Secured and 2nd and 3rd Lien 46%-83% (depending — Withdrawn because Unsecured Notes Debt on note series) of insufficient interest.
Debevoise & Plimpton Private Equity Report l Winter 2009 l page 27 Debt Exchange Offerings: A Flash in the Pan? (cont. from page 27) legal considerations associated with these As noted above, however, the new stimulus existing financing arrangements before it transactions. legislation significantly mitigates this tax can proceed with any debt exchange offer. The Commercial Equation liability in future exchange offers. First, the issuer needs the capacity to issue The benefits received by the lenders new, usually secured, debt and, second, the The common commercial equation in each exchanging their notes included security, issuer must have the right to redeem or of these transactions is the borrower seeks to guarantees, and, in a few cases, cash or prepay the existing notes subject to the obtain a reduction in its debt load by preferred equity. An exchange is attractive exchange. offering lenders a stronger security position to lenders when the increase in value and other enhancements with respect to the Additional Debt Capacity provided by the security or other new debt securities, with the net result that In many of the recent exchange offerings, enhancements exceeds the diminution in post-offering the lender holds debt with a including those by Realogy Corporation, principal amount of the converted notes reduced principal amount which, because of Neff Corp., Finlay Fine Jewelry Corporation and other impairments. For example, if an its enhanced credit position, should trade at and Harrah’s Entertainment, Inc., the issuer’s notes had been trading at 25% of a premium to the exchanged debt. capacity to issue new, secured debt existed face value and the issuer provides an option More specifically, the benefits for the in the senior secured credit facilities through to exchange those notes for secured term borrower in these exchanges included a incremental or “accordion” features whereby debt with a face value of 50% of the variety of reduced principal amounts, longer the issuers have the right to incur indebt- exchanged notes, the exchange would be terms, lower interest rates and modified edness up to a fixed amount. Accordions attractive to any investor believing that the covenants. One potentially significant off- generally permit increased indebtedness newly-issued exchanged term debt would setting cost, however, has been tax liability under the same terms of the original facility trade above 50% of its principal value. for the borrower on cancellation of or terms that are no less advantageous to This, in turn, will depend not only on how indebtedness income incurred pursuant to the original lenders with respect to the market values the specific enhancements the redemption of the original notes in subordination, security and maturity. to be provided in the newly-issued exchange exchange for new debt with lower par value. To maximize exchange benefit while debt, but also on the impact of the complying with these accordion caps, some borrower’s reduced total debt load on the issuers structured their exchange offers to pricing of the exchange debt. apply only to certain classes of notes and In addition to getting the While some issuers, including Neff often limited the exchange amounts within Corp. and Finlay Fine Jewelry Corporation, pricing equation right, at such classes. For example, in the Realogy succeeded in untying this Gordian knot, for Corporation exchange offer, of the others it proved all but insoluble. For least two significant legal maximum $500 million in new exchange example, Hovnanian Enterprises, Inc. issuance, priority was given to subordinated issues need to be managed to complete its exchange offer but noteholders, then to senior noteholders, participation included only notes totaling while PIK-toggle holders were able to evaluated under an $71 million, or significantly less than 10% participate only to the extent that the of the notes eligible for exchange, suggesting issuer’s existing financing exchange was not fully subscribed by the that the added security did not sufficiently subordinated and senior cash-pay compensate noteholders for the diminution arrangements before it noteholders. Because the value of these in face value. Another exchange offer, from various instruments was potentially can proceed with any Station Casinos, Inc., was withdrawn diminished by the new—and newly- because of insufficient interest. The table debt exchange offer. secured—debt being issued in the exchange on page 23 summarizes the principal terms offer, this tiering led to considerable of several of these recent exchange offers. discontent among those noteholders whose Legal Hurdles participation in the exchange was limited. In addition to getting the pricing equation As a result, certain holders of PIK-toggle right, at least two significant legal issues notes issued by Realogy Corporation need to be evaluated under an issuer’s CONTINUED ON PAGE 29
page 28 l Debevoise & Plimpton Private Equity Report l Winter 2009 Debt Exchange Offerings: A Flash in the Pan? (cont. from page 28) brought suit in Delaware Chancery Court to maturity, or no higher priority than the also raised other legal questions which enjoin the exchange offer because of what prior debt and benefit from no increase in remain unanswered and could ultimately they considered to be unfair treatment. One guarantees or security. pose challenges to similar future exchanges. of the arguments raised by the Realogy The limitation on a grant of new One question is fraudulent conveyance: if Corporation plaintiffs was that the security in a permitted refinancing was also the borrower was insolvent at the time of an “accordion” provisions in Realogy’s senior challenged by the plaintiffs in the Realogy exchange issuance, there is an argument credit facility only permitted Realogy to Corporation litigation, and the court ruled that, if the new debt was more valuable issue new debt in exchange for cash proceeds in their favor, enjoining the exchange offer. than the old, it would be considered a and thus did not permit Realogy to issue The court found that the grant of a second- fraudulent conveyance to the exchanging new senior secured term loans in exchange lien security interest in the new debtholders. Another concern is coercion for tendered notes. The Court rejected the indebtedness to be issued in the exchange and discrimination: in those exchanges in plaintiffs’ arguments, referring to them as violated the restrictions on permitted which the offer is combined with “hyper-technical,” thereby providing some refinancing because the existing notes being amendments to existing indentures, lenders comfort that exchange offers of the type exchanged were not secured. The decision may be coerced into participating in the initiated by Realogy can be issued under was a highly technical one however, based exchange by the potentially changed terms similar accordion provisions of other senior largely on the interplay between the of their indentures. credit agreements. It should be noted, applicable indenture and the precise * * * however, that a different court might reach a language of Realogy’s senior secured facility, Any exchange offer will float or founder first different decision and that differences in the and could well have come out differently and foremost on its commercial terms. That specific language in the “accordion” terms had the senior credit agreement first been said, the dual issues of debt capacity and might lead to different results. amended to avoid this interplay. This is redemption and repayment right constitute In addition to “accordion” features, important because first-lien lenders like important obstacles to be carefully navigated senior debt facilities generally include Realogy’s senior lenders may be favorably by prospective borrowers seeking to offer additional baskets that may be tapped to disposed to cooperate in making such secured debt in exchange for existing notes. permit the issuance of new indebtedness, amendments in these circumstances since After the rash of exchange offers in late including general indebtedness baskets, an exchange would reduce the debt-load of 2008, it appeared briefly as if the risks and though such baskets are likely to be smaller the borrower to the senior lender’s challenges posed by such transactions was than available “accordions.” advantage without directly impairing its discouraging new transactions, but, as we go priority on the security. Right to Redeem to press, at least two new exchange offers are In a similar challenge to the ability of an The second principal legal hurdle is an on the market. Both Freescale issuer to replace unsecured notes with issuer’s ability under its existing financing Semiconductor and AbitibiBowater are secured indebtedness filed shortly before the facilities to redeem or prepay the exchange offering to exchange unsecured notes for Realogy decision, second-lien lenders to notes in question. Generally, senior secured secured debt and interim results from both Neff Corp. challenged Neff Corp.’s loan agreements have provisions limiting offers indicate significant interest from the exchange offer on similar grounds, seeking a the redemption or prepayment of junior eligible noteholders. Given the continuing preliminary injunction from the Supreme and/or unsecured facilities; however there weakness in the credit markets, the Court of the State of New York. The are often exceptions to these limitations complexity of many capital structures and request for a preliminary injunction was including if the notes in question are being the recent tax changes relating to the withdrawn, however, without a ruling. The redeemed in connection with a refinancing. cancellation of indebtedness income referred Neff Corp. exchange proceeded to a The reasoning behind this exception is that to above, it appears that debt exchanges will successful conclusion, though the litigation a refinancing should not disadvantage remain a valuable tool for borrowers to remains pending with the plaintiffs seeking senior or secured lenders provided that the reduce their leverage. compensatory damages. refinancing meets several criteria. These Peter B. Alderman criteria vary among different facilities but Additional Legal Considerations [email protected] generally require that the new debt be of no In addition to the principal hurdles greater principal amount, no earlier discussed above, these exchange offers have
Debevoise & Plimpton Private Equity Report l Winter 2009 l page 29 Everything Old Is New Again: PIPEs Go Up-Market (cont. from page 1) restrictions that made control investments securities and the backstop of a parallel induce PIPE investors to accept non- by private equity firms in financial public offering (or private placements) of cumulative dividends, since the issuer institutions either difficult or impossible. It up to an additional $150 million of similar cannot pay even a penny dividend on its seems likely that these factors will remain securities in return for a cash commitment common stock without having paid its present in 2009 and perhaps beyond, and fee. While backstopped offerings give the preferred dividends in full. that we will continue to see large-scale PIPE issuer assurance that it will meet its capital In most cases, the preferred security will transactions involving a broad array of raising goals, PIPE issuers should consider not have a fixed redemption date or be private equity firms. the implications of an unsuccessful public redeemable at the option of the holder. The structuring of PIPE transactions, offering as well as the additional time Financial institution issuers are often particularly in financial institutions, involves required to complete the transaction. engaging in PIPE transactions against the numerous interrelated business, legal and Type of Security backdrop of capital reviews by ratings agencies or regulatory assessment of risk- tax issues. Key considerations include the PIPE transactions can involve a variety of based capital and the issuer generally will following: securities, including straight common, not be able to treat the investment as equity Dealing with Investment preferred (convertible or non-convertible), for accounting purposes or get its desired Consortia convertible debt or a combination of the ratings and capital treatment if the The largest PIPE transactions in 2008 foregoing. Investors sometimes get equity redemption decision is in the hands of the involved multiple investors joining together kickers in the form of warrants in addition holder. Even where redemption is solely at to invest in distressed financial institutions. to their primary security. Although less the option of the issuer, ratings agencies will Most often, the transaction was led by a common than warrants, investors often insist that the issuer enter into capital private equity or hedge fund firm, who took sometimes receive call options for an replacement covenants that prohibit the lead in performing due diligence and incremental investment within a specified redemption except in connection with a negotiating the basic contracts, with the period of time. As discussed further below, concurrent issuance of new equity. transaction then being opened up to certain in some cases, the security is economically of the issuer’s existing institutional equivalent to common stock but initially Dealing with Shareholder shareholders. For example, TPG Capital’s takes the form of preferred stock in order to and Regulatory Approval approximately $2 billion investment in bridge regulatory or shareholder approval Requirements Washington Mutual was accompanied by requirements. Assuming the issuer has sufficient an additional $5 billion investment from a If the PIPE security is a true preferred authorized capital stock and, in the case of group of Washington Mutual’s largest stock, a key consideration for the investor preferred stock, the issuer’s board has blank- institutional shareholders. The anchor will be the terms of the dividend. In check authority, the most likely investor may receive greater governance addition to the coupon itself, the parties requirements for shareholder approval will rights and better economic terms, but its must agree on the length of the no-call come from the rules of the stock exchange investment may also be subject to tighter period, whether or not the dividend is on which the issuer’s securities are listed. If transfer and standstill restrictions. cumulative and whether accumulated the investment involves the issuance of Alternatively, PIPE transactions can be dividends compound. While a non- more than 20% of the issuer’s outstanding accompanied by a parallel public cumulative dividend clearly puts the common stock—either directly or on an as- shareholder rights offering underwritten by investor at economic risk, since under converted basis—the issuer will need to the anchor investor. For example, as part of Delaware law an issuer has no duty to pay obtain the approval of its shareholders Warburg Pincus’s initial investment in preferred dividends even if it otherwise has under NYSE and NASDAQ listing rules. MBIA, Warburg agreed to purchase $500 the funds available, dividends on preferred Investors need to bear in mind that the million worth of common stock and to instruments issued by banks and other 20% limit is measured off of the number of backstop a rights offering of an additional financial institutions to date have more shares outstanding prior to the new $500 million in return for warrants. often than not been non-cumulative. The investment, and hence the limit on a pro Similarly, J.C. Flowers’s investment in MF belief that a bank will totally eliminate forma basis is only 16 2/3%. Global involved the purchase of $150 dividends on its common stock only as a The foregoing threshold is significantly last resort has often been sufficient to million worth of convertible preferred CONTINUED ON PAGE 31 page 30 l Debevoise & Plimpton Private Equity Report l Winter 2009 Everything Old Is New Again: PIPEs Go Up-Market (cont. from page 30) reduced if the PIPE investor is already a approval is delayed or ultimately not contractual consents can cause a delay “substantial security holder,” in which case forthcoming. These include increasing the between the signing of the PIPE any issuance greater than 1% (or, if the sale dividend rate and/or decreasing the commitment and closing. Where the is for cash and the price is at least the greater conversion price of the preferred shares, financing is needed to avoid a credit of the stock’s book and market value, 5%) decreasing the exercise price of issued downgrade or other adverse business requires shareholder approval. While private warrants, triggering a cash payment consequences, it is obviously important to equity firms usually will not have an existing obligation from the issuer to the investor the issuer to limit the risk that closing equity interest in the PIPE issuer, this and providing the holders of the preferred would not occur. As a result, some restriction could still apply to their stock with special consent rights to distressed issuers may be able to avoid a transactions if a coinvesting institutional significant transactions. In some “material adverse change” condition or need buyer is a substantial security holder. Issuers transactions, if approval is never obtained to bring down representations, although it and investors must also consider whether the and the preferred security cannot be is almost always the case that funding transaction would result in a “change of converted into common shares, the security would continue to be conditioned on the control,” which triggers the requirement for can become mandatorily redeemable at a accuracy of the representations as of the shareholder approval under the NYSE listing price that provides the investor the same date they were originally made. rules even if the foregoing objective return it would have had if it had converted On the other hand, where the size of the thresholds are not exceeded. into common shares and sold those shares PIPE investment is sufficiently large that In addition to the potential need to at the prevailing market price on the date of the investor may be deemed to be in obtain shareholder approval, investments in redemption. control of the issuer, the parties have to many types of financial institutions require At the same time, the parties must take consider whether the issuer needs to have a prior regulatory approval at even lower care to ensure that the economic fiduciary out. For example, in the case of investment thresholds. For example, in consequences of the failure to obtain Thomas H. Lee Partners’ and Goldman most states an investment of more than shareholder approval are not deemed to be Sachs’s investment in Moneygram, which 10% of the voting stock of an insurance coercive of the shareholder vote. There is ultimately represented approximately 79% company requires prior approval, as does an little interpretive guidance regarding what of the company’s voting power, Moneygram investment of more than 10% in an entity the exchanges will view as coercive or was granted a one-month “go-shop” period regulated by the UK Financial Services impermissible. However, so long as the during which it was free to actively solicit Authority. revised terms of the security are no more alternative transaction proposals and given The need for such approvals is often in favorable to the holder than the market the right to terminate the original trans- conflict with the issuer’s desire to obtain price of a deeply subordinated non- action, in exchange for a 2% termination funding quickly and unconditionally. convertible instrument, the risk that the fee, if a superior deal was struck. While it is possible to seek from the terms would be found to be coercive should Although the Moneygram PIPE is applicable exchange an exemption from the be limited, particularly if the need for notable for its majority equity stake, shareholder approval requirement on funding is real and the issuer has no better compressed timeline and the pre-signing grounds of financial distress, that is a step alternatives available to it. In addition, exclusivity arrangement with THL and that—at least until recently—most issuers issuers often review transactions with the Goldman, it is not sui generis. It is often have been highly reluctant to take. Instead, appropriate division of the applicable the case that PIPE issuers have no ability to the conflict is often addressed by structuring exchange prior to signing, and investors shop the deal prior to signing because of the the investment as a preferred stock that typically require that the closing is urgency of their capital needs and, if the becomes convertible only once the requisite conditioned upon the issuer having been equity stake is sufficiently high, the issuer regulatory and shareholder approvals are advised by the applicable exchange that the might still require a fiduciary out to fulfill obtained. underlying shares of common will be listed. its Revlon duties. A number of PIPE The parties to such transaction have Closing Conditions transactions for significant minority stakes agreed to a variety of mechanisms designed have included fiduciary outs. For example, Even where it is possible to structure both to incentivize the issuer (and its in One Equity Partners’ investment for around regulatory or shareholder approvals, shareholders) to obtain the approval and to the need to obtain antitrust clearance or CONTINUED ON PAGE 32 protect the investor in the event that the
Debevoise & Plimpton Private Equity Report l Winter 2009 l page 31 Everything Old Is New Again: PIPEs Go Up-Market (cont. from page 31) approximately 34% of X-Rite’s common $5.00. Upon a change of control, Corsair provisions will make issuers more reluctant to stock, X-Rite was prohibited from actively was entitled (1) to receive additional NCC raise additional equity in circumstances soliciting transaction proposals but could common stock valued at an amount equal where the protection would be triggered entertain unsolicited proposals and, subject to the percentage difference between $5.00 Governance to the payment of a 3% fee, terminate its and the greater of $2.50 or the implied PIPE transactions are typically structured as agreement with One Equity in favor of a issue price multiplied by the aggregate minority investments and the investor does superior deal. purchase price paid for the convertible not get nearly the same degree of control preferred (and any shares of common stock Price Protection that a private equity sponsor is accustomed purchased via exercise of the warrant), Perhaps the most heavily negotiated issue in to receiving in a leveraged buy-out transaction. grossed-up to compensate it for any recent large PIPE transactions has been the Nevertheless, as the size of PIPE transactions diminution in value resulting from such extent to which the investor will be has grown in recent years, so to has the lead payment and (2) to cause NCC to purchase protected if the target company issues new investor’s governance rights. its warrant, in cash or common stock at the capital on more favorable terms following In most cases, an equity stake of around election of NCC, for the higher of its fair the closing of the investment. In 2008, 10% is required to gain the right to market value or its option value using a PIPE investors were quite successful in designate board members. Above 10%, the Black-Scholes methodology. If Corsair achieving such protection, generally lasting number of designees depends upon the chose not to exercise its put right with for up to 2 years following closing. specifics of each transaction, the envisioned respect to the warrant, the exercise price of Price protection typically covers relationship between the investor and the the warrant would be reduced to the issuances of common stock or common- issuer and in many cases regulatory implied issue price in the change of control, linked securities for an implied price per considerations. For example, Leonard subject to the $2.50 floor. common share less than granted to the Green’s 17% stake in Whole Foods garnered Less than six months after Corsair’s investor. Aside from being time limited, the right to designate two directors to investment, NCC was sold to PNC protection against offending issuances is Whole Foods’ ten member board; while for Financial Services Group in a stock-for- sometimes subject to a minimum threshold a 19% stake in BPF, Carlyle received the stock deal having a conversion price that (for example, $300 million in the case of right to designate only one director to BPF’s valued the NCC common at $2.23 per National City Corporation) and often 13 member board. The PIPE investor’s share. Without the price protection, the excludes certain anticipated issuances (for right to continue to designate representatives sale would have resulted in Corsair owning example, pursuant to compensation plans to the issuer’s board following the initial approximately $350 million worth of PNC or concurrent offerings/placements prior to issuance is typically contingent upon the size common stock, plus warrants to purchase closing). In addition to new share issuances, of its ownership stake, measured as a approximately 1.5 million shares of PNC price protection has been applied to change percentage of the outstanding equity or as a common at a substantial premium. With of control transactions and liquidations percentage of the initial purchase. The the price protection, though, Corsair where the implied value of the common committee membership of board designees received approximately $740 million worth stock falls below the price granted to the is also subject to negotiation. Typically, of PNC common shares plus $240 million investors. where the investor has the right to designate in cash in exchange for its warrant. The potential benefit of such provisions one representative, the representative is On the other hand, regulators and ratings was made clear in the case of Corsair’s afforded the right to sit on a specified agencies have become increasingly skeptical investment in National City Corporation. committee and granted observer rights for of price protection covenants. In a number There, Corsair invested $785 million in a other committees. As the number of of instances, the Federal Reserve has required NCC convertible preferred instrument investor designees increases, investor modifications to price protection covenants having a conversion price of $5.00 and designees are typically afforded proportional in order to allow bank issuers to treat the received warrants exercisable to purchase representation on all committees, subject to investment as Tier 1 capital, and rating 39,250,000 additional shares of common at applicable legal and governance agencies often give the issuer a lower level of an exercise price of $7.10. Corsair’s requirements. equity credit for investments that are investment was protected against change of Although terms of the convertible accompanied by strong price protections. control transactions where the implied value The concern in each case is that these CONTINUED ON PAGE 33 of NCC’s common stock was less than page 32 l Debevoise & Plimpton Private Equity Report l Winter 2009 Everything Old Is New Again: PIPEs Go Up-Market (cont. from page 32) preferred stock used in a PIPE transaction cap could also be tied to regulatory “control” be treated as interest income that is tax will typically provide class voting rights on thresholds. Most standstills also restrict a exempt to both non-U.S. partners and tax- limited matters, investors do not typically standard slate of other actions by the exempt partners but subject to a 35% tax have contractual veto or consent rights. investor, including proposals for rate in the hands of a U.S. individual (such Nonetheless, depending on the leverage of fundamental transactions, solicitation of as the individuals receiving the carried the parties and the size of the equity stake proxies or attempts to influence or control interest). By contrast, if a PIPE is structured involved, it may be possible for investors to management (other than through its as preferred stock, the coupon will typically gain veto rights over certain actions. For director designees). be treated as a dividend that is tax-free to example, in One Equity Partners’ investment Given their longer-term investment any tax-exempt partners, subject to a 30% for approximately 34% of X-Rite’s common horizon, private equity sponsors often trade withholding tax in the case of most non- stock, aside from board and committee liquidity for increased governance rights and U.S. partners and eligible for the 15% tax rights proportionate to its equity ownership, better terms. Most, if not all, PIPE rate in the hands of a U.S. individual. One Equity also negotiated for prior transactions involving private equity Similarly, in many cases the coupon will approval rights over (1) acquisitions investors are structured as issuances of accumulate, or PIK, rather than be paid in exceeding a specified aggregate amount, unregistered securities with trailing cash. If the PIPE is structured as debt, the (2) issuances of new shares, (3) entrance into registration rights. A separate registration PIK interest will give rise to current income new lines of business, (4) incurrence of debt rights agreement typically requires the issuer to the fund (and, in particular, any U.S. over specified levels, (5) transactions with to meet a specified timetable for an effective individual partners). By contrast, if the executive officers, directors or substantial shelf registration and grants the investor PIPE is structured as a preferred stock, it is security holders, and (6) increases to the size additional, but limited, demand and piggy- usually possible to structure the terms of the of X-Rite’s board. back registration rights. In addition to this preferred so that any PIK dividends are not Standstill and Transfer structural limitation, PIPEs involving private currently taxable. Restrictions equity investors typically prescribe additional * * * transfer restrictions. These transfer As debt financing markets continue to As PIPE investors have sought greater equity restrictions generally include a lock-up experience turmoil and public companies stakes in the issuer, standstill provisions period (typically 1 to 3 years, averaging 18 remain in need of fresh capital, we expect restricting additional share accumulations months) during which no issued shares can private equity firms to be presented with a and “hostile” actions by the investor have be transferred other than to specified wealth of PIPE investment opportunities in become routine. The standstill period permitted transferees, generally including 2009. While that availability coupled with typically terminates when the investor owns affiliates, limited partners or shareholders. the scarcity of more traditional investment less than a specified percentage (usually 5%) After the lock-up period, transfers generally opportunities may make PIPE transactions of the outstanding common stock or voting continue to be subject to distribution appear increasingly attractive to a wide range power of the issuer. In some transactions, limitations, such as caps on the amount of private equity firms, the success of such including MF Global and Boston Private transferred in any single transaction or over investments will require both financial Financial, the duration of the standstill specified intervals, and the investor often discipline and a high level of attention to period was also subject to a fixed time limit, continues to be subject to limitations on contractual terms. As was demonstrated by such as 3-5 years after the investment date. transfers to competitors of the issuer or several high-profile transactions in 2008, The standstill would also typically terminate persons who already hold (or in some case particularly given volatile markets and upon certain extraordinary occurrences (e.g., who would hold following the transfer) uncertain capital requirements, the strength board approval of a change of control more than a specified percentage of the of the investor’s contractual protections can transaction, board recommendation of a issuer’s common stock. be the difference between a successful tender offer or exchange offer or a significant investment and a failure that is both quick change to the composition of the issuer’s Tax Issues and public. board). All standstill provisions cap the The form of a PIPE transaction can have a investor’s acquisitions at some level above material impact on the after-tax returns of Gregory V. Gooding the percentage ownership upon the closing the partners of the private equity fund [email protected] of the PIPE transaction. In transactions holding the investment. For example, if a Jeremy Rossman involving financial institution issuers, the PIPE is structured as debt, the coupon will [email protected]
Debevoise & Plimpton Private Equity Report l Winter 2009 l page 33 Deconstructing Equal and Ratable Security Clauses (cont. from page 20) the negative pledgee more power than is creditor will be limited in scope to fit Several examples of collateral trust necessary to satisfy the strictures of the within the “permitted liens” basket provided agreements are available publicly, including negative pledge clause. in the indenture—or, where the scope of those for the Allied Waste transaction, the the negative pledge is limited to “principal subject of an SEC exemption order, and Releases of Collateral properties,” to assets other than the Solutia Inc., where the collateral trust In equal and ratable security transactions, “principal properties.” arrangement figured in bankruptcy decisions regarding the release of collateral In such situations, in addition to careful litigation. Those examples and others show are generally left in the hands of the bank crafting of the collateral package, parties will how in practice the variety of issues agent. The fact that the language of many frequently adopt express “savings language” encompassed by the requirement to grant indentures requires the grant of an equal in the agreements that create the new an “equal and ratable” security interest have and ratable pledge only “for so long as” the security interests. The savings language been addressed. A review of available triggering debt is secured supports this says, in essence, that to the extent that the collateral trust agreements shows that while allocation of power. A more fundamental liens granted by the new security agreement a broad consensus supports the concern that counsel frequently address is would give rise to an obligation to grant an understanding that “equal and ratable” whether or not the bank agent can “equal and ratable” security interest under requires a pledge of equal legal rank over unilaterally release an interest in collateral at the bond indenture, the grant of the the same pool of collateral, with pro rata a time when the bondholders’ debt is in security interest is limited so that it does not distribution of proceeds after default and default. Faced with this question, many do so. The existence of such savings enforcement, there is more disparity with conclude that collateral cannot be uni- language gives legal comfort to the parties respect to the control rights granted to the laterally released without creditor consent that the new arrangements do not violate beneficiaries of equal and ratable pledges. when a “triggering event” has occurred— the relevant bond indenture. At the same Collateral trust agreements also contain either an acceleration of the bond debt or a time, the new creditor will need to assure evidence of the lack of certainty regarding bankruptcy event. Whether or not such a itself that the savings clause does not the meaning of “equal and ratable.” The triggering event had in fact occurred at the materially impair its expected security agreements frequently use the phrase “equal time of the release of collateral by the bank package. and ratable” to describe the nature of the agent was a central issue in the Solutia Where the grant of an equal and ratable security interest and the manner of bankruptcy case last year. security interest cannot be avoided, the application of proceeds. Many contain The form of creditor consent to a release market has adopted a common solution to express affirmations that the agreement of collateral following the occurrence of a the implementation of an “equal and effectuates an “equal and ratable” pledge— triggering event can take different forms as ratable” security package—the collateral with the expectation that the repetition of well. Some believe that creditor consent trust. In a collateral trust agreement, a that mantra will make it so. requires a majority vote of all secured single trustee acts on behalf of all of the In the absence of clear legal precedent creditors—bondholders and bank lenders secured parties—new bank creditors and explaining what “equal and ratable” means, voting together in a single pool. Others existing bondholders. A security interest is the market seems to have generally accepted believe that following the occurrence of a granted in the borrower’s assets for the the collateral trust and similar structures as triggering event, the representative of each benefit of all secured creditors. The ways to address the various potentially category of secured debt—the bank agent collateral trust agreement and the related ambiguous interpretations. The absence of and the noteholder trustee—must each security documents contain explicit rules case law challenging the transactions in consent to the release. regarding the nature of the assets pledged, which such structures have been used and Structuring in the Context of the distribution of the proceeds and control the acceptance by indenture trustees of such an Equal and Ratable Clause over dispositions and releases. Some arrangements is the best vote of approval Parties faced with an equal and ratable transactions implement an equivalent available. clause have a huge incentive to structure a structure more simply through the bank Gregory H. Woods III transaction so that the clause is not security agreements—with the collateral [email protected] triggered. As an initial matter, if possible, agent, rather than a collateral trustee, as the any liens granted to the new secured beneficiary of the pledge. page 34 l Debevoise & Plimpton Private Equity Report l Winter 2009 Emerging Markets Shine in a Difficult Year (cont. from page 12) The majority of fund agreements in the early stages of development. In fact, particularly if the investor is interested in both emerging and developed markets many funds that have come to the participating in co-investment opportunities include a clawback provision that requires market in recent years are “first time or developing an active direct investment the carried interest recipient to return any funds.” Firms sponsoring first time program in the market. excess carried interest it has received. funds often rely on a somewhat higher Terms: Co-Investment Rights However, if an emerging markets fund management fee to pay start-up costs Access to co-investment opportunities has sponsor has distributed carried interest to and ongoing business expenses, become a highly negotiated term in private individual team members, it may be time including salaries and rent. equity funds across all markets in recent consuming and costly to seek the return of Terms: Oversight years. Half of the investors surveyed by these distributions, particularly if the and Transparency EMPEA last year have negotiated co- individual team members are located in one Despite the recent growth in the industry, investment rights with fund sponsors, and or more developing jurisdictions where investors remain sensitive to investment many of these investors reported that obtaining a judicial remedy may be risks traditionally associated with emerging securing co-investment rights is an difficult. As a result, investors often markets private equity, including concerns important factor in their decision to consider a clawback provision to be a less related to the quality and transparency of commit to a fund. As noted above, some effective form of protection for funds in emerging markets’ legal regimes and investors participate in emerging markets emerging markets than it is for more business practices. Many investors share a funds as part of a plan to expand their traditional funds. concern that these risks mean that overall investment activity in a region, either Terms: Management Fee investments in less developed markets are by becoming active direct investors or in According to a survey of limited partners more likely to cause violations of laws, some instances sponsoring their own fund conducted by EMPEA in 2008, regulations, policies or guidelines applicable products. Co-investments present investors management fees in emerging markets to an investor. Investors based in the with the opportunity to learn about direct averaged 1.95% per annum as compared to United States, for example, focus on the investment in an emerging market without 1.80% per annum for developed markets. measures fund sponsors take to prevent requiring the investors to have the capacity This higher percentage is likely the result of violations of anti-money laundering rules to conduct full-scale due diligence of the a number of factors, including the relative and anti-bribery regulations such as the target. In this way, co-investment rights size and vintage of the average emerging U.S. Foreign Corrupt Practices Act. dovetail with the rights to information markets fund as compared to the average Attention to risk management and discussed above in enabling investors to developed markets fund: internal policy guidelines causes many continue to learn about the private equity investors to request rights to receive more industry in a specific region. Emerging markets funds are generally detailed information about emerging smaller than their western counterparts. * * * markets funds and their investments than a Funds with aggregate commitments in While the repercussions of the current fund sponsor investing in developed markets excess of $1 billion are still rare, and dislocations in the global markets for would ordinarily be requested to provide. investors almost always seek tighter emerging markets private equity remain to Additionally, investors in many emerging limits on emerging markets funds’ be seen, it will be difficult in light of markets funds seek enhanced rights to maximum commitments. Investors increased financial and political risk to monitor the activity of the sponsor as a generally request lower management fee sustain the recent pattern of growth in means of continuing their due diligence on percentages as the size of a fund 2009. Nevertheless, it seems likely that the fund and the specific market. For increases, based on the argument that increasing numbers of institutional investors example, many emerging markets funds the purpose of the management fee is to will include emerging markets assets in their have larger and more active advisory enable the fund sponsor to pay the costs portfolios and that sponsors of private committees with rights that check the of managing and operating the fund, equity funds investing in these regions will authority of the sponsor than would be true and not to be a source of profit in need to continue to work closely with this of a developed markets fund. An investor addition to the sponsor’s carried interest. expanding investor base. may also seek advisory committee (or, in Unlike their counterparts in developed certain circumstances, investment Geoffrey Kittredge markets that receive management fees committee) representation to bolster their [email protected] from multiple funds, in many cases familiarity with how business is conducted Gerard C. Saviola across a range of products, many private and deals are done in a particular market, [email protected] equity firms in emerging markets are in
Debevoise & Plimpton Private Equity Report l Winter 2009 l page 35 Bridging the Gap (cont. from page 16) expectations and avoid unintended Sellers may tolerate payment limitations for a to preferred stock with a special dividend rate consequences is to set a cap and perhaps a period of time, especially where there is an and perhaps mandatory redemption floor on the earnout payments. attractive interest rate, but they may require provisions. Where a seller’s equity stake in that the buyer or the acquired company the acquired company is substantial (at least Other Types of Retained agree to substitute alternate financing for the 10-15%), a seller may obtain governance Seller Interests in an Acquired seller paper at a specified future date or press rights such as one or more board seats or Company for the inclusion of other mandatory veto rights with respect to extraordinary In light of the constraints in today’s credit redemption rights (e.g., upon a change of transactions. markets, even if a seller and buyer agree on control). Sellers who anticipate that a private When rollover equity takes the form of the valuation of the target company, a buyer equity buyer will resell the acquired company buyer’s stock, tax structuring often becomes may not be able to raise sufficient funds to during the term of the seller paper or take crucial. Unless the transaction qualifies for pay that amount using traditional debt the company public may request the right to tax-free reorganization treatment, the sellers financing. In such event, sellers may be able be prepaid or convert the loan into company generally will be subject to tax on the shares to address the issue either by accepting a note stock at that time. A buyer may want the they receive even though these shares may be issued by the buyer as partial consideration right to convert the loan into company stock illiquid or subject to transfer restrictions, and or by retaining a minority equity interest in if it is not able to arrange for substitute taxable gain triggered by the receipt of such the acquired company. Like an earnout, the financing within a required time period. consideration would not be eligible for use of seller paper or rollover equity also Sellers may seek the ability to freely transfer deferral under the installment method. The keeps sellers “invested” in the acquired the loan to a third party in order to convert sellers may insist on a structure that qualifies company, which can be particularly desirable it into cash, but a buyer should resist, par- for tax-free treatment, but this may run for a private equity buyer that will rely on ticularly if seller is also requesting registration counter to the buyer’s tax objectives (e.g., the management sellers to run the business post- rights or if the buyer wishes to offset indem- desire to obtain a step-up in basis). If tax- closing. nity claims against payments on the note. free treatment is not available, tensions may Seller Financing Depending on the structure of the arise when the parties attempt to agree on a A “seller note,” i.e., a note issued by the transaction and the characteristics of the value for the buyer’s stock for tax reporting buyer to the seller, will typically bear interest, seller note, this form of consideration may purposes, which is desirable to ensure that payable in cash or in kind, at a rate similar to also provide a seller with installment method each side reports the transaction consistently. that of a bridge loan or a high yield security. treatment for tax purposes and thus the Sellers may push for a low valuation, but that Periodic principal payments are not usually advantage of deferring gain with respect to may not be attractive to the buyer for a made, but instead are due at maturity (a so- the portion of the purchase price represented variety of reasons, including because the called “bullet” payment). by the note, subject to certain applicable tax buyer has used or plans to use its stock as Seller paper that stretches the purchase limitations. currency in other transactions or to price is often unsecured and deeply compensate management. Rollover Equity subordinated to other indebtedness of the * * * Instead of seller paper, the parties may prefer acquired company, including any third-party In today’s challenging deal market, finding to use target company stock (or the stock of acquisition financing. Payments on the note alternatives to easy financing and crisp an upper level holding company) as part of will usually be tightly restricted, with debt valuations has never been more important. the consideration. This structure could be service permitted only for so long as there is Through the creative, careful and preferable to a private equity buyer if it wants no default under the senior debt. While constructive use of tools such as earnouts, to reduce overall target company such terms are found in most seller seller financing and rollover equity, deal indebtedness. However, a seller should be financings, in certain circumstances (e.g., if makers should be able to navigate the aware that the equity interests likely will be seller paper represents a significant portion of complications inherent in using these subject to significant transfer restrictions the purchase price), the debt may more techniques and still get deals done. generally limiting its ability to sell the shares closely resemble third-party financing and to a third party other than in connection Kevin A. Rinker sellers may have additional rights, such as free with a sale by the private equity buyer or [email protected] transferability (to provide liquidity), after an IPO. restrictive covenants and cross-acceleration Meir D. Katz Rollover equity can take different forms, and/or cross-default tied to the senior debt. [email protected] ranging from common stock with few rights page 36 l Debevoise & Plimpton Private Equity Report l Winter 2009