Private equity in United States: market and regulatory overview

A Q&A guide to private equity law in the United States.

The Q&A gives a high level overview of the key practical issues including the level of activity and recent trends in the market; investment incentives for institutional and private investors; the mechanics involved in establishing a private equity fund; equity and debt finance issues in a private equity transaction; issues surrounding buyouts and the relationship between the portfolio company's managers and the private equity funds; management incentives; and exit routes from investments. Details on national private equity and venture capital associations are also included.

To compare answers across multiple jurisdictions visit the Private Equity Country Q&A Tool.

This Q&A is part of the Practical Law multi-jurisdictional guide to private equity. For a full list of jurisdictional Q&As visit

Larry Jordan Rowe and Debra K Lussier, Ropes & Gray LLP

Market overview

1. How do private equity funds typically obtain their funding?

The primary sources of funding for private equity funds in the US are:

  • Public pension funds.

  • Endowments/foundations.

  • Funds of funds.

  • Corporate pension funds.

  • Banks and other financial institutions.

  • Insurance companies.

  • Family offices.

  • High net-worth individuals.

  • Sovereign wealth funds.

As of April 2011, the largest investors were (Dow Jones, Private Equity Analyst, Sources of Capital, April 2011):

  • Public, corporate, and union pension funds, accounting for about 33.6% of total capital. Public pension funds remained the largest single type of investor, providing about 24.8% of total capital commitments.

  • Sovereign wealth funds, with dramatically increased commitments from 3.7% of total capital commitments in 2009 to 11.5% in 2010.

  • Funds of funds, providing about 8.8% of total capital commitments, a decrease from 2009, where fund of funds accounted for 11.5% of total capital commitments.

  • Endowments and foundations, providing about 8.6% of total capital commitments.

2. What are the current major trends in the private equity market?

Private equity fundraising continues to be difficult for sponsors, although sponsors raising larger funds had some success in 2012, which pushed the amount of capital raised to US$113 billion, a 13% increase over 2011 (Pitchbook IH 2013 Private Equity Fundraising and Capital Overhand Report).

Prospective investors, buttressed by the Institutional Limited Partners Association's Private Equity Principles (ILPA Principles), which were released in 2011 and gave a collective voice to the demands of investors, continue to scrutinise the terms in private equity partnership agreements, including requiring:

  • Tighter distribution provisions.

  • Stronger clawbacks.

  • Greater reductions in fees payable by investors if outside fees are collected by the general partner or its affiliates.

  • More transparency through reporting.

Deal making did not live up to expectations and declined by 14% in 2012. In the near term, the downward trend may continue, as deals that would otherwise have closed in the first quarter of 2013 were rushed to completion in the fourth quarter of 2012 to avoid the risk of higher taxes. However, with 2007 and 2008 vintage funds sitting on more than US$100 billion, and five year investment periods coming to an end, private equity sponsors would be expected to begin to deploy this massive amount of capital soon and for deal activity to increase (Pitchbook 2013 Annual Private Equity Breakdown, Pitchbook IH 2013 Private Equity Fundraising and Capital Overhand Report).

3. What has been the level of private equity activity in recent years?


The fundraising environment continues to be difficult for private equity sponsors, particularly for managers trying to raise a relatively small amount of capital. Only 15 funds with commitments of US$100 million or less were raised in 2012, a 48% decrease from 2011. In contrast, four funds with commitments of US$5 billion or more were raised in 2012; only one mega fund was raised in each of 2010 and 2011. The four mega funds represented 26% of all capital raised in 2012. (Pitchbook 2013 Annual Private Equity Breakdown).

Overall, 112 private equity funds closed on about US$113 billion in capital in 2012, a 13% increase in fundraising from 2011 (Pitchbook IH 2013 Private Equity Fundraising and Capital Overhand Report).

The number of new hedge funds declined sharply in 2012. 572 new hedge funds were formed in 2012, an almost 25% drop from 2011 (Preqin).


Investment activity of private equity funds, both in terms of amount invested and deal flow, decreased significantly in 2012 following two consecutive years of growth. US$313 billion of capital was put to work in 2012, down from US$359 billion in 2011. 1,807 deals closed in 2012, a 14% decrease from 2011 (Pitchbook 2013 Annual Private Equity Breakdown).


Private equity deal making declined by 14% in 2012, despite an optimistic view by many that the amount of pent up capital and easier access to debt financing would sustain the upward trend from 2010, when 1,985 deals closed, and 2011, when 2,106 deals closed.

Even the much-anticipated December investment frenzy fell short of expectations, and only 451 deals closed in the fourth quarter of 2012, down from 529 in the fourth quarter of 2011 and 618 in the fourth quarter of 2011.

However large deals, those valued at US$1 billion or more, were abundant in the fourth quarter. 19 such deals closed, which contributed to the second highest quarter for invested capital (US$102 billion) in the last four years (Pitchbook 2013 Annual Private Equity Breakdown, Pitchbook IH 2013 Private Equity Fundraising and Capital Overhand Report).


Exit activity was robust in 2012 with private equity firms realising 587 investments, an increase from 513 in 2011 and 479 in 2010. 172 exits were made in the fourth quarter, as a record-breaking US$53 billion in capital was disposed of by private equity firms concerned with the threat of looming tax hikes in 2013. Records were also set in terms of dispositions of investments of US$1 billion or more, as 43 large exits were executed (Pitchbook 2013 Annual Private Equity Breakdown).



4. Are there any proposals for regulatory or other reforms affecting private equity in your jurisdiction?

Changes in general solicitation prohibition

The Jumpstart Our Business Startups Act enacted on 5 April 2012 (JOBS Act) directed the Securities and Exchange Commission (SEC) to amend Rule 506 of Regulation D (Rule 506), promulgated under Section 4(a)(2) (previously Section 4(2)) of the Securities Act of 1933, as amended (Securities Act). This amendment proposes to allow issuers to engage in "general solicitation" and "general advertising" in offerings made under Rule 506, so long as all buyers of the securities in such offerings are accredited investors.

On 29 August 2012, at the conclusion of an unusually contentious open meeting, the SEC proposed an amendment to Rule 506 to implement these provisions of the JOBS Act. If adopted as proposed, the amendment will provide certain hedge funds, and private equity funds, with substantially more freedom in marketing fund interests. However, significant questions remain regarding what steps fund sponsors may be required to take under the new Rule 506(c) to verify:

  • That investors in Rule 506(c) offerings are "accredited investors".

  • The status of Regulation S offshore offerings, where issuers have engaged in general advertising or general solicitation in connection with a simultaneous Regulation D offering.

  • The extent to which Commodity Futures Trading Commission (CFTC) regulations may continue to constrain the ability of private fund sponsors to engage in general advertising and general solicitation.

Rule 506(c) was issued as a proposed rule, and not an interim final temporary rule. As a result, existing restrictions on general solicitation and general advertising continue to apply to private fund offerings in the US, pending adoption of the final rule.

Increase in equity holder threshold for public reporting

The JOBS Act also increased the equity holder threshold for companies required to register under the Securities Exchange Act of 1934 (Exchange Act). Under the prior framework, a company (including a private fund) that has at least 500 shareholders of record and more than US$10 million in assets must register under section 12(g)(1)(A) of the Exchange Act. Once a company has registered under Section 12(g), all of the public company reporting requirements under the Exchange Act apply, including the need to file annual, quarterly, and current reports, proxy statements, and certain transaction reports.

The JOBS Act amended Section 12(g)(1)(A) of the Exchange Act, to require an issuer to register its securities with the SEC when it has total assets exceeding US$10 million and a class of equity security that is held of record by either:

  • 2,000 persons in total.

  • 500 persons who are not accredited investors.

This change is helpful to sponsors of private funds, and particularly sponsors of funds that target high net worth individuals (such as funds of funds), because it allows them to organise funds with up to 2,000 accredited investors.

Change to accredited investor definition

On 29 December 2011, the SEC adopted final rules implementing changes to the definition of accredited investor. As set out in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), the definition of accredited investor continues to provide for a net worth threshold for natural persons of US$1 million. However, for the purposes of this threshold, the net worth calculation excludes the person's primary residence.

Change to qualified client definition

Private equity fund managers registered with the SEC are generally prohibited from charging performance and incentive fees/allocations, under section 205(a)(1) of the Investment Advisers Act of 1940 (Advisers Act). However, an exemption in Rule 205-3 permits the charging of such fees/allocations to an investor if the investor is a qualified client.

In 2012, the SEC issued an order to raise the thresholds qualified clients must meet in connection with the charging of performance and incentive fees/allocations. Under the previous rules, a qualified client included:

  • A natural person who or a company that has at least US$750,000 under the management of an investment adviser, immediately after entering into an advisory contract with the investment adviser.

  • A natural person who or a company that the investment adviser reasonably believes has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than US$1.5 million, at the time an advisory contract with the investment adviser is consummated.

Under the SEC's order, the US$750,000 and US$1.5 million dollar amounts have been increased to US$1 million and US$2 million, respectively.

Recission by CFTC of certain registration exemptions

Prior to the Dodd-Frank Act, commodity interests included futures contracts, options on futures contracts, and options on commodities. As a result, most private equity firms did not need to concern themselves with commodity laws.

However, the Dodd-Frank Act added the term swap to the existing list of commodity interests, which is a broadly defined concept that includes most over-the-counter derivatives contracts. As a result, if a private equity fund trades even one commodity interest contract or holds itself out as being able to do so, the sponsor of the fund will be deemed a commodity pool operator (CPO), and the adviser to the fund will be deemed a commodity trading advisor (CTA). Without an exemption, any CPO or CTA must register as such and become a member of the National Futures Association (NFA).

On 9 February 2012, the CFTC adopted a final rule rescinding an exemption relied on by many private equity sponsors; the exemption for private funds whose investors are qualified purchasers or entities that are accredited investors (Rule 4.13(a)(4)). Private funds operating under the Rule 4.13(a)(4) exemption had until 31 December 2012 to comply with CFTC rules without relying on Rule 4.13(a)(4).

Many private equity sponsors that had previously relied on Rule 4.13(a)(4) applied for exemption under Rule 4.13(a)(3). The CFTC determined to maintain the Rule 4.13(a)(3) exemption, which it had also proposed to rescind, for funds which trade only a de minimis level of commodity interests, and which are not marketed as vehicles for trading in commodity interests. However, the CFTC did revise the exemption to take into account swaps trading in the de minimis threshold calculations.

Under the Rule 4.13(a)(3) exemption, a fund must keep its trading below a 5% threshold level, or keep the net notional value of its derivatives trading from exceeding 100% of the liquidation value of the fund's portfolio.

Clearing of swaps

On 28 November 2012, the CFTC issued final rules that require certain interest rate swaps and credit default index swaps to be cleared. This is the first mandatory clearing determination by the CFTC under the Dodd-Frank Act. Compliance with the rules will be phased in beginning 11 March 2013, and continue through the third quarter of 2013. The rules require market participants, including private funds, to submit a swap that must be cleared to a derivatives clearing organisation as soon as technologically practicable, and no later than the end of the day of execution. The following types of swaps will be subject to the clearing requirement:

  • Fixed-to-floating interest rate swaps, basis swaps, and forward rate agreements in US dollars, Euro, Pounds Sterling or Japanese Yen, and overnight index swaps in US dollars, Euro and Pounds Sterling.

  • Untranched credit default swaps on certain North American indices (CDX.NA.IG and CDX.NA.HY) and European indices (iTraxx Europe, iTraxx Europe Crossover, and iTraxx Europe HiVol).

Implementation of FATCA

On 8 February 2012, the Internal Revenue Service (IRS) and Treasury Department released long-awaited proposed regulations on a set of statutory rules commonly referred to as the Foreign Account Tax Compliance Act rules (FATCA). The FATCA rules were first introduced in 2009 and officially added to the Internal Revenue Code of 1986 by the Hiring Incentives to Restore Employment Act of 2010 on 18 March 2010.

FATCA establishes a new information reporting regime to identify US persons holding assets through offshore entities and overseas accounts. Non-compliance with FATCA generally leads to a 30% withholding tax on most US source income and, potentially, on all or a portion of non-US source income.

The specific application of the FATCA rules to private equity funds and hedge funds will depend on the structure of a given fund group. Under FATCA, foreign financial institutions, which include non-US private funds, and US withholding agents, including US private funds, will be required to withhold 30% on withholdable payments to entities and accounts that do not meet FATCA's requirements. Withholding is expected to be phased in beginning 1 January 2014.

Final regulations under FATCA are expected to be released by the end of the year.

Delay in Volcker Rule

In 2011, the federal banking agencies and the SEC proposed regulations to implement the Volcker Rule. Subject to certain exceptions, the Volcker Rule will prohibit a banking entity from acquiring or retaining any equity, partnership or other ownership interest in, or otherwise sponsoring or investing in any private fund, which would include most hedge funds or private equity funds. The Volcker Rule will have an impact on most private fund investments made and interests held in these funds by banking entities.

The Volcker Rule will permit banking entities to establish and invest in private funds in certain limited circumstances, unless such investments would do any of the following:

  • Involve or create a material conflict of interest between the banking entity and its customers, clients or counterparties.

  • Create a material exposure by the banking entity to high-risk assets or strategies.

  • Pose a threat to the safety and soundness of the financial stability of the US. The most notable exceptions are:

    • De minimis exception for investments in bank-sponsored funds.

    • Foreign fund exception. By taking advantage of a foreign fund exception, foreign banking entities may be able to sponsor private funds outside the US and make investments in private funds organised outside of the US, so long as the fund interests are only offered and sold outside the US.

    • Sponsored fund exception. Banking entities will be permitted to organise a private fund, with no more than a de minimis investment, and offer it only to the banking entity's clients who use its investment services.

The Volcker Rule was expected to be brought into effect in 2012. However, it now appears that it will become effective sometime during the early part of 2013. The reprieve will allow private fund sponsors and banking entities to continue to review vintage private fund investments for compliance, as well as more recent investments and commitments made since the passage of the Dodd-Frank Act. Generally, each entity subject to the Volcker Rule is given two years to comply once it becomes effective. The final rule also implements the three one-year extensions to the compliance period permitted under the Volcker Rule.

Form PF

In 2012, sponsors were required for the first time to file Form PF. Form PF requires advisers to report the concentration of a fund's beneficial owners by type of investor. Reporting this information may require advisers to collect additional data about a fund's investors, in order to classify each investor as a member of a specified group. These groups include:

  • Individuals that are US persons (including their trusts).

  • Individuals that are not US persons (including their trusts).

  • Broker-dealers.

  • Insurance companies.

  • Investment companies registered with the SEC.

  • Private funds.

  • Non-profit entities.

  • Pension plans.

  • Banking or thrift institutions.

  • State or municipal government entities (and their pension plans).

  • Sovereign wealth funds and foreign official institutions.

  • Investors that are not US persons whose beneficial ownership is unknown and cannot reasonably be obtained.

  • Any other type of owner not listed.

Form ADV requires a similar but shorter list of investor types (funds of funds and non-US investors).


Tax incentive schemes

5. What tax incentive or other schemes exist to encourage investment in unlisted companies? At whom are the schemes directed? What conditions must be met?

There is generally no available tax incentive or other scheme to encourage investment in unlisted companies.


Fund structuring

6. What legal structure(s) are most commonly used as a vehicle for private equity funds in your jurisdiction?

The most commonly used vehicle for private equity funds is the Delaware limited partnership, which gives limited liability to the investors who are limited partners in the limited partnership. The fund's sponsor, or an affiliate, typically acts as the general partner and has unlimited liability for the limited partnership's obligations.

A Delaware limited liability company (LLC) may be used instead of a Delaware limited partnership. However, the LLC is far less popular. There are disadvantages to using an LLC, particularly for funds that invest outside of the US or which have non-US investors. The two primary drawbacks are:

  • LLCs are not recognised as tax transparent in some jurisdictions.

  • In some jurisdictions, investors and LLCs may have difficulty accessing the benefits of tax treaties.

Both limited partnerships and LLCs are generally treated as tax transparent for US tax purposes. While every US state can be used as a jurisdiction in which to form a limited partnership or an LLC, Delaware is generally considered the best choice because of its well-thought out and well-developed statutory regime and, partly because so many fund sponsors choose Delaware, its well-developed body of case law.

Some private equity funds, due to the nature of their investors or the focus of the fund's investments, are organised offshore. The Cayman Islands is the most typical offshore jurisdiction for a private equity fund with a broad investment mandate. Funds organised in the Cayman Islands generally provide a similar level of limited liability to investors to that provided by a Delaware vehicle. Funds with a more narrow geographic focus are often organised in other jurisdictions.

7. Are these structures taxed, tax exempt or tax transparent (flow through structures) for domestic and foreign investors?

Private equity funds in the US (or offshore with a US fund sponsor) are typically treated as partnerships for US tax purposes, regardless of whether they are organised as limited partnerships or LLCs. The fund itself is then not taxed in the US. Instead, the fund's income flows through to each investor and is taxable at the investor level. The character of the income also flows through to the investors so that capital gains realised by the fund maintain that character in the investors' hands. The flow-through tax treatment applies to both US and non-US investors. However, other jurisdictions may impose taxes on investors' income and even on the fund itself.

8. What (if any) structures commonly used for private equity funds in other jurisdictions are regarded in your jurisdiction as not being tax transparent (in so far as they invest in companies in your jurisdiction)? What parallel domestic structures are typically used in these circumstances?

Almost all non-US entities can elect to be treated as a partnership and be tax-transparent for US tax purposes. In some circumstances, fund sponsors may wish to use a non tax-transparent investment vehicle to allow investors to avoid US filing requirements and tax obligations. If so, the entity itself must make the required US filings and tax payments.


Investment objectives

9. What are the most common investment objectives of private equity funds?

Private equity funds generally seek to achieve significant long-term capital gains by acquiring a controlling interest in a number of private investments and then improving the management and operations of those companies. The typical term of a private equity fund is ten years (often with a right granted to the sponsor to extend for up to two years). Capital is drawn down from investors during an investment period of generally three to six years, with an investment period of five or six years being the most common. The manager uses the remainder of the term to increase the value of the portfolio investments and seek exit opportunities. Additional capital may be called down after the investment period to meet any additional capital needs of existing portfolio companies and to pay expenses of the private equity fund.


Fund regulation and licensing

10. Do a private equity fund's promoter, principals and manager require licences?

As a result of the Private Fund Investment Advisers Registration Act of 2010 (Registration Act), which was signed into law as part of the Dodd-Frank Act, an investment adviser to a private equity fund is likely to have to register with the SEC.

Also, if a private equity fund trades even one commodity interest contract or holds itself out as being able to do so, the sponsor of the fund will be deemed a CPO, and the adviser to the fund will be deemed a CTA. Without an exemption, any CPO or CTA must register with the CFTC and become a member of the National Futures Association (see Question 4).

11. Are private equity funds regulated as investment companies or otherwise and, if so, what are the consequences? Are there any exemptions?


Any issuer that is engaged in investing or trading in securities is considered an investment company and, as a result, must register as an investment company under the US Investment Company Act 1940 (Investment Company Act) unless an exception is available.

There are two exceptions to registration as an Investment Company which private equity funds often use:

  • The fund has outstanding securities that are beneficially owned by fewer than 100 persons (section 3(c)(1), Investment Company Act). Various look-through rules apply in calculating whether a fund has 100 investors.

  • The fund has outstanding securities which are owned exclusively by persons who are qualified purchasers at the time of acquisition (section 3(c)(7), Investment Company Act).

Qualified purchasers are:

  • Natural persons, family-owned companies and trusts with at least US$5 million in investments.

  • Companies that own and invest at least US$25 million.

If using the 3(c)(7) registration exemption for funds where all the investors are qualified purchasers, there is no limit on the number of investors that a fund can have, although the Exchange Act requires registration for any class of securities held by 2,000 persons in total or 500 persons who are not accredited investors (see Question 4).

In addition, an issuer engaged in a public offering must register the offering.


If the securities are offered by an issuer in a transaction that does not involve any public offering, there is no need to register. To qualify as a non-public offering:

  • The offering must be private and not involve a general solicitation (see Question 4, Changes in general solicitation prohibition).

  • The issuer must have a substantive relationship with each prospective investor before the offering and must have knowledge of an investor's suitability to purchase interests in the private offering.

  • There cannot be any advertisement, article or notice, or any communication in any newspaper, magazine or similar media or any radio and television broadcast, that has the purpose or effect of offering or selling the fund.

Issuers must also take precautions regarding their websites. Issuers should restrict internet pages that provide access to private offerings of securities to prospective investors.

12. Are there any restrictions on investors in private equity funds?

There are special rules limiting non-US investors' involvement in obtaining oil and natural gas leases from the US government.

13. Are there any statutory or other limits on maximum or minimum investment periods, amounts or transfers of investments in private equity funds?

There are no statutorily prescribed maximum or minimum investment periods. Depending on the nature of the private equity fund, investment periods generally range from three to six years, with five or six years being by far the most common. Due to recent economic conditions, many funds have had a difficult time deploying capital and, as a result, have sought extensions of investment periods from their investors. This can be accomplished with an investor vote.

There are no statutory limits on investment transfer amounts. However, if fund interests are transferred to investors who do not meet statutorily prescribed conditions for a registration exemption, that exemption may be lost. In addition, in certain cases the flow-through tax treatment of the fund vehicle may be lost if, as a result of transfers, the fund is considered a publicly traded partnership. Fund sponsors must be careful to ensure that fund interests are not transferred so as to cause these types of problems. As a result, fund documents usually prohibit transfers without the consent of the fund sponsor and generally require a number of conditions to be met to permit a transfer.

To avoid regulation under the Employee Retirement Income Security Act of 1974, fund sponsors may also need to limit the number of pension plan and similar types of investors in the fund and therefore typically control transfers to these types of investors.

Concerns about credit worthiness and money laundering also generally cause fund sponsors to perform due diligence on each new investor in a fund, similar to the type of diligence performed on the initial investors in the fund.


Investor protection

14. How is the relationship between the investor and the fund governed? What protections do investors in the fund typically seek?

In the typical private equity fund, the fund sponsor or its affiliate serves as general partner or managing member and, in that capacity, controls almost all activities of the fund. Investors are generally not involved in the operations of the fund. Some of the more common protections investors seek are:

  • Inclusion of an advisory committee made up of representatives of investors, whose approval is required for certain conflicts of interest, valuation matters and other matters.

  • Investment parameters which cannot be exceeded without investor (or sometimes advisory committee) approval.

  • The ability to remove the general partner (or managing member) for cause or sometimes even without cause.

  • The ability to terminate the fund for cause or without cause.

  • The ability to terminate the investment period early, if the key persons running the fund are no longer devoting sufficient time to the fund or for other causes.

The investor vote required to remove the general partner or terminate the fund or the investment period without cause may be as high as 80%.


Interests in portfolio companies

15. What forms of equity and debt interest are commonly taken by a private equity fund in a portfolio company? What are the relative advantages and disadvantages of each? Are there any restrictions on the issue or transfer of shares by law?

Common forms

Private equity funds commonly take an interest in a portfolio company that provides for a threshold financial return that the portfolio company must achieve for the holders of residual interests to obtain any benefit from their interests in the portfolio company. This often takes the form of convertible preferred stock, in which the preferred stock has a set dividend and liquidation preference that must be returned to the holders of the preferred shares before the holders of common shares receive anything. The convertible preferred shares convert into common shares at specified ratios, allowing the holders of the preferred shares to obtain ownership interest in the common shares if they wish to do so.

Variants of this include combinations of two (or more) types of interests, for example:

  • Notes and warrants to obtain common stock.

  • Non-convertible preferred stock and common stock issued together.

  • Non-convertible preferred stock issued with warrants.

Advantages and disadvantages

Although each of these capital structures seeks to achieve roughly the same result, the benefits and disadvantages of each type of structure can vary, depending on the investor and portfolio company's tax situation, degree of control and method of exercising the control desired by the holder of the securities.


There is generally no legal restriction on the transfer of any of these as securities, though typically there are extensive contractual restrictions on the ability to transfer interests in a portfolio company.



16. Is it common for buyouts of private companies to take place by auction? If so, which legislation and rules apply?

Buyouts of private companies commonly take place by auction. A financial adviser is often engaged by the seller to manage the auction process. The financial adviser

seeks to narrow the number of potential bidders to a limited number of likely buyers. This group of potential buyers is then asked to submit final bids. The seller may enter into negotiations with one or more of them. There is no legislation that generally governs sales of private companies other than anti-fraud and anti-trust


17. Are buyouts of listed companies (public to private transactions) common? If so, which legislation and rules apply?

Buyouts of listed companies (public to private transactions) are common, although as with buyout transactions of all types the number of such transactions has dropped steeply over the past several years.

A public to private transaction requires compliance with a number of Securities Act rules including those governing proxy contests or tender offers (depending on the method used for the acquisition) and disclosure rules. If the target company is established in Delaware (which is common) or in states which follow Delaware common law, the target's directors have a fiduciary duty to obtain the best price for the target company. As a result, targets seek and generally obtain the ability to terminate acquisition agreements if they receive a superior offer (at the cost of paying a break fee).

Care also must be taken to follow process-related requirements, created by both statute and case law (for example, providing the required notice to shareholders and complying with charter and bye-law provisions).

Target companies must also adhere to the rules of the exchanges they are listed on, although these generally do not pose much of a problem if other legal and regulatory requirements are being met.

There are two principal forms an acquisition of a US public company can take:

  • A one-step transaction, involving a proxy solicitation and a vote of the target's shareholders to approve the merger, which then takes place after the solicitation and vote.

  • A two-step transaction, involving a tender offer by the buyer, followed by a merger after the buyer acquires voting control of the target's stock directly from its shareholders in the tender offer.

One-step transactions can take a great deal longer than two-step transactions. Until recently, one-step transactions have been private equity sponsors' preferred route, despite the additional amount of time they involve. Recently there has been an increase use of two-step transactions involving a tender offer.

Principal documentation

18. What are the principal documents produced in a buyout?

Regardless of whether a public to private acquisition is one-step or two-step, the principal agreement is a merger agreement between the target company and the acquisition entities formed by the private equity sponsor. The merger agreement is necessary because it is almost impossible to locate every single shareholder in a public company, and the merger agreement eliminates the need to do so.

In a private acquisition, the principal agreement is one of the following:

  • A merger agreement.

  • An equity purchase agreement.

  • An asset purchase agreement.

The type of agreement depends on the transaction structure, which depends on numerous factors. In a private acquisition, there may be additional agreements between the seller(s) and the private equity sponsor dealing with ancillary matters such as real estate leases, escrow arrangements, transition of services and so on.

The acquisition entity, the private equity sponsor's fund and/or the management team may, in connection with the agreements for acquisition and funding of the acquisition entity, enter into other agreements, including:

  • Equity commitment letters.

  • Debt commitment agreements.

  • Guarantees.

  • Subscription agreements.

  • Equity contribution agreements.

  • Shareholders' agreements.

  • Registration rights agreements.

  • Employment agreements.

  • Non-competition agreements.

Private equity sponsors generally provide the seller with an equity commitment letter from the relevant fund. The equity commitment letter is the fund's binding commitment to provide the equity capital to the acquisition entity. Alternatively, a seller may insist on a direct guarantee from the private equity fund. If the sponsor has agreed to a no-financing condition transaction (see Question 19), the guarantee also ensures that the seller can collect the reverse break fee in the event of a triggering termination event.

Buyer protection

19. What forms of contractual buyer protection do private equity funds commonly request from sellers and/or management? Are these contractual protections different for buyouts of listed companies (public-to-private transactions)?

Buyer protections in a private acquisition generally include:

  • Representations and warranties. Buyers typically obtain representations and warranties from the seller covering both the entity or assets being sold and the ability to sell them.

  • Interim operating covenants. Buyers typically require covenants from the seller requiring the seller to, between signing and closing:

    • operate the business as usual;

    • not enter into certain transactions without the buyer's consent.

  • Closing conditions. Buyers also typically obtain closing conditions, including:

    • receipt of required governmental and third-party consents by the seller;

    • no material adverse change in the target entity;

    • receipt of buyer's debt financing;

    • compliance with covenants by the seller;

    • a bring-down of seller's representations and warranties.

  • Post-closing indemnification provisions. The seller must usually indemnify the buyer for breaches of the seller's representations, warranties and covenants. This may also include specific indemnities for pre-closing taxes, known environmental issues and other matters. Sellers typically require buyers to agree to a basket cap, so that small amounts are not indemnified, and a cap on potential indemnity claims. There is also typically a reasonable survival period, during which the buyer can bring an indemnification claim post-closing. Indemnification baskets, caps and the corresponding survival periods are usually highly negotiated.

Typically, a private equity sponsor does not seek any special protections from the target's management team. If the target's management team is selling equity in the transaction, members of the team normally share pro rata in any post-closing indemnification obligation and escrow hold-back.

Private equity funds' obligations to close are sometimes not subject to their receipt of debt financing. In exchange, funds negotiate for a cap on the total damages payable to the seller if they fail to close due to a failure to receive their debt financing or for any other reason. The cap typically takes the form of a reverse break fee payable by the fund. These reverse break fees are typically a small percentage (2% to 3.5%) of the total transaction value, or may be slightly more if the sponsor fails to close for any reason other than a failure to obtain debt financing. In such deals it is common to have provisions barring sellers from being able to seek specific performance to force the closing, even if all conditions to the buyer's obligations to close the deal have been satisfied.

In a public to private transaction, there is typically no post-closing indemnification or other post-closing protections, so buyers rely on interim operating covenants and the no-material-adverse-change closing condition as their key protections.

20. What non-contractual duties do the portfolio company managers owe and to whom?

The principal non-contractual duty that portfolio company managers owe the target company is the common law duty of good faith and loyalty. This duty of loyalty prohibits management from disadvantaging the company for their own benefit or to pursue company opportunities for themselves. The duty of loyalty generally requires disclosure to the board of directors once an opportunity involving the target company presents itself. Management representatives on the board of directors usually withdraw from board deliberations concerning these opportunities to avoid the conflict of interest.

21. What terms of employment are typically imposed on management by the private equity investor in an MBO?

Beyond typical employment terms such as title, term, compensation (including incentive compensation), benefits, termination and severance, the most important employment terms typically imposed on management by a private equity sponsor are non-competition, non-solicitation and confidentiality terms.

State law governs employment contracts and so the enforceability of non-competition clauses can vary widely from state to state. Most states will enforce a non-competition clause that is reasonable in scope (considering restrictions on types of employment, geography and duration), although some states (such as California) will not enforce non-competition clauses due to them being against public policy.

Non-solicitation clauses typically cover employees, customers and suppliers. The scope of these clauses often does not extend to general solicitations through mass-media that are not targeted at any particular person or group.

22. What measures are commonly used to give a private equity fund a level of management control over the activities of the portfolio company? Are such protections more likely to be given in the shareholders' agreement or company governance documents?

In a single sponsor transaction, the private equity sponsor typically controls all of the fully diluted equity of the company other than that owned by management (usually 10% to 20%). As a result, the sponsor has both voting and economic control over the business.

The private equity sponsor and the other equity holders generally enter into a shareholders' agreement that gives the sponsor the right to nominate a majority of the company's directors, and includes a voting provision under which all parties to the

agreement agree to vote in favour of the sponsor's board nominees. Shareholders' agreements also usually contain provisions, such as drag-along rights, that give the sponsor control over exit transactions.

In consortium transactions, or in a transaction where there are one or more significant minority investors, the shareholders' agreement may include provisions requiring a super-majority vote that gives the minority a veto over certain fundamental transactions, such as financings, significant add-on acquisitions, sales of significant assets and exit transactions. In consortium transactions there is often also a desire to place such voting provisions and the provisions relating to the nomination and election of directors in the company charter, which is often more difficult to amend than a shareholders' agreement.


Debt financing

23. What percentage of finance is typically provided by debt and what form does that debt financing usually take?

The percentage of financing typically provided by debt depends on the size of the transaction and how much debt can be obtained under prevailing market conditions. The typical level of debt financing now used in a private equity leveraged buyout transaction is substantially lower than was seen before the summer of 2007 and the onset of the credit crisis. In addition, terms are substantially less borrower friendly than in previous years.

The fundamental different types of debt financing used in buyout transactions are:

  • Senior secured first and/or second lien financings.

  • Subordinated mezzanine financings.

  • Senior secured bonds.

  • Unsecured senior or subordinated bonds.

  • Convertible and other hybrid debt financings.

A senior secured financing is senior to the borrower's other debt and a significant portion of the borrower's assets serve as collateral. Such financings consist of one or more term loan facilities that are used to finance the acquisition and a revolving credit facility that is used for working capital. How much of each of these types of debt are used depends on:

  • Availability.

  • The size of the overall financing.

  • The costs of each type of financing.

  • The fund sponsor's preferences among the types of debt financing available.

Lender protection

24. What forms of protection do debt providers typically use to protect their investments?


Debt providers typically protect their investments by obtaining security interests in the borrower's assets and by obtaining guarantees from the borrower's subsidiaries, secured by the relevant subsidiaries' assets.

There are a number of contractual and structural mechanisms that are also used by debt providers. Debt providers can contract with each other to subordinate one class of creditors to another class. The two groups can agree that one group will not have any rights in an insolvency proceeding until the other class of creditors has been repaid in full.

Debt providers can also obtain structural seniority by extending debt to an operating company subsidiary of a holding company, rather than to the holding company itself. Lenders at the operating level are repaid before creditors with a claim at the holding company level, because the operating company subsidiary must satisfy all of its debt claims in an insolvency proceeding before the holding company receives whatever value is left as a result of its holding equity in the subsidiary.

Contractual and structural mechanisms

Contractual covenants also provide lenders with some protection. Such covenants can include obligations to maintain the financial health of the borrower as well as other negative and affirmative covenants. Lenders can also be protected by keep-well arrangements under which fund sponsors agree to provide the borrower with capital in certain situations.

Financial assistance

25. Are there rules preventing a company from giving financial assistance for the purpose of assisting a purchase of shares in the company? If so, how does this affect the ability of a target company in a buyout to give security to lenders? Are there exemptions and, if so, which are most commonly used in the context of private equity transactions?


There is no prohibition on a company giving financial assistance in connection with the purchase of its own shares. Courts can void guarantees and security given by a target company if a fraudulent transfer has occurred (such as a transfer of assets when the transferor is insolvent). Creditors in LBO transactions often rely on the guarantee provided by the acquiring fund that the borrower and its subsidiaries will be solvent after the buyout transaction, including any debt resulting from the transaction and the provision of any guarantees and security.


Not applicable.

Insolvent liquidation

26. What is the order of priority on insolvent liquidation?

Most portfolio companies in need of bankruptcy relief use the provisions of Chapter 11 of the Bankruptcy Code, regardless of whether the goal of the proceedings is the liquidation of the business or the reorganisation of the business as a going concern.

The statutory priorities for repayment are:

  • Secured claims, to the extent of the value of the underlying collateral.

  • Administrative claims (generally, claims that arise after a bankruptcy is commenced and before the effective date of the plan of reorganisation).

  • Priority claims (for example, certain claims for unpaid wages and taxes).

  • General unsecured claims.

  • Equity.

A senior secured creditor with liens on a material portion of a debtor's assets may agree to be effectively subordinated to the payment of a predetermined portion of administrative and priority claims, as the price of liquidating through Chapter 11. This is because a Chapter 11 liquidation can be more advantageous for the senior secured creditor than simply foreclosing on its collateral.

In a bankruptcy proceeding, the rights of any single holder, including rights relating to priorities of distribution, can be waived by an affirmative vote of a majority of holders (that is, two-thirds in amount and one-half in number) within the same class. Inter-creditor and subordination agreements are enforceable in a Chapter 11 proceeding to the same extent as outside of bankruptcy.

A court can also subordinate one creditor's claim to another creditor's claim (or the claims of all other creditors) if it is shown that the creditor has engaged in inequitable conduct (for example, fraud or breach of fiduciary duties) that resulted in an injury or disadvantage to the other creditor(s). If so, the subordinated claim is treated as lower in priority than the claim to which it is subordinated, but the subordination does not affect its treatment in relation to any other claim or to equity.

Additionally, a court will look past the form of debt to determine its substance and may recharacterise debt as equity (and treat it as lower in priority than all claims) if this is determined to be the economic substance of the transaction.

Equity appreciation

27. Can a debt holder achieve equity appreciation through conversion features such as rights, warrants or options?

It is possible for a debt holder to participate in the appreciation of equity value through convertible securities such as rights, warrants or options, but it is not very common in US buyout transactions. Debt holders generally do not participate in the equity in large transactions. In small- and middle-market transactions, it is common for mezzanine lenders and hedge funds to invest alongside the equity participants in the equity rather than receiving warrants or other convertible securities, although in some transactions, share purchase warrants are a part of the overall financing provided by the debt holders.


Portfolio company management

28. What management incentives are most commonly used to encourage portfolio company management to produce healthy income returns and facilitate a successful exit from a private equity transaction?

The most common management incentives used to encourage portfolio company management are:

  • Share options.

  • Restricted shares.

  • Other share-based awards.

  • A combination of these.

In small- and middle-market transactions, incentive plans commonly account for 10% to 15% of the fully diluted equity. Incentive plans are relatively smaller in larger transactions and commonly account for between 5% and 10% of the fully diluted equity. Incentive awards are usually subject to both time-based vesting (for at least some portion of the awards) and performance-based vesting. Performance-based vesting is usually based on the sponsor's return on its investment.

Restricted stock is sometimes used to allow the recipient to gain favourable tax treatment by electing to be taxed on the fair market value of the common share grant at the time of grant and to pay income taxes at ordinary income rates, with appreciation generally taxed at capital gain rates on realisation.

Senior managers may also be required to invest in the transaction, either through a direct cash investment or through the rollover of their current equity holdings in the target company. The structure, nature and amount of such required investment depends on individual circumstances. Sponsors generally work with managers to try to design equity rollovers in a tax-efficient manner.

29. Are any tax reliefs or incentives available to portfolio company managers investing in their company?

Corporations can offer incentive share options (ISOs). ISOs are taxed at capital gains rates when the shares are sold if certain requirements are met. No tax is due when they are exercised and therefore the issuer is not entitled to a tax deduction. To achieve capital gains treatment, the shares must be held for both:

  • Two years following the ISO's grant date.

  • One year after the ISO is exercised by the manager.

Companies are limited in the amount of ISOs they can grant and as a result ISOs are not widely used.

Portfolio companies that are operated in a pass-through form can grant managers profits interests in exchange for performing services for the company. These profits interests generally represent the right to a share of the venture's future profits and are treated as capital gains at the level of the manager, to the extent that the underlying income is a capital gain. This differs from ordinary income from the exercise of non-qualified share options or the vesting of restricted shares without a section 83(b) election. When the portfolio company is sold the gain is typically treated as capital gains at the level of the manager.

Bills have been introduced in congress several times over the last few years that propose to tax carried interest earned by managers of private equity and hedge funds at ordinary income rates (they currently receive capital gains treatment). No action has been taken on the most recent proposed bill, and it is likely that no action will be taken in the near future.

30. Are there any restrictions on dividends, interest payments and other payments by a portfolio company to its investors?

So long as the dividend payments are in accordance with the portfolio company's charter and contractual obligations, the payment of dividends by a solvent company is generally unrestricted. State laws generally prohibit the payment of dividends by a company that is a going concern if after giving effect to the distribution, the company would not be able to pay its existing and reasonably foreseeable debts, obligations and liabilities.


Exit strategies

31. What forms of exit are typically used to realise a private equity fund's investment in a successful company? What are the relative advantages and disadvantages of each?

Forms of exit

The three most common forms of exit used to realise a private equity fund's investment in a successful company are the:

  • Sale to a financial buyer such as another private equity fund.

  • Sale to a strategic buyer.

  • IPO.

Sales to financial buyers or strategic buyers can take the form of either a sale of the company or of assets. It is also possible to have a carve-out sale in which a portion of a successful company is sold or even, on rare occasions, brought public.

Private sales, whether to financial or strategic buyers, are significantly more common than IPOs. The viability of an IPO depends to a great extent on market conditions.

Advantages and disadvantages

The advantage of an IPO is that it is possible to realise significantly greater value in the long term. However, in most IPOs the fund sponsor does not sell most (or any) of its shares. Instead, newly issued shares are sold to the public. As a result, even with a successful IPO, the fund sponsor still has market risk in relation to its shares in the company, as well as the continued business risk of operating the portfolio company.

Although greater value may be realised over the long term from an IPO, the private sale is by far the more common exit strategy. The advantage of a private sale is that the private equity fund sponsor realises all of the value of the sale immediately and no longer has to deal with either business or market risk in relation to its investment.

Sales to other private equity fund sponsors remained a particularly common form of exit in 2012. From a fund investor perspective, a sale to another private equity fund may mean there is no exit at all if the investor is also invested in the acquiring fund.

32. What forms of exit are typically used to end the private equity fund's investment in an unsuccessful/distressed company? What are the relative advantages and disadvantages of each?

Forms of exit

The two primary forms of exit used to end a private equity fund's investment in an unsuccessful company are to sell the company (an asset or a stock sale) where the equity holders do not receive anything, or to enter into voluntary bankruptcy.

Advantages and disadvantages

The bankruptcy procedure is preferred because the buyer gets clean title to all of the assets and the seller is assured of having no remaining liabilities. In a sale of the company outside of bankruptcy, no matter how strong the contractual arrangements may be, the seller is always left with the possibility that liabilities may remain its responsibility.

In a voluntary bankruptcy, the portfolio company can sell all or substantially all of its assets with court approval. It is unusual for such sales to result in any proceeds being paid to the equity holders, and some classes of creditors may also receive proceeds equalling only a small percentage of their claims.


Private equity/venture capital association

The National Venture Capital Association (NVCA)


Status. The NVCA is a trade association that represents the US venture capital industry.

Membership. The NVCA comprises more than 450 member firms.

Principal activities. The NVCA aims to foster a greater understanding of the importance of venture capital to the US economy and support entrepreneurial activity and innovation. It represents the venture capital community's public policy interests, strives to maintain high professional standards, provides reliable industry data, sponsors professional development, and facilitates interaction among its members.

Contributor profiles

Larry Jordan Rowe

Ropes & Gray LLP

T +617 951 7407
F +617 235 0201

Professional qualifications. Massachusetts, US

Areas of practice. Private investment funds; hedge funds; investment management; private equity transactions.

Debra K Lussier

Ropes & Gray LLP

T +617 951 7588
F +617 235 0521

Professional qualifications. Massachusetts, US

Areas of practice. Private investment funds; hedge funds; investment management.

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