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 global guide to private equity. For a full list of jurisdictional Q&As visit www.practicallaw.com/privateequity-mjg.
The primary sources of funding for private equity funds in the US are:
Public pension funds.
Funds of funds.
Corporate pension funds.
Banks and other financial institutions.
High net-worth individuals.
Sovereign wealth funds.
As of June 2014, the largest investors were (Dow Jones, Private Equity Analyst, Sources of Capital, June 2014):
Public, corporate and union pension funds, accounting for about 39% of total capital. Public pension funds remained the largest single type of investor, providing about 32% of total capital commitments. In 2013, public pension funds accounted for 30% of total capital.
Sovereign wealth funds, with 12% of total capital commitments. This represented a slight increase from 2013, when sovereign wealth funds represented 11% of total capital commitments. Sovereign wealth funds accounted for just 3.7% in 2010.
Endowments and foundations, providing about 5% of total capital commitments, a marked decrease from 2013, when endowments and foundations provided 10% of total capital commitments.
Funds of funds, providing about 6% of total capital commitments, which was slightly lower than 2013 levels.
Private equity firms continued their robust fundraising efforts in 2014, closing on US$189 billion in capital commitments. Prior to 2014, the industry saw three consecutive years of increasing fund closings and raised capital, culminating in US$220 billion in capital commitments in 2013, which represented a 59% increase over 2012, and the best fundraising since 2008. The amount of capital raised in 2014 is more than double the total from 2010, a time when some feared investors had lost faith in PE funds as an asset class (Pitchbook 2015 Annual Private Equity Breakdown).
In 2014, there were 109 funds raised with less than US$100 million in commitments, more than twice the number of such funds raised in 2009 (Pitchbook 2015 Annual Private Equity Breakdown).
Capital invested reached a post-crisis high of US$523 billion in 2014, spurred in large part by an increase in middle-market deals. Investments between US$100 million and US$1 billion increased by 58% compared to 2013. Though there are usually a number of "mega deals" exceeding US$10 billion to bolster invested capital, the largest deal in 2014 was US$5.4 billion. Compared to prior years, the middle market offered better opportunities than large markets, where competition and valuations drove away investors (Pitchbook 2015 Annual Private Equity Breakdown).
Minority investments and add-ons continued to grow compared to platform buyout deals. Add-on investments comprised 60% of all control investments in 2014. This shift reflected a growing trend in specialisation across the PE industry, where firms now seek to exploit knowledge of particular markets through focused investments in fewer companies (Pitchbook 2015 Annual Private Equity Breakdown).
In 2014 fund closings and raised capital remained at comparable levels to the high-water marks in 2013, which was the best year for fundraising since 2008. Sponsors had success raising funds of all sizes in 2014, closing 109 funds with less than US$100 million, more than twice the number raised in 2009. 2014 also continued the resurgence of mega funds. Private equity sponsors raised eight funds of US$5 billion or more. Combined with the 12 mega funds raised in 2013, the last two years saw the most mega funds raised since 2007-2008. However, there are signs that private equity fundraising is slowing, and may have reached a post-recession peak. Capital commitments fell in each quarter of 2014, and capital overhang, at US$535 billion, remains at 2007 levels (Pitchbook 2015 Annual Private Equity Breakdown).
Overall, 283 private equity funds closed on about US$189 billion in capital in 2014, a 14% decrease in fundraising from 2013 (Pitchbook IH 2015 Private Equity Fundraising and Capital Overhang Report).
The number of new hedge funds declined for the second consecutive year in 2014. 872 new hedge funds were formed in 2014, representing a 23% decrease from 2013 and a 33% decrease from 2012 (2015 Preqin Global Hedge Fund Report).
Invested capital rose slightly to US$523 billion in 2014, thanks in large part to a 58% increase in deals between US$100 million and US$1 billion. In contrast, only eight transactions over US$2.5 billion closed in 2014, compared to 14 in 2013. The amount of invested capital represented a 1% increase from 2013. The number of deals closed was largely unchanged from 2013, increasing from 2,947 transactions to 2,955 (Pitchbook 2015 Annual Private Equity Breakdown).
Private equity deal making remained essentially unchanged in 2014. Following an active fourth quarter in 2013, in which 805 deals closed, deal making got off to a strong start in 2014, with 851 deals closing in the first quarter. Deal flow decreased throughout the year, with only 625 deals representing a combined US$109 billion in the fourth quarter.
Deals valued at US$2.5 billion or more were less common in 2014 than they were in 2013. Sponsors closed eight of these deals in 2014, compared to 14 in 2013. The industry shifted its focus to middle-market investments in 2014, with transactions between US$100 million and US$500 million increasing by 15% (Pitchbook 2015 Annual Private Equity Breakdown).
Exit activity was again robust in 2014, with private equity firms realising 904 investments, which was the second-highest total of the past ten years and represented an increase of 10% in exit flow from 2013. These exits comprised US$241 billion in capital, the highest total in a decade. Exit activity was bolstered by high valuations and eager public markets (Pitchbook 2015 Annual Private Equity Breakdown).
Final Volcker Rule regulations and recent developments
In December 2013, the federal banking agencies, the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) issued final regulations to implement the Volcker Rule. Subject to certain exceptions, the Volcker Rule prohibits a banking entity from:
Acquiring or retaining any equity, partnership or other ownership interest in any private fund.
Otherwise sponsoring or investing in any private fund, which includes most hedge funds and private equity funds.
The Volcker Rule affects most private fund investments made and interests held in these funds by banking entities.
The Volcker Rule permits banking entities to establish and invest in private funds in certain limited circumstances, unless these 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 to the Volcker Rule's general prohibitions 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 (if the fund interests are only offered and sold outside the US).
Sponsored fund exception. Banking entities can 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 deadline for full compliance with the final Volcker Rule regulations is 21 July 2015. This reprieve will allow private fund sponsors and banking entities to continue to review vintage private fund investments for compliance, and more recent investments and commitments made since the passage of the Dodd-Frank Act.
In 2014, 15 major law firms actively representing private fund sponsors and investors signed a consensus interpretation memorandum, prepared under the auspices of the Private Equity Growth Capital Council. The memorandum provides that the Volcker Rule should not require the integration of private funds offered and sold by non-bank sponsors to non-US banking entities with parallel funds offered to US investors. Such integration would effectively bar investment by non-US banking entities in parallel fund structures established by US fund sponsors. The view of the signatory law firms is that investments in such parallel funds by non-US banking entities should not be prohibited by the Volcker Rule, and such arrangements are not evasions of the Volcker Rule. That interpretation is based on the Volcker Rule final regulations. By reaching agreement on this important Volcker Rule interpretative issue, the firms intend to ease concern over the integration issue, which has slowed the development of Volcker Rule compliant structures for new private funds seeking investment by non-US banking entities and the restructuring of legacy investments into Volcker Rule compliant structures.
On 18 December 2014, the Federal Reserve Board announced that banking entities invested in private equity fund and hedge funds would have until 21 July 2016 to comply with the Volcker Rule with respect to investments made prior to 31 December 2013. The Board also announced its intention to act next year to grant banking entities an additional one-year extension of the conformance period until 21 July 2017.
"Bad actor" amendments to Regulation D
As required by section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC adopted amendments to Rule 506 that disqualify securities offerings from exemption under Rule 506 if the offerings involve certain "felons" or other "bad actors" (Bad Actor Amendment). In the language of the amendments, an offering will not be able to rely on Rule 506 if a "covered person" (see below) has had a "disqualifying event" (see below).
Covered persons (that is, persons who could be considered "bad actors" under the rule) include:
Investment managers of issuers that are pooled investment funds; directors and officers of issuers; general partners and managing members of investment managers; directors and executive officers of general partners and managing members.
The issuer (that is, the fund itself).
Directors, executive officers, and other officers participating in the offering; general partners or managing members of the issuer.
20% beneficial owners of the issuer.
Promoters connected with the issuer at the time of sale.
The disqualifying events most likely to apply to covered persons of private funds in connection with a sale of interests are as follows:
Certain SEC cease-and-desist orders.
Criminal convictions, court injunctions and restraining orders in connection with the purchase or sale of a security, making of a false filing with the SEC, or the conduct of certain financial intermediaries.
Final orders from certain state and federal regulators that either:
bar a person from associating with a regulated entity in the business of securities;
find a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct.
The Bad Actor Amendment does not apply if the issuer can show it did not know and, in the exercise of reasonable care, could not have known that a covered person with a disqualifying event participated in the offering.
In 2014, the SEC's Division of Corporate Finance (Division) issued new guidance (in the form of "Frequently Asked Questions") to clarify what constitutes a "beneficial owner" for the purposes of the Bad Actor Amendment. Consistent with its informal oral guidance the Division had been providing to the industry, the Division clarified that for the purposes of the Bad Actor Amendment, a "beneficial owner" is interpreted the same way as under Rule 13d-3 of the Securities Exchange Act of 1934 (as amended) (Exchange Act). Therefore, a "beneficial owner”" generally includes any person who, directly or indirectly (through any contract, arrangement, understanding or otherwise) has or shares, or is deemed to have or share, voting power (including the power to vote or direct the vote of such security) and/or investment power (including the power to dispose or to direct the disposition of such security). As a result, even larger limited partners may not be "beneficial owners" for the purposes of the Bad Actor Rules if they don't have the power to vote or investment power.
SEC regulation of private fund advisers
In 2014, the SEC announced its plan to target registered investment advisers who have never undergone a formal compliance examination. SEC Inspections Chief Andrew Bowden stated in a meeting of the Regulatory Compliance Association that the SEC planned to prioritise the review of the approximately 4,400 registered investment advisors who have never faced a SEC exam. Mr Bowden noted it specifically intended to focus on the about half of those advisers that have been registered for more than three years and are domiciled in the US.
While some advisers and adviser trade associations have welcomed the SEC's initiative to step up exams, citing the increased standardisation and fairness across the industry that would come as a result of the exams, others have expressed doubt that the SEC will have the proper management and resources to fulfil these ambitious goals.
Implementation of FATCA
On 17 January 2013, the Internal Revenue Service (IRS) and Treasury Department released long-awaited final regulations on a set of statutory rules commonly referred to as the Foreign Account Tax Compliance Act rules (FATCA). 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 effective date for FATCA withholding on certain US source payments was 1 July 2014.
The specific application of the FATCA rules to private equity funds and hedge funds depends on the structure of a given fund group. Foreign financial institutions (including non-US private funds) and US withholding agents (including US private funds) must withhold 30% on withholdable payments to entities and accounts that do not meet FATCA's requirements.
Alternative Investment Fund Managers Directive
The Alternative Investment Fund Managers Directive 2011/61/EU (AIFMD), which governs alternative investment fund managers (AIFMs), required EU member states to implement the AIFMD into national law as of 22 July 2013. AIFMD was duly implemented by the majority of EEA member states, with others implementing later or planning to implement at varying points this year. Following implementation, the transitional provision in the AIFMD exempted many non-EEA private fund managers from compliance with the AIFMD until the transitional period ended on 22 July 2014.
Managers that were marketing funds in any member state in reliance on the transitional relief on a "private placement" basis prior to 22 July 2014 were required to stop marketing before 22 July 2014 or consider the new conditions for marketing in that jurisdiction that will apply at the end of the transitional period. These conditions vary by jurisdiction and usually involve a form of registration or notification with the regulator in the relevant jurisdiction. Managers have been required to consider the obligations under AIFMD that now apply by virtue of marketing a fund in any member state. These obligations are mandated by the AIFMD and cover:
Disclosure and reporting to investors.
Reporting to the regulators in the applicable member states.
Certain disclosure provisions triggered by acquisitions of stakes in EEA companies.
Anti-"asset stripping" provisions relating to EEA companies.
The AIFMD does not apply where an investor invests on its own initiative, and the manager responds to the investor's request for fund information (reverse solicitation). Neither the European Commission nor ESMA has published any guidance on what constitutes "reverse solicitation", meaning that it is left to the interpretation of each member state regulator, few of whom have published any guidance themselves. Managers that previously relied on a "reverse solicitation" approach in their offering of interests to EEA investors (taking them outside AIFMD) have needed to consider whether that approach can continue, and if so, whether enhanced compliance procedures are desirable.
AIFMD enables each member state to permit non-EEA AIFMs to market to professional investors in their country. The current private placement regimes of certain member states that have implemented AIFMD can be grouped as follows:
France and Italy: no private placement regime available.
Germany and Denmark: registration with regulator required; fund must appoint a depositary.
Austria: registration with regulator required; fund must appoint a legal representative in Austria.
Sweden, Finland and Luxembourg: registration with regulator required.
UK, Ireland and The Netherlands: notification to regulator required.
Tax incentive schemes
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.
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.
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.
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
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 commodity pool operator (CPO), and the adviser to the fund will be deemed a commodity trading adviser (CTA). Without an exemption, any CPO or CTA must register with the CFTC and become a member of the National Futures Association.
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.
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. In general, to qualify as a non-public offering:
The offering must be private and not involve a general solicitation.
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.
The concerns regarding general solicitation do not apply to offerings relying on new Rule 506(c) of Regulation D. Under Rule 506(c), a transaction may qualify as a non-public offering even if the issuer engages in "general solicitation" and "general advertising".
An offering can maintain the exemption under Rule 506(c) so long as all of the following conditions are satisfied:
The issuer takes reasonable steps to verify that the purchasers of the securities are accredited investors.
All purchasers of securities are accredited investors, either because they come within one of the enumerated categories of persons that qualify as accredited investors or because the issuer reasonably believes that they do at the time of the sale of securities.
The integration and resale restriction terms of Rules 501, 502(a) and 502(d) are satisfied.
Because of the 2013 "bad actor" amendments to Rule 506 (see Question 4, " Bad actor" amendments to Regulation D), an offering involving "felons" or "bad actors" may not rely on Rule 506 for exemption from registration.
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.
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
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.
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.
Application of withholding taxes or capital gains taxes
Depending on the facts and circumstances of a particular portfolio company investment, US or non-US withholding taxes and/or capital gains taxes may apply. The applicability of such taxes depends on a number of factors, including:
The jurisdiction in which the investment is made.
The manner of exit from the investment.
Whether gains are derived from current income or on sale of the asset.
The use of holding companies.
The availability of tax treaties.
The tax characteristics of the ultimate beneficial owners.
Whether an applicable taxing authority taxes indirect transfers, which is more regularly a concern in the People's Republic of China and in India.
For many investments in portfolio companies, structuring alternatives may be available to partially mitigate the applicability or amount of capital gains tax and/or withholding tax.
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 rules.
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.
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.
Equity contribution agreements.
Registration rights 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 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.
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.
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.
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.
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. While the typical level of debt financing fell at the onset of the credit crisis, the level of debt financing now used in a private equity leveraged buyout transaction is similar to levels before the summer of 2007.
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:
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.
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.
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.
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.
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.
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
The most common management incentives used to encourage portfolio company management are:
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.
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.
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.
Investment documents may include protections regarding the Foreign Corrupt Practices Act (FCPA). The FCPA generally prohibits fund executives from offering or giving bribes to a "foreign official, "foreign political party or party official," or any candidate for foreign political office, to obtain or retain business opportunities. The FCPA generally applies to:
US persons, including US companies, controlled subsidiaries and affiliates of US companies, and citizens, nationals and residents of the US, wherever located.
In certain circumstances, non-US persons, including non-US companies and non-US citizens outside the US.
The US Department of Justice (DOJ) and the SEC both enforce the FCPA. Violators of the FCPA may be subject to both criminal and civil penalties. In criminal cases, firms are subject to a fine of up to US$2 million per violation of the anti-bribery provisions. Individuals are subject to a fine of up to US$100,000 and/or imprisonment for up to five years, per violation. However, under the Alternative Fines Act, the fines imposed on firms and individuals can be much higher: the actual fine can be up to twice the benefit that the defendant sought to obtain by making the corrupt payment. In civil actions, a fine of US$10,000 can be assessed for each act committed in furtherance of the offence, potentially making the total fine greater than US$10,000. Fines imposed on individuals must not be paid by their employer or principal. In addition, persons or firms found in violation of the FCPA can be barred from doing business with the US government and can be ruled ineligible for export licences.
Investment documents may also include protections from the UK Bribery Act (Bribery Act). The Bribery Act is similar to the FCPA, which criminalises the payment of bribes to foreign officials. However, the Bribery Act is more expansive in three ways:
Most significantly, the Bribery Act imposes a strict liability criminal offence that applies to any company with ties to the UK that fails to prevent an associated person (that is, anyone performing services on the company's behalf) from paying a bribe. The only defence to liability is if the company can prove that it had adequate procedures in place to prevent the bribery from occurring.
The Bribery Act does not contain any exceptions for facilitation payments or relatively insubstantial payments made to facilitate or expedite routine governmental action.
The Bribery Act criminalises purely commercial bribery that is unconnected to any public or governmental official, unlike the FCPA.
Additionally, investment documents may include protections regarding the OECD Convention on Combating Bribery of Foreign Public Officials in International Business Transactions (Convention). The Convention applies to the bribing of foreign public officials. The Convention applies irrespective of, among other things:
The value of the advantage and its results.
Perception of local custom.
Local authorities' tolerance of these payments.
The alleged necessity of the payment in order to obtain or retain business or other improper advantage.
The Convention applies as soon as an offer or promise is made, whether directly or through intermediaries, and applies even in cases of a third party beneficiary. Penalties are specified by each country but are comparable to FCPA penalties. Many countries specify unlimited fines and ten years' imprisonment.
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.
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.
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.
*The authors would like to thank Bartholomew C Galvin for his contribution to this article.
Private equity/venture capital association
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.
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Larry Jordan Rowe
Ropes & Gray LLP
Professional qualifications. Massachusetts, US
Areas of practice. Private investment funds; hedge funds; investment management; private equity transactions.
Debra K Lussier
Ropes & Gray LLP
Professional qualifications. Massachusetts, US
Areas of practice. Private investment funds; hedge funds; investment management.