According to David Sonter, private equity partner at Freshfields Bruckhaus Deringer, "debt financing for private equity transactions has fundamentally changed as a result of the financial crisis", noting that some of these changes return the market "to the norms of around ten years ago, before the global liquidity boom". Figures from CMBOR show that debt constituted 31% of total finance to European buyouts in 2010, compared to 51% at the height of the market in 2007 (see Sources). Although there are widespread reports of senior debt becoming more available to private equity, it is clear that there has not been a return to the very highly geared packages being struck before the financial crisis.

In a number of cases, sponsors have sought to replace the funding gap from a relative absence of leverage by writing greater than normal equity cheques. On occasion, larger sponsors keen to conclude the acquisition of an attractive target within a short time frame have funded the acquisition price entirely with equity, with the intention of replacing much of that equity with debt shortly after completion. This has been seen on secondary sales in particular, where the target is already a known and understood credit. Simon Beddow, private equity partner at Ashurst, notes that "clearly this has knock-on effects in terms of the possible reduction of leverage on returns and the risk profile for the sponsor funds in putting more money into a transaction, which fed into increased caution at the financial structuring and diligence phases".

For a discussion of the equity-underwritten acquisition of Marken from Intermediate Capital Group for £975 million, see Article, Private equity buyouts after the crisis. For a discussion of the effect that reduced leverage may have on a sponsor's investment returns, see Practice note, Internal rate of return (IRR): an introduction.

It is due to these instances of equity underwriting that CMBOR acknowledge that the true debt for acquisitions percentage across European buyouts may be higher than the reported 31%, as that figure represents the position at the beginning of investments, before any equity refinancing.

The effects of the financial crisis on acquisition finance have not just been felt in the reduced debt-to-equity ratios seen on 2010 private equity investments. The past year has also seen changes in the types of finance available to fund buyouts.

David Carter, partner in Ashurst's private equity practice, considers that "the major trend to have emerged during the last year in deal financing was the re-emergence of the high yield bond market. With the liquidity in the leverage market contracting back in terms of amount available to lend and multiples available for each deal, sponsors looked to the high yield bond market to fill the gap". These bonds, which commonly replace a significant proportion of the subordinated debt tranches on larger investments, are often arranged shortly after completion, due to their complexity and the time they require to arrange. To enable the acquisition to take place, sponsors will seek senior debt or bridging finance before using the proceeds of the later bond issue to refinance some or all of that debt. In July 2010, Bridgepoint confirmed the successful completion of a £250 million high yield bond issue, in connection with its £414 million take-private of Care UK (see PLC What's Market, Bridgepoint Capital Limited offer for Care UK plc). Bridgepoint intended to use the bond proceeds to refinance the senior debt provided at completion. For an overview of high yield bonds, see Practice note, High yield bonds.

Assuming that inflationary fears do not drive bond investors away, the high yield trend looks set to continue in 2011, with Advent reported to be planning the launch of a high yield bond issue to partially refinance debt employed on its acquisition of The Priory Group (see Articles, Reuters: IFR-Priory Bond Moves Step Closer After Sale to Advent).

Other developments in financing that have developed, or are expected to develop, as a result of the relative scarcity of senior acquisition debt include:

The importance of liquidity within a bond issue means that high yield bonds feature only in the largest deals. However, despite the expansion in the sources of finance for deals, senior banks will make senior, leveraged debt available to the most attractive deals. In relation to the mid-market, Simon Beddow notes that "the leverage market has seen a revival reflected in the willingness for the banks to lend to the larger mid-market transactions". According to Emma Danks, private equity partner at Taylor Wessing, there have, however, been fewer banks in the market.

A number of contributors note that bank debt is now much more expensive, being re-priced to more normal cost levels as lenders insist on "proper" margins and high arrangement fees. For the larger deals, banks are also able to insist upon greater pricing and flex rights to protect themselves against syndication risk. David Sonter also highlights the following trends on larger financings:

Emma Danks points out the banks' caution over equity cure rights, a relatively common feature of pre-crisis covenant-lite loan agreements:

It also appears that banks are now much more discerning in deciding to which deals they will lend. Emma notes the increased level of diligence being carried out by banks before lending:

As a result of this increased engagement by the banks, the M&A and the financing workstreams inter-relate much more than they have done before. Although stapled debt packages have been important in auction processes, 2010 has reportedly seen bidders involved in complex financing processes seeking early exclusivity, to allow the parties to finalise their debt financing, syndication or documentation. The resulting loss of competitive tension leads to its own complexities. According to David Sonter, enhanced flex rights for underwriting banks are also feeding back into the M&A process, with the pricing of some acquisitions being set by reference to the extent to which flex is used by financing banks to syndicate the debt.

Overall, it seems that banks are keen to lend only to the safest propositions and to the strongest private equity houses. It is therefore even more important for sellers to properly prepare a business for sale. Preparatory vendor due diligence has, since the recent crisis, become an even more important part of a seller's work on an auction. As David notes:

"A business with material risks such as unresolved regulatory or tax issues, or material revenue concerns is unlikely to attract financing in this market. In addition, the current European economic uncertainties and concerns about the robustness of forecasts generally have made sponsors cautious about valuations, and any material contingencies will have a material adverse impact on valuation (at best) or a failed auction (at worst)."

Where finance is available for the larger transactions, it is much more complex and takes much longer to arrange than it did during the boom. For Chris Bown, chair of Freshfields' private equity team:

"Sadly the days are now gone when you could throw five or six banks in a room and get a documented and underwritten £1 billion plus debt package within two weeks (even for a company that is not performing at its best)."

It will be interesting to see how this trend develops if the Takeover Panel makes the proposed amendment to the Takeover Code, under which the "put up or shut up period" for making a firm offer is restricted to four weeks (see Takeover Code).

Ashurst's David Carter reports that "during the early part of last year, there was a lot of talk about banks clubbing together to fund larger transactions. This never really became apparent since the larger deals did not happen". Below the very largest deals, however, Emma Danks says that "the syndicated deals that we have seen have been club deals (where all the banks are in the deal on day one). The sense we have is that banks remain very reluctant (or even unable) to underwrite private equity loans above a level of debt that the bank is actually willing to hold itself long-term".

Many predicted that the initial public offer (IPO) would provide one of the more viable exit routes for investments in 2010. At that time, the private M&A market looked thin, with the credit markets largely closed for business. Trade buyers were expected to focus inwards on protecting core assets and disposing of others, rather than be acquisitive. Although funds had a large amount of committed funds to invest, the returns available in the secondary buyout market did not often look very attractive due to a scarcity of available leverage for transactions (see Article, Private equity: the impact of the financial crisis: The future).

In fact, secondary buyouts, in which an existing private equity owner sells to a new, incoming investor, played the greater role in 2010 buyouts. 16 of the largest European buyouts took place by way of a secondary transaction and secondary buyouts accounted for 62% of UK transactions, according to CMBOR research (see Sources).

PLC What's Market lists within its scope just five successful flotations of companies with private equity or venture capital backers in 2010, with two of those being overseas issuers. A number of planned IPOs were scrapped, with common reasons reported as including continued volatility in the markets and uncertainty over European sovereign debt problems. In addition, institutional investors reacted against the perceived over-pricing of certain companies, especially on those where the IPO proceeds were to be applied in paying down excessive leverage acquired in the pre-crisis boom period. For a discussion of a number of IPOs of private equity-owned companies in the US, the UK and Spain in the first half of 2010 and the broader trends they reveal, see Article, IPOs of private equity-backed companies in 2010.

The markets' suspicion of sponsors seeking a realisation through a flotation is likely to continue in the early part of 2011, pending a greater return of the M&A markets and more realistic pricing of transactions. Lovefilm, rumoured to have been lining up an IPO in the early part of this year, has instead been sold to the trade by its private equity owners. On the other hand, it has been reported that ISS, the private equity-backed Danish facilities management multinational, is no longer talking to private equity house Apax regarding a secondary buyout, but will now pursue an IPO (see Article, Reuters: ISS owners drop $8.5 billion Apax talks to pursue IPO).

Emma Danks notes that 2010 has not seen material changes in equity terms, other than as a natural consequence of there having been a large number of secondary transactions:

"It has been necessary to focus on issues such as what proportion of management's proceeds are required by the institutions to roll over, and ratchets seem to be becoming a popular tool again as a means to incentivise management."

Simon Beddow notes that management teams are "being expected to provide much more comfort by way of their participation in the diligence process and cover sought by way of warranties". Locked-box structures continue to be used on the acquisition side, according to Emma, but "the re-emergence of completion accounts deals has not really happened to the extent anticipated by some commentators at the onset of the financial crisis, although it has happened to some degree".

The CRC Energy Efficiency Scheme Order 2010 (SI 2010/768) was drawn up in response to the UK's commitment to reduce its emissions both at the international level (under the Kyoto Protocol) and at the national level (under the Climate Change Act 2008). Conceived as a trading scheme to capture those larger organisations that consume significant supplies of electricity, one potential effect of the Order was to aggregate the electricity supplies to private equity firms and their subsidiary portfolio companies, requiring them to participate in the scheme as if they were all companies within the same corporate group.

Although the scheme might require a fund (or, in some cases, its sponsor) to fund its and its subsidiary companies' participation in the scheme, sponsors could take comfort from the fact that the scheme was designed to be revenue neutral. As originally designed, monies would be recycled back to participants according to their proportion of the total emissions covered by the scheme, adjusted by metrics based on their relative efforts to reduce their emissions. However, on 20 October 2010, despite the first phase of the scheme having begun on 1 April 2010, certain changes were announced to the scheme. The government will now retain the monies raised by the scheme that were expected to be recycled back to participants. Instead of being revenue neutral for the government, the scheme now appears to be a form of stealth tax.

Further proposals for change, including the delay of phase 2, have yet to be finalised. On 25 January 2011, the government published five discussion papers on how to simplify the CRC. The discussion papers include options to amend the scheme which, if implemented, might remove many of the private equity industry's concerns over the existing scheme. Comments on the discussion papers can be submitted until 11 March 2011. As such, the industry will continue to keep a close eye on developments, given the impact the scheme in its present form will have on the covenants and warranties a sponsor will have to seek under the investment documentation. For more information on the proposals, see Legal update, CRC: DECC publishes five discussion papers on simplifying the scheme.

For more on the scheme's application to private equity, see Practice note, CRC Energy Efficiency Scheme: issues for private equity, which sets out links to more detailed materials.

The passing of the Bribery Act 2010 raised further questions for private equity lawyers. Section 7 of the Act creates a new criminal offence under which commercial organisations may be liable for any bribery committed for its benefit by associated persons performing services for or on behalf of that organisation. Such commercial organisations will be able to defend themselves against liability by ensuring the existence of adequate procedures designed to prevent such bribery.

In response to its obligations under the Act, the Ministry of Justice (MoJ) issued in late 2010 a consultation on draft guidance on factors to take into account in drafting such adequate procedures. Private equity practitioners have expressed concern that neither the Act nor the associated guidance contains sufficient detail for private equity firms to determine the procedures they should put in place.

In a letter to the MoJ in December 2010, the British Private Equity and Venture Capital Association (BVCA) raised a number of industry-specific concerns on the Act including, in particular, the question of whether the relevant authorities might treat a portfolio company as associated with its private equity investors for the purposes of the section 7 offence. The BVCA has offered to draft guidance on the Act for the private equity sector, including relating to the issues to consider when preparing procedures to guard against bribery being committed on its behalf. It remains to be seen whether the MoJ will take up that offer and, if it does, whether it would be prepared to endorse that advice.

Concern over the adequacy of MoJ's guidance is not limited to private equity, with many representative bodies, including the CBI, lobbying for greater clarity before the final guidance is published ahead of the Act's implementation. Originally scheduled for April 2011, current reports indicate that the government will delay the Act's implementation until three months after publication of the final adequate procedures guidelines.

For more on the Bribery Act 2010 and links to more detailed PLC resources, see Practice note, Bribery Act 2010.

As in 2009, private equity's greatest concern over the last 12 months centred around the European Commission's proposed AIFM Directive). By early 2010, there was general acceptance that the proposal, developed at a political level following continued pressure from European socialists, would not disappear and that the Directive would pass into law in some form. As a result, efforts turned to damage limitation, with the most controversial provisions of the Directive being those relating to the proposed marketing passport for funds and funds managers based outside the EU.

The European Parliament finally adopted a settled form of the text of the AIFM Directive on 11 November 2010, which is expected to come into effect during March 2011, giving member states two years to transpose its terms into national law (see Provisional version of the AIFM Directive as adopted on 11 November 2010). For an introduction to PLC's resources on the AIFM Directive, see Practice note, A guide to the AIFM Directive: index.

2011 will see the European Commission and ESMA develop its proposals on level 2 measures under the AIFM Directive. The Directive will require over 90 secondary measures, many of which will be key to the overall impact of the rules on private equity (see Practice note, The AIFM Directive: secondary measures). ESMA concluded its first consultation, on the general approach it should take, on 14 January 2011. Both the BVCA and the European Private Equity and Venture Capital Association (EVCA) responded to that call for evidence and there can be no doubt that the industry will continue to be fully engaged with the process during 2011 (see Legal updates, ESMA publishes further responses to CESR's call for evidence on AIFM Directive implementing measures and EVCA responds to CESR call for evidence on AIFM Directive implementing measures).

In the aftermath of the controversial takeover of Cadbury plc by Kraft Foods Inc. (see Article, Cadbury Takeover: a Krafty manoeuvre), the Takeover Panel launched a consultation on certain aspects of the Takeover Code (see Legal update, Takeover Code consultation: review of certain aspects of the regulation of takeover bids). The most significant proposals for private equity, restated in the Panel's response statement of October 2010, are:

(See Legal update, Takeover Code: response to consultation on review of certain aspects of takeover regulation.)

According to Freshfields' Chris Bown:

"These changes will give listed company boards greater power to protect themselves and likely (if implemented) to adversely impact the ability of private equity houses to implement UK take-private transactions unless the target board gives its full (and early) co-operation."

Even where sponsors are able and willing to attempt such transactions, Gavin Brown, Slaughter and May corporate partner, notes that the proposals "represent a significant disadvantage compared to corporate bidders."

For further practitioner discussion of the proposed changes to the Code, see Article, Proposed changes to the UK Takeover Code.

Despite the time and attention that the debate over industry regulation will continue to require of those engaged in the process, few expect the resulting rules to materially impact the terms on which investments are agreed. The overall effect will be most strongly felt at the fund level, where sponsors will have to take particular care in navigating a still-moving set of rules to ensure compliance.

As Simon Beddow notes, "we would anticipate that the general raft of emerging legislation will be taken comfortably in the stride of the private equity houses and do not see these as operating as a break on the road to recovery in private equity". David Sonter agrees, noting that "the industry has traditionally been good at adjusting to regulatory change at the fund level and I expect they will adjust over time with limited impact on transaction terms".

However, this is not to say that changes do not need to be made to documents and processes.

Whatever effect the legislative and regulatory changes may have on transaction documents, there can be little doubt that private equity M&A activity is returning in the UK. For Gavin Brown:

"Refinancings, rather than M&A activity, were the basis for a good deal of the debt issued in 2010. There is a sense that there will be more M&A activity this year. I think this is driven to some extent by easing in the credit markets from the position we saw in 2008 and 2009 in particular. As a result there is an increased chance of more debt being issued and loan desks becoming more profitable."

However, the picture for 2011 is not entirely positive. Gavin also notes that the outlook must be tempered by continuing concerns over sovereign debt problems within the eurozone, which could slow the lending thaw.

For David Sonter, a number of factors will limit the size of the private equity market, including "slow growth across European economies, structural changes in the debt markets, the increasing appetite of emerging market companies to buy assets in Europe, a limited appetite for private equity-sponsored IPOs, continuing sovereign debt concerns, inflation fears and LPs being more discerning in their investment allocations". Over time, he believes that these factors "will reduce the ability of some of the smaller, less well-known private equity houses to raise funds". This reinforces predictions that all but the biggest sponsors will need to be able to demonstrate significant sector expertise to attract limited partner investment in new funds, at a time when investors are reportedly reducing their commitments to alternative assets. With reports of the larger houses moving into the mid-market to source deals, the opportunities to establish a track record are harder to come by. Those not able to do so may find it very difficult to compete in a market being squeezed by the bigger players.

As for the nature of 2011 deals, "last year ended with a flurry of secondary buyouts and we expect the first half of the next year to continue in that vein", notes David Carter. It has been interesting to note that a number of secondary buyouts have involved companies being sold to larger private equity firms reflecting, as noted above, the larger players' moves into the mid-market in their quest for suitable investment targets. There has been criticism from outside the industry, and from a number of institutional investors, of this proliferation of secondary transactions. For sponsors, such transactions may be attractive not only because they generate fees and income, but also because an exit will add to its investment track record. However, investors argue that these pass-the-parcel transactions deliver very limited or no return to those investors who hold interests in both the buyer and seller funds.

David Carter also points out that:

"Last year, the theory was that the banks were being pressed to dispose of non-core assets and were encouraging their customers to do the same. However, with the corporate divestments, low interest rates mean that those companies that were able to support their interest payments were likely to hold on to their assets. As for the banks, while there have been some disposals, the tsunami of assets entering into the market has not yet arrived."

With interest rates set to rise, coupled with the expected easing of the lending markets, 2011 might see a number of those non-core assets being offered to the market. Emma Danks also points out that, although the banks might look to off-load some assets acquired through often distressed debt-to-equity swaps, "the banks are themselves capable (although inadvertent) private equity owners and so fire sales are unlikely".

With private equity keen to invest, there may be a number of attractive opportunities for new, rather than more secondary, acquisitions. As Gavin Brown notes, "one has to think that there will be more first-time investments in 2011 - it would be depressing to think that there could be fewer".