Private equity in Australia: market and regulatory overview
A Q&A guide to private equity law in Australia.
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-guide.
IPOs. There has been a relatively high level of exit activity from private-equity backed IPOs, driven by a broader IPO appetite generally in Australia in the last year.
Fewer mid to upper market buyouts. As a result of the competition provided by the strong IPO market.
Private equity (PE) joint ventures. A rise in the number of material and high-profile PE joint ventures, such as the KKR, Varde, Deutsche Bank consortium to acquire GE's consumer loan book and Leighton Holdings and Apollo Global Management's operations and maintenance services joint venture.
Tough fund-raising market for domestic PE funds. Fund-raising continued to be difficult for the broader domestic PE funds resulting in a contraction of the number of domestic PE fund managers.
Increase in activity from offshore PE. An increased focus from international PE funds even if no physical presence in Australia (for example Apollo, Platinum and Bain).
Australian Private Equity and Venture Capital Association (AVCAL) has identified a 30% increase in private equity fund-raising in 2014 compared to 2013 (an increase from $720m to $933m), while this still falls below the ten-year annual average of $2.5bn.
Money was raised by only seven private equity (PE) funds, which is the lowest number since 2004, and the amount raised primarily reflects the close of a Quadrant PE fund worth $850m. The remainder of funds raised relate to niche growth funds and final closings of funds that has raised the majority of their commitments in the previous financial year.
Total private equity investment in 2014 was $1.96bn (the lowest since the 2005 financial year) with only 64 companies receiving investment (compared to 67 in 2013).
Large investments of more than $150m made up roughly a third of deal value (but only 3% of PE investments by number). Almost half of the total amount invested by private equity was made up of mid-market deals.
Of 208 PE investments made in 2014:
Buyouts accounted for 40%.
Expansion/growth investments accounted for 25%.
Late stage venture capital accounted for 15%.
Secondary purchase/ replacement capital accounted for 12%.
Seed, start-up and other early stage accounted for 4%.
Rescue/turnaround accounted for 2%.
According to AVCAL, there were 55 PE exits in 2014 representing the highest number in private equity exits in the last five years.
Of this number:
18 exits were effected by trade sale.
12 by way of IPO and by secondary sales.
A change in IPO trends saw more sponsors retaining a stake on listing and increased use of cornerstone investments in backing the IPOs.
The government has released a Board of Taxation report that recommended a suite of new collective investment vehicles (CIVs) to be introduced. However, the report recommended that CIVs should not have the ability to control an active business; consequently these reforms are unlikely to be used by domestic private equity (PE) funds.
Domestic PE funds are typically structured as unit trusts that qualify for the 'Managed Investment Trust' (MIT) regime. Proposed reforms will impact domestic PE funds in various ways, including:
A MIT being deemed to be a fixed trust which will provide certainty on distributing capital gains to foreign investors free of Australian tax (see Question 5).
MITs being prohibited from deriving 'non-arm's length income' from related parties.
The significant investor visa regime, which provides a fast track to permanent residency for individuals investing A$5m in Australia, has been amended so that at least A$500,000 (expected to increase to A$1m in 2017) must be invested in venture capital limited partnerships or early stage venture capital limited partnerships (see Question 5).
The international Base Erosion and Profit Shifting project is likely to impact PE funds in the areas of thin capitalisation, transfer pricing, treaty shopping and permanent establishments.
Finally, from 1 July 2016, any entity that acquires certain kinds of direct and indirect interests in Australian land and resource assets off-market from a foreign resident is required to pay 10% of the purchase price to the Australian Taxation Office (ATO).
The government is currently reviewing the legislative framework around crowd-sourced equity funding (CSEF). The latest consultation papers suggest that CSEF will be available for Australian public company fundraisers up to $5 million in a twelve-month period (including from retail investors, who may invest up to $10,000 per CSEF investment and $25,000 in aggregate within the same time-frame), but may not extend to proprietary companies, although consultations are still taking place. Draft legislation for public company CSEF is expected in late 2015.
Tax incentive schemes
Direct investments by foreign residents
Non-residents are subject to Australian tax on:
Australian sourced income, subject to the application of any relevant double tax treaty.
Capital gains made on the disposal of 'Taxable Australian Property', being either:
an asset used in carrying on a business in Australia through a 'permanent establishment'; or
an investment in Australian land or a 10% or greater investment in an Australian land rich entity.
The Australian Taxation Office's (ATO) position is that profits on the sale of assets held by private equity investors are generally taxed as income, and it takes an expansive view on what constitutes Australian source income. Accordingly, the key issue is whether benefits under a tax treaty that has been entered into by Australia apply.
Where treaty benefits apply, any gain must only be subject to tax if the gain is:
Attributable to an Australian permanent establishment.
Has an Australian source.
Where treaty benefits do not apply, any gain must be subject to Australian tax if it has an Australian source regardless of whether it is attributable to an Australian permanent establishment.
A private equity fund vehicle that is a limited partnership (LP) is generally treated as a company for Australian tax purposes; such that LPs located in a non-tax treaty country generally get no treaty benefits.
However, a partner of the LP will generally be eligible for tax treaty benefits provided that the:
Partner meets applicable tax treaty requirements.
LP is treated as tax-transparent in the partner's home jurisdiction.
This means that treaty benefits may apply to a proportionate part of the gain.
The ATO continues to focus on "treaty shopping", which occurs where entities in tax treaty countries are interposed between the private equity LP and the Australian investment for the dominant purpose of securing treaty benefits.
Managed Investment Trust (MIT)
A MIT is able to make an election such that shares, units, real property or options are only subject to the CGT provisions. This generally means that foreign investors in the MIT are only subject to Australian tax for MIT assets that are land or Australian land rich entities (see above). It also allows Australian investors to apply the CGT discount to distributions of gains made by the MIT.
The requirements for a MIT include:
The trust must be a managed investment scheme (MIS) for corporate law purposes.
The trustee must be an Australian resident, or be managed in Australia. The trust meets the 'widely held membership requirements' (generally requiring 25 members) and does not breach 'closely held tests'. Qualifying investors often insist on restrictions on membership of their trust to ensure the MIT status is not compromised.
The trust must not be carrying on a 'trading business' or control another entity that is carrying on a 'trading business', being a business other than investing in land primarily for the purpose, of deriving rent, and investing or trading in shares, units or other financial instruments. Domestic PE funds are often comprised of multiple trusts, and control of an investee via voting power or exercise of veto powers is usually split across the trusts comprising the fund, so that no one trust itself can be considered to control an investee.
Venture Capital Limited Partnerships (VCLPs) and Early Stage Venture Capital Limited Partnerships (ESVCLPs)
VCLP regime. A VCLP (a limited partnership) provides the following benefits:
Exempting certain classes of foreign investors from Australian tax on gains (both income and capital gains) on eligible investments held for at least 12 months.
Treating the carried interest of the general partner as being capital for tax purposes, allowing principals and executives of the general partner to be eligible for a 50% discount on tax on the carried interest.
To qualify as a VCLP and to be eligible for tax concessions, the limited partnership must:
Be unconditionally registered as a VCLP with government authorities.
Invest only in eligible investments or permitted investments (such as certain loans).
In order to be an eligible investment, several requirements must be satisfied, including:
Eligible investments include shares and units (together with options) in unlisted Australian entities with total assets of no more than A$250 million (or, if listed, it must de-list within 12 months).
The primary activity of the investee company or unit trust must not be:
property development or land ownership;
construction or acquisition of infrastructure and related facilities; or
investments directed towards deriving income in the nature of interest, rent, dividends, royalties or lease payments.
Due to these investment restrictions, mid-market funds are often comprised of a VCLP to make eligible investments and stapled MITs to make ineligible investments.
Unlike the MIT regime, a VCLP cannot elect to have its gains deemed to be a capital gain.
An ESVCLP (also a limited partnership) is targeted at early stage venture capital activity, and the key differences compared to a VCLP are as follows:
Australian and foreign investors are exempt from Australian tax on gains (both income and capital gains) on eligible investments held for at least 12 months.
Eligible investments are limited to entities with total assets of no more than A$50 million and must be divested once entity has assets exceeding A$250 million.
The committed capital cannot exceed $100m.
The ESVCLP cannot be structured as part of a bigger fund or attached to a unit trust.
Domestic based funds typically comprise several unit trusts that qualify as a managed investment trust, 'stapled' to a venture capital limited partnership for eligible investments.
Due to the limitations that apply to an early stage venture capital limited partnership (see Question 5), these are generally used solely for funds focussed on early stage venture capital (for example, seed and Series A rounds).
Unit trusts are tax transparent in relation to income (but not losses) provided the unit trust does not qualify as a public unit trust which controls a trading business (see Question 5). Where a unit trust is not transparent, it is taxed at the company tax rate of 30%.
A unit trust is required to withhold tax from distributions to foreign resident investors. Trusts that qualify as a MIT also benefit from a reduced rate on withholding on distributions of Australian sourced income or capital gains from Taxable Australian Property.
Venture Capital Limited Partnerships (VCLPs) and Early Stage Venture Capital Limited Partnerships (ESVCLPs)
A VCLP and ESVCLP are generally tax transparent.
Private equity funds in Australia raise a significant portion of their capital (often a majority, for any given fund) offshore and as a result generally follow global norms in terms of typical objectives, investment mandates and key fund terms.
Accordingly, buyout funds raised by established managers will typically have an investment objective of targeting majority positions in mature and stable companies generating positive cash flows and falling within a specified enterprise valuation range. These funds will typically target an annual internal rate of return of 25% or greater and a multiple of money of at least 2.0 times for any given investment.
The enterprise value mandate for any given fund is typically set at a level which will allow that fund to aim to make four to six investments during its term. These are typically ten-year funds with a five-year investment period. Fund mandates for local managers typically require a majority of investments to be made with the fund's primary target geography (for example, Australia and New Zealand, or Asia-Pacific) and will typically exclude certain types of investments (for example, property, resources, and early stage technology).
Expansion capital and venture funds typically have similar investment objectives to buyout funds, with the key difference being the targeting of a greater number of investments per fund (tending to range to six to eight deals per fund for expansion capital funds and up to eight to ten deals per fund for venture capital funds). Expansion and venture funds are also more likely to target minority or 50/50 deals (rather than requiring a control position).
A further key mandate difference for venture funds is that they will typically be free to invest in companies which may not yet have reached break-even, and in companies reliant on new technologies or upon continuing development of technologies or products.
Fund regulation and licensing
Yes. The activities of raising a private equity fund and operating a fund over time (including in making and selling investments) involve a range of activities which are classified under the Corporations Act 2001(Cth) as the conduct of a "financial services business" which attracts an obligation to hold an Australian Financial Services Licence (AFSL).
In a typical local private equity firm, the various fund vehicles will each be managed or advised by a single entity within the group which holds an AFSL authorising it to carry on those activities. The manager's licence will include authorisations for provision of general financial advice, arranging for issuance of units or other interests in the fund to investors and arranging for the acquisition and disposal by the fund entities of investments in target entities.
In addition, each fund entity which is structured as a trust will typically appoint an entity holding an appropriate AFSL to act as its custodian. This entity can be provided by a third party (for example, a provider of trust services) or it can be a second licensed group entity, typically holding an AFSL authorising it only to act as custodian.
Local private equity managers are typically licensed to deal only with wholesale investors. Separate licensing and other regulatory requirements apply to funds which might wish to deal with retail investors.
Where the manager entity holds an appropriate AFSL, individual executives, principals, promoters or employees of the private equity house are not required to be separately licensed. A small number of the key executives will be identified "responsible officers" under the manager's AFSL and will have responsibility for the manager's compliance with the conditions of its licence.
Private equity funds are regulated under the regime for the licensing of providers of financial services (see Question 10). They are not separately regulated as investment companies.
A typical private equity fund operating only in the wholesale market is not subject to the statutory disclosure regimes which apply to investment companies or financial institutions seeking to raise money from, or provide money to, retail investors. As a result, its private placement memoranda will neither be classified as either a "prospectus" (under the corporate fund raising rules), nor a "disclosure document" (under the equivalent rules governing trusts and other financial services institutions).
Similarly, trusts which are constituent entities in a private equity fund will usually be structured so as to be purely wholesale vehicles. On this basis they are not subject to the higher statutory corporate governance attaching to registered managed investment schemes under Chapter 5C of the Corporations Act.
There are no absolute restrictions on the identity or character of investors in private equity funds raised from Australia.
There are often tax or regulatory parameters attaching to the constituent entities of private equity funds which give rise to de facto restrictions on the type of investors who can participate in the asset class. Key drivers in this regard include the following:
Wholesale: as a practical matter, most (or perhaps all) private equity funds currently in operation in Australia target the wholesale market only. They will typically hold an Australian Financial Services Licence (AFSL) which allows them to deal only with wholesale clients (rather than retail clients) and will want managed investment schemes in their fund structures to be wholesale in nature, so that they are not governed by the retail investor type protections applying under Chapter 5C of the Corporations Act. Accordingly, investors in private equity funds are typically required to be wholesale in nature; broadly equating to institutional investors and high-net worth individuals. It is open to a private equity fund to target funds from retail investors, in which case these restrictions will not apply. In that instance, however, the manager will need to obtain an AFSL allowing it to deal with retail customers, each trust would need to be registered under Chapter 5C of the Corporations Act, and various additional disclosure and other regulatory requirements would apply.
AML / CTF: like most developed countries, Australia has extensive anti-money laundering and counter-terrorism financing laws. These rules will naturally rule out investors unable or unwilling to facilitate typical know-your-client and related checks.
Tax: constituent fund entities structured as trusts will typically wish to qualify as managed investment trusts (see Question 5).
Some private equity funds make use of venture capital limited partnerships or early stage venture capital limited partnerships, each being a form of limited partnership which must satisfy specific requirements under tax laws and is then afforded specific beneficial tax treatment (see Question 5).
These forms of partnership are each required to have a fund term of at least five years and not more than 15 years.
The industry generally has freedom of contract as to investment periods and the formulation of rules around transfers of investments in private equity funds.
Australian private equity (PE) managers now generally raise a majority of their funds offshore in the wholesale institutional limited partnerships market. Accordingly, the relationship between the investor and the fund is governed by fund documents which will typically comply with global market norms for funds of this kind.
A key local variance for Australian private equity funds is the level of complexity of fund structures. For most private equity houses, in light of their desired investment mandate and the makeup of their investor base, there is no single legal structure capable of functioning as a single-vehicle private equity fund (other than for very small venture capital funds, which may be able to use only a venture capital limited partnership or early stage venture capital limited partnership as their fund vehicle). As a result, the majority of larger venture funds and almost all expansion and buyout funds need to use multiple fund entities for each fund and as a result have significantly more complex fund structures than their offshore peers.
Key fund terms will almost invariably comply with global PE norms. Key investor protections typically sought will include the following:
Advisory Board: there will typically be an advisory board, comprised of representatives of the larger investors, with oversight of corporate governance matters and conflicts of interest.
'No fault divorce': a sufficient majority of investors will typically have the right to remove the manager without cause.
Removal for cause: a sufficient majority (often set at a lower percentage threshold than for no fault removal) of investors will have the right to remove the manager in the event of a default (for example, breach of the fund documents, insolvency and so on).
Clawback: investors will have the right to see a final calculation of carried interest entitlement performed on winding up of the fund, with the manager (and, in some cases, individual managers or their investment vehicles who have been the beneficiaries of carried interest distributions) to repay any excess distributions made during the life of the fund.
Other: the fund documents will contain various other standard investor protections, including:
carve-outs to the indemnification of the manager and its associates (for example, in cases of fraud, negligence or breach of duty);
extensive investor reporting requirements;
limitations on raising of new funds;
protocols for management of conflicts of interest;
suspension of the investment period in the event of loss of key investment professionals; and
express fiduciary-style duties imposed on the manager, and so on, as typical in the global wholesale market for closed-end private equity funds.
Interests in portfolio companies
Private equity funds commonly take equity and debt interests in their portfolio companies. The composition of interests is driven by several factors, including tax, the portfolio company's cash flows and its ability to service debt interest and the deal struck with management (including how the private equity fund intends to incentivise out-performance).
The most common forms of equity and debt interest are as follows:
Subordinated loans. In the portfolio company's capital structure, these loans will generally be unsecured and be subordinated to the portfolio company's senior and mezzanine debt (such as the debt used to fund the acquisition) and will ordinarily convert into ordinary equity at the fund's election (usually just prior to an exit event).
Coupon-bearing preferred equity. This equity will rank in priority to the ordinary equity and will convert into ordinary equity on an exit event.
Ordinary equity. This equity will usually sit pari passu with the equity given to the company's management team.
Less commonly seen instruments taken by private equity funds include warrants. These instruments, which are essentially options over unissued shares, are more commonly seen in special situation or "distressed" acquisitions where the fund may acquire the debt of the target company rather than its equity.
It is common for private equity sponsors to impose controls on the issuance or transfer of equity in portfolio controls. These controls are normally provided for in the portfolio company's governance documents. The key controls relate to:
Anti-dilution. To protect the private equity sponsor against equity dilution, the issuance of any new equity by the portfolio company will normally require the prior approval of the private equity fund's nominee directors. Private equity and non-private equity shareholders alike will also ordinarily have "pre-emptive" rights to participate in any new issues proportionately with their existing holdings.
Transferability. Outside of exit events (where the fund will often be able to force or "drag" the other shareholders into the transaction), transfers of equity by non-sponsor shareholders are usually restricted.
In a private company context, the key restrictions on the issuance and transfer of equity are contractually agreed between the shareholders and the company at the time of the sponsors investment. In addition to the contractually agreed restrictions on the transfer or issuance of shares agreed contractually, several general legal restrictions operate on the transfers or issuance of shares, including foreign investment approval requirements and anti-trust / competition rules.
For listed companies and unlisted companies with more than 50 shareholders, additional restrictions apply. In particular, restrictions apply on the circumstances in which an entity may acquire more than 20% of the shares in an Australian public company and there are restrictions on related party transactions involving shareholders in Australian public companies.
Withholding taxes for foreign investors
The rate of withholding will depend on whether the interest is classified as debt or equity for tax purposes. It is possible for legal form equity (such as redeemable preference shares) to be classified as debt for tax purposes, and for legal form debt (such as a profit participating loan) to be classified as equity for tax purposes.
Distributions on tax equity is subject to dividend withholding tax unless the company has paid Australian tax on the profits that are being distributed (referred to as imputation). The rate of withholding is 30%, but can be reduced to between 0 to 15% under an Australian tax treaty.
Distributions on tax debt is subject to 10% interest withholding tax. An exemption can apply for:
Debt offered to the public (other than associates of the company).
Foreign tax exempt pension funds.
Sovereign wealth funds.
If the fund does invest in 'Taxable Australian Property' then the rate of withholding will depend on whether or not the fund entity qualifies as an MIT.
For managed investment schemes the rate of withholding is 15% to investors in countries with which Australia has an exchange of information agreement or 30% for investors in other countries.
It is common for buyouts of private companies to take place by (or initially start off as) an auction or 'competitive bid' process where a company is advertised for sale by its owners.
In these processes, the owners will ordinarily instruct their commercial advisers (often an investment bank) to solicit as many bids as possible. After all of the bids are received, it is customary for the owners to then run a small group of bidders 'head to head' or enter into an exclusivity arrangement with the preferred bidder for a specific period of time. In this second category, if an agreement consummating the buyout isn't signed before the end of the exclusivity period, the owners of the company will be free to re-engage with other bidders.
In terms of legislation and rules, the sale of a private company (whether by a competitive bid process or otherwise) does not attract the same level of legal process as a sale of a public or listed company. However, some material corporate and commercial laws are relevant including foreign investment approval requirements and anti-trust / competition rules.
Buyouts of listed Australian companies are relatively common. Major transactions in the past few years have included:
A$12 billion proposed acquisition of Asciano Limited by a consortium led by Brookfield Infrastructure, by a scheme of arrangement (deal announced in August 2015 and due to be completed in December 2015).
A$6.5 billion scheme of arrangement pursuant to which Japan Post Holdings Co., Ltd acquired Toll Holdings Limited (transaction completed in May 2015).
A$2.37 billion acquisition of Australian Gas Networks Limited (formerly Envestra) by Cheung Kong Infrastructure consortium (September 2014).
A$2.2 billion takeover of David Jones Limited by Woolworths Holdings Limited (July 2014).
Buyouts of listed Australian companies are regulated by Chapter 6 of the Corporations Act 2001 (Cth) and the transactions generally proceed through either an off-market or on-market takeover bid or through a shareholder and court approved scheme of arrangement (only appropriate for non-hostile acquisitions).
Adoption of a takeover bid or a scheme of arrangement depends on the commercial context, circumstances and client objectives. The consideration payable for takeover bids or schemes of arrangement may be either cash, scrip (shares) or a combination of both.
The documents applicable to a buyout will vary depending on the nature of the transaction, but can be broadly divided into public transactions (takeovers and schemes) and private transactions (all other forms of buyout).
Key documentation includes:
Sale and purchase agreement: the primary acquisition document.
Subscription agreement: for the issue of equity securities as part of the buyout.
Governance documents: the constitution and shareholders agreement, regulating the company's operations and governance (and potentially including the rights attaching to different classes of share).
Management equity participation documents: the terms on which equity is issued to management as part of the alignment / incentivisation structure.
Financing documentation: the terms of external debt finance to the company, potentially including senior and mezzanine debt financing, inter-creditor arrangements and security over the target's assets.
Shareholder loans: the terms of loans granted by shareholders to the company (if applicable).
The core documents prepared for a takeover include:
Pre-bid acceptance agreement: entered into by the bidder and one or more target shareholders to sell their shares or accept the takeover bid.
Subscription agreement: between the parent company of the bidding vehicle, where the parent agrees to provide funds to the bidding vehicle to pay for takeover acceptances.
Bid implementation agreement (for friendly bids): the terms governing the implementation of the takeover bid.
Bidder's statement and target's statement: regulated documents in respect of the bidder's offer and the target company's response (including director recommendations).
The core documents for a scheme include:
Confidentiality agreement (entered into between the bidder and the target).
Scheme implementation agreement: entered into between the bidder and the target, setting out among other things, the key principles relating to the scheme, including break fee arrangements, 'no shop and no talk arrangements', notification obligations and rights to match.
Option agreement/voting arrangements with individual target shareholders.
Scheme booklet: setting out scheme disclosures to target shareholders.
Scheme of arrangement: notice of meeting of shareholders and explanatory memorandum.
Deed poll: binding the acquiring company to the scheme of arrangement.
Private equity buyers typically require the sale agreement to include:
A comprehensive set of seller warranties.
Indemnities from the sellers in respect of breach of warranties, taxation and other specific indemnities on a case by case basis
A restraint on the sellers from competing with the business of the target for a specified period of time and within a specified geographic area.
The warranties and indemnities given by the sellers will sometimes be supported by a warranty and indemnity insurance policy.
To the extent that managers of the target are sellers, they will provide the warranties and indemnities under the sale agreement in their capacity as sellers. However, if certain key managers are not sellers and are remaining in the business, a private equity buyer may seek a more limited set of warranties from those managers in respect of the target's business. It is also common for private equity buyers to require key managers to sign up to new employment agreements on terms acceptable to the buyer and which contain additional buyer protections.
In the context of a buy-out of a listed company, the implementation documentation for the scheme of arrangement or takeover will usually include warranties given by the target in respect of the target's business. If such warranties are breached in the period between signing and completion, this will give rise to a termination right in favour of the buyer.
If managers are also directors of the portfolio company, then they will owe directors duties to the portfolio company. Such duties include the duty:
To act with reasonable care and diligence.
To act honestly and in good faith in the best interests of the portfolio company and for a proper purpose.
To avoid actual and potential conflicts of interest.
Not to improperly use their position as a director, or information obtained in their position as a director, to gain an advantage for themselves or someone else or to cause detriment to the portfolio company.
Employees of a portfolio company (whether they are directors or not) also have certain duties owed to their employer, regardless of the content of their employment contract. Such duties include the:
Duty to refrain from misusing confidential information of the employer during and after termination of the employee's employment.
Duty to work with care and diligence.
Duty to act honestly and in good faith.
Duty to obey lawful and reasonable directions of the employer.
As part of an acquisition, private equity buyers typically require that key managers of the portfolio company sign up to new employment agreements containing certain protections in favour of the private equity buyer.
Examples of such protections include:
Restraints: post-employment restraints (applicable for a specified period of time and within a specified geographical area) that are designed to protect the employer if a manager leaves the business by prohibiting the ex-manager from competing with the employer or soliciting customers, suppliers or employees of the employer.
Notice period: lengthy notice periods that are intended to ensure managers cannot depart from employment on short notice to join another business (note however that the notice period is typically symmetrical so that each party will need to give the same period of notice prior to termination).
Intellectual property: an express provision that all intellectual property created during the employment of the employee will be owned by the employer.
Confidentiality: more substantive confidentiality obligations owed by the employee than what would otherwise be owed under common law.
Incentives: short term incentives (for example, bonuses) and long term incentives which are forfeited on cessation of employment.
The types of control protections sought by a private equity buyer will usually depend on the level of its shareholding in the portfolio company, as the degree of control is normally reflective of its shareholding. Control protections therefore differ depending on whether the private equity buyer is a majority shareholder (in which case it would seek to unilaterally control the day-to-day activities of the portfolio company) or if the private equity buyer has a minority interest (in which case it would seek negative control rights).
Assuming the private equity fund is a majority shareholder, the most common form of protection is control of the business through its shareholders and board voting rights and a requirement for key decisions to be taken at board or shareholder level (as appropriate).
Although private equity buyer protections can be included in the constitution of the portfolio company, it is more common for the shareholders' agreement of a portfolio company to contain such protections. The portfolio company is usually a party to the shareholders' agreement, and the terms of the shareholders' agreement will prevail to the extent of any inconsistency between it and the constitution.
In the Australian market, acquisitions are typically 50 to 60% debt funded.
The majority of debt capacity in the market is provided by domestic banks. There are also sizeable contributions from international investment banks and Japanese and European banks. Non-bank financial institutions make up the remainder of the debt market and are increasingly looking to become more active in the market. Debt liquidity is currently exceptionally strong.
Acquisition debt will usually be in the form of senior secured term loan facilities with a maturity date of between three to five years. Typically up to 30% of the term loan will be amortising debt with the remainder repayable on maturity. A revolving facility will commonly be included to provide working capital for the target group.
Historically, an acquisition debt package often included subordinated 'mezzanine' term loans which are priced higher and have a longer maturity date than senior debt. Mezzanine loans have become less common in the last couple of years given the high levels of senior debt liquidity coupled with record low pricing and other market dynamics.
Another style of financing increasingly adopted by sponsors is the use of 'holdco PIK' debt to replace some of their equity contribution with debt at the holdco level. Under this structure, debt is provided to a holding company above the senior lender borrowing group and injected into the bid vehicle. This structurally subordinated debt will not have the benefit of guarantees or security from the guarantors of the senior debt. It relies on distributions by the bid vehicle for repayment.
Thin capitalisation rules will also be relevant when considering the appropriate level of debt in the group.
Over the last 18 months, there have also been a small number of acquisitions funded through the US term loan B market.
Senior and subordinated debt provided in an acquisition finance will be guaranteed by members of the target group.
The obligations will be secured by a security package. Where there is more than one lender, the security is usually granted to a security trustee who holds the security for the secured creditors. The security package will usually comprise security over all of the assets of the bid vehicle and certain target group members. Often the security package will also include security over the shares in the bid vehicle and possibly the other assets of any holding company of the bid vehicle.
Contractual and structural mechanisms
Loan agreements will contain contractual protections in the form of representations and warranties, positive and negative undertakings, financial undertakings and events of default. Any breach by the borrower group will generally entitle lenders to accelerate their debt and enforce their security. The list of representations and warranties, undertakings and events of default in an acquisition finance facility will usually be more onerous for the borrower group than a typical corporate finance facility..
If the funding structure includes subordinated debt, the senior lenders and subordinated lenders (as well as the borrower and the guarantors) will enter into an inter-creditor agreement to govern the terms relating to permitted payments of debt obligations, priority of debt and the respective rights and obligations of the different class of lenders to each other.
The Corporations Act prohibits a company providing financial assistance to a person to acquire shares in the company or any of its holding companies except in limited circumstances. Therefore, the grant of guarantees and security by any target company to secure the financing for the acquisition will be prohibited unless one of the exceptions applies.
The provision of financial assistance is permitted if one of the following circumstances applies:
The giving of the financial assistance does not materially prejudice:
the interests of the company or its shareholders; or
the company's ability to pay its creditors.
The assistance is approved by shareholders of the company and shareholders of the company's ultimate Australian holding company under section 260B of the Corporations Act.
The financial assistance is exempted under section 260C of the Corporations Act.
In the context of acquisition financing, usually the second exemption, known as a "whitewash procedure", will be utilised to enable target companies to grant guarantees and security securing the financing for the acquisition. The shareholder approvals and lodgement with ASIC of notice that approval has occurred must be done at least 14 days before the giving of the financial assistance. Lenders will therefore usually provide a period for this process and the financial assistance to be provided after financial close (typically 28 to 35 days).
On liquidation, the liquidator will wind up the company and apply the assets to satisfy the company's liabilities. Any surplus will be distributed to the shareholders.
Assets will generally be applied in the following order:
Payment of any costs in connection with realising assets.
Payment to secured creditors except to the extent of the proceeds of secured circulating assets.
Payment of employee entitlements.
Payment to secured creditors of the proceeds of secured circulating assets to the extent not applied above.
Payment to unsecured creditors.
Remainder to shareholders.
Some exceptions to this waterfall apply including:
For certain payments to third parties having the benefit of a contract of insurance or reinsurance, such claims have absolute priority over all creditors other than secured creditors for non-circulating assets and the liquidator/receiver for the costs of recovery.
Liquidators/administrators' costs where the assets are realised by a receiver. These would rank before employee entitlements (except where employees have priority over circulating assets).
Funds advanced to pay employees prior to the liquidation which have the same priority as the amounts paid would have had if owed to the employees in the liquidation.
It is rare for financiers to require or for borrowers to agree to the issue of warrants, options or other convertible instruments. However, in deals involving subordinated debt to be provided by non-bank financiers, these instruments are sometimes included to provide the debt provider with equity appreciation.
Portfolio company management
Most private equity investments involve key managers of the portfolio company becoming shareholders in the portfolio company. This is intended to align the interests of the private equity buyer and the managers in respect of the economic performance of the portfolio company. Although the structure of the investment by managers will vary on a case by case basis, common structures used by private equity buyers are as follows:
Options: Managers can be granted options (often with a zero strike-price) over unissued shares in the portfolio company, with such options to automatically vest and convert to shares in the portfolio company on the occurrence of certain events. Options will usually be service-based, performance-based, or a mixture of both.
Shares: Managers can be given the opportunity to directly subscribe for shares in the portfolio company, and such shares may be a different class of share (with different rights) to those held by the private equity buyer. It is common for the subscription price for such shares to be funded by way of a mixture of the manager's personal funds and a limited-recourse loan from the portfolio company.
Phantom schemes: Managers can be offered participation in a cash bonus arrangement under which the amount of the bonus payable to the manger is determined by reference to the increase in value of the shares in the portfolio company.
Shares and options granted for less than their market value are subject to the employee share scheme (ESS) provisions, which generally result in the manager's gain being taxed as income rather than as a capital gain. The taxing point under the ESS provisions is either when the shares or options are granted, or on a deferred basis (such as when vesting or exercise occurs).
From 1 July 2015:
Tax will be generally deferred for qualifying options until exercise rather than vesting.
To qualify for deferral:
options will no longer be required to be subject to a 'real risk of forfeiture' at grant; and
an employee can hold up to 10% of the ownership interests in the employer, up from 5%.
The maximum deferral period will be extended from 7 to 15 years from grant.
Further concessions have been provided for start-ups.
If the ESS provisions do not apply a gain made by a manager may be eligible for the 50% CGT discount. The provision of a loan to the manager to acquire shares at market value or issuing options 'out of the money' may result in the ESS provisions not applying.
An Australian company may be restricted from making payment of dividends or interest payments (or similar) to its investors by the terms of its:
The Corporations Act 2001 (Cth) (Corporations Act) specifies the circumstances in which a dividend may be paid. The Corporations Act states that a company must not pay a dividend unless each of the following requirements is satisfied:
The company's assets exceed its liabilities immediately before the dividend is declared and the excess is sufficient for the payment of the dividend.
The payment of the dividend is fair and reasonable to the company's shareholders as a whole.
The payment of the dividend does not materially prejudice the company's ability to pay its creditors.
It is increasingly common for transaction due diligence to include anti-corruption / anti-bribery enquiries and for transaction documents to include specific anti-corruption / anti-bribery warranties that cover both domestic and international compliance (for example, the Foreign Corrupt Practices Act and the UK Bribery Act).
Bribery and corruption is prohibited under a range of Australian federal, state and territory laws, including the Commonwealth Criminal Code and state and territory Crimes Acts. Directors can have exposure under those laws where they had knowledge of or involvement in the company or agent's conduct. The penalties for breach involve either imprisonment and/or fines. For example, the penalties for bribery of a foreign or Commonwealth public official are, in the case of individuals, imprisonment for up to 10 years and/or a fine of $1.8 million, and in the case of companies, the greater of $18 million, 3 times the value of the benefit obtained, or 10% of the companies' annual turnover in the previous 12 months.
Forms of exit
The most common forms of exit are:
Trade sale. Sale of the investor's interest in the portfolio company or the business of the portfolio company to a third party (often one operating in the same industry as the company). A trade sale often provides the advantage of a clean exit for cash consideration. The disadvantages include problematic due diligence processes with vendors reluctant to disclose commercially confidential information to competitors and also, depending on the nature of the target's market and the combined market shares of the target and acquirer, it is possible a sale could encounter anti-trust / competition regulatory issues.
Initial Public Offering (IPO). Listing of the company's shares on a stock exchange so that shares can be sold to the public and institutional investors. In recent times, the strong Australian IPO market has offered private equity funds relatively high returns (as compared to the trade sale / secondary markets). On the downside, IPOs do not currently offer private equity a clean exit as the market requires vendors to have 'skin in the game' and retain a material stake under subject to escrow conditions for a period post IPO.
Secondary buyouts. Sale of the investor's interest in the company to another private equity investor. Secondary sales can often be transacted more quickly and cost effectively than IPOs and trade sales and anti-trust / competition issues are less common.
In an unsuccessful but solvent portfolio company, a private equity fund can exit its investment by selling its shares in the portfolio company (possibly at a loss), redeeming its preference shares, facilitating repayment of its shareholder loans or a combination of these actions. In a distressed portfolio company, the ability of the private equity fund to redeem preference shares or be repaid shareholder loans is likely to be restricted if the senior debt of the portfolio company remains outstanding.
In circumstances where a distressed portfolio company has solvency issues so that it cannot pay its debts as and when they fall due, the private equity fund may put the company into administration or pursue a voluntary liquidation. In circumstances where the portfolio company is solvent but distressed, there have been examples of private equity funds 'exiting' through debtor controls transactions some of which can leave the private equity funds with a small residual equity interest (for example, consensual debt for equity swaps, creditors' schemes of arrangement or s444GA orders under a deed of company arrangement).
Private equity/venture capital associations
Australian Private Equity & Venture Capital Association (AVCAL)
Status. AVCAL is a national association which represents the private equity and venture capital industries. These firms provide capital for early stage companies, later stage expansion capital, and capital for management buyouts of established companies.
Membership. AVCAL's members comprise most of the active private equity and venture capital firms in Australia.
Principal activities. AVCAL's objective is to facilitate an environment where private equity and venture capital can flourish, through advocating on behalf of the industry and providing members with skills and networks.
Published guidelines and information sources. See www.avcal.com.au.
Australasian Legal Information Institute
Description. The Australian Legal Information Institute is a joint facility of UTS and UNSW Faculties of Law providing, among other things, a database of reported cases and legislation.
Mark Currell, Partner
Herbert Smith Freehills
Professional qualifications. New South Wales solicitor 2005, England and Wales solicitor 2000, Master of Applied Finance (FINSIA) 2008
Areas of practice. Private equity, mergers and acquisitions, special situations, distressed debt.
- Blackstone: on it $2 billion acquisition of GE's real estate portfolio.
- Element Financial: in its acquisition of GE's $2 billion Australian and NZ vehicle and equipment leasing business.
- KKR: on its $80 million investment in Keystone Group and the related takeover of Pacific Restaurant Group.
- CHAMP Private Equity: on the $200m sale of LCR to Archer Capital.
Hayley Neilson, Partner
Herbert Smith Freehills
Professional qualifications. New South Wales solicitor, England and Wales solicitor
Areas of practice. Acquisition and leveraged finance, restructuring and corporate finance.
TPG Capital in relation to financing of the acquisition of Ingham Enterprises and the subsequent sale and leaseback of certain properties and re-capitalisation of Inghams Enterprises.
Greencross Limited in relation to financing of its acquisition of the City Farmers Group.
Leighton Holdings Limited in relation to the financing for the joint venture between Apollo Global Management and Leighton of Leighton's business services division
Pacific Equity Partners in relation to its joint venture with SCA, a Sweden-based global consumer goods company, and the financing for the joint venture group and the subsequent re-capitalisation and subsequent IPO financing.
Cameron Blackwood, Director
Herbert Smith Freehills
Professional qualifications. Bachelor of Business (Hons) and Bachelor of Laws (Hons) from the University of Technology, Sydney, and a Master of Taxation from the University of Sydney. Admitted as a solicitor in New South Wales
Areas of practice. Mergers and acquisitions, employee share schemes, private equity.