Fundamentals of Private

Equity Deal Structuring

Laura O’Neill
Partner
SJ Berwin LLP
27 February 2009

CP3:804204.1
 Contents
The main players
The classic buyout structure
Equity finance
Debt finance
The principal legal documents
Equity documents - the main points to consider
The main players (1)

Sellers/existing shareholders
The main players (2)

Bank/Debt provider
The main players (3)

Private Equity house

The main players (4)

Management
The main players (5)

Accountants, financial, tax and other advisers

The main players (6)

and finally….the lawyers

 The classic MBO structure
Management
Investor eg 85% eg 15%
Ordinary Topco Ltd Ordinary shares
shares (Investment vehicle) (“sweet equity”)
Shareholder
debt Inter-company
loan

£ Price
Newco Ltd Vendor
Banks Senior/ (Purchasing and debt vehicle)
mezzanine Shares
debt

Target
Equity finance (1)
• subscription for ordinary shares by:
– PE house/Investor
– Management - incentive to make business succeed (‘sweet equity’)
(ranks behind all other debt and equity)
• further funds invested:
– usually by way of loan notes or preference shares
– give Investor a preferred right to income and to capital on a winding
up but unsecured and subordinated to bank debt
– form the majority of Investor’s equity contribution
– interest rolls up or “PIK” notes used
– no payments during term of the notes - return back-ended
Equity finance (2)
• What is sweet equity?
– say Management cut a deal with Investor whereby Investor will
acquire the target for £100 million and Management will have 20%
equity in the buy out vehicle
– all things being equal Management will have to pay £20 million for
their 20% stake
– however, with leverage of, say, £60 million, the equity requirement
is £40 million, hence Management need to provide £8 million but
Management is unlikely to have this sort of money
– so Investor provides the majority of the equity requirement in the
form of “quasi-equity” (loan notes or preferred shares) - in this
example say £39 million with the balance of £800,000 in the form of
ordinary shares (the real equity)
– Management, therefore, only needs to subscribe £200,000 for 20%
of the ordinary shares to entitle it to 20% of any upside
Debt finance (1)
• Usually forms largest part of required funding
• 2 sources of this debt: “senior debt” and “junior debt”
• Senior debt
– so called because it ranks ahead of all other debt of Newco group
– often divided into two types of facility being:
(1) term facility
– to finance the acquisition and associated costs and expenses
– also to refinance existing Target indebtedness
– sometimes a capex facility will be put in place to fund large
ongoing capital costs
(2) revolving credit facility
– to fund ongoing working capital needs of the business
– larger transactions will be syndicated (i.e. underwriting banks will
sell part of commitment to participant banks to reduce balance
sheet exposure)
Debt finance (2)
• Junior debt
– so called because it occupies a position between debt and equity
– subordinated (junior) to the senior debt but will usually receive interest
payments (provided no major event of default occurs)
– generally shares the senior security, but on a second ranking basis
– sometimes attaches warrants giving lenders the right to shares in
Topco
– warrants allow mezz provider to share in increase in value of equity of
Target group and provide higher return on investment to compensate
for subordinated nature of debt
Debt finance (3)
• How does leverage work?
– say a business has an enterprise value (EV) of £100 million - without
any leverage it will cost Investor £100 million
– if it is then sold a year later for £120 million, a £100 million investment
has generated a £20 million profit (i.e. a 20% profit)
– if, however, Investor used debt of £80 million to buy the business then
business has only cost it £20 million
– hence selling the business a year later for £120 million generates a net
return of £40 million – a £20 million investment has generated a £40
million profit or a return of 2 x the original £20 million investment (or a
200% profit)
The principal legal documents (1)
• A buyout essentially involves 3 separate processes/transactions:
– the acquisition
– between Newco and Sellers for acquisition of Target
– the equity arrangements
– deal between Investor and Management
– debt finance
– between Newco and banks/providers of finance for acquisition of
Target/working capital etc.
The principal legal documents (2)
• Acquisition documents
– Sale and Purchase Agreement (‘SPA’)
– contains the terms of the sale whether it is of shares, assets or a
business
– Disclosure Letter
– will contain disclosures against the warranties in the SPA
– Tax Deed
– trade mark/trade name licences
– property documents/transfers
– transitional service agreements
The principal legal documents (3)
• Equity documents
– Investment Agreement (aka Subscription and Shareholders
Agreement)
– governs relationship between Management and Investor, contains
equity and shareholder debt subscription mechanics, Investor rights,
Management obligations and restrictions and provisions governing
operation of business going forward and “exit”
– new Topco Articles
– provisions controlling the constitution and share capital of Topco,
including dividend rights, transfer restrictions and good leaver/bad
leaver provisions
– shareholder debt instrument
– constitutes shareholder debt (loan notes, deep discount bonds, PIK)
which forms majority of equity funding

– new Service Agreements for Management

The principal legal documents (4)
• Finance Documents
– Senior Finance Agreement (‘SFA’)
– contains terms on which senior lenders will advance funds and
restrictions on operation of Target going forward and ability of Investor
to extract cash from the business
– Mezzanine Finance Agreement (‘MFA’)
– broadly mirrors terms of SFA with minor changes (e.g. increased
pricing and weaker financial covenants - 10% extra headroom)
– security agreements
– details what security is taken over what assets (eg. debentures
(incorporating fixed and floating charges) from Newco and guarantees
from Target/subsidiaries guaranteeing Newco’s borrowings)
– Intercreditor Agreement
– details the ranking between lenders (senior and mezz) as well as loan
note holders of Investor and any preferred equity
Equity documents – main points to
consider
• Warranties
• Board representation
• Default/swamping rights
• Vetoes/consent matters
• Information rights
• Drag-along/tag along
• Restrictive covenants
• Leaver provisions
• Share transfers
• Ratchets
Warranties (1)
Warranties (2)
• Contractual statements by Management, confirming accuracy of
position/events
• Primarily to focus Management’s mind and force disclosure
• Management can be sued if inaccurate
• Covers matters such as:
– business plan properly and diligently prepared/reasonableness of
assumptions
– accuracy of due diligence reports
– personal information, including other business activities, financial
background, no criminal record, no pending litigation etc.
– no breach of the SPA (in particular Seller warranties)
• Contentious issues include scope, financial thresholds and caps,
and whether joint and several or several and proportionate liability
Board representation (1)
Board representation (2)
• Investor director(s)
– entrenched rights with “fast-track” appointment/removal procedures
• Observer(s)
• Notice of meetings, quorum, blocking vote
• Committees: Remuneration, Audit, Nominations, others
• Boards of subsidiaries
• Directors’ fee
• Chairman
Default/Swamping rights (1)
Default/swamping rights (2)
• Enables Investor to ‘step in’ and take voting control if Topco
underperforms
• Board and/or shareholder level
• Triggered by defaults, e.g. banking covenants about to be
breached, failure to pay loan stock interest, failure to hit budget,
bad behaviour etc.
• Contentious issues include materiality, remedy period, duration,
and whether and when they lapse
Vetoes/consent matters (1)
Vetoes/consent matters (2)
• Management essentially have day-to-day control of Target but
important decisions require “Investor consents”
• Cover trading matters such as:
– entering into material contracts – hiring/firing
– pursuing litigation – major leases
– major capex – disposing of
business/major assets

• Cover structural matters such as:

– issuing shares – buying-back shares
– raising finance – reconstructions
– paying dividends – share transfers
– exit
Information rights (1)
Information rights (2)
• Monthly Management accounts
• Minutes of each board meeting held
• Projected cashflows & P&L
• Testing against banking covenants
• Audited accounts
• Annual business plan & budget
• Rights of inspection/audit
Drag-along/tag along (1)
Drag-along/tag along (2)
• Drag-along:
– ability for Investor to enforce sale of whole
– all other shareholders have to sell at same time
– usually on same terms and at same price unless there are different
classes of shares with different orders of priority on an exit
– often a moratorium for initial period, say two years
– sometimes a right for Management to match any offer received by
Investor
• Tag-along:
– right for minority shareholders to block a transfer unless they are also
given an opportunity to exit on the same terms
– should not catch permitted transfers (e.g. syndication and intra-group)
• Should not catch permitted transfers (e.g. syndication and intra-
group)
Restrictive covenants (1)
Restrictive covenants (2)
• Protective undertakings covering:
– non-compete
– no poaching of staff, customers, suppliers
– confidentiality
– no ‘bad mouthing’
– use of business names
• Contentious issues include duration, territories, scope and carve
outs for existing interests
Good leaver provisions (1)
Good leaver provisions (2)
• Where a manager ceases to be employee/director – what happens
to his/her shares?
• Usually bought back/sold – if “good leaver” then typically get higher
of price paid/fair market value
• “Good Leaver” = death, permanent illness/disability, if Investor
agrees
• Others may include – unlawful termination, resignation after ‘x’
years service
• Vesting of shares as time passes, e.g.
– ⅓ after year 1, ⅔ after year 2, rest after year 3
– once vested, shares not subject to good leaver/bad leaver provisions
Bad leaver provisions (1)
Bad leaver provisions (2)
• “Bad leaver” = typically “if not a Good Leaver” or gross misconduct,
voluntary resignation, breach of restrictive covenants
• Price would be lower of subscription price paid or fair market value
Share transfers
• General prohibition unless it triggers drag-along/tag-along rights
• Investor’s right to syndicate and/or transfer to other funds
• Permitted transfers, i.e. to family trusts, privileged relations or other
funds or with Investor’s consent
• Otherwise pre-emption rights apply
• Deed of adherence to investment agreement
Ratchet
• Increases Management’s equity if certain performance criteria are
met
• Performance criteria usually based on a realisation (target
IRR/minimum multiple based return eg. 2.5 times) but can follow
targets such as EBIT
• Part of Investor’s preferred shareholding converts into worthless
deferred shares
• Means of bridging the commercial gap between Management
optimism and Investor conservatism