Many passive co-investments involve a syndication by the sponsor's primary fund of its interest of a target company in the period either after signing the M&A agreement or after closing the M&A transaction.
However, as the average size of private equity-led buyouts increases (due in part to the rise of mega-deals), sponsors are looking for commitments earlier in the transaction process in order to pay larger purchase prices. Sponsors are therefore increasingly approaching co-investors before the transaction is signed, asking them to commit to funding the transaction through an equity commitment letter (ECL) in favour of either the sponsor or the buyer, which is then enforceable by the seller1.
Co-investors who commit pre-signing, particularly in the auction context, are exposed to increased deal risk and are often required to agree to fund broken deal expenses and a reverse termination fee. In exchange, sponsors will give these co-investors more frequent and increased co-invest allocations and sometimes preferable co-invest terms and governance rights beyond what is available in a typical passive co-investment. However, committing pre-signing introduces several issues for co-investors to consider, which we will explore below.
Form of equity commitment letter
Co-investors committing pre-signing may be required to either enter into an ECL with the sponsor or directly with the buyer, which is then enforceable by the seller. Often, to avoid negotiating an ECL with multiple parties, the seller will prefer a single ECL from the sponsor for the full sponsor equity check, including the expected co-investors' commitments. The sponsor will then negotiate a separate ECL from each co-investor, the terms of which often mirror those negotiated by the sponsor in its ECL for the full sponsor equity check. Co-investors should ensure that the funding obligations and conditions in their ECL with the sponsor align with the funding obligations and conditions of the sponsor in its ECL for the full sponsor equity check so that there is never a situation where the co-investor is obligated to fund under its ECL but the sponsor is not in turn obligated to fund under its ECL.
Fund investors are increasingly sensitive to bearing prospective co-investors' allocable share of broken deal expenses.
This "back-to-back" construct allows co-investors greater scope to negotiate conditionality to funding that is specific to co-investors, as outlined below. Sellers will often resist this conditionality as an internal matter to be dealt with between the sponsor and its co-investors, particularly in an auction context where co-investor-specific provisions in the ECL may make a bid less competitive. In cases where the co-investors sign an ECL that is enforceable by the seller and are unable to include the co-investor-specific provisions outlined below, co-investors can address the relevant issues in another agreement with the sponsor, such as an interim investors agreement.
Broken deal expenses and termination fees
A sponsor may require co-investors committing pre-signing to bear their pro rata share of all fees, costs and expenses incurred by the sponsor if the potential transaction is not consummated. The obligation to bear broken deal expenses may be set out in an interim investors agreement, a cost-sharing agreement or other agreement between the co-investors and the sponsor rather than in the ECL itself. Co-investors may resist the obligation to bear broken deal expenses altogether or ask that their share of broken deal expenses be capped so they know their maximum exposure when getting investment committee approvals. Co-investors may also request a budget and estimates of expenses as of the date of signing the cost-sharing agreement. A further request that co-investors may make as a trade-off for taking on liability for broken deal expenses is if the transaction is consummated then all or a portion of the co-investors' expenses will be paid by the target.
Broken deal expenses may instead be borne solely by the sponsor's primary fund with co-investors having no liability for these expenses. However, fund investors are increasingly sensitive to bearing prospective co-investors' allocable share of broken deal expenses and may negotiate a requirement in the sponsor's primary fund LPA that the primary fund require co-investors to bear such costs where an ECL or other similar binding agreement has been entered into.
Where the sponsor has agreed to a reverse termination fee, co-investors who commit pre-signing may be required to contribute their pro rata share of such fee and may be required to enter into a limited guaranty to support the payment of such fee.
There are several protections that co-investors should consider including if they agree to bear their share of a reverse termination fee. To avoid liability for the fee in circumstances where a co-investor is ready, willing and able to fund its commitment at closing, the co-investor may request that the sponsor bear the full amount of the reverse termination fee if it is triggered because of an action or omission by the sponsor. Likewise, a co-investor may request that it not have any liability where the reverse termination fee is triggered by failure of one or more other co-investors to fund their respective commitments when required. In those cases, either the sponsor agrees to bear the portion of the reverse termination fee attributable to the non-breaching co-investors or the breaching co-investors are required to bear the entire reverse termination fee. Co-investors often resist the latter construct as it could result in them bearing a reverse termination fee that is out of proportion to, or even larger than, their equity commitment.
The decision to bring co-investors into the transaction is often made at the last minute, and this compressed timeline can put significant pressure on co-investors.
Where co-investors agree to pay a reverse termination fee, as a quid pro quo they should consider requiring that they will share pro rata in any termination fee paid by the target to the sponsor (e.g., in the context of an acquisition of a public company, where the target shareholders vote down the transaction or the target board withdraws its recommendation to support the transaction). Sponsors are typically amenable to this request. A co-investor may also request that if it is to share in the burden of any reverse termination fee, then it will share in the benefit of any transaction fee, monitoring fee or other similar fee that the sponsor takes from the target, although sponsors grant this request less frequently.
Equity commitment and conditions to funding
A co-investor should ensure that its ECL states the co-investor will not be required to contribute any amount in excess of its equity commitment as set forth in the ECL and that its equity commitment will be used solely for the purposes of financing the acquisition of the target, including related fees and expenses. The co-investor's obligation to fund under the ECL should also be subject to the satisfaction of certain conditions. When signing a back-to-back ECL with the sponsor, the co-investor should ensure that the conditions in its ECL align with the conditions in the ECL the sponsor signs for the full sponsor equity check. In addition, while the sponsor or the seller will seek to minimize the conditionality of the co-investor's obligation to fund, co-investors should consider including the following conditions:
- The closing of the M&A transaction occurring concurrently with the funding of the equity commitment.
- The concurrent funding by the sponsor and other co-investors of their equity commitments under their respective ECLs.
- The debt financing being funded concurrently with the funding of the equity commitment.
- There having been no increase in the consideration payable by the sponsor (or no increase beyond a certain cap) and no amendment to the M&A agreement or waiver of a condition in the M&A agreement that affects the purchaser in a material and adverse manner without the prior consent of the co-investor. An increase in consideration, other adverse amendments or waivers may alternatively trigger the ability for the co-investor to terminate its obligation to fund its commitment under the ECL. Co-investors may address these issues through an interim investors agreement or joint bid agreement with the sponsor rather than the ECL if the ECL is negotiated with the seller.
- The entering into by the co-investor and the sponsor of an agreed-to form of co-investment agreement. In rare cases, depending on the timing of the transaction, the sponsor and co-investors are able to negotiate the final form of co-investment agreement prior to signing the ECL, which would be appended to the ECL. More typically, however, the sponsor and co-investors negotiate a term sheet for the co-investment agreement with each co-investor's obligation to fund its commitment being conditional on the final form of co-investment agreement containing the terms and provisions set forth in the term sheet. Less often, and typically in situations where the time between the sponsor approaching co-investors and signing the M&A agreement is limited, it may be agreed that the form of co-investment agreement be negotiated post-signing of the ECL on terms agreeable to the co-investors. Given the funding uncertainty that this introduces, sponsors do not favor this approach and so this approach is not common. This is another condition that may be instead addressed in an interim investors agreement or joint bid agreement if the co-investor signs its ECL directly with the sponsor.
Termination of funding commitment
A co-investor will want to ensure that the ECL and its obligation to fund its equity commitment terminate in certain circumstances, including upon any of the following events occurring:
- If the M&A agreement is terminated.
- In the case of a back-to-back ECL, if the sponsor terminates its ECL for the full sponsor equity check.
- A specified outside date. Typically, this is just the outside date under the M&A agreement, after which the sponsor is under no legal obligation to complete the acquisition. In some cases, co-investors may request that the ECL state the actual date of the outside date as opposed to just referring to the definition in the M&A agreement since the outside date in the M&A agreement may be extended by the sponsor and the seller by way of waiver or amendment without the consent of the co-investors. This is particularly relevant for co-investors who have investment committee approvals that expire after a certain date. Such co-investors will need to ensure that their approval for the acquisition does not expire prior to the outside date.
- As noted above, an increase in the transaction consideration or amendment to the M&A agreement or waiver of a condition in the M&A agreement that affects the sponsor in a material and adverse manner will give rise to a termination right for the co-investors.
Pre-signing co-investments are often negotiated on a compressed timeline relative to post-signing or post-closing syndications. In addition to the typical desire to get the M&A transaction signed up as quickly as possible, the decision to bring co-investors into the transaction is often made at the last minute. The compressed timeline can put significant pressure on co-investors, who can be left with little time to negotiate the ECL and other co-investment documents. Co-investors must review and react quickly to the documents and focus on the points that are most important to them. They must also be able to obtain any required investment committee approvals, have signatories available and authorized to sign and be able to address any requests for "know your client" (KYC) or anti-money laundering (AML) documents or evidence of financial wherewithal, all on an expedited basis. As a result, sponsors will often limit access to pre-signing co-investments to co-investors with experienced deal teams and back-offices who have demonstrated an ability to execute on a transaction expeditiously.
Equity cut backs
The aggregate equity commitment of the sponsor and the co-investors will typically cover the maximum transaction consideration and expenses that could be payable. If a lesser amount is required to be funded at closing of the M&A transaction, the sponsor may want flexibility to reduce the equity commitment of co-investors at the sponsor's discretion, including the ability to reduce the allocation to the co-investors while maintaining the allocation to the sponsor. However, co-investors who have taken transaction risk by committing to the transaction pre-signing may want to ensure that they receive a sufficient equity allocation and accordingly request that any such reduction be made pro rata amongst the sponsor and the co-investors.
A sponsor may also want the right to reduce the co-investors' equity commitments for any reason, typically to preserve the flexibility to bring in a strategic investor or another sponsor in a "club deal". In such case, co-investors may request a cap on the amount by which their commitments may be reduced.
A co-investor may wish to negotiate the flexibility to assign its obligation to fund its equity commitment and, if applicable, pay the reverse termination fee either to an affiliate or to another entity managed by or affiliated with the same investment manager. This is particularly true where the co-investor is an asset manager that has multiple investment entities that could participate in the transaction, and the exact allocation among those investment entities is only to be determined prior to closing the M&A transaction. A sponsor will typically require the transferring affiliate to remain liable under the ECL and limited guaranty.
Most favored nations
To the extent there are other co-investors, a co-investor should consider requesting a most favoured nations clause in the ECL allowing it to elect preferential terms, including termination rights and funding conditions, that may have been granted to other co-investors. Alternatively, a co-investor could request a representation that all ECLs entered into with other co-investors provide for the same terms and conditions as were negotiated by such co-investor and that there are no side agreements with other co-investors providing for differing terms and conditions.
Creditworthiness of co-investors
Where a co-investor signs an ECL enforceable by the seller directly, the seller may ask for evidence to corroborate the co-investor's financial wherewithal to meet its obligation to fund its equity commitments and/or limited guaranty. Often, this evidence comes in the form of an extract from the co-investor's balance sheet showing assets significantly in excess of its funding obligations in the transaction. A seller may also ask for KYC and AML documents in advance of signing the ECL. These are topics that a co-investor may wish to raise early in the process, especially if the co-investor cannot provide a balance sheet extract or has any unique KYC or AML considerations, to ensure that the co-investor has sufficient time to work with the seller to deliver satisfactory evidence of its creditworthiness and appropriate KYC and AML documentation.
To ensure equal treatment among co-investors, co-investors will often ask for a requirement that the sponsor or the seller, as applicable, cannot enforce the ECL or the limited guaranty against any co-investor unless it enforces them against all co-investors.
As long as the private equity market remains robust, we expect to see a trend towards co-investors committing to transactions prior to signing. These transactions raise issues for co-investors that are distinct from those they face on a typical passive co-investment, including the issues discussed above.
1. For an overview of this and other recent trends in co-investments, see " Evolving together: Latest trends in co-investments".
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