UK: The European Lawyer's Private Equity Book, UK Chapter

1. MARKET OVERVIEW

1.1 Types of investors

Investors in private equity funds targeting UK investments comprise in the main pension funds, funds of funds, banks, insurance companies, government agencies, private individuals and family offices. During 2009, according to the British Private Equity and Venture Capital Association (BVCA), a total of £2.9 billion was raised by UK private equity funds (including venture capital funds) for investment in the UK and overseas. This sum was contributed to by those sectors in the following proportions: pension funds (18 per cent), insurance companies (10 per cent), corporate investors (14 per cent), banks (seven per cent), funds of funds (18 per cent), government agencies (six per cent), academic institutions (two per cent), private individuals (four per cent), sovereign wealth funds (six per cent) with the remainder (15 per cent) coming from a variety of other sources. According to the BVCA, £2.9 billion was invested during 2009 by private equity funds into UK companies, of which £296 million comprised venture capital investment.

1.2 Types of investments

Private equity funds will invest in businesses at almost any stage in their lifecycle and divide into a number of distinct types focusing on businesses at different stages in their development. At the smaller end of the scale, start up and seed financings will often be undertaken by private equity investors who specialise in venture capital, although recently there have been several multi-million pound start ups which have been backed by firms often more associated with more traditional leveraged buyouts. Moving up the scale of investment size, it is commonplace to divide the UK buyout market into three tiers, being the upper, mid- and lower market, the mid-range stretching from between £50 million to £500 million with the other two tiers falling on either side respectively. Private equity investors will typically seek to position themselves in a particular market, and while many will operate in two tiers, few will be active in all three. In addition, many private equity investors will focus their activities on particular industry sectors, such as healthcare, retail or heavy industry.

During a business' early stages, private equity financing (seed and start-up and, in certain circumstances, growth capital as well) will typically be unleveraged as banks and other institutions will usually be unwilling to lend where there are few or no assets in the business over which security can be taken. Equally, where a private equity investor takes a minority stake in the business, this will usually be unleveraged as, without control, the private equity investor will be unable to require the business to grant security over the underlying assets.

Once a business has developed to a point where it has a material asset base and some certainty as to the extent of future revenues and cashflow, private equity investment will typically be seen more favourably by lenders provided the company is able and willing to grant security over those assets, revenues and cash. However, at the time of writing, the effects of the credit crunch are still being felt in the UK and banks remain generally cautious over lending to finance private equity investments.

2. FUNDS

2.1 Fund structures

The most commonly used vehicle for a private equity fund is a limited partnership, constituted and governed by a limited partnership agreement to which all investors must adhere. Typically, an English limited partnership is used although there are circumstances in which a Scottish limited partnership is preferred. Scottish limited partnerships have separate legal personality, whereas English limited partnerships do not. A limited partnership structure is beneficial as it provides investors with limited liability (as they each subscribe to the fund as a 'limited partner') and is also a tax transparent vehicle, meaning that income and gains are taxed in the hands of the investors and there is no tax at the level of the partnership. This structure also enables the fund managers to receive their management fees and performance fees in a tax efficient manner.

Limited partnerships are typically closed-ended, meaning that investors are locked in and cannot withdraw their interests in the fund (usually for five to 10 years). Limited partnerships will have a 'general partner', who is liable for the debts and obligations of the partnership and is responsible for the management of the partnership under law. In practice, however, such management duties are usually delegated to a separate manager entity. Limited partners must not take part in the day-to-day management of the fund (or they jeopardise their limited liability status) and they invest in the fund by committing to provide a certain amount of money. This is not usually contributed in full at the outset but in separate tranches during the investment period at such times as the general partner may request.

Offshore fund structures are also used to avoid tax leakage at the level of the manager. Such offshore funds are commonly incorporated in the Channel Islands or the Cayman Islands, typically as offshore limited partnerships. The manager of an offshore fund will often be established offshore as well to avoid tax leakage.

2.2 Regulation of fund raising and fund managers

Private equity funds are typically unregulated collective investment schemes and therefore the fund vehicle itself will not be subject to authorisation by the Financial Services Authority (FSA). However, where carried out in the UK the fund must be established and operated, and its portfolio managed, by an authorised person. Operating a collective investment scheme is a regulated activity under the Financial Services and Markets Act 2000 (FSMA) which requires FSA authorisation, along with dealing in investments, advising on investments and arranging deals in investments, and the manager of the fund will therefore typically be authorised and regulated by the FSA. As a separate regime from that applicable to regulated activities under the FSMA, a fund cannot be marketed to potential investors in the UK (or outside the UK, if such communications may be 'capable of having an effect in the UK') by an unauthorised person, unless an exemption is utilised.

Exemptions typically revolve around the category of investors to which the fund is marketed, with exemptions including communications to 'investment professionals', 'certified high net worth individuals' and 'sophisticated investors'. The category of 'investment professionals' includes FSA authorised persons, therefore a fund can be marketed via an independent financial adviser using this exemption. Certain of these exemptions will require legal disclaimers to be included in marketing materials and in some cases they will impose other conditions, for example the provision of a signed statement confirming the status of the investor.

A new European directive was proposed by the European Commission in 2009 in relation to the regulation of alternative investment fund managers (AIFM), which will impose new regulatory requirements on fund managers once it has been approved and implemented. The AIFM directive proposes to regulate fund managers, rather than funds, and this will include both hedge fund managers and private equity managers. The scope and application of the initial draft of the AIFM directive was very unclear and its precise content is currently subject to intense political discussion and lobbying. The implications of the AIFM directive coming into force are unclear and will depend on the exact content of the final version of the AIFM directive, as well as the circumstances of each individual fund manager. The AIFM directive is likely to be agreed upon during the course of 2010, meaning that the rules would come into force in 2012. See section 7 below for further discussion on this point and further details on the content of the AIFM directive.

2.3 Customary or common terms of funds

The following table sets out the typical terms of a private equity fund.

3. DEBT FINANCE

3.1 Restrictions on granting security

General

It is generally possible for an English company to grant security over any or all of its assets. English law recognises a number of security interests which are easy to create and do not require onerous formalities. It is not necessary to use separate security documents for different types of asset; it is very common to use a single document which creates a mixture of mortgages, fixed charges and floating charges over all or substantially all of a company's assets. English companies may also provide third party security but care should be taken to ensure that the directors have considered their legal duties to the company, which include a duty to promote the success of that company itself. The shareholders may by resolution approve, or later ratify, an action which would otherwise be a breach of duty and the lender(s) will often require a shareholders' resolution to approve the grant of security.

Financial assistance

A public company is prohibited from giving financial assistance (broadly defined and including loans, guarantees and security) for the purposes of the acquisition of its own shares or the shares of its holding company. In addition, any private company which is a subsidiary of a public company is prohibited from giving financial assistance for the acquisition of shares in that public company.

Guarantees

Guarantees can be given in a wide variety of situations although care needs to be taken to ensure that they do not prove to be invalid.

Where an upstream guarantee is proposed to be given by a subsidiary in relation to its parent's obligations to repay debt it is important to ensure that, in resolving whether to approve the guarantee, the directors of the subsidiary company comply with their statutory and common law duties as directors such as their obligation to promote the success of the company.

In addition, the giving of an upstream guarantee by a company which is not able to pay its debts as they fall due, or becomes unable to pay its debts as they fall due as a result of giving the guarantee, can be liable to attack and invalidation as a 'transaction at an undervalue' if the company enters insolvency proceedings within a period of two years thereafter.

If a subsidiary company guarantees a parent's obligation to repay debt in circumstances where the guarantee is likely to be called and the subsidiary is unlikely to be promptly and fully reimbursed for the amount it pays under the guarantee, there is a risk that the guarantee could be seen as an indirect way of returning capital to the parent. To the extent that any provision which is made in the subsidiary's accounts against the possibility of the guarantee being called (and the consequent reduction in that company's net assets) exceeds its distributable profits, the grant of the guarantee could be held to be an unlawful distribution and therefore potentially void.

It is advisable for a lender to require evidence that these issues have been addressed by the directors in cases where they may apply (for example, in the directors' resolution or a separate director's certificate).

Registration of security

Security is generally effective as soon as it is created between the parties. However, some registrations are necessary or desirable in order to prevent retrospective invalidity or to confer priority.

With nearly all types of security created by a company, the security document, together with the prescribed notification form setting out particulars of it, must be registered at the UK Companies Registry within 21 days after creation, failing which the security will be void against any liquidator or administrator and the creditors of the relevant company.

With a mortgage or charge over real estate, registration of the security document at HM Land Registry or the applicable land charges registry will also usually be made in order for the lender to obtain priority for the security.

3.2 Inter-creditor issues

Background

An inter-creditor agreement typically regulates the rights and obligations of different lenders or groups of lenders, both before and after insolvency. In a typical buyout structure involving senior, mezzanine and equity investor debt, it will provide that the senior debt (including any hedging debt) ranks ahead of the mezzanine debt, which in turn ranks ahead of any equity investor debt. In more complex structures it will also regulate any additional types of debt such as senior notes, second lien debt, junior mezzanine debt, high yield bonds or payment in kind (PIK) notes.

Contractual subordination as provided for in an inter-creditor agreement is generally considered to be valid under English law. While some senior lenders may seek structural subordination in addition to contractual subordination, there is no legal requirement for this.

Traditionally in the UK market, the inter-creditor agreement has been the least standardised document. While there is some consistency in the commercial terms of acquisition finance deals, the documents drafted often vary in structure and format. However, in March 2009 the Loan Market Association (LMA) launched its recommended form of inter-creditor agreement for use in leveraged finance transactions, with a revised form subsequently launched in November 2009 following consultation with a number of mezzanine investors. The revised form contains a number of alternative options and footnotes dealing with likely areas of contention between senior and mezzanine lenders.

Key issues

As the leveraged finance market returns, both senior and mezzanine lenders are focusing more closely on the terms of inter-creditor agreements, probably as a result of lessons learned from recent restructurings.

To provide a full list of issues which may be raised by senior lenders, bondholders, mezzanine lenders and equity investors in relation to inter-creditor agreements (especially on the new LMA inter-creditor agreement) is beyond the scope of this book. However, some of the issues which are commonly debated between senior and mezzanine lenders are as follows:

• Structural subordination – should the subordinated creditors also be structurally subordinated? Typically senior lenders will accept contractual subordination only.
• Limitations on amendments to the senior debt documents – a fairly restricted list will usually be agreed (eg changes to prices, tenor or amount of senior debt). Exceptions are often agreed including allowing for an increase in margin by one per cent, an increase in tenor by up to 12 months and an increase in senior debt by up to 10 per cent of closing day commitments.
• Permitted payments to subordinated creditors – should these include principal repayments upon illegality or a tax gross-up, interest payments, enforcement costs and expenses, and waiver fees? What should be the trigger for blocking these payments (eg any senior default or just certain material senior defaults) and how long should such a block remain in effect (typically for mezzanine this is either 90 or 120 days)?
• Enforcement rights for subordinated creditors – what should be the triggers and what should be the length of the standstill periods (typically for mezzanine these have been 90 days for a payment default, 120 for a financial covenant default and 150 for any other breach)?

In addition to these typical issues, subordinated creditors are also looking to enhance or further protect their positions in restructurings. Issues raised by mezzanine lenders in some recent transactions have included:

• Restrictions on senior lenders' right to release principal debt, guarantees and security on a disposal – including restricting the circumstances when such release may be effected and imposing obligations on senior lenders to show that a fair price has been obtained (eg a fair value opinion from an investment bank – akin to US high yield bond requirements).
• Security over the shares in the top company in the structure in favour of the mezzanine lenders – giving them the ability to cut off the equity investors from any economic interest (a common feature of infrastructure deals).
• A right to convert mezzanine debt into equity without the consent of senior lenders (this is currently prohibited under most inter-creditor agreements).
• A right for the mezzanine lenders to effect an equity cure of a financial covenant breach under the senior facilities agreement (to prevent a senior enforcement in circumstances where the equity investors are unable, or unwilling, to fund the equity cure).

As the volume of new transactions increases, positions on these and other contentious points should (as before) become more standardised.

For the most part equity investors have very few rights under an intercreditor agreement (given their position). However, where payment of any upfront fees, ongoing fees or, perhaps, a repayment of loan notes or dividend (subject to certain financial covenant tests) to the equity investors is permitted, it will be important to check that such payments are expressly permitted and to clarify any additional conditions (eg no default). The equity investor will almost certainly be the controlling shareholder of the group so will not need the other protections re anti-layering, amendments etc.

3.3 Syndication

Methods

There are three main ways of distributing debt among lenders/investors in the UK market: an underwritten syndication, a 'best efforts' syndication and a 'club' deal.

For a truly underwritten deal there are typically three phases. During the underwriting phase, the equity investor will select a bank or banks (referred to as mandated lead arrangers or MLAs) who will initially underwrite the required facilities. Depending on the size of the facilities, the MLAs may then look in phase two to bring in other sub-underwriters before funding takes place. As the final phase, and as soon as practical after the funding has occurred and the transaction has closed, the MLAs (together with other sub-arrangers, if there are any) will look to complete a general syndication of the facilities to the institutional investor market along with other banks that may be interested in participating.

For a 'best efforts' syndication, arrangers will only fund up to their approved hold levels. They will, however, structure and agree the financing package and agree to use their best efforts to bring in other institutional investors and banks to meet the agreed total funding requirement.

For a 'club deal', the equity sponsor or a lead bank will assemble a 'club' or group of lenders to provide a facility on identical terms. The lenders will typically all share the same fees in the deal and will all agree the terms of the financing. Because all the lenders have input in negotiating the facility agreement, the negotiations are often time-consuming and can result in the 'lowest common denominator' positions of the club being reflected in the documentation. For this reason, club deals have traditionally been unpopular with equity investors and, during the credit boom, were limited to the smallest transactions (sub-£100 million). Club deals are typically done by banks and specialist debt investors rather than the wider institutional investor market.

Syndication issues

In acquisition finance deals, syndication takes place after the terms have been struck and the initial money lent. In order to ensure the success of syndication, an MLA will seek to ensure that the deal structure and terms fall within market-acceptable parameters and norms. However, in the period between signing its commitment and closing of the syndication, an event may occur in the market which has an adverse impact on the syndication (perhaps because the perception of risk and pricing in the wider market has changed or because investor liquidity has dried up). In these situations (as was the case following the collapse of Lehman Brothers) underwriters risk being left with huge amounts of debt which they cannot syndicate save at a significant discount and thereby resultant loss.

For this reason, MLAs seek to include a market flex provision in their commitments. The market flex provision allows the MLAs to change the pricing, terms and/or structure of the loan if this proves necessary to ensure a successful syndication.

Depending on the strength of the market, there are typically extensive negotiations over the ability of the MLAs to invoke these provisions (eg the level at which a successful syndication occurs and what obligations are imposed on the MLAs to pay away their fees to potential participants) and over setting caps on the overall economic impact that such changes can have on the borrower group.

In pre-2008 deals, the amount of liquidity in the market often led to syndications being oversubscribed. This enabled equity investors to push for a 'reverse flex' which reduced the pricing or pushed additional debt into the cheaper tranches (with the MLAs sharing a percentage of the upside for the borrower group as a fee). Following the end of the credit crunch the reverse flex has started to return to the market for deals which are oversubscribed; however, it is limited to increasing quantum as opposed to changes in pricing.

There are other issues to be considered, such as the extent of assistance required from the borrower group and equity sponsor on syndication, but these issues have been comprehensively debated and standardised positions are well understood.

3.4 Alternative means of financing

Before the summer of 2007 and the onset of the credit crunch, private equity professionals would expect financing structures to involve some or all of the following types of term debt: senior, second lien, mezzanine, PIK and other similar instruments; and 'covenant-lite' loans, 'PIK toggles' and OpCo/Propco structures were often encountered.

At the time of writing, at least as far as the UK market is concerned, second lien, PIK and the other exotic instruments have all but disappeared, with financing structures reverting to those more closely associated with 2002- and 2003-vintage transactions. In many cases, financing structures are limited to senior-only loans with an amortising tranche A facility and bullet tranche B facility. Where subordinated debt is included in the structure, this is being provided by specialist mezzanine houses or via debt funds of equity investors and typically includes some form of equity participation as well as non-call protections.

Equity underwrites

With the continuing liquidity problems in the leveraged financing markets, a trend has emerged of some equity investors funding the entire transaction with equity and then looking to bring together a club or syndicate of senior lenders (or perhaps asking the target's existing lenders to continue their existing facilities). Such processes are often run as competitive tenders and allow more time for the sponsor to procure the best terms.

High yield bonds

There has been a resurgence in the high yield bond market, driven in part by market conditions but also by a wave of refinancings of corporate ('fallen angels') and leveraged loan facilities. As a result of banks needing to refinance upcoming maturities there has been a willingness to share security with bondholders on a pari passu basis (although the exact terms of pari passu are yet to be consistently applied – both the Association for Financial Markets in Europe (AFME) and the LMA are working on forming agreed pari passu principles). However, high yield debt remains relatively unavailable in the small and medium enterprise environment (ie below £150 million) unless such notes are placed with specialist investors.

Vendor financing

Another increasing source of funding has been vendor financing. This is seen as attractive for the vendor as it enables the vendor to account for the sale on the basis of a higher purchase price albeit partially funded by the vendor loan. The vendor also benefits from income on the vendor loan, typically at a high PIK coupon. From the purchaser's perspective, this provides another source of funding enabling it to achieve a higher leverage. Typically vendor loans will be unsecured and subordinated to senior loans; however, in exceptional cases vendors may successfully argue that they are arm's length, third-party lenders.

Asset-based lending (ABL)

There has been a growing acceptance of ABL structures as a financing option in private equity deals, whether as part of the funding structure for the acquisition or as a refinancing tool subsequently. ABL is relatively inexpensive compared with cashflow or term loan financing and typically has fewer financial covenants. English law is broadly conducive to asset-based products, particularly by the ability to take floating security over assets. ABL facilities also allow borrowers with a working-capital need to borrow only what they require to operate as their asset base fluctuates. However, there remain concerns about its initial funding potential (as it relies on asset valuation rather than earnings before interest, taxes, depreciation and amortisation) and on the certainty of funding.

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