1 Legal framework
1.1 Which general legislative provisions have relevance in the private equity context in your jurisdiction?
In relation to private equity transactions specifically, the following will generally be of relevance:
- The EU Alternative Investment Fund Managers Directive (AIFMD) requires managers of alternative investment funds (including most private equity funds) to be authorised by the Financial Conduct Authority (FCA) and to comply with a range of prudential, organisational and conduct of business rules. The AIFMD applies restrictions on asset stripping for 24 months from the date of acquisition of control and certain transparency notifications requirements.
- Where a transaction involves communication that could amount to a financial promotion, restrictions under the Financial Services and Markets Act 2000 will need to be considered.
- More generally, the Companies Act 2006 and associated company law apply to any M&A transaction as well as common law principles of contract law. As detailed later in this Q&A, FCA change of control approvals, competition clearances (which for some deals will be further complicated by Brexit) and developing foreign direct investment regimes (in the United Kingdom and other jurisdictions) may also be relevant.
- Where the target is (or has previously been) listed on a UK-regulated market, the Takeover Code may apply (ie, a statutory set of rules administered by the UK Takeover Panel setting out an orderly framework within which the takeover must be conducted).
1.2 What specific factors in your jurisdiction have particular relevance for and appeal to the private equity market?
Despite the political and economic uncertainty created by Brexit and the disruption caused by the COVID-19 pandemic, the private equity market in the United Kingdom has shown remarkable resilience and continues to attract investment from across the globe. It was the first European market in which private equity and buyouts took root and the features that enabled it to do so are even stronger today:
- deep pools of debt and equity money;
- an ecosystem of advisers who are based mainly in London and are second to none; and
- an open economy receptive to private equity.
The strength of English law and the English legal system is another factor. We often see transactions with no connection to the United Kingdom being run out of London because that is where the financial advisers are often based and due to the familiarity with English law.
2 Regulatory framework
2.1 Which regulatory authorities have relevance in the private equity context in your jurisdiction? What powers do they have?
Private equity firms in the United Kingdom are regulated by the Financial Conduct Authority (FCA) and are subject to specific requirements, including prudential, organisational and conduct of business rules. The FCA has a broad range of enforcement powers – including criminal, civil and regulatory – to protect consumers and take action against firms that do not meet its standards. For example, it can:
- withdraw a firm's authorisation;
- issue fines;
- make a public statement (therefore bringing reputational damage); or
- commence criminal proceedings.
The industry also has its own self-regulatory regime, by way of the Walker Guidelines for Disclosure and Transparency in Private equity and the supporting Private Equity Reporting Group, which essentially provide a set of rules and established oversight and disclosure comparable to those faced by FTSE 350 companies, operated on a comply or explain basis.
2.2 What regulatory conditions typically apply to private equity transactions in your jurisdiction?
Both the UK merger control and inward investment regimes may apply. While UK merger filings are voluntary and non-suspensory, the UK Competition and Markets Authority will have jurisdiction to investigate a transaction where:
- the target has a UK turnover of more than £70 million; or
- the transaction results in a share of at least 25% of the supply or purchase of goods or services in the United Kingdom (or a substantial part of it) being created or enhanced.
If one of these thresholds is met, the UK government can also intervene on public interest grounds relating to national security, financial stability, media plurality or public health. Where the target is active in computing hardware, quantum technology, military/dual-use goods, artificial intelligence, cryptographic authentication technology and/or advanced materials, such thresholds are reduced to £1 million and a 25% market share (no increment required). A voluntary filing should be considered where the thresholds are met. The UK government can also intervene regardless of thresholds if the transaction involves a current/former defence contractor that holds confidential, defence-related information. The United Kingdom's proposed foreign direct investment regime is likely to result in conditions appearing in deals involving foreign buyers including some private equity buyers.
If the target is a financial services business, or if one or more entities within its group carry on activity regulated by a financial services regulator (eg, arranging consumer credit), regulatory approval may be required if the transaction entails a change of ‘control' of the regulated entity. In the United Kingdom, the thresholds for ‘control' are usually as low as 10% or 20%, and the term often captures indirect controllers. Failure to obtain change of control approval before completion is a criminal offence.
3 Structuring considerations
3.1 How are private equity transactions typically structured in your jurisdiction?
Rather than investing directly in the target, the private equity investors (whether on a primary, secondary or subsequent buyout) will generally invest, for tax and finance reasons, through a stack of newly incorporated companies (special purpose vehicles) known as the ‘newco stack'. Most commonly, a triple or quadruple stack of newcos will be used as follows:
- Bidco: Acquires the shares in the target, and on leveraged transactions will be the primary borrower, so that the lending institutions can have direct rights against the company that owns the business.
- Cleanco: Usually required by the lending institutions so that they can take security over Bidco shares. The lenders will also take security over the target and its subsidiaries (given that Bidco is a shell company), so that the security package covers the operational entities in the group and the assets of the business.
- Midco: Will be the issuer of any shareholder debt held by the private equity investor and managers (if reinvesting into the newco structure).
- Topco: The chain of newly incorporated companies will ultimately be owned by the private equity investors and the management team, which will hold shares at the Topco level.
Typically, the private equity investor will acquire a controlling stake. However, increasingly, minority investment and co-investment strategies are coming to the fore. We also saw an uptick in public-to-private transactions prior to the COVID-19 crisis erupting.
3.2 What are the potential advantages and disadvantages of the available transaction structures?
The newco acquisition structure is largely driven by:
- the structuring objectives of the private equity investor;
- the requirements of the lenders on a leveraged transaction; and
- tax considerations.
Other than the fact that it may appear complex to those unfamiliar with the private equity transaction structure, there are no real disadvantages – albeit that on secondary (and subsequent) buyouts, there may be a need to tidy up structures by winding-up any redundant newcos in a pre-existing stack.
Where a private equity investor acquires a majority stake, it can expect a whole host of provisions in the equity documentation with management, aimed at protecting the private equity investment and allowing control over exit. There are fewer ‘rules of thumb' in relation to minority investments and co-investment structures, and a carefully considered approach to the legal terms will be essential. The structural and economic terms of the transaction (eg, the amount of investment; the level of rollover; the size of any sweet equity pot; the amount of debt to be raised; and the ranking of securities as between shareholders) will influence the legal terms. Provided that the private equity investor can strike the correct balance under the deal documents, minority investments and co-investments can open opportunities to invest with less risk.
Public-to-private transactions provide an opportunity to acquire listed companies at attractive multiples. However, executing a buyout within the constraints of the Takeover Code presents a unique set of challenges.
3.3 What funding structures are typically used for private equity transactions in your jurisdiction? What restrictions and requirements apply in this regard?
Funding for the transaction will typically be by way of equity and shareholder debt (from the private equity investor and management) and third-party debt. Private debt providers (eg, private equity firms with their own credit arms) have come to the fore recently, to some extent replacing traditional bank lenders.
The private equity investor's funds will usually be invested in a combination of ordinary shares in Topco and shareholder debt in Midco (and/or preference shares in Topco). These funds are then pushed down to Bidco via share subscriptions and/or inter-company loans. The managers' equity investment will be structured as ‘sweet equity' (ordinary shares without a proportionate holding of shareholder debt/preference shares) and, for those reinvesting more than is required to acquire sweet equity, an element of additional equity and shareholder debt/preference shares in the same proportion as the investor holds those instruments (the ‘institutional strip'). The managers will often fund their reinvestment using a proportion of manager sale proceeds and/or bonuses received from the previous ownership/exit.
As an alternative to preference shares, preferred ordinary shares are sometimes issued to the private equity investor and management. In lieu of carrying an automatic right to a fixed dividend, such shares have a right to a fixed yield on a return of capital which ranks ahead of any other payments in the equity waterfall. Regardless of the types of instruments held, the shareholder debt will always rank behind the bank debt, and almost invariably ahead of the ordinary and preference/preferred ordinary shares.
3.4 What are the potential advantages and disadvantages of the available funding structures?
There are important differences between loan notes, preference shares and preferred ordinary shares in terms of the form and circumstances of making a return to the holder (interest on loan notes versus fixed dividends on preference shares or a right to a fixed yield on a return of capital on preferred ordinary shares).
Under UK company law, a company must have distributable reserves in order to make a dividend payment on shares; whereas returns on loan notes are not subject to the same company law requirement. This can be a big factor when considering future refinancing options, as it is much quicker and easier to refinance out loan notes through repayment of inter-companies.
From a tax perspective, interest payments will be subject to UK withholding tax (unless an exception or relief applies), but may be deductible for the issuer. Conversely, dividend payments do not generally give rise to UK withholding tax or tax deductions. Interest is taxed as income; as is a dividend or other distribution paid on shares. Depending on the relevant legal terms, the proceeds of the sale of preference shares cum dividend allocable to the coupon component may be taxed as capital or recharacterised as income. The same is true for the sale of preferred ordinary shares, although the risk of income treatment is reduced. As most jurisdictions impose lower tax rates on capital returns than on income returns, capital treatment is usually (but not always) preferred.
3.5 What specific issues should be borne in mind when structuring cross-border private equity transactions?
As with any cross-border transaction, it should be considered whether any merger control and/or foreign direct investment filings might be required. This may affect the structure of the transaction, as it is often the case that where a filing is required, the transaction cannot complete lawfully without receipt of a clearance decision from the relevant public authority, necessitating split signing and completion.
Competition merger control regimes are present in most jurisdictions and usually there are turnover and/or market share jurisdictional thresholds that must be met for a merger filing to be required. These thresholds will often involve a consideration of the turnover and/or market shares of both the target and the acquirer. Such acquirer thresholds are regularly met by private equity firms, as typically the combined turnover of all the firm's portfolio companies will need to be considered.
Foreign direct investment regimes take the form of additional controls present in certain jurisdictions which may require clearance from a public body for, or otherwise prohibit, certain investments in that jurisdiction by foreign undertakings. While the applicability of foreign direct investment regimes varies greatly between countries, such regimes should be considered where the target has subsidiaries, assets or employees situated in a jurisdiction that differs from the country in which the private equity firm is considered to be based.
We also see financial assistance prohibitions in some jurisdictions causing structuring issues and specific securities regimes (eg, in the United States) affecting the way in which shares can be issued to management.
3.6 What specific issues should be borne in mind when a private equity transaction involves multiple investors?
The specific issues will depend on the nature of the co-investment (ie, the percentage split), but areas of contention and negotiation will centre around alignment of interest (particularly in relation to exit strategy). It is imperative to identify any potential conflicts in investment strategy and misalignment of interest early on in order to address the legal terms of the co-investment. The mechanics of investor consent rights and who goes on the target board will need to be considered carefully, as well as mechanics around further funding and its impact on legal terms if the further funding adjusts the original subscription.
4 Investment process
4.1 How does the investment process typically unfold? What are the key milestones?
The process will vary depending on whether it is an off-market proprietary deal or an auction. In recent years, we have seen the prevalence of competitive auction processes, where sellers create competitive tension between interested parties with a view to maximising price.
In the first round of a typical auction process, interested parties will enter into a confidentiality agreement (also known as a non-disclosure letter) before being granted access to an information memorandum and possibly a limited data room of information on the target. A process letter sent to first-round bidders will outline:
- how the auction process will be run;
- the deadlines for first-round offers; and
- the information required to be submitted when making an offer.
First-round bids are non-binding indicative offers.
For bidders that progress to the second round, a second process letter will outline the second phase, including the date for submission of the final offer, which will be binding in nature. At this stage, access is granted to a full data room for the bidders to undertake full due diligence, and drafts of key transactional documents will be shared (eg, sale and purchase agreement, disclosure letter and if management are to reinvest, an equity term sheet), so that bidders can provide their mark-ups with the final offer. On auction processes, the sellers will almost always prepare the draft sale and purchase agreement and bidders that can accept the draft sale agreement with fewest amendments are much more likely to be attractive to the seller.
4.2 What level of due diligence does the private equity firm typically conduct into the target?
The scope of legal due diligence will vary depending on the nature of the business, but will generally cover a review of:
- share ownership and any restrictions or relevant arrangements relating to shares;
- constitutional documents;
- historical corporate transactions and share capital reorganisations;
- material contracts with customers and suppliers;
- employment law matters;
- real estate;
- intellectual property and information technology;
- data protection compliance;
- environment, health and safety;
- ongoing litigation; and
- compliance with laws and regulation.
More often than not, legal due diligence is reported on a ‘by exceptions' or ‘red flag' basis rather than by full narrative; but it will be important to ensure that on leveraged deals, and also on deals where warranty and indemnity insurance is being used, the scope of the due diligence and level of detail in the report are satisfactory to the bank and the underwriter.
Commercial, financial and tax due diligence will also be undertaken and depending on the nature of the target business, specialist due diligence may be necessary (eg, in relation to data protection compliance, sanctions and export control issues and specific environmental issues). Increasingly, we are seeing private equity houses undertaking, as a matter of course, a thorough environmental, social and corporate governance (ESG) analysis, reflecting the relevance of ESG to the overall investment strategy, and specialist insurance due diligence has also become very common.
Clearly, a consideration of the target's Brexit risk has been on the agenda in recent years and feeds in to the legal, financial and commercial due diligence exercise; and more recently, buyers have been looking carefully at the impact of the COVID-19 pandemic and how well the target has realigned itself for the future.
4.3 What disclosure requirements and restrictions may apply throughout the investment process, for both the private equity firm and the target?
A public to private transaction of a UK-incorporated public company must be conducted in accordance with the Takeover Code (a set of principles-based rules designed to provide a fair and transparent environment in which to conduct a bid). The Takeover Code seeks to ensure a level playing field between bidders in relation disclosure and diligence. However, on a buyout of a private company (as is the case for any other private M&A), there is no requirement or restriction in relation to the seller's disclosure of information to bidders, save that under English law, it is not possible for a seller to carve out liability (eg, in the warranty limitations provisions) for fraud or fraudulent concealment.
More generally, on any M&A transaction (public or private), the parties will be subject to confidentiality restrictions set out in a confidentiality agreement (also known as a non-disclosure agreement (NDA)). The restrictions in an NDA largely focus on the confidential nature of the information disclosed to the buyer/investors in relation to the target group and its business; but there will also be a mutual element to the confidentiality restrictions, to ensure that the fact of the potential transaction, the negotiation of terms and any information shared in relation to the potential buyer and the investors are not disclosed without the relevant consent.
Sellers will also need to be mindful of confidentiality restrictions which might be contained in contracts the target has entered into.
4.4 What advisers and other stakeholders are involved in the investment process?
Both buy and sell side will typically have legal advisers, and often corporate finance advisers, to guide them through the process and assess the fairness of the terms of the transaction. Other specialist advisers may also be involved in the due diligence process. On a buyout, it has become increasingly common for management teams – particularly where they have made a significant investment – to receive their own independent legal, tax and financial advice, focusing in particular on the warranties and limitations on liability under the share and purchase agreement and the terms of the equity deal with the incoming private equity investor.
5 Investment terms
5.1 What closing mechanisms are typically used for private equity transactions in your jurisdiction (eg, locked box; closing accounts) and what factors influence the choice of mechanism?
The locked box mechanism has become the most common approach to pricing for UK buyouts rather than a closing accounts mechanism. The parties fix the price at a date prior to exchange, with a set of accounts prepared to that date being diligenced by bidders. The economic risks and rewards of owning the business are passed to the buyer from the locked box date and the seller's ‘no leakage' covenant provides pound-for-pound recovery for value leakage to the sellers (or their connected persons) between the locked box date and completion.
Private equity sellers prefer the certainty that comes with a locked box mechanism in terms of the price to be received and the timing of receipt. The ability to quickly distribute proceeds to investors without having to wait out a further adjustment period makes the locked box structure particularly attractive. Private equity buyers also generally prefer the certainty of a locked box, unless there is significant uncertainty that would be better dealt with through completion accounts. The disadvantage of a locked box for the buyer is that there is no opportunity post-completion to review the position of the target at its point of acquisition and adjust the price.
On locked box transactions with split exchange/completion, sellers are increasingly requesting an equity ticker, allowing the seller to benefit from notional cash (and post-tax) profits generated in the business between the locked box date and completion. This is typically structured as a day rate, calculated by reference to profits generated in the locked box period or by reference to a fixed yield on the upfront consideration).
5.2 Are break fees permitted in your jurisdiction? If so, under what conditions will they generally be payable? What restrictions or other considerations should be addressed in formulating break fees?
On private company buyouts, break fees (also referred to in the United Kingdom as ‘cost underwrite') will occasionally be included in exclusivity letters to protect the buyer against abort costs where the transaction falls over on account of the sellers; but they must provide reasonable compensation for costs incurred and must not be punitive in nature in order to be enforceable under English law. The value added tax (VAT) treatment of the break fee payment is somewhat uncertain (and can be affected by the structuring and legal terms of the break fee): the allocation of the risk and cost of such VAT will then be the subject of commercial negotiation.
On a take-private, however, the Takeover Code does not allow (other than in very limited circumstances) break fees, exclusivity, non-solicit or conduct of business restrictions. Instead, bidders are expected to rely on the target's ongoing obligations to comply with regulatory disclosure requirements and restrictions in the Takeover Code aimed at preventing the target from taking action to frustrate the bid.
5.3 How is risk typically allocated between the parties?
UK private equity sellers (despite usually holding the majority and therefore receiving the greatest proportion of the sale proceeds) will invariably refuse to give any warranty and indemnity (W&I) protection to the buyer beyond warranties as to title (to sell their shares) and capacity (to enter into the sale and purchase agreement). The rationale behind this is that the private equity investor is a passive investor only, not involved in the day-to-day operations of the business. There is also a desire to be free from contingent liabilities so that sale proceeds can be quickly distributed to the investors.
A buyer can seek to minimise its potential exposure by:
- obtaining warranties from the management team relating to historic issues in the business;
- carrying out more extensive due diligence to identify any risks in the business (the extent of the due diligence largely being driven by the scope of business warranties offered up by the management sellers); and
- purchasing W&I insurance, which is now a very common feature in UK M&A deals.
Of course, a private equity buyer will ordinarily be backing the management sellers to run the business going forward and will therefore be extremely reluctant to make a claim against warranties given by its own management team. Warranties against this backcloth do not have the same risk-sharing purpose as they do in other private sale and purchase contracts. The incoming private equity investor in a secondary buyout is likely to take more comfort from the amount of the continuing management rollover or reinvestment.
5.4 What representations and warranties will typically be made and what are the consequences of breach? Is warranty and indemnity insurance commonly used?
Under English law, there is a distinction between representations and warranties. The former may allow an action for misrepresentation (and theoretically a right to rescind; but in practice, this will be lost once it becomes impossible to restore the parties to the pre-contractual position) and the latter a contractual claim for breach of warranty.
There is a further distinction between warranties (a claim for damages/loss) and indemnities (a pound-for-pound claim for the underlying liability). Although less common in the current market, sometimes a tax indemnity is given for unexpected pre-closing tax liabilities.
A private equity seller is unlikely to give any warranties or indemnities beyond title and capacity; therefore, business warranties (and if one is given, a tax indemnity) will be given by management. A private equity buyer will expect a wide-ranging list of warranties, subject to any competitive pressures in an auction process.
W&I insurance can, and frequently does, plug the gap between buyers (wanting a fuller set of business warranties given on an absolute basis) and sellers (insisting on blanket awareness and/or a very small cap on liability). A tax indemnity can often also be obtained from the insurer. Bidders are usually encouraged to take out a buy-side policy, so that the warrantors can either cap their liability at the level of the self-insured excess or even give warranties on a non-recourse basis. Since W&I insurance policies are usually buy-side policies, the buyer runs the claims process and the seller is not at risk of insurer default.
6 Management considerations
6.1 How are management incentive schemes typically structured in your jurisdiction? What are the potential advantages and disadvantages of these different structures?
Management's incentivisation usually takes the form of ‘sweet equity', being a separate class of ordinary shares in Topco, with no obligation to subscribe for further instruments. It is sweet because of its cheap investment cost compared with the amount being invested by the private equity investor in its shareholder debt/preference share instruments; and unlike those instruments – which will only ever deliver a fixed return – the ordinary shares will be entitled to an uncapped amount (ie, the remaining equity value in the business, subject to growing the business at a rate greater than the coupon on the debt/preference shares). This is often where value on return is truly created.
The size of the sweet equity pot is a matter of negotiation, but is typically between 10% to 30% of the ordinary share capital, depending on deal size and management team dynamics.
Performance ratchets are sometimes used to incentivise and reward exceptional performance or to bridge any gap in expectation regarding the size of the sweet equity pot. Essentially, if targets relating to the private equity house's return (one or both of an internal rate of return or money multiple return) are met, management's equity proportion is increased to give a greater share of the exit proceeds. Ratchets can be ‘top slice' (where additional equity is calculated by reference to the proceeds above the relevant hurdle only) or ‘cliff' ratchets (where additional equity is calculated by reference to all proceeds). The precise mechanic will be tailored to the transaction and the tax position of management requires careful consideration.
6.2 What are the tax implications of these different structures? What strategies are available to mitigate tax exposure?
The aim is for management to sell their sweet equity shares on an exit at a gain, with the growth in value being subject to capital gains tax. To achieve this, various employment tax risks need to be managed.
Management must acquire their sweet equity shares for consideration at least equal to their tax (unrestricted) market value; otherwise the differential is treated as employment income (taxed on acquisition). Her Majesty's Revenue & Customs (HMRC) accepts that this is the case (and no employment tax arises) if the arrangement meets the conditions in its 2003 memorandum of understanding with the British Private Equity and Venture Capital Association. Otherwise, an independent contemporaneous valuation is usually recommended. If paying market value consideration would be too expensive, alternative share-based incentives could be considered (eg, options or growth shares/joint ownership arrangements).
Provided that a manager enters into a ‘Section 431(1) election' with his or her employer company within 14 days of acquiring the shares, no employment tax should arise in relation to genuine capital growth in their shareholding going forwards, subject to a number of anti-avoidance rules (eg, shares are sold for more than market value or the value of shares is artificially increased).
The United Kingdom has very generous rollover provisions, so management can either:
- roll over any proceeds which are reinvested (HMRC clearance may be advisable); or
- fund their reinvestment in the buyer structure out of their net of tax share proceeds in order to ‘bank' any accrued gain at current capital gains tax rates (if they expect the tax burden to increase in the future).
6.3 What rights are typically granted and what restrictions typically apply to manager shareholders?
The typical starting point is a prohibition on all transfers of securities by managers other than pursuant to:
- very narrow permitted transfer rights (to family members and family trusts for tax planning purposes);
- compulsory transfer provisions for leavers;
- drag-along rights; and
- if included, tag-along rights.
This is how the private equity investor ensures that the securities issued to management serve the purpose of aligning management with the investor in seeking to add value to the business.
Management will also be subject to obligations and restrictions in relation to the running of the business, to ensure that the private equity investor retains a level of control. This is further discussed in question 7.1.
Given the centrality of management to the private equity investor's investment decision, the private equity investor will seek comfort in the form of post-termination restrictions (eg, non-compete and non-solicitation). It is common for restrictive covenants to feature in the investment agreement as well as the acquisition agreement and managers' individual service contracts, giving the private equity investor overlapping protection. The scope and duration of such restrictions must be reasonable to be enforceable.
Cooperation obligations on management are also key to the private equity investor's ability to control the exit process and any refinancings/restructurings that may be required during the lifecycle.
If managers have made a significant investment or hold a substantial stake, they may also negotiate some form of veto rights, focused on maintaining the key economic terms and equality of treatment of equivalent instruments through the investment. It is also common for management to have the right to transfer their shares in the target to close family members.
6.4 What leaver provisions typically apply to manager shareholders and how are ‘good' and ‘bad' leavers typically defined?
Leaver provisions are key to management participation and to the alignment of economic interest through to exit. Typically, a manager who leaves prior to exit may be required to transfer his or her shares at a set price to a new manager, an existing manager, an employee benefit trust or the company (although the latter can have tax disadvantages for the leaver).
Leavers are categorised as ‘good' or ‘bad' depending on the nature of their departure and this will determine the price they receive for their shares. A good leaver will generally receive fair value and a bad leaver the lower of fair value and cost. The precise definition of ‘good' and ‘bad' will be negotiated; but as a rough guide, ‘good' commonly captures leavers who die or leave the business due to ill health, while ‘bad' captures voluntary resignation and summary dismissal.
A category of ‘intermediate' leaver can help to address the more contentious position where a manager has been dismissed for performance reasons. An intermediate leaver is neither good nor bad, and will receive a good leaver valuation for a growing proportion of his or her shares as time passes, and a bad leaver price for the balance.
While the market norm on both primary and secondary buyouts is for leaver provisions to apply to managers' sweet equity, different considerations apply on a secondary buyout to the managers' institutional strip. In the past, it was uncommon for leaver provisions to apply to the strip. Now they are appearing in some form more often.
7 Governance and oversight
7.1 What are the typical governance arrangements of private equity portfolio companies?
The governance structure will be set out in the articles of association of Topco (and its subsidiaries) and an investment agreement between the private equity investor and management. If there are loan notes in the structure, a loan note instrument will also be constituted by the issuer.
The investment agreement will set out who will sit on the Topco board (typically the key executive directors, one or more non-executive investor directors and an independent chairman), and will include checks and balances to ensure that management run the business lawfully and within agreed parameters, including conduct of business covenants, investor information rights, investor consent rights and investor board appointment rights. Increasingly, there is also emphasis on conducting the business of portfolio companies in an ethical and sustainable manner, with an appropriate level of corporate governance.
Investor information rights will be driven by the private equity firm's own reporting lines (eg, the need to pass on certain information to the underlying investors and compliance with the Walker Guidelines).
Being a public document, the content of the articles will be limited to key constitutional provisions, including details of:
- share capital;
- rights attaching to shares;
- restrictions on share transfers;
- board and shareholder proceedings; and
- shareholders' rights against the company.
Under English law, the articles form a contract between the members and the company (ie, not a contract between members themselves); therefore, provisions regarding the checks and balances that a private equity investor wants to impose on management are included in the investment agreement.
7.2 What considerations should a private equity firm take into account when putting forward nominees to the board of the portfolio company?
Having an investor director or investor directors appointed to the board of Topco and possibly other group companies is crucial to the private equity firm's monitoring of the performance of its investment. Typically, the investor director(s) will have disclosure rights allowing the sharing of information acquired at board level with the wider investor group.
However, the position of an investor director can be complex in certain situations. Essentially, two parallel roles need to be balanced:
- acting as a representative of the private equity investor; and
- acting as a director of the investee group company.
Normally, the two roles are broadly compatible, as they both require that the investor director act with a view to maximising shareholder value; and although there is a statutory duty on directors to avoid situational conflicts of interest, there is also a statutory procedure for pre-authorising such conflicts in the articles. However, in circumstances of financial distress, this dual role can put the investor director at increased risk of being in breach of his or her directors' duties. A common example of this is where further funding is being discussed at board level, but the investor director knows that the private equity investor will not provide further funding – the investor director's duty to disclose relevant information to his or her co-directors conflicts with his or her wish not to disclose sensitive investor-side information. In potential conflict situations, it is important that investor directors seek legal advice on their own personal position.
7.3 Can the private equity firm and/or its nominated directors typically veto significant corporate decisions of the portfolio company?
On a majority investment, the private equity investor will typically have broad appointment powers, including the right to appoint a majority of the board, and favourable quorum requirements to ensure that it controls the board of Topco and potentially other group companies; but given the sensitivities referred to above, investor directors rarely sit on all subsidiary boards. Decision making at the operating level therefore often lies with management, which is helpful in allowing them the autonomy they need to run the business on a day-to-day basis; but the private equity investor will want some control over key decisions to control its investment. This is achieved through the inclusion of investor consent rights in the investment agreement.
Most investor consents operate as a negative right (ie, the newcos and management agree not to take certain actions without the private equity investor's consent). Such consent rights will cover, among other things:
- acquisitions and disposals (including, if applicable, protection against asset stripping for compliance with the Alternative Investment Fund Managers Directive (AIFMD));
- capital commitments;
- loans and borrowings of the group;
- employee remuneration and benefits;
- property disposals and acquisitions;
- changes to constitutional documents and share capital; and
- the appointment and removal of directors.
On leveraged transactions, an additional layer of veto rights will be introduced through the lender consent requirements as set out in the financing documents.
Where the private equity investor is taking a minority position, veto rights may be more streamlined, focusing on economic protection and fundamental strategic matters.
7.4 What other tools and strategies are available to the private equity firm to monitor and influence the performance of the portfolio company?
To ensure that each group company and the target comply with applicable laws and regulations and principles of corporate governance (and, if applicable, the investor's own policies and protocols in relation to investee companies), each newco and management will be required to undertake to comply with a pre-agreed list of positive covenants set out in the investment agreement, which usually includes:
- the maintenance of adequate insurance policies for the group;
- compliance with laws and licences;
- and compliance with group-wide policies (eg, anti-bribery and corruption, environment, health and safety and data protection policies).
A contractual right to receive regular information in relation to the business and access rights to the officers, employees and premises of the group allows the private equity investor to monitor performance of the investment and to ensure compliance with applicable laws, regulations and corporate governance obligations (eg, financial crime laws, the AIFMD and the Walker Guidelines), in addition to information that the investor directors, by virtue of their position on the board, may acquire and disclose to the investor group. In the absence of any specific information rights set out in the investment agreement, the private equity investor will be entitled to receive only the information available to any other shareholder as a matter of company law (ie, the annual accounts). Monthly management accounts, details of and changes to operating budgets and the business plan, and information relevant to assessing compliance with law and regulation and the minutes of all board meetings will typically be requested.
8.1 What exit strategies are typically negotiated by private equity firms in your jurisdiction?
Trade sales and sales to other private equity buyers are the most common exit paths for private equity in the United Kingdom. Save in the case of distressed assets, these sales are almost invariably structured as share sales (although this may be preceded by a pre-sale reorganisation or hive-down if only part of the target is being disposed of at that time).
As the private equity asset class has matured, sales from one private equity owner to another have become commonplace. A private equity investor may even invest in the same business for a second time, purchasing from a subsequent owner and taking advantage of pre-existing knowledge of a business and sector, and potentially utilising capital from a subsequently raised fund. Initial public offerings (IPOs) are less common in the current market, but are important to the large-cap market in particular.
A sale to trade will often result in a better price for the sellers, but a more protracted deal process. Corporate buyers tend to be more demanding than private equity firms over deal protection (eg, warranty coverage, tax indemnities and post-completion adjustments), which can result in more negotiation over terms. Due diligence by corporate buyers may also be more involved, given the need to ensure synergies and corporate fit. Private equity bidders, on the other hand, often have the edge in terms of deal deliverability and speed of execution. Being in the business of executing deals, they may also be more streamlined than corporates when it comes to approval processes.
8.2 What specific legal and regulatory considerations (if any) must be borne in mind when pursuing each of these different strategies in your jurisdiction?
Sales to trade and private equity are generally free from burdensome legal and regulatory considerations, and can provide a quick and simple exit route (assuming no change of control or merger control requirements). With trade sales, there may be heightened risk of antitrust issues where the buyer is a direct competitor of the target and potentially greater concerns about sharing commercially sensitive information early in the process.
Typically, an auction process will be open to both trade and private equity bidders, so that the sellers can compare price and deal terms. Where management are keen to stay with and grow the business, a sale to private equity provides an opportunity to reinvest alongside the incoming investor; but where management are keen to exit, a sale to trade at a higher price may be more attractive. Given the general approach to warranties and indemnities (as discussed in question 4.1), there will be limited exposure for the private equity seller on an M&A exit.
An IPO is more tightly regulated and with the preparation of a prospectus there may be increased exposure for the private equity investor. Preparation of a prospectus and the typical ‘road show' required for an IPO launch will also be distracting to senior management (more so than a typical M&A disclosure process). Another key factor to consider is that an IPO is highly unlikely to result in a complete exit on listing and shares retained will be subject to underwriters' customary lock-up requirements.
9 Tax considerations
9.1 What are the key tax considerations for private equity transactions in your jurisdiction?
A private equity transaction will be structured, so far as commercially practicable, to minimise tax leakage in relation to the acquisition funding, the operation of the business going forward and on a future exit. The structure will need to make any expected requirements of the portfolio group prior to exit – such as servicing interest payments (typically, third-party debt will be cash paid and shareholder debt/preference shares will roll up to exit), extracting excess cash or injecting further funding – in as tax efficient a manner as possible. The main tax structuring considerations on a typical buyout include the following:
- Tax efficient returns on strip and sweet instruments: Usually, capital treatment is desired for shares, but income treatment is accepted for interest returns on shareholder debt (see questions 3.4 and 6.2).
- Limit UK withholding tax on loan note interest: The ‘quoted Eurobond exemption' from withholding tax will apply if the loan notes are listed on a ‘recognised stock exchange' (eg, the International Stock Exchange in the Channel Islands). Alternatively, double tax treaty relief may be available (although this is not always straightforward).
- Corporation tax relief on interest payments on shareholder and external debt: This is useful to maximise, as it can shelter tax in the group; but as the UK tax code now contains various potential restrictions on deductibility (especially on shareholder debt), this is not as significant a factor in practice as it was in the past.
9.2 What indirect tax risks and opportunities can arise from private equity transactions in your jurisdiction?
A share sale will be exempt from value added tax (VAT), but will give rise to stamp duty payable by the purchaser (at 0.5% of the amount of the consideration).
An asset sale (which, as noted above, is rarely the preferred outcome) is prima facie subject to VAT, unless any of the assets qualify for a VAT exemption or the sale is a transfer of a going concern.
An investor will usually seek advice on a deal-by-deal basis on how to structure its adviser engagements so as to minimise irrecoverable VAT cost (and, if relevant, maximise corporation tax relief) on transaction costs.
Employment tax risks in relation to management incentive arrangements will also need to be managed – see question 6.2.
9.3 What preferred tax strategies are typically adopted in private equity transactions in your jurisdiction?
Restrictions on corporation tax relief and withholding tax exposure in relation to interest payments mean that recently, the strip investment more often consists mainly of preference or preferred shares, with less – or even no – shareholder debt (see questions 3.3 and 3.4).
An exit is typically structured so that the investor and management sell their shares in Topco directly to the buyer, rather than selling lower down the group. This usually gives capital treatment on share proceeds and avoids any potential tax leakage on (or delay in) repatriating cash proceeds up the stack compared to if the sale were made further down the stack.
A flexible reinvestment strategy can be offered to management, so that they can either cash out and reinvest to ‘bank' any accrued capital gains at current rates or secure tax-deferred treatment to ‘roll over' any accrued gain until a future exit. In the United Kingdom, Her Majesty's Revenue & Customs (HMRC) clearance tends to be sought on behalf of management to confirm that:
- tax-deferred treatment will apply; and
- HMRC will not seek to challenge the rollover as giving rise to taxable income under the ‘transaction in securities' anti-avoidance provisions.
In the current climate, where the tax profile of a group can have a direct effect on its reputation, private equity investors have differing appetites as to what level of tax planning (be that in terms of acquisition structuring, management incentive arrangements or within the portfolio group) is considered appropriate.
10 Trends and predictions
10.1 How would you describe the current private equity landscape and prevailing trends in your jurisdiction? What are regarded as the key opportunities and main challenges for the coming 12 months?
The UK buyout market has shown remarkable resilience despite Brexit and COVID-19, and deal activity has remained relatively strong. There was some stalling in reaction to the initial lockdown (Q2 2020); but as the world starts to navigate the ‘new normal', we are seeing an uptick in M&A – although it is heavily concentrated in certain sectors and valuation of targets is often challenging.
Against this backdrop, and in the face of ongoing competition from strategic buyers, buyout firms are turning to creative investment strategies, including:
- bolt-ons (where COVID-19 deal risks are often lower);
- corporate carve-outs (as companies seek to sell underperforming or non-core assets);
- minority and co-investment strategies; and
- consortium bids.
There have also been more fund-level transactions and a move – particularly among bigger players, – towards expanding specialisms to provide for alternative investment strategies. Continuation vehicles for fund-to-fund transactions are increasingly popular, as well as specialist tech-focused, real estate and infrastructure funds, growth funds and longer-term funds.
We have also seen an uptick in distressed restructurings and distressed M&A, but not yet to the extent that might have been expected – in part due to lenders being supportive of businesses that have realistic prospects of recovery. Whether this is the case in 2021 for those sectors in which economic conditions remain challenging remains to be seen.
10.2 Are any developments anticipated in the next 12 months, including any proposed legislative reforms in the legal or tax framework?
In addition to navigating the ‘new normal' in the wake of COVID-19, we await to see what impact Brexit will have on private equity transactions. While there are many legislative changes relating to Brexit that will impact on fund regulation and marketing, the impact on private equity transactions will principally be to add complexity – notably in relation to competition clearances and due diligence as a result of parallel, but no doubt diverging regimes in some areas. Brexit may also impact on the ways in which those advising on cross-border deals can operate.
Aside from Brexit, the tightening of foreign direct investment regimes in the United Kingdom and abroad will likely result in more foreign investments being subject to review. It will also be interesting to see how distressed portfolio company work may change following the introduction of the Corporate Insolvency and Governance Act 2020 – specifically, whether there will be a wide adoption of the free-standing moratorium and the new restructuring plan mechanism.
There is continuing speculation that there will be significant changes to the UK capital gains tax rules, fuelled in part by the need for additional fiscal revenue, but also by a recent review by the Office of Tax Simplification. The initial report from that review proposed either aligning the rates of tax on income and capital or a rethink of the tax treatment of shares held by employees and managers. Any such change could materially impact on private equity structures for management and could also affect fund (especially carried interest) structures.
It will also be interesting to see whether the US trend of increasingly using special purpose acquisition companies as an alternative to a traditional initial public offering for companies seeking to go public will be seen in the United Kingdom.
11 Tips and traps
11.1 What are your tips to maximise the opportunities that private equity presents in your jurisdiction, for both investors and targets, and what potential issues or limitations would you highlight?
For general partners, it is key to respond to investor demands, particularly around liquidity. For example, the longer-term funds allow liquidity opportunities while holding onto good assets and allowing greater flexibility in terms of timing of exit in a volatile market. It is becoming increasingly clear that a broader menu than just the traditional 10-year fund is required; as is an appetite to explore consortium bids, co-invest opportunities and minority investment while valuations are at such high levels. Of course, it is easier for the bigger private equity players to adopt such widespread strategies and it may take time for smaller firms to emulate this; but there are opportunities to explore.
For portfolio companies, it is mainly about timing the cycle with the investor, which may require a more flexible approach to exit and more liquidity options. Portfolio companies can also work with the general partner to explore bolt-on strategies, to take advantage of an appetite to deploy capital in this way.
We cannot ignore the fact that many investments will suffer in the current climate, and that careful consideration will need to be given in distressed situations where further funding may be required, working closely with the general partner to explore the options available and potentially refocusing business plans and strategy.
- Chris Hale (Chair Emeritus, Private Equity and Financial Sponsors)
- Ian Shawyer (Partner, Private Equity and Financial Sponsors)
- Carys Clipper (Knowledge Counsel, Private Equity and Financial Sponsors)
- Simon Skinner (Partner, Tax)
- Sivanti Devakumar (Senior Associate, Tax)
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.