1 Legal framework
1.1 Which general legislative provisions have relevance in the private equity context in your jurisdiction?
US private equity funds are formed to be exempt from registration under the Investment Company Act of 1940 and thus are not directly regulated by the US Securities Exchange Commission (SEC). The various states do not regulate them either.
Although private equity funds are not regulated entities, the offering by a private equity fund of its own interests and the acquisition by a private equity fund of securities in portfolio companies may implicate numerous US federal and state laws. The following laws are the most relevant to those activities.
Securities Act of 1933: This federal act regulates the offering and sale of securities in the United States, and is thus relevant to the offering by a private equity fund of its own interests and to the acquisition of by a private equity fund of portfolio company securities. Private equity funds must be offered pursuant to an exemption from registration under the Securities Act, most commonly relying on Section 506 of Regulation D for sales to ‘accredited investors' and Regulation S for sales to non-US persons. Private portfolio companies rely on the same or other exemptions from the Securities Act when offering their own securities to investors.
Investment Company Act: This federal act regulates investment companies and other pooled investment vehicles (including mutual funds) that engage primarily in investing, reinvesting and trading in securities, and whose own securities are offered to the investing public. Private equity funds must be structured and offered pursuant to an exemption from the Investment Company Act, typically relying on Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act.
Section 3(c)(1) provides an exemption for any fund:
- whose outstanding securities (other than short-term paper) are beneficially owned by not more than 100 persons (or, in the case of a qualifying ‘venture capital fund', 250 persons); and
- which offers its securities in a private placement that is exempt from registration under the Securities Act.
Section 3(c)(7) provides an exemption for any fund whose outstanding securities are owned exclusively by persons who, at the time of acquisition, are ‘qualified purchasers', and which offers its securities in a private placement that is exempt from registration under the Securities Act. In the case of a natural person, the investor (alone or together with a spouse or spousal equivalent) must own not less than $5 million in investments to satisfy the definition of ‘qualified purchaser'.
Investment Advisers Act of 1940: This federal act regulates investment advisers – meaning any person or firm that, for compensation, engages in the business of providing advice to others or issuing reports or analyses regarding securities. The term ‘investment adviser' includes private equity fund managers. An investment fund manager to a private equity fund must register with the SEC under the Investment Advisers Act, unless it can claim an exemption. Exemptions from the Investment Advisers Act upon which private equity fund managers rely include the following:
- Private fund adviser exemption (Section 203(m) and Rule 203(m)-1 of the Investment Advisers Act): This exempts:
- an investment adviser with its principal office and place of business in the US (‘US investment adviser') which:
- acts as an investment adviser only with respect to ‘qualifying private funds'; and
- manages total private fund assets of less than $150 million; and
- an investment adviser with its principal office and place of business outside of the United States (‘non-US investment adviser') which:
- has no clients that are US persons except for one or more qualifying private funds; and
- manages at a place of business in the United States only private fund assets valued less than $150 million.
- Notably, a non-US investment adviser relying on the exemption:
- could manage an unlimited amount of capital in the United States through qualifying private funds, so long as it does not manage $150 million or more at a place of business in the United States; and
- could manage assets of clients other than qualifying private funds at a place of business outside of the United States, so long as its only US person clients are qualifying private funds.
- has no place of business in the United States;
- has, in total, fewer than 15 clients and investors in the United States in private funds advised by the investment adviser;
- has aggregate assets under management attributable to clients in the United States and investors in the United States in private funds advised by the investment adviser of less than $25 million; and
- does not:
- hold itself out generally to the public in the United States as an investment adviser; or
- act as a US registered investment adviser or a ‘business development company' under the Investment Company Act.
Even if a private equity fund manager is exempt under the Investment Advisers Act, its activities could subject it to registration as an investment adviser under the securities laws of one or more US states (often referred to as ‘blue sky laws' for arcane historical reasons). Blue sky laws vary by state, so must be considered state by state based on the location of the manager's activities. Some but not all states provide an exemption from registration for an investment adviser that advises a small number of clients and/or a minimal amount of capital in the state. Those states will typically treat a private fund as a single client for the purposes of any de minimis exemption.
Securities Exchange Act of 1934: This federal act regulates the securities industry and public companies, including with respect to the corporate reporting and disclosure obligations of public companies, and investor activity with respect to public securities – for example:
- reporting of holdings and activities in public companies;
- reporting and restrictions with respect to tender offers and proxy solicitations; and
- prohibitions of fraudulent activities in connection with the offer, purchase or sale of securities (eg, insider trading).
In the case of private equity funds, the Securities Exchange Act is mostly relevant to their investments in public company securities, including in portfolio companies that go public after the private equity fund's initial investment.
Employee Retirement Income Security Act of 1974, as amended (ERISA): This is a federal tax and labour law that establishes minimum standards for pension plans in private industry. In the case of private funds, under a look-through rule set forth in the US Department of Labor's ‘plan assets regulations', absent an exemption, the assets of a fund would likely be treated for the purposes of ERISA as if they were assets of any investors that are employee benefit plans subject to ERISA or Section 4975 of the Internal Revenue Code. Furthermore, the manager of a private equity fund would be deemed a fiduciary with respect to those assets, which would make operating the private equity fund impractical for various reasons. Accordingly, US private equity funds seek to rely on an exemption, such as:
- by qualifying as a ‘venture capital operating company'; or
- by ensuring that benefit plan investors (as defined in Section 3(42) of ERISA) hold less than 25% of each class of the fund's equity interests (excluding certain interests held by the fund's manager and its affiliates).
Foreign Account Tax Compliance Act (FATCA): This is a federal law aimed at tax evasion by US persons using foreign entities to hide assets and income from the US Internal Revenue Service (IRS). FATCA generally requires foreign financial institutions (FFIs) and certain other non-financial foreign entities to report on the assets of their US account holders or be subject to a 30% withholding tax on US source investment income. To avoid the withholding tax, an FFI that invests in the United States must afford the IRS a significant level of transparency with regard to its US investors. Some non-US jurisdictions have entered into intergovernmental agreements (IGAs) with the United States to address local privacy issues implicated by sharing owner information. Although IGAs vary in scope and mechanics, they generally permit non-US FFIs organised in those jurisdictions to report information regarding the FFI's investors to the local taxing agency, which will then share with the United States specified information on the US investors.
State ‘blue sky' laws: As mentioned above, various states have their own securities laws, which may be implicated by a private placement of interests to investors in a state or by acting as an investment adviser in the state. Private equity fund managers will typically seek to avoid registration as investment advisers under state blue sky laws. A private equity fund that makes a private placement under Regulation D of its interests to investors in a state may be required to make Form D filings in that state accordance with Regulation D under the Securities Act, unless an exemption is available.
State corporate law: Legal entities can be formed in any US state and the laws of any state with a connection to a transaction could be relevant in any particular situation. However, most corporations in the United States are Delaware corporations, and most investment funds and management entities are formed as Delaware limited partnerships or Delaware limited liability companies (LLCs), so the most relevant state laws for the offering by a private equity fund of its own interests and the acquisition of securities of portfolio companies are:
- the Delaware General Corporation Law;
- the Delaware Revised Uniform Limited Partnership Act; and
- the Delaware Limited Liability Company Act.
This Q&A focuses on Delaware law because it is prevalent in US corporate transactions; but readers should understand that in any particular situation, the law of a different US state may apply and that law may differ from Delaware law.
1.2 What specific factors in your jurisdiction have particular relevance for and appeal to the private equity market?
Various factors in the United States have created a large ecosystem for the private equity industry, including the following.
Legal and regulatory environment supports capital formation: US federal and state law is very receptive to establishing and growing businesses:
- Entity formation and annual maintenance costs are affordable for most small businesses.
- One of the SEC's stated missions is to facilitate capital formation. Over the past several years, the SEC has made a noticeable effort to improve and streamline its regulations to facilitate capital formation, particularly for smaller companies and start-up ventures.
- Employment laws in most US states are less restrictive than in many other jurisdictions. Most employment relationships are ‘at will', meaning that either the employer or the employee can terminate the relationship at any time for any reason (in the case of the employer, subject to certain anti-discrimination rules). As a result, it can be easier in the United States than in some other jurisdictions to hire employees or to terminate them due to the employee's performance, the employer's financial issues or no reason at all (other than certain discriminatory reasons).
- US bankruptcy laws are relatively forgiving, which allows entrepreneurs and businesses to take risks and recover if a business fails.
Availability of capital: The United States has a large number of private equity investors, including public pension funds, endowments and foundations, funds of funds, corporation pension funds, insurance companies, family offices and high-net-worth individuals.
Availability of investment opportunities: The United States has an active and developed start-up market, backed by angel investors, venture capital investors, seeding platforms and, ultimately, private equity investors, providing a steady pipeline of investment opportunities at every stage of development.
2 Regulatory framework
2.1 Which regulatory authorities have relevance in the private equity context in your jurisdiction? What powers do they have?
The Securities and Exchange Commission (SEC) is an independent US federal government regulatory agency tasked with:
- protecting investors;
- maintaining fair, orderly and efficient markets; and
- facilitating capital formation.
As such, the SEC is the primary federal agency relevant to private equity. The SEC enforces the Securities Act, the Securities Exchange Act, the Investment Company Act, the Investment Advisers Act and other statutes.
The SEC requires public companies, registered investment advisers and other regulated market participants to provide regular disclosure of significant financial and other information to give investors timely, accurate and complete information for making confident and informed investment decisions.
The SEC may audit and inspect registered investment advisers.
The SEC may enforce the federal securities laws in various ways (depending on the particular statute and the violation), including by:
- imposing monetary penalties;
- issuing ‘cease and desist' orders; and
- barring individuals and firms from participating in the markets.
The SEC may bring civil actions in US district courts and may bring administrative proceedings before independent administrative law judges. The SEC does not have criminal authority, but may – and does – refer matters to state and federal prosecutors. The SEC may cooperate with foreign regulators.
Various other US federal and state regulators could be relevant in the case of private equity investments in regulated industries or regulated companies (eg, banking, finance, transportation, utilities, gaming and communications). See also question 2.2, which discusses US regulatory oversight of investments that may impact on US national security.
2.2 What regulatory conditions typically apply to private equity transactions in your jurisdiction?
Regulatory conditions for investments in private equity funds: As described in question 1.1, private equity fund offerings are structured to be exempt from registration under the Investment Company Act and the Securities Act. They are also structured to prevent the fund manager from being deemed a fiduciary with respect to capital invested by benefit plan investors under the Employee Retirement Income Security Act. Subscription materials will require investors to provide information and documentation necessary for the fund manager to verify the investor's qualifications to invest in the offering. The fund's manager may reject subscriptions that would be problematic under any of these laws or regulations, or for any other reason.
Regulatory conditions for investments in portfolio companies: There is usually little regulatory involvement in investments by a private equity fund unless the target is a regulated entity. However:
- a private equity transaction of significant size might require a pre-merger notification under the Hart-Scott-Rodino Antitrust Improvements Act of 1976; and
- an investment by a private equity investor that is a non-US person might require a notice filing with the Committee on Foreign Investment in the United States.
If applicable, completion of these filings and clearance of the related regulatory review process will be closing conditions for the acquisition.
3 Structuring considerations
3.1 How are private equity transactions typically structured in your jurisdiction?
Private equity fund structure: A typical US private equity fund will be structured as a tax pass-through entity – commonly a limited partnership, but sometimes a limited liability company (LLC). Delaware is the most common jurisdiction of formation. A pass-through entity provides several tax benefits to a private equity fund's US taxpayer investors and to the private equity fund's manager, as described in question 3.2.
However, it is generally sub-optimal for US tax-exempt investors to invest in a tax pass-through, because they could become subject to taxes from ‘unrelated business taxable income' (UBTI). The general idea behind UBTI is that a tax-exempt organisation should be exempt only from taxes that are substantially related to the purpose of its tax exemption, and that UBTI items fall outside of that purpose. UBTI can arise for a private equity fund if the fund invests in a company that is a tax pass-through that engages in a trade or business in the United States, or if the fund borrows money. When investing in a private equity fund, US tax-exempt investors often avoid UBTI by investing indirectly in the fund through an entity that is taxed as a corporation (a ‘blocker'), which ‘blocks' UBTI from flowing directly to the tax-exempt investor.
A common approach for managers of private equity funds with a significant number of US tax-exempt investors is to form a parallel offshore investment vehicle (eg, a Cayman Islands exempted company or an exempted limited partnership, or comparable entities in the British Virgin Islands or other jurisdictions). If structured properly, the offshore fund can offer its interest both to US tax-exempt investors and to non-US investors. The offshore fund will elect to be taxed as a corporation for US income tax purposes, which will block UBTI from flowing up to US tax-exempt investors. It will also block ‘effectively connected income' (ECI) from flowing up to non-US investors, saving them from tax withholding obligations in the United States with respect to that income. ECI is similar to UBTI, in that it can arise when a non-US taxpayer engages in a trade or business in the United States or invests in a tax pass-through entity that engages in a trade or business in the United States.
A private equity fund can instead structure itself through a US-offshore ‘master-feeder' structure, where the master fund is an offshore fund formed to directly invest in all portfolio companies and is treated in the United States as a tax pass-through. US taxable investors invest indirectly in the master fund through a US feeder fund (typically a Delaware limited partnership), which is treated in the United States as a tax pass-through. US tax-exempt investors and non-US investors invest indirectly in the master fund through an offshore feeder fund that is treated as a corporation for US tax purposes. The advantage of this structure is that there is only one investing entity, which can provide some operational simplicity and potential savings. However, master-feeder structures are used less often by private equity funds than by funds with more liquid strategies, because:
- there are operational benefits than for private equity funds (eg, because they do not have to routinely rebalance positions); and
- the use of side-by-side funds makes it easier to create holding structures that optimise taxes for investors in each fund.
As in many other jurisdictions, Delaware law provides for entities (‘series limited partnerships' or ‘series LLCs') which allow segregated pools of capital to be held by different investors in the same legal entity, while the assets of each series are protected from the creditors of each other series. However, unlike in many other jurisdictions, series entities have not become popular in the United States, for the following reasons:
- Delaware (and other state) entities are so inexpensive to form and maintain that a series entity would not provide the same financial savings as in many other jurisdictions;
- Series entities have not been thoroughly tested under US tax, bankruptcy and liability laws and non-US laws;
- The legal costs for preparation of formation and offering documents for a private equity fund involving series entities would likely be high, because most US standard fund documents are for separate entities and converting those into series documents would require substantial revisions;
- A series could lose its protections from creditors of other series if the manager's personnel fail always to treat each series as a separate entity (eg, by maintaining separate books and records, and signing contracts in the fund's name rather than solely in the name of a specific series); and
- Administration firms and auditors generally do not provide discounts on separate series compared to separate entities.
Also note that each series will be treated as a separate client under the Investment Adviser Act and (likely) state blue sky laws.
Portfolio company investments: Private equity funds typically invest directly in privately issued equity securities of their portfolio companies. These include common stock, convertible preferred stock, warrants, convertible notes and other securities and investment instruments. Later stage private funds (or buyout funds) might engage in larger M&A transactions (eg, mergers, tender offers), which can be structured in almost any manner used in US M&A transactions; but a discussion is beyond the scope of this Q&A.
3.2 What are the potential advantages and disadvantages of the available transaction structures?
As described in question 3.1, limited partnerships and LLCs are the most favourable (and nearly universal) entities for US private equity funds, because they are tax ‘pass-throughs', meaning that the fund's income is passed through to its partners without being taxed at the level of the fund. By contrast, in the United States, a corporation is subject to double taxation, meaning that it is taxed on its income as a separate entity and if it distributes income to its shareholders, they will be taxed on those distributions. An additional benefit of a tax pass-through for private equity investors is that many portfolio investments will be held for longer than one year and taxed at preferable capital gain rates, and the character of the taxable income is passed through to the investors.
Another advantage of a tax pass-through is that the managers' performance-based compensation can be structured as a partnership allocation (often referred to as a ‘carried interest'), which provides the opportunity for the fund manager to receive that income at preferential long-term capital gain rates. It also can be better for investors, because a US individual taxpayer might be unable to fully deduct his or her share of the performance fees paid to the manager, whereas structuring performance-based compensation as carried interest would avoid that potential problem.
LLCs provide limited liability for all members, including the manager; while the general partners of a limited partnership are subject to general liability. The general partner of a private equity fund formed as a limited partnership will be a separate legal entity (LLC or corporation), to shield the ultimate controlling persons (eg, the fund manager's principals) from the general partner's liability. By contrast, the managing member of an LLC might a separate legal entity for operational reasons, but this structure is not necessary to shield the ultimate controlling person from general liability, because the managing member already has limited liability. Thus, LLCs can permit simpler structures than limited partnerships because an LLC manager can be an individual rather than a separate legal entity.
Notwithstanding that LLCs can allow for simpler private equity fund structures, limited partnerships remain the preferred entity for most US private equity funds. This might be because LLCs are a relatively recent creation in the United States and took some time to gain traction; but LLCs are now very common throughout United States. Perhaps the most persuasive reason is that the treatment of US LLCs in some countries is unclear under treaties or local laws, which could result in LLCs being treated less favourably for tax purposes and/or private placement exemptions than limited partnerships in non-US jurisdictions. LLCs are more often used in private funds with no international aspect.
As explained in question 3.1, at present we see few advantages and several disadvantages to using series entities in a US private equity fund structure.
3.3 What funding structures are typically used for private equity transactions in your jurisdiction? What restrictions and requirements apply in this regard?
Private equity funds: Private equity funds are ‘capital call' funds, meaning that investors make ‘capital commitments' to the private equity fund, agreeing to contribute up to a maximum commitment amount to the fund over its term. However, investors fund their capital contributions only when the fund manager calls for them, usually after identifying and committing to an acquisition or when needed to pay the private equity fund's expenses. Capital contributions are typically due within a specified period after the funding notice (eg, 10 or 20 days after notice). Default in promptly funding a capital contribution can have significant consequences, up to and including forfeiture by the investor of its entire interest in the fund.
The private equity fund may call capital commitments for investments in new portfolio companies only during the ‘investment period', which is a set period after the fund's launch (eg, five years). After the investment period, the fund may call remaining capital commitments for limited purposes, such as:
- completing investments to which the fund committed before the end of the investment period;
- making follow-on investments in existing portfolio companies; and
- paying fund expenses.
Many private equity funds permit limited ‘recycling' of capital invested in investments that were purchased and held for only a short time (eg, 18 months).
Private equity funds sometimes enter into credit facilities to allow the fund to make short-term borrowings, such as bridge loans to allow the fund to close an investment prior to receiving capital contributions from the investors, or to pay management fees and fund expenses. The private equity fund's leverage is typically capped at a specified percentage of the aggregate capital commitments to the fund.
Portfolio company acquisitions: Investments in targets may be structured in almost any manner used in M&A transactions. For example, an acquisition may be funded through a combination of an equity investment by the private equity fund and an investment by a mezzanine lender and/or bank debt.
3.4 What are the potential advantages and disadvantages of the available funding structures?
One advantage of a capital call fund is that the investors' commitments are drawn down over time, so investors do not have to contribute their entire commitment when they subscribe to the fund. This affords investors some control over their personal liquidity. However, it is difficult to predict the timing of capital calls and distributions, so investors might have to reserve capital in liquid, stable investments (likely with low returns) to ensure that cash can quickly be accessed when the fund calls for it.
From the fund's standpoint, a disadvantage of having to call capital is that it can delay closing a pending transaction, particularly if any investors default on their capital contributions. (On this point, defaulting on a capital call can result in very negative consequences for the defaulting investor, potentially including forfeiture of its interest.) However, calling capital earlier than needed would cause a drag on the fund's performance, which could also reduce the manager's performance-based compensation.
A private equity fund might enter into a credit facility to allow it to close transactions before receiving capital contributions called from investors. A credit facility can also give a manager greater operational flexibility in managing the fund's finances. The potential disadvantages of a credit facility are the costs and the risks inherent in leverage. Use of a credit facility can also affect (arguably inflate) the fund's internal rate of return (IRR), if the IRR is calculated based from the date on which investors fund capital calls rather than the date on which the investment is made using the credit facility.
3.5 What specific issues should be borne in mind when structuring cross-border private equity transactions?
Taxation is a critical consideration in any cross-border transaction. Some of those topics are discussed elsewhere in this Q&A. However, tax considerations vary based on the facts and circumstances of the transaction, so the discussion in this Q&A only touches on a few of those considerations.
Investments into the United States by foreign persons may have Committee on Foreign Investment in the United States implications (see question 2.2).
Investments in US regulated industries by non-US investors are generally more restrictive than for US investors and should be carefully analysed.
US private equity investors investing outside the United States should engage local counsel to help them navigate the legal, tax and regulatory issues specific to that jurisdiction.
Cross-border transactions can also result in practical complications, including relating to wire transfers, execution and delivery of documents and other closing mechanics.
3.6 What specific issues should be borne in mind when a private equity transaction involves multiple investors?
Corporate law in the United States generally protects freedom of contract, allowing parties to structure their relationships in the manner they deem fit, within the confines of the law. However, it also provides less protection for parties which enter into contracts that are not drafted to protect their interests. Thus, it is critical as a minority investor in a private equity transaction (or as a co-investor in a group of investors) to ensure that the agreements protect your interests.
When multiple investors participate in a private equity investment, the lead investor might receive rights that give it greater control over the portfolio company than the co-investors. This could be merely due to the level of the lead investor's ownership (ie, because the lead investor will hold a voting percentage giving it effective control over certain decisions). This could also result from the portfolio company giving the lead investor the right to nominate a director, or giving the holders of a series of shares the right to nominate a director (if the lead investor will control that appointment due to its voting percentage in that series).
To increase their influence on portfolio companies and otherwise protect their own interests, minority investors in US private equity transactions will usually try to obtain some or all the following customary rights (whether an investor will successfully acquire them in any particular transaction depends on the facts and circumstances of the transaction, including the relative negotiation leverage of the parties).
Board participation or observer rights: Although board rights are often reserved for the lead investor, in some situations a minority investor might be able to acquire rights to board representation. Alternatively, an investor might receive board observer rights, allowing it to designate an individual to attend board meetings as a non-voting participant, perhaps subject to the board excluding the observer from sensitive board matters. Board observer rights can also be important for satisfying the venture capital operating company exemption from the Employee Retirement Income Security Act discussed in question 1.1.
Information rights: Minority investors usually seek contractual rights to receive periodic updates, reports and information from portfolio companies on various matters and material developments. Although state corporate law may require corporations to provide shareholders with certain books and records inspection and information rights, that information is typically minimal and less detailed than private equity investors expect from portfolio companies. Moreover, companies may be able to limit inspection rights and information rights, so minority investors may seek protections against that.
Right of first refusal: ‘Right of first refusal' and ‘right of first offer' are terms used to describe contractual rights whereby an existing shareholder that wishes to sell its shares to a third party must first offer them to other existing shareholders.
Pre-emptive rights: Pre-emptive rights allow an investor to purchase its pro rata shares of shares being sold by the portfolio company, subject to customary exceptions (eg, grants of stock options to employees under existing plans, issuances upon conversion of convertible securities), to prevent its ownership being diluted.
Tag-along rights: These rights allow an investor to sell alongside other investors in a sale to a third party.
Drag-along rights: These rights allow a controlling investor or group of investors to force other shareholders to sell alongside them in a sale to an acquirer of the company. This prevents holdouts when the majority wish to sell. This is not necessarily beneficial to the minority investors, but is usually coupled with tag-along rights.
Anti-dilution: Anti-dilution rights protect a shareholder's shares from being diluted by issuances of securities at a price below the price paid by the shareholder. Essentially, this results in an automatic adjustment to the number of shares held by the holder. This is a common protection in US venture capital and private equity investments in convertible preferred stock; it adjusts the number of shares of common stock issuable upon conversion of the convertible preferred stock. Unlike in some other jurisdictions, the anti-dilution mechanism usually does not require the investor to pay additional capital to subscribe for new shares.
Negative consent rights: Private equity investors will typically have contractual rights to consent to major transactions and decisions. Minority investors might protect themselves by ensuring that approval percentages are high enough to require one or more co-investors' vote rather than just the vote of the lead investor. Specific classes or series of shares may hold specific negative consent rights (eg, given to all series of convertible preferred stock, voting as a class, or to a specific series of preferred stock). Among other things, these rights might cover:
- change of control of the portfolio company;
- investment in or acquisition of another company;
- incurrence of debt;
- changes to organisational documents;
- entry into or revision of material agreements;
- material expenditures;
- entry into or revision of affiliated transactions;
- material deviations from the approved budgets or changes in strategy; and
- key personnel decisions.
These rights could be set out in various locations within the portfolio company's governing documents and agreement, such as in:
- the certificate of incorporation or bylaws;
- a shareholders' agreement;
- an investor rights agreement; and/or
- a voting agreement.
Minority investors might seek other, less common rights to exit an investment. For example, a minority investor might:
- ask for a put right to require other investors to purchase its interest in specific circumstances; or
- seek the right to force the company to offer itself for sale if there has been no exit transaction by a set date.
4 Investment process
4.1 How does the investment process typically unfold? What are the key milestones?
Although the details will vary, private equity investments usually unfold as follows:
- Introduction: Private equity investors and portfolio companies can be introduced in myriad ways. The initial contact could be initiated by the investor, the portfolio company, investment bankers, co-investors, existing portfolio companies or anyone else.
- Initial discussions: The parties may discuss the basic terms of a potential investment, such as the size of the investment, pricing, timing, the type of investment instrument and other material terms. If the parties agree on these basics, they might memorialise the terms in a non-binding term sheet or letter of intent. This step might not apply to an auction, except perhaps in case of a ‘stalking horse' bid.
- Due diligence: The private equity investor will conduct due diligence on the target. The scope and depth of review will vary, but due diligence usually starts with financial and business due diligence and progresses to legal, tax and operational matters if the initial checks are satisfactory. Documents are usually shared through virtual data rooms.
- Investment committee/governing body approval: In the case of a private equity fund investor, the investment may require the approval of an investment committee or other governing body. The investment team may prepare an extensive memorandum for the investment committee, including details of the target's business, finances, customers, industry, competitors, management team and strategic plan, as well as the investment rationale/thesis, major risks, exit strategy and anticipated returns.
- Negotiation, execution and closing: Assuming that the private equity investor and the target have obtained any necessary approvals, they will negotiate terms for the transaction and sign the contract if they come to an agreement. Closing of the transaction will usually be scheduled to allow time for the fund to call capital from its investors and may also be subject to satisfaction of various conditions, which could include:
- Hart-Scott-Rodino and/or Committee on Foreign Investment in the United States clearance;
- receipt of specific regulatory approvals;
- receipt of any required third-party consents; and
- anything else necessary for the transaction or agreed by the parties.
4.2 What level of due diligence does the private equity firm typically conduct into the target?
This can vary based on diverse factors, such as:
- the stage of the target's business;
- the size of the potential investment;
- the complexity of the target's business;
- whether the investor is a lead investor;
- the investor's normal approach to due diligence; and
- whether the investor identifies areas of concern during the initial due diligence.
The private equity firm will typically engage an outside law firm to conduct red flag due diligence, which may extend to specific areas that are relevant to the target's business (eg, IP rights for a technology business; organised labour concerns and environmental liabilities for a manufacturer). A private equity firm might also engage an accounting firm to review financial information or engage other experts as necessary.
4.3 What disclosure requirements and restrictions may apply throughout the investment process, for both the private equity firm and the target?
Term sheets and letters of intent are typically non-binding. However, if the parties execute a term sheet or letter of intent, they might be deemed to have a common law obligation to negotiate in good faith.
A signed transaction agreement will include various representations and warranties, and may include pre-closing covenants. Regardless of whether the agreement includes pre-closing covenants, the parties will likely have a common law obligation to work together in good faith to close the transaction, which could imply an obligation to give notice of problems that arise between signing and closing.
Pre-closing covenants will typically cover all material items necessary to close the transaction, including obtaining necessary approvals (eg, regulatory clearances and third-party consents); and will oblige each party to give notice to the other of breaches of representations and warranties. The target might be restricted from entertaining alternate offers and/or be required to provide notice to the private equity firm of any competing bids that it may receive.
4.4 What advisers and other stakeholders are involved in the investment process?
The investor will normally engage legal counsel, and possibly accountants and other advisers, to assist in due diligence. Both parties will hire legal counsel to negotiate and close the transaction. Counsel to either party might take the lead in drafting the legal documents.
Investment bankers and brokers are sometimes involved in transactions, although it is more likely that a target will be the party engaging them, because private equity firms usually conduct their own financial and investment analysis and probably do not need outside assistance to navigate the investment process.
In larger acquisitions that involve a financing component, banks, mezzanine lenders and other lenders might play a role.
In some situations, a controlling shareholder of the target will take an active role in negotiation and execution of the transaction, particularly if venture capital and/or private equity investors control the target.
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?
This will depend on the stage of investment and perhaps the size of the investment. For example, a private equity investment in a Series C round of a venture capital-backed target would not include a post-closing mechanism. Absent any material breach of representations and warranties, there would be no remedy for ‘leakage' between signing and closing.
For transactions that include a purchase price adjustment mechanism, closing accounts remain the dominant approach in the United States. The locked box mechanism is a relatively new concept in the United States, but appears to be slowly increasing in popularity. One factor influencing the choice of mechanism might be the familiarity of the parties and their counsel with the methods. We most often see locked box closing mechanisms when:
- one party is from a jurisdiction where this mechanism is more common (eg, a Europe); or
- one or more of the parties has previously been involved with an acquisition that included this mechanism.
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?
Larger US acquisitions often include provisions for break-up fees, exclusive negotiations, no-shop clauses and other mechanisms, to reduce the risk of the parties walking away from the transaction. Delaware law tends to be most relevant to these matters, but this can vary based on the domicile of the parties and the governing law provision of the contracts.
Typically, a break-up fee is paid by the seller to the buyer if the transaction fails to close due to specified actions of the seller, such as breaching the exclusive negotiations clause or entering into a transaction with a different buyer. However, a break-up fee can also run in the other direction (from the buyer to the seller). If a transaction includes a break-up fee, this will normally be included in the acquisition agreement.
Delaware courts allow acquisition transactions to include protection measures, as long as those provisions do not unreasonably prevent potential bidders from making higher offers. Whether the protection measures in any specific transaction are reasonable will depend on the facts and circumstances. However, Delaware courts routinely find break-up fees in the range of 3% to 4% of the transaction's equity value acceptable and have indicated that slightly higher break-up frees may be acceptable for smaller transactions.
Sometimes a non-binding letter of intent will include a termination fee to cover one or other party's due diligence and negotiation expenses.
5.3 How is risk typically allocated between the parties?
Risk is allocated in the transaction agreement. The target will typically provide extensive representations and warranties about the company, the business and any sellers; whereas the buyer's representations and warranties will be much more limited. In some situations, (typically smaller or earlier stage transactions), the transaction agreement may not include an indemnity provision. In that case, breaches of representations and warranties will be addressed in a breach of contract case under applicable law and within the applicable statute of limitations.
Many purchase agreements include detailed indemnity provisions, which may include:
- caps on total indemnity;
- purchase price escrow mechanisms; and
- time limits on claims (which may be shorter than the applicable statute of limitations).
When purchase agreements include indemnity provisions, they commonly make the indemnity provision the exclusive remedy for breaches, to avoid a party circumventing any caps, time limits and other limitations by suing for breach of contract.
Representations and warranties insurance policies might back the indemnities in larger transactions. A policy can be used either as an exclusive source of recovery or in conjunction with other sources of indemnification (eg, purchase price escrow or seller indemnity).
5.4 What representations and warranties will typically be made and what are the consequences of breach? Is warranty and indemnity insurance commonly used?
The company will usually make extensive representations and warranties, and will provide disclosure schedules detailing any qualifications to those representations and warranties. The specific representations and warranties will vary based on the company's business, but often include the following:
- The company was properly formed and exists in good standing;
- The agreement was duly authorised and enforceable against the company and does not violate applicable law;
- The company has all necessary governmental consents and licences needed for its business and the pending transaction;
- The seller will pass to the buyer title to the shares, free and clear of liens and encumbrances;
- The company's capitalisation is as represented to the buyer;
- The financial statements are accurate and the company has disclosed all material liabilities in the financials or otherwise;
- The company has disclosed all material developments related to its business;
- The company is in compliance with laws applicable to its business;
- The company has disclosed all material litigation relating to its business;
- The company has paid its taxes when due;
- The company has no material environmental problems;
- The company is in compliance with employee laws; and
- The seller / company has disclosed certain information regarding the company's employee benefit plans, IP rights, material contracts, insurance policies, real property, assets and related-party transactions.
In some jurisdictions, it is the practice to treat anything disclosed by the seller in a virtual data room as if it were disclosed in the purchase agreement – that is, the buyer will be deemed to have constructive knowledge of everything that has been disclosed in the data room and cannot later assert that the information was not fully and fairly disclosed. By contrast, in US transactions, it is typically the seller's obligation to highlight any exceptions to the representations and warranties by listing them in detail on the disclosure schedules. This effectively puts more risk on the seller, because the buyer might be able to successfully assert a breach of a representation and warranty claim for something that was disclosed in due diligence, but not highlighted in the disclosure schedules.
As mentioned in question 5.3, representations and warranties insurance policies are sometimes used in larger transactions. However, most insurers have little incentive to underwrite a policy for a small transaction, because they likely cannot set the premium at a level that would be acceptable to the insured party and also recover the expected costs of underwriting the policy and dealing with future claims.
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?
Incentives for personnel of the manager: Managers of private equity funds typically receive a partnership allocation of profits (ie, the ‘carried interest'). The sponsor's principals share the carried interest and selected employees may also participate. How a firm allocates carried interest among its personnel and the specific terms applicable to carried interest grants can vary widely by firm. For example, individuals might receive a set percentage (or number of ‘points') in every investment made by the fund; or points could vary by portfolio investment based on who has responsibility for the investment. Participation in the carried interest is often subject to vesting. Vesting approaches vary – for example, vesting may apply separately to each deal based on the date on which the fund invested in the portfolio company; or may be linked to the launch of the fund for all portfolio investments. Vesting is intended to incentivise the employee to remain at the company for the life of the private equity fund. Vesting periods can vary, but are often intended to align with the expected average term of portfolio investments or the expected life of the fund (eg, five to 10 years).
Incentives for personnel of portfolio companies: In the case of private equity portfolio companies, management teams typically receive equity-based incentive compensation in the form of stock option grants. Grants to new employees normally vest over four years after the grant date, with 25% vesting on the first anniversary (called a ‘cliff vest') and the remainder vesting pro rata on a monthly or quarterly basis over the next 36 months. Additional grants to existing employees will also usually be subject to four-year vesting on a monthly or quarterly basis, but will start vesting immediately rather than being subject to the one-year cliff vest. (The idea of the cliff vest is to avoid giving a grant to an employee who quickly leaves the company; additional grants are given to employees who have already demonstrated their value and loyalty to the company.)
Stock options are generally tax advantageous for portfolio company employees because, as explained in question 6.2, they defer taxes until exercise or, for incentive stock options (ISOs) that have satisfied specified holding periods (as explained in question 6.2), until the shares received upon exercise of those options are sold.
6.2 What are the tax implications of these different structures? What strategies are available to mitigate tax exposure?
Carried interests for general partner personnel: See questions 3.1 and 3.2. In addition, recipients of carried interest grants subject to vesting will normally opt to make an election under Section 83(b) of the Internal Revenue Code to be taxed at ordinary income rates on the value of the grant as of the date of grant; otherwise, they would be taxed at ordinary income rates on the value at the date(s) of vesting. This is normally a sensible choice, because the value of the carried interest on the grant date can usually be deemed to be nil for income tax purposes (because carried interest will be received only if there are future profits), while carried interest might be much more valuable on the vesting date.
Stock option grants for portfolio company personnel: Stock option grants allow portfolio company employees to participate in the company's growth and provide the opportunity for deferral of tax payments on the value of the grants. However, they are subject to very specific restrictions under the US tax rules, so companies must take care when granting them, as described below.
Minimum exercise price of fair market value: Stock options granted by US employers must be valued at fair market value (FMV) of the underlying shares as of the date of grant. If they were valued below FMV, the options would be treated as non-qualified deferred compensation, which is problematic under the Internal Revenue Code. Thus, the issuer must determine the FMV of its shares whenever options are issued, consistent with Internal Revenue Service guidelines, or can hire an outside appraiser to value them. Many US companies that grant employee stock options will engage a 409A valuation firm to do the valuation (named after the section of the Internal Revenue Code relating to deferred compensation).
ISOs versus non-qualified stock options: In the United States, there are two general types of employee stock options – ISOs and non-qualified stock options (NSOs). US stock option plans often give the directors discretion to grant both or either. The main differences are as follows:
- ISOs: ISOs are tax favoured over NSOs. The holder is not deemed to receive taxable income when the option is exercised; and if certain requirements (including post-exercise holding periods) are met, the gains on the stock when sold may be treated as long-term capital gains, which are taxed at lower rates than ordinary income. The downside is that ISOs are subject to very specific requirements and limitations, including that:
- they may only be granted to employees and cannot by their terms be transferred other than by will or inheritance laws;
- they are subject to maximum amounts which can vest annually for any employee; and
- the company cannot take a tax deduction when the holder exercises the ISO.
- NSOs: An NSO is any option that does not qualify as an ISO. Even if the company intends to issue ISOs, if the option does not satisfy all of the ISO requirements, the option will not necessarily be invalid; it will just receive the less favourable treatment of an NSO. NSOs are easier to administer than ISOs. Holders of NSOs pay tax at ordinary income tax rates (rather than preferential long-term capital gain rates) at option exercise on the difference between the value of the shares on the exercise date and the exercise price; and the company can take a tax deduction for the compensation expense upon option exercise.
6.3 What rights are typically granted and what restrictions typically apply to manager shareholders?
Grants of carried interest to the personnel of a private equity fund manager will typically be subject to vesting as detailed in question 6.1.
6.4 What leaver provisions typically apply to manager shareholders and how are ‘good' and ‘bad' leavers typically defined?
Leaver provisions relating to carried interest grants to manager personnel are usually subject to vesting requirements. ‘Good leavers' are entitled to keep all vested carried interest as of their departure. A ‘bad leaver' is typically defined as someone who engages in certain acts of criminal behaviour or who violates certain non-compete and/or non-solicitation covenants. In addition to losing any unvested carried interest, ‘bad leavers' may forfeit some or all of their vested carried interest. A ‘good leaver' is usually defined as anyone other than a bad leaver.
7 Governance and oversight
7.1 What are the typical governance arrangements of private equity portfolio companies?
As discussed in question 3.5, private equity funds will often obtain board representation in portfolio companies and may also obtain approval rights for specific material matters. These rights may be memorialised in an agreement among shareholders and the company (eg, voting agreement, shareholders' agreement, investor rights agreement) and/or embedded in the portfolio company's certificate of incorporation and/or bylaws.
7.2 What considerations should a private equity firm take into account when putting forward nominees to the board of the portfolio company?
Potential conflicts: Private equity firms often appoint their employees to serve as directors on the boards of portfolio companies (‘designated directors'). Having a designated director can give insight and input into the portfolio company's activities. However, this practice can result in conflicts of interest for the private equity firm's designated directors.
Each designated director will have fiduciary duties to the portfolio company and its shareholders as a whole, and cannot advance the rights of the private equity firm over those of the portfolio company and its other shareholders. A designated director might also have fiduciary duties to the private equity funds managed by his or her employer. This could result in in conflicts of interest where the company's best interests diverge from those of the private equity fund. Failure to navigate these issues properly can result in exposure for breach of fiduciary duty.
In some situations, a designated director might have to recuse himself or herself from decisions. To mitigate this risk, private equity firms and their designated directors should take efforts to ensure that a board includes a number of truly independent directors, who can help the company to navigate decisions where material conflicts arise. The board can delegate certain decisions to a committee consisting of all or a majority of independent directors.
By contrast, shareholders can generally act in their self-interest (although a controlling shareholder might be deemed to owe fiduciary duties to the minority in certain circumstances). Because shareholders can generally act in their own interest, it may be helpful if certain material decisions are subject to a vote of shareholders, or a vote of a separate class or series of shareholders, rather than approval by the board of directors.
Protection of confidential information: A designated director must maintain the confidentiality of the portfolio company's confidential information. Portfolio company boards should adopt clear policies on sharing confidential information and addressing conflicts of interest, and directors should abide by them.
Antitrust issues: If a private equity fund invests in portfolio companies that are competitors, suppliers, customers or advisers to other portfolio companies, and designates employees to serve on their boards, in additional to creating conflicts of interest, those ‘interlocking directorates' could violate US antitrust laws. Each situation must be considered and addressed based on the specific facts, but it might be possible to mitigate some concerns by establishing informational barriers between directors on the various boards.
7.3 Can the private equity firm and/or its nominated directors typically veto significant corporate decisions of the portfolio company?
Directors of Delaware corporations each have one vote, and a Delaware corporation cannot give any director (including the chairman in the capacity of board member) a greater say in a specific decision, other than by requiring such a high voting percentage for the decision that the director has an effective veto. However, the board may delegate certain decisions to a committee, which will give the committee members more control over specific board decisions delegated to the committee.
Because directors have only one vote, it might be preferable to subject significant corporate decisions to the approval of a specified voting percentage of the shares (or of a specific series or class of shares) controlled by the private equity firm.
7.4 What other tools and strategies are available to the private equity firm to monitor and influence the performance of the portfolio company?
Some private equity investments provide for milestones that the portfolio company must achieve before the private equity firm will infuse additional capital.
In addition to capital, many growth stage companies seek private equity investors that can help them to navigate their growth. By providing assistance and mentoring management, investors can monitor the company and influence its performance.
8.1 What exit strategies are typically negotiated by private equity firms in your jurisdiction?
There are several potential exit strategies, including the following:
- Sale to a strategic or financial investor: The exit strategy for most private equity portfolio companies will be a sale to strategic buyer or to a new financial investor (eg, another private equity fund).
- Initial public offering (IPO). Although less common today than in the past, some exits are effected through IPOs and follow-on sales after the company is public. The private equity fund might be allowed to participate as a seller in the IPO, but will usually continue to hold most or all its shares after the IPO and will be unable to sell them in the market during the underwriter's lockup period (typically 180 days) after the IPO. Private equity investors will typically receive ‘registration rights' from the portfolio company, which will facilitate their selling shares in the public markets after the portfolio company is public. Sometimes registration rights agreements will give shareholders the right to demand that the company attempt an IPO.
- Leverage recapitalisations. Some exits can be facilitated through a leveraged recapitalisation – a corporate finance transaction through which a company borrows money to buy back shares, reducing the level of equity in its capital structure. A leverage recapitalisation may return capital to the private equity fund, although it will not necessarily effect a full exit from the position.
- Sale to third party: A private equity fund investor might fully or partially exit its position in a portfolio company in connection with its exercise of tag-along rights or another investor's exercise of drag-along rights, as discussed in question 3.6.
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?
In the case of a strategic buyer or new financial buyer, its acquisition of the portfolio company will typically be subject to the same legal and regulatory issues that may arise when a private equity fund invests in a portfolio company.
Once a portfolio company has gone public, a private equity fund with substantial holdings in the company or which has appointed a director may become subject to various Securities Exchange Act requirements, potentially including Section 13 public position reporting and Section 16 reporting and ‘short swing profits' rules. In addition, the private equity fund will have to sell its shares pursuant to Rule 144 under the Securities Act, or under a registration statement pursuant to the Securities Act.
9 Tax considerations
9.1 What are the key tax considerations for private equity transactions in your jurisdiction?
Private equity transactions typically generate mostly capital gain for individual US taxpayers, rather than ordinary income, and those gains are usually long-term capital gains, which are taxed at favourable rates. As of 2020, the highest US federal individual income tax rate for ordinary income is 37%. Short-term capital gains (for assets held for less than a year) are taxed at the ordinary income rates. The highest long-term capital gains rate is 20%.
However, in the case of carried interest allocations to private equity fund managers, the fund manager will be taxed at short-term capital gains rates for any capital gains from assets that have not been held for at least three years. This was a recent change implemented under the US Tax Cuts and Jobs Act, aimed at eliminating a perceived unfair benefit for hedge fund managers managing shorter term trading strategies, but receiving a large amount of their compensation at favourable long-term capital gains rates through carried interest.
When investing in a fund treated as a tax pass-through, investors will be taxed annually on the fund's income and realised gains, if any, whether or not they receive any cash distributions from the fund (referred to as ‘phantom income'). This can result in investors having to pay their tax obligations from other resources. Some funds address this by allowing or requiring the fund to make ‘tax distributions' to its partners (or perhaps only to the fund's manager in respect of the carried interest) in amounts intended to cover the partners' US federal, state and local income tax obligations. However, it might not always be possible or advisable for a fund to make tax distributions (ie, because it might have insufficient available cash to do so).
Other key tax considerations for private equity funds are discussed elsewhere in this Q&A. Investors should consider the specifics of any particular private equity transaction at the time of investment and the time of exit.
US taxable investors are taxed on their worldwide income.
On the other hand, US private equity is typically very tax favourable to non-US investors, which are generally exempt from US net income taxation if their activities consist solely of trading in securities or commodities for their own account (as described in Section 864 of the Internal Revenue Code). However, non-US investors will be subject to US net income taxation to the extent that their income (including income they receive as an investor in a tax pass-through entity) is deemed ‘effectively connected income' under the code.
9.2 What indirect tax risks and opportunities can arise from private equity transactions in your jurisdiction?
See question 3.1 regarding unrelated business taxable income for tax-exempt investors and effectively connected income for non-US investors.
If a US private equity fund engages in a US trade or business, or is treated as deriving income that is effectively connected with a US trade or business, its corporate non-US investors might become subject to a 30% US branch-profits tax and branch-level interest tax with respect to their investments in the fund (although the tax rate might be reduced or eliminated entirely for residents of countries with favourable tax treaties with the United States). Even if a US private equity fund is not engaged in a US trade or business, a non-US investor will nonetheless be subject to a withholding tax of 30% on the gross amount of certain US source income that is not effectively connected with a US trade or business. Non-US investors can mitigate some of these issues by investing through an offshore blocker entity.
The United States and the various states generally do not impose transfer taxes on sales of securities, and does not impose value added taxes.
9.3 What preferred tax strategies are typically adopted in private equity transactions in your jurisdiction?
See questions 3.1, 3.2, 6.2, 9.1 and 9.2.
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?
Obviously, COVID-19 has created opportunities for some businesses and has wreaked havoc on others. The private equity landscape has adjusted and will continue to adjust to these challenges. Many companies have raised capital to shore themselves up, sometimes from existing investors and sometimes from new investors. Over the next 12 months, private equity firms will likely be juggling the protection of their investments in existing portfolio companies with the opportunities to be seized in the current market.
10.2 Are any developments anticipated in the next 12 months, including any proposed legislative reforms in the legal or tax framework?
During 2020, the Securities and Exchange Commission proposed and/or adopted several regulatory changes aimed at encouraging capital formation, including:
- adopting an expanded definition of ‘accredited investor';
- proposing an exemptive order for ‘finders' that help investment managers to raise capital;
- adopting rules to harmonise the private placement exemptions; and
- adopting a new principals-based marketing rule under the Investment Advisers Act (replacing the ‘advertising rule' and the ‘solicitation rule', which were more proscriptive and prescriptive rules).
We believe that these are positive developments for private fund managers.
The new Biden administration may propose new statutory or regulatory initiatives, although we do not expect to see any immediate dramatic changes or any reversal of the recent changes relating to private funds. However, with Democrats now controlling Congress and the presidency, they might push for tax increases to pay for the past few years' massive stimulus bills and other deficit spending.
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?
There are many businesses seeking capital and there are many investors seeking to invest in good businesses. The best investors not only identify good investments, but also help to make them better and more valuable. Investors should differentiate themselves from their many competitors to demonstrate why they are the right partner for the target.
To the extent that targets can select their investors, consider picking investors that will provide something beyond money. Depending on the strength of your team and the stage of the target, this could be capital market advice, strategic assistance, operational assistance, connections or whatever else is needed. Or it could be investors that will give you relative freedom to achieve your business plan.
Most private equity investments sink or swim based on the strength of the management team, so it is important to invest in good teams. But no matter how strong the management team might be, don't partner with one that has a completely different view for the company's business plan from yours.
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.