The 2023 Landscape for Private Equity Transactions
So far in 2023, M&A markets have been disrupted in many jurisdictions. This is a consequence of geopolitical events, rising interest rates and inflation, an energy crisis in Europe, and volatility in capital and financial markets, to name just a few. The disruption has also negatively impacted private equity deal flow. As a result, private equity investors are currently experiencing a meaningful backlog both in putting to work the funds that their investors have committed, and in selling portfolio businesses to return proceeds to those investors.
The Outlook
The outlook for private equity nevertheless remains very positive. Global mega-trends will drive attractive investment opportunities; these include digitalisation, decoupling, population growth and ageing societies in some mature markets (leading to, for example, increasing demands on healthcare), decarbonisation and energy transition, and efforts to address infrastructure spending deficits.
Globally, the amount of capital available for private equity and other private capital investments has over the last years risen to unprecedented levels. A further increase can be expected.
Additionally, an increasing number of private equity investors are branching out and expanding the types of asset classes and transactions they target. Whether it is infrastructure, debt, venture capital, growth, or minority investments – “private equity” is becoming “private capital” and expanding its reach accordingly.
Private Equity in an Increasingly Regulated World
The continuous evolution of regulation is a key legal trend impacting private equity transactions across jurisdictions. There are rising scrutiny and enforcement levels, whether in antitrust or foreign investment regulation. Recently enacted EU foreign subsidies rules will going forward require additional filings. And, in times of geopolitical volatility, the different sanctions regimes impact investments.
Private Equity Transactions by Negotiated Agreement
Most private equity transactions are concluded by negotiated sale and purchase agreement. Private equity investors may take the role of buyer or seller (upon exit) – or, in a secondary buyout, both.
M&A market terms tend to vary from one jurisdiction to another. There are markets that typically are more seller friendly (most European jurisdictions, with the UK known to be particularly seller friendly). Other markets are more buyer friendly (with the USA as a good example). Sometimes, market terms are also a function of market maturity; eg, less developed markets tend to have greater variability in terms.
Notwithstanding different M&A market terms around the world, private equity investors typically take very similar positions in negotiated transactions, regardless of jurisdiction and market practice. It is useful to look at these typical private equity positions both from a buy-side and a sell-side perspective.
Private Equity Buyers
Consideration mechanism
Private equity buyers are usually comfortable with either a locked-box or a completion accounts consideration mechanism.
In a locked-box sale and purchase agreement, the purchase price is determined based on a historic balance sheet of the target business. The purchase price is then fixed in the sale and purchase agreement (sometimes subject to interest or a per diem amount). The buyer is protected by ordinary course and no leakage provisions (ie, the locked-box). For a private equity buyer, this has the advantage of high certainty at signing regarding the amount of the purchase price that will become due at completion. There is little risk of unexpected over or underfunding. Market practice in European jurisdictions, such as France, Germany, the UK, Austria, Switzerland, Sweden and Spain, favours locked-box consideration mechanisms.
By contrast, in a completion accounts mechanism, the purchase price is not calculated and trued up until after completion. The purchase price is based on a completion date balance sheet of the target business and calculation rules set out in the sale and purchase agreement. This gives the buyer the comfort that the purchase price is determined concurrently with the buyer taking control of the target, with no interim (locked-box) period. There are situations where completion accounts are the only appropriate approach, such as in complex carve-outs or other circ*mstances where there are no historic accounts for the target business that a locked-box could be based on. Also, longer regulatory clearance periods may lead to completion accounts becoming more popular with buyers to reduce the risk of changes in the target business during the pre-closing period of the transaction. Completion accounts mechanisms are common in the USA, China, Canada, Japan, Brazil and Singapore.
Conditionality
Like any other buyer, a private equity investor will aim to use conditionality as a risk mitigant if possible and where advisable. However, market practice and the competitive deal environment generally dictate which conditions are acceptable to sellers.
In all jurisdictions, market practice allows regulatory conditions, particularly in respect of suspensory antitrust and foreign investment regimes.
However, financing conditions are uncommon in most jurisdictions, where instead sellers typically expect buyers to provide proof of “certain funds” at signing – regarding both equity and debt financing. Financing conditions are seen in the US market and are not wholly unusual in China.
US M&A transactions will often include the repetition of representations and warranties and the absence of litigation as conditions. Third-party consents and “no material adverse effect/change” (MAE or MAC) conditions are often included in US deals as well. MAE or MAC conditions have been uncommon in Europe in the last decade.
In the USA, a buyer is often required to pay a reverse break fee if it exercises a termination right, particularly if a debt financing condition was included and not satisfied. In Europe, however, break fees are not a common feature, even where transactions face material concerns that conditions may not be satisfied by the agreed longstop dates.
Warranties and indemnities
Notwithstanding the thorough due diligence that they typically conduct, private equity buyers usually seek contractual protection against identified risk items. This often includes pre-closing tax and other risks that buyers are aware of at signing and that can be covered by indemnities (rather than price reductions, which in particular tend to be seen unfavourably in competitive situations).
In all markets, private equity buyers try to ensure robust warranty protection in respect of fundamental risks, such as ensuring title to shares. In more seller-friendly markets, such as in Europe, warranties covering business risks are sometimes not offered by sellers or are made subject to extensive limitations. In these situations, private equity buyers, in addition to relying on their due diligence, often consider bridging the gap between the seller’s and their respective positions by taking out warranty and indemnity (W&I) insurance. In many places this can be done for a modest additional cost. W&I insurance is, however, still unusual in some markets, such as China, Japan, the Philippines, and Brazil.
Private Equity Sellers
Exit certainty and control
Firstly, an important prerequisite for selling, and a common feature in all private equity deals, is that the private equity investor seeks to retain full flexibility and freedom to trigger and successfully drive an exit on its own terms, without restrictions from, for example, management shareholders or co-investors. Corresponding rights of the private equity investor are typically included in the shareholders’ agreement.
It is also important to a private equity seller to be able to deliver the entire target business to the chosen buyer. This is often achieved by structuring an exit so that it takes place at a level of the investment structure where the investor has sole control over the sold entity. If that is not possible, the investor will want to rely on drag-along rights – whereby it can force minority shareholders to sell at the same terms. Drag-along rights are common in private equity transactions globally. Sometimes, these are subject to economic protection for the minority shareholders, such as in the form of minimum price or return thresholds.
In some jurisdictions, there are specific conditions that must be satisfied for a drag to be enforceable. It is common in many markets for co-shareholders that are subject to a drag to also have a tag-along right under certain circ*mstances.
Terms of Sale
In most cases, a private equity seller will prefer a locked-box consideration mechanism in the sale and purchase agreement, as this entails far-reaching protection on price.
In addition to price protection, and subject to what market practice (and buyers) allow, private equity sellers usually seek to limit the conditionality of transactions so that they enjoy completion certainty. In all markets, the exceptions are conditions in respect of suspensory antitrust, foreign investment, and other regulatory clearance requirements.
Private equity sellers are very focused on minimising post-closing liability in order to maximise flexibility of a swift repatriation of proceeds to fund investors. Typically, therefore, they aim not to provide business warranties or indemnities, and try not to have to hold back proceeds in escrow or similar mechanisms. In all markets, remaining warranty protection is subject to limitations, such as caps, thresholds and de minimis provisions. If indemnities cannot be avoided, they tend to be narrowly tailored and have bespoke limitations. One of the reasons why W&I insurance has risen to previously unknown levels of popularity in many jurisdictions is that it is an effective bridge-building tool, allowing private equity sellers a clean exit while at the same time providing buyers with their desired substance-backed W&I protection.
In some jurisdictions, such as the UK, it is not unusual for members of management to provide warranties, particularly if they are themselves shareholders. Sometimes, management warranties are used in combination with W&I insurance to cover the substantive risk.
Public Deals and IPOs
Public-to-private transactions represent a small portion of all private equity transactions. They are commonly seen in the USA, Germany and the UK. Public deals are often voluminous and yield an attractive differential between the public and private market valuations of the target business. However, in many markets, the likelihood of the successful execution of public deals tends to be lower than that of private deals, and there is a frequent absence of customary or “market standard” terms. Also, there are legal barriers to public-to-private transactions in some jurisdictions, such as in China. Most public takeover regimes have mandatory offer thresholds, pricing rules and a disclosure regime for significant shareholdings (and, in some jurisdictions, there are broad concepts of attribution of target shareholdings between funds and investment/portfolio companies).
The popularity and frequency of private equity exits by IPO varies as a function of the volatility of capital markets more generally. In Europe in particular, dual-track exits (ie, where a sale and an IPO are pursued in parallel) are common for larger portfolio businesses, in times where the capital markets are receptive.
Management Equity and Other Incentives
The alignment of interests between the private equity investor and the portfolio company management is a key feature of private equity transactions globally. The detailed approach to management incentivisation varies from jurisdiction to jurisdiction, as do the preferred or typical structures. The structuring of management incentives is often tax driven. In many jurisdictions, equity investments by management are frequent and the easiest way of ensuring “skin in the game”. Sometimes, management equity is combined with a management co-investment, which further increases alignment. Alternative approaches such as options, participation in investor proceeds, virtual share programmes and exit bonus arrangements are also common in some jurisdictions.
Management incentive schemes typically include mechanisms that allow the investor to call or forfeit the incentives of a leaver, with the economic consequences varying according to the nature of the circ*mstances of the departure (ie, whether the situation concerns a “good leaver” or a “bad leaver”). Many schemes include vesting features that allow managers to secure their position in the scheme over time.
In almost all markets, managers are subject to restrictive covenants, such as non-compete and non-solicitation. These can be part of the equity arrangements or set out separately in employment agreements.
