Transaction formalities, rules and practical considerations
Types of private equity transactions
What different types of private equity transactions occur in your jurisdiction? What structures are commonly used in private equity investments and acquisitions?
By ‘private equity transaction’, we mean an acquisition or disposal whether the buyer or the seller is owned and controlled by a private equity fund.
Most private equity acquisitions are governed by a private sale and purchase agreement, pursuant to which the buyer acquires the holding company of the group. Asset sales are less common: typically, a pre-sale reorganisation would be carried out to ensure all the assets of the target business are housed in a single corporate structure.
Public-to-private transactions can be effected by a bidder making an offer for the listed company (usually under the City Code on Takeovers and Mergers (the Code), which applies to a UK target whose securities are admitted to trading on a regulated market (eg, the London Stock Exchange) or a multilateral trading facility in the United Kingdom (eg, AIM)). An alternative very commonly used in the United Kingdom is a scheme of arrangement, which is a statutory procedure under the Companies Act 2006 (CA 2006) whereby a company can make an arrangement with its members. As a scheme is proposed by the target, in practice it is only possible for a recommended transaction.
Private equity funds often comprise multiple parallel partnerships that together constitute the fund. The fund making the acquisition will typically set up a special purpose vehicle as the buyer, and that is the entity that contracts with the seller.
Corporate governance rules
What are the implications of corporate governance rules for private equity transactions? Are there any advantages to going private in leveraged buyout or similar transactions? What are the effects of corporate governance rules on companies that, following a private equity transaction, remain or later become public companies?
As well as the CA 2006, public companies in the United Kingdom may be subject to various rules and requirements regarding governance and disclosure, including under:
- the Listing Rules;
- the Disclosure Guidance and Prospectus Rules;
- the AIM Rules;
- the Code; and
- the Corporate Governance Code.
These rules and regulations generally cease to apply when a company is delisted or its shares cease trading on the relevant exchange but will apply again if the private equity purchaser later exits by way of an initial public offering.
The corporate governance requirements applicable to a private company are generally less onerous. CA 2006 stipulates requirements for annual reporting and certain other disclosure requirements. Private equity funds with portfolio companies of sufficient size in the UK are subject to the Walker Guidelines, which include recommendations (on a comply-or-explain basis) as to governance and enhanced disclosure with those companies and their controlling private equity firms. Compliance with the Walker Guidelines is monitored by an independent body, the Private Equity Reporting Group. In addition, the Alternative Investment Fund Managers Regulations (AIFMD) require a UK alternative investment fund manager (AIFM) to make certain disclosures, including with respect to the acquisition of controlling stakes and its intentions as to UK portfolio companies’ future business and the likely repercussions on employment. AIFMD also restricts asset-stripping by imposing additional requirements in the event that a distribution is made by a portfolio company during the two-year period following the acquisition of control by a UK AIFM.
Issues facing public company boards
What are some of the issues facing boards of directors of public companies considering entering into a going-private or other private equity transaction? What procedural safeguards, if any, may boards of directors of public companies use when considering such a transaction? What is the role of a special committee in such a transaction where senior management, members of the board or significant shareholders are participating or have an interest in the transaction?
All directors of English companies are subject to statutory duties, including the duty to act in good faith to promote the success of the company for the benefit of its members as a whole. They must also:
- act within their powers;
- exercise independent judgement;
- exercise reasonable care;
- skill and diligence;
- avoid conflicts of interest; and
- declare any interests in proposed transactions.
These duties are owed to the company and not (other than in exceptional circ*mstances) to shareholders.
The Code includes a number of General Principles that apply in the case of public-to-private transactions, including that:
- target shareholders must be treated equally;
- target shareholders must be given sufficient time and information to enable them to reach a properly informed decision about the bid;
- the target board must act in the interests of the company as a whole and not deny target shareholders the opportunity to decide on the merits of the bid;
- false markets must be not be created;
- a bidder must only announce a bid after ensuring it can fulfil any cash consideration and taking all reasonable measures to secure the implementation of any other type of consideration; and
- a target must not be hindered in the conduct of its affairs for longer than is reasonable by a takeover bid.
The Code also requires that target boards obtain competent independent advice as to whether the financial terms of any offer are fair and reasonable.
Under the Code, a director of the target will normally be regarded as having a conflict of interest where it is intended that he or she should have any continuing role (whether in an executive or non-executive capacity) in either the bidder or target post-acquisition. In any event, there is likely to be a conflict between the duties a director owes to the target and those owed to the bidder. There may also be a conflict of interest in other circ*mstances; for example, if a director has been appointed as a representative by a target shareholder that makes an offer for the target or wants to roll over into the bidder structure.
Directors of the target should disclose full details of a potential conflict to the board of the target as soon as they are aware of it. A committee will need to be formed of all of the directors of the target who will not have a continuing role post-acquisition, which will be responsible for the target’s response to the offer and will decide, after taking independent advice, whether the proposal should be recommended to shareholders.
All directors are responsible for ensuring compliance with the Code, and the Panel on Takeovers and Mergers (the Panel) can take enforcement action against companies and directors that do not do so.
Disclosure issues
Are there heightened disclosure issues in connection with going-private transactions or other private equity transactions?
The General Principles in the Code aim to ensure a high degree of transparency for target shareholders and the market generally, but apply to all take-private transactions, not just those involving private equity sponsors.
Under the Code, a potential bidder for a UK-listed target may be required to make an announcement confirming its interest in making an offer if there is rumour or speculation or an untoward movement in the target’s share price. A potential bidder cannot restrict the target from making an announcement about a possible offer. The Code also requires:
- disclosure of certain interests and dealings in target shares following the commencement of an ‘offer period’; and
- disclosure of certain information about the offer and the bidder in the offer or scheme document.
Under the disclosure rules for UK-listed companies, a person must notify the issuer and the Financial Conduct Authority (FCA) as regulator of the percentage of voting rights he or she holds as shareholder (directly or indirectly) if the percentage of those voting rights reaches, exceeds or falls below 3 per cent, and each 1 per cent threshold above the 3 per cent threshold. For non-UK issuers, the thresholds are 5, 10, 15, 20, 25, 30, 50 and 75 per cent.
These disclosure requirements do not apply to private companies. However, there is a requirement to disclose (on both private and public registers) ‘people with significant control’ over UK companies (broadly speaking, with an interest of 25 per cent or more or satisfying other indicia of control). The rules are complex, especially when applied to private equity fund structures. In addition, under AIFMD, a UK AIFM must notify the FCA if it acquires control (meaning more than 50 per cent of the voting rights of a non-listed company or 30 per cent or more of the voting rights of a listed company) of a UK company.
Timing considerations
What are the timing considerations for negotiating and completing a going-private or other private equity transaction?
The Code includes requirements relating to the timetable for a public-to-private transaction. For example, if a possible offer for a target is announced, the Code automatically imposes a ‘put-up-or-shut-up’ deadline of 28 days, by which time the potential bidder must either announce a fully diligenced, fully financed ‘firm intention’ to make an offer or down tools. The Panel on Takeovers and Mergers (Panel) may grant an extension to the put-up-or-shut-up deadline, typically only with the agreement of the target board. The Code also prescribes deadlines for certain milestones in a takeover offer process, including the publication of an offer or scheme document and satisfaction of offer conditions.
Generally speaking, the acquisition and sale of private limited companies is not regulated in the United Kingdom, so the parties have a great deal of flexibility as to the timing and conduct of the process, subject to any mandatory antitrust or other regulatory clearances that may be required prior to completion.
Dissenting shareholders’ rights
What rights do shareholders of a target have to dissent or object to a going-private transaction? How do acquirers address the risks associated with shareholder dissent?
As a matter of English law, a shareholder’s ability to block a transaction generally depends on the size of its shareholding.
In the case of a takeover offer of a public company, the bidder can set the acceptance threshold at any level that is more than 50 per cent. A bidder for a UK company has a legal right to buy out the minority – the ‘squeeze-out right’ – which is triggered on satisfaction of a dual test: a bidder needs to have acquired, or to have unconditionally contracted to acquire, both 90 per cent of the shares to which the offer relates and 90 per cent of the voting rights in the company to which the offer relates.
One of the principal advantages of a scheme of arrangement is that, once the scheme has been approved by 75 per cent of each class of shareholder to which the scheme relates and a majority in number of shareholders and is approved by the court, the bidder can acquire 100 per cent of the shares to which the scheme relates. Assuming the shareholder meetings are convened and held properly, other technical requirements are fulfilled and the target shareholders are provided with sufficient information on the scheme, the court would only be expected to decline to sanction the scheme if it considered that the shareholders who attended the meeting did not fairly represent all the holders of the shares that are subject to the scheme (eg, if the vote were not genuine or if it were procured by misrepresentation, bribery, bullying or with a view to advancing other external interests). Although the court must be satisfied that an intelligent and honest person, being a member of the voting class and acting in respect of its own interest, might reasonably approve the scheme, it will generally take the view that shareholders are the best judges of their own commercial interests.
Disputes during a bid process are generally resolved by the Panel Executive and, if necessary, the Hearings Committee, which hears appeals against decisions by the Panel Executive.
Purchase agreements
What notable purchase agreement provisions are specific to private equity transactions?
In the United Kingdom, in private sale and purchase agreements, locked box mechanisms are generally favoured, particularly by private equity sellers. This structure involves fixing a value as at the locked box date, based on the balance sheet as at the locked box date. The seller covenants to procure that the target does not pay any value to the seller from that point. If there is any such value leakage, the seller must repay it to the buyer by way of pound-for-pound indemnity.
Where the acquisition is of a business that is being carved out from a larger business and does not have its own stand-alone balance sheet or audited accounts, it is more likely that completion accounts will be used as the consideration mechanism. However, this is rare for a private equity seller that is selling an entire business.
Private equity buyers will expect customary business warranties (in addition to title and capacity) from sellers, except private equity sellers. Management who hold shares in the target normally provide business warranties on a secondary buyout. The cap on liability for breaches of these warranties is generally low, limited to a percentage of the net returns to the manager shareholders. As such, their function is more to elicit disclosure than to allocate risk between buyers and sellers. It is also very common for managers’ liability to be capped at £1 with a warranty and indemnity insurance policy (a W&I policy) taken out to cover any liability for breach up to an insured cap (typically 10–20% of the consideration). A W&I policy thereby serves the purposes of both disclosure and mitigation of the risk of unknown liabilities for the buyer.
Participation of target company management
How can management of the target company participate in a going-private transaction? What are the principal executive compensation issues? Are there timing considerations for when a private equity acquirer should discuss management participation following the completion of a going-private transaction?
Equity incentivisation of the management team is a fundamental principle of alignment on UK private equity transactions. Private equity acquisitions are typically funded by a combination of external debt funding and preferred return instruments (either preference shares or shareholder loans) with a very small portion of the equity funding funded through the subscription monies for the ordinary shares. All the upside from the investment (beyond the preferred return) flows through to the ordinary shares, for which the management team normally subscribes, and this investment is known as ‘sweet equity’. Sweet equity is typically subject to restrictions on transfer, time-based vesting (usually over a four- to five-year period) and leaver provisions that allow for the repurchase of equity from managers who leave the employment of the group, with the price determined by the circ*mstances in which they become a leaver.
In the case of a public-to-private transaction, the Code includes specific requirements that apply if it is intended that the target’s management team will retain an interest in the business or that the target’s management team will receive another form of incentivisation. These include obligations to disclose details of the incentivisation arrangements, obtain a fairness opinion from the target company’s independent adviser, obtain the approval of target shareholders and occasionally obtain the Panel’s consent
These obligations apply where the bidder has entered into, or reached an advanced stage of discussions on proposals to enter into, any such arrangements. As a result, bidders usually put incentives in place after the closing of the transaction.
Tax issues
What are some of the basic tax issues involved in private equity transactions? Give details regarding the tax status of a target, deductibility of interest based on the form of financing and tax issues related to executive compensation. Can share acquisitions be classified as asset acquisitions for tax purposes?
On the acquisition of a UK incorporated company, stamp duty will normally be payable at a rate of 0.5 per cent of the consideration paid for the shares acquired. Complex rules exist for determining the stamp duty payable where some or all of the consideration is deferred or contingent. Care will need to be taken where the acquirer assumes debt of the UK target or agrees to ensure outstanding debt is repaid by the UK target to avoid increasing the amount of stamp duty payable. Transaction costs are unlikely to be tax-deductible, but should form part of the capital gains tax base cost of the shares acquired, thereby reducing the capital gain upon exit. Value added tax will also generally be payable in respect of transaction costs, although in very limited cases this may be recoverable.
Given the importance of debt financing in private equity structures, detailed analysis will be required to ensure that the tax-deductibility of interest expense is optimised. In principle, interest expense is deductible, subject to an interest limitation on the group’s net interest expense (usually 30 per cent of the taxable earnings before interest, taxes, depreciation, and amortisation of the borrower group). Additional limitations and transfer pricing restrictions can apply in the context of related party debt (eg, shareholder loans) or profit-participating loans. If, as is likely, the acquiring company and the target form a UK tax group, deductible interest expense of the acquirer may be offset against the UK taxable profits of the target group. Where hybrid entities (which are opaque in one jurisdiction but transparent in another) or hybrid instruments (which are treated as debt in one jurisdiction but equity in another) are involved, the UK anti-hybrids legislation can apply to counteract any tax mismatches. Withholding tax will need to be deducted from interest payments on debt that has a term of one year or more unless an exemption applies. Dividends on ordinary or preference shares are neither tax deductible nor subject to withholding tax.
In some cases, private equity funds plan to extract value from the target prior to an exit, in which case it will also be necessary to analyse how distributions from the target business through the holding structure to the funds can be made on a tax-efficient basis. Dividends received by UK companies should generally benefit from an exemption from corporation tax, and there is no withholding tax on dividends paid by UK companies. The likely structure of an exit should also be taken into account when designing the acquisition structure. Where the exit is by way of a sale by a UK holding company, relief from UK tax on chargeable gains may be available under the United Kingdom’s substantial shareholding exemption, provided that certain conditions are met (in particular, that the group being disposed of is a trading group). Except where the group is invested more than 75 per cent in UK land, the disposal by a non-UK resident company of shares in the UK holding company of a UK group will not normally be subject to UK capital gains tax.
Where a management equity plan is to be introduced, the tax treatment of UK members of the management team will need to be considered. Complex tax rules apply to shares that are acquired by way of employment and are subject to forfeiture and other restrictions. The acquisition, vesting, lifting of restrictions and (or) disposal of such shares can trigger employment taxes if less than unrestricted market value (UMV) is paid for the shares. It is therefore typical to ensure that management acquires their securities for no less than UMV (with a valuation often being carried out to support the price paid) or, alternatively, management can elect to pay tax on the difference between UMV and the price paid. The effect of this is that any gain on a future disposal of the shares will be taxed at capital gains tax rates. Where loans are advanced to UK managers to fund their investment, an income tax charge will apply unless interest is paid at a rate at least equal to the HMRC official rate of interest or the loan is for a de minimis amount. If management intend to roll their existing investment in the target into shares in the acquisition group, that will need to be structured on a tax-neutral basis.
Transactions structured as share acquisitions cannot be classified as asset acquisitions for UK tax purposes.
While this section focuses on the taxation of the underlying UK investments (rather than the holding structures) of private equity funds, it is noteworthy that significant tax advantages are available to UK qualifying asset holding companies held by qualifying funds and certain other investors. This will be of interest to private equity funds that wish to hold their underlying investments through a UK holding company. Qualifying UK asset holding companies would benefit from a broad range of tax reliefs; for example:
- an exemption for capital gains on the disposal of investments (other than investments in UK land-rich companies);
- an exemption from UK withholding tax on interest;
- the ability to deduct profit participating interest; and
- the ability to repatriate gains by way of a share buyback without jeopardising capital gains tax treatment for investors.
The tax regimes of jurisdictions other than the United Kingdom should be considered as well, because a private equity fund will typically have investors around the globe and may make investments into the United Kingdom through non-UK entities.
