Several important factors need to be considered during an acquisition by a private equity fund—not least, its exit strategy, as Marc Parrott explains.
After a number of years in which merger and acquisition (M&A) activity was relatively dormant, and many private equity managers were more focused on restructuring troubled investments made before the financial crisis, the markets are now seeing a return of private equity managers to M&A activity.
Strategic corporate acquirers and private equity funds are both becoming more active as they see more meaningful signs of recovery in the US economy and are becoming more optimistic that this recovery, and a broader global recovery, will be sustainable. These types of broad macro considerations will apply to corporate deal-making generally, whether by strategic corporate acquirers or by private equity funds.
In every merger or acquisition deal there are many common considerations regardless of the buyer’s identity, including the importance of negotiating the price, the representations and warranties, and the need to conduct thorough due diligence. But there are many other factors to be considered during an acquisition by a private equity fund that are different from those of a strategic corporate acquirer.
First, and most obviously, any private equity fund general partner, investment manager or investment advisor considering a potential transaction will need to ensure the proposed investment falls within the investment mandate, and investment restrictions, set out in the offering documents (ie, private placement memorandum or offering memorandum) and partnership agreement, etc, of the relevant fund (together, the Fund Documents).
The Fund Documents may include investment mandate requirements such as geographical target countries or economic zones for investment, target size requirements regarding minimum net assets or minimum revenues, target industries, and minimum leverage requirements.
In addition, the documents may impose portfolio diversification limits on the amount of the overall fund that may be invested in any single portfolio investment, and may exclude investments in certain industries such as weapons or tobacco products manufacture.
Many private equity funds include wording in their Fund Documents that provides for investors to be relieved of their obligation to make a capital contribution if any breach of applicable laws or applicable regulations would result. These types of “excuse provisions” will usually provide that, where a particular investor will not participate in a particular drawdown, all the other investors will be required to make an additional drawdown pro rata to cover the shortfall.
Of course, no investor would be required to contribute an amount that would cause its total capital contributions to exceed the amount of its total capital commitment.
This mechanism usually means that the relevant private equity fund will be able to meet its contractual obligations under any share purchase agreement that has been entered into. However, if any investor needs to invoke an excuse provision it will be best to determine this as soon as possible in the acquisition evaluation process, in order to avoid last minute issues when the transaction is nearing closure.
Any relevant confidentiality requirements, under a non-disclosure agreement or confidentiality agreement entered into with the seller, will need to be observed. For this reason it is helpful to ensure, at the time such an agreement is made, that the fund can make necessary disclosures to the investors for the purposes of ensuring that there are no excuse provision issues.
In addition to the terms of the Fund Documents themselves, the general partner, investment manager or investment advisor will need to consider whether any “side letter” provisions, which would prohibit or otherwise affect the terms of the proposed investment, are relevant. The ever-increasing prevalence of side letters means this will continue to be a potential issue to be considered at the time of making any proposed portfolio investment.
"If the intention is to undertake a leveraged acquisition, the lender of lending syndicate will need to be provided with sufficient security for the provision of finance.”
Another factor that the general partner, investment manager or investment advisor will need to consider is the requirement to make a drawdown of capital from the investors. As most private equity funds draw down capital commitments from their investors only as and when required, the fund will not generally be holding the relevant capital at the time that a share purchase agreement is entered into in respect of a new portfolio investment. There will, invariably, be a requirement to provide a certain period of prior notice to investors in connection with making a drawdown of any portion of their capital commitments. This period will vary but, in certain instances, may be material, so the wording in any share purchase agreement entered into on behalf of the fund will need to take account of this in terms of the closing timing and mechanics.
If it is contemplated that further capital will, or may have to, be invested in subsequent tranches after the proposed initial investment, then another factor that the general partner, investment manager or investment advisor will need to consider is the implication of any prescribed “investment period”.
As most private equity funds allow for the drawdown of capital commitments from their investors only during a fairly limited period during the first part of the fund’s term, typically referred to as the “investment period”, the fund may not be able to make further investments in any portfolio (“follow-on” investments) after the termination of this investment period.
In the case of private equity funds that do allow follow-on investments, this further investment requirement will have an impact on the internal rate of return of the fund’s investment in the relevant portfolio company, and for this reason it is preferable that such follow on investments are part of any original financial projections in respect of the investment.
If the intention is to undertake a leveraged acquisition, the lender or lending syndicate will need to be provided with sufficient security for the provision of finance. This security could take the form of a charge over the shares in the portfolio company being acquired, or a charge over other assets of the relevant fund. In other cases, there is a potential requirement for security interests to be given by investors over their undrawn capital commitments. This is to provide recourse to the lender not only to the current assets of the fund, but also to the further capital that may be drawn down, up to the full amount of each investor’s capital commitment.
In the context of acquisitions by a private equity fund, due to the term of the relevant fund being limited, the general partner, investment manager or investment advisor will, even at the time of making the investment, need to be thinking about the exit strategy. Typically, the term of a private equity fund will be in the range of five to eight years, with a possible one- or two-year extension to provide for the orderly liquidation of the fund’s investments. This does not allow for a long-term buy and hold strategy.
Rather, taken together with the “carried interest” performance fee model adopted as the industry standard, the requirement and motivation is for the general partner, investment manager or investment advisor to make acquisitions followed by rapid financial and operational restructuring, in the expectation that this will result in an improved asset for which the value can then be crystallised through an appropriate exit strategy.
Typical exit strategies include an initial public offering (IPO) and stock exchange listing, or a sale to a strategic corporate acquirer for whom, due to perceived synergies, the asset will have a value sufficient to provide the fund with its desired internal rate of return (IRR) on the investment. The general partner, investment manager or investment advisor should be considering the identity of potential strategic corporate acquirers at the time that it is contemplating making the investment.
As can be seen, when working on M&A deals where the acquirer is a private equity fund, it is important to ensure that fund counsel is involved with the team working on the transaction in order to ensure that the above, and other, fund-specific considerations are properly taken into account.
Marc Parrott is a senior associate at Campbells. He can be contacted at: firstname.lastname@example.org
Marc Parrott specialises in investment funds of all types, including private equity funds and hedge funds. He also advises clients on various other aspects of mainstream corporate and finance law. He has significant experience in the Cayman Islands, having practised with Walkers. Parrott has also had considerable top-tier international experience in Australia with Freehills, in London with Linklaters and in Dubai with King & Spalding LLP.