This country-specific Q&A provides an overview of the legal framework and key issues surrounding Private Equity in the United Kingdom.
This Q&A is part of the global guide to Private Equity.
For a full list of jurisdictional Q&As visit http://www.inhouselawyer.co.uk/index.php/practice-areas/private-equity-2nd-edition/
What proportion of transactions have involved a financial sponsor as a buyer or seller in the jurisdiction over the last 24 months?
Total UK PE activity in 2018 represented around 30% of overall M&A activity according to figures released by Experian and KPMG. Over the last 12 months, in the backdrop of heightened levels of political and economic uncertainty surrounding Brexit, the UK PE market has experienced a measure of decline in deal volume. KPMG reported that total PE investment in the UK fell in the first half of 2019 to its lowest level since pre-2014 representing a decrease of c. 35% in deal volume from the same period in 2018.
What are the main differences in M&A transaction terms between acquiring a business from a trade seller and financial sponsor backed company in your jurisdiction?
The principle of a ‘clean exit’ for private equity sellers in order to return cash to investors following an exit is a key driver for some of the main differences we see between M&A transactions involving sponsors versus trade sellers.
Private equity sellers typically favour locked box price pricing mechanisms to provide pricing certainty at signing. Trade sellers are not necessarily opposed to locked box mechanisms but many trade sales involve a level of separation or carve-out from the trade seller’s business that could make locked box mechanisms unsuitable.
Normally selling sponsors only give fundamental warranties with management giving the business warranties. A trade seller will normally give both fundamental and business warranties as management are unlikely to see a significant payout from the transaction, and may also stand behind a tax indemnity. W&I insurance is becoming more prevalent in transactions involving PE and trade sellers alike as trade sellers look to do transactions on terms which replicate a sponsor’s clean exit.
Buyers are also unlikely to obtain comfort from private equity sellers with respect to non-competes or non-solicitation covenants relating to the business, while trade sellers are likely to offer some protections within acceptable parameters.
On an acquisition of shares, what is the process for effecting the transfer of the shares and are transfer taxes payable?
Shares in certificated form (which is usually the case for private limited companies) are transferred by an instrument of transfer, most commonly a stock transfer form. On the sale of a UK company, unless the transfer value is less than £1,000 or certain exemptions apply, the signed stock transfer form will need to be stamped by HMRC (which usually takes around 6 weeks) in order for the transfer to be written up in the shareholders’ register. HMRC will charge stamp duty of 0.5% of the total consideration attributable to the shares being transferred and this duty is customarily for the buyer’s account. Until a stamped form is returned and the shareholders’ register is updated to reflect the new ownership, legal title of the shares does not pass to the buyer. Accordingly, the buyer will require voting powers of attorney from the selling shareholders to enable it to vote the purchased shares prior to the register being updated.
Public listed company shares typically take the form of uncertificated shares and may be transferred without a written instrument of transfer through an electronic clearance system. Such transfers generally attract stamp duty reserve tax (at a rate of 0.5% of the consideration payable by the buyer).
How do financial sponsors provide comfort to sellers where the purchasing entity is a special purpose vehicle?
It is standard for sponsors to provide an equity commitment letter at signing to provide the seller comfort that the sponsor’s fund(s) will provide equity financing to the acquisition vehicle to fund the equity financing portion of the purchase price. It is also common to include a separate commitment to fund damages suffered by the seller should closing not occur as a result of the buyer’s breach of the terms of the purchase agreement. The level of damages to be funded under the equity commitment letter is normally left up to a court to determine, typically capped at the equity commitment amount. A debt commitment letter may also be used to evidence the availability of sufficient funding to the acquisition vehicle. This will often be supported by an interim facility agreement that the debt provider agrees to sign on short notice if required.
How prevalent is the use of locked box pricing mechanisms in your jurisdiction and in what circumstances are these ordinarily seen?
The ‘locked box’ mechanism is the most common pricing structure on UK private equity deals. The key advantage of the locked box is that it gives both the seller and the buyer certainty of a fixed price and does not give rise to the same complexity and risk of associated disputes as the completion accounts mechanism. However, certain deals may not be suited for locked box mechanisms, for example (i) if the transaction involves a business reorganisation or carve-out following the locked box date and therefore the target does not have appropriate standalone accounts and (ii) if the target’s working capital is subject to high degrees of volatility (e.g. open to the effects of seasonality) and therefore it is difficult to price based on a fixed historic date.
What are the typical methods and constructs of how risk is allocated between a buyer and seller?
Sellers in competitive processes will usually propose terms where all risk relating to the target business passes to a buyer at signing.
In terms of deal pricing risk, the locked box mechanism at its heart is a seller friendly pricing mechanism as the buyer has virtually no opportunity to adjust the price following signing. The buyer will need to manage its risk by diligencing the locked box balance sheet and ensuring that the locked box is effectively ‘locked’.
Risks associated with operational matters of the business are normally only covered by warranties given by management and backed by W&I insurance. Material adverse change clauses are unlikely to be accepted and bring down of business warranties are also uncommon. Indemnities or escrows for contingent liabilities are normally strongly resisted by sellers and bidders in competitive processes often prefer to ‘price in’ any contingent liability to avoid appearing uncompetitive by requesting indemnities or escrows.
Risks associated with deal certainty are also usually for the buyer’s account and a seller will not accept conditionality to closing save for anti-trust or regulatory consents which are mandatory and suspensory in effect.
How prevalent is the use of W&I insurance in your transactions?
The use of W&I insurance is becoming the norm in private equity exits. For sellers, W&I insurance can help achieve a clean exit (e.g. with no escrow) and in some cases offer nil exposure for the warrantors for warranty claims. For buyers, W&I insurance can enhance the warranty protection on offer by extending the duration and scope of warranty coverage. It is also possible for buyers to include a tax deed (subject to a £1 cap or synthetic) to cover most unidentified tax risks and/or to obtain separate coverage for identified tax risks.
It is common in auction processes for the seller to arrange a stapled sellside policy which ‘flips’ to a preferred bidder. The stapled policy can help with a quicker underwriting process and, if well managed, the W&I process can be a useful sellside tool to manage auction dynamics.
In highly competitive auctions, a bidder may forego the inception of a W&I policy at signing (to deliver signing earlier than other bidders who see signing contingent on the inception of the policy) and finalise its work on W&I post-signing.
How active have financial sponsors been in acquiring publicly listed companies and/or buying infrastructure assets?
Many sponsors have been active in both the public markets and in acquiring infrastructure assets over the last 12- 24 months as they continue to deploy capital in alternative ways. According to figures released by Bain & Co., take-private deals globally reached their highest level in 2018 in terms of both value and count since 2006/07 and can, in part, be explained by the scarcity of quality assets. For UK take-private deals, the depreciation of the pound has also been a contributing factor in this upward trend. Pension funds and similar long-term institutional investors have also been more active in infrastructure deals attracted by traditionally steady returns and stable risk profiles.
Outside of anti-trust and heavily regulated sectors, are there any foreign investment controls or other governmental consents which are typically required to be made by financial sponsors?
The question of whether any government consents or similar investment approvals are required is highly deal specific but, under recent revisions to the UK Enterprise Act 2002, it is possible we will see a significant increase in the number of deals being reviewed by the UK government on national security grounds. Advent’s takeover of Cobham plc, a UK defense contractor, is undergoing a review by the UK government for its potential impact on national security and is one of two recent high-profile private equity deals to attract government security, alongside the UK government’s review of the sale of satellite operator, Inmarsat Plc, to a consortium which includes Apax and Warburg Pincus.
How is the risk of merger clearance normally dealt with where a financial sponsor is the acquirer?
Sellers normally require that each bidder submits details of any required merger clearance at the bid stage and each bidder’s risk profile with respect to merger clearance will form part of the seller’s assessment of a bid.
Sellers are likely to request a ‘hell or high water’ obligation (i.e. a divestiture obligation in respect of both the PE sponsor’s portfolio and the target group) from buyers in the purchase agreement, as well as provisions to allow the seller to closely monitor the merger clearance process.
Have you seen an increase in the number of minority investments undertaken by financial sponsors and are they typically structured as equity investments with certain minority protections or as debt-like investments with rights to participate in the equity upside?
Minority investments are common and take a number of forms including LPs investing alongside the sponsor as a passive co-investor (likely on a no carry, no fee basis) or credit funds making use of equity instruments to complement their investment model (e.g. in the form of preferred equity with limited governance rights). In the context of larger deals, club or consortium deals are also on the rise with no one sponsor having a controlling majority.
How are management incentive schemes typically structured?
Typically senior management are incentivised with direct equity interests in the investment holding structure (in the form of ‘sweet’ equity) at the same level as the sponsor’s investment and any rollover investment. This ‘sweet’ equity takes the form of ordinary shares and sits behind the investor and rollover investments and offers the equity upside for management if the business performs well.
The size of the sweet equity pot for allocation and the terms relating to sweet equity are deal specific. It is quite common to see ratchet provisions and sweet equity typically vests over a 4-5 year period, sometimes 100% vesting only being achieved at the point of exit for the sponsor.
Bonus schemes are often seen as a drain on cash and management typically prefer the capital gains tax treatment in respect of equity rather than income tax levied on a cash bonus.
Are there any specific tax rules which commonly feature in the structuring of management’s incentive schemes?
The UK rules on employment related securities should always be considered when structuring equity incentives for UK management.
UK managers will commonly want to ‘roll over’ gains on any existing securities they hold into their new investment so the capital gains tax rules on share for share exchanges are often relevant and commonly require the use of put and call options to permit UK managers to roll up the new structure.
Typically, management will make section 431 elections, which means that they will be subject to a charge to income tax by reference to the unrestricted market value of their sweet equity where this exceeds the amount they pay for their shares. As a result, the valuation of the sweet equity is an important consideration and traditionally HMRC have accepted low valuations, but this may be changing. Valuation issues can also be significant on the award of sweet equity to new managers during the investment lifecycle when the value of the business may have increased.
Future disposals of sweet equity are typically subject to capital gains tax for UK managers at a 20% tax rate. Until recently, it was possible to structure sweet equity for senior UK managers to qualify for entrepreneur’s relief, attracting a 10% tax rate. However, the rules have recently changed so that, broadly, it will be difficult for managers to qualify unless their individual share of the sweet equity pot amounts to at least 5% by value of the total ordinary share capital.
Are senior managers subject to non-competes and if so what is the general duration?
It is usual for non-competes (as well as other restrictive covenants including non-solicitation obligations) to be given by senior management and duration will depend on the context in which they are given. Where a manager is a selling shareholder (and is receiving a notable portion of the sale proceeds), then such manager will typically be expected to give a non-compete covenant which applies for between 12 months and at the upper limit 36 months from completion. Re-investing or new managers will be expected to give restrictive covenants in the investment agreement which typically have a tail of 12 month to 24 months from the time of the senior manager’s departure from the business or the last date on which they hold shares. Typically, service agreements for senior management will also include restrictive covenants which run for a period of 6 to 12 months from when they cease to be employees. It is possible for these obligations to overlap in scope and duration.
In all cases, care should be taken in determining the scope and duration of the restrictive covenants. The English courts will normally only enforce restrictive covenants to the extent that the restrictions are reasonable and serve to protect legitimate business interests.
How does a financial sponsor typically ensure it has control over material business decisions made by the portfolio company and what are the typical documents used to regulate the governance of the portfolio company?
On control investments, the sponsor will typically hold 75% of the voting rights and maintain effective voting control over its investment. Additionally, the sponsor will wish to ensure that it has multi-layered contractual protection (in the form of positive covenants and negative controls regarding the operation of the business) over governance maters. The principal governance documents are the investment agreement and the company’s articles of association.
Key forms of contractual protection and controls for the sponsor include: (i) the investor consent regime pursuant to which sponsors will have a consent (or veto) right over key decisions relating to the company (e.g. new acquisitions and disposals, capital expenditures); (ii) enhanced information rights for the sponsor and (iii) the ability to appoint and remove any director to the board.
Is it common to use management pooling vehicles where there are a large number of employee shareholders?
A separate management pooling vehicle on UK deals is unusual. However, it is fairly common for managers to be required to hold their shares through a nominee (e.g. the trustee of the employee benefit trust). This allows the sponsor to deal with a single legal holder of the shares, but it is not a perfect solution as managers will generally be entitled to call for delivery of their shares from the nominee.
What are the most commonly used debt finance capital structures across small, medium and large capital financings?
Large private equity financings typically involve senior secured debt consisting of a broadly syndicated ‘term loan B’ together with a revolving facility that are each secured on a first ranking pari-passu basis. Senior secured debt also frequently takes the form of New York law governed high yield bonds as well as, or instead of, a term loan B. The extent to which high yield bonds supplement loan financing or become the primary source of debt finance (and whether a European issuer seeks to tap into the US leveraged finance markets) are a feature of the markets and investor appetite at any particular time.
Larger private equity financings also frequently incorporate additional layers of debt to stretch leverage. Second-lien debt is often introduced and is now regularly privately placed with credit funds. In addition, unsecured New York law governed high yield bonds or payment-in-kind notes or loans are often incurred at a holding company above the senior secured group.
Small to mid-sized private equity financings are typically in the form of senior secured loans. Traditional banks continue to offer this capital solution but are commonly displaced by credit funds and alternative capital providers offering unitranche loans. A commercial bank is then typically engaged to provide a ‘super senior’ ranking revolving facility.
Is financial assistance legislation applicable to debt financing arrangements? If so, how is that normally dealt with?
English company law prohibits a public company from providing financial assistance for the purchase of its own shares or the shares of its holding company, and a private company from providing financial assistance for the purchase of shares of a public holding company. For this reason, where a transaction includes a target that is a public company, it is common for the public company to re-register as a private company before it provides the relevant financial assistance to avoid any breach of the prohibition.
For a typical financing, is there a standard form of credit agreement used which is then negotiated and typically how material is the level of negotiation?
A sponsor backed borrower will now typically provide its own bespoke precedent documentation and will often use precedent documentation for another portfolio company of the sponsor as a starting point. The Loan Market Association precedents can be useful references for boilerplate drafting but are largely no longer the starting point.
Negotiation is typically material around deal specific requirements of the sponsor and in private deals can be highly bespoke with negotiation being often more significant.
What have been the key areas of negotiation between borrowers and lenders in the last two years?
Negotiations over the last two years have continued to focus heavily on the definition of EBITDA in leveraged finance transactions both in the loan and high yield bond markets. EBITDA is not only relevant to calculating maintenance covenants but it also remains the benchmark for incurrence covenants and is fundamental to the calculation of basket thresholds as many of such baskets grow as EBITDA increases. Uncapped addbacks for projected cost savings and synergies are regularly resisted by lenders, and 2019 has seen a decrease in the proportion of deals that permit this.
The ability to incur incremental debt on a senior secured, junior secured and/or unsecured basis either inside or outside the day one finance documentation is also a key area of negotiation. While borrowers have successfully negotiated broad flexibility in this area, lenders continue to push for key structural protections including, maturity and amoritsation limitations, non-obligor debt caps, intercreditor accession thresholds and most-favoured-nation protection.
The rise of EBITDA cures has accompanied the prevalence of cov-lite loans. Borrowers expect to be able to add cure amounts to EBITDA and this flexibility together with the extent of the ability to make consecutive cures, overcures and RCF prepayment cures have consistently featured as negotiation points in recent years.
Have you seen an increase or use of private equity credit funds as sources of debt capital?
Credit funds continue to increase their share of loan activity across Europe. Notwithstanding their historic focus on lower mid-market financings, credit funds are increasingly looking to deploy capital in the upper mid-market and large-cap transactions. To this end, certain credit funds are teaming up with other credit funds or underwriting banks to provide capital solutions for larger financings.