This country-specific Q&A provides an overview to private equity laws and regulations that may occur in 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/practice-areas/private-equity/
What proportion of transactions have involved a financial sponsor as a buyer or seller in the jurisdiction over the last 24 months?
There’s been a strong and consistent deal flow in the past few years involving financial sponsors. Based on BVCA data (the UK’s private equity industry the value of private equity investments annually since 2016 has consistently remained between £21.5 and £22.5 billion.
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?
Financial sponsors need to achieve a clean exit which allows them to upstream a clearly defined amount of proceeds from the transaction to their investors. The clean exit approach is important for both the purchase price mechanics and the warranty and indemnity coverage given by sellers. Most exits from financial sponsors are structured on a ‘locked-box’ basis with an effective date prior to signing and no purchase price adjustments or earn-out mechanisms. Also, in most sponsor deals, the buyer receives very limited fundamental warranties (i.e. authority, capacity and title) with the optionality for the buyer to take out a W&I insurance for operating warranties (which is often provided as a stapled product in auction processes (i.e. procured by the seller and paid for and incepted by the purchaser).
We hardly see any forms of indemnity being offered unless there is a tax indemnity the sole recourse for which is against a W&I insurance policy.
The time limitations for all other claims are very short.
On an acquisition of shares, what is the process for effecting the transfer of the shares and are transfer taxes payable?
For all English companies, the process for effecting the transfer of the shares requires the transfer of legal title to the shares and , if the transfer value is in excess of £1,000, the payment of a stamp duty transfer tax by or on behalf of the purchaser to the UK tax authority (which is currently a rate of 0.5% of the price paid for the shares).
In a private company context where shares are in certificated form, the process would customarily involve the seller executing a pro-forma stock transfer form which the purchaser would then submit to the UK tax authority within 30 days of the transfer alongside the transfer tax payment. Once the form is stamped by the tax authority then the target company would update its share register to record the transfer. At that point, legal title to the transfers would have transferred to the purchaser. Given the time gap between the signing of the form and the updating of the register, the customary method of ensuring that the purchaser can exercise its rights as a shareholder in the target company in this period is by the grant of a power of attorney from the seller to the purchaser to enable it to vote on shareholder resolutions in the name of the seller.
In a public company context, shares are usually held in uncertificated form and transferred through an electronic clearance system (e.g.CREST). CREST maintains an electronic register of members (usually financial institutions who are then holding the shares on behalf of the relevant investors) and trades are effected electronically by CREST transferring the ownership in the shares once it has received the payment for the transfer (including the transfer tax payable).
The stamp duty transfer tax is legally borne by the purchaser and in the UK market this liability is not customarily shared or passed back to the seller. Failure to pay the transfer tax within 30 days of the transfer results in penalties and interest and prevents the purchaser from being able to register itself in the company’s register of members and enforcing its rights as a shareholder in a UK court (in either case unless and until paid).
How do financial sponsors provide comfort to sellers where the purchasing entity is a special purpose vehicle?
Sponsors usually provide the seller with equity commitments and certain funds debt commitment letters prior to signing.
The equity commitment letters are usually structured as an irrevocable commitment given by the fund to the acquisition vehicle pursuant to which the financial sponsor commits itself to invest certain funds in the acquisition vehicle for the purpose of either paying the purchase price or, if closing does not occur as a result of the purchaser’s breach, a damages claim.
The equity commitment letter is often issued solely for the benefit of the purchasing entity (which is a requirement driven by the relevant fund’s governance or structure) but may be enforced by the seller on its behalf against the relevant fund entity.
The form of equity commitment letters are now relatively standard and so there does not tend to be a high degree of negotiation around them.
How prevalent is the use of locked box pricing mechanisms in your jurisdiction and in what circumstances are these ordinarily seen?
Locked-box structures are currently the most common pricing structure in UK M&A transactions. There are a number of key benefits to using a locked box concept, primarily it gives certainty of price for both the buyer and seller at the time of signing the deal, reduces the complexity and risks around preparing, reviewing and potentially disputing a final price derived from completion accounts and in auction processes enables competing bids to be more accurately compared.
There are certain types of transactions where locked box constructs are more difficult to construct and these are primarily in situations where there is a pre-sale reorganisation of operational businesses (e.g. carve-out divestitures). These transactions tend to rely on pro-forma balance sheets involving a number of adjustments and therefore cannot robustly support the locked box mechanic and relevant leakage undertakings.
What are the typical methods and constructs of how risk is allocated between a buyer and seller?
The current market for sale terms is very seller friendly.
The most important risk allocation method is the locked-box itself which passes all economic risks and rewards following the effective date to the buyer.
The effective date will be based on a historic balance sheet date which has been diligenced by the purchaser. The Seller is usually expected to provide fundamental warranties following such date and for the period between signing and closing a customary set of purchaser consent rights in respect of material business issues.
All operating issues are either not covered in the share purchase agreement at all or have primary recourse as against a W&I insurance policy.
In the most competitive auction processes where there is a compressed timetable, we have seen instances of buyers signing share purchase agreements with no protection (outside of vendor due diligence and some buyer due diligence) and obtained W&I insurance coverage between signing and closing following a comprehensive confirmatory due diligence exercise.
We do not see any closing conditions except for mandatory regulatory approvals (i.e. no bring-down, no MAC) in which case most transaction documents contain either a strict hell or high water clause for the merger clearance or a corresponding contractual penalty/break fee.
How prevalent is the use of W&I insurance in your transactions?
The use of W&I insurance has become an important component of M&A transactions in the UK.
Historically, financial sponsor purchasers have used W&I insurance in auction processes in order to limit potential seller exposure and thus making their offer more attractive.
In recent years, W&I insurance has also become more popular in transactions involving corporate sellers and it is therefore fair to say that at least 60% of all M&A transactions now incorporate W&I insurance.
Given the competition and supply in the W&I insurance market, other than for high risk/regulated sectors, pricing has come down and speed of inception does not materially impact the transaction timetable.
Insurance products have also expanded from providing an insurance solution to operating warranties only to also covering title warranties, specific tax insurance and zero seller liability structures (i.e. no skin in the game by the Seller) without incurring substantial additional premiums.
How active have financial sponsors been in acquiring publicly listed companies and/or buying infrastructure assets?
In the last 12 to 24 months there has been a considerable increase in interest in take private transactions both in the UK and across Europe which we expect to continue. Examples of recent take private transactions in the UK market include the acquisitions of, eSure Group Plc, John Laing Infrastructure Fund Limited, ZPG Plc, CityFibre Infrastructure Holdings plc, Laird Plc and Paysafe Group plc. Most of these acquisitions have tended to involve a consortium of sponsors teaming up to acquire the asset.
Of the 28 successful take private transactions in the last 2 years, 22 have been sold to financial sponsors, with a total deal value of approximately £11.28 billion.
The infrastructure market is attracting a wider pool of sponsors who have been raising funds to meet demand for assets that are considered Core + and which can be held over a longer period than the typical 3-5 year hold period.
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 UK generally welcomes foreign investment, and in the vast majority of cases financial sponsors are able to invest in UK companies without undergoing foreign investment review of any kind. The UK government nevertheless has the ability to review transactions on public interest grounds relating to defence, media, and prudential stability, either because they meet certain criteria or as a matter of discretion. These powers have been used in recent years to secure commitments from merging parties to safeguard the public interest - for example, in 21st Century Fox’s bid for Sky, and Melrose’s acquisition of GKN. The UK anti-trust authority (the CMA) also has jurisdiction to review transactions that involve military and dual-use products, as well as technologies of a sensitive nature such as quantum technology. Further, a proposed new regime for National Security and Infrastructure Investments, which will give the government additional powers over deals involving critical infrastructure, has been the subject of a public consultation and is undergoing further review, but this is not expected to become operative until at least 2020.
How is the risk of merger clearance normally dealt with where a financial sponsor is the acquirer?
In the UK the anti-trust review process is a voluntary regime (i.e. a purchaser can technically close without clearance but then be subject to an investigation following closing) and therefore in this market sellers do not normally (as a matter of course) accept a condition precedent of receipt of UK anti-trust clearance.
If antitrust clearances are agreed to be condition precedent to completion, the risks of clearance are usually passed to the purchaser by the use of either a “strict hell or high water” clause for the merger clearance or a corresponding contractual penalty (whether by way of fixed amount or contractual damages) if the merger clearance cannot be obtained.
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?
There’s been a significant increase in the number of minority investments by financial sponsors over the last few years and we expect this to continue. We have seen many different capital structures from pure common equity investments with certain control rights for the operating business as well as a preferred equity or debt-like structure with limited governance rights (more akin to debt securities) but with the ability to participate in equity returns (e.g. through warrants, equity kickers or within the capital rights of the securities themselves).
How are management incentive schemes typically structured?
Most management incentive schemes are structured on an equity basis granting the managers direct equity interests in the purchaser’s acquisition group structure. If structured properly, equity results in gains being subject to capital gains tax rather than share option, exit bonus or phantom share schemes which attract higher rates of tax for the individuals and social security contributions for the portfolio company which employs them.
Often management’s equity is structured to deliver a return on any exit after a certain IRR and cash exit multiple is achieved by the financial sponsor to align the management team’s returns with those of the fund management team.
Are there any specific tax rules which commonly feature in the structuring of management’s incentive schemes?
UK tax law has a specific set of rules governing the tax treatment of equity incentive awards. One of the key principles is that the relevant individual should subscribe for his equity at the unrestricted fair market value of the equity at the time of subscription. Valuations are undertaken to provide supporting evidence of this.
Are senior managers subject to non-competes and if so what is the general duration?
The general rule is that the maximum period of time that a court would be willing to enforce a non-compete in an employment context would be 6- 12 months. There is no requirement (like in other jurisdictions) to pay compensation to the individual in order to enforce.
If the manager is also involved either as seller or a shareholder in the purchaser’s acquisition structure then there may be the ability to extend the non-compete protections in those scenarios.
Clearly there are other contractual and non-contractual remedies that an employing company may be entitled to rely upon to protect its business (e.g. confidentiality, duty of fidelity and director’s fiduciary duties) that may extend beyond that period.
Like in many other jurisdictions, the balance between restraint of trade and protection of legitimate business interests makes enforceability fact specific.
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?
Normally the key documentation that drives governance and behaviour is (i) the shareholders’ agreement and company’s articles of association; and (ii) the management teams employment contracts.
On a control investment:
- it is often the case that the financial sponsor has more than 75% of the voting rights in the target group by reference to its shareholding and therefore so can pass all shareholder resolutions on its own (subject to some fundamental corporate law protections designed to protect minority shareholders from abuse); and
- in any event, the shareholders’ agreement will provide for the ability for the financial sponsor to control the composition of the group’s board of directors, include veto rights over material business decisions (including amendments to business plans and adoption of annual budgets) and oblige the management team to submit regular financial and event driven reporting to the sponsor for the purpose of monitoring its investment.
Is it common to use management pooling vehicles where there are a large number of employee shareholders?
In the UK a customary structure is to use a trust arrangement whereby a trust holds the equity on behalf of the relevant beneficiaries. The aim of this is to minimise (i) the administrative burden of circulating shareholder resolutions to a large number of shareholders; and (ii) reduce the number of parties who may be required to sell their interests on an exit.
However, one of the downsides of creating a management incentive scheme that can deliver a capital gains rate of tax is the requirement for managers to hold equity (whether beneficially or via a nominee arrangement) and this can be administratively burdensome when dealing with a large number of employee shareholders.
What are the most commonly used debt finance capital structures across small, medium and large financings?
Small and mid-cap deals have seen strong competition between traditional banks offering senior financing and credit funds providing unitranche or similar facilities. For larger acquisitions and refinancings, sponsors have a wider range of options and will consider both term loan facilities in the London market and New York senior secured (or unsecured) notes. The very largest financings may also access the US loan market. The split between these instruments depends primarily on investor demand at the time and so differs from deal to deal. Many transactions see complex structures combining term loan facilities, senior secured notes and senior unsecured notes.
Is financial assistance legislation applicable to debt financing arrangements? If so, how is that normally dealt with?
UK public companies are prohibited from giving financial assistance for the acquisition of their shares or the shares of any holding company (whether public or private). This means that guarantees and security cannot be taken from a target company or subsidiary of a target company which is a public company. However, the prohibition does not apply to UK private companies so it is common, particularly in the context of public to private acquisitions, for target companies to be re-registered as private companies following completion of the acquisition, at which point the financial assistance prohibition falls away
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?
Documentation is very bespoke, with sponsors developing their own precedent forms as well as negotiating specific provisions to reflect their strategy for the particular portfolio company
What have been the key areas of negotiation between borrowers and lenders in the last two years?
Over three quarters of European leveraged loans are now covenant-lite (with no financial covenants for the term loans and a ‘springing’ covenant for the benefit of revolving lenders only). Many loan agreements on larger deals now contain New York bond-style covenants, importing bond market concepts.
Have you seen an increase or use of private equity credit funds as sources of debt capital?
Debt funds have been steadily increasing their share of mid-market financings over the past few years, with private credit funds responsible for almost half of mid-cap loans in the first half of 2018. In addition to unitranche deals, funds are also competing to offer stretched senior facilities, at a lower price with lower leverage. Structures have also evolved to include built-in revolving facilities (often offered through co-operation with a bank) reducing the overall margin for the direct lending product. The size of deals that credit funds are prepared to underwrite has been rising and, in this competitive market, a few very strong credits have even seen unitranche financings advanced on cov-lite terms.