This country-specific Q&A provides an overview to private equity laws and regulations that may occur in United States.
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?
Of the private target M&A transactions in the US for which Kirkland has been involved in the last 12 months, approximately: (i) 63% of such transactions involved a financial sponsor as buyer from, or seller to, a non-financial sponsor entity; (ii) 18% involved a sale from a financial sponsor to a financial sponsor and (iii) 19% did not include a financial sponsor buyer or seller. From Bloomberg sources, in the last 12 months, approximately 6,300 transactions with aggregate deal value of $430 billion have included a financial sponsor as either buyer or seller, which represents approximately 41% of all US M&A transactions by volume and 47% by value.
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 the warranty and indemnity coverage given by U.S. sellers. In order to address this most sales by financial sponsors are structured with: (i) standard purchase price adjustments based on net debt and target working capital items but with sole recourse to an escrow amount for downward purchase price adjustments; (ii) fundamental and operational warranties tend to be covered by R&W insurance; and (iii) the time limitations for all other claims (if any) are very short.
On an acquisition of shares, what is the process for effecting the transfer of the shares and are transfer taxes payable?
The stock purchase agreement and accompanying stock power are the documents which evidence the transfer of stock in private limited liability corporations.
The U.S. does not have any transfer tax on stock transfers.
How do financial sponsors provide comfort to sellers where the purchasing entity is a special purpose vehicle?
US sponsors provide both debt and equity commitment letters and employ a limited specific performance construct whereby if there is a debt financing failure, the Sponsor is only liable for a reverse termination fee but can be forced to fund the entire deal with equity (further discussed below).
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 paying the purchase price.
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 transactions are used in a small minority of transactions in the U.S.
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.
For transactions with a separate signing and closing, the obligation of the buyer to close is typically conditioned upon target’s compliance with its pre-closing covenants in all material respects, as well as the accuracy of the target’s representations and warranties as of closing. The vast majority of transactions we have worked on required the representations and warranties to be true and correct as of closing subject to a material adverse effect qualifier (scraping the reps of materiality), with the balance subject to a materiality or no qualifier.
In addition, the majority of transactions do not include a condition that buyer shall have obtained its financing. However, buyer and sellers regularly allocate financing risk by adopting either the “Private Equity Model” or “Fully Equity Backstopped Model” of financing risk allocation.
The Private Equity Model provides that if all closing conditions are satisfied, target has right to force buyer to fund and close, but only as long as debt financing is available. Otherwise, target cannot force buyer to close, but if debt financing is unavailable and closing conditions are satisfied, target is entitled to payment of a reverse termination fee (typically as its exclusive remedy). Approximately 67% of the transactions we have worked on in the last 12 months (with a separate signing and closing) used the Private Equity Model and in such instances, the median reverse termination fee was 5% of enterprise value.
The Full Equity Backstop Model provides that if all closing conditions are satisfied, target has the right to force buyer to close (regardless of whether the buyer’s debt financing is available, if sought) or to sue for damages (often capped). Approximately 33% of the transactions we have worked on in the last 12 months (with a separate signing and closing) used the Full Equity Backstop Model.
In competitive auction processes, buyers are increasingly willing to forgo post-closing indemnification from sellers. 30% of all transactions we have worked on in the last 12 months did not include any post-closing indemnification. In those transactions where the parties agreed to include post-closing indemnification there has been downward pressure on the size of the incentive equity cap due to seller leverage and increasing use of R&W Insurance, with approximately 44% of deals having a basic indemnity cap of 2% or less.
How prevalent is the use of W&I insurance in your transactions?
The use of R&W insurance is an important component of M&A transactions. Approximately 50% of all transactions we have worked on in the last 12 months used R&W Insurance. For deals with a financial sponsor acquirer and/or seller, approximately 53% used R&W Insurance, whereas less than 30% of strategic acquirers used R&W Insurance.
Given the competition and supply in the R&W 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 each of calendar years 2016 - 2017 there were 81 announced sponsor-backed take-private acquisitions in the U.S. The number of sponsor-backed take private transactions in 2018 is on pace to modestly exceed prior years’ numbers with 79 announced deals year-to-date (as of December 11). 2018 average transaction size is approximately $2 billion whereas the average in 2017 was approximately $1 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.
As of Q4 2018, there were 187 private infrastructure funds in the market seeking to raise a total of $147 billion, with North America-focused funds dominating the market, having raised nearly three-quarters of the aggregate global total in Q3. Funds in the market include a number of the best-known infra sponsors, including the latest funds from GIP, EQT, ECP, EIG and others.
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 United States has implemented an increasingly rigorous national security investment review regime over the last three decades, as foreign direct investment in the U.S. has grown and the nation's national security profile has evolved. Today, the Committee on Foreign Investment in the United States (CFIUS) administers this regime under the authority of the President.
CFIUS is an inter-agency national security body empowered to review certain transactions involving a “foreign person” (including foreign co-investors and non-passive foreign limited partners investing through U.S. funds) and a U.S. business in order to evaluate a transaction’s impact on U.S. national security. CFIUS has the authority to impose measures or conditions to mitigate any national security risks posed by transactions within its jurisdiction, and may even recommend that the President block (or, in the case of completed transactions, unwind) such transactions for national security reasons. Certain transactions also implicate complex policy and political factors, which must be carefully addressed in the context of pursuing CFIUS clearance.
In recent years, CFIUS has closely scrutinized transactions involving private equity acquirers and co-invest structures. New CFIUS reform legislation legislation passed in 2018 codified increased disclosure requirements applicable to private equity sponsors and investors, and a “pilot program” effective in November 2018 mandates that transaction parties submit short-form CFIUS “declarations” for certain investments. Forthcoming regulations to implement CFIUS reform are expected to further strengthen CFIUS’ agency authorities.
How is the risk of merger clearance normally dealt with where a financial sponsor is the acquirer?
In the United States, the Hart-Scott-Rodino (HSR) antitrust review process is mandatory for most acquisitions exceeding a statutory threshold (currently $84.4 million). Inevitably, completion of the HSR review is a closing condition in any transaction to which the HSR Act applies.
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, a reasonable best efforts clause, or a corresponding contractual penalty (whether by way of fixed amount or contractual damages) if the merger clearance cannot be obtained.
It is not unusual for a financial buyer to accept a “hell or high water” provision where the risk is believed to be very low; the clause protects the seller against an undisclosed competitive overlap within the buyer’s portfolio. Where the financial buyer’s portfolio contains companies that overlap with the target, and this overlap is known or disclosed, the risk tends to be shared, with the allocation often being an important part of the deal negotiations.
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 has 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 programs are structured on an equity basis granting the managers direct equity interests or the value of the equity interest 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 equity which attract higher rates of tax for the individuals and social security contributions for the portfolio company which employs them. Profits interest structures are the most popular choice, which results in capital gains if structured properly. In addition, stock options, phantom equity and restricted stock units are often used, which results in ordinary income to management and a compensation deduction for the portfolio company which employs them.
Often a portion of management’s equity is structured to vest and 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 with a portion of management’s equity also structured to vest and deliver value over a 4-5 year period, subject to continued employment through each vesting date and the value of management’s equity appreciating above the buyer’s acquisition cost.
Are there any specific tax rules which commonly feature in the structuring of management’s incentive schemes?
Under U.S. tax law, a key principle for profits interest and stock options are for those awards not to have any built-in value at the time of grant. 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 1- 2 years. There is no requirement (like in other jurisdictions) to pay compensation to the individual in order to enforce, but the courts in the U.S. will require consideration for entering into a non-compete. In the U.S., the state law will govern the enforceability of the non-compete and determine the adequacy of the consideration.
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 behavior is (i) the company’s constitutional documentation; and (ii) the management team’s employment contracts.
On a control investment 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?
Management pooling vehicles are less common in the U.S. as management’s interests do not typically carry voting rights and are required to sell their interests in connection with a sale.
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 and senior secured (or unsecured) notes. 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.
Large cap deals have seen much larger second lien capacity, oftentimes privately placed with direct lenders but for the largest transactions the bank/bond structure remains the most prevalent.
Is financial assistance legislation applicable to debt financing arrangements? If so, how is that normally dealt with?
Fraudulent conveyance rules effectively limit the amount of indebtedness that a borrower can take on but this is not legislated in the same way as the type of financial assistance legislation found in Europe.
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?
Negotiation has focused on the terms of “most favored nation” pricing protection of syndicated term loans as well as continued convergence with U.S. high yield terms. In addition, 2018 saw certain borrower advancements in high yield terms where the market had historically been slower to adapt.
Have you seen an increase or use of private equity credit funds as sources of debt capital?
Private equity credit funds like Bain Credit, GSO, TPG, Carlyle, New Mountain and KKR Credit have historically been a source of debt capital, with market share increasing in line with market share increases for private debt fund providers generally and seemingly disproportionately to commercial bank providers.