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?
Financial sponsors typically ensure their control over material business decisions by negotiating important rights in the portfolio company's governance documents. The governance documents for private equity portfolio companies typically include:
• a shareholders’ agreement;
• new articles of association; and
• by-laws for the management board and supervisory board (if any).
The main areas of concern in the governance documents are the private equity fund’s rights to appoint sponsor representatives (and/or observers) to the supervisory board (if any) or advisory board (if any), sponsor representative liability, veto rights of the fund (and/or the sponsor representative), dilution protection for the fund, a liquidation preference for the fund, restrictions on dealings with shares (typically including a lock-up, rights of first refusal, tag-along, and drag-along rights), exit rights for the fund (via a trade sale, an IPO or a shotgun mechanism) as well as reporting, information and access rights.
In most cases, the fund will also insist that senior management signs up to an incentive scheme and that all of the management team (and sometimes also certain other key personnel) enter into new employment agreements at terms agreed with the fund.
To the extent the above arrangements are included in the articles of association (which have some benefits for some (but not all) of them from an enforcement perspective), they are publicly accessible through the companies register. In addition, certain arrangements may have to be disclosed if the target is a listed JSC and Securities Law disclosure requirements are triggered.
The governance documents will typically include veto rights of the fund (and/or a sponsor representative in a supervisory board) over major corporate actions and strategic decisions (such as acquisitions and disposals, major litigation, indebtedness, changing the nature of the business, business plans and strategy) although the specific requirements vary widely from fund to fund and deal to deal. Usually such veto rights are structured to fall away if the relevant fund’s interest is reduced below a certain quota. Where multiple funds invest, they will generally insist that all investors vote on the veto matters, with quorum and majority voting requirements varying widely from deal to deal.
A financial sponsor would typically enter into a management services agreement with the key management members of the financial sponsor’s portfolio companies. The management services agreement would set forth, among others, the responsibilities and compensation of the key management members, causes for termination of such key management members or agreement, non-competition and non-solicitation obligations, and certain reporting requirements.
A financial sponsor would also typically nominate one or more directors to serve in each portfolio company to facilitate the financial sponsor’s oversight of the portfolio company’s business operations. Such directors would attend the board meetings at which material business issues and agenda items would be discussed and approved.
Furthermore, certain fundamental corporate actions and events relating to the portfolio company, including amendments of articles of incorporation and mergers and other corporate reorganizations, are subject to approval by a resolution of the general meeting of the shareholders, and a financial sponsor having control over a portfolio company would be able to either approve or reject such actions or events.
Financial sponsors usually reserve the right, in their capacity as shareholders, to nominate directors on the board of directors of the portfolio company. Under Mauritius law, major transactions, i.e. transactions involving the acquisition or disposition of assets of the company amounting to more than 50% of the value of the assets of the company at the time of the transaction require shareholder approval. The sponsor can also set out in the shareholders agreement, investment agreement or the constitution those matters which are reserved for shareholder prior approval. The constitution of the portfolio company will govern the general management of the company. The shareholders agreement or investment agreement can also set out some of the governance rules as agreed between the parties.
The financial sponsor's and management's investment in the portfolio company will customarily be governed by a shareholders' agreement, providing the financial sponsor with decisive influence over the portfolio company. The shareholders' agreements customarily include provision on inter alia board representation and quorum, consent rights, information rights and discretion over exit timing and execution. Usually, the agreements also include provisions enabling the financial sponsor to acquire the shares from members of the management whose employment with the portfolio company is terminated, and may include leaver provisions determining the amount payable to the departing senior manager.
From a corporate law perspective, in a (private) Swiss company limited by shares, most decisions on shareholder level require a simple majority – in particular the election of the members of the board of directors. For certain important matters a qualified majority of at least two-thirds of the voting rights represented and an absolute majority of the nominal value of shares represented is required. The rights and obligations according to corporate Swiss law are usually amended and/or specified in a shareholders' agreement. Sufficient protection should be included in the shareholders' agreement to ensure compliance with the shareholders' agreement.
The financial sponsor typically ensures that it has control over material decisions made by the portfolio company by means of subjecting such decisions either to the prior approval of the general meeting (in which the financial investor holds the majority of the votes cast) or the supervisory board of the company (reserved matters). In addition, the financial sponsor usually is entitled to appoint, suspend and dismiss all (or the majority of) the members of the management board and, if established, the members of the supervisory board. Pursuant to Dutch law, a supervisory board has to act in the interest of the company as opposed to shareholders who may act in their own interest. Therefore, decisions relating to material corporate and financing matters and fundamental business decisions are usually made subject to the approval of the general meeting only. It is common to include arrangements in respect of the governance of a portfolio company in a shareholders’ agreement and the articles of association of the portfolio company. Reasons to not include all such arrangements in both documents, but only in the shareholders’ agreement are, amongst others, the fact that the articles of association are to be filed with the Dutch trade register as a result of which these are publically accessible.
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.
There are three ways in which financial sponsors typically ensure some level of control over the portfolio company:
(i) Information rights – the least far-reaching method of ensuring some level of control is by imposing information covenants on the company towards the financial sponsor. This duty to inform can be periodical, topical or a combination of both.
(ii) Nomination rights – financial investors, even when holding only a minority of the shares, usually obtain the right to nominate one or more members to the board of directors of the portfolio company. However, it is important to note that each director of a Belgian company has the fiduciary duty to act within the company’s best interest, thereby disregarding the interest of its nominating shareholder.
(iii) Veto rights – the most intrusive way of obtaining control as a minority investor is by requesting veto rights over specific corporate actions or material business decisions, either at the level of the board or the shareholders’ meeting. Veto rights are usually attached to a separate class of shares, which are issued to the financial sponsor.
The governance of the portfolio company is usually regulated through a shareholders’ agreement and the articles of association of the company. Note that in Belgium the articles of association of a company are in principle publicly accessible.
These would be controlled in the following way in a shareholders’ agreement:
a. a list of reserved matters which require the financial sponsor’s consent;
b. control by the financial sponsor of the management board of portfolio company;
c. detailed business plans and budgets that the company is bound by.
Additionally, the financial sponsor typically holds the majority of the voting rights for the shareholders’ meeting of the target company.
The most commonly used measures to give a private equity fund a level of management control include: (i) restrictions on the management's actions without the consent of the private equity fund, until “exit” is achieved (veto rights and negative covenants), (ii) right to be represented at the board level of the target investment and subsidiaries, (iii) limitations preventing the management from developing competing businesses for a period after the investment.
Control rights are usually included in shareholders agreements (as opposed to the by-laws or articles of association, since not all investor protection rules in Portuguese companies can be included in the latter). Nevertheless, the by-laws also feature key provisions such as rights granted to special class shareholders and supermajority provisions at board and shareholder meeting level.
Normally the key documentation that drives governance and behavior is the shareholders’ agreement (or joint venture agreement) and the portfolio company’s articles of association. These documents usually specify corporate governance (e.g. shareholders’ meeting, board meeting and management structures, including right to appoint certain key executives) and voting arrangements (e.g. reserved matters for shareholder’s or board’s approval). Sometimes, additional agreements (e.g. framework agreement, IP license agreements, supply agreements) are also used to offer non-Chinese investors additional protection on enforcement and recourse.
Financial sponsors typically exert controlling influence by securing the right to nominate a majority of the members of the board of directors (and, by extension, the CEO). This control is typically further strengthened by the provisions in the shareholders’ agreement, which is the key document regulating the governance of the company, relationships between the shareholders, ownership and exit. While there are a number of provisions in the Finnish Companies Act concerning, e.g. the governance of the company and the protection of the rights of minority shareholders, it is common for the parties to a shareholders’ agreement to replace these provisions with more detailed provisions. In sponsor backed companies, the minority shareholders commonly waive most of minority protection mechanisms of the Companies Act. Financial sponsors sometimes – especially in situations where they do not hold an outright majority of the shares and votes – require veto rights in shareholders’ agreements.
Upon closing, a supervisory board is generally set up comprising a majority of members appointed by the financial sponsor. Certain material decisions, including the decisions affecting the business of the group, shall be approved by the supervisory board before they are implemented by the managers.
The list of decisions that requires the prior approval of the supervisory board is set out in a shareholders’ agreement entered into between the financial sponsors and the managers of the target group. This agreement will contain further details on the governance of the portfolio company and will also describe, among others, the liquidity rights of the shareholders. In order to ensure that the provisions of the shareholders’ agreement will be enforceable under French laws, its main terms will generally be reflected in the articles of association of the holding companies.
With regard to the management of the target companies, in case of a German limited liability company, rules of procedures are often implemented, linking management decisions above certain thresholds to the approval of supervisory or advisory boards or the shareholders’ meeting. These corporate bodies are usually implemented through the articles of association and are dominated by representatives of the financial sponsor and thus the sponsor has control over material business decisions. In addition thereto, shareholders can instruct management of a German limited liability company with a simple shareholders’ resolution. Where the target company is a German stock corporation, there is no right to directly instruct the management of the company and there is less flexibility with regard to the corporate governance structure, the financial sponsor as majority shareholder can use its influence on the appointment of supervisory board members and management board members to control material business decisions.
In view of equity participations held by management, financial sponsors typically aim to have the controlling voting rights under any structure. Therefore, financial sponsors will limit the management's influence as equity holder to a minimum which can be done by establishing an indirect investment structure for the management participation program. The respective pooling vehicles established by the financial sponsor for the investment structure are solely managed and represented by an entity held by the respective financial sponsor in order to ensure that a financial sponsor has control over the investment.
(a) The financial sponsor needs to ensure that it has appropriate representation in the Board of Directors of the operating entity by appointment of board members that have veto powers over specific important decisions. Subject to the exclusive powers of the shareholder meeting to resolve on certain matters, the Board of Directors is competent to decide on every act concerning the management of the company. Greek law provides for a one-tier board system. As the relevant provisions of law are considered of mandatory nature, the Articles of Association cannot introduce a two-tier system, by establishing a supervisory board. Following the acquisition of the operating entity the financial sponsor should request that the Articles of Association include the right of the financial sponsor to appoint specific members of the Board of Directors (not exceeding 2/3 under the current regime and 2/5 according to the new company law which will come into force on 1.1.2019), determining at the same time the conditions under which such right is to be exercised.
(b) Furthermore, the financial sponsor should ensure that increased quorum provisions and manner in which both board and shareholder meetings are convened and conducted are inserted in the Articles of Association of the operating entity. In respect of the convocation of the Board meetings, the new Company Law allows the flexibility to non-listed companies to provide other convocation formalities than those provided in the law. The Articles of Association should also clearly provide for matters for which the Board of Directors is solely responsible, and the specific quorum and majority in order to reach a decision on specific matters. Furthermore, the financial sponsor needs to ensure that it receives regularly the necessary financial and other information as and when required to monitor the investment and exercise its rights.
(c) Also appropriate mechanisms should be inserted in the Articles of Association of the operating entity to deal with any potential voting deadlock, including call and put options mechanism where such a deadlock arises. The new Company Law explicitly provides that Articles of Association may include standard restrictions on the transferability of the shares, which are extensively applied in practice, and that put and call option agreements can be registered with the shareholders registry, consequently ensuring the implementation of such agreements in practice.
This is governed by a shareholders agreement with the usual consent matters, board control and tight delegated authorities to subsidiaries.
There are a number of common approaches to ensuring that a financial sponsor has control over material business decisions. Typically, even with a minority shareholding, financial investors will seek to have a board nomination right (at a minimum then are granted information rights and observer status). As a matter of Luxembourg law, it is not possible to have a shareholder appoint a board member unilaterally; however, the common approach is to be granted a nomination right with parties giving a voting undertaking to vote in favour of the appointment of a person so nominated. In addition and depending on the financial sponsor’s negotiation power in the particular transaction, they may provide in the relevant documentation that certain key business decisions can not be taken without either (i) the vote of the financial sponsor’s nominated board member or (ii) the consent of the financial sponsor shareholder.
It is worth noting that if an element of control is vested in the financial sponsor only through a nominated board member, this may not offer adequate comfort as such board member is required as a matter of Luxembourg law to act in the company’s interest and would not therefore be free to take into account its nominating shareholder’s interest in a specific matter. Board composition and alignment of voting rights must also be considered.
When it is agreed that certain matters may only be carried out by the board and/or the shareholders having obtained the consent of the financial sponsor shareholder, it is common to have such recorded in the Articles as reserved matters.
Although not a right which vests any control in a shareholder, it is also standard practice to have all shareholders in a company vested with standard information rights.
Typically a shareholders agreement, together with the articles of association of the portfolio company, are used to regulate its governance. As Luxembourg law requires that the articles of the traditional corporate vehicles (SARL, SA and SCA) be published, parties may choose to include certain confidential information in the shareholders agreement only. As mentioned in the response to question 11 above, the sociétés en commandite spéciale (being without legal personality) and the sociétés en commandite simple have become more popular in recent years, one advantage of them being that the relevant partnership agreement is not required to be published in full and there is therefore no issue regarding potential misalignment of certain provisions as there can be when governance is included in both a shareholders agreement and the articles of association but without being replicated in full in the articles of association to avoid public disclosure of confidential information.
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.
The financial sponsor regularly holds the majority of the shares and voting power in the portfolio company and as a result thereof controls the appointment of board members and CEO in the portfolio company. In addition thereto, in case there are other shareholders, the ownership of the portfolio company is normally regulated by a shareholders agreement according to which the financial sponsor and/or its representatives on the board may have veto rights in relation to certain material business decisions. Further, the board in a Swedish company regularly adopts governance documents to establish structures for the decision-making process in the company. Common documents include rules of procedures for the board, instructions to the CEO and instructions for financial reporting. Since the financial sponsor normally has the power to appoint the board (or a majority thereof), it may indirectly dictate the content of such governance documents and thereby ensure control.
Governance mechanisms are usually included in the Memorandum and Articles of Association, including the creation of equity share classes having clearly defined rights (e.g. A Shares, B Shares etc.), and the establishment of reserved matters requiring a qualified majority of the directors or shareholders of the company. Shareholders’ Agreements are also widely used to regulate more detailed mechanisms which the shareholders wish to keep private and outside of the public domain. The shareholder agreement may be subject to a governing law other than Malta and can be made to supersede the company’s Articles of Association in case of conflict.
Financial sponsor has board nomination rights, veto rights and information and inspection rights in a portfolio company.
Board nomination rights are standard for minority investments. Indian company law casts fiduciary and statutory duty on every director of a company to act in its best interest and, by implication, disregarding the interest of the nominating shareholder.
Veto right over material business decisions are standard in the Indian context; this right is structured in the form of a prior consent of the financial sponsor as an entity and not as consent of the financial sponsor’s nominee on the board of the portfolio company. The rationale for such structure is due to the fiduciary and statutory duty of a director as stated above. In context of public listed companies and transactions involving anti-trust approvals, receiving such affirmative rights for the acquirer are limited because of the regulatory implications.
Information and inspection rights are also standard in the Indian context; these include periodic disclosure by the portfolio company with respect to accounts and financial information, customer contracts, resignation by key managerial personnel, budgets and business plan. Inspection rights to examine the books and records as well as meet the key managerial personnel of the portfolio company are usual and at the cost of the financial sponsor.
The above rights are recorded in investment agreement or a shareholders’ agreement and, for the purposes of enforceability are required to be recorded in the articles of association of the target company. It is important to note that articles of association of the portfolio company are filed with the Registrar of Companies and are publicly accessible.