#4785 - Management Buyouts And Private Equity Funds - Mergers and Acquisitions (Private Acquisitions)

• potential for really big capital growth

• less restrictive/more flexibility than floating (basically private co. flexibility)

• incentivisation - personal efforts go towards their rewards

• not restricted by listing co procedure

• fund likely to leave in 3-7 yrs - could be a pro - on secondary b/o M often given chance to buy more equity

• PEF offers skill/expertise

• PEF often revise e’ee contracts and cull pointless staff - leaving more of the profits for M

• usually have to use personal wealth (as M) to buy in - take out loan/debt fin against their personal assets

• dilution of equity thr/ratchet provision if IRR [Internal Rate of Return - ideal profit calculated by PEF] not made

• PEF might restrain M in the form of covs and in the form of good leaver/bad leaver cl’s

• maximum potential equity for M is set out @ beginning -> no potential to exceed as ratchets only ever work downwards

• Ws - although mainly for flushing out info re T - d’ors are still made personally liable (usually capped @ 3 yr’s salary)

• fees involved (eg. lawyers) will need money to cover this as well

• PEF takes control - can appoint/remove d’or, reserve right to appoint chairman and execs and negative covs (saying what T can’t do)

Return of investment/Exit

1. flotation of Newco1 on a recognised exchange

2. sale of N1 to trade B

3. secondary b/o

Position of M, Duties and Obligations to be borne in mind during negotiation

• Directors’ Duties: M have d’ors’ duty to act in a way that will promote success of co for existing s’ers (s.172 CA) as well as duty to declare interest (s.177)

• M must therefore make sure they obtain highest price for T and to obtain lowest Ws (but they themselves are the B!)

• Duty to exercise r’able care and skill and diligence (s.174 as well as fiduciary duty in e’ent contract).

• E’ent contract: as e’ers they owe T good faith = unlikely that interest of both co’s will be the same: eg. time, confidentiality (M will get a confidentiality letter from T giving permission to avoid breach of their duty)

• Action? in practice, d’ors who are part of MBO will not participate, any retiring/independent d’ors will act as S or if none existing, T will appoint independent d’ors to do the job. M who participating in MBO must retire [cf. board mins] to avoid this conflict of interest

• What to do before approach to PEF?

• DD to reduce risk/liability

• PEF will ask M For Ws (not as contractual redress but) to flush out info

IRR

What is purpose of ratchet and how goes it work?

• used to incentivise M, usually set @ something attainable

• To work out - take the current number of shares [X] as 20% so divide by 20 then multiply by 100 to work out what new number of shares post ratchet would be

• Then minus X as number of shares M already hold will never chance so new M s’ing = Y

• Minus however many shares M already own (X) and the remaining number will need to be converted to ord shares on a successful ratchet

BVCA MOU conditions

BVCA Memorandum of Understanding conditions:

- BVCA is optional but if you sign up for BVCA Memo it’s a safe haven for ensuring shares for M are taxed under CGT not income by HMRC when the shares are sold by M to achieve their capital gain so in practice everyone does it

Wheres shares are subject to a ratchet arrangement

Conditions (1), (2), (4) and (6) from above apply, plus:

1. the ratchet agreements must vary according to performance of the co and not of individual s’ers (in the other words they can’t act as a quasi bonus scheme)

2. ratchet arrangement must exist @ same time PEF acquires its ord shares; and

3. M must pay a price for share that reflects maximum economic entitlement they could achieve under ratchet (basically ensuring ratchet works to decrease M’s entitlement if IRR isn’t met, ensuring ratcheting up doesn’t happen)

Transfer Pricing Rules

• once it has been decided what proportion of ord shares will be held by M and PEF, PEF will then either take the balance of its investment in convertible pref shares issued by N1; or convertible LNs (usually issued by N2)

• one ad of DF over EF is that repayments are tax deductible therefore it seems logical that every MBO structure would prefer LNs

• however, co’s ability to deduct interest payments is limited by transfer pricing rules (‘TPRs’)

• to the extent that NE agrees to pay more interest to PEF than it would have paid to an unconnected party acting on arms’ length terms (eg. a bank), N2 may not be permitted to deduct the ‘excess’ interest vs its taxable progits.

• Eg. if rate of interest N2 has agreed to pay PEF is higher thatn it would have agreed to pay to bank, HMRC may disallow the difference between two interest rates as a deduction

• Also, if PEF has agreed to lend an amount of money to N2 (@ high rate of interest) where bank would not be willing to lend @ all (eg. because of gearing) then all of the interest payable by N2 on PEF loan may be disallowed

• Basically - LNs not as tax efficient as people think as need to be on commercial unconnected 3rd party terms

Drag Along

• although there are stat squeeze-out and sell-out provisions in ss.979-984 CA these are optional so PEF prefer to have their own bespoke ones in N1 Arts of Assoc to deal w/a situ where stat provisions aren’t satisfied. Also found in Investment Ag (usually both) depending on firm’s preference

• designed to operate @ time of exit

• where majority s’ers require minority s’ers to sell their s’ing on sale of business (as 100% s’ing is more attractive to Bs)

• ss.979-984 have a series of provisions by which drag/tag along occurs but thresholds are v high (s.979 - 90% for drag) also significantly using stat threshold triggers compulsory acq procedure which are v.costly

• in the context of an MBO, CA will only succeed if M hold less thatn 10% so PEF is unlikely to want to rely on it

• the minimum % required to trigger contractual drag shouldn’t be lower than PEF’s s’ing

• PEF will want to make sure it’s included and will want to control timing and consideration of drag