i Deal activity
Although the buyout market remained healthy in 2019, competition from strategic buyers, higher public equity market valuations, uncertainty regarding tax and regulatory policy under the Trump administration and a worry over a global recession led to an overall decrease in both absolute transaction value and number of transactions compared with 2018.
Private equity sponsors completed 4 per cent fewer US buyout transactions in 2019 than in 2018, while the total amount invested fell by over 7 per cent.2 Despite this decline, private equity firms led a number of large buyouts, including Blackstone's US$18.7 billion acquisition of US logistics assets from GLP, US$7.5 billion take-private of Merlin Entertainments and US$11 billion take-private of Ultimate Software; Goldman's US$2.7 billion acquisition of Capital Vision Services; the US$5.4 billion take-private of Dun & Bradstreet by a consortium of investors, including CC Capital and Thomas H Lee; the US$6.5 billion take-private of Buckeye Partners LP by IFM Global Infrastructure Fund; Veritas Capital Fund and Elliott Management Corp's US$5.5 billion take-private of Athenahealth; and the US$2.7 billion take-private of WestJet by Onex Corp. The 2019 market for private equity sponsor-led take-private transactions was roughly flat in terms of the number of deals, but the aggregate value of those deals jumped over 162 per cent compared with 2018 – driven, in large part, by the sizable take-privates mentioned above.
There was another year-on-year decrease in the number of US growth equity investments by private equity firms (i.e., purchasing a minority equity stake in a mature firm) in 2019, with the total number of deals down 12 per cent from 2018 levels. Aggregate reported value was also down meaningfully, dropping nearly 40 per cent compared with 2018.3
Exit volume in 2019 continued to remain significantly below the 2014–2015 peak, with the value of 2019 exits falling to the lowest levels since 2012. Year-on-year exits were down nearly 17 per cent by number and just over 28 per cent by volume.4 Despite these weaker exit numbers, 2019 saw a continued increase in general partner (GP) led secondary offerings (i.e., secondary sales of limited partner (LP) interests in an existing fund) as buyout funds looked to both hold on to promising portfolio companies and provide LPs with a means of liquidity outside of traditional majority sales.
Despite the overall slowdown, there were several notable sales in 2019: Apax Partners, CPPIB and PSP Investments sold Acelity to 3M for US$6.7 billion and Blackstone announced the pending sale of Refinitiv to the London Stock Exchange for US$27 billion, including debt, just 10 months after acquiring Refinitiv from Thompson Reuters for US$20 billion.
Due, in part, to disappointing, high-profile listings by venture capital-backed companies such as Uber, Lyft and Pinterest, the failed WeWork initial public offering (IPO) and the January 2019 US government shutdown, the sponsor-led IPO market fell meaningfully from already depressed 2018 levels: just 23 private equity-backed companies went public in 2019.5 Notable 2019 private equity-backed IPOs included pet supplier Chewy (backed by BC Partners), chemical manufacturer Avantor (backed by New Mountain Capital) and direct-to-consumer dental company SmileDirectClub (backed by Clayton, Dubilier & Rice, Kleiner Perkins and Spark Capital).6
In 2019, secondary portfolio company buyouts (i.e., sponsor-to-sponsor transactions) continued to grab an increasing share of the total number of M&A exits with more than half of all targets being sold to financial sponsors.7
Looking ahead, the market for IPOs, corporate acquisitions and sponsor-to-sponsor buyouts will continue to be important for private equity firms looking to liquidate their inventory of portfolio companies, which continue to sit at an all-time high.8 In addition, the overall volume of GP-led secondary sales will increase as average holding periods trend higher and longer-term private investors (pension funds, family offices, sovereign wealth funds, etc.) continue to pursue direct investments alongside buyout funds.
The overall volume of US debt financing was down year-on-year, mirroring the overall decline in deal volume. According to Thomson Reuters, total US dollar-leveraged lending in 2019 fell over 31 per cent compared with 2018 levels (to just under US$900 billion).9 Lending to private equity sponsors for all purposes, including M&A, refinancing and dividend recaps, also experienced a sharp decline from 2018's record numbers - falling nearly 37 per cent.10
The 2019 buyout market also saw the first decline (albeit slight) in year-on-year leverage levels since 2015. The average debt multiple for larger broadly syndicated leveraged buyouts (LBOs) remained roughly flat at six times earnings before interest, tax, depreciation and amortisation (EBITDA), while the average debt multiple for middle-market LBOs decreased from roughly 5.6 times EBITDA at the end of 2018 to 5.3 times EBITDA at the end of 2019.11
General partner investing
2019 saw continued activity in the level of GP stakes investing, whereby private equity funds invest in the management companies of other sponsors. A record number of GP stakes investments closed in 2019, led by funds such as Dyal (a group within Neuberger Berman), AIMS (a group within Goldman Sachs) and Blackstone.12 These transactions give sponsors the ability to monetise a portion of their future management fees and carry without the trouble of publicly listing. Given the large funds raised to pursue GP stakes investing – over US$23 billion in 2019 alone (an increase of nearly four times 2016 levels) – a continued increase in activity is expected in this space in 2020.13 In fact, Dyal closed on its US$9 billion fund in the fourth quarter of 2019 (which is already 60 per cent invested) and is expected to begin fundraising for its next vehicle in 2020. In addition, new entrants to the space, including Aberdeen Standard Investments, Goodhart Partners and Stonyrock Capital Partners, are currently in the market raising new GP stakes funds.14
Despite overall slower deal activity in 2019, fundraising by sponsors reached record levels, jumping 52 per cent from 2018 levels to over US$300 billion.15 2019 also saw a growing market for 'long-dated' funds, with large players in the traditional sponsor market, such as Blackstone and Vista Equity Partners, looking to attract new capital to funds with investment horizons of 20 years or more.
ii Operation of the market
The US market for corporate control is very efficient. Many private targets are sold through an auction run by investment bankers or similar intermediaries. While a smaller proportion of public targets are sold through a full-blown auction, the legal framework (in general) attempts to duplicate an auction by encouraging a target's board of directors to follow a process designed to secure the highest reasonably attainable price for stockholders.
From a legal point of view, the US market for sponsor-led going-private transactions is driven primarily by the following considerations:
- the fiduciary obligations of the target's board of directors, as defined by the laws of the target's state of incorporation (most frequently, Delaware);
- financing risks; and
- the rules of the Securities and Exchange Commission (SEC) regarding tender offers or proxy solicitations.
Each of these factors influences not only the time required to purchase a US public target but also the transaction's structure.
Delaware courts have held that when a target's board decides to sell the company it must satisfy what are known as Revlon duties.16 Revlon requires a contextually specific application of the board's normal duties of care and loyalty designed to ensure that it conducts a process to seek and attain the best value reasonably available to the target's stockholders. There is no single, court-prescribed course of action for a board to follow (e.g., conducting a pre-signing auction for the target or always using a special committee of disinterested directors to negotiate with a suitor). However, certain conventions – such as fiduciary outs and limits on termination fees and other deal protections – have arisen in response to guidance from Delaware courts to balance the target board's obligation under Revlon and the bidder's desire to obtain deal certainty. For example, many deals feature a 'go-shop' exception to a target's customary 'no-shop' covenant.17 In a typical go-shop, the target is given a window – usually 25 to 40 days – to actively seek a superior offer. If a qualifying topping bid emerges during the go-shop period, the target may terminate its agreement with the original acquirer by paying a reduced termination fee and enter into a new agreement with the higher bidder. Most importantly, from a private equity bidder's perspective, Delaware courts have concluded that a target board that does not conduct a pre-signing auction or market check can satisfy its Revlon duties by including a go-shop in the merger agreement, so long as the rest of the process and other deal protections are satisfactory.18
Parties to a US leveraged take-private must contend with the risk that debt financing may not be available at closing. Unlike in some other countries (e.g., the United Kingdom), 'certain funds' (i.e., a fully negotiated and executed credit agreement between a buyer and its lenders delivered at deal announcement) are neither required nor available in the United States, and financing commitment letters, no matter how 'tight' (i.e., lacking in preconditions), cannot be specifically enforced even if the providers of the letters have clearly breached their terms. In response, dealmakers have crafted a model that has become the most common (but by no means the sole) way to allocate the risk of financing failure.
This model generally allows a target to obtain, as its sole pre-termination remedy, an order from a court, known as an order for 'specific performance', forcing a buyer sponsor to make good on its commitment to provide the necessary equity financing and to complete the merger if, and only if, all the conditions to the merger are satisfied, the debt financing is available for closing and the target agrees to close when the equity is funded. If, on the other hand, the target chooses to terminate the merger agreement, either because the private equity sponsor is unable to close because the necessary debt financing is not available or otherwise breaches the agreement, then the sponsor must pay the target a reverse break-up fee (usually an amount greater than the target's termination fee) and the transaction is terminated. Payment of the reverse break-up fee is the target's sole and exclusive remedy against the sponsor and its financing sources, even in the case of a wilful breach.19
Parties to a sponsor-led take-private transaction add yet another level of complexity when they choose to proceed via a two-step tender offer (rather than a one-step merger). In a tender offer, the sponsor offers to purchase the shares of the target directly from the stockholders, obviating the need – at least in the initial step – for a stockholder vote. The sponsor's obligation to complete the tender offer is typically conditioned upon stockholders tendering more than 50 per cent of the outstanding shares. If this 'minimum tender' condition is satisfied, the sponsor must acquire all untendered shares in a 'back-end' merger, the terms of which are set out in a merger agreement executed by the target and buyer on the day they announce the tender offer. Depending on the circumstances of the deal, including the target's state of incorporation, the back-end merger can be completed immediately after the closing of the tender offer; otherwise the buyer must engage in a long (three- to four-month) and expensive proxy solicitation process and hold a target stockholders' meeting before it can complete the back-end merger.
Failure to acquire all the outstanding stock on the same day the tender offer closes makes it much more difficult to use debt financing because of the application of US margin stock rules, a highly complex set of laws and regulations that, in general, prohibit any person from financing the acquisition of US public company stock with more than 50 per cent debt financing secured by the target's stock or assets. Many sponsor-led US take-private transactions are more than 50 per cent leveraged, so parties to such transactions must find solutions that satisfy the margin rules if they wish to enjoy the benefits of a tender offer.
The easiest way to avoid a delayed back-end merger is for the buyer to acquire in the tender offer a supermajority of the target's shares – in Delaware, 90 per cent – allowing the buyer to complete a 'short-form' merger immediately after closing the tender offer. By completing the back-end merger essentially simultaneously with the offer, a sponsor can more easily structure its debt financing to comply with the margin rules and lender demands for a lien on the target's assets. In most deals, however, it is not realistic to expect stockholders to tender such a large proportion of the outstanding shares.
Dealmakers address the potential delays of a full-blown back-end merger process and the complications presented by the margin rules largely by relying on a 'top-up' option or Delaware General Corporation Law Section 251(h).
In a top-up option the target agrees, upon completion of the tender offer, to issue to the buyer a sufficient number of its authorised but unissued shares to allow the buyer to reach the threshold required for a short-form, back-end merger. Delaware courts have approved the top-up option structure, with a few easily satisfied caveats,20 largely because it puts money in stockholders' hands more quickly without harming their interests. The primary limitation of the top-up option is mathematical: the number of shares required to hit 90 per cent may be very large because the calculation is iterative, so it is often the case that a target does not have enough authorised but unissued shares in its constituent documents to utilise the top-up option.
Enacted by Delaware in August 2013, Section 251(h) eliminates, subject to certain conditions, the requirement for stockholder approval of a back-end merger after a tender offer for a listed company, or one with more than 2,000 stockholders of record, if the buyer acquires more than the number of shares required to approve a merger (typically a bare majority, but it could be more if the target's certificate of incorporation so requires) but less than the 90 per cent threshold for a short-form merger.
Section 251(h) is an important and useful innovation, as it allows the buyer to acquire all the outstanding shares and the non-tendering stockholders to receive the merger consideration without the lost time and expense of a three to four-month proxy solicitation process.21 Furthermore, in June 2016, Delaware passed an amendment to Section 251(h) giving target management and other target stockholders the opportunity to exchange all or a portion of their target stock for buyer stock without running afoul of Section 251(h) rules, a limitation that had previously favoured the use of the top-up option in certain circumstances. As a result, the use of the top-up option, either in lieu of or as a backup in the event the Section 251(h) conditions cannot be satisfied, will continue to slow going forward.
For many years, practitioners have accepted that stockholder lawsuits are simply part of the price of acquiring a public target, regardless of how well the target's board managed the sale process. Prior to 2016, the vast majority of public company deals valued over US$100 million faced at least one shareholder lawsuit.22 These lawsuits, often filed within hours of a transaction's public announcement, were frequently settled for the target's promise to disclose additional information about the transaction process and the payment of a fee to the plaintiffs' lawyers. However, key 2015 and 2016 cases saw Delaware courts sour on these 'disclosure only' settlements.23 In addition, recent case law has given additional clarity to deal process road maps that provide the target company with the 'business judgement' standard of judicial review, a standard that makes it difficult for plaintiffs to prevail.24 While this trend has had the expected effect on the volume of nuisance lawsuits in Delaware, with public company merger litigation trending down over the past half-decade, there has been a partially offsetting increase in deal litigation in other states and federal courts as plaintiffs seek more favourable venues for claims.25
During 2016 and 2017, as litigation focused on allegedly flawed sale process declined, plaintiffs shifted their focus to appraisal actions. Delaware General Corporation Law Section 262 permits stockholders of Delaware corporations to seek appraisal of his or her shares in lieu of accepting the merger consideration negotiated by the target and the acquirer. Historically, Delaware courts had given substantial weight to the merger price in determining the true 'fair market value' of a stockholder's shares.26 Several 2016 Delaware cases saw judges lessen or eliminate their historical reliance on the merger price as evidence of value and instead focus on financial projections and related discounted cash flow analysis to come to their own independent calculation of fair market value for a target.27 These judicially derived values often varied substantially from the merger price. Interestingly enough, these 2016 cases suggested that Delaware courts were more apt to discount the deal price and give more weight to their own analysis in instances where the acquirer was a private equity sponsor.28 As a result, the plaintiffs' bar rushed to file appraisal actions in 2016 and 2017, particularly where the acquirer was a private equity sponsor. The year 2017 ended, however, on a sour note for plaintiffs eager to have a Delaware judge second-guess deal consideration. Two key appraisal cases were overturned by the Delaware Supreme Court on appeal, including one with a private equity acquirer.29 The message in those cases was clear – Delaware courts should be deferential to the merger price unless there are sale process breakdowns that make the merger consideration suspect. Given the return to reliance on deal price as the primary indicator of value in appraisal actions, 2019 continued to see the volume of appraisal litigation in Delaware fall from 2016 and 2017 peak levels.30
Because it is easier to maintain confidentiality and the consequences of a failed auction are less dire, a full-blown auction for a US private target is more common than for a public target. In an auction for a US private target, the target's advisers typically invite several bidders to conduct limited due diligence and submit indicative bids, with the highest and most credible bidders invited to conduct further due diligence and submit additional bids. The time required to sell a private target can vary considerably: an auction and sale process for a desirable private target can take, from start to finish, as little as two months, while other processes may take many months. If the buyer requires debt financing, the health of the debt markets also affects the length of the process.31
In an auction, a private equity firm must compete not only on price but also on terms, timing and attractiveness to management. While in the past private equity bidders often conditioned their bids on receiving necessary debt financing, in today's market such a condition is likely to affect the competitiveness of a bid adversely, particularly in a larger deal. Indeed, in the current market many private-target acquisition agreements (a clear majority in larger deals) contain the same conditional specific performance and reverse break fee mechanism now common in take-private transactions.
The US buyout market has also seen continued growth in the use of commercial insurance policies intended to protect buyers or sellers (or both) against various transaction-related risks, such as breaches of representations and warranties. These insurance products often allow parties to bypass difficult negotiation over post-closing indemnification by shifting specified transaction risks to a sophisticated third party in the business of taking such risks. An increasing number of private equity firms have successfully used M&A insurance to either make their bids more attractive to sellers or limit their post-closing liabilities when exiting an investment.
Management equity practices vary across US private equity firms, but certain themes are common:
- executives with sufficient net worth are expected to invest side-by-side with the sponsor to ensure they have sufficient 'skin in the game';
- management equity entitles the holder only to modest stockholder rights – in some cases, only the right to be paid in connection with a distribution or liquidation;
- holders of management equity get liquidity when and to the same extent that the sponsor gets liquidity; and
- incentive equity (and at times part or all of management's co-invested equity as well) is subject to vesting, whether upon passage of time, achievement of various performance goals, or a combination of the two.
The size of the management incentive equity pool generally ranges from 5 to 15 per cent, depending on the mix between time- and performance-based vesting, with smaller deals generally congregating at the upper end of the range, and larger deals generally at the lower end.
The prospect of participating in a potentially lucrative incentive equity pool can be powerful motivation for management to prefer a private equity buyer over a strategic buyer unlikely to offer a similar plan (and who might fire management instead). A private equity bidder for a private target can use this to its advantage, particularly when management cooperation is key to a successful sale. When pursuing a public target, however, such a strategy carries additional risk, as Delaware courts, the SEC and the market are sensitive to the conflict of interest presented when a target officer – particularly the CEO – has a personal incentive to prefer one bidder over another.
For this reason, the board of a public target often instructs its management not to enter into an agreement with a private equity suitor regarding compensation or equity participation before the stockholders have voted on the deal (or tendered their shares to the buyer). Indeed, it is often in a private equity buyer's interest not enter into an agreement with management before the stockholder vote, because the SEC (by way of its Rule 13e-3) requires substantial additional disclosure in such situations. In addition, management participation in a transaction prior to a stockholder vote may increase the risk (and potentially cost) of stockholder lawsuits opposing the deal.
II LEGAL FRAMEWORK
i Acquisition of control and minority interests
The US federal system – in which the federal (i.e., national) government exercises supreme authority over a limited range of issues, and the individual states exercise authority over everything else occurring within their respective jurisdictions, with overlaps seemingly everywhere – presents private equity firms with a complex legal maze to navigate when acquiring control of or investing in the equity of a target company. A private equity firm contemplating an investment in the United States confronts the following regulatory regimes:
- federal securities laws and regulations, administered by the SEC;
- state corporation law (usually the Delaware General Corporation Law), alternative business entity law (usually the Delaware Limited Liability Company Act or the Delaware Limited Partnership Act) and securities laws (called 'blue-sky' laws);
- federal, state, local and foreign tax laws and regulations;32
- Hart-Scott Rodino Antitrust Improvements Act (the HSR Act) pre-merger antitrust review;
- particularly when making a minority investment in a public target, the rules of the stock exchange where the target's shares are listed, such as the New York Stock Exchange or the Nasdaq National Market;
- potential review by the Committee on Foreign Investment in the United States of an investment by a non-US investor in a US target, if the investment threatens to impair national security; and
- industry-specific regulatory schemes – such as those found in the energy, pharmaceutical, medical device and telecommunication industries – that may require advance notification to or even approval by a governmental authority.
The first three regulatory schemes – federal securities laws, state corporate and securities laws, and tax – affect every investment a private equity firm may make in the United States. The HSR Act applies only if a deal exceeds specified levels,33 and the applicability of the others depends on the nature of the target and, in some cases, the characteristics of the buyer as well.
In general, neither US federal securities laws and regulations nor Delaware corporate and other business entity laws focus upon the substance of a transaction. Rather, the federal scheme is designed to ensure that parties to the transaction – whether a direct sale of stock, a merger, a tender offer or issuance of shares – receive adequate disclosure, and in some cases adequate time to make a fully informed investment decision, and Delaware law is chiefly concerned with the process followed by the company's governing body when considering the transaction, except in the case of interested transactions, which are subject to entire-fairness review (looking at both process and price).
Regulatory schemes outside Delaware law and US federal securities laws and regulations, however, often do look at the substance of transactions and can be influenced by political movements. For example, deal practitioners have seen increased difficulty in getting clearance for transactions with Chinese and other foreign acquirers under the Trump administration.34 The Trump administration has also taken a firmer stance on antitrust review of transactions – a development that took many by surprise.35
ii Fiduciary duties and liabilities
In general, stockholders of a Delaware36 corporation do not owe any duty, fiduciary or otherwise, to one another. Thus, a private equity firm is free to act in its own interest, subject to very limited exceptions,37 when deciding to vote or sell its portfolio company stock, subject to contractual rights (e.g., tag-along or registration rights) of the company's other stockholders. On the other hand, a controlling stockholder may be liable to the corporation or its minority stockholders if the controlling stockholder enters into a self-interested transaction with the corporation at the expense of the minority.38
All directors (and officers) of a Delaware corporation, including sponsor representatives on the board, owe the corporation and its stockholders the following duties:
- a duty of care, requiring a director to be reasonably informed and to exercise the level of care of an ordinarily prudent person in similar circumstances;
- a duty of loyalty, requiring a director to act in the interests of the corporation and its stockholders and not in his or her own interest; and
- a duty of good faith, or perhaps better stated a duty not to act in bad faith, often described as the intentional or reckless failure to act in the face of a known duty, or demonstrating a conscious disregard for one's duties.
Subject to limited exceptions, when reviewing the conduct of a corporation's directors Delaware courts will apply what is known as the 'business judgement rule', which presumes that a director acted with reasonable care, on an informed basis, in good faith and in the best interest of stockholders, and not second-guess the director's decisions. Only if a plaintiff proves that a director made an uninformed decision or approved a self-interested transaction will the courts apply the 'entire fairness' doctrine and require the director to prove that the price and the process leading to the disputed transaction were fair to the corporation and its stockholders. In addition, when reviewing certain transactions, such as the imposition of defensive measures (e.g., a poison pill) or the sale of control in the absence of a 'fully informed' disinterested shareholder vote39 (see the Revlon discussion in Section I.ii), Delaware courts apply what has come to be known as 'enhanced scrutiny', a standard more rigorous than the business judgement rule but less than entire fairness, in which the court reviews the adequacy of the process leading to the challenged transaction and whether the price was reasonable.
Delaware law also allows a corporation to exculpate its directors (but not officers) from monetary liability for a breach of the duty of care,40 and to indemnify its directors and officers against claims and expenses arising out of the performance of their board duties.41 Such exculpation and indemnification are not available, however, for any director or officer found to have breached the duty of loyalty.
A sponsor representative on the board of a Delaware corporation must also be aware of the corporate opportunity doctrine, under which a corporate officer or director must offer the corporation any business opportunity that the corporation is financially able to undertake, that is within the corporation's line of business, and with respect to which the corporation has an interest. The corporate opportunity doctrine can cause a problem for a sponsor owning or expecting to invest in a competing or similar business, but it can be disclaimed if appropriate language is included in a company's articles of incorporation.
If a Delaware corporation has preferred and common stock, its board owes its duties only to the common stockholders if there is conflict between their interests and those of the preferred stockholders.42 If a corporation is insolvent (or in bankruptcy), then the board's fiduciary duties are owed to the corporation's creditors, not its stockholders.43 If a financially struggling corporation is in a grey area known as the 'zone of insolvency', then its directors have a duty to maximise the enterprise value of the corporation for the benefit of all those with an interest in it.44
Limited liability companies
Recently, private equity firms have begun to prefer Delaware limited liability companies (LLCs) over corporations when structuring an investment. Delaware law allows sponsors and their co-investors to craft custom LLC governance provisions, including the total elimination of voting rights and fiduciary duties (other than the contractual duty of good faith and fair dealing),45 which streamline decision-making and avoid potential personal liability of sponsor board representatives. The added flexibility of an LLC is both a benefit and a burden, as Delaware courts have consistently held that any modification to traditional corporate principles must be clearly and unambiguously stated in the LLC's operating agreement; otherwise, traditional corporate principles will apply (perhaps in unexpected ways).
Using an LLC, which is treated like a partnership for tax purposes (unless an election is filed with the Internal Revenue Service to be taxed as a corporation), eliminates corporate-level tax and thus can also be more tax-efficient for certain investors – although the reduction in the corporate-level tax rate and other changes implemented as a result of the Tax Cuts and Jobs Act passed in December of 2017 has made that benefit less certain. Non-US investors who are not US taxpayers, however, must exercise caution when investing in an LLC, as they may be obligated to file a US tax return and pay US income tax on their US effectively connected income.
III DEBT FINANCING
The huge US market for acquisition debt financing is highly sophisticated and efficient, with many experienced investors and service providers and multiple options for a private equity sponsor seeking to finance an acquisition.
No two deals are the same, and the availability of certain types of debt financing depends on market conditions, but US LBO financing structures typically fit into one of the following categories:
- senior and bridge loans, with the bridge loan usually backstopping a high-yield bond offering, typically used in very large deals;
- first-lien and second-lien loans, typically used in upper-middle-market deals, with the availability and pricing of second-lien debt highly dependent on market conditions;
- senior and mezzanine loans, typically used in middle-market deals;
- unitranche loans, which combine senior and mezzanine features into a single blended loan, typically used in middle-market deals; and
- senior loans only, typically only used in smaller deals or deals in which the private equity sponsor is using very little leverage.
Except for smaller deals (US$100 million or less), most lending facilities are arranged by a financial institution and then syndicated to other lenders,46 including banks, hedge funds and special purpose entities – known as collateralised loan obligations – created to invest in these loans.
Because UK-style certain-funds debt financing is not available in the United States, the parties to an LBO – the lenders, the private equity sponsor and even the target – inevitably face market risk between execution of the acquisition agreement and closing. Those parties, particularly the sponsor, must therefore carefully manage that risk in the agreements, especially in the interplay among the debt and equity financing commitment letters and the acquisition agreement.47
The non-pricing terms (i.e., excluding items such as fees, interest rates and original issue discounts) of an LBO loan – such as affirmative, negative and financial covenants, collateral requirements and defaults – vary considerably from one deal to the next, based on the size of the transaction and the perceived creditworthiness of the borrower.48 In general, however, loans for smaller deals are more similar to one another with respect to affirmative, negative and financial covenant requirements. Non-pricing terms for larger loans occupy a wide spectrum ranging from a full covenant package to 'covenant-lite' loans. In a syndicated loan, key terms, including pricing and debt structure, are typically subject to some limited changes in favour of the lenders – referred to as 'flex' – in the event that the loan cannot be syndicated in the absence of these changes (which may not include, however, additional conditions precedent to funding).
US private equity investors are cautiously optimistic over 2020's prospects. Although a phase one trade deal with China, the continued abundance of dry powder and low interest rates provide some tailwinds for US private equity going into 2020, concerns remain: a looming presidential election, protectionist trade policies in the United States and abroad, disruption in the public equity markets, high valuations for acquisition targets and the prospect of increases to interest rates, could all lead to economic disruptions and dampen private equity investment activity. On the other hand, US private equity firms have proved their ability to thrive in changing and challenging times, with many posting solid returns in the midst of the Great Recession, others successfully managing the difficult process of leadership change and the industry as a whole adapting to an entirely new regulatory and tax regime.
1 Paul W Anderson is a partner at Kirkland & Ellis LLP. The author thanks Stephen Ritchie and the firm's research staff for their help in drafting this chapter.
2 PitchBook, 2019 Annual US PE Breakdown.
3 PitchBook data.
4 See footnote 2.
5 PitchBook data.
6 IPO Vital Signs data.
7 See footnote 2.
8 PitchBook data.
9 S&P Global Market Intelligence LCD's Quarterly Leveraged Lending Review: 4Q 2019.
12 See footnote 2.
16 Revlon v. McAndrews & Forbes Holdings, Inc (Del Sup Ct 1986). Many states do not follow Revlon; some states, such as Indiana (Indiana Code Section 23-1-35-1(d)), Pennsylvania (Pennsylvania Business Corporations Law Section 1715) and Wisconsin (Wisconsin Business Corporations Law Section 180.0827), have constituency statutes permitting directors to consider not only price, but also other stakeholders' interests, such as the target's employees, suppliers and communities in which the target operates, when considering a sale.
17 A no-shop covenant prohibits the target from actively seeking an acquisition proposal, but typically allows a target to respond to an unsolicited proposal that could reasonably be expected to lead to a better transaction for target stockholders.
18 See, e.g., In re Topps C S'holder Litigation (Del Ch 2007) and In re Lear Corp S'holder Litigation (Del Ch 2007). There are many dimensions to a go-shop's terms, such as the length of the go-shop period, the size of the reduced fee and limitations on what constitutes a superior offer, each of which is taken into account when evaluating the board's compliance with Revlon.
19 Not all deals follow this model. In some deals, sponsors have assumed all the financing risk and granted the target full specific performance; on the other, rarer end of the spectrum, buyers have agreed to a two-tiered reverse break-up fee, with a smaller fee payable if debt financing is unavailable, and a larger fee payable if the sponsor breaches its obligation to close (even if debt financing is available).
20 See Olson v. ev3, Inc (Del Ch 2011). The buyer must pay cash for at least the par value of the issued shares (with the remainder purchased with a demand note, the terms and conditions of which were approved by the target's board), and the top-up option shares must be ignored if any dissenting stockholder elects to seek an appraisal of its shares.
21 In 2014, the Delaware legislature amended Section 251(h) to eliminate the 'no interested stockholder' condition in the original statute, which essentially prohibited acquirers from entering into support agreements with target stockholders, a common feature of private equity sponsor take-privates.
22 Cornerstone Research, 'Shareholder Litigation Involving Acquisitions of Public Companies', August 2016; Cain, Matthew D, Fisch, Jill E, Davidoff Solomon, Steven and Thomas, Randall S, The Shifting Tides of Merger Litigation (4 December 2017).
23 See, In re Riverbed Technology, Inc (Del Ch 2015); In re Aruba Networks, Inc Stockholder Litig. (Del Ch 2015); and In re Trulia, Inc Stockholder Litig. (Del Ch 2016).
24 See, e.g., Kahn v. M&F Worldwide Corp (Del 2014); Corwin v. KKR Financial Holdings LLC (Del 2015); Singh v. Attenborough (Del 2016); In re Solera Holdings, Inc Shareholder Litigation (Del Ch 2017).
25 Cain, Matthew D, Fisch, Jill E, Davidoff Solomon, Steven and Thomas, Randall S, The Shifting Tides of Merger Litigation (4 December 2017).
26 Stockholder must vote against merger; merger consideration is all or part cash (i.e., no appraisal rights where target stockholders are being paid solely in shares of an acquirer listed on a national securities exchange); before the vote on the merger, the stockholder delivers to target a written demand for appraisal of his or her shares; and within 120 days of the effective date of the merger, the stockholder commences an appraisal proceeding by filing a petition demanding a determination of the value of his or her shares.
27 See, In re Appraisal of Dell Inc (Del Ch 2016); In re Appraisal of DFC Global Corp (Del Ch 2016).
28 The court in Dell found the fair market value to be 28 per cent higher than the merger price, while the courts in DFC and Farmers found the fair market value to be 7 per cent and 11 per cent higher than the deal price, respectively.
29 See footnote 27.
30 Cornerstone Research, 'Appraisal Litigation in Delaware: Trends in Petitions and Opinions 2006–2018'.
31 While in theory Revlon and related principles of Delaware law apply equally to the sale of a private target as to a public target, in practice a buyer often deals directly with target stockholders (or at least controlling stockholders), minimising or even eliminating the board of directors' role and the related legal issues.
32 The tax implications of any private equity transaction are tremendously complex. For a thorough discussion of the issues, see generally Ginsburg, Levin and Rocap (footnote 45).
33 See Kirkland Alert (January 2020) for the most recent HSR filing thresholds, available at https://www.kirkland.com/publications/kirkland-alert/2020/01/2020-hsr-revised-thresholds-announced.
34 'Trump and Warren Find Common Ground on Antitrust', The New York Times, 6 December 2017.
36 This section deals only with the laws of Delaware. The laws of other states may be materially different.
37 See, e.g., Abraham v. Emerson Radio Corp (Del Ch 2006).
38 See, e.g., In re Loral Space and Communications Inc (Del Ch 2008).
39 See, e.g., Corwin v. KKR Financial Holdings LLC (Del Ch 2015); City of Miami Employees' and Sanitation Employees' Retirement Trust v. Comstock (Del Ch 2016).
40 Delaware General Corporation Law Section 102(b)(7).
41 Delaware General Corporation Law Section 145.
42 In re Trados (Del Ch 2013).
43 Geyer v. Ingersoll (Del Ch 1992).
44 North American Catholic Educational Programming Foundation, Inc v. Gheewalla (Del Sup Ct 2007).
45 See Ginsburg, Levin and Rocap, Mergers, Acquisitions, and Buyouts – Transactional Analysis (Wolters Kluwer, September 2015), Section 1602.3.
46 The 'marketing period' for a syndicated loan, during which the institution arranging the loan assembles the lending syndicate, typical runs for between three and four weeks.
47 See discussion in Section I.
48 Many middle-market and most – if not all – larger loans are rated by credit rating agencies such as S&P and Moody's.