- The shareholders’ agreement for a private equity joint venture will typically include rights and obligations on the shareholders that operate so as to facilitate a realisation of the shareholders’ investment. The contractual nature of these arrangements requires the participants to consider in advance their respective objectives to the form and timing of their ‘investment realisation’ and to ensure the shareholders’ agreement provides the necessary rights and protections to achieve their exit plan.
- A ‘one-size-fits-all’ approach to customary exit rights (e.g. drags, tags, mandated IPO, etc) can result in unwelcome outcomes if consideration has not been given to factors that could complicate the application of the exit, e.g. non-cash consideration, complex capital structures or consistency (or otherwise) in the application of sale obligations such as escrows or restraints.
- Private equity joint venture participants’ interests in an exit scenario are rarely perfectly aligned and therefore the inclusion of appropriate rights and protections in the joint venture shareholders’ agreement are critical to facilitating the a clean exit and to avoid adverse economic or commercial outcomes.
Contractual mechanisms to control investment realisation
The shareholders’ agreement (or other relevant governance documentation) for a private equity joint venture will customarily include rights and obligations of the shareholders and the company that provide for the realisation of the shareholders’ equity investments. From the perspective of the private equity sponsor, these terms are fundamental as they are intended to provide it with both:
- control over the form and timing of the realisation of its investment, and
- the ability to maximise its return on investment.
The minority shareholders will seek to hold related rights to facilitate their participation in the private equity sponsor’s exit from the business. In the absence of such rights, there is the risk the minority shareholder’s equity interest amounts to an unmarketable parcel of shares in a private company with no liquidity right.
The mechanisms commonly used by private equity sponsors, as majority shareholders, to facilitate an exit that provides it with both control and the ability to maximise return are described below.
A drag or 'drag-along' right is a right of the private equity sponsor (as majority shareholder) to force all other shareholders to sell their shares to a third party on broadly the same terms as the private equity sponsor will sell its shares.
This right enables the private equity sponsor to both maximise the addressable market for the investee business (by delivering a corporate group with no minority equity interests) and potentially achieve a higher 'premium for control' share valuation by delivering 100% of the shares to the buyer.
Material issues in negotiating drag rights can include:
- Non-cash consideration
Drag rights may often only be invoked if the transfer is for cash consideration. This restriction limits the benefit of the drag provision for the private equity sponsor where there is an attractive exit that offers scrip consideration or a mix of cash and scrip.
In contrast, for minority shareholders there are genuine reasons to resist a drag provision that operates on sales other than for cash consideration – in particular, the risk of being forced to exchange their current shareholding for new shares in an unknown company in which the opportunity to realise the cash benefit of the initial investment may be more difficult or remote. This risk is accentuated if there is no open market in the exchange shares or if the governance regime of the new company does not facilitate the sale of minority shareholdings, such as a general prohibition on disposal of shares and no tag right.
- Complex capital structures
Often private equity investments involve complex equity capital structures that are used to 'layer' equity returns or provide 'upside' if certain performance thresholds are satisfied. For example, an investee company may, in addition to its ordinary shares, issue:
- preferred equity to the sponsor that provides for a preferred return over ordinary shares, often by way of a fixed or variable coupon,
- different classes of share to management that are subject to a 'ratchet' that provide for the managers' return on equity to increase relative to the sponsors, as the sponsors return on equity exceeds specified thresholds, or
- equity securities convertible into shares such as warrants, options or convertible notes.
- Variations in sale terms
A key consideration when enforcing any drag right will be whether the buyer will agree to sale documentation which imposes the same terms on all vendor shareholders, such that the private equity house can exercise its right to require other shareholders to sell on substantially the same terms as those upon which it is selling.
To the extent that material variation in terms can be anticipated, it is prudent to cater for that variation in the drafting of the drag clause (and any corresponding tag clause). Key areas in which this may be the case include non-compete terms (where the private equity house may wish to negotiate for no non-compete, or only a more limited non-compete to apply to it as opposed to other investors) and warranty and indemnity settings (where a private equity house, particularly if holding only a minority stake, may wish to limit its liability more extensively than that of management shareholders, or may require an ability to have warranty and indemnity insurance put in place to cover these liabilities).
The quid pro quo for the majority shareholder's drag right in a private equity joint venture is typically a minority shareholder tag right that permits the minority shareholders to participate in a sale of shares by the majority shareholder on substantially the same terms.
A key negotiating point in settling the scope of the tag right is whether it should only apply on a sale of 100% of a majority shareholder's shares or on all sales by the majority shareholder (in which the minority shareholders would have a right to sell an equal proportion of their shares). If the tag right applies only on a total sale by the majority shareholder, there is a risk that the majority shareholder could 'game' the system by selling a significant majority, but not all, of its shareholding thereby facilitating an almost complete economic exit without triggering the minority shareholders' tag right.
In practice, this risk is mitigated by the challenge a seller would have finding a buyer willing to invest into a company with disgruntled minority shareholders. Also, in most cases, the existing shareholders' agreement is unlikely to provide a prospective buyer with the kind of rights, as against the minority shareholders, as it would be likely to require (unless it is able, under the terms of the existing shareholders' agreement, able to 'step in' to the rights of the seller).
In addition to drag rights which provide for a clean exit in a private share sale context, the shareholders' agreement for a private equity joint venture will often include an express objective, acknowledged by the shareholders, to achieve a liquidity event or exit within a prescribed time period, such as within three years of the date of the investment.
In addition, the private equity sponsor will commonly hold, alongside the investee company (which it controls), the benefit of obligations on minority shareholders to cooperate and facilitate an exit (whether by way of IPO, share sale or sale of the business assets) instigated by the majority shareholder or the board of the investee company.
Sometimes, more detailed and specific obligations are imposed on minority shareholders in respect of an IPO exit including obligations to:
- transfer their shares in exchange for shares in an IPO special purpose vehicle,
- give all consents and pass all resolutions required to effect the IPO, and
- escrow a portion of their shares in an IPO exit (subject, in most cases, to the minority shareholder not being required to escrow a greater proportion of its shares than the sponsor majority shareholder).
Issues to be addressed in exit mechanisms
Potential issues to be addressed in exit provisions in private equity joint ventures include the following.
Different shareholder rights and obligations on exit
A key issue relevant to a sale of shares in a private equity joint venture (whether by way of share sale or an IPO) is whether all shareholders dispose of their shares on the same terms or whether different terms apply to different shareholders.
While shareholders will receive the same price per class of share as each other shareholder of that class, it may be advantageous for some shareholders for different treatments to apply between shareholders on certain points. Since the obligations of a shareholder on an exit are generally provided for in an investee company's shareholders' agreement these issues relevant to exit need to be considered and negotiated at the inception of the joint venture.
Representations and warranties
In an exit by way of share sale, it is customary for the selling shareholders to provide the buyer with a range of legal and commercial representations and warranties in respect of the state of affairs of the company and business being sold. In this context, the question arises of whether the full suite of representations and warranties should be provided by all of the selling shareholders or just by the sponsor that is the majority shareholder and the effective controller of the sale process.
Minority shareholders will often resist being required to provide the same representations and warranties as the private equity sponsor on the basis that the minority shareholders (if subject to a drag) have no control over the warranty package agreed by the sponsor in the sale documentation. Consistent with this position, minority shareholders often seek to limit their warranty obligations on a share sale to providing customary capacity and title warranties.
From a private equity sponsor's perspective, it will not want the 'value' of its warranty package to be diminished by the buyer not having recourse to all shareholders for a breach of warranty (if the warranties are given only by the private equity sponsor, it is solely carrying the risk of claims). Accordingly, the private equity sponsor will typically make the argument that if all shareholders are to receive the same price per share on exit, then each needs to take the same exposure on warranties and indemnities.
The emergence of warranty and indemnity insurance as a standard component of private equity transactions (whereby the warranty claim risk is insured) also operates to some degree to de-risk the minority shareholders' exposure to broad warranty claims and supports private equity sponsors' demands for minority shareholders to provide the same warranties as the sponsor.
Escrow and sell-down
In order to achieve an exit by way of IPO, it can be necessary for private equity sponsors to lock-up or escrow all or part of their shareholding in the listing vehicles for a period of time post-listing or until certain financial thresholds are satisfied.
Private equity sponsors will sometimes look to include provisions in investee company shareholders' agreements that require minority shareholders to also agree to escrow conditions that are necessary to facilitate an IPO exit. Minority shareholders will often resist such provisions due to the uncertainly they create in respect of investment realisation. A compromise is sometimes reached by such terms being qualified by 'reasonableness' or 'market practice' (as verified, for example, by advice from the underwriters to the IPO) and the minority shareholders not being required to accept escrow conditions more onerous than those imposed on the private equity sponsor.
It is common for buyers of private equity investee companies to require an undertaking from the selling shareholders not to compete with the investee business for a period of time following completion of the sale.
The commercial basis of this non-compete is that the portion of the price being paid, by the buyer for the sale shares is attributed to the goodwill value attributed to the selling shareholders not using their knowledge of the sale business to compete for a period of time post completion.
Some private equity sponsors will need to resist non-compete provisions in order not to limit their investment mandate. In certain circumstances, however, most private equity sponsors can accept some form of non-compete (often limited to the relevant investing fund, rather than other funds managed by the same firm, and subject to specific carve-outs to protect existing investments or areas of anticipated investment).
As noted above, where variation in non-compete terms is a possibility upon exit, it is crucial that that variation is contemplated in the drafting of the drag, tag and exit provisions of the shareholders agreement so as to maximise the private equity fund's ability to enforce those provisions in order to generate a liquidity transaction.
The contents of this publication are for reference purposes only and may not be current as at the date of accessing this publication. They do not constitute legal advice and should not be relied upon as such. Specific legal advice about your specific circumstances should always be sought separately before taking any action based on this publication.
© Herbert Smith Freehills 2020