Secondary, tertiary (OR FOURTH) SUCCESSIVE

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1 Secondary, tertiary (OR FOURTH) SUCCESSIVE buy-out in Germany by Dr. Andrea von Drygalski, P+P Pöllath + Partners A private equity fund has a limited life even if the number of the fund s life is a double digit. Therefore, at one point in time there is the need to transfer the fund s participations. Successful and active investing and managing at the start of most private equity funds in the nineties meant selling the portfolio companies to a strategic investor or exiting through an IPO. That was the fund s goal as written in its shareholder agreements. During the last few years, the investment circumstances have changed due to a variety of factors both economic and other. The commercial environment for most of the fund s targets does not permit an IPO and strategic investors which have a strong desire to buy all the targets of the private equity funds are few. Private equity funds now have to look for alternative exit routes. Currently, recaps are very popular, though it returns at least the funds and something on top but is not a real exit. However, it is a real exit if one private equity investor sells to another private equity investor. A secondary buy-out is born. Secondary buyout transactions may not be mistaken for secondary private equity transactions where limited partners of private equity funds sell their shares in a secondary market, or secondary direct transactions where not a single target is bought, but a whole package of participations. By the way, if a target is sold to a private equity investor for the third time, this makes it a tertiary buy-out, of which the market has already had a few! Thus far, the market has not seen the sale to a private equity investor for the fourth successive time what would we call it? However, exit pressure is not the only motivation to go for a secondary: even if an IPO is possible, people say that a private equity investor which is selling may achieve better prices in a secondary transaction due to the requests of and the liquidity in the market. Many private equity investors are looking for targets and a large amount of money is available from the banks. They offer very favourable financing conditions regarding the amounts of leverage and interest percentages. The current results from the German buy-out statistics show: apart from take-overs in the classical German Mittelstand, secondary transaction sales from private equity firms to private equity firms pushed the market ahead. 5

2 Let us discuss the various aspects in a secondary buy-out transaction from both the selling and the buying sides. THE PROCESS AND THE PLAYERS IN SECONDARY TRANSACTIONS The vendor due diligence covers all areas: financial due diligence market due diligence tax due diligence legal due diligence environmental due diligence insurance due diligence. Secondary buy-outs are most often accomplished by way of an auction, sometimes (depending on the quality of the target) with the number of buyers limited to minimise the due diligence burden and to provide incentives for buyers to join the auction and perform due diligence. Financial intermediaries play an important role in secondary buy-out transactions. For large transactions, traditional investment banks often take part, but smaller boutiques are also seen here. They organise the auction, contact potential buyers, prepare and administer the due diligence, the negotiation or auction process and the closing events. THE TERMS AND CONDITIONS IN GENERAL Typically, targets in a secondary buy-out sell according to a special set of terms and conditions. These can vary widely based on many factors specific to the fund sector, specific portfolio status, market conditions for the sector, the fund s advisory team, competition and many others. Once those terms have been agreed upon between the parties, a purchase and sale agreement specifying those terms is signed. More and more often, the terms in secondary SPAs reflect an acquisition of shares at a stock exchange. In detail: 6 PREPARATION OF THE SECONDARY The auction process is prepared by information memorandums and in most cases by a vendor due diligence, such vendor due diligence facilitating the auction process and enabling the selling fund to simultaneously invite various bidders. Virtual data rooms are also meant to alleviate the difficulties of the process, but are disliked by the buyer and its advisors. Internet access only, without being allowed to print or copy even if life should ideally be electronic sometimes makes it hard to work with the data to practically convert it into a report. But of course, virtual data rooms avoid legions of buyers and their advisors on site. However, this can normally also be achieved by ordinary data rooms located at the offices of advisors or intermediaries. The object of the sale Typically, the target s shares are sold. The sale of the target s assets would leave the private equity fund with a shelf company to be disposed of. However, the most important reason is, of course, to avoid dividend taxation. If shareholder loans were granted, they are also sold together with the shares. The economics Purchase prices tend to be high in secondary buy-out transactions. Most often, the competition raises the prices and the sellers take what they can get. Purchase prices tend to be fixed prices. Buyers are asked to name their firm offer, already having taken into account all the financial details. Until mid-year, purchase prices are based on the last available year-end balance sheet. In the second half of the year, however, the seller has to struggle to press for a fixed

3 CO-PUBLISHER Article: Secondary buy-outs in Germany P+P Pöllath + Partners Kardinal-Faulhaber-Straße 10, Munich, Germany Tel: +49 (89) (General) Fax: +49 (89) (General) Web: andrea.drygalski@pplaw.com Mergers & Acquisitions Dr. Andrea von Drygalski, Partner Tel: +49 (30) andrea.drygalski@pplaw.com Privatisation Contact Dr. Carsten Führling, Partner Tel: +49 (30) carsten.fuehrling@pplaw.com Stock Exchange Law Contact Dr. Matthias Bruse, Partner Tel: +49 (89) matthias.bruse@pplaw.com Corporate Governance Contact Reinhard Pöllath, Partner Tel: +49 (89) reinhard.poellath@pplaw.com

4 8 purchase price based on an outdated balance sheet of the previous year. Sellers try to avoid closing balance sheets, which only leads to never-ending battles among the parties auditors. Equity adjustments are avoided. Net debts adjustments are avoided. From a timing point of view, however, at least net debt adjustments on the basis of the target s final figures to be obtained shortly after closing is sometimes acceptable for both sides. Working capital adjustments are reviled and discussions hereof are led in advance. Closing conditions Closing conditions are kept simple and easy. Carve outs or corporate actions like resigning from corporate offices and the like are done beforehand. Closing mostly depends on the antitrust requirements. Representations, warranties and indemnities Secondary buy-outs tend to be like buying a share at the stock exchange. There, one would also not receive reps and warranties. What is commonplace? Sellers guarantee for the standard corporate life of the target, including title to the shares (and shareholder loans, if applicable). Discussions get tighter, however, if subsidiaries should be included, especially those in more remote areas of the world. Apart from the standard corporate guarantees, there are more and more deals which contain no further reps, warranties or indemnities at all. If competition is tough, private equity buyers accept such standards, although there still remains a strong contrast between buyer and seller. The typical private equity buyer does not know the industry and has to rely only on advisors for due diligence, and therefore wants to be protected by a standard warranty catalogue; the deal also has to be brought through the fund s investment committee. If there is less competition or the target has its deficits: the buyer names its due diligence issues in order for them to be covered. The tax issue is more likely to be covered as an indemnity in a purchase agreement, even if no other representations and warranties are given. The seller has to accept that this is a past issue which leads to a direct cash impact for the buyer in the future, for which no means are planned. The same is applicable for the environmental issue. However, in this area special due diligence reports help to keep the issue out of the SPA. Larger litigation cases having a financial impact in the future may have to be covered in the purchase agreement. For the seller, it sometimes helps that the target might still be protected by warranties and indemnities from the primary buy-out. The seller will strictly try to limit the scope of liability, if any is accepted at all, to its own holding period of the target. The most import negotiation issue for the seller is the overall liability cap in the purchase agreement in order to be able to quantify the amounts which are not to be distributed to the investors. The cap is automatically linked with the liability periods, which are short in secondary buy-outs! In this field, buyer and seller often negotiate purchase price reductions instead of reps and warranties and indemnities. Due to the legal situation of the private equity fund, the purchaser will press hard to secure the liability of the seller, if accepted at all. Escrow arrangements are most common, but bank guarantees are also seen. Most private equity funds stop the IRR calculation upon receipt of the purchase price anyway.

5 Non-compete covenants might be easy to provide, but may restrict future investment. Therefore, the covenant mostly prohibits the acquisition of real competitors of the portfolio target in the future (for a limited period of time). MANAGEMENT IN THE MIDDLE BETWEEN THE SELLER AND THE BUYER Management is experienced from the primary buy-out. Management knows the motives, the ideas or the rationale of the buyer as a financial investor. From this point of view, private equity investors are interchangeable for the management. Management has already experienced a due diligence with a financial investor with all the consequences of much activity, a large number of questions, no knowledge of the business and the special financial requirements. Management has already gone through a management presentation. Buy-out contract work is less problematic for management. They have seen an SPA and the customary finance documents of the banks. Even if the managers have not really negotiated their MPP agreements in a primary, they are at least familiar with the type of agreement. Such a situation, however, may also reverse for the buyer in a secondary, as the next contractual round with management may be tougher. Management s willingness to take an active role in a secondary depends on the size of the target: (i) Managers of large-size targets (formerly being part of larger industry entities) are more independent and self-conscious. They know their own value. Due to the size of the deal, they gain substantial proceeds from the primary which leads to greater satisfaction. (ii) Managers of mid-size targets (Mittelstand) are keener on the incentives offered by the new MPP in the secondary. Their stake from the primary proceeds is smaller. The reinvestment number regarding the proceeds of the primary tends to be around 75%. 100% is not feasible. Potential proceeds from the secondary are most likely only half of those from the primary. Management plays an important political role in the play between seller and buyer in a secondary: The managers may influence the seller s decision on whom to choose as a buyer. Managers want to accept the buyer which offers the best conditions for them in the next round; they may always threaten to leave their jobs and not to reinvest. Management, if qualified, is a must for the buyer. Management is the caretaker of the target and the only player with knowledge of target (as neither the seller nor the buyer really knows the target). Therefore, both parties depend on management for proper disclosure. As compensation for management s decisive role in the process, seller might ask the managers for extra guarantees for which the management is personally liable (with their own funds, but limited to the proceeds of the secondary). In Germany, management s reinvestment must be specially taken care of from a legal point of view. The simultaneous sale of the management s participation and reacquisition of a participation of the acquisition vehicle is regarded as a hidden capital contribution which is governed by many rules which if not observed lead to the invalidity of the acquisition of the participation. VIEWPOINT Current private equity investors tend to restructure their portfolio companies and to exploit their financial 9

6 means and know-how to create new growth and value improvement potentials essential to sell on in a secondary. There may be times when there is no tertiary or even a fourth successive sale without a substantial growth story. Currently, the growing secondary buy-out market at high purchase prices is partly the product of many leverage which may be easily obtained. However, more leverage implies more risk. If a leveraged deal gets into troubled waters later, lenders will scrutinise borrower s and target s disclosure and other pre-funding behaviour. There might be many opportunities for legal liability, as well as personal liability which should be kept low. Dr. Andrea von Drygalski is a Partner at P+P Pöllath + Partners in Munich. For further information, please telephone +49 (89) or andrea.drygalski@pplaw.com

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