Presenting a live 90-minute webinar with interactive Q&A Negotiating Private Equity M&A Key Deal Terms Rollover Equity; Bolt-on, Tuck-in and Platform Acquisitions; Earnouts and More WEDNESDAY, OCTOBER 25, 2017 1pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: John J. McDonald, Partner, Troutman Sanders, New York Michael Weinsier, Partner, Troutman Sanders, New York The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10.
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PRIVATE EQUITY M&A KEY DEAL TERMS: ROLLOVER EQUITY, BOLT-ON, TUCK-IN AND PLATFORM ACQUISITIONS, EARNOUTS, SELLER PAPER, REVERSE BREAK FEES AND REP &WARRANTY INSURANCE John McDonald Partner Troutman Sanders LLP john.mcdonald@troutman.com Michael Weinsier Partner Troutman Sanders LLP michael.weinsier@troutman.com
CURRENT TRENDS IN PRIVATE EQUITY M&A DEALS Positives for M&A Deals M&A deal volume remains quite strong, although activity has leveled off as compared to 2016. According to PitchBook, there were 45,665 M&A deals worth a combined $2.166 trillion announced during the first half of 2017, compared to $2.776 trillion across 50,641 deals in the second half of 2016. Consumer confidence continues to be high, although there is widespread sentiment that a correction is coming in the financial markets. Despite two interest rate hikes earlier in 2017 and more expected in the future, interest rates are likely to remain well below pre-financial-crisis levels for years. Historically high EBITDA multiples have motivated private equity firms to sell their portfolio companies now. According to PitchBook, the median EBITDA multiple of about 13.6 has stayed well above the historical average of 12.0 and is close to the ten-year high of 13.7 in 2007. Strategic investors hold large cash reserves, which they are using to make acquisitions given relatively limited prospects for organic growth. Private equity firms have significant dry powder and are coming up against the ends of their funds' investment periods. 6
CURRENT TRENDS IN PRIVATE EQUITY M&A DEALS Negatives for M&A Deals Volatility due to Trump administration actions and statements. Dealmakers are uncertain whether President Trump s pro-dealmaking perspective will stimulate US economic activity or be outweighed by the uncertainty resulting from the frequent changes within his administration and his public statements. It is unclear whether Trump proposals for tax reform and infrastructure spending, which could be a major boon to corporate America, will actually occur. Restrictions by the PRC government on outbound investments have caused a substantial decline in M&A activity by Chinese companies in the US in 2017, as compared to prior years. President Trump s actions relating to Obamacare have caused substantial uncertainty in the healthcare industry, which has recently been a major source of economic activity in the US. M&A transactions are subject to increasing antitrust scrutiny, both domestically and internationally. Unclear global geopolitical outlook North Korean nuclear activity is a cause of great concern. 7
CURRENT TRENDS IN PRIVATE EQUITY M&A DEALS Positives for Private Equity Deals The private equity fundraising market remains robust, and more funds are seeking capital commitments than ever before, with 1,289 private equity funds in the market at the start of 2017, representing a 12% increase since the beginning of 2016. In 2016, 830 private equity investment vehicles raised about $347 billion in capital commitments, with the largest funds (over $5B) reporting a higher percentage of the capital raised, continuing a trend of the last three years. According to one recent survey of institutional investors, 89% of respondents expected to maintain or increase their capital allocated to private equity investments in the next 12 months. This trend is likely fueled at least in part by continued record distributions, which outpaced capital calls in the first half of 2016. Private equity funds that held closings in the years leading up to the financial crisis have begun reaching the end of their initial ten-year terms. Vintage 2006 to 2008 funds represented $524 billion of total unrealized assets as of June 2016, a sharp decrease of nearly 50% from the $1.1 trillion in total unrealized assets for such funds as of June 2015. As PE funds approach the end of their terms, sponsors are focused on exits from portfolio companies as well as sponsor-led recapitalizations. 8
CURRENT TRENDS IN PRIVATE EQUITY M&A DEALS Negatives for Private Equity Deals Excessive competition at no point in history has the private equity space been as competitive as it is today. Between 2000 and 2016, the number of private equity firms globally has tripled and the amount of assets under management has grown from almost $600 billion in 2000 to almost $2,500 billion. The huge amounts of capital that have flowed into the private equity industry also mean that accumulated dry powder is at record highs. Dry powder grew to more than $500 billion by March 2017. Increased competition from strategic buyers strategic buyers have accumulated vast amounts of cash and often compete against PE funds in the acquisition of target assets. Increased regulation further evidence that private equity is a maturing industry is the increased amount of regulation the sector has experienced in recent years. LP scrutiny and pressure according to a survey conducted by Preqin in June 2016, LP investors in private equity funds are increasingly requesting lower management fees, asking for more transparency from fund managers, and requesting reduced carried interest performance fees. 9
KEY TERMS IN PE M&A ROLLOVER EQUITY Rollover Equity - Introduction To enhance alignment of interests between the PE sponsor and the portfolio company s management team and increase their skin in the game, the PE sponsor often requires management team members to roll over some of their existing equity, rather than permitting them to cash out all of their target company holdings in the buyout. In a rollover, the management team members exchange a portion of their equity in the target company for one or more classes of equity in the PE sponsor s acquisition vehicle, which is usually the parent company of the portfolio company. Rollover meaningfully reduces the size of the PE sponsor s equity check for the acquisition, enabling it to invest its fund s capital across a broader range of portfolio companies, enhancing diversification. Rollover requires requires the management team to take ownership of the higher valuation for the target company that they advocated in the sale process, while creating an additional means of wealth creation for them upon exit if their projections concerning valuation of the target company are actually realized. 10
KEY TERMS IN PE M&A ROLLOVER EQUITY Amount of Rollover Equity The amount of equity rolled over by the management team in a particular buyout transaction varies depending on several factors, including: The amount of available debt financing for the buyout and resulting need for the PE sponsor to fill any gap in the capital stack for the acquisition. The amount of equity financing that the PE sponsor is willing to commit to the buyout and the ownership dilution that the PE sponsor is willing to accept due to the rollover. The aggregate amount and percentage of existing equity of the target company owned by the management team, as opposed to non-management equityholders. The amount of co-investment by the management team (i.e., new money invested), if any, that is expected in connection with the buyout, in addition to the rollover. The expected tax treatment of the rollover. Management team members typically rollover into 15-25% of the equity of the postbuyout entity. 11
KEY TERMS IN PE M&A ROLLOVER EQUITY Rollover Equity Tax-Free Exchange A key structuring issue in any rollover is whether the rollover can be accomplished on a tax-free basis, so that management is not taxed upon exchange of its existing equity in the target company for equity in the post-buyout entity (i.e., the acquisition vehicle). A successful tax-free rollover defers (but does not permanently eliminate) payment of capital gains taxes resulting from appreciation in the value of the equity from the management team member s original acquisition of the target company equity until the subsequent liquidity event for the portfolio company. The tax is deferred (and not permanently forgiven) because the management team member receives a carryover tax basis in the post-buyout entity equity issued in the rollover exchange. The management team members use that carryover tax basis (subject to any adjustments during their ownership period) to determine any taxable gain or loss upon sale of the post-buyout entity equity in the subsequent liquidity event for the portfolio company. 12
KEY TERMS IN PE M&A ROLLOVER EQUITY Equity Securities Received in the Rollover In the buyout, the sponsor usually receives a combination of common and preferred equity or a single class of preferred equity with characteristics of both common and preferred equity. Generally, the bulk of the PE sponsor s investment is in preferred equity that: Has a liquidation preference ahead of all common equity. Often has participation rights to share pro rata with the common equity in liquidation proceeds following payment of the preferred equity s liquidation preference. The equity securities received by the management team members in the rollover are often (but not always) the same equity securities received by the PE sponsor in the buyout. This is distinct from any incentive equity that they receive without being required to pay for it, which is typically common equity. Management team members are usually required to execute a stockholders agreement or a limited liability operating agreement subjecting the rollover equity to right of first refusal, tag-along, drag-along and other transfer and voting restrictions. Rollover equity is sometimes subject to vesting requirements, particularly if options or other deferred compensation are rolled over that were subject to vesting before the buyout. 13
KEY TERMS IN PE M&A BOLT-ON, TUCK-IN & PLATFORM ACQUISITIONS Bolt-On Acquisitions In a bolt-on acquisition, a PE sponsor typically causes an existing portfolio company (the platform company ) to acquire another, usually smaller, company in the same or an adjacent industry as the platform company, sometimes as part of a roll-up strategy of consolidating companies in a fragmented industry. A bolt-on target company typically produces products or services that are one of the following: The same product or service as the platform company, but which distributes to or services a different geographical area. Products or services that are an extension of, or in an adjacent or complementary category to, the platform company s existing products or services. A bolt-on acquisition can involve a stand-alone company or a product line or division of a larger company. Enables the platform company to take advantage of built-in efficiencies of the combination and realize economies of scale. The terms bolt-on and add-on are often used interchangeably. 14
KEY TERMS IN PE M&A BOLT-ON, TUCK-IN & PLATFORM ACQUISITIONS Structuring Bolt-On Acquisitions A bolt-on acquisition can be structured as a equity purchase, an asset acquisition or a merger. An asset purchase structure can help protect the buyer from historical liabilities of the target company, but will trigger anti-assignment clauses in its contracts and that will require consent of the contract counterparties, and is often the least tax efficient from the seller s perspective. Use of an equity purchase or merger structure avoids much of the anti-assignment clause issue and is more tax efficient from the seller s perspective, but results in retention of the target company s historical liabilities. The most common structure is a purchase by the platform company of the bolt-on company s equity, with the bolt-on company becoming a subsidiary of the platform company parent. However, if the bolt-on target is a product line or other part of a larger company, or there are otherwise only specific assets of the bolt-on target that the platform company wants to acquire, an asset purchase is typically the best structuring option. Bolt-on asset purchases are typically structured as an acquisition by a newly-created entity that is a subsidiary of the platform company. 15
KEY TERMS IN PE M&A BOLT-ON, TUCK-IN & PLATFORM ACQUISITIONS Platform Company vs. Bolt-On Company A platform company must have all resources necessary to run as a stand-alone operation, including: Human resources Information technology Accounting, payroll and finance Sales and marketing Customer service Back-office operations A bolt-on acquisition target company can be much more limited (sometimes consisting merely of a product line or other select assets) and can have significant operational deficiencies that would be an issue for a buyer looking to acquire the target company as a stand-alone business. However, that may not be not problematic for the PE sponsor because its platform company has the necessary resources. 16
KEY TERMS IN PE M&A BOLT-ON, TUCK-IN & PLATFORM ACQUISITIONS Platform Company vs. Bolt-On Company (cont.) When acquiring a platform company, a PE sponsor seeks target companies that have significant market share and a strong market position, with earnings that are both consistent and predictable. However, when acquiring a bolt-on company, consistent and predictable earnings may be less important to the PE sponsor because: The acquisition is being made to take advantage of specific target company assets or abilities, which may make the historical profitability of the target company less important. The target company may be losing money due to high costs or expenses, which can be eliminated by the PE sponsor as the target company is integrated with the portfolio company s operations. The PE sponsor is typically looking to improve the performance of the platform company and by taking advantage of: The target company s expanded product line or geographical reach. Operational synergies that can enable it to pay a multiple comparable to that of a strategic buyer. Economies of scale. 17
KEY TERMS IN PE M&A BOLT-ON, TUCK-IN & PLATFORM ACQUISITIONS Bolt-On vs. Tuck-In Acquisition Bolt-on generally refers to an acquisition of a business that supplements or otherwise adds to services performed/products sold by the platform company, while tuck-in usually refers to an acquisition of a business that performs a service that is already performed, or sells a product that is already sold by, the platform company. Bolt-on acquisitions often add geographic or market diversity to a platform investment, while tuck-in acquisitions may involve a product line acquisition or other discrete assets. Bolt-on acquisition targets are typically larger, relative to the platform company, as compared to tuck-in acquisition targets. All of the above being said, in practice, the terms are sometimes used interchangeably and there may be overlap between the characteristics of target companies that are the subject of bolt-on and tuck-in acquisitions. 18
KEY TERMS IN PE M&A EARNOUTS Earnouts Generally An earnout is a mechanism used in M&A transactions in which a portion of the purchase price is determined based on the performance of the target company over a specified period of time after the closing of the acquisition. Earnouts are typically used where there is a gap between the seller s and buyer s beliefs about the valuation of the target company. Earnouts can be attractive to PE sponsors because they help reduce the risk of overpaying by calibrating the purchase price to the target company s future financial performance. Typically, an earnout is structured as one or more contingent payments of purchase price after the closing that become payable if specified earnout targets are satisfied within specified periods. If the target company fails to achieve the earnout targets within the specified periods, the buyer either isn t required to make the earnout payments or they are paid in smaller amounts. In addition to addressing valuation gaps, earnouts also act as a form of seller financing, in which the buyer effectively pays the purchase price to the sellers out of the profits of the acquired company. That can be attractive because it reduces the size of the PE sponsor s equity check for the acquisition. 19
Earnout Structures and Targets KEY TERMS IN PE M&A EARNOUTS Earnout structures can vary widely because they must be tailored to suit the target company s business and the parties expectations. However, there are some common issues in all earnouts, including: Determining the earnout targets and the method for determining how they are satisfied. Setting the earnout periods and structuring the payments. Sometimes, providing for a buyout or acceleration of the earnout payments, as discussed below. Parties can use either financial targets or non-financial criteria for earnouts. Most earnouts involve financial targets such as revenue, net income or earnings before interest, taxes, depreciation and amortization (EBITDA). However, some earnouts are based on achievement of non-financial criteria such as receiving FDA approval of a drug being developed by the target company, which will substantially increase the value of the target company s business. 20
KEY TERMS IN PE M&A EARNOUTS Earnout Period, Timing and Payment The length of earnout periods will subject to negotiation by the parties based on the target company s business. Most earnouts last between one and three years after closing of the acquisition, but there are earnouts with shorter or longer periods. The amount of the earnout payments can be: A fixed dollar amount if the earnout target is met. If there are multiple earnout payments, their amounts can be increased, decreased or kept constant during the earnout period. A multiple of the amount by which the target company s performance exceeds the earnout target. A percentage of the earnout target amount (for example, a percentage of an EBITDA target). Determined using another agreed upon formula. There are sometimes catch-up or aggregation concepts, in which the seller receives an earnout payment if the target company s performance in subsequent earnout periods overcomes shortfalls in earlier periods. 21
KEY TERMS IN PE M&A EARNOUTS Acceleration and Buyout of Earnouts Acceleration provisions cause all earnout payments to become immediately due upon the occurrence of certain events before the end of the earnout period, such as: Sale of the target company or a substantial amount of its assets. Breach by the buyer of covenants relating to post-closing operation of the target business. Termination by the buyer of target company employees (but note that this can have adverse tax consequences for the seller). Bankruptcy or insolvency of the buyer. These provisions protect the seller from changes that adversely affect the target company's ability to satisfy the earnout targets or the buyer s ability to make the earnout payments when they become due. Buyout provisions enable the buyer to pay a specified amount to satisfy any remaining earnout payment obligations to the seller. This can be useful when a buyer wants to sell the target company before the end of the earn-out period and would like to avoid having to work around seller earnout rights that can impede the sale of the target company. 22
KEY TERMS IN PE M&A EARNOUTS Avoiding Earnout Disputes A Delaware Chancery Court judge once remarked that earnouts convert today s disagreement over price into tomorrow s litigation over the outcome. As a result, great care needs to be used in defining the events that will result in earnout payments to help avoid subsequent disputes. Parties can help avoid disputes by clearly stating in the purchase agreement the accounting methodology that will be used in calculating any financial earnout targets and attaching example calculations showing the earnout payment amounts under various scenarios. Some other key issues to address in order to avoid earnout disputes include: The buyer s obligation to support the target company during the earnout period by, for example, making capital expenditures and/or routing business toward the target company. The seller s decision making authority (if any) regarding operation of the target company business during the earnout period. Whether the target company s operations must be conducted by the buyer in the same manner during the earnout period as they were by the seller prior to closing of the acquisition. 23
KEY TERMS IN PE M&A SELLER PAPER Seller Paper Generally Seller paper is promissory notes issued by the target company to the seller as part of the purchase consideration in an acquisition. Although seller paper can be a primary financing source for an acquisition, it is more typically mezzanine debt financing that is a part of the capital stack constructed by a PE sponsor for the acquisition, which is subordinated to the senior debt financing obtained from an institutional lender. Seller paper is used for a variety of reasons, including: To fill the gap between the purchase price and the amount of senior debt financing available. To stretch the purchase price beyond market value, while minimizing the risks to the buyer and its financing sources. To help incentivize the seller to stay actively engaged in the target company business after closing. To enable the seller to defer taxes on a portion of the purchase price into future tax years when its marginal tax rate is lower. Subordination provisions and default remedies are particularly important to sellers. 24
KEY TERMS IN PE M&A SELLER PAPER Typical Seller Paper Terms PE sponsors often advocate use of seller paper by noting that it can provide the seller with an attractive interest rate, as compared to other investments opportunities in today s low interest rate environment, which is coming from a business that the seller knows very well. Some typical terms of seller paper include: The Seller paper is typically unsecured and subordinated to the senior debt. However, monthly interest and sometimes principal payments can typically be made on the seller paper as long as no event of default has occurred under the senior debt financing. Seller paper typically constitutes from 10-40% of the total purchase price. Interest rates on the seller paper are typically comparable to unsecured mezzanine debt 6-10% per annum. The maturity of the seller paper is often the same as the senior debt financing 5-7 years after closing of the acquisition, subject to acceleration upon a subsequent sale of the target company. 25
KEY TERMS IN PE M&A REVERSE BREAK-UP FEES Reverse Break-Up Fees Generally A reverse break-up fee is a payment that the buyer makes to the seller if the transaction fails to close because of the occurrence of a specified event. Reverse break-up fees have become the norm in acquisitions of publicly-traded companies since the 2008 financial crisis, particularly in deals in which the buyer is a PE sponsor, as the buyer wants to protect itself from potentially substantial liability to the seller if it cannot close the acquisition. The most common trigger for a reverse break-up fee is the buyer s failure to obtain debt financing necessary to close the acquisition. Additional reverse break-up fee triggering events include failure to obtain antitrust and other regulatory approvals necessary to close the acquisition. The buyer typically is prohibited from exercising the termination right if it purposely engages in conduct that results in occurrence of the event that triggered the termination right. 26
KEY TERMS IN PE M&A REVERSE BREAK-UP FEES Payment of Reverse Break-Up Fees The reverse break-up fee caps the buyer s monetary liability to the seller due to its inability to close the acquisition transaction at the stated amount. Reverse break-up fees are usually larger in amount than conventional break-up fees 4-5% of purchase price, as opposed to 2.5-3.5% of purchase price although the percentages can vary depending upon the size of the transaction. It is unusual for a buyer to have pure optionality, in which it can elect to pay the reverse break-up fee and walk away from the acquisition for any reason. The parties typically specify in the purchase agreement that the "specific performance" provision, under which the seller can force the buyer to close the acquisition, does not apply if the buyer exercises its right to terminate the transaction and pay the reverse break-up fee. The reverse break-up fee is typically payable by the buyer to the target company, in full, upon its exercise of the termination right. 27
KEY TERMS IN PE M&A R&W INSURANCE Rep and Warranty Insurance Generally Representation and warranty (R&W) insurance provides a source of recovery to the insured (typically the buyer) if the seller s representations and warranties in the purchase agreement are inaccurate. R&W insurance has gone from being virtually non-existent to very common within the last five years, particularly in M&A transactions involving PE sponsors. The key benefit is that the amount of purchase consideration placed into escrow and seller recourse are substantially reduced (typically 1-5% of purchase consideration, rather than 10-20%), while the buyer can recover an additional amount through claims against the R&W insurance policy. R&W insurance is particularly attractive to PE sponsors selling portfolio companies because it increases the amount of purchase consideration received upon closing, which helps maximize their return on investment (ROI) and carried interest compensation from portfolio company investments. While coverage under the R&W insurance policy adds expense to the transaction (premiums are typically 1-4% of the coverage amount, plus expenses), it can expedite the process of negotiating the purchase agreement. That is particularly true for negotiating the materiality thresholds in the reps and warranties, the escrow amount and the indemnification deductible/threshold and cap. 28
KEY TERMS IN PE M&A R&W INSURANCE Advantages of Rep and Warranty Insurance In competitive auction processes, the smaller escrow amount and more limited postclosing liability of the seller resulting from use of R&W insurance can provide a buyer s bid with a significant strategic advantage over other bidders not utilizing R&W insurance. R&W insurance can provide the buyer with broader or longer duration protection against breaches of the target company s reps and warranties than it may otherwise be able to negotiate with the seller. R&W insurance policies can be either buyer-side or seller-side. Buyer-side policies are more popular because claims are not precluded if the target company s management team or stockholders had knowledge of the issue. Coverage under the R&W insurance policy starts once the retention has been satisfied typically the amount of the deductible, plus the amount of transaction consideration placed into escrow. R&W insurers typically want sellers to have some skin in the game, but coverage can be obtained with no recourse against the seller (although at a higher insurance premium amount). 29