A secondary buyout is the sale of an investee company by a
private equity owner (or consortium) to another private equity
owner (or consortium). According to the British Centre for
Management Buyout Research, 15 of the 20 largest private equity
exits in 2003 (excluding IPOs) in continental Europe were secondary
buyouts and, in the first nine months of 2004, there were 63
secondary buyouts in the UK, almost the same as the number of trade
sales in the same period. There has been at least one instance of a
tertiary buyout. Secondary buyouts and recapitalizations are now
viable exit alternatives to trade sales and IPOs and, for the
private equity seller, carry some real advantages: completeness of
exit (in comparison to a recapitalization or, usually, an IPO) and
speed of execution (in comparison to a trade sale or IPO). As with
recapitalizations, they have been fuelled at least as much by the
highly competitive debt market as they have by the softness of the
IPO market (several secondary buyouts have been of companies for
which there was reportedly a strong IPO appetite, for example,
Saga).
Structure
The structure of a secondary buyout is likely to be little
different to that of any other buyout: the purchase will be
effected by a chain of new companies formed by the private equity
purchaser, the bottom one of which will acquire the existing
holding company of the target group. Multiple holding companies are
necessary for structural subordination (and tax) reasons. One or
two sub-holding companies are likely to be present in the existing
structure. This can result in a group with many companies between
the ultimate holding company and the trading companies; something
that can be cleaned up post deal, but seldom is.
The target group's existing acquisition debt will fall to be
repaid in full on the change of control, which the secondary buyout
entails. This will be out of a new facility made available to the
purchasing group (often by the banks that provide the existing
facilities). As with all buyouts, the purchaser will want as much
as possible to take advantage of unitary taxation (which allows
profits in one company in a jurisdiction to be set against interest
costs of other (for example, acquiring) companies in the same
jurisdiction). This typically involves establishing newcos in
various jurisdictions to make individual company acquisitions and
is easiest when the target group is a disparate collection of
subsidiaries of a trade seller.
So purchasing one holding company can be financially inefficient
and consideration should always be given to whether there should be
a staggered sale or a subsequent debt pushdown. A staggered sale
involves the target company selling subsidiaries (at full value) to
the purchaser group before the target company is sold to the
purchaser group. Private equity sellers are probably more
accommodating of this structure than a trade seller, as they will
be fully familiar with, and sympathetic to, the reasons (and might
well urge it to maximize the sale price). Any consequences of a
staggered approach should be carefully considered; there might be
increased stamp duty or consent might be needed for subsidiary
company transfers that are not necessary for holding company
transfers (for example, workers council approvals).
The analysis of the security package of the new senior debt must
recognize that it will be refinancing old acquisition debt and
shareholder debt that (in all probability) financed the
subscription of shares in companies in the target group structure.
In the UK, for instance, this can make the whitewash procedure
under sections 155 to 158 Companies Act 1985 extremely complex.
In theory what is sold need not be the existing holding company;
it could be the trading subsidiaries, with the proceeds (after
repayment of bank and shareholder debt) being distributed by the
holding company to its shareholders. As the sale will, to be tax
efficient, need to comply with the participation exception
requirements of the jurisdiction of the holding company (which can
be rather restrictive and complicated, for example, the substantial
shareholding rules in the UK) and a distribution may be tax
inefficient for some recipients (for example, individual UK
taxpayers) this structure is not common.
The shareholder-financing structure of the new acquisition
vehicle is likely to be the same as that of the original buyout,
that is, shareholder debt carrying a coupon that rolls up to
redemption and a small ordinary share capital base. Management,
who, if they did not before, will have come to fully appreciate the
hurdle nature of coupon on the shareholder debt, are likely to be
disappointed to discover that the new rate is higher than the old
one. This is because for any individual UK taxpayer (including
through a co-invest scheme) holding shares subject to restrictions,
there have since April 2003 been tax issues if the shareholder debt
is not at least as expensive as the dearest third party debt (that
is, the mezzanine debt).
Management participation
A secondary buyout provides a clean and complete exit for the
private equity seller, but the management and employee shareholders
are in a different position. The purchasing private equity house
will be expecting management going forward to be incentivized by
subscribing for sweet equity in the form of ordinary shares in the
purchasing vehicle (in commercial terms these entitle the holders
to a share of the increase in the value of the company over the
period of investment after financing costs (including the
shareholder loan return)). But, especially where management have
made substantial gains from the first buyout, they will also want
management to demonstrate their commitment and be tied in by making
a substantial reinvestment in an institutional strip of ordinary
shares and shareholder debt.
Management may find themselves in a position of conflicting, if
not interests, at least emotions; although as ordinary shareholders
in the target group they will welcome the purchaser paying a high
price, as (re-)investors in the new group they will be concerned at
the level of leverage that has resulted in that price. The level of
reinvestment (or management rollover) is often the main area where
the views of the selling private equity house, management and
buying private equity house are (in each case for good reason) most
different.
If management do roll over this needs to be done in a
tax-efficient manner. For UK taxpaying individuals that means,
principally, ensuring that: (a) the transaction does not trigger a
taxable gain (but that instead any gain can be rolled over); (b)
the transaction does not fall foul of section 703 ICTA 1988; and
(c) that the shareholder debt is structured in a tax-efficient
manner.
As far as (a) is concerned, the relevant legislation (Taxation
of Chargeable Gains Act 1992) allows the gain on the ordinary
shares to be rolled over if the acquiring company will own at least
25% of the target after the transfer. Because the acquiring group
will consist of a chain of at least two companies and the managers'
ordinary shares will be in the top company (and shareholder debt in
that or another company) this will necessitate a series of flip-up
arrangements, under which management momentarily receive securities
in the acquiring sub-holding company before transferring them up
the chain.
If management own at least 5% of any class of shares of the
target company (possible if there was a ratchet as these are often
structured with separate classes) they would be advised to obtain
Inland Revenue clearance to the rollover structure. This can have a
timing impact.
In considering (b) and the question whether the transaction will
fall foul of section 703 ICTA 1988 this will be an issue if
management are receiving cash and/or loan notes as well as equity
in the acquiring group (which they often will be). The Inland
Revenue is taking an aggressive approach to secondary buyouts
structured in this way. The Revenue is likely to argue that, if
there are any distributable reserves in the target company either
at the time it is acquired or when the loan notes are redeemed,
then management should be taxed as if any cash or loan note
redemption amounts are a distribution. This is clearly unattractive
from a tax perspective if management had anticipated paying capital
gains tax at 10% (that is, with full taper relief) on disposal
proceeds. An advance clearance procedure exists in respect of
section 703 ICTA, which can help identify if this is likely to be
an issue. Those advising management should alert them to the
issue.
As regards (c), shareholder debt would normally be structured as
a deep discount bond, the discount element equating to the coupon.
For UK tax purposes this is generally treated as incurred (and
therefore off-settable against group UK trading profits) when
accrued rather than paid. Likewise, holders of the bonds within the
UK corporate tax net will be taxed on an accruals basis. For the
non-taxpaying pension funds and the like, which constitute the vast
bulk of the private equity houses' investors, this is of no
concern. Individual holders of deep discount bonds will only be
taxed on the discount when they receive it. However, if the bond is
ultimately not paid, the individual will not realize a loss. So
individuals may prefer that their investment were structured as an
interest roll-up note rather than one issued at a discount.
Provided the note contains certain technical drafting provisions,
the individual will be allowed a loss if the loan is not paid.
Another reason for the UK management's loans being interest-bearing
rather than DDBs is that any gain made on the equity of the target
can be rolled into the former but not the latter. One therefore
generally sees two shareholder debt instruments, which have the
same economic terms but one of which is interest bearing and the
other one of which is a discount bond.
Representations and warranties
Over the last 20 years or so the market practice has developed
that European leveraged buyout houses will not give
representations, warranties or indemnities on a sale (other than as
to title and capacity). Pragmatically, of course, there will be
situations where they will give coverage in respect of specific
matters provided that their exposure is capped at an amount that,
because they cannot ask for money back from their investors, is
placed in escrow. In assessing the price offered they would
disregard (or say they are disregarding) the amount in escrow.
This is not an approach that trade buyers are at all comfortable
with. It leads to much discussion and sometimes means warranty
insurance is put in place.
Private equity purchasers are more accepting of the position for
the simple reason that they cannot argue against what would be
their own position. None of the following are legal reasons, but
they might also be relevant: the business has been through due
diligence twice (at the time of the first buyout and as part of the
sale process); it has been run with a view to a sale or an IPO so
should have been cleaned up; it will have been subject to the
rigorous controls, monitoring and reporting that private equity
houses and lending banks impose; it is a separate standalone
business (that is, without complicated intra-group arrangements
with the vendor that need to be unwound); and management are
unlikely to conceal something from their future owners.
To buttress this last point the private equity buyer will seek
warranties from the continuing management regarding the business.
Their purpose is not to provide full cover but to concentrate
management's minds to disclose any issues. As such, it is becoming
market practice that they are largely qualified by reference to
management's knowledge (albeit while imposing an enquiry obligation
on them) and that the cap on liability is a proportion (anywhere
between around 40% and 100%) of management's cash proceeds (that
is, after taking account of reinvestment). Indeed, it is not
uncommon in auctions for the selling shareholders to put forward a
management warranty deed as part of the process.
Completion accounts
Transactions are typically priced on a debt-free/cash-free
basis, meaning that it is necessary to agree/determine what exactly
cash and debt is, how much it is and how the purchaser can be
satisfied it inherits sufficient working capital (rather than it
having been turned into price-increasing cash, for instance by
squeezing debtors, not paying creditors and running down stock). On
the face of it, this requires completion accounts. In the secondary
buyout arena especially there is a growing preference (on both
sides' part) against completion accounts in favour of the locked
box principle under which the price for the shares is set on the
basis of a pre-exchange (perhaps not audited) balance sheet, that
is, by adding the cash and deducting the debt shown on that balance
sheet to/from the headline price. The purchaser then takes the
benefit burden of the target's performance between the date of that
balance sheet and completion and pays interest on the purchase
price for this period. The sellers confirm that between those two
dates there have been no dividends or charges, that is, that the
box has been locked.
There are clearly limits to this approach; it does not work well
if performance in the interim period is not predictable and/or the
reference balance sheet is too old. There is no reason why it
should not be as attractive to trade buyers but it seems that
private equity buyers are more receptive to the concept. This is
perhaps simply a matter of their experience that agreeing
completion accounts provisions can be a major and time-consuming
exercise; that if completion accounts really do just cover
debt/cash and working capital it is unlikely to result in
adjustments beyond what due diligence anticipated; and, in the
light of that, that a clean proposal involving a payment on
completion and no adjustment is attractive in a competitive
auction.
Author
biography
Bruce Hanton
Ashurst
Bruce Hanton has been a partner of Ashurst in London since 1996.
He specializes in corporate law with a particular emphasis on
private equity transactions, both domestic and cross border.
Recent transactions on which he has acted include: the secondary
buyout of Safety-Kleen Europe Limited, a pan-European services
company; the buyout of Total Fitness Limited, a UK health club
chain; the sale by Foseco Group Limited of Chem-Trend Limited; the
secondary buyout of German shower company Grohë; the
public-to-private of Fitness First plc; and the buyout of the Irish
convenience stores group BWG Limited.
Ashurst
Broadwalk House
5 Appold Street
London
EC2A 2HA
Tel: +44 20 7638 1111
Fax: +44 20 7638 1112