The challenge of Australian dual tracks

Strong equity markets have prompted sellers to consider dual tracks. But running two deals at once prompts legal challenges for both buyers and sellers

During the past 12 months the number and size of Australian initial public offerings (IPOs) launching successfully has surged. The continuing strength of the IPO market has in turn supported a resurgence in dual track sale processes. Selling a business is a high stakes poker game; sellers of Australian businesses in 2014 can keep calling trade buyers, knowing their IPO hand is strong.

A traditional dual track sale process involves a seller running a trade sale process and preparing for an IPO at the same time. Other sale processes or transactions can be run competitively. The recent Healthscope process, for example, involved potential trade sales of the whole of the business, part of the business, an IPO and a sale and leaseback option. UGL's recent sale of its DTZ business was run in parallel with a demerger proposal, whereas Brambles' demerger of Recall this year proceeded as the preferred alternative to earlier trade sale proposals.

The structure of the dual (or triple or quadruple) track process aside, the seller's objective is obvious: to build competitive tension and obtain the best possible sale price.

Dual track processes are not suitable in all situations – factors to consider include:

Does the seller need a complete exit or can it retain an interest in the sold business post-transaction?

Some private equity funds which have recently sold down through Australian IPOs have retained stakes of up to 50%. This is a departure from past practice, where 100% sales were common, and brings Australia more into line with international practice. A stake may need to be retained commercially to show skin in the game, countering market concerns that private equity owners may be selling at the top of the market and leaving public shareholders with little upside. In some circumstances, the Australian Securities Exchange (ASX) Listing Rules may mandate a level of retention or escrow.

It is rare, on the other hand, for a financial investor to retain any interest in a business it sells to a trade buyer.

The competitive benefit of a parallel track must outweigh any transactional damage that track may cause

Of course, a preference for 100% exit will not necessarily preclude a dual track process, even if the IPO option would involve a retained stake; it just means the IPO pricing would need to be significantly better than the trade sale pricing for the IPO to win. What post-transaction legal risk is the seller willing to take and how can this be laid off?

Another clean exit issue is the allocation of post-transaction liability. In a trade sale, allocation of legal risk is primarily governed by contract with some residual risk governed by statute (e.g. general misleading and deceptive conduct laws). In an IPO, legal risk is governed primarily by statute, in particular the prospectus provisions of the Corporations Act 2001.

While prospectus liability cannot be contractually excluded, sometimes a more benign liability position may be achievable under an IPO than under a trade sale, where purchasers generally insist on at least basic warranties. That is because of structuring opportunities (which may mean private equity vendors are not technically vendors of shares, and are therefore not liable unless they are knowingly involved in a particular contravention) and also because of the availability of due diligence defences.

Two products have changed the way sellers approach post-transaction legal risk. The use of warranty and indemnity insurance in trade sales has increased significantly, particularly where financial investors are selling out. Prospectus liability insurance is also available and can cover underwriters, controlling shareholders, sellers and directors. In each case, the cost of obtaining coverage has decreased in recent years. However, warranty insurance may be less vulnerable to the risk of cover being vitiated by alleged non-disclosure, as it can be taken out by the purchaser (unlikely ever to be the guilty party in relation to non-disclosure) rather than by the vendor (who benefits from separate back-to-back contractual releases), whereas this is not practicable in the IPO context.

While insurance is a useful tool to allocate legal risk, exceptions to coverage mean that a seller still needs to run robust legal due diligence and verification processes to reduce the possibility of an uninsured claim.

Are the additional transaction costs outweighed by the competitive tension gained by running a dual track process?

A dual track process will cost more than a single track process, although not necessarily much more. There is significant crossover between trade sale and IPO workstreams, for example in due diligence and preparation of an information memorandum and prospectus. Identifying how far each process will be run and what the likely costs are before embarking will maximise efficiencies.

Like the traveller in Robert Frost's The Road Not Taken, a seller in a dual track process will reach a point where it must choose between paths.

The seller who goes furthest towards a locked-in deal down both paths will build the most competitive tension. Once a path is abandoned, the competitive pressure it places on the other path is lost. An alternative sale or underwriting, if not locked in, may be retraded.

However, there can be risks in following both paths almost to conclusion – for example, failure to achieve a trade sale which has been strongly pursued can lead IPO buyers to question value, particularly since trade buyers will generally be able to benefit from synergies (which IPO buyers cannot) and the IPO market will generally expect pricing to leave some value 'on the table' to support a premium on listing. Trade buyers will also often publicly talk down the asset (despite stringent confidentiality arrangements), which can adversely impact IPO pre-marketing.

In summary, a sale of a strongly sought asset may benefit from dual tracks, pursued strongly until almost the end, but the competitive benefit of a parallel track must outweigh any transactional damage that track may cause. It is important to consider this in advance and structure the transaction accordingly.

Also, in order to effectively pursue two tracks, overall transaction structuring must be carefully thought out, as structural issues can materially affect value.

Tax and stamp duty need to be considered. In Australia, depending on the business being sold, significant stamp duty may be payable in a trade sale but not in an IPO.

Another key factor in an IPO context will be minimising seller liability under prospectus rules. For example, sellers will have per se liability for a direct sell-down, but not if they sell their business to a company which in turn raises capital to fund the purchase.

Change of control consent issues and contractual constraints on provision of information (in a prospectus or to prospective trade buyers) will also be important.

The terms on which advisors are engaged are also critical to maintaining the integrity of a dual track process. Where the same advisor is engaged on the trade sale and IPO tracks, that advisor should be engaged and fees structured to reduce the conflict of interest usually created by different fee models, and align the advisor with the seller. Another approach is to engage separate advisors for each track.

Even the most carefully planned dual track process will flounder if it is not executed properly. A dual track process requires careful coordination to ensure that issues in one track do not cause false sale signals to participants in the other or destroy value in the underlying business.

Management incentives

Sellers should provide strong, clear and track-agnostic incentives to management to ensure they support the highest value option. Management will be involved extensively in a dual track process, giving presentations to bidders, presenting at investor roadshows, responding to due diligence requests, organising information and, at the same time, running the underlying business.

Along with this enormous workload, management will be concerned about their post-transaction careers. Sellers should carefully consider the best way to incentivise management and align them with the dual track sale process. In many cases some form of existing management equity or incentive scheme will already be in place. These schemes should be reviewed in light of a decision to pursue a dual track sale and if necessary supplemented with sale bonuses, post-transaction equity schemes and other incentives to ensure that management do not face a conflict of interest that affects their ability to assist with the dual track process.

Information provision and due diligence

Disclosure of information in a dual track process can raise a number of legal issues. While there is some crossover between the due diligence processes run for a trade sale and for an IPO, the key difference is control. In a trade sale, bidders will request information and, if not satisfied with the depth or quality of information provided, will seek warranties and indemnities. In an IPO, the due diligence process seeks to identify information required to be disclosed in the prospectus and the seller will have an opportunity to control the dissemination and qualification of that information, subject to meeting the prospectus disclosure threshold.

The seller who goes furthest towards a locked-in deal down both paths will build the most competitive tension

A vendor due diligence report prepared by the seller's advisors is a useful tool that can help streamline buyer due diligence, ensure that sunk transaction costs for an IPO due diligence stream are utilised and give sellers earlier and better control over the information conversation. Reliance on vendor due diligence reports is commonly given, and the terms on which reliance is given are generally acceptable to domestic, international, financial and trade buyers. Issues in preparing and providing vendor due diligence reports can arise where the business being sold has international operations, due to the application of securities and other laws in offshore jurisdictions (for example, US laws make US firms reluctant to provide useful vendor due diligence reports, particularly where they may raise funds through securities issuance). Confidentiality arrangements

Participants in trade sale and IPO processes should sign confidentiality agreements. As well as the usual provisions commonly found in those agreements, special consideration should be given to dual track specific issues. These include no disparagement clauses, insider trading compliance provisions, no collusion, and no financier lock-up provisions and, in some cases, restrictions on post-IPO takeovers.

Sellers should also design their information disclosure process to retain maximum value in the business being sold. This includes black boxing and staggering release of information to trade buyers to minimise the risk of damage to the business if it completes an IPO after sensitive disclosures have been made to competitors. They should also prepare a leak strategy, having regard to the pre-prospectus publicity rules and the effect of a leak on each track of the process.

Protecting an IPO vendor that retains a stake

As noted above, a feature of many recent Australian IPOs has been the retention of a stake in the listed company by the seller or proponent of the IPO (see Veda, Healthscope, Spotless and many others).

When sellers retain a stake at IPO, they must address issues such as their rights to appoint directors, approve or consent to specific transactions and to receive information, as well as exit or sell down assistance provisions. Under Australian law and the ASX Listing Rules, there is generally less flexibility in an IPO to include bespoke provisions than in many other jurisdictions, including the US.

If the retained stake is large – greater than 30% – the seller may, depending on the composition of the rest of the register, have a de facto ability to appoint directors. If the stake is small or the seller is looking for more certainty, specific director appointment provisions can be included in the constitution of the listed company. These will need to be approved by ASX, but approval has been given in the past.

It is not common for a selling shareholder with a retained stake to have specific business approval or consent rights. Where these rights exist, they generally relate to non-pro rata securities issues, major acquisitions and disposals and some effective input into senior executive appointments and remuneration. Typically these rights only exist for so long as the selling shareholder maintains a 50% or greater stake in the listed company. Given the level of control a 50% shareholder in an ASX-listed company enjoys without specific rights, the value of specific rights is open to question; although they can assist in specific situations where governance principles would otherwise recommend or require that the listed company act through its independent directors.

Information access rights are common, particularly where a shareholder needs to consolidate the financial performance of the listed company into its accounts. However, sellers need to consider the effect of information access rights on how the seller can exit its retained stake.

Information access rights can give rise to perceived and actual insider trading issues, and constrain the timing of a block trade, for example by limiting transaction timing to windows immediately following results announcements. Recent block sell-downs of retained private equity stakes in Veda and Greencross both occurred immediately after results releases.

Unlike the position in the US, where formulaic registration rights agreements can provide sellers a clear path to market, sell down assistance provisions provided by Australian-listed companies in favour of IPO vendors take a variety of forms. A shareholders agreement may simply include broad assistance obligations, but can also address the manner and timing of the sell down, responsibility for costs of the listed company providing assistance and general reasonable endeavours provisions.

The strength of a dual track process is centred in the credibility of both tracks. Without a strong capital market and sufficient demand from trade and financial buyers, a dual track process will result in additional costs, potential damage to the underlying business and not provide the competitive tension necessary to justify the dual track.

The resurgence of IPOs in Australia means dual track processes are now viable and valuable for sellers. The emergence of products such as warranty and indemnity insurance and prospectus liability insurance further facilitates dual track processes by allowing sellers to limit post-transaction liability.

The Australian market is now a good environment for dual track processes and sophisticated sellers, supported by experienced and capable management teams and advisors, should feel confident that they will realise benefits.

By partner Philippa Stone and senior associate Nick Baker at Herbert Smith Freehills in Sydney