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Private Equity Transactions
Understanding Some Fundamental Principles
By Jeffrey A. Blomberg
Private equity investing has generated worldwide attention over the last few years. Many reasons are cited for its proliferation, including an abundance of cheap debt financing as well as companies with publicly traded securities seeking to escape the burdens of Sarbanes Oxley. Similar to what occurred in the late 1990s with respect to venture capital investing, many inexperienced players are arriving on the private equity scene. In particular, hedge funds, which have access to sizable amounts of capital, are diverting their attention from short-term trades and seeking to make private equity-type investments. This article provides a brief review of some basic elements of a private equity transaction and some key considerations that distinguish private equity deals from more traditional mergers and acquisitions.

Basic Elements
Private equity sponsors (also referred to as financial sponsors) seek to acquire companies that they can grow or improve (or both) with a view toward eventual sale or public offering. In terms of growth, the financial sponsor will usually acquire a platform company in a particular industry and then seek to add additional companies to the platform through acquisition. These add-ons may be competitors of the original platform company or may be businesses with some link to it, but they will be added with the goal of increasing the overall revenues and earnings of the platform investment.

Strategic buyers, on the other hand, are companies that are already in the target company's industry or in a similar industry. While strategic buyers use acquisitions for growth, they may have different goals than a financial sponsor. For example, a strategic buyer may not be concerned about an exit strategy for an acquired business because it expects a seamless integration of the target into its own operations.

The next essential ingredient for a private equity target is EBITDA (or earnings before interest, taxes, depreciation, and amortization). Private equity investors generally acquire new companies through leveraged buyouts. The use of leverage distinguishes financial sponsors from strategic buyers engaged in more traditional merger and acquisition transactions. A private equity sponsor needs the assets of the target company as collateral to borrow the funds necessary to acquire the company. Therefore, private equity investors seek target companies that can generate sufficient cash to service the debt that is incurred to acquire them. Sufficient cash is also needed to pay ongoing management fees to the private equity sponsor's own management company to cover the sponsor's overhead expenses. The amount of debt used to finance the transaction compared to the amount of equity capital infused differs in each deal. The variance in the amount of leverage employed in each transaction is often indicative of the experience and deal sophistication of the private equity sponsor.

In contrast, because strategic buyers often can fund acquisitions from cash on hand, they generally do not need to incur debt and can consummate transactions more quickly. In addition, unlike financial sponsors, strategic buyers will consider acquiring businesses with negative EBITDA because they may not be concerned about debt service. Moreover, strategic buyers are not relying on management fees to cover overhead expenses. Therefore, the spectrum of acquisition targets is broader for strategic buyers.

Private equity investors also are looking for a particular type of seller (references to "seller" refer to the owners/operators of the target company). Since the private equity sponsor will not run the target company's day-to-day operations following the closing, it is imperative that the seller be willing and desirous of continuing to run the company. Ideally, the target must have a founder or principal who will remain with the business and partner with the private equity sponsor to implement its strategy for growth and eventual exit. This is in stark contrast with the desire of strategic buyers who often do not want members of the target's management to continue with the business following the closing. More traditional merger and acquisition transactions usually lead to job eliminations to maximize efficiency. Strategic buyers in the same industry as the target usually have personnel in their organization who can run the target's business.

Equity Participation by the Seller
Financial sponsors not only need to retain senior management but also need to incentivize them to perform. Because the seller will have received potentially "life-changing" money at closing, the private equity investor needs to have mechanisms in place to ensure the seller will be motivated to maximize value for the new enterprise. As a condition to closing, a private equity buyer may require that the seller reinvest some of the proceeds received at closing into the new company so that he or she has "skin in the game." The buyer will also require the principal to enter into a long-term employment agreement with the new operating company. These measures are designed to align the interests of the seller with that of the financial sponsor.

In a traditional acquisition, stock options are generally used to incentivize new employees. Absent a situation involving employees with unique skills (like a designer with a famous label), the strategic buyer may not believe that any additional incentives are necessary for its new employees. However, keeping the seller motivated is of principal concern to the private equity investor. While the financial sponsor is technically the seller's new "boss" as the employer, the relationship is portrayed as more of a partnership. It is for this reason that the financial sponsor insists that the seller have an equity interest in the new company through either a rollover of existing stock or reinvestment of some of the proceeds received at closing into the new parent holding company.

The nature of the stock that sellers are permitted to buy is usually a function of what the private equity investor believes is necessary to achieve its desired rate of return on its investment. In some deals, the seller will be able to buy the same stock that the private equity investor holds. However, in other transactions, the seller may only be permitted to acquire junior securities, often for a nominal price. Obviously, the latter scenario may not provide the same "skin in the game" as having the seller's capital standing side by side with that of the financial sponsor. In either case, the stated goal is to give the seller a "second bite of the apple" when the private equity sponsor builds the business and then experiences a liquidity event. The seller must wait for a liquidity event to be able to realize the benefits of his or her shares. In a more traditional acquisition made by a strategic buyer, the seller might get stock of the buyer or options to purchase shares of stock that when exercised can be sold in the open market (assuming the company's stock is publicly traded).

Restrictions on the Seller's Stock
Regardless of what is paid for the stock received by the seller and whether it is a security of equal value (i.e., pari passu) with, or subordinate to, that of the private equity investor, it will be subject to multiple restrictions. First, the seller may not own the stock free and clear regardless of its purchase price. Such stock may be subject to vesting over time and may also be subject to performance vesting criteria that are only tested at such time as the issuer experiences a liquidity event such as a sale or an initial public offering. These conditions seem similar to a traditional stock option plan whereby options vest over a four- or five-year period but differ in that the seller will not be able to reap the benefits of the stock until the financial sponsor is exiting the investment.

The stock will also be subject to repurchase in the event the seller is no longer employed by the company or its subsidiaries. There are two reasons for this. If the parties are no longer working toward the same goal and business plan, the financial sponsor will see no benefit in allowing the seller to retain the shares. Second, the stock held by the seller is usually needed for the next CEO or senior manager to be hired by the company. To permit the original tranche of stock to remain outstanding and a new block to be given to a new CEO or senior manager would dilute the private equity investor's investment and adversely affect its financial returns upon a sale. The nature of this repurchase is often the subject of intense negotiation. Both the price (that is, whether it will be bought back at cost or fair market value) and form (that is, whether the purchase price will be paid in cash or over time with a promissory note) will likely be negotiated.

In addition to being subject to repurchase, the stock held by the seller will be subject to restrictions on transferability. Measures must also be taken to ensure that the financial sponsor does not end up partnering with anyone other than whom it has chosen, i.e., the seller. A stockholder's agreement will be put in place that restricts the transferability of the shares issued by the company. Other than transfers for estate planning purposes, the shares held by the seller will not be transferable except upon a liquidity event. Typical restrictions include having the seller's shares subject to rights of first offer and/or first refusal and co-sale rights. Rights of first offer require the stockholder to offer his or her shares to certain current stockholders and/or the company prior to seeking a third-party buyer. Rights of first refusal require a stockholder to offer to sell his or her shares to the company and/or other stockholders on the same terms as a third-party offer it receives. Co-sale rights permit a stockholder to "tag along" and have his or her shares purchased as part of another stockholder's sale to a third party. The private equity investor does not want to have stockholders who may cause problems or interfere with its business plan. Additionally, the private equity investor wants to partner with people who understand its business, share its strategies, and are likely to want to exit the investment when the private equity group so determines.

Typical Structure of a Transaction
In order to implement the goals described above, private equity transactions must be structured differently than traditional mergers and acquisitions transactions. Unlike many strategic buyers, private equity sponsors keep their portfolio companies separate. Instead, the financial sponsor will create a new "platform" holding company that will serve as the parent for the new target and any operating companies subsequently acquired. The holding company's sole purpose is to hold the securities of the operating company(ies) that are acquired by the financial sponsor. Different platform portfolio companies are not merged with one another to avoid being exposed to each other's liabilities. The financial sponsor will purchase a majority of the capital stock of the holding company. In order to consummate the platform's initial acquisition, that holding company will form a wholly owned subsidiary to act as the acquirer in the transaction. The private equity fund will control the board of directors of both the new holding company and the new operating company. To the extent that add-on investments are made for the platform, they will be made under the umbrella of the new holding company either through a newly formed subsidiary into the original operating company or as one of its subsidiaries.

In addition to the shares issued to the financial sponsor for its investment, any other equity securities to be issued in the transaction, whether to the seller for his or her rollover investment or by way of stock options, will be done by the holding company. There are several reasons for this. From a structuring perspective, it ensures that the equity securities in the operating company can be pledged to the lender at closing of the transaction without any person having the right to hold up the deal by refusing to pledge his or her securities. The holding company owns 100 percent of the outstanding equity securities in the operating company and therefore can pledge those securities to the lender at closing. This may also prevent the investors from having to pledge their shares in the holding company since the lender may deem itself fully secured by holding the equity securities of the operating company. Additionally, by having shares in the holding company, sellers can benefit from additional acquisitions to the extent they are made through newly formed subsidiaries of the holding company even if the seller does not participate in that particular acquisition. This structure also makes it easier to sell off or discontinue certain operating companies without affecting the rest of the platform.

It is possible that strategic buyers might seek to segregate an acquired business to avoid having its liabilities taint its existing business. However, it is more likely that a strategic buyer will integrate a target's business into its own to benefit from the synergies created by consolidating the operations of both companies.

Conclusion
The formula for success is not that complex: leverage the target company's assets to borrow sufficient cash to buy out the position of the principal and leave enough for working capital needs. Then the goal is to grow the business at the same time it services its own debt out of cash flow. The barriers to entry are fairly low provided that viable acquisition targets can be identified and there is available debt financing. However, as was the case during the dot-com boom and bust, those who delve into private equity investing without understanding some of these basic principles may not be satisfied with their results. The general strategies, philosophies, and structures outlined above have proven to be very successful over a long period of time for many different investors. These principles should be considered by any new private equity investor not just because they work, but also because when bidding on deals this is likely what the competition will be offering to a potential seller. This structure is also one that will make the other players, like potential lenders and co-investors, more comfortable with the transaction.
Blomberg is a member of Pullman & Comley, LLC, in Stamford, Connecticut. His e-mail is jblomberg@pullcom.com.

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