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This blog from our Corporate Team provides an overview of transactions with a Private Equity house and considerations for both an investor and the target company. Private equity can be used for raising working capital but also, more commonly, to support an exit or partial exit of founders/shareholders.
Background and recent trends
Despite the overall downfall in private equity transactions across the North West in 2023, statistics show that the region has still performed better than other regions outside of London.
Notwithstanding such a downturn in the volume of transactions across the year, there has been a significant increase in the value of PE investments.
It is also envisaged, due to the under-utilised cash funds currently held by PE houses and the need for the funds to be generating income, that private equity transactions are expected to increase over 2024/25 - especially as there is still an appetite for fundraising by investors.
Understanding private equity funds
PE houses invest in target companies with the aim of improving their profitability, sometimes through income-based returns, and eventually selling the target company for a higher return for the investors.
PE houses will often target companies in the market that generate high recurring fees and are scalable and capable of high growth.
In 2023, the most notable sectors in which target companies have benefited from private equity include software/technology, financial services and business support services.
Risk and internal audits
It is important for a management team to strike a balance between raising enough finance to grow the company whilst also maximising any value of any retained shareholding and minimising any personal exposure.
An internal audit/due diligence exercise prior to any discussions with PR fund managers prior to any investment will enable any commercial, financial, tax and/or legal issues to be identified by a management team and, if possible, resolved at an early stage before a PE house carries out its own due diligence exercise.
The target company will also need to present itself to the PE houses with detailed financials, including a business plan (ideally using a corporate finance professional who can assist with the preparation of the financials). Once a PE house has been selected, they may do a deeper dive into the financials before issuing Head Terms.
Following the agreement of Head Terms and before any investment is made, the PE house will then carry out a thorough due diligence exercise on the target company.
The thrust of some of this will be driven by the values, investment strategy and investment objectives of the PE house (for example, ESG may play a part), and the extent of it will be to alleviate/mitigate any risks and to ensure there are sufficient contractual protections in place in the transaction documentation (by way of warranty and indemnity protection).
All of these will aim to balance the right type of investment and risk profile with maximising return for their investors.
Investment structures
Investment into a target company is normally by way of debt (i.e., loans) or by way of equity (i.e., subscription for shares). The investment may also be a combination of both or potentially a hybrid, for example, by issuing a loan note instrument which is convertible into shares or the issuing of preferred redeemable shares.
When considering debt finance, it is also necessary to consider security for such debt, including taking a debenture (or other charges) over the assets and undertaking of the target company. This may also require entering into inter-creditor arrangements or deeds of priority with other existing creditors of the company, including its bank, management and other investors (as appropriate).
Whether a deal will involve debt or equity will depend on many factors, including the financial circumstances of the target company, the tax treatment, the amount of share capital the existing management is willing to dilute and the general level of risk of the company’s business.
Key investment documents
Depending on the type of investment made, the main investment documents include:
- Investment agreement – to cover terms, such as warranties (to be given by the management team), the provision of financial information, the appointment of directors and restrictions on management;
- Articles of Association – to provide for different share classes, good leaver/bad leaver/early leaver provisions, anti-dilution, any pre-emption rights on shares and drag/tag along rights attaching to the shares; and
- If there is a sale of shares from founders/shareholders, there will be a share sale agreement – to cover the transfer of shares, consideration, warranties from and restrictions on the sellers and a tax covenant.
Exit strategy
A PE house will look at an investment life-cycle of 3 to 5 years, at which point (provided it has made a sufficient return) it will look to realise its investment by exiting the company.
The way in which a PE house exits a company generally differs from a traditional sale and purchase transaction. For example, a PE house can exit a company by:
- Selling the holding company of the group structure (which includes the target) to a third party;
- another PE house buying out the target company;
- floating the target company’s shares on a stock exchange;
- Selling a portfolio of investments to a new fund (which includes the target) or
- Permitting a limited partner of the PE house to transfer its interest in the target (or a proportion of the shares held by the PE house) to a new investor.
Where a PE house investment has not been as successful as envisaged, it will also be looking for an appropriate exit or saving strategy. That said, there are fewer options available in such a scenario, and a PE house will need to act quickly to ensure the investors do not make any further losses.
It may first try to save the company and implement plans to restructure the target company’s external debt, provide additional funding (if the target is salvageable) and/or create a new management team and business plan.
Alternatively, the PE house may be looking for a clean break and, therefore, will look to sell the company (at a loss), liquidate the company to try and realise any assets left in the capital of the target (which is likely to be minimal) or put the target into administration.