Private Equity Newsletter
IPOs - Attractive Exit Alternative For Financial Sponsors
By Thomas J. Friedmann, Stephen M. Leitzell and Gregory A. Schernecke
The strong U.S. initial public offering (IPO) market, coupled with favorable regulatory changes and market acceptance of innovative transaction structures, has increased the attractiveness of the IPO as an exit alternative to financial sponsors.
In 2014 the U.S.IPO market was more active by several measures than at any time since the end of the Tech Boom in 2000. There were 288 initial public offerings in the United States in 2014, the highest total since 2007 according to IPO Watch, a quarterly survey by Pricewaterhouse Coopers. Total IPO proceeds reached US$83.9 billion in 2014, which approached the aggregate proceeds of US$92.6 billion raised in 2000. High stock market valuations and an energetic IPO market have led many financial sponsors to take their portfolio companies public. According to IPO Watch, financial sponsors backed 61 percent of all US IPOs by number and 71 percent by value in 2014.
In addition, new and innovative transaction structures, such as the so called “Up-C” or Umbrella partnership C-corporation structure, have provided financial sponsors with attractive, flexible tax structures to consider in evaluating whether to test the public markets. Specifically, these structures allow financial sponsors to maintain advantageous flow through tax treatment and certain indicia of control over their portfolio companies even after an IPO -- rights which were formerly lost for a sponsor in a traditional IPO. These structures combined with the regulatory changes brought by the JOBS Act, have created an environment that give financial sponsors more options than ever before when considering the exit strategy for their portfolio company investments.
Innovative Corporate Financing Structures Enable Financial Sponsors to Perpetuate Attractive Tax & Governance Characteristics of Recently Private Companies
The robust 2014 IPO market was driven by more than just a general increase in stock market valuations. Critical changes in US regulation, increased acceptance of sponsor-friendly governance provisions and the development of attractive corporate financing techniques combined to drive a surge of financial sponsor participation in the new issue market.
Controlled Company Structures
Since 2002, the Sarbanes Oxley Act has heightened the corporate governance standards of US public companies and, by design, has increased the regulatory burden and cost of compliance applicable to US public companies, including those seeking to complete an IPO. However, many of the restrictions applicable to public companies under the Sarbanes-Oxley Act and the related regulations and listing rules implementing that law are relaxed for “controlled companies,” which are companies a majority of the voting shares of which are held by another company or entity.
The derogation from corporate governance standards for controlled companies has particular relevance for financial sponsors and the portfolio companies they take public. Most financial sponsors do not sell all or even any of their interest in a portfolio company at the time of its IPO, which is generally reserved for additional issuances of primary shares by the portfolio company. Rather, a financial sponsor will typically look to exit completely or in stages after the IPO pursuant to privately negotiated block sales or registered secondary offerings. In this way, the financial sponsor obtains the benefits of a liquid market for its interest in the portfolio company and a clear indication of the value of its investment, without placing undue pressure on the portfolio company’s prospects for a successful IPO or post-offering stock price through excessive selling. As a result of this typical IPO process, most sponsored portfolio companies that complete an IPO remain “controlled companies” under the parlance of the Sarbanes Oxley Act.
As a result of these factors, the controlled company exceptions under the Sarbanes-Oxley Act have created numerous avenues for financial sponsors, or groups of financial sponsors acting in concert, to retain a measure of control over their portfolio companies even after such companies complete an IPO. For example, a controlled company is not required to have a board comprising a majority of independent directors. In contrast, a majority of the board of directors of a non-controlled company must be independent within one year of listing on either the New York Stock Exchange (NYSE) or NASDAQ. As of 2011, the median level of director independence among a group of 28 controlled companies was 37 percent, and 64 percent of such companies had classified, or staggered boards. This percentage is significantly higher than non-controlled listed companies and contrasts sharply with the guidance of stockholder advisory firms such as RiskMetrics/ISS. Such classified boards can enable financial sponsors to retain disproportionate representation on the board of directors of a portfolio company following an IPO. And, while controlled companies are legally required to have fully independent audit committees within one year of listing on either the NYSE or NASDAQ, they are not required to have independent nominating and corporate governance committees, as are non-controlled companies.
Likewise, controlled companies are not required to undertake an independent nominating process for directors if they are subject to contractual provisions regarding the nomination of their directors. As a practical matter, this means that financial sponsors can, by retaining control over a portfolio company following its IPO, subject such company to restrictions on the ability of its independent directors, or board of directors generally, to nominate directors for election by the stockholders. Financial sponsors have utilized these provisions of the law to retain the right to nominate or designate directors to serve on the board and/or specific committees of the board of directors of companies which they control. Controlled companies often have other provisions in their organizational documents that serve to enable their control persons, which often include financial sponsors or groups of financial sponsors, to retain control over such companies, including multiple share classes with disparate voting rights, veto rights or limitations over specified actions by such company or the board of directors (including amendments to the organizational documents, change of control, liquidation, non-pro rata dividends or repurchases), provisions permitting stockholder action by written consent, favorable fee arrangements for affiliates of the financial sponsor(s), limitations on access to information by prescribed persons and transfer restrictions imposed on certain key stockholders (including rights of first offer and tag-along rights) that are more typically found in private companies. These contractual rights have been increasingly preserved, along with pre-IPO beneficial tax treatment (as more fully described below), as part of the “Up-C” structure, which based on the number of successful offerings over the past three years seems to have gained market acceptance as evidenced by the fact that 75% of the Up-C IPOs reviewed by Dechert since 2005 priced at or above their initial filing ranges.
Taking a page from the market for real estate investment trusts, financial sponsors and other significant stockholders have pioneered the use of the so-called Up-C structure in connection with IPOs. Prior to an IPO, many portfolio companies of financial sponsors are organized under state law as limited liability companies that are treated as partnerships for income tax purposes. As a result, such portfolio companies pay no entity level corporate income tax. Until fairly recently, the convention was to convert any such limited liability company into a C-Corporation prior to the closing of its IPO (and typical sponsor-backed portfolio company LLC agreements contain provisions providing for automatic conversion upon an IPO). As a result, stockholders of the new corporation experienced double taxation in respect of their share of the income of such corporation after the IPO was completed, with the corporation first paying corporate income tax and then the stockholders paying income tax on any dividends they received.
To avoid this outcome, or at least to defer the onset of double taxation for as long as possible, financial sponsors and other controlling stockholders have developed and adopted the Up-C structure. In this structure, the original portfolio company (“OpCo”) is restructured as a less than wholly owned subsidiary of a C-corporation (“HoldCo”). The incumbent owners of such OpCo continue to hold their interests in the OpCo directly in the form of limited liability company interests or some equivalent interest. Public investors in the IPO actually acquire shares of common stock in HoldCo, through which they own an allocable portion of OpCo. HoldCo becomes, as a result of the IPO, the public company that is listed on a national securities exchange, houses the executive management team of the company and its board of directors. In connection with the pre-IPO restructuring, the incumbent investors in OpCo receive a non-economic interest in HoldCo that entitles them to vote their allocable portion of the voting stock in OpCo at the HoldCo level. As a result of these machinations, the incumbent investors in OpCo retain their ability to receive distributions from OpCo directly, and not through a taxable corporation, thereby avoiding double taxation on any such distributions; however, they do not suffer any diminution of their proportional voting interest in HoldCo as a result of such structuring. In most cases, if an interest holder in OpCo subsequently transfers its interest to a third-party, such interest is automatically converted into a share of common stock in HoldCo. Through this mechanism, incumbent OpCo investors (including financial sponsors) do not suffer any adverse liquidity consequences from their ownership of securities at a level in the capital structure below HoldCo. Additional benefits are typically realized by the sponsor in the Up-C structure through the implementation of a tax receivable agreement between HoldCo and the sponsor and other owners of OpCo equity. Under the terms of such a tax receivable agreement, HoldCo pays to the owners of OpCo equity, including the sponsor, a portion (typically more than 50%) of the amount of any tax benefits realized (or deemed realized) by HoldCo as a result of increases in the tax basis of the assets of OpCo resulting from any redemptions or exchanges of OpCo equity interests by HoldCo.
As a result of the financial sponsor’s ownership of the non-economic interest in the public HoldCo, the listed company will typically be a “controlled company” of the financial sponsor under the Sarbanes-Oxley Act. Over the last several years we have seen multiple successful deals come to market where, through rights embedded in a Shareholders Agreement or the OpCo organizational documents, which are publicly disclosed in the IPO process, financial sponsors are able to maintain real control rights in the listed company, even after an IPO has been completed. These control rights are extremely valuable to financial sponsors because it gives them increased comfort that their representatives on the HoldCo Board will be able to continue to guide the portfolio company even after the IPO, helping to ensure an ultimately successful exit.
We reviewed approximately 20 recently completed Up-C IPO transactions involving financial sponsors. We found that many of the following rights were generally successfully maintained by the financial sponsor after the IPO in a majority or more of the identified transactions:
- the right to appoint and remove directors;
- the right to approve of the hiring or firing of the Chief Executive Officer;
- the right to approve of any change in business strategy or business plan by OpCo;
- the right to approve any acquisition or disposition by OpCo or incurrence of indebtedness by OpCo or HoldCo;
- the right to approve any change of control of OpCo or HoldCo;
- the right to approve of any issuances of additional equity interests;
- the right to approve of the payment of any dividend or distribution; and
- the right to approve or amend any equity incentive plan
Recent regulatory changes under The Jumpstart Our Business Start-ups (JOBS) Act appear to have boosted the overall IPO market as well as the number of financial sponsors seeking IPO exits for their investments. Additionally, the benefits available to IPO issuers under the JOBS Act are applicable to both qualifying non-controlled company and controlled company issuers alike, further facilitating the ability of financial sponsors to more efficiently implement the innovative transaction structures noted above.
Among its many provisions, the JOBS Act (1) enables companies that meet the broad definition of an “emerging growth company,” or EGC, to benefit from provisions that streamline and simplify the IPO process and (2) assists newly public companies in adjusting to the rigors of public ownership and SEC reporting in the first years after an IPO. The JOBS Act defined an EGC as any company having total gross revenues of less than US$1 billion during its most recently completed fiscal year prior to commencing an IPO. Thereafter, a company remains an EGC and continues to benefit from the favorable provisions of the JOBS Act until (1) the end of its first fiscal year in which it has gross revenues over US$1.0 billion; (2) the end of the fiscal year ending after the fifth anniversary of its IPO; (3) the date on which it issues more than US$1.0 billion in non-convertible debt in any three-year period, and (4) the date on which it becomes a “large accelerated filer” under the Securities Exchange Act of 1934 (“Exchange Act”), meaning its total market capitalization exceeds US$700.0 million. In light of this expansive revenue threshold, approximately 77% of the companies brought to market met the EGC definition in 2014.
Under the JOBS Act, an EGC may elect to comply with several relaxed disclosure and operational requirements under the Securities Act of 1933 (the “Securities Act”) that otherwise apply to companies seeking to register with the SEC. For instance, an EGC is only required to provide two years of audited financial statements rather than the three years mandated for non-EGC registrants, and need not provide selected financial data for any years prior to the first of its two required audited years. This shortened disclosure period can yield significant savings for portfolio companies of financial sponsors and often will allow sponsors to take portfolio companies to market faster, particularly as many such companies will often have undergone complex change of control transactions during the five fiscal-year period prior to an IPO. Absent such relief, these portfolio companies would have to audit a third fiscal year to include in their registration statements and prepare unaudited financial statements for two additional years.
The JOBS Act also enables EGCs (or persons acting on their behalf) to “test the waters” by communicating with certain sophisticated investors, including qualified institutional buyers and institutional accredited investors, to gauge their interest in investing in such companies even before filing a registration statement with the SEC. Prior to the passage of the JOBS Act, any such communication would have constituted unlawful “gunjumping” and led to a cooling off period before an IPO registration could commence. Another provision of the JOBS Act facilitates research coverage of IPO candidates by enabling the publication of research reports by brokers, dealers and exchange members during the “quiet” period after an EGC’s IPO and prior to the expiration of any IPO underwriter’s “lock-up” period. The law also facilitates the publication of research regarding EGCs by specifying that research regarding an EGC that has filed or intends to file an SEC registration statement does not constitute an “offer” of the EGC’s securities under the Securities Act. Absent such relief, publication of research concerning a candidate for an IPO would raise the specter of liability for the firm publishing such research and for the company that is the subject of such report. The impact of these changes in the regulations governing the publication of research at or around the time of an IPO remains unclear, as the SEC continues to interpret such regulations, market practice continues to evolve, and certain leading investment banks must navigate between the flexibility afforded by the JOBS Act and continuing restrictions to which they are subject under a 2003 Global Research Analyst Settlement with the SEC.
Finally, and perhaps most importantly, the JOBS Act facilitates IPOs by permitting EGCs to file their initial registration statement and subsequent amendments with the SEC on a confidential basis until 21 days prior to the commencement of the EGC’s roadshow. While this confidential filing provision has been well received by all manner of potential IPO candidates, it is particularly attractive to financial sponsors, as it permits them to undertake a discrete “dual tracking” exit process, whereby a financial sponsor can privately market a portfolio company to potential strategic buyers or other financial sponsors without necessarily disclosing that it may elect instead to exit through an IPO if the prices offered by potential buyers are not sufficiently high, and without losing any time in bringing such portfolio company to market if disposition negotiations break down. Allowing financial sponsors to confidentially dual track a proposed exit for their EGC portfolio companies provides sponsors with greater flexibility and control than ever was available before in managing a contemplated exit.
The strong IPO market of the past few years has provided opportunities for financial sponsors that have not existed in the past. These opportunities have resulted from the general strengthening of the public capital markets combined with favorable regulatory changes under the JOBS Act as well as market acceptance of innovative structures which have given financial sponsors a stronger position in post-IPO companies than was previously considered possible. These structures are being used now with increasing frequency by financial sponsors to manage successful exits from their portfolio company investments, and we believe have achieved market acceptance.
Doing Business with Russia Following Sanctions: What PE Firms Need to Know
By Laura M. Brank
It has now been over a year since the United States and the European Union began imposing sanctions on Russian and Ukrainian individuals and entities in connection with the situation in Ukraine. The sanctions have major implications for private equity firms transacting and operating in the region and subject to U.S. law, and present unique challenges given Russia’s exposure to, and major presence in, the global market. After numerous rounds of sanctions imposed by the U.S. Government and sanctions legislation passed by Congress, it has become clear that the U.S. sanctions will not be removed soon even if the EU allows its sanctions to expire later this year, which is quite possible.
Many banks and U.S. corporations have taken a very conservative approach in complying with the Ukraine-related sanctions in expectation that they will continue to worsen and in order to be consistent with their global sanctions compliance programs. While understandable, such an approach does not take into account the distinct nature of the Ukraine- related sanctions, which are very targeted and may be distinguished from broader Iran-type sanctions. It is still very much possible for U.S. persons to carry out business with Russian parties and indeed the current situation may create strategic opportunities for funds in certain sectors where investment is badly needed and welcomed, such as agriculture, life sciences and technology. This article summarizes the sanctions and attempts to clarify a number of points which have created confusion for parties transacting with Russian parties and suggests what should be done to ensure compliance with sanctions and to mitigate risks of violation of sanctions while exploiting possible opportunities.
Overview of Ukraine-Related Sanctions
Specially Designated Nationalist List
Persons and entities targeted by the U.S. in response to the Ukraine crisis generally fall into either of the Specially Designated Nationals (SDN) or the Sectoral Sanctions Identifications (SII) Lists, both of which are managed and maintained by the Office of Foreign Assets Control (OFAC) of the U.S. Department of the Treasury. Executive Orders 13660 and 13661 of 6 March 2014 and 20 March 2014, respectively, provide the legal framework by which OFAC is given the authority to place individuals and entities on the SDN List.
Generally, SDN-type sanctions require the blocking of all property and interests in property of any listed person, and prohibit engaging in financial and trade transactions with, or for the benefit, of a person on the SDN List. The “blocked” property or “frozen” assets remain with the target; however, the exercise of powers and privileges normally associated with ownership is prohibited unless specifically authorized by OFAC. Entities that an SDN-listed person owns – defined as a direct or indirect ownership interest of 50% or more – are also blocked, even if that entity is not explicitly identified on the SDN List.
Sectoral Sanctions Identification List (SSI List)
The SSI List is a new type of sanction, the framework for which was established by Executive Order 13662. Under the order, the Secretary of Treasury, in consultation with the Secretary of State, may impose sanctions on certain sectors of the Russian economy. Thus far, such sanctions have been applied to companies in the financial services, energy, and defense related sectors in Russia. Although the executive order was issued on 20 March 2014, it was not until 16 July 2014 that OFAC made its first SSI List designations.
Designations to the SSI List are made pursuant to Directives 1 through 4. Directives 1 and 2, which target the financial and energy sectors, respectively, were introduced as part of the first SSI designations on 16 July 2014, whereas Directives 3 and 4, which target the military/defense and oil and gas exploration sectors, respectively, were issued as part of the designations of 12 September 2014. SSI List designations apply to U.S. persons or persons within the United States and prohibit engaging in transactions with respect to the provision of financing for, and other dealings in new debt of longer than 30 days maturity for entities listed pursuant to Directive 1 (90 days maturity for debt issued before 12 September 2014) and Directive 3, and 90 days maturity for those listed pursuant to Directive 2 with an added prohibition on dealing in new equity with respect to entities listed under Directive 1 (certain financial institutions). New debt, includes bonds, loans, extensions of credit, loan guarantees, letters of credit, drafts, bank acceptances, discount notes or bills, or commercial paper with a maturity of more than 90 days if issued between 16 July - 12 September 2014, and with a maturity of more than 30 days if issued after 12 September 2014. New equity includes stocks, share issues, depositary receipts or any other evidence of title ownership issued on or after 16 July 2014. Directive 4, which targets oil and gas exploration technologies, prohibits the provision, exportation or re-exportation of goods, services, or technology in support of exploration or production for deepwater, Arctic offshore or shale projects that have the potential to produce oil in the Russian Federation, or in the maritime area claimed by the Russian Federation and extending from its territory.
SSI-type sanctions were introduced to apply targeted pressure on the Russian Government without significantly affecting the Russian civilian population. It is important to note that the designation of entities on the SSI List does not constitute a blocking action (as an SDN designation would) and does not require U.S. persons to block the property or interests in property of the designated entities. Therefore, U.S. persons can continue to transact business with companies on the SSI List provided that such transactions do not violate the SSI sanctions (i.e. mainly providing financing, or facilitating financing to such SSI List entities beyond 30 or 90 days, as relevant). Moreover, it is possible to freely transact business with companies in such sectors (i.e., only certain transactions with certain companies are prohibited and not all transactions with all companies in the sector) provided that: (i) they are not acting as an agent for a sanctioned entity; and (ii) the U.S. person complies with U.S. export controls with respect to provision of equipment and materials to Russia in the energy and defense sectors.
Who is Covered by Sanctions?
U.S. sanctions apply to “United States persons”, which, pursuant to the Executive Orders establishing the framework for designating entities to the SDN and SSI Lists, means “any United States citizen, permanent resident alien, entity organized under the laws of the United States or any jurisdiction with the United States (including U.S. branches of foreign companies), or any person in the United States.” U.S. sanctions, generally do not apply to non-U.S. subsidiaries of U.S. companies (although non-U.S. branches of U.S. companies are covered), except to the extent that the U.S. company controls the subsidiary’s decisions; and non-U.S. companies whose shares are publicly listed on a U.S. exchange. This is in contrast to other broader sanctions imposed by the U.S. Government.
Control Over SDN/SSI Entity
Both SDN- and SSI-type restrictions extend to entities that are 50% or more owned by a designated person.
Furthermore, pursuant to a new OFAC rule issued in August 2014, the 50% rule also extends to persons that are 50% or more owned in aggregate by designated entities.
In defining whether an entity is “controlled” by a sanctioned entity OFAC looks to both ownership and control together, when determining whether to block an entity. As OFAC has clarified, in cases where an entity is controlled, but not 50% or more owned by one or more designated persons, it is not considered automatically blocked. OFAC, however, has cautioned against doing business with such entities, warning that they may constitute targets for future designation. Companies dealing with entities that may be controlled – but not 50% or more owned – by a blocked person should also be wary of violating EU sanctions, which stipulate that funds and resources controlled by a listed person would also be frozen (in addition to those “owned” and “held”). While the EU provides general criteria for determining whether an entity is controlled by another entity or person, it allows its member states to interpret control on an individual basis.
Carrying Out Due Diligence on Russian and Ukrainian Persons
While transacting business in Russia and with Russian parties is still very much possible, U.S. persons, especially those based in the U.S. or with operations in the U.S., dealing with Russian persons should take steps to ensure that their business activities do not violate U.S. sanctions.
All transactions with Russian counterparties should be carefully analyzed to determine compliance with relevant sanctions and export controls. Careful assessments should be made for transactions in sectors targeted by U.S. and EU sectoral sanctions, such as banking, defense/military and energy (including oil and gas exploration). Furthermore, shareholders, directors, customers, and business partners or other key persons in a relevant company should be screened to determine whether any of them are subject to sanctions (expressly or as persons controlled by sanctioned persons); or if there are any ongoing or expected transactions with the blocked persons or companies controlled by blocked persons, and whether such transactions involve dealing with, or exporting to, entities in Crimea (trade with Crimea is generally prohibited by a separate executive order issued at the end of 2014).
Contracts concluded with Russian counterparties in high-risk sectors should provide for the possibility of termination due to sanctions, as well as liability for violating sanctions provisions. Companies subject to U.S., as well as EU, law should also identify and include provisions allowing for the instant termination of agreements and obtain end-use statements for contracts, purchase orders, or agreements, including representations by Russian counterparties affirming that they are not acting as an agent or otherwise on behalf of a sanctioned person or engaging or facilitating in the export or re-export of restricted goods for military-use of certain energy operations, as well as to Crimea in general. Contracts should be updated or drafted to include penalties for breaching sanctions-related provisions and clauses.
Transacting with Debt and Equity of SSI-Designated Entities
As mentioned before and as confirmed by OFAC, U.S. persons may conduct business with SSI-designated entities as long as they do not violate any of the prohibitions imposed by the relevant Directive. However, caution should still be exercised when dealing with such entities, especially when determining whether an instrument in the secondary market constitutes prohibited “new debt” or “new equity” of the SSI-designated entity in question. While providing loans and other types of financing after the date on which an entity was designated on the SSI List are obvious examples of “new debt”; companies should also strive to make sure that payments for services or goods delivered to a designated entity does not exceed 30 (entities subject to Directives 1 and 3) or 90 (entities subject to Directive 2) days, as such payment may be considered as credit beyond the acceptable maturity date.
U.S. sanctions imposed on Russian and Ukrainian entities over the last year are complex and evolving in form as the situation in Ukraine develops. For instance, at the end of last year, the U.S. Congress passed the Ukraine Freedom Support Act, thereby codifying sanctions related to Ukraine. However, while the law mandates sanctions on Russian parties to some extent, it also largely continues to allow the President considerable discretion in applying such sanctions.
While the geopolitical uncertainty creates real challenges for companies doing business in the region, it is possible to continue to successfully operate and/or pursue new business opportunities in Russia provided proper due diligence is carried out and compliance measures are pro-actively applied.
ACE Portal, in association with NYSE, Brings Technology to Private Equity Fundraising – An Interview with the General Counsel
By Craig L. Godshall, Roger Mulvihill and Kevin P. Scanlan
In the Summer 2014 issue of the PE Newsletter we reviewed a private placement platform set up by ACE Portal, in partnership with the New York Stock Exchange, to facilitate the private placement of securities by issuers. The recent modification of the SEC’s rules on general solicitation and advertising, which formerly prohibited general solicitation and advertising in private placement offerings relying on Regulation D, has created an opportunity for intermediaries to introduce innovative platforms to access a larger universe of potential investors and streamline the offering process. Although initially set up to handle traditional company private placements, we pointed out in the article (and ACE confirmed) that the platform may be useful in raising funding for private equity and other funds. This opportunity may be particularly true for mid size funds ($200- $800 million) which often have difficulty raising money in the current market notwithstanding a compelling strategy and track record. The article generated a substantial amount of interest in private fund raising through the platform and we thought it might be informative to conduct a question and answer interview with the General Counsel of ACE Portal, Jason Behrens, with a focus on fund formation. Welcome Jason.
Jason: Thank you for including me as part of the PE Newsletter. Before joining ACE, I practiced extensively in the area of private fund raising and am pleased to discuss how ACE Portal can be useful in fund raising by PE and other funds.
Dechert: It’s probably useful at this point to briefly review the manner in which the platform operates. We understand that only placement agents, who are registered as broker-dealers (as virtually all are), may list a fund in formation on the platform.
Jason: Only SEC-registered broker-dealers who are members of FINRA can post a fund offering on the platform. Although not the focus of this interview, I should also note that ACE is equipped to handle all private placements that are represented by a broker-dealer, including both corporate equity and debt offerings, not just fundraises. Each of our agent members executes an engagement agreement with ACE that contains several representations from the agent regarding its good standing with FINRA, required licenses, approvals and registrations and clean operating history, similar to the representations contained in a standard placement agent agreement with a fund sponsor. Currently, over 65 registered broker-dealers have joined the ACE community.
Dechert: We know you are in the early stages of utilizing the platform for fund formations, but how many funds have been listed, and have any closed on all or a portion of their target raise yet?
Jason: We are in the early stages in terms of fund formations, primarily because ACE’s management team made the decision to focus initially on the corporate side of the platform to leverage their expertise and relationships garnered through decades of investment banking experience. That said, ACE has received significant interest from both fund sponsors and placement agents in our recent efforts to scale on the fund side. As a result of these efforts, we have managed to break into the upper echelon of funds, an aggregate of fourteen fund offerings have been listed, and a few such funds have closed. The ACE platform was not responsible for filling the entire book for these closed funds, but the goal is to have more investment dollars come through the ACE investor member network as we continue to mature in the funds space. We are still in the early innings.
Dechert: If a placement agent does not wish to utilize the platform for fund raising are there other features of the site which may be of interest such as downloading documents, verifications, etc.?
Jason: In addition to the fundraising tools, placement agents can utilize ACE’s technology to manage the private placement process. Agents can track and record investor attestations, upload and organize offering materials, manage document visibility and distribution, automate the confidentiality agreement process and access ACE’s full suite of communication management tools. ACE also provides a fully integrated data room and book builder, enabling placement agents to manage their process to a closed community of investors. We like to think of ourselves as a data room on steroids.
Dechert: One attraction of your platform is its identification with the NYSE and the potential to reach an investor base which may be beyond the reach of many sponsors and even placement agents. We understand the potential investor reach is in excess of $100 billion. How does that breakdown among high net worth (accredited) individual investors, family offices and institutions, fund of funds, etc.? Are there a substantial number of wealth managers interested in the platform?
Jason: Out of the potential investor AUM, a significant majority is backed by qualified purchasers and up (i.e., ultra high net worth investors, family offices and institutions). We have seen interest from several major wealth management firms, particularly in light of their recently stated goals to increase investment allocations to alternative assets. Note that in some cases, larger investment management firms that join ACE as one institutional investor member actually represent upwards of hundreds of millions (or even billions) of investment dollars on behalf of their clients.
Dechert: We understand that the investor base is worldwide including a substantial interest from Asia. Is ACE continually adding additional potential investors to the platform?
Jason: The platform was built with an initial focus on the U.S., both from the supply and demand side of the equation, but as we continue to receive interest from abroad, our efforts are expanding to the international arena. Thus far, the majority of foreign interest has originated from Asia and Europe, but we hope this will be a global phenomenon in the not-too-distant future.
We are early stage on the demand side of the platform, as we opted to build out supply first. We did not want to invite a plethora of investors to a platform with no product, as that would not bode well for repeat visits. The jury is out on whether we chose the chicken or the egg, but the pen is expanding nonetheless.
Dechert: We know this may be evolving, but how do you charge members of the ACE community?
Jason: Currently, the site is free for all investor members. Placement agents that list a fund on the platform have a choice between a flat posting fee and a monthly subscription fee. Both posting fees and subscription fees differ based upon a number of factors, including data usage needs. The posting fee is a one-time charge, regardless of the length of time to close. As we continue to grow, we remain flexible regarding fee arrangements and are happy to discuss each arrangement on a case-by-case basis. We currently do not charge success fees.
Dechert: We understand that ACE Portal/NYSE provides a platform but is not a registered broker dealer and is not responsible for, and does not review, the documents and other materials posted on the platform. Presumably this material is the responsibility of the placement agent and sponsor? Does a potential investor have access to the placement agent and sponsor? Can the placement agent and sponsor screen the potential investors it wishes to follow up with?
Jason: All documents and materials posted to the platform are reviewed and prepared by the placement agents and their fund sponsor clients. ACE does not offer or sell any securities, solicit investors for securities offerings, participate in the purchase or sale of any securities, assist in the preparation or distribution of offering materials or offer any advice in connection with any of the foregoing. As a result, ACE is not registered as a broker-dealer or an investment adviser. Each placement agent member’s contact details are accessible to potential investors so that they can reach out directly to ask questions and further discuss the investment opportunity as desired. Notably, while ACE does not vet investment opportunities posted to the platform, we do screen potential placement agents who seek to post such opportunities. Fund sponsor contact details are not typically provided, but the discretion to do so is left to the agent and its sponsor client.
Regarding investor screening, ACE Portal provides each placement agent with ultimate discretion over what, if any, additional vetting procedures it wants to subject potential investors to prior to providing access to the private data room. It is between the placement agent and its issuer client whether or not the issuer will have a role in such vetting procedures, but the platform itself is designed as a tool specifically for agents.
Dechert: Would the posted materials be similar to the documents utilized in any fund formation, including a private placement memorandum and subscription agreements?
Jason: That is correct; however, thus far, the information posted to a fund data room has been limited to a brief teaser document on the investment opportunity, a private placement memorandum, and an executive summary sheet or management presentation. The form of fund subscription agreement could also be uploaded to the data room for investor downloading.
Dechert: Whose responsibility is it to assure that investors meet the SEC test of “accredited investor” or “qualified purchaser”? Some portals with which we are familiar have attempted to incorporate this verification process through the platform, for example, investor tax returns or financials.
Jason: It is the placement agent’s, and ultimately its fund sponsor client’s, responsibility. As we are not a registered broker-dealer or investment adviser, ACE does not vet investors, ensure investor qualifications are met or determine suitability of any fund offerings. We do, however, provide information to our placement agent members that they can utilize in their vetting procedures if desired, including status attestations made by ACE investor members. Further, we are currently in discussions with a few third parties, the primary business of which is investor verification, and we envision incorporating this as an additional service to our agent and investor members.
Dechert: Fund raising for private equity firms can take many forms. We understand the platform could be used in a variety of fund raising situations. For instance, could a placement agent use it to fill out an offering where an anchor investor already exists? Could it accommodate side letters with different investors?
Jason: A placement agent can use the platform to fill out an offering where an anchor investor already exists. In fact, this is a use case we specifically envisioned as we developed the site. Given the host of marketing options provided to an ACE member placement agent, from keeping an offering invite-only, that is, using it purely as a data room and for its transaction management tools, and not for marketing to its proprietary investor member base, to marketing an offering solely to institutional investors, or opening it up to individual accredited investors, the platform provides placement agents with ultimate discretion and flexibility.
Dechert: Private funds offered on the platform will still need to comply with the Investment Company Act. Generally funds in formation rely on one of two exemptions under the Act: Section 3(c)1 which limits the beneficial owners in the fund to not more than 100 investors or Section 3(c)7 which limits the beneficial owners in the fund to qualified purchasers (generally an individual with a liquid net worth of $5 million or an institution with a net worth of $25 million). If Section 3(c)7 is relied upon, all investors must be qualified purchasers, that is, the sponsor cannot “mix and match” with accredited investors and qualified purchasers. Unless the investors are all qualified purchasers, a $200 million fund, for instance, would need to average $2 million per investor to stay below the one hundred beneficial owner limit of Section 3(c)1. Do you see this requirement as a significant limitation on use of the platform? In other words, do you think that the accredited investor base on the platform has an appetite for investments at this level? Or, alternatively, does it appear that there are enough potentially interested qualified purchasers in the investor base to qualify a fund under the 3(c)7 exemption?
Jason: These requirements do not pose any limitations on the use of the platform, as ACE’s placement agent members have complete flexibility as to whom they market their clients’ funds. As I mentioned before, agents can limit visibility to a fund’s offering on the platform to solely qualified purchasers if desired. While the platform does permit marketing to accredited investors, in our experience, we have observed that most placement agents tend to limit their marketing reach to qualified purchasers and up. Also, the majority of ACE investor members are, at a minimum, qualified purchasers. Moreover, as ACE is not a crowdfunding platform and is more institutional focused, we tend to attract investor members who are more accustomed to investments at this higher level.
Dechert: A number of potential sponsors who are interested in listing a fund in formation on the platform have asked us how they should proceed. Is there a way to identify placement agents who are comfortable with the ACE Portal/NYSE platform and interested in considering additional fund formation clients?
Jason: We are happy to speak with Dechert fund formation attorneys or their respective fund sponsor clients upon request to formulate a list of potential placement agents who could be a good fit for the particular fund sponsor. As a result of our members’ privacy/confidentiality requirements, we generally do not freely pass along a list of all of the agents that are registered members of ACE. In those instances where we have distributed a list of prospective placement agents, we have contacted each named agent in advance and received consent to pass along their contact details.
Dechert: Following the SEC’s decision to relax its rules on general solicitation, a number of other intermediaries have entered the market with platforms, often it seems as their own sponsored sites. What do you see as your competitive advantage?
Jason: The new legislation has definitely sparked innovation, and ACE is not alone in this burgeoning space. However, unlike our perceived competition, ACE, in association with NYSE, does not disintermediate or otherwise compete with placement agents. An SEC-registered, FINRA-approved placement agent must be engaged on every offering that is posted to the ACE platform. ACE does not enable issuers to go straight to investors, and ACE is not a crowdfunding platform. We believe that placement agents play an important role in the private placement process, ensuring a certain degree of regulatory oversight and providing potential investors with access to information that is necessary to making informed investment decisions, aiding investor protection generally.
Operating in affiliation with NYSE’s globally recognized brand and co-locating in NYSE’s iconic headquarters is invaluable to ACE as we strive to become the technology backbone for the private capital markets. Our partnership with the NYSE enables us to leverage NYSE’s expertise in driving transparent, efficient, and auditable processes in the public domain and apply it to the private context. As new technology platforms emerge in this vibrant and evolving space, ACE’s relationship with NYSE will continue to be a unique differentiator for market participants.
Dechert: Thank you, Jason, for a very informative presentation.
Impact of the Cigna Health Decision on the Use of the Merger Structure in Private Acquisitions
By Carmen J. Romano and Kevin M. Silk
When buying a private company controlled by a private equity sponsor but with a substantial number of other shareholders, a common technique to avoid the need to obtain signatures from all the shareholders to a stock purchase agreement is to effect the transaction by way of a merger, that once approved by the requisite shareholders, binds all shareholders to the transaction. The recent Delaware court decision in Cigna Health raises some challenges that practitioners will need to manage when using the merger structure. Since all shareholders would not be signing the merger agreement, it was also common to require a shareholder to submit a signed letter of transmittal as a condition to receiving its merger consideration, and to include in the letter of transmittal not only a representation regarding ownership of the stock being tendered, but also an agreement to be bound by various post-closing obligations, such as indemnity obligations, appointment of a shareholder representative to settle indemnity claims or post-closing purchase price adjustments, and a release of all claims against the transaction participants other than for the merger consideration. In some instances, we have even seen efforts to include non-compete and non-solicitation covenants in letters of transmittals.
The recent decision of the Delaware Court of Chancery, Cigna Health and Life Ins. Co. v. Audax Health Solutions, Inc.,1 has called into question the continued viability of this technique by holding that certain post-closing indemnity obligations and shareholder release provisions in the letter of transmittal were unenforceable against Cigna. However, the Court’s holding was narrowly tailored to the facts of the case, and while Cigna may have created more questions than it answers, through practical techniques and diligent planning, buyers can mitigate the effects of this decision.
In Cigna, the Court held two provisions of the intended merger structure unenforceable against a non-signatory shareholder of the acquired company; (a) a post-closing indemnity obligation to the extent that it put 100% of the merger consideration at risk of repayment to the acquiror for an indefinite period of time and (b) a broadly-worded shareholder release in a letter of transmittal that was sent to shareholders after the merger was consummated. Regarding the shareholder release, the Court determined that the shareholder is entitled by law to the merger consideration as a pre-existing duty that arises and vests upon the closing of a merger. Therefore, there was no additional consideration flowing to shareholders asked to sign a letter of transmittal in order to receive their pro rata portion of the merger consideration. Since the release was not supported by consideration, the Court ruled it unenforceable. The Court rejected the argument that the release was “part and parcel of the overall consideration” since the release was not even mentioned in the merger agreement.
The Court expressly limited its determination that the post-closing indemnity obligations were unenforceable in this instance because the combination of the uncapped indemnity and perpetual survival period placed a non-signatory shareholder’s entire merger consideration at risk for an indefinite period of time. The Court found that Section 251(b)(5) of the Delaware General Corporate Law requires stockholders be able to ascertain the value of the merger consideration either precisely or within a reasonable range of values, at or about the time of the merger. This allows dissenting shareholders to evaluate the merger and knowingly choose between accepting the merger consideration or exercising their appraisal rights. Since the indemnification survived indefinitely and could encompass all of the merger consideration, there was no point in time at which the merger consideration in this case could ever become firm or determinable, and thus, according to the Court, violated Section 251(b)(5) and was unenforceable. The Court distinguished the facts of this case from those in Aveta, Inc v. Cavallieri,2 which held that a post-closing price-adjustment was permissible under Section 251(b)(5), because in Aveta the adjustments were based on the company’s financial statements and did not place all the merger consideration at risk for an indefinite period of time. While the Cigna opinion lacked clear guidance on when provisions that put merger consideration at risk would be invalid, Vice Chancellor Parsons took pains to point out that the opinion was limited to the facts of the case and did not address the validity of indemnification obligations limited to amounts held in escrow, the general validity of post-closing price adjustments, or whether price adjustments that cover all of the merger consideration may be permissible if time-limited or whether non-time limited price adjustments as to some portion of the merger consideration would be valid.
Our view is that the decision on the indemnity obligation would have come out differently if the indemnity was subject to a reasonable cap and time period. Nevertheless, until Delaware courts provide further guidance, practitioners need to be mindful of the decision and to the extent possible structure around it or take steps to mitigate its impact. We offer below some techniques to consider:
- Secure support agreements and joinders from as many shareholders as possible prior to the closing and/or as a condition to the closing. The Court has made clear that even in the merger structure, “individual stockholders may contract–such as in the form of a Support Agreement–to accept the risk of having to reimburse the buyer over an indefinite period of time for breaches of the Merger Agreement’s representations and warranties.”
- Require shareholders that do approve the deal to be responsible for more than their pro rata share of indemnity obligations in the event some shareholders are non-signatory. This could be particularly useful with respect to “fundamental” representations, which are more likely to be uncapped and indefinite.
- Mandate control shareholders to exercise any available drag along rights before closing.
- Where possible, rely on an escrow/holdback of a portion of the merger consideration to satisfy representation and warranty indemnity obligations or a purchase price adjustment. Similarly, provide expressly for offset rights against post-closing payouts for deals that have earnouts and other forms of contingent consideration.
- Specify in the merger agreement that a portion of the merger consideration will be withheld as additional consideration for the acceptance and agreement to the terms of the letter of transmittal.
- Draft the merger agreement to include, with particularity, all contemplated post-closing target shareholder obligations and releases and state in the merger agreement that the purchase price is in consideration for and based on the expectation of enforceability of these obligations and that shareholders will be required to submit a letter of transmittal agreeing to these obligations as a condition to receiving the merger consideration.
- Describe in the merger agreement any post-closing indemnifications as obligations that give rise to clawback rights of the acquiror against the merger consideration and as integral factors of and limitations to the merger consideration.
- Agree upon temporal limitations for specific representations and warranties and limit the total exposure to an agreed upon percentage that is less than 100% of the total merger consideration to increase the likelihood of enforceability.
Secure representation and warranty insurance to mitigate the risk that the agreed upon remedies are deemed unenforceable.
1) Cigna Health and Life Ins. Co. v. Audax Health Solutions, Inc., et al, Del. Ch. Nov. 26, 2014.
2) Aveta, Inc. v. Cavallieri, 23 A.3d 157 (Del Ch. 2010).