· A Private Equity Fund (‘PE Fund’) is:
- A fund set up for the purposes of investing in unlisted securities.
- Note: This may include ‘taking private’ a listed company through a successful takeover process.
· In its simplest form, a private equity fund (the ‘Fund’) gathers money from a number of different investors and then seeks out opportunities for investing that money in order to make a return (both in income and capital growth) on that money, for the investors. Investors in private equity funds include high net worth individuals and institutional investors such as banks, pension funds and insurance companies. At any time, a single Fund will hold investments (usually shares and loan notes) in a number of different companies.
· These companies are commonly referred to as the Fund’s ‘portfolio companies’.
- What fund vehicle is used for a PE Fund?
· The typical structure used by a PE fund in the UK is a Limited Partnership. The key elements of the structure are:
* A General Partner (GP) The GP has full responsibility for operating the limited partnership. It has unlimited liability for its debts and obligations.
- Limited Partners (LPs) The LPs have limited liability unless they take part in management of the partnership business.
- PE Funds also have a limited lifespan (typically 10 years plus 2 extensions of 1 year) within which investors’ money will be returned to them (as the structure is closed ended).
· The key benefits of using this structure for a fund are:
* an investor role with limited liability and no active management rights;
* flexibility and privacy – as the agreement forming the partnership will not be public and accounts are not required to be filed; and
* tax transparency.
· Generally speaking, there are three main types of private equity (or private capital) activity:
- the funding of a new business with little or no track record: Venture Capital;
- the funding of an existing, more mature business to help it develop: Development Capital; and
- the funding of purchases of established businesses where there is still a margin for improvement of performance (somewhat confusingly, the term private equity or PE is often used synonymously with these transactions. However, the term ‘private capital’ is becoming a more common general term).
- The acquisition vehicle
· The Fund will set up an acquisition vehicle (a newly incorporated company or group of newly incorporated companies) into which it invests which will acquire the target company or business (‘Target’). The company into which the Fund invests is known as ‘Topco’ in this knowledge stream.
· Often, the Fund will set up a second company as a wholly owned subsidiary company of Topco that will be the acquisition vehicle (‘Bidco’).
· The corporate structure is typically tax driven and can be complex - often involving more than two newcos in the chain and/or companies incorporated in jurisdictions outside of the UK.
two newco structure
- Following the buy-out, the management (whether existing or new management) (‘Management’) will devote their time and efforts to make the bought-out business successful.
- Sometimes, the Management will be compensated for their time and effort by means of salary and bonuses alone but frequently the Management will also subscribe for equity shares in Topco so that if the venture proves successful, they can receive a proportionate part of the capital gain in value of the bought-out business.
· Virtually all buy-outs use a certain amount of ‘leverage’ or debt finance, using the assets of Target as security. Sometimes you will hear of a buy-out being referred to as a leveraged buy-out (‘LBO’). This debt funding sits alongside the funding put into the structure by the Fund (so-called ‘equity funding’)
- Standard buy-out structure
· Before completion
* Prior to completion, lawyers acting for the Fund (where the transaction is initiated and driven by the Fund) will arrange for the transfer of two shelf companies (‘Topco’ and ‘Bidco’) into the ownership of the Fund by transferring the subscriber shares in Topco to the Fund and by transferring the subscriber shares in Bidco to Topco (so that Bidco becomes a wholly-owned subsidiary of Topco).
* If the transaction is being driven by Management their lawyers will set up Topco and Bidco with Management holding the subscriber shares.
* The bulk of the investment in Topco by Management and the Fund and in Bidco by the bank will not occur until completion. Bidco will be the company which actually purchases the Target. Until completion, the Target is still owned by the existing owners (‘Seller(s)’).
· After completion
* At completion, the funding of Topco and Bidco, the acquisition of shares/assets in the Target by Bidco and the granting of security by Bidco (and Target, where the shares of Target have been acquired) to the bank will happen simultaneously.
* The investment from Management and from the Fund will go into Topco. This money will be passed from Topco to Bidco, either by way of an intragroup loan or by Topco investing in further shares in Bidco.
* The bank will lend money to Bidco. In return for the loan to Bidco, the bank will expect to be given security over the assets of Bidco and the Target (where the shares of Target have been acquired). Once the monies are in place, the acquisition of Target by Bidco can be completed. The bank will usually expect Bidco’s borrowing to be guaranteed by Target (where the shares of Target have been acquired).
· Whilst the Fund may well achieve an income return in the form of dividends or interest from Topco, the major return on the investment by the Fund will be the capital return achieved upon ‘Exit’. A successful Exit occurs upon one of the following occurring:
- the IPO of Topco on a recognised exchange; or
- the sale of Topco to a trade buyer; or
- a secondary buy-out (where one Fund buys from another) or further buy-out.
· Most successful Exits occur between three and seven years after the acquisition of the target by Bidco. Where the venture proves to be unsuccessful, the Exit will probably be by way of either:
- a sale of the Fund’s equity in Topco to Management; or
- an administration or insolvent liquidation of Topco.
- Parties in the MBO/MBI
· Private equity fund ‘Fund’
· Seller
· Lawyers for the private equity fund/borrower.
* Prepare and negotiate the acquisition documents on behalf of Bidco. Negotiate the loan facilities agreement, any intercreditor agreement, equity documentation.
· Lawyers for the lenders.
* They prepare security documentation, fee letters; ancillary finance documentation and review the due diligence to assess their risk.
· Lawyers for management team.
* Advise on structure of management’s equity investment and negotiate key documents.
· Accountants. T
* he Fund will appoint accountants to carry out full accounting due diligence on the target and to analyse and report on the Management’s business plan and financial projections.
· The lenders.
* The lenders are often a bank, a second lender or a credit fund or small club of lenders.
· Seller’s solicitors.
* They conduct negotiations for the sale of the target.
· Management team.
* Core directors of the target or external team put together by the Fund.
- So how do the parties decide how much of the value of Topco should go to the management and how much should go to the Fund?
investment
· The Fund will work out how much it wants to be able to earn from the investment and this will be expressed as a target ‘internal rate of return’ (‘IRR’). The Fund will want to ensure that the Management are sufficiently incentivised to work hard to make a success of the venture so that the Fund receives the required IRR on its investment. This incentivisation of the Management in a buyout can be achieved by devising a mechanism known as a ratchet whereby the Management’s proportion of the equity on an Exit will be adjusted according to the actual success of the bought-out business and the value at the Exit.
· The parties will agree the proportion of the equity to which the Management should be entitled if the Fund’s required IRR is achieved at the time of the Exit. If the venture proves less successful and the Fund’s IRR is lower, then the Management’s share of the equity will be reduced accordingly.
· Once the parties have agreed the proportion of the equity to which the Management should be entitled if the Fund achieves its required IRR, the share structure will be organised so that the Management subscribe for that proportion of the ordinary share capital. The Fund will then subscribe for the remaining ordinary shares.
· The rest of the money to be invested in Topco by the Fund will either be in the form of convertible preference shares or convertible loan notes which may be converted into ordinary shares in accordance with the provisions of the ratchet, depending on Management’s overall entitlement once the performance of the target has been reviewed.
· The class rights associated with the shares in Topco and the terms of the ratchet will therefore be the subject of much negotiation. Note that ratchets can operate in a variety of different ways and that this is just one example.
· Ratchet provisions will normally be found in the Articles of Topco or alternatively, in the Investment/Subscription Agreement.
* Less likely to be in articles because amended articles will have so be filed making them public docs
- Interest relief on borrowings made by the management – conditions for set off
- there must be a loan to an individual which is applied in acquiring shares. These shares must be ordinary shares within the meaning of section 160 of the Corporation Tax Act 2010;
- at the time the shares are acquired, the company in which they buy the shares (in this case, Topco) must be a close company. This means, broadly, that Topco must be controlled by five or fewer participators or by shareholders all of whom must be directors of the company. It does not matter if it ceases to be a close company soon after the investment;
- throughout the accounting period in which the investment is made by the management and subsequently in all periods in which the interest is paid on the loan, the company must exist for the purpose of carrying on a commercial trade or holding shares in or securities of or making loans to subsidiaries that exist wholly or mainly for the purposes of carrying on a commercial trade; and
- throughout the period between the loan being made and the interest being paid, the individual must either have owned shares in the company and worked for the greater part of their time in the actual management or conduct of the company (or an associated company) or hold a material interest (broadly 5 per cent or more) in the company. In the case of management, the former condition is likely to be satisfied.
- Interest relief on borrowings made by the management
· The requirement that Topco is a close company when the investment is made is generally satisfied by ensuring that when Topco is set up or taken off the shelf, the management invest nominal sums in proportion to their intended equity investment (the Fund will not hold any shares in Topco at this time). Provided that more than 50% of the shares in Topco are held by five or fewer managers or held by management who have been appointed directors of Topco, this will ensure that Topco qualifies as a close company.
· The managers then borrow the necessary amounts and subscribe the vast majority of their investment at completion, in return for a new issue of ordinary shares in Topco. Immediately afterwards, the Fund subscribes for its shares in Topco. At this point Topco may cease to be a close company, but this sho
- Potential income tax and national insurance liability in connection with shares acquired by management
· The management will want to minimise their liability to income tax charges in relation to their shares in Topco. Since the management are acquiring their Topco shares by reason of employment, if they pay less than full market value for their shares, they may be subject to income tax on the difference between the market value and the amount they pay. If income tax becomes chargeable in relation to these shares, there may also be a corresponding liability for Topco to pay employer’s national insurance contributions. Therefore, it is important that the management pay full market value for their Topco shares.
· Furthermore, if the management’s shares are subject to any restrictions on the management’s ability to deal with them, including restrictions which are quite normal in a buyout such as good leaver/bad leaver provisions, the shares will be ‘restricted securities’.
· In this case, there is a risk that the management will either be required to pay more income tax on acquisition of the shares or will suffer a further charge to income tax at a later date, for example on a sale of the management’s shares or if the restrictions on their shares are lifted or varied.
- Safe harbour provisions
· A Memorandum of Understanding between the British Venture Capital Association and HMRC (commonly referred to as ‘the MOU’) deals with the income tax treatment of managers’ equity investments in venture capital and private equity backed companies. The MOU contains the provisions of a ‘safe harbour’. It sets out a number of tests to be applied in a buy-out situation.
· If all of the tests are satisfied, then HMRC will accept that the management have paid full market value for their Topco shares and that no income tax charges will arise in relation to the management’s shares, either on acquisition or at a later date.
· The tests which must be satisfied vary depending on whether the shares are subject to ratchet arrangements or not. The purpose of these tests is to ensure, so far as possible, that the only financial benefit the management obtain through holding their shares in Topco is the capital gain genuinely arising as a result of the increase in value of the target over the period of the investment and to ensure that the reward the management receive in consideration for their work for the company is only provided in the form of salary and bonuses, which will be paid under the PAYE system and thus chargeable to income tax and national insurance contributions.
- Where the shares are not subject to ratchet arrangements
· The following conditions must be satisfied:
- the management’s shares must be ordinary share capital;
- where leverage is provided (for example by way of preference shares or loan notes) by any other holder of ordinary share capital (generally the Fund), this must be on commercial terms;
- the management must acquire their shares at the same time as the Fund. You have already seen that the management subscribe for their shares just before the Fund to ensure that the management can claim interest relief on the amounts they have borrowed to fund their investment. This satisfies the ‘same time’ test for the purposes of the MOU;
- the management must be fully remunerated for the work they do by salary and bonuses through a separate employment contract;
- the price paid by the management for their ordinary shares must not be less than the price paid by the Fund for its ordinary shares; and
- the management’s shares must not have any features that give them rights not available to other holders of ordinary share capital.
- Where the shares are subject to ratchet arrangements
· Conditions 1 (ordinary shares), 2 (leverage on commercial terms), 3 (simultaneous acquisition of shares) and 4 (remuneration through salary and bonuses) on the previous slide must still be satisfied and in addition:
- the ratchet arrangements must vary according to the performance of the company and not of the individual shareholder (in other words they must not operate as a quasi bonus scheme dependent on individual performance);
- the ratchet arrangements must exist at the time the Fund acquires its ordinary shares; and
- the management must pay a price for their shares that reflects the maximum economic entitlement they could achieve under the ratchet.
· This last requirement means that the management will have to begin with their maximum potential proportion of the equity, which will then be reduced through the ratchet if at the time of the exit, the target has not achieved the relevant performance targets.
How can companies dedeuct tax and how is this restricted?
- Management are permitted to set off the interest they pay on their borrowings against their income for income tax purposes provided certain conditions are met including the requirement that the shares are ordinary shares and Topco is a close company.
- Management should ensure that they pay full market value for their Topco shares to minimise their income tax liability. However, if the shares are subject to restrictions, then there is a risk of further income tax liability.
- The safe harbour provisions in MOU provide that no income tax charges will arise in relation to management’s shares provided certain tests are satisfied.
- The transfer pricing rules means that a company’s ability to deduct interest payment against taxable profits is restricted
You act for a management team of 6 in a proposed management buy out of a private limited company (‘Target’). The management team have secured investment from a private equity investor (‘Fund’) and the buy out will utilise a double newco structure. Each member of the management team will be a director of Topco and in return for their investment will each own ordinary shares representing 4% of Topco’s issued share capital with the Fund owning the remainder. One member of the management team (‘Manager’) intends to take out a bank loan to fund her investment.
What advice should you give to the Manager about her ability to set off the interest she pays on her bank loan, for income tax purposes?
The Manager is likely to be able to claim interest relief.
The Manager is unlikely to be able to claim interest relief as the Manager will not hold a material interest in Topco.
The Manager is unlikely to be able to claim interest relief asTopco will not be a close company at the time the Manager acquires the shares.
The Manager is unlikely to be able to claim interest relief as Target, not Topco, will exist for the purpose of carrying on a commercial trade.
The Manager is likely to be able to claim interest relief.
Correct. Whilst the other options might sound plausible, they are each incorrect. Each of the conditions required for the Manager to be able to claim interest relief have been satisfied or the transaction can be structured in such a way to ensure the conditions are satisfied.
You act for the management team in relation to a management buy out of a private limited company which specialises in the manufacturing of electrical components for cars (‘Target’). The structure of the transaction will involve a new company (‘Newco’) being set up to buy the shares in Target. Your client has considered various funding options for the purchase of Target including a bank loan to Newco in relation to which the best interest rate it has been offered is 4.4%. The management team have ultimately decided against the bank loan and have secured financial investment into Newco from a private equity fund (‘Fund’). The Fund have agreed to make their investment into Newco in return for ordinary shares and convertible loan notes with an interest rate of 6.3%.
What advice should you give to your client in relation to the tax deductibility of the interest payable by Newco on the convertible loan notes?
Newco is unlikely to be permitted to deduct interest paid to the Fund on the convertible loan notes from the taxable profits of Target.
Newco is likely to be permitted to deduct interest at a rate of 4.4% paid to the Fund on the convertible loan notes from the taxable profits of Target.
Your client is likely to be permitted to deduct interest at a rate of 1.9% paid to the Fund on the convertible loan notes from the taxable profits of Target.
Newco is likely to be permitted to deduct interest at a rate of 6.3% paid to the Fund on the convertible loan notes from the taxable profits of Target.
Newco is likely to be permitted to deduct interest at a rate of 4.4% paid to the Fund on the convertible loan notes from the taxable profits of Target
Correct. Whilst the other options might sound plausible, they are each incorrect. The transfer pricing rules mean that if the rate of interest that Newco has agreed to pay on the loan notes held by the Fund is higher than it would have agreed to pay to a third party bank on arms length terms, HMRC may disallow the difference between the two interest rates as a tax deduction.
You act for a private equity investor in relation to a management buy out of a private limited company (‘Target’). The structure of the management buy out will consist of the management team and your client investing into a new company (‘Newco’) which will then acquire the shares in Target. The parties have agreed that ratchet provisions will apply. Before the operation of the ratchet, the management team will collectively own 10% of the entire issued share capital of Target and your client will own the remaining 90%. After the exercise of the ratchet, the management team will own 8% of the entire issued share capital of Target and your client will own the remaining 92%. Your client is currently negotiating the provisions of the investment agreement and wants to ensure that it will have the option to exit by way of a share sale in 3-5 years.
What advice should you give to your client to ensure that it will have the option to exit by way of a share sale in 3-5 years?
Your client should include drag along provisions that are effective once an offeror has offered to buy 92% of the share capital of Target.
Your client should include tag along provisions which will allow your client to force the minority shareholders to sell their shares provided your client accepts an offer from the offeror to buy its shares.
Your client should include drag along provisions that are effective once an offeror has offered to buy 90% of the share capital of Target.
Neither drag along nor tag along provisions would assist your client in this scenario.
Your client should include drag along provisions that are effective once an offeror has offered to buy 90% of the share capital of Target.
Correct
Correct. Your client will want drag along provisions inserting into the documentation and will want them to apply in relation to pre-ratchet thresholds in case the ratchet is never triggered. Tag along provisions benefit the minority shareholders rather than the majority shareholders.
