Navigating the Legal Terrain of Private Equity
Core Concepts in Private Equity Law
General information regarding the investment and operating practices of private equity groups helps identify the key issues to consider when facing a private equity investor. The term "private equity" is a widely used in the industry to describe investments in a variety of instruments and businesses, although its most common form is buyout funds.
Private equity funds are typically limited partnerships formed by investors, including financial institutions, insurance companies, pension funds, funds of funds, sovereign wealth funds and families. Often areas in the fund’s target region are off limits to investments. Private equity funds are managed by their principals and limited partners, based on a partnership agreement. A private equity fund raises capital from a relatively smaller number of institutional investors whose size of individual contributions are large, while an investment bank will raise many smaller amounts from a much larger number of public-market investors through an IPO or follow-on offering . Because there aren’t many investors in a private capital fund, a majority vote of the limited partners is required for the fund’s management to take any action requiring consent, such as extending the initial investment period or selling the fund’s portfolio companies. Private capital funds tend to invest a wealth of resources and efforts into conducting honest and exhaustive due diligence and analysis of prospective acquisitions.
Private equity funds invest in a portfolio of companies, typically eight to ten if the fund needs to make three acquisitions per year for a period of five years – a typical fund’s investment horizon. Such funds still manage to diversify risks through their investment strategy of targeting multiple companies within the same industry that are all at different stages of their life cycle. This is accomplished through the use of co-investors, who can take over portions of additional deals that arise.
Legal Structures Common in Private Equity
Private equity is often structured using a variety of legal entities that create distinct and complex layers for all parties involved in the structuring. While explanations of all private equity fund structures are outside the scope of this article, the most commonly used structures are described below.
Limited Partnerships
When a private equity fund is organized as a limited partnership, an experienced fund manager typically acts as the general partner and one or more other investors act as limited partners. The role of the general partner is to provide management, expertise, and guidance in the investment decisions of the partnership. Conversely, the limited partners monitor the general partner and receive distributions based on the size of their initial capital contributions. All distributions to the limited partners are generally considered a return on their capital investment (as opposed to ordinary income). However, income and losses are typically allocated to all partners.
Limited Liability Companies
These funds can take the form of a private equity fund (generally taxed as a partnership) that is organized as an LLC. An LLC is a hybrid legal entity, and often viewed as a hybrid between a corporation and a partnership, that limits the liability of its members. Most investors prefer the LLC structure because it provides them with limited liability. Similarly, investment managers prefer the LLC structure because it provides them with protection from personal liability. Like the limited partnership structure, income and losses are allocated to members (typically based on the size of their capital contributions).
Investment Management Companies
In this structure, which is often used by more sophisticated fund managers and investors, the investment manager creates two different entities: a limited liability company in which the investment manager is the sole member and that acts as an investment manager to the RIC, and the RIC itself. In contrast to the management company model used by real estate funds, this structure does not contain two legal entities, the investment manager and the management company. This structure also has tax and regulatory advantages because it enables the investment manager to receive capital gains without paying separate entity level tax, placing the investment manager in the same tax position as its RIC clients.
The Regulatory Environment for Private Equity
Due to the potential for systemic risk, vast unregulated public exposure and the possible significant impact private equity activity can have on the economy, private equity is subject to numerous regulations. These regulations are designed to protect investors, safeguard the infrastructure and confine systemic risk to particular sectors of the economy. A number of traditional regulatory bodies such as the Securities and Exchange Commission (SEC), Federal Reserve and the Financial Industry Regulatory Authority (FINRA) oversee a portion of the private equity market. More recently, new oversight bodies and additional regulations have emerged. Prominent regulators include the SEC, the Federal Trade Commission (FTC), the Commodities Futures Trading Commission (CFTC), FINRA and various state bodies.
Private equity is regulated under several federal laws including: the Investment Advisers Act of 1940 as amended (Investment Advisers Act), the Investment Company Act of 1940 as amended (Investment Company Act), the Securities Act of 1933 as amended (Securities Act), the Securities Exchange Act of 1934 as amended (Exchange Act) and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank).
The Investment Advisers Act regulates the activities of private equity advisers. It requires those advisers that meet certain criteria to register with the SEC and adhere to a number of requirements and regulations. The Investment Advisers Act contains substantive and procedural provisions such as prohibiting fraud, creating disclosure rules and regulating advertising. Private equity advisers also include the Federal Trade Commission’s authority in the regulation of private equity.
The Investment Company Act regulates the activities of private equity funds that meet certain certain criteria. Private equity funds typically fall under one or more of these exemptions from registration, but must nevertheless comply with certain regulatory disclosure and corporate structure requirements. The Securitization Director oversees the compliance of the Private Equity Funds under the Investment Company Act.
The Securities Act primarily focuses on the sale of securities. It does not provide direct supervision to the private equity markets, but does regulate the sale and disclosure of certain private equity fund interests.
Similar to the Securities Act, the Exchange Act provides another avenue for federal oversight of private equity. It provides supervision over the sale and disclosure of certain private equity fund interests. The Exchange Act also supervises the secondary trading of certain private equity fund interests.
The Dodd-Frank Act was enacted as a response to the 2008 financial crisis. It created one of the most extensive changes in U.S. financial regulation in decades. It established the Financial Stability Oversight Council and the Office of Financial Research, significantly increased the authority of the SEC and restricted the Federal Reserve System’s supervision of nonbank financial institutions. It also increased the authority of other federal institutions. Both the SEC and the CFTC gained new rules and responsibilities regarding the regulation of private equity funds.
Numerous state laws also regulate private equity, including those in the financial services industry. Individual states may impose stricter requirements than the federal government. For example, these laws may require registration and licensure in each state a firm plans to solicit business. Additionally, SEC rules allow states to audit the records of investment advisers who have private equity interests and sell them locally.
Legal Due Diligence in Private Equity Transactions
Legal due diligence is a critical component of the private equity transaction process. It enables investors to thoroughly assess the risks and opportunities associated with a target company prior to a deal being finalized. A successful due diligence process minimizes the exposure to any legal liabilities and sets the foundation for a successful transaction or investment.
The due diligence process initiates after the initial valuation of the target facility and prior to a purchase agreement being executed. The purpose is to identify and analyze any legal, commercial, financial or political concerns that may affect the sale of the company or would influence the decision to continue with the investment. It facilitates obtaining a complete picture of the company’s status and informs the investor of any necessary investments and/or negotiating points that should be considered by the time the transaction closes.
The legal due diligence process can be broken down into the following steps:
– Interview key personnel – identify the legal reasons for the acquisition and familiarize yourself with the company’s history.
Identify the scope of the due diligence – establish what documents are required, who will provide them, when they will be provided and how they will be reviewed.
Conduct the review process – make a thorough point-in-time examination of the legal documentation and review/assess all statutory and regulatory disclosures and compliance.
Inform the buying company – present a clear report of your findings and inform them of any major issues or concerns that may be present.
- Provide your advice and recommendations for areas of concern.
- Finalize your report – set out the observations and concerns in formal legal documentation.
- Ensure that all post-closing obligations are met – supervise the execution of the sale by ensuring all funding and other obligations are satisfied.
Legal due diligence is the cornerstone of all private equity transactions and should not be taken lightly. It is through this that you can ensure you have thoroughly addressed all possible issues and concerns, and that you have all the information required to make an informed and educated decision on whether to proceed with the transaction, or if you need to negotiate modifications to the deal.
Negotiating Contracts in Private Equity
The legal aspects of negotiating private equity agreements are critical to the success of any investment strategy. In most cases, it is the minority stakeholders who do not negotiate the terms and conditions. However, it is always beneficial to know what is popular and what is not, and what is possible and what is not.
Investors will discuss their various rights in different ways but common terms will include:
A. Drag Along Agreements – usually in the form of clause in the by-laws or articles or incorporation.
B. Rights of First Offer/Refusal – where a given group of stakeholders must approve the purchase first.
C. Put and Call Options – the right to sell or buy back an investment at a certain point in time.
Term "Drag Along" means that an existing stakeholder can sell a given portion of its interest even though the buyer would prefer to buy the entire stake. In the event of a sale of the targeted company, the minority shareholders have to ‘drag along’ or ‘follow along’ with the majority – in this case, they must follow along with the sale.
If initially unimpressed with the deal offered, the investor can ask the company for a draft of their private placement memorandum showing how the deal is structured and how the equity, within the company, is being subdivided, and what the investments are being allocated to do within the company. There will be a discussion of terms and conditions in order for everyone to decide whether the deal makes economic sense.
The documents give details on economic interests and how shares are being or will be distributed and will also show how the equity is going to be divided. Equity is the ownership stake and interest within the company.
Once an investor decides to make an investment in order to acquire equity in the private equity investment fund, a subscription agreement is then executed. This is a way for the investing party to subscribe to a given fund and acquire a proportional stake in the fund.
There should also be a limited partnership agreement. In a limited partnership agreement, there will be a general partner and investors will be limited partners. There are also limited liability companies where there are members and managers. The two types of funds are very similar. The agreement typically shows what powers each person within the arrangement has.
The fund structure is a blackbox structure where the general partner selects the "black box" or fund in which to invest . The general partner selects overall investments but may use a third-party – a portfolio manager, to manage the investments. The general partnership may also designate an allocation committee. The portfolio manager makes investments on behalf of the selected hedge fund. The general partner is the one who has control over the fund and the investor is along for the ride. This is not unusual. In many scenarios, a consulting firm is also utilized. The fund of funds manager might focus on several different types of investing including:
- Private equity funds
- Hedge funds
- Combinations of the two
The investor is another player in the mix – the proponent or promoter of the fund which has taken outside capital. The general partner is able to make broader or narrower investments. These investments can be in long positions or short positions. With long positions, more revenue or income is expected. Shorting is where an investor bets that a certain position will fall in value. A short-seller is a seller first before acquiring the position in order to bet that the value will fall. In a falling market, the same stock will be "bought back in" at a lower price.
Fund structures are typically very blackbox in nature (mystery). Investing in funds is unlike investing in hedge funds, where the investor is more likely to know and can make decisions. In a fund structure, investors do not know where their capital is going to be invested. Newer investors, especially if they are investing in the private equity fund for the first time, will ask about the strategies, the fund’s guidelines, and what they are targeting. Investors will also want to see the results of previous funds. The investor will typically want to know the gross returns of previous funds.
One of the key strategies in private equity is buying and holding. As a result, the investment funds of a private equity fund can last up to ten years. The investor is in the mix for ten years and will see returns/distributions in that time. The investor is only responsible for the capital that was initially used to fund the investment.
Investors will want information on how quickly the money can be called. In a typical agreement, the investment will be called down and a shorter time frame (3 to 5 years) is common. An investment fund agreement can explain whether an investor has the right to have excess cash returned immediately. Other terms of the agreement may stipulate capital returns once a certain amount of capital is called down.
Private Equity and Intellectual Property
Intellectual property (IP) laws can have a major impact on the value of private equity investments, particularly in tech-centric or innovation-driven private equity. According to Deloitte’s Global Private Equity Outlook, some of the most significant expected M&A trends in 2018 include digital transformation and disruptive technologies. Given the central role of IP in the digital economy, these trends are not likely to reverse anytime soon. While the valuation of many traditional assets often falls into a consensus range between buyers and sellers, valuations of IP are much more subjective. For example, in a transaction where one party overestimates the value of the target company’s IP, the other party might end up footing the bill for its target’s excess optimism.
Many private equity firms rely on general IP terms and conditions in their portfolio company deals, however these provisions may not be sufficient for those investing in tech-driven assets. Instead, specific IP provisions should be tailored to protect important IP components, such as algorithms or technical know-how, which are key to the success of many technology businesses.
All private equity funds should have an established IP due diligence checklist and an IP terms and conditions list. Often, these lists are tailored to the specific investor and the particular deal. But even if general lists are used, they provide a foundational level of protection to deal teams.
It is also important to involve a good IP attorney early in the due diligence process. The IP attorney will be able to help answer critical questions like:
Often, the due diligence phase will identify issues that can be fixed in the purchase agreement IP provisions. While some terms and conditions are standardized, others are unique to the company’s specific technology. Finding industry-specific terms that apply to the deal will help provide a good deal of protection during the closing process of the deal.
Arranging legal transactions strategically is a critical component in a smart private equity transaction. Protecting your investment in IP assets will prevent hiccups down the line, especially if those assets are sizable portions of the business.
Exit Strategies and Legal Issues
As investors pursue an exit strategy, they will often find that the legal considerations surrounding it are far more complex than anticipated. Whether an investor pursues an IPO, a buyout or a merger, understanding the legal framework of such a transition is essential. Otherwise, there is the possibility for regulatory hurdles to cause issues or for investors to inadvertently expose themselves to unnecessary risk by failing to establish the appropriate agreements early on in the process.
Because most private equity strategies center around the eventual sale of assets, the focus on exit strategies is nothing new. In fact, the number of buyout agreements executed in the past four years is estimated at around 4,000, and with recent instability in the market, it is believed that as many as 2,000 more are still to come. In the face of so many opportunities for such agreements, however, few investors have any real familiarity with what exit strategies entail because it is rare that a business is sold before a private equity fund is required to return its investment to its limited partners (LP).
Without the benefit of this experience, it is easy for investors to overlook critical details that may expose them to long-term liability. With that in mind, this post will outline the exit strategies that private equity investors typically consider and highlight the general legal challenges that accompany them.
Emerging Legal Standards in Private Equity
Emerging legal trends in private equity may be shaped by the evolving impact of technology, environmental, social, and governance (ESG) considerations, and changing regulatory landscapes. The growing pervasiveness of technology in private equity transactions – from data analytics in due diligence to blockchain in portfolio companies – will require a deeper expertise from legal counsel. As technology becomes more integrated into private equity , a strong understanding of how to leverage such technology for legal and commercial purposes will be highly sought after.
The increasing focus on ESG considerations presents both challenges and opportunities for legal advisors to private equity firms. Counsel will need to continue to find ways to incentivize and structure ESG goals into transactions while also navigating related regulations – particularly in light of potential global divergence on ESG issues.
Finally, private equity law firms will be challenged to continually stay ahead of regulatory changes – including compliance with the UK National Security & Investment Act and other laws resulting from the hostilities of foreign adversaries.