Private Equity Funds – preparing for a successful investment exit

The ultimate goal for almost any private equity fund ("PE Fund") when investing in a corporate vehicle is to achieve a substantial return on its investment within a short, restricted timeframe (usually around five years). Consequently, it is important for a PE Fund to consider early on – even before making the investment - how it will exit an investment vehicle (and that the management team are on board with this – see further below).

There are several ways a PE Fund can exit an investment but two of the most common methods are trade sales (involving the sale of the company to another company, typically in the same industry or sector) and secondary buyouts (where another private equity-backed company purchases and refinances the investment vehicle). This article will outline (1) how a PE Fund prepares for an exit; and (2) key aspects of trade sales and buyouts, including in relation to the purchasers, control and governance, timing and warranty protection.

Effective exit planning

1. Preparation pre-investment

Before investing in any company a PE Fund will complete due diligence on the target, including interviews with the management team to ensure their aims are aligned when considering available exit routes. Although the PE Fund and management team will likely have different perspectives on the investment it is crucial that both parties have at least a similar goal in relation to the PE Fund exit and this is especially so when market conditions and/or the economic climate are less favourable. If the PE Fund and the management team have different exit aims in mind the investment is unlikely to happen.

2. Preparation post-investment

It is not uncommon for the exit vehicle (i.e. the entity to be sold - usually the holding company of the target group) to start preparing for its eventual sale shortly after the PE Fund investment has completed. With the aim of a smooth, timely and profitable exit there will likely be a review of the target company’s administration and document management processes and an audit of its assets and material contracts (e.g. for change of control provisions) amongst other reviews and investigations to ensure everything is orderly. There will also likely be an implementation of any recommendations following the investing fund’s due diligence processes at this stage.

The Exit

1. Trade Sale

Although a trade sale is usually arranged as a sale and purchase of the entire issued share capital of the exit vehicle it can also be a sale of the assets which make up a target group’s business.

Benefits and challenges

• Strategic buyers – The buyer in a trade sale will often be a strategic player operating in a similar sector to the exit vehicle with the necessary expertise to take the business forward. A strategic buyer is more likely to be willing to pay a premium to access new resources and markets and strengthen its own market position (as well as achieving savings though synergies in operations). This may, in turn, result in a higher exit valuation for the PE Fund. There are, however, also risks in transacting with a strategic buyer who is also a competitor as it will be necessary to disclose confidential business information to them before the transaction documents are signed. Even if a non-disclosure agreement has been signed it is not a guarantee that the buyer will keep the business information confidential and not use it to their business advantage if they decide not to complete the transaction.

• Clean break and change of control – If the consideration is paid in cash in full this will provide an immediate “clean break” for the PE Fund provided the PE Fund is also able to negotiate limited ongoing obligations to the buyer e.g. limiting any warranties it gives to the buyer (please see below) and resisting any requirement to give restrictive covenants.

• Timing – PE Funds will have more flexibility in the timing of a trade sale which can happen at various stages in the exit vehicle’s lifecycle. Factors influencing the timing of an exit include, the strategic priorities of the PE Fund and the pervading economic and market conditions.

• Warranties protection – PE Funds will generally resist the giving of warranties and indemnities to any buyer mainly because it is not usually involved in the day-to-day business and management of the exit vehicle and also because of its main purpose - to invest and return funds to its own shareholders. Consequently, a PE Fund often restricts the warranties it is prepared to give to any buyer to: (1) having title to the shares of the exit vehicle; and (2) capacity to sign the sale and purchase transaction documents.

• Secondary Buyout – A secondary buyout involves a re-capitalisation or re-financing of the exit vehicle whereby another company backed by a different PE Fund purchases the exit vehicle.

Benefits and challenges

• Specialised PE Funds – In a secondary buyout, the new incoming PE Fund is often specialised in the sector in which the target business operates and sees potential in it to lever its own strategies for profit. A secondary buyout can prove beneficial for all involved – (1) the outgoing PE Fund can potentially exit and release funds to its shareholders earlier than originally planned; (2) the incoming specialist PE Fund can use its knowledge and experience to further develop the target business and generate additional value; and (3) due to the continuity in a secondary buyout, management will have the opportunity to roll over the sale proceeds into equity and realise the business’s growth potential with the incoming PE Fund.

• Clean break and change of control – Similar to trade sales (1) the outgoing PE Fund will look for a “clean break” and to try and achieve this, the consideration is often paid via a “locked box” mechanism (i.e. the seller and buyer settle the price prior to completion based on a balance sheet value drawn up at an agreed date (please see our earlier blog on locked boxes here); and (2) there is usually also the same resistance from the outgoing PE Fund (and in this instance probably also the management team too) to provide warranty cover to the buyer/incoming PE Fund (please see below).

• Timing – Also, similar to trade sales, the outgoing PE Fund has some flexibility as to when it realises its investment in the exit vehicle. There will, however, have to be sufficient potential in what remains of the exit vehicle’s lifecycle to allow for further development so that the incoming PE Fund can create enough value for its shareholders.

• Warranty protection – The key difference between a trade sale and a secondary buyout is the warranty cover given to protect the investment of the incoming PE Fund. In this type of exit it will not only be the outgoing PE Fund who resists providing warranty cover - the management will also be more likely to resist providing comprehensive warranty cover mainly because on a secondary buy-out their share of the consideration is likely to be much less than on the original buy-out. Consequently, to help bolster its warranty protection the incoming PE Fund will usually either negotiate for the management to arrange warranty and indemnity insurance or arrange the insurance for itself (please see our earlier blog on warranty and indemnity insurance).

Conclusion

A successful exit for a PE Fund means maximising returns and ensuring a smooth exit process. This can be achieved through early exit planning and preparation, including consideration of the exit routes available. By taking these factors into account, PE Funds are better positioned to achieve their ultimate aim of delivering value to their investors.

How Brodies can help

If you would like to discuss anything raised in this blog in more detail or discuss any other matter in relation to private equity funding, please do not hesitate to get in touch with one of our corporate lawyers or private equity lawyers.