Private Equity Perspectives - Taylor Wessing

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Private Equity Perspectives The year of the IPO?

In the current market, private equity sponsors are increasingly looking at IPOs as a real exit option for their portfolio investments. Strong demand for equities as a result of growing investor confidence in the recovering US and European economies and a desire for private equity firms to realise heavily-leveraged investments made just before the financial crisis have been the principal drivers for the wave of private equity-led IPOs in 2013. Rumours of the return of the private equitybacked IPO exit first gained momentum during BC Partners’ partial exit from Foxtons last summer. Amidst an upturn in fortunes in the UK housing market, the estate agency completed its highly-anticipated flotation on the London Stock Exchange last September. Purchased by BC Partners in 2007 for £360 million with £300 million bank debt, Foxtons became a notable casualty of the financial crisis and the ensuing downturn in the property market, resulting in lenders Bank of America Merrill Lynch and Mizuho temporarily stepping in in a debtfor-equity swap after the private equity firm breached its banking covenants. Proceeds gained from the listing will allow Foxtons to fully repay its outstanding debts but it is understood that the float marks the beginning of BC Partners’ expected exit from the company. With the likes of Merlin Entertainments (backed by Blackstone and CVC), owner of Madame Tussauds and Legoland, and skiwear maker Moncler (backed by Carlyle and Eurazeo) concluding 2013 with their own respective listings in London and Milan, this trend of private equity-backed floats is set to continue throughout 2014. However, rather than an IPO being viewed as a sell-down event where the private equity investor would try to maximise the issue price of an IPO, in most cases since the financial crisis the private equity investor will be retaining all or a majority of their shareholding in the portfolio company post-IPO. For example, following Merlin Entertainment’s flotation on the London Stock Exchange, Blackstone retained a 22.6 percent shareholding in the company whereas CVC retained 13.1 percent. Consequently, there has been a change in approach in the last 18 months which has led to a greater focus on the company’s performance post-IPO.

Below are some key issues that need to be considered by private equity funds when preparing for an IPO as a potential exit route: Market risk This transactional risk still remains key to the whole process and is the main reason why an IPO as an exit route for private equity investors have been more difficult to execute in recent years. Counter-parties on trade sales or secondary buy-outs may be able to see through a shortterm blip in market conditions but the access to institutional investor capital through an IPO process can disappear very quickly depending on market sentiment at the time. Whilst this is still the case, the level of volatility in the market has fallen considerably since the start of 2013. On most larger deals, the pre-marketing public awareness campaigns are starting further out from the launch date for an IPO (commonly around 6-9 months) to try and ensure a successful outcome on debut – but equally this means that if there is a need to postpone the transaction, it can be seen as a very public failure. In the mid-market, including the majority of IPOs on the AIM market, the issue can be different, as many portfolio companies lack the visibility to attract enough institutional investor attention or, if they do, the risk is that the small to mid-cap investors can exercise significant pricing power as a result. Post-IPO selling restrictions On an IPO, the directors and significant shareholders of the company will typically be required to enter into lock-in agreements which restrict their ability to dispose of shares in the company for a period of time post-IPO. Lock-in agreements typically provide that the shareholder will not dispose of, charge or otherwise encumber any of their shares in the company for a certain period following admission (usually 12 months) other than in very limited circumstances. In most cases, there will also be a further period (again, usually 12 months) during which any sale must be effected through the company’s broker.

The aim of such agreements is to provide an element of stability to the share price by ensuring that large amounts of stock will not be dumped onto the market, which could damage investor confidence and cause the share price to slump. The private equity investor will therefore be exposed to market risk for the duration of the lock-in period in respect of any retained shares, with no ability to sell if the market begins to turn or the company’s performance declines. Corporate governance An IPO will impose a set of regulatory obligations to a wide group of stakeholders within the company – this includes the adoption of a corporate governance framework that aims to protect the interests of the whole group (and not just the private equity investor) through the structure and operation of the company’s board of directors. In the UK, this framework is set out in the UK Corporate Governance Code – whilst not mandatory, it states that companies must either comply with its guidelines or explain any deviations. In practice, it is followed by companies with a Premium listing on the London Stock Exchange and, in relation to companies with a Standard listing or those on AIM, they will generally state in their IPO prospectus or admission document that they intend to comply with the Code where relevant for a company of their size. Contractual rights to board representation have historically terminated on an IPO, although some more recent IPOs have seen some contractual rights to appoint a certain number of directors continue, subject to the private equity investor’s equity ownership staying above a certain threshold. The imposition of a solid corporate governance framework will be seen by institutional investors as critically important to their decision on whether to invest – for some, if there is a controlling private equity shareholder post-IPO and the board of directors is not viewed as being sufficiently independent, they may not invest at all or, if they do, it may impact on the valuation they are willing to pay for their investment. As a result, the acceptance of an independent board of directors and adherence to the corporate governance standards of the relevant stock exchange may be vital to the success of the IPO process.

Underwriting agreement – warranties and indemnities The underwriting (or placing) agreement is one of the principal documents that will be entered into in connection with an IPO. Typically, the agreement will contain a number of warranties in relation to the company and its business, together with an extensive indemnity for claims and losses incurred by the investment bank in connection with the IPO. Private equity investors in Europe are often reluctant to provide any warranties or indemnities on an exit process other than as to title and capacity (which differs to the position in the US where private equity sellers traditionally have given business warranties). In practice, it is becoming common for a private equity seller to provide a limited series of warranties covering title and capacity to the shares being sold as part of the process, but also to provide some additional warranties around the accuracy of information relating to the company and the business contained in the IPO prospectus or admission document. The investment bank will almost certainly insist on the management team of the company giving warranties in the underwriting agreement. In the context of a private equity backed IPO, the non-executive directors will be relatively new to the company and are unlikely to have a detailed knowledge of the business. In such circumstances, the underwriter may be willing to accept a lesser degree of comfort from the nonexecutive directors and any warranties provided will be given subject to a number of contractual limitations (including monetary caps). Management incentivisation post-IPO Developing an effective executive incentive plan is an important step for any company moving towards an IPO. The most common incentive plans used by public companies are equity-based. Most companies will establish an option pool at the time of the IPO which usually accounts for up to 10% of the existing share capital of the company. These options give members of the management team the right to purchase shares at a specified price for a specified period of time. Alternatively, management may be granted performance shares, the ultimate value of which is determined by the number of shares earned and the value of such shares when earned.

A primary concern with any new incentive plan for a private equity investor is value dilution. It is therefore critical that all parties agree an acceptable dilution rate at an early stage in the IPO process.

In our view, the market is likely to see a continued uptick in the number of private equity-backed IPOs in 2014. Whilst none of the obstacles above are insurmountable, it is critical for a private equity investor to consider these issues at the planning stage for an IPO to ensure that the risk of an aborted process is minimised.

Europe > Middle East > Asia

Key Contact

Russell Holden Partner, London +44 (0)20 7300 4678 [email protected]

www.taylorwessing.com

© Taylor Wessing LLP 2014 This publication is intended for general public guidance and to highlight issues. It is not intended to apply to specific circumstances or to constitute legal advice. Taylor Wessing’s international offices operate as one firm but are established as distinct legal entities. For further information about our offices and the regulatory regimes that apply to them, please refer to: www.taylorwessing.com/regulatory.html NB_001340c_03.14