From time to time, private equity sponsors will exit a portfolio company investment by selling the portfolio company to buyers led by another fund managed by the same sponsor. Because the sponsor is essentially on both sides of the transaction, the sponsor must carefully consider and fairly address the customary business and legal issues arising in a typical private mergers and acquisitions (M&A) transaction. This note suggests a streamlined legal process that offers efficiencies of cost and timing, while still ensuring fairness to the investors in both the seller and buyer funds.
At the outset, it should be noted that there is no shortcut to financial fairness, particularly a fair price for the asset. Achieving fair pricing of an interfund transaction is of special concern because of the sponsor's control of both the buyer and the seller. The conflict should be addressed by outside fairness analyses and price negotiation conducted by independent committees of investors of the buy- and sell-side funds, generally outside the influence of the sponsor. It would be preferable for each of the funds to be separately advised and to receive its own fairness opinion. However, it may be possible to obtain a dual fairness opinion from a single adviser that has no relationship with either of the funds, or at least has not been preferentially engaged by one or the other of the funds.
The Transactional Process
Beyond financial fairness, there are various other elements of a purchase and sale that are challenging to reproduce in a transaction between funds under common sponsorship. Typically, a purchaser engages in extensive diligence of its acquisition target. This exercise includes legal diligence, financial and tax diligence, and a quality of earnings analysis, and, where the target conducts its activities in a regulated industry, professionals may be engaged to advise on compliance with the particular regulatory regime. New to the scene, but of increasing prominence, are cybersecurity and a deep dive into the information technology systems of the target. (See the Kramer Levin M&A Monitor, December 2020.)
There is also the negotiation of the agreement of purchase and sale, the disclosure schedules, and perhaps a suite of ancillary documentation. In a typical M&A transaction, the principal transactional documents will migrate numerous times back and forth across the table, or in contemporary times, across the ether of electronic communication. Representations and warranties, covenants and indemnification will be hard-fought, and outcomes will be the product of arm's-length negotiation that will reflect the respective leverage of the parties and their differing incentives to conclude the transaction. Costs can run up quickly at every stage.
With the omnipresence of the sponsor, it may be difficult to create the requisite adversarial environment that ordinarily provides assurance of an equitable outcome for both parties. Common sponsorship may also breed a false sense of complacency, particularly in relation to business and transactional risks that an acquirer would ordinarily approach with caution and concern. In part, of course, it may well be the case that common sponsorship does contribute a legitimate element of assurance that is absent in third-party transactions. The sponsor's management of the two funds and its oversight of their respective portfolio companies does provide a level of familiarity and comfort with the target that is lacking in the more conventional M&A context. Nonetheless, the conflicts cannot be ignored.
Addressing the Conflicts
One option to address the conflicts in interfund M&A transactions is to engage two separate legal advisers, one each to represent the seller and the buyer, and to pursue the customary legal diligence process and adversarial negotiation of the purchase agreement and related documentation. Each counsel would report to a fund committee comprised of independent investor representatives of that fund, free to make its own decisions and to consult — or not consult — with the sponsor in its discretion. This route would both mitigate substantive conflict concerns and dispel the appearance of a tilted playing field. The downside to this approach is the cost. Not only might the sponsor object to the duplication of legal expense, but also the investors themselves might question the need for a full-fledged adversarial legal process. In addition, it may be unreasonable to expect that these special committees will be intimately involved in the legal detail that could be of consequence if claims arise post-closing, such as the scope of the representations, survival periods, baskets and caps, materiality scrapes, anti-sandbagging provisions and escrows.
Some private equity sponsors may instead elect to utilize a single law firm as "deal counsel." The buyer and seller funds would each still have its own investor committee, making decisions on its own behalf, but the single deal counsel would be neutral, charged with arriving at a transaction that is fair to both sides. The practicality of this approach is questionable, however. Law firms do not typically function as transactional arbitrators. More fundamentally, if the parties are anticipating a conventional purchase and sale agreement, there really is no substitute for an adversarial process in which both sides are independently advised. Without the sponsor putting its thumb on the scales, deal counsel will be hard pressed to decide how seller- or buyer-friendly the representations should be or how to balance the competing interests of the parties on indemnification.
To address some of these concerns, sponsors may choose to model the interfund purchase agreement on the contract used by the seller fund when it originally acquired the portfolio company. That agreement will have been negotiated at arm's length, which arguably validates the neutrality of its terms, allowing the use of a single counsel. However, it is very unlikely that representation and warranty insurance will be available in a sale between commonly managed funds. If the original purchase contract relied on insurance to cover indemnification, that agreement will have to be retooled with a more "old school" indemnification package, which once again raises concerns of conflicted negotiation.
In any case, just as important as the negotiating process is the exercise and defense of post-closing remedies. This is something that the sponsor would ordinarily handle on behalf of a fund. It is not an activity in which an investor committee would ordinarily be involved, even if the committee were engaged in approving the key terms of the transaction. The single, neutral counsel that served as draftsman during negotiations will be unavailable to either fund for this purpose. Both funds would therefore be required to retain independent legal advisers should the buyer fund make a claim under the transaction documentation for breaches of representations and warranties that emerge during the survival period.
An Alternative Approach
An alternative approach to addressing the conflicts that inhere in interfund transfers may be to forgo the traditional format of M&A documentation and to utilize an abbreviated purchase agreement that is tailored to the specific circumstances of these transactions. The agreement would contain certain customary "fundamental representations," including authorization to enter into the transaction, ownership of equity and accuracy of the financial statements. Representations of this sort are fairly standard and should not require substantive negotiation, diligence and disclosure schedules.
The purchase agreement would not, however, include the usually extensive roster of business representations. Instead, indemnification would be based on a "my watch"/"your watch" allocation of risk. The seller fund would be generally responsible for all pre-closing liabilities, including any unknown pre-closing liabilities that come to light within a specified time after closing. The buyer fund would generally assume all post-closing liabilities. In what is essentially a no-fault model, there would be no need for opposing counsel to tussle over the intimate details of the representation and warranty package or to devote time and resources to the negotiation of indemnification provisions. Also avoided is the need for intensive and time-consuming diligence, allowing management of the portfolio company to remain focused on running the business. A single counsel can advise on the documentation, and should post-closing liabilities arise, their allocation and attribution should be relatively straightforward. Potential conflicts of the sponsor are largely alleviated, as the allocation of risk between the buyer and the seller is fixed by the express terms of the contract.
The streamlined legal approach will not obviate the need to ensure a fair price on both sides of the transactional table, so independent financial advice may still be required. Other financial terms will need to be addressed as well. The sponsor, in conjunction with deal counsel, will be advised to prepare a detailed term sheet that addresses certain basic financial terms, including working capital or other post-closing purchase price adjustment mechanics, tax treatment — for example, with respect to tax assets such as net operating losses, basis step-up and tax deductions for transaction expenses — the sharing of transaction costs/filing fees, and the size and duration of any holdback escrow to fund any liabilities of the seller fund that come up post-closing. These provisions can be negotiated at the term sheet stage by the respective independent committees of the funds, with the assistance of the internal management of the portfolio company and perhaps the funds' financial advisers.
This approach is clearly not advisable in all situations. For example, the buyer fund should probably insist on more traditional representation and warranty protection where there is a complex regulatory component to the transaction or when the target portfolio company is suspected of having significant legacy problems — for example, IT issues — that could bleed over into the post-closing period for an extended period of time. But in situations where the portfolio company to be transferred appears relatively clean and the concern is with the unknown, the no-fault model offers ease and timeliness of implementation and considerable savings of professional expense.
Sponsors that find this transactional pathway attractive and appropriate will need to discuss the approach in advance with co-investors and lenders to ascertain whether they will agree to participate in the transaction on this basis. The approach will also need to be vetted and approved in principle by independent limited partner committees of both funds, prior to embarking down this (legal) road less traveled.
Although somewhat unusual, the streamlined legal approach suggested here can significantly minimize conflicts for the sponsor, limit transactional costs, reduce the time demands on management, substantially simplify the legal documentation and accelerate consummation of the transfer of a portfolio company between funds under common management. The sponsor, while guiding the process along, must remain evenhanded and "above the fray," and the approach will require buy-in from the various constituencies to the transaction. The trust that investors and others have in the sponsor, partly based on the sponsor's financial track record and the transparency with which it has conducted itself, will likely go a long way toward acceptance of this approach. In appropriate circumstances, however, it should yield meaningful benefits for all concerned.
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