The private equity industry is well-placed to deal with this volatility. Private equity fund investments are generally made for a longer term and so funds can ride out down-turns, depending on where they are in their life-cycles. But this does not mean that private equity funds are shielded from market volatility. It has become challenging for fund managers and investors to manage existing portfolio investments. For those funds which are being established or in their investment periods, it is even more difficult for fund managers and investors to determine the values of proposed investments in this economic environment.
Fortunately, there were many lessons learned in the global financial crisis of 2007/2008 which the private equity fund industry can apply to mitigate the uncertainty of valuing proposed investments in this kind of economic environment. A few options are set out below.
Convertible Instruments and Minority Acquisitions
A major impact of the spread of COVID-19 disease is constrained liquidity in the market for new acquisitions. Depending on the medium- and long-term effect of the spread of the virus, fund managers may have to reduce the capital they otherwise would have deployed into investments they are interested in. Fund managers may be able to acquire options or instruments apart from equity which may be converted into equity on the achievement of certain triggers. If funds acquire minority interests in portfolio companies (especially if valuations are depressed), this also allows those funds the opportunity to increase their stakes in those portfolio companies at a later stage. In addition, fund managers may be able to negotiate minority protection provisions into their shareholding agreements in respect of those portfolio companies so that they are not prejudiced by taking minority stakes. Sellers of minority interests in companies can expect investors to try to negotiate for negative controls in those companies at the very least. Fund managers could also negotiate protections for the funds they manage against underperformance, e.g. extensive financial reporting provisions to make sure the investors know about underperformance, and the ability to sell their interests back to the sellers in the event that those companies do not meet performance targets post-acquisition.
Conversely, parties may agree to negotiate for “material adverse change” clauses which deal specifically with materially adverse changes in market conditions (with very specific triggers) due to COVID-19. Given that this deals with market conditions rather than company-specific conditions, sellers may not be likely to accept this, but it does give buyers the potential for an exit mechanism if market conditions worsen and business performance of the acquired company cannot improve.
When market conditions are uncertain, sellers will have to accept that prices for their assets may be depressed in the short- and medium-term. This may make them unwilling to sell to buyers they see as opportunistic. Buyers, on the other hand, will be unwilling to accept prices for assets they are not sure will increase in value. A way to get around this tension is for sellers to accept a low initial purchase price for their interests in companies and then receive an additional amount (or amounts) later, often with the buyer using the proceeds of the business of the same companies to pay the seller if the company has performed well after the sale. Given that sellers are often familiar with the functioning of the companies they are selling, they are usually confident that those companies will perform well after the sale, even in depressed markets. However, given that they are often giving up control of those companies and at the same time relying on its performance, those sellers often negotiate sale terms which mean that those companies must continue to be run as they had been before the sale transaction. For buyers the benefit is that they can secure agreement when they otherwise may not have, they pay less for the companies in question and often can rely on the companies acquired for paying the earn-out. There are many variations on how to structure the earn-out. However, earn-out provisions often invite dispute and litigation – buyers and sellers disagree regarding whether the company was appropriately run following the sale transaction (particularly when the buyers have negotiated to run the acquired company in previously agreed ways), as a consequence, disagree on the performance of the companies acquired and on payment of the earn-out amount.
Given that market conditions will be uncertain at least in the medium-term, fund managers, investors and sellers will need to be innovative about structuring deals in the months, and possibly years, to follow. The global financial crisis has provided several lessons on deal-structuring in uncertain market conditions and those lessons should be followed. As set out above, there are a number of ways to structure deals when buyers and sellers are uncertain of the value of the assets involved in transactions, including minority acquisitions and earn-out provisions. In addition, there are many other innovative solutions for deal-structuring involving minority acquisitions, earn-out provisions, and other means for parties to structure their transactions. We have experience advising on portfolio company acquisitions by private equity funds and on advising private equity funds more broadly in this climate (further information on that is contained here.