Private Equity M&A Activity

Private equity M&A activity in the US looks set to break records in 2021, continuing its dramatic rebound from the low point of early 2020, as sponsors continue to seek outlets to deploy historic levels of committed capital, estimated to be in the trillions of dollars. This, coupled with a continuing scarcity of quality transaction targets, historically low interest rates and the spectre of an increase in capital gains tax rates, has led to a more competitive landscape, characterised by higher valuations, faster transaction timelines and more seller-favourable terms and structures.

R&W insurance

Representation and warranty (R&W) insurance has become a fixture of private equity deals, penetrating even the lower-middle M&A market. As claims experience grows, parties are becoming more confident in R&W policies, which, together with the seller-friendly M&A market, has resulted in R&W insurance and "public company-style" transactions with limited or no seller recourse becoming commonplace in auction processes for quality targets. These dynamics continue to force buyers to conduct due diligence early in the process and close transactions quickly, often without the benefit of exclusivity under a signed letter of intent.

Strategic buyers, SPACs and minority investments

Other factors have added to an already frothy market. Strategic buyers, who largely remained on the sidelines for most of 2020, are again active participants in the M&A market. Special purpose acquisition companies (SPACs) have become a popular exit route and means of accessing the public markets at high valuations supported by public company multiples. The popularity of SPAC transactions highlights sponsors’ continued interest in non-traditional investments in 2021 too. Similarly, more sponsors are pursuing minority investments as a means to deploy capital at attractive valuations in a less crowded space.

Add-ons

These same dynamics have pushed private equity sponsors to increasingly emphasise “buy and build” or roll-up strategies. With less competition for smaller targets, PE-backed platform companies can acquire add-on targets at lower earnings multiples, and the sponsor can often sell the combined companies at a higher multiple. This arbitrage opportunity has led many sellers to undertake add-on M&A transactions shortly before or simultaneously with a sale process for the platform investment.

In 2021, private equity M&A activity is healthy across most sectors. Technology, media, telecom, software and healthcare companies, in particular, have been attractive in the wake of the COVID-19 pandemic and associated government-mandated lockdowns and have been some of the most active sectors in terms of M&A value and volume. On the other hand, the hospitality, leisure, retail and food service sectors have been slower to recover from the effects of COVID-19 and continue to suffer from short and medium-term uncertainty.

FFCRA and the CARES Act

In 2020 the US federal government enacted emergency COVID-19 relief legislation for businesses and employees, including the Families First Coronavirus Relief Act (FFCRA) and the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). Among other things, the FFCRA expanded employee paid leave protections for COVID-19-related reasons, creating compliance issues for sponsors, their portfolio companies and targets. The CARES Act authorised two new lending programmes, the Main Street Lending Program (MSLP) and Paycheck Protection Program (PPP), which afforded financial assistance to businesses at attractive rates, in the latter case, subject to loan forgiveness if put towards payroll and other specified uses. While most private equity-owned businesses are not eligible for PPP loans, potential buyers of any business that has received a PPP loan should carefully review the target’s compliance with programme rules since all PPP loans, especially those over USD2 million, are subject to potential audit by the Small Business Administration.

2017 Tax Cuts and Jobs Act

The 2017 Tax Cuts and Jobs Act continues to influence private equity acquisition deal structures. Factors included in structuring decisions now include the option to expense 100% of the tangible assets of a target in the same tax year as the acquisition, net operating loss deductions and interest expense limitations. The reduced corporate tax rate, elimination of corporate AMT and several favourable tax characteristics of corporations have expanded the options in entity choice in a market previously dominated by pass-through structures such as limited liability companies.

Foreign Investment Review Risk Modernization Act of 2018

The Foreign Investment Review Risk Modernization Act of 2018 and the final regulations issued thereunder in 2020 (FIRRMA) expanded the scope of CFIUS (discussed in 3.1 Primary Regulators and Regulatory Issues) in the context of transactions involving US real property interests, certain critical infrastructures and technologies and personal data.

Personal Privacy Rights

Recent privacy law developments (including the EU’s General Data Protection Regulation and California’s Consumer Privacy Act of 2018) continue to have a global impact on companies with significant operations involving personal data. And while the markets await more certainty in the interpretation and enforcement of these new laws, private equity funds continue to grapple with the new requirements and tailoring pre-acquisition due diligence and post-acquisition compliance monitoring practices to identify and manage the potential exposure under a legal paradigm with continued momentum towards enhanced personal privacy rights and substantial penalties for non-compliance.

US federal regulation of private equity M&A transactions is typically focused on three areas:

• oversight of the offering and sale of securities in an M&A transaction;
• clearance of transactions for antitrust compliance; and
• review of transactions involving foreign investment for national security concerns.

State law may affect M&A transactions, including with respect to fiduciary duties, shareholder rights and the transaction’s structural requirements. Transactions involving targets in regulated industries or operations may have additional regulatory oversight.

Oversight of Offering and Sale of Securities in M&A Transactions

The US Securities Exchange Commission (SEC) and various states regulate the sale of securities. Oversight is limited in M&A transactions between sophisticated, accredited investors, except in public acquisitions or where securities are offered to a large group of sellers as part of the acquisition consideration.

Clearance of Transactions for Antitrust Compliance

Under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (the HSR Act) and other applicable federal statutes, antitrust oversight is the domain of the US Department of Justice (DOJ) and the Federal Trade Commission (FTC). The primary regulatory burden in M&A transactions exceeding relatively low thresholds for transaction value and size of transaction participants is providing prior notice of the transaction to the DOJ and FTC. The parties may not close the transaction until the expiration or termination of post-notice waiting periods, during which regulators may request additional information or challenge the transaction. While rare, the expiry of the waiting period does not foreclose a government challenge post-closing.

Review of Transactions Involving Foreign Investment for National Security Concerns

Under FIRRMA, the Committee on Foreign Investment in the US (CFIUS) has broad authority to review certain transactions that involve foreign investment. While notifying CFIUS of most transactions is voluntary – because CFIUS has the power to recommend changes or rescission of completed transactions – it is customary practice to notify CFIUS in advance about transactions involving foreign investment in sensitive US real estate or companies that own or operate critical infrastructure or maintain and collect sensitive personal data of US citizens.

Mandatory filings are required for certain investments in any company that produces or develops enumerated critical technologies and any transaction resulting in the acquisition by a foreign government-controlled entity of 25% or more of a direct or indirect voting interest in a covered US business.

Despite the pressures to close transactions quickly in the current market, legal advisers representing private equity acquirers generally conduct a thorough due diligence investigation of target companies. These investigations involve reviewing materials provided by the target or an investment banker who facilitates information and document requests.

The scope of legal due diligence review is broad and typically includes detailed examinations of the target’s equity ownership, organisational documents, equity holder arrangements, material contracts, financial statements, and records related to tax, real property, intellectual property, environmental investigations, legal compliance, litigation, employees and employee benefits.

In recent years, PE sponsors and their limited partners have focused due diligence efforts (and investments) on environmental, social and governance (ESG) and diversity, equity and inclusion (DEI) practices and, since 2020, on the impact of, and the target’s response to, COVID-19, including the target’s use of any government assistance, such as PPP loans, which could create obstacles to or delay a transaction closing.

In addition, advisers typically search publicly available lien, litigation and bankruptcy filings in jurisdictions relevant to the target’s operations and interview target management for clarification of key issues. Among other important matters, legal advisers seek to identify obstacles to completing a transaction, including required consents or notices and restrictions that may impact the private equity sponsor’s valuation, such as non-competition, most-favoured nation pricing, exclusivity or non-solicitation provisions. Increasingly, legal due diligence investigations focus on matters receiving heightened government and media scrutiny, such as anti-corruption compliance, data privacy and sexual misconduct.

The prevalence of R&W insurance in acquisitions has resulted in the production of more formal due diligence work product authored by advisers and heightened focus on conducting a comprehensive due diligence investigation. Prior to issuing a policy, the R&W insurance underwriter conducts its own independent legal due diligence investigation, reviews the due diligence reports prepared by the buyer’s legal and other advisers and conducts interviews with those advisers on the content of their reports and the scope of their investigation.

Historically, private equity buyers have not relied on vendor (sell-side) due diligence reports. Sellers increasingly engage advisers to conduct a quality of earnings analysis and due diligence on select matters, and provide these reports to bidders to control the messaging on valuation and any potential concerns. However, buyers generally rely on their own review of these matters, and definitive transaction agreements typically eliminate the buyers’ legal recourse for materials not expressly included in the agreement’s representations and warranties.

Most US private equity-sponsored buyout acquisitions are structured as privately negotiated agreements, taking the form of a purchase and sale of equity or assets, or a merger.

Purchase and Sale Transactions

Purchase and sale transactions are used where the seller is a single owner or a small, controlled group of equity holders. Transactions are customarily structured as mergers (which typically require approval from less than all equity holders) where broader groups of equity holders exist or where the potential recalcitrance of minority equity holders might delay or block a traditional purchase and sale transaction.

Mergers

Merger structures are occasionally employed to limit post-closing seller liability in the transaction, with the target company being the sole non-buyer party to the merger agreement and recourse to equity holders of the target limited or non-existent.

Court Involvement

Courts rarely participate in acquisition transactions, other than in US federal bankruptcy cases. In those cases, private equity buyers (often specialised distressed asset funds) may acquire the equity or assets of a bankrupt debtor following a court-supervised marketing process, with the transaction agreements privately negotiated by the debtor (or a trustee) and the buyer and approved by the bankruptcy court following one or more hearings.

"Take-Private" Transactions

In "take-private" transactions (see 7.1 Public-to-Private), private equity-sponsored acquisitions may also utilise public tender offers, typically followed by mergers.

Auctions and Proprietary Transactions

In the current seller-friendly market, most transactions result from broadly marketed auction processes, but private equity buyers continue to devote significant energy to identifying so-called "proprietary" targets where buyer and seller negotiate the transaction without a competitive bid process. Auctions tend to result in more favourable seller outcomes in both economic and legal terms, but they require dedication of target management resources over a lengthy marketing and auction period. In recent years, however, buyers of quality targets frequently attempt to "pre-empt the process" by conducting due diligence and making an offer on an accelerated timeline, often completing work towards, and signing, a definitive agreement before other process participants submit competing bids, but without the traditional "exclusivity" previously afforded a favoured bidder. This trend, along with the proliferation of "public company-style" transactions (see 6.8 Allocation of Risk), has quickened the pace of deal-making, even in formal auction processes. Transactions involving smaller targets or those with limited potential buyers based on industry, regulatory or other considerations often result from proprietary negotiations.

Private equity-sponsored buyout transactions for platform investments typically involve a special purpose buyer entity formed and funded by the private equity fund shortly before the acquisition. Co-investor, employee and seller-reinvested equity financing is usually invested in this buyer entity rather than directly in the target.

Frequently, unaffiliated co-investors invest in the buyer indirectly through additional upstream special purpose entities controlled by the private equity fund. This structure is intended to limit the private equity fund’s contractual exposure in the acquisition, both under the primary acquisition agreements (where upstream fund-level guarantees are generally non-existent or limited to narrow, specific areas, such as reverse termination fees) and debt-financing arrangements (where lenders customarily require guarantees from the buyer entity but not the fund).

The structure enhances flexibility in exit options where co-investor or employee investments exist, allowing the private equity fund to control seller conduct directly without having to enforce contractual remedies under drag-along agreements. Minority investments by private equity funds typically employ a similar special purpose entity.

Private equity acquisitions are almost universally financed with a mix of equity and debt. While debt financing levels typical of the leveraged buyout eras of the 1980s and 2000s have not been prevalent in the market to any comparable extent since the 2008 credit crisis, most private equity-sponsored buyouts are financed with significant levels of debt, with some form of borrowed money often representing half or more of the acquisition financing.   

Private equity sponsors typically employ senior secured term debt as a primary source of debt financing, but mezzanine debt may be used where sufficient senior credit is not available. Banks remain the preferred lenders in private equity-sponsored acquisitions, but increasingly, debt funds and other non-traditional lenders are providing primary senior debt financing rather than only mezzanine and other subordinated lending.

The majority of the equity in a private equity buyout is typically provided by the private equity sponsor. However, minority equity investments by private equity funds have recently become more common as business owners seek alternative financing sources and private equity sponsors seek lower risk, diversified investments at relatively attractive valuations. The private equity sponsor typically provides an equity commitment letter in transactions structured with a separate signing and closing.

"Club Deals"

"Club deals", where multiple private equity funds form a consortium to bid jointly for a target, have fallen out of popularity over the last two decades, a trend driven by anti-competition concerns on the part of regulators and sellers seeking more robust auctions. Additionally, club deals pose challenges in negotiating deal terms on accelerated timeframes in the current seller-friendly market, and they can create post-acquisition governance issues. However, club deals have seen a modest comeback in recent years, as private equity funds look for broader opportunities to deploy high levels of available capital.

Co-investors

Co-investors are frequently included in private equity-sponsored transactions, providing sponsors with flexibility in obtaining equity financing without overly concentrating a portfolio and providing investors with the ability to employ funds without customary fees and carried interest allocations and, in some cases, to exercise more control over their investments.

Co-investments

Co-investments arise from a variety of sources, including "rollover" equity reinvested in the restructured target by existing selling equity holders and direct investments by the sponsor’s limited partners, the target’s management and lenders of acquisition financing. Increased rollover equity is one potential solution to bridge valuation gaps, allowing sellers to share more substantially in an upside exit scenario. 

Base Purchase Price and Closing Account Adjustments

The purchase price in a typical US private equity-sponsored acquisition is generally a base purchase price (typically reflecting the enterprise value of the target), reduced by certain amounts at closing – including indebtedness of, and transaction expenses incurred by, the target (often paid in full by the buyer at closing) – and adjusted for variations in working capital or other accounts at closing from a negotiated target amount.

Closing account adjustments are typically estimated shortly before closing and finalised an agreed period of time after closing based on the actual closing account values reflected in financial reports prepared by the buyer. Disputes over working capital adjustments are customarily resolved by an agreed-upon neutral third party.

Sellers’ payment obligations in connection with closing account adjustments are frequently secured by a portion of the purchase price held in escrow pending resolution of the closing account values. By contrast, buyers’ closing account adjustment payment obligations are rarely secured by escrowed amounts. Well-positioned sellers negotiate for the adjustment escrow to be a buyer’s exclusive recourse for negative purchase price adjustments, often in exchange for a matching collar on positive adjustments.

Earn-Out Payments

A portion of the purchase price is sometimes contingent upon satisfaction of certain specified post-closing revenue or profit targets. These so-called "earn-out" payments are typically used to bridge valuation gaps, particularly in the wake of the COVID-19 pandemic. The terms applicable to earn-outs are usually heavily negotiated, particularly with respect to the conditions, standards used to measure their satisfaction, and conduct of the business post-closing, and have been even more so recently as longer earn-out measurement periods and larger (as a percentage of transaction value) earn-out payment amounts have become more common.

Earn-out payments are more common in transactions with private equity buyers than with private equity sellers. Earn-out payments are frequently the subject of post-closing disputes that are typically resolved by a neutral third party, similar to disputes over closing account adjustments.

Locked-box consideration mechanisms are rare in US private equity-sponsored acquisitions, other than in the context of cross-border transactions with sellers in jurisdictions where such mechanisms are more prevalent, or in limited circumstances where sellers enjoy a relatively strong bargaining position and buyers seek to enhance their bid values for competitive targets.

Disputes between the parties regarding closing account purchase price adjustments are typically submitted for binding resolution to a neutral third party, often a financial accounting or audit firm. This generally follows a specified period of negotiation among the parties.

While conditions to the buyer’s obligation to close an acquisition are often negotiated based on specific characteristics of the transaction and the target, some of the following key closing conditions (and variants of them) are customary:

• required regulatory approvals have been obtained or satisfied, including approval or the expiration of applicable waiting periods under the HSR Act;
• shareholder approval (in the case of a merger or a sale of substantially all assets) has been obtained;
• the representations and warranties of the target and seller(s) are true and correct as of the closing with an agreed level of materiality (often tied to a “material adverse effect” in the current seller-friendly market), and the target and seller(s) have performed their pre-closing covenants;
• no litigation or other proceeding exists that prevents the closing;

• specifically identified required third-party consents or notices have been given (these are typically limited to material contracts); and

• pay-off letters and lien-release authorisations have been obtained from lenders that will be repaid at closing.

Private equity buyers often negotiate for a condition that no "material adverse effect" has occurred between signing and closing. Other transaction-specific conditions may be negotiated, including delivery of new restrictive covenant or employment agreements, effectiveness of ancillary transactions occurring simultaneously, and satisfactory remediation of material matters uncovered in due diligence. However, in competitive sale processes, buyers often forego additional conditions to avoid the perception of enhanced execution risk in their proposals. Financing and due diligence conditions are rare except in very buyer-favourable circumstances.

Private equity buyers traditionally resist so-called "hell or high water" covenants, which require the buyer to take all actions necessary to obtain applicable regulatory approval of the transaction, including – in the case of clearance under the HSR Act – commencing litigation, divesting assets or agreeing to restrict other business operations. This is particularly sensitive to private equity funds with diverse holdings where antitrust scrutiny of the transaction could trigger obligations under these covenants that would adversely affect the fund’s other portfolio investments. However, the recent seller-friendly M&A market has seen some private equity buyers soften their opposition to some forms of hell or high water covenants, particularly where little antitrust risk is foreseeable.

In transactions where the acquisition agreement provides a private equity buyer with the right to terminate the acquisition agreement for its failure to obtain debt financing (see 6.7 Termination Rights in Acquisition Documentation), upon the buyer’s exercise of the termination right, the buyer is typically required to pay a reverse termination fee (customarily between 3% and 7% of the base purchase price, depending on the transaction size) as the target’s and the seller’s exclusive remedy for the buyer’s failure to close. Otherwise, termination fees are uncommon in private equity-sponsored acquisitions, except in transactions with public company targets.

A typical acquisition agreement may be terminated before closing by a private equity seller or buyer under limited circumstances, including where the closing has not occurred before a specified outside date, or the counterparty fails to cure its material breach of the agreement.

In transactions funded by significant acquisition debt financing, private equity buyers often negotiate the right to terminate the acquisition agreement if adequate debt financing is not secured by a specified date in exchange for payment of a reverse termination fee (see 6.6 Break Fees). Under this approach, the buyer customarily makes representations regarding debt-financing commitments obtained at signing and is typically bound by covenants to use reasonable efforts to secure the financing. Despite the prevalence of debt financing in private equity M&A transactions, in recent times buyers have increasingly used full equity backstops, with no financing condition or reverse termination fee, as a tool to differentiate their bids in the eyes of sellers who are intensely focused on deal certainty in the wake of COVID-19.

Allocation of risk is primarily governed by a negotiated package of indemnities provided by the seller. General indemnities typically cover losses suffered by the buyer as a result of any inaccuracy or breach of the representations and warranties made by the seller or the target in the acquisition agreement. In addition, narrowly tailored specific indemnities may cover known concerns identified in due diligence.

Bolstered by the availability of R&W insurance policies, sellers, particularly private equity sellers, increasingly seek to minimise post-closing liabilities by negotiating for limited post-closing liability. This "public company-style" allocation of liability results in structures with minimal or no significant post-closing seller liability that rely almost exclusively on R&W insurance to manage buyer risk.

Given the seller-friendly M&A market in the wake of the COVID-19 pandemic, sellers are often able to allocate the risk of adverse effects from COVID-19 to buyers in the form of specific carve-outs from the definition of “material adverse effect”. Likewise, sellers typically maintain reasonably broad flexibility to respond to the pandemic as they see appropriate, subject to notice, consultation or the consent rights of the buyer.

In a traditional private equity transaction, the seller is responsible for the representations and warranties related to the target (whether made by the seller or made by the target and backstopped by the seller through indemnity). While the target’s management is usually involved in reviewing the representations and warranties and preparing disclosure schedules, management is rarely a party to or contractually liable under the acquisition agreement, other than to the extent of management’s equity holdings.

Classification of Representations and Warranties

Limitations on a seller’s liability for representations and warranties depend on both the nature of the representations and warranties and whether the transaction involves R&W insurance or another recourse-limiting feature. Generally, representations and warranties are classified (for liability limitation purposes) as either "fundamental" or "non-fundamental" based on their subject matter and the extent to which they are critical to the essence and validity of the transaction.

Seller liability for the handful of fundamental representations and warranties survives closing for a relatively long time (often 20 years or more, where permitted by applicable state law) and is often capped at the purchase price. By contrast, seller liability for non-fundamental representations and warranties typically survives for only 12 to 24 months and is capped at a small percentage of the purchase price (usually 15% or less, and as little as 0% to 1% in R&W insurance transactions).

Indemnification for non-fundamental representations and warranties is ordinarily subject to a deductible (of up to 1% of the purchase price) borne by the buyer which sometimes excludes losses below a small threshold. Some representations and warranties defy the broad fundamental/non-fundamental classification. For example, representations and warranties related to taxes often feature an intermediate survival period tied to the tax statute of limitations and liability capped at the purchase price. Those related to environmental or employee benefit matters may have longer survival periods or not be subject to deductibles and other indemnification limits.

Representations and Warranties Outside of the Acquisition Agreement

The custom in US private target transactions is to limit the legal reliance of all parties to the four corners of the acquisition agreement. Accordingly, the acquisition agreement precludes reliance by the buyer on representations and warranties outside of those expressly included in the agreement, and similarly limits exceptions to those representations and warranties to matters identified in disclosure schedules to the acquisition agreement. Materials made available in data rooms or otherwise may not be relied on by either party in connection with liability issues, except to the extent expressly incorporated into the acquisition agreement.

Indemnity Escrow

A portion of the purchase price in a private equity transaction is typically deposited in escrow to backstop the seller’s indemnity obligations. While traditionally a buyer would have direct recourse to the seller for at least a portion of the indemnity obligations in excess of the indemnity escrow, it has become more common for the indemnity escrow to serve as the exclusive source of a buyer’s recovery, with limited exceptions for breaches of fundamental representations and warranties, taxes, breaches of covenants and perhaps an indemnity unique to the transaction. Escrow holding periods usually match the general survival period for a seller’s liability for non-fundamental representations and warranties.

R&W Insurance

The use of R&W insurance in private M&A transactions involving private equity funds has increased dramatically in recent years, enhancing the viability of transactions that significantly limit seller liability for representations and warranties even in the lower middle market. Indemnity escrows that previously ranged between 5% to 15% of purchase price typically drop to between 0.5% to 1% in R&W insurance transactions, and often buyers agree to eliminate the indemnity escrow entirely in transactions with R&W insurance.

The use of R&W insurance shows no signs of slowing in the current environment. Broad COVID-19 exclusions have given way to tailored, target-specific ones, and a dramatic increase in claims against R&W insurance policies has given parties comfort that R&W insurance can be an effective substitute for direct recourse against sellers. Though recent claims experience has resulted in temporarily increased pricing, that is expected to be offset by new market entrants and a more competitive landscape for R&W insurance. 

Litigation over post-closing disputes in private equity transactions is rare, in part because private equity funds often resist litigation due to reputational risk. Accordingly, private arbitration is popular among private equity participants in M&A transactions. Post-closing disputes commonly arise in connection with closing account adjustments. These disputes are ordinarily resolved by private negotiation or by a neutral third party.

Earn-out payments are another area of frequent dispute, as they often call for a closing-account type of reconciliation for determining earn-out payments on a frequent, repeated basis, potentially over several years. The increased size, scope and reliance on earn-outs in the wake of the COVID-19 pandemic (see 6.1 Types of Consideration Mechanisms) may result in more disputes in the coming years. Tax and environmental liability are additional areas of common seller liability, but these issues are usually identified before closing, through careful due diligence, and are the subject of specific indemnities (often with special escrows), minimising dispute over coverage post-closing.

Public-to-private or "take-private" transactions represent a modest portion of the overall volume of US private equity-funded transactions. The overall number of public-to-private acquisitions has been relatively flat in recent years, but that may change as private equity firms assess less traditional avenues to deploy capital.

Shareholding disclosure thresholds and filing requirements are defined in the Securities Exchange Act of 1934, which provides as follows.

First, any party (or parties acting together) acquiring more than 5% of a class of voting equity securities of a US public company must file a publicly available Schedule 13D or 13G with the Securities and Exchange Commission (SEC). Schedule 13D, the document required of potential acquirers, is due within ten calendar days of crossing the 5% threshold and must be promptly amended following certain changes. Among other things, Schedule 13D discloses the acquirer’s identity, purpose for the investment, securities beneficially owned and consideration paid for the securities. 

Second, a party engaging in a take-private transaction of a public company that is an "affiliate" of such company must file a Schedule 13E-3 prior to undertaking a tender or exchange offer or merger. Schedule 13E-3 requires, among other things, disclosure of the purpose and effects of the transaction and why the filing party believes the transaction is fair to the shareholders of the public company. Determination of whether a party is an affiliate of a public company depends on the specific facts and circumstances, although a general rule of thumb is that an owner of 10% of the company who has the right to appoint one or more directors to the company’s board is presumed to be an affiliate for this purpose. 

In addition, the HSR Act generally requires that any acquisition of voting securities, non-corporate interests or assets in excess of certain thresholds (USD92 million as of 2021) be reported to the DOJ and the FTC prior to any such acquisition. Thereafter, the acquisition cannot be completed before the applicable waiting period (30 calendar days for most transactions) either expires or is terminated earlier, upon request by the filing parties granted at the discretion of the regulatory agencies. The agencies may also extend the review period by requesting that additional information and materials be submitted.

US federal securities laws do not require bidders acquiring a significant portion of a public company’s shares to make mandatory offers to acquire additional shares from the company’s other shareholders. However, the laws of three US states (Maine, Pennsylvania and South Dakota) include "control share cash-out" provisions permitting shareholders of corporations incorporated in such states to demand that bidders acquiring more than a specified percentage of shares (as low as 20% in Pennsylvania) purchase their shares at a specified price (eg, the highest price paid per share by the bidder in recent share acquisitions).

Cash is the primary form of consideration to acquire US target companies. Issuance of shares may require registration of the offering with the SEC, an expensive and time-consuming process. However, if structured in accordance with applicable provisions of the US Internal Revenue Code of 1986, as amended, a transaction involving the exchange of target company stock for acquirer stock may qualify, in whole or in part, as a tax-free reorganisation under which receipt of the acquirer stock by the target company’s shareholders would not be taxable.

Acquisitions of US public companies are typically effected pursuant to merger agreements, under which either (i) the public company’s board of directors and shareholders approve a one-step merger under applicable state law, or (ii) the acquirer first makes a public tender or exchange offer soliciting shareholders to sell their shares for the proposed consideration (cash, in the case of a tender offer, or securities, alone or in addition to cash, in the case of an exchange offer), and then acquires the remainder of the target company’s shares through a statutory second-step or "squeeze-out" merger.

Bidders may make takeover offers subject to the satisfaction of specified conditions, which typically include the following.

• Regulatory approval, including necessary antitrust approvals under the HSR Act, as well as other regulatory approvals that may be implicated by the transaction or the nature of the acquirer. If the acquirer is a non-US person, a submission to CFIUS may be required, or a voluntary submission may be advisable to eliminate the risk of the transaction being unwound later.
• The absence of any change, event or circumstance that has had or is reasonably likely to have a material adverse effect on the target company.
• The target company complying with representations, warranties and covenants in the merger agreement.
• If the offer includes a tender or exchange offer, tender by shareholders of a minimum number of target company shares (often the number required to approve or complete a second-step merger).
• The requisite shareholder approval.

Transactions may be conditioned on the acquirer obtaining adequate equity and/or debt financing. When such a condition is accepted, target companies typically require that the acquirer has binding commitments from its financing sources at the time the merger agreement is signed and also require a "reverse termination fee" payable by the acquirer. That fee is typically the target company’s sole recourse if such financing is not funded.

The target company often agrees to pay a termination or "break-up" fee to the acquirer if the merger agreement is terminated in certain circumstances, such as:

• requisite shareholder approval not being obtained when a competing offer from another potential acquirer exists; or
• the target company entering into an agreement with another acquirer within a specified period of time after termination of the merger agreement.

The merger agreement typically governs the target company’s ability to solicit or support competing offers and must accommodate the directors’ fiduciary duties to the target company’s shareholders under applicable state laws. Provisions may range from permissive ("go shop") to restrictive ("no shop"). The merger agreement may provide the acquirer with "matching rights" or a "last look" allowing it to match superior third-party bids received by the target company. Although less common recently, the acquirer may seek a "force the vote" provision requiring the target company’s board to present the transaction to a shareholder vote, even if the board withdraws its support of the transaction.

If a bidder has acquired the requisite shares to approve a statutory merger under applicable state law and the target’s organisational documents, the bidder can effect a second-step or "squeeze-out" merger to acquire the target company’s remaining shares. 

State laws typically require that mergers be approved at a meeting of the company’s shareholders, unless (i) the target’s organisational documents permit mergers to be approved by written consent of the shareholders, or (ii) the bidder has acquired the statutory number of shares to effect a short-form merger, which permits an expedited process without a shareholders' meeting.

Short-Form Mergers

Most state laws require that the bidder hold 90% of the outstanding shares to effect a short-form merger. However, some state laws (including Delaware) permit bidders to complete short-form mergers following first-step tender offers in which enough shares are acquired to approve a merger under the target’s organisational documents (which may, for example, be a simple majority of the outstanding shares).

Governance Control

If a bidder does not seek or obtain 100% of the target’s shares, it may nevertheless obtain significant governance control with respect to the target. A bidder acquiring the requisite shares under applicable state law and the target’s organisational documents to elect directors (typically a plurality of the votes cast) may nominate and elect all directors, although for companies with staggered director terms, electing all directors may take several years. Significant share ownership may provide a bidder with blocking rights on matters submitted to shareholders and permit the bidder to seek negotiated rights.

Potential acquirers often seek "lock-up" agreements from principal shareholders of the target company to tender their shares or vote in favour of the merger. Such agreements are typically entered into simultaneously with the signing of the merger agreement. 

Under Delaware law, restrictions imposed under such tender or voting agreements, together with the obligations of the company’s directors under the terms of the merger agreement, may not be so broad as to impede the directors’ ability to exercise applicable fiduciary duties and entirely preclude the company from pursuing a better offer from a competing bidder. Depending on the circumstances, lock-up agreements may also be subject to restrictions under SEC regulations.

Hostile takeovers are permissible in the USA, although they are far less common than friendly takeovers and face significant hurdles. State statutes permit corporations to implement takeover defences such as shareholder rights plans ("poison pills") and staggered terms for directors to deter potential hostile acquirers.

Poison Pills and Staggered Boards

Poison pills are triggered when an acquirer accumulates a certain percentage of the target’s outstanding shares and they threaten substantial dilution of the acquirer's holding and a significantly higher acquisition cost. Under staggered board terms, only a minority of the total number of the company’s directors (typically one third) are re-elected or replaced in one year.

Risks of Hostile Takeovers

In addition to the challenges presented by takeover defences, hostile acquisitions typically take longer to complete than negotiated transactions, impose higher acquisition costs that may include litigation, and limit the bidder’s ability to conduct robust due diligence with the co-operation of the target company’s board and management.

Hostile acquisitions may present potential reputational risks to the bidder, especially if the attempted takeover is ultimately unsuccessful or the target engages in a negative publicity campaign against the bidder. Private equity buyers seldom pursue hostile takeovers and often agree with their investors not to make investments other than on a friendly basis.

Private equity sponsors commonly rely on equity to align their incentives with management, and the level of participation varies widely from sponsor to sponsor. Management equity may arise from rollover equity, cash investment in the post-closing company, or incentives issued in connection with or after the transaction closing.

Private equity sponsors often seek to retain, rather than replace, existing management teams and therefore wish to maintain management’s commitment to the post-closing business. Accordingly, private equity buyers often permit a target’s management to make significant investments in the acquiring company (from 10% to as much as 50% of the transaction’s equity financing) through rollover equity or new investment.

The scale of incentive equity in the post-acquisition equity capitalisation is, by contrast, somewhat more uniform in private equity transactions. Historically, incentive equity commonly represented around 10% of a private equity-sponsored company’s fully diluted equity, but more recently, incentive equity pools have increased to approach 15% and above, particularly in smaller companies. In step with this trend, private equity sponsors may rely on more aggressive performance thresholds for incentive equity participation.

The breadth of participation in incentive equity programmes varies by industry and investment size. Typically, incentive equity participation is limited to "C-level" management and other key employees. However, in certain industries, such as technology and life sciences, broader incentive equity participation among less-senior employees is more common and is often a necessity to attract and retain skilled employees in tight labour markets.

While rollover equity is more often pari passu with the sponsor’s equity in terms of liquidation preferences, participation rights and other economic terms, sponsors consider subordinated equity structures for management and rolling equity holders, particularly with respect to investments in targets with valuation uncertainties or known issues, or as a tool to bridge valuation gaps. Regardless of economic parity, the private equity sponsor typically retains broad, exclusive control over matters such as governance, additional equity financing and liquidity.

Forms of Incentive Equity

Incentive equity in private equity investments takes many forms, including profits interests, stock options, phantom equity, stock appreciation rights and restricted stock. Stock options and profits interests are the most common forms and share similar mechanics, permitting management to participate in equity value above the value at the time of issuance.

Profits interests

The generally employee-favourable tax treatment of profits interests (typically permitting capital gains treatment on liquidity, while proceeds from stock options are taxed at ordinary income rates in most circumstances), together with the increased popularity of limited liability company structures in private equity investments, has led to a marked trend towards profits interests over stock options in recent years. The prevalence of stock options persists in software and other technology sectors.

Restricted stock

Restricted stock and similar types of capital equity are less commonly used for incentive equity, and usage is limited to corporations. Unlike stock options or profits interests, the value of restricted stock is taxable to the recipient at issuance. Accordingly, unless the recipient pays fair market value in exchange for the equity, the employee would have an upfront tax obligation without any corresponding liquidity.

To avoid this tax timing dilemma, the issuer company can lend the fair market value of the restricted stock to the employee to finance the employee’s purchase of the stock. The terms of these loans are subject to the rules of taxing authorities and must not be entirely non-recourse. They are generally repaid in connection with liquidation of the stock or termination of the employee’s employment relationship.

Vesting of management equity differs based on the type of equity. Generally, rollover equity and cash investments by management are fully vested upon issuance, as is the equity purchased by other investors. Incentive equity, however, is customarily subject to vesting requirements, with vesting commonly occurring incrementally over periods of three to five years.

The frequency of incremental vesting varies (it is usually annually or monthly), sometimes with "cliff" vesting of a larger portion after the first vesting period, followed by a straight-line vesting schedule for the remainder. Incentive equity may also be subject to performance vesting conditions, commonly tied to a multiple of the private equity sponsor’s return on invested capital.

Vesting determines the treatment of incentive equity upon termination of the employee’s employment. If vested upon termination of an employee’s employment, incentive equity is typically owned by the terminated employee and is often subject to repurchase by the company (as described below), while unvested equity is typically cancelled or otherwise surrendered without consideration.

Time-based vesting of incentive equity is often accelerated in connection with certain specified liquidity events, and less commonly in connection with termination of the employee’s employment by the company without cause or by the employee for good reason.

Management equity is typically subject to repurchase by the company following certain events. Repurchase rights are usually broader (and less favourable to the employee) for incentive equity, and narrower (and more favourable to the employee) for rollover equity or cash investments. The repurchase price also typically differs between incentive equity and rollover equity or cash investments.

The repurchase price is often the fair market value of the equity, but if the employee’s employment is terminated by the company with cause or by the employee without good reason, then the repurchase price for incentive equity may be some nominal amount (or no amount). These "good leaver/bad leaver" provisions occasionally apply to management rollover equity or cash investments, but it is more common for that equity to be repurchased at fair market value in all circumstances.

Repurchase rights may be permissive or mandatory, and management put rights are uncommon in private equity-sponsored companies.

Private equity sponsors typically seek restrictive covenants from management shareholders, either in the definitive acquisition agreement, incentive, rollover or cash investment equity documentation, employment agreement or separate restrictive covenant agreement. Generally, these restrictive covenants include non-competition, non-solicitation (of employees, customers and other business relationships) and no-hire restrictions, as well as non-disparagement, non-interference and confidentiality covenants.

The term and scope of these obligations are subject to negotiation and vary across transactions, but five-year terms that cover the entire world are not uncommon in merger and acquisition transactions involving businesses with a material international presence.

Enforceability

The enforceability of restrictive covenants (including specific, often technical, requirements for enforcement) varies from state to state within the USA and depends on the consideration given for the agreements. While most jurisdictions have historically enforced non-competition and non-solicitation restrictions on selling shareholders in the context of M&A transactions, enforceability is less certain in many US states in ordinary employment relationships (and in some states, these restrictions are unenforceable). Moreover, the DOJ has taken the position that certain restrictions not critical to a separate, legitimate business arrangement may be per se illegal.

In recent years, enforceability may not be certain even in the context of merger and acquisition transactions. States enforce non-competition and non-solicitation restrictions only to the extent that they are reasonably limited in duration and scope and tailored to protect the goodwill and business of the acquired company. Furthermore, the FTC has challenged covenants that unduly eliminate competition (which is more relevant in strategic acquisitions, including add-on transactions) or restrict activity beyond what is necessary to protect the buyer’s investment.

Management equity generally represents a minority position in the post-acquisition equity capitalisation. Incentive equity holders commonly have only economic rights. Holders of equity obtained by purchase (including rollover equity and cash investments) typically have minority protections that fall into four categories: anti-dilution, exit participation, restrictions on sponsor-affiliate transactions and information rights.

Anti-dilution

Anti-dilution rights of management equity holders typically take the form of participation (or pre-emption) rights to subscribe for additional equity in post-closing issuances to maintain their proportionate equity position. In private equity-sponsored companies, participation rights often apply only to issuances to the private equity sponsor or its affiliates, permitting the sponsor to dilute the management minority equity holders to the same extent that the sponsor dilutes itself through third-party equity financing. Less commonly, participation rights apply to a broader array of equity financing.

Exit Participation

Exit participation rights of management equity holders are designed to prevent a private equity sponsor from exiting its investment without providing liquidity to management and other minority investors. The rights are commonly provided as so-called "tag-along" rights, which permit minority holders to sell their equity on a pro rata basis (described in more detail in 10.3 Tag Rights). Additionally, registration rights agreements often provide minority investors the right to participate in registration of public securities for resale, although these agreements have become less relevant in recent years as public offerings of securities in private equity-sponsored companies are less common.

Restrictions on Sponsor-Affiliate Transactions

Minority investors may negotiate restrictions on proposed transactions between the private equity sponsor or its affiliates and the company. These rights are aimed at preventing the sponsor from using its control of the company to extract value that the minority would otherwise be entitled to, by virtue of its equity position.

Information Rights

Minority investors typically receive limited information rights, often including periodic financial statements but occasionally broader rights. Because management would typically have access to that information (at least while employed by the company), minority information rights are often of limited value to management equity holders.

Occasionally, management and other minority investors with significant capital equity positions negotiate rights to appoint board members. Private equity sponsors rarely surrender control of the governing board. Likewise, minority investors in a private equity-sponsored company rarely have veto rights over company action. Minority investors are usually subject to a series of restrictive provisions, including the private equity sponsor’s "drag-along" rights (described in 10.2 Drag Rights), strict restrictions on the transfer of equity, and rights of first refusal in favour of the company and the sponsor on most transfers of equity. Consequently, the sponsor has nearly absolute control over operations, financing, acquisitions and liquidity.

In most US states, including Delaware, statutory minority rights are limited, and in limited liability companies minority rights are almost entirely left to contract provisions.

Private equity sponsors typically enjoy broad control rights over portfolio investments in which they hold a majority interest, ordinarily controlling appointment of at least a majority (and often all) of the governing board and rarely ceding much if any control to minority holders, except in the context of limited minority protections (described in 8.5 Minority Protection for Manager Shareholders). Accordingly, private equity sponsors commonly have legal control of all operational, capital and liquidity matters, although as a practical matter, they frequently defer to a significant extent to existing management on operational matters.

In minority private equity investments, a fund often negotiates for specific veto rights, including with respect to exit transactions, additional equity, material deviations from approved budgets and enhanced information rights. Control rights in the context of minority investments vary broadly depending on the size of the investment, the parties involved, and the fund’s investment strategy.

Private equity funds that hold controlling equity positions in a portfolio investment may be liable for the company’s conduct in certain circumstances. For example, majority equity holders may be liable for the company’s employee pension obligations under the US Employee Retirement Income Security Act of 1974 (ERISA), the company’s compliance with various environmental regulations, or for the company’s failure to comply with the requirements of the Worker Adjustment and Retraining Notification Act of 1988 and state labour regulations. Law enforcement bodies have increasingly brought or threatened action against controlling equity holders for the criminal conduct of operating companies, including under the federal False Claims Act and the Foreign Corrupt Practices Act (FCPA), typically in situations where heightened levels of operational control are exercised.

Civil liability may also pass to controlling private equity funds in scenarios where lack of required corporate formalities and other bad acts can result in limited liability structures being disregarded under corporate veil piercing and other alter ego theories. Sponsors can minimise the risk of exposure to portfolio company liability by observing traditional corporate formalities, installing formal governance bodies at portfolio companies separate from those of the fund, documenting thorough due diligence of potential criminal conduct before the acquisition, and regularly exercising diligent oversight of the company’s conduct after the acquisition.

In an effort to insulate private equity funds from control liability (described in 9.2 Shareholder Liability), as well as to enhance exit value and avoid reputational losses, controlling private equity sponsors will commonly insist that their portfolio companies adhere to robust legal compliance policies, including with respect to anti-corruption under the FCPA and state laws, compliance with employee benefits requirements under ERISA and, increasingly, policies addressing sexual misconduct and ESG and DEI matters. This oversight often involves regularly auditing policy compliance, but is balanced with a concern that a fund’s exercise of too much control over day-to-day compliance may actually increase the risk of control liability generally.

Average holding periods for private equity investments have increased over the last decade, replacing the traditional three to five-year period historically characterising those investments with average periods recently exceeding six years. This may be driven in part by the increased popularity of funds with long-term investment horizons focused on minimising transaction costs and other inefficiencies incident to shorter investments. Additionally, the effects of the COVID-19 pandemic are expected to at least temporarily extend holding periods.

The most common exit for a private equity investment is a complete liquidation in a buyout transaction. Most private equity funds will not reinvest in an exit transaction because the terms of the fund generally dictate that the fund be wound up before a reinvested investment is likely to be liquidated.

Private equity sponsors holding a controlling equity position typically enjoy broad rights to compel the sale of minority equity positions in connection with the majority’s exit. These "drag-along" rights usually apply to all minority investors, including institutional co-investors, although the specific terms of the drag rights may be negotiated individually. Drag-along rights are commonly triggered by the sale of a controlling stake in the company, but occasionally apply to smaller transfers, such as sale of a majority of the controlling equity holder’s position. Drag-along rights are seldom exercised.

Buyers are typically sensitive to minority dissent in a transaction and reticent to close an acquisition unless each equity holder is a party to the acquisition agreement. More often, an alternative transaction structure (such as a merger or asset sale) is employed to avoid minority hold-up value or refusal to deal. Accordingly, drag-along rights have more value in establishing the expectations of the parties and creating a mostly symbolic threat than they have in practice.

Management and other minority investors generally have rights to participate (on a basis proportionate to their respective investment positions) in a complete or partial exit led by the majority private equity sponsor. These "tag-along" rights are commonly triggered by any sale of equity (other than specified permitted transfers such as transfers to affiliates and estate planning transfers), but thresholds may be negotiated to permit partial exits without minority participation, as when a sponsor has a plan to sell down equity to co-investors. Tag-along rights usually require the sponsor seller to use some level of reasonable or best efforts to facilitate participation in the transaction by the tag-along investors, and the sponsor may not complete the exit if the prospective buyer refuses tag-along investor participation.

In the recent past, IPOs were relatively rare in the USA, particularly among private equity-sponsored companies. However, SPAC transactions have become a fixture of the current M&A market. In these hybrid M&A-IPO transactions, the SPAC raises capital in an IPO to finance a subsequent acquisition of a private target within a timeframe specified in the SPAC’s organisational documents. The target becomes public as a result of the transaction. The number and size of SPAC transactions have increased dramatically in the last 18 months to the point that SPAC transactions now make up a substantial portion of all IPO volume in the US. Traditional IPOs by private equity-backed companies have also seen a resurgence.

Lock-up periods applicable to private equity and other pre-IPO equity holders are typically 90–180 days. Relationship agreements are not a common feature of US IPOs.