Over the past ten years private equity firms have looked with increasing frequency to add-on acquisitions by their portfolio companies to drive growth. Add-ons allow sponsors to take advantage of operational and financial synergies that are not available to them upon the initial acquisition of a portfolio company, giving them an edge in auctions over other private equity firms and sometimes exclusive opportunities that are more typically the preserve of strategic buyers – all boosting returns on exit.
According to data from Preqin, the prevalence of add-on acquisitions has grown from 1/5 of all private equity transactions representing 2% of overall deal value in 2008 to nearly 1/3 of all private equity transactions and over 13% of overall deal value in 2013. This publication reported last year on the key issues in these add-on acquisitions (see: “Strategic Thinking: Special Considerations for Private Equity Sponsors Contemplating Add-on Acquisitions” in the Winter 2013 edition of the Debevoise & Plimpton Private Equity Report).
We have recently observed the development of two important variations on the traditional add-on transaction. At the bidding stage, we have seen an increase in “two for one” simultaneous acquisitions – eliminating the traditional timing gap between closing of the first portfolio company acquisition and closing of the first add-on acquisition.1 We have also begun to see private equity funds in later stages of their investment periods or that are otherwise capital constrained bringing in another private equity firm to fund, alongside the first private equity firm’s portfolio company, investments into add-on targets. This article will explore this second new add-on structure, which brings elements of traditional private equity club deals into the world of add-on transactions, and significantly increases the complexity of these transactions.
The appeal of the “New Club Deal,” as we’ll call these transactions, is significant. For the sponsor of the existing portfolio company, it is the opportunity to participate in an acquisition process and access investment returns that it otherwise could not. The original sponsor brings to the table the traditional advantages of a strategic buyer in terms of synergies and sector expertise, supported by a full management team able to assess and diligence a target. For the new sponsor, the New Club Deal provides an opportunity to leverage synergies and sector knowledge arising from the original sponsor’s portfolio company, offer a more attractive price in an auction process and perhaps access an exclusive opportunity. But these deals require careful advance planning, creative negotiation and thoughtful process management in order to ensure smooth execution.
Two Diligence Exercises
The preparatory phase raises a number of unique challenges in a New Club Deal. As is typical in any club deal, the two sponsors will need to work out the terms of their joint approach to the target. But the stakes and issues are different from those in the typical club deal. In the case of a New Club Deal, the sponsor providing new equity must also use the preparatory phase to run a parallel diligence process with respect to the original sponsor’s portfolio company. These processes can put significant stress on the portfolio company’s management team. The management team will be called upon to gather information and answer questions to support the new investor’s diligence, and simultaneously asked to conduct business diligence with respect to a significant acquisition – all at a time when some members of management may feel concerned about their own future employment prospects. Where a management team is lean, recruiting outside advisors to provide early support can be critical. Care must also be taken to ensure that the pacing of the buy-side diligence of the target and the sell-side diligence on the original portfolio company by the new sponsor do not get out of sync. The same is true of the negotiation of the transaction agreements.
New Money, Differing Interests
The outcome of those parallel diligence processes will be two inter-linking agreements: (1) an investment agreement between the new sponsor, the original sponsor and the existing portfolio company, and (2) an acquisition agreement between the existing portfolio company’s acquisition vehicle and the sellers and/or the target company.
An investment agreement of this kind between an original and a newly investing sponsor is an unusual animal. It must contain the customary representations, warranties and potentially indemnities of a standard acquisition agreement in order to provide the new sponsor with support for its due diligence on the original portfolio company, as well as purchase price adjustments, closing conditions and the other usual features of an acquisition agreement. But these issues must be negotiated in the unique context of how the target company will perceive them. Buyer conditionality is anathema to sellers, so closing conditions are typically narrowly limited other than a requirement that the acquisition of target and the new sponsor’s investment be consummated substantially simultaneously. For example, an original sponsor (and a savvy target) might ask that any materiality measure used to judge the accuracy of representations and warranties at closing be measured against the combined company rather than the existing portfolio company alone. To simplify the negotiations and diminish tensions between old and new sponsor, the parties may agree that the investment agreement will adopt the representations and warranties given to target, either in whole or in part.
Because the sponsors are entering into a long-term partnership, the original sponsor may resist indemnities that could result in disputes after closing. The new sponsor, on the other hand, may seek such protections as compensation for limited closing conditionality. Where indemnities and purchase price adjustments are agreed, given cash constraints, an equity based adjustment mechanism (i.e., altering each sponsor's ownership of the portfolio company) may be more appropriate than cash payments, requiring the parties to work through the inherent complexity of such mechanisms.
In addition, the investment agreement must address – or at least begin to address in the form of a well-developed term sheet – the many potentially complex intra-sponsor issues that will exist in the life of the joint venture through exit. Key points include structuring, governance (including allocation of board seats and any shareholder veto rights over key actions), executive management and management equity arrangements, transfer restrictions and other exit rights such as drag-along rights.
The negotiation of these issues raises challenges beyond those typically encountered in club deals. The sponsors are fundamentally aligned in their desire for the investment in the target to be successful, and as private equity investors will generally share similar investment approaches. However, the new sponsor and original sponsor are not identically situated. The original sponsor will be at a later stage in its investment with respect to the portfolio company and likely toward the end of its investment period. As a result, the parties may have differing tax structuring needs and will have different investment horizons. A new sponsor might, for example, resist a near-term drag right in favor of the original sponsor – possibly insisting on performance hurdle conditions in order to ensure that the original sponsor does not seek an exit before the full benefit of the transaction has been realized. Governance arrangements must also reflect the possibility that an indemnification claim backed by an equity-based remedy could upset initial expectations as to relative ownership. These issues may be addressed through step down thresholds for board seats and shareholder veto rights, and limitations on the potential shift in equity interests.
Keep it Simple from the Target’s Perspective
The complexity of a New Club Deal is significant, but to succeed the sponsors must do their best to make that invisible to the target. This is particularly the case in a competitive auction context, where the target will resist risk to the availability of the new sponsor’s equity financing or any debt financing that is tied to the performance of the original portfolio company. A variety of techniques may be used to limit that risk. As noted above, the new sponsor may agree to limited closing conditions for its equity investment. The lenders may be persuaded in some circumstances to make the closing of any financing contingent only on the performance of the target company and the fulfillment of conditions under the main acquisition agreement, and not to insert additional conditionality tied to the performance of the portfolio company. Sponsors may also offer a “reverse termination fee” remedy with customary triggers if the transaction is not consummated when required in accordance with the acquisition agreement, perhaps with responsibility for any fee allocated by the sponsors to the party who is deemed responsible for the failure to close. Finally, sponsors may provide equity commitment letters to the acquisition vehicle and limited guarantees similar to those seen in a more typical leveraged buyout structure.
Three’s Not a Crowd
New Club Deals are an attractive solution for sponsors that cannot act on an attractive add-on investment opportunity due to lack of capital or a desire not to over-lever their portfolio company. Such deals also provide an opportunity for the incoming sponsor to find exclusive or semi-exclusive opportunities in which they may be able to reap the benefit of strategic-like synergies. While the old saying goes that two’s company but three’s a crowd, three is a very welcome number for New Club Deals. Given the number of sponsors managing late stage funds and not raising new capital in the current market, we expect to see more New Club Deals in the future.
1 Recent examples of simultaneous acquisitions include Clayton, Dubilier & Rice’s acquisition of Brand Energy and Harsco Infrastructure and Apax Partners’ acquisition of One Call Care Management and Align Networks.