Private Equity (“PE”) financing has emerged as a major investor class and has been a driver of economic growth of companies over the world. This note summarizes the key steps involved in consummation of a PE investment.
In order to make a PE investment, the PE investor has to undertake a series of steps. A typical private equity investment commences with the PE investor seeking out a company requiring investment or being approached by such a company. The selection of the investee company after undertaking a background check of the investee company and its holding company (ies) / promoters is the most significant step in a PE Investment.
Following this, a basic document, such as a term sheet, memorandum of understanding or a letter of intent is executed between the PE investor and the investee company, in order to lay out the broad terms and conditions of the investment and expressing the intention to enter into definitive agreements. The consummation of the investment and execution of definitive agreements may also be subject to fulfilment of certain conditions precedent, to be spelt out in the initial document. If the transaction necessitates a diligence, then the execution of definitive agreements is generally subject to a favourable outcome of such diligence.
Once the initial document is in place, the PE investor usually conducts a legal, tax and financial due diligence on the investee company. The scope of the due diligence largely depends on the nature of the PE investment. A PE investment that envisages an investment by way of the PE investor and the promoter coming together to incorporate a start-up investee company may not require a due diligence, unless the diligence to be carried out is on the promoter(s) itself. However, if the PE investment involves investment in the share capital of an existing company, a comprehensive due-diligence is imperative.
Simultaneously with the due diligence process, the PE investor and the investee company commence negotiations in respect of the definitive agreements. The most common definitive agreements in a PE transaction are investment documents, including share subscription agreements, share purchase agreements and shareholders’ agreements between the PE investor, the investee company and the promoters/shareholders. There may be other documentation agreed on between the parties depending on the structure and other terms of the deal, such as trade mark licenses and technology transfer agreements, where one of the parties transfers its business or technology to the newly incorporated company or an escrow agreement for safeguarding shares, consideration or assets, etc.
The critical part in drafting the definitive agreements is inclusion of the representations, warranties and indemnities to be provided by the investee company and the promoters to the PE investor. The representations and warranties are nothing but an assertion of facts – past, present and future, in relation to the business and affairs of the investee company, legal compliance, its financial condition, taxes, disputes, etc. The representations and warranties provided by the investee company and its promoters generally form the basis on which the PE investor is induced to make investment in the investee company and can be appropriately drafted by considering the findings of the due-diligence exercise. In the event there are any irregularities in the findings of the due-diligence exercise, the PE investor may require the same to be ironed out as a condition precedent to the investment. However, in the event there are certain irregularities which cannot be rectified as a condition precedent, the rectification of such irregularities is made a condition subsequent in the definitive agreements and is supplemented by a suitable indemnity.
Another important to consider in the documentation of the definitive agreements is the indemnity obligation of the investee company and the promoters. An indemnity in PE transactions is a contractual obligation of the investee company and the promoters to compensate the PE investor for any loss incurred by such the PE investor on account of a breach of a contractual obligation or misrepresentation undertaken by the indemnifying party. The right to indemnity is one given by the definitive agreement(s) and is in addition to the right to claim damages arising from such breach, which is available under law.
The definitive agreements set out the framework of corporate governance and decision making in the investee company. They also set out detailed provisions in respect of transfer of shares and other securities of the investee company. In most PE transactions, the PE investor has board representation in the investee company along with certain veto rights. The veto rights usually extend to matters relating to corporate governance (such as changes to board composition, amendments to the charter documents, related party transactions, mergers and acquisitions etc.) and certain high-level operational matters (such as entering into litigations, taking on loans, substantial sales of assets, etc.).
Exit strategy is a very critical part of making PE investments. It is important for the PE investor to be able to divest its shareholding and exit in the most profitable, tax-efficient and expeditious manner. The most common exit options available to a PE investor are as follows (i) Buy-back / Redemption of shares, (ii) Initial Public Offer (IPO); (iii) Put / Call Options; (iv) Strategic Sale; (v) Drag Along Right; etc.
The definitive agreements often enumerate certain ‘events of default’ or ‘material breaches’ upon the occurrence of which the PE investor shall have the right to accelerate an exit at a substantially higher default price and terminate the definitive agreements. In such events, a default drag along right / default put option right generally serve to act as a deterrent against breaches and defaults.
Lastly, the definitive agreements set out the governing law, jurisdiction and dispute resolution mechanism, in the event of there being any disagreements / disputes between the parties. Arbitration has emerged as an effective form of dispute resolution and institutional arbitration remains a popular choice for most PE investors. Further, it is necessary to identify the governing law, which serves to determine the sub¬stantive law that will apply to any legal proceedings which may arise from the agreement and an informed choice must therefore be made between jurisdictions when determining the governing law and jurisdiction of the definitive agreements.