What is Private Equity?
As financial markets and institutions evolve, the complexities of their legal underpinnings only increase. The need for specialized knowledge increases with the sophistication of each market and each client in that market. The concept of private equity in its current form is less than 20 years old but has already expanded and contracted a number of times, in terms of both the number of deals made and the amount of money flowing into the market, as well as in terms of who is a participant in the market. These changes are the result of a number of factors, including expansion of previously existing markets (real estate, leveraged buyouts, venture capital), the creation of new markets (special purpose acquisition corporations ("SPACs")), and the adoption of new legal structures. Each of these substantive law developments has its roots in many of the topics covered by this blog. While the history of private equity, as a legal and economic matter, is beyond the scope of this guide, it may be worthwhile to establish that due to the factors discussed above, the substantive law of private equity will only grow in importance.
Private equity generally refers to the investment by institutional and high-net-worth investors in companies that are not listed on a public exchange. This non-listed status is important because the relatively high returns obtained by private equity investors are largely a result of the illiquid nature of their investments. These returns are limited by the cost of capital and are often available from non-listed entities due to operational inefficiencies, undervalued assets, or underdeveloped management, among other reasons . In addition to an illiquid investment horizon, private equity investments also require a greater involvement from their investors; they are not simply passive investments. These investors also face a number of regulatory hurdles, especially as there has been a concerted effort by regulators throughout the world to end some perceived abuses and lessen information asymmetries. As a result of this increased oversight, private equity firms have been forced to level the playing field to the extent possible and act as fiduciaries to their investors.
The funds raised by private equity investors are not, however, just given to portfolio companies. They are first given to a private equity fund, which in turn invests those funds. Again regulation plays a role, as most private equity funds can only raise money from accredited or "qualified" investors. This regime has grown 250% – from $707.1 billion in 2006 to $2.5 trillion today. When funds are raised, they are distributed to portfolio companies in which the private equity fund takes an ownership interest (equity) or a debt position (bond). Private equity investors tend to use a special valuation method where they assign very high values to future I.P. and intangible assets of portfolio companies. This allows them to receive a larger piece of the portfolio company while lowering their share price. This "liquidity discount" for I.P. and intangible assets has allowed private equity funds to avoid unfair realizations of gain or loss while providing greater control to managers of portfolio companies. The private equity market in New York, the U.S., and the world will likely continue to grow.
What is Private Equity Law?
Private equity law encompasses the body of legal principles, rules, and statutes that govern transactions involving private equity funds, their investors, and the companies in which they invest. Private equity itself refers to capital investment made through investment funds or firms, typically in private companies, with the goal of achieving a high return on investment. Through private equity funds, investors (called limited partners) provide capital to an investment manager (also known as a general partner), who pools the capital and then makes investments in private companies directly and/or through acquisitions of public companies.
The key legal elements of private equity law include federal securities laws, tax and employment laws, and corporate laws. From the outset, private equity is subject to federal securities law, particularly the Investment Company Act of 1940, which includes certain exemptions for fund managers. In addition, securities laws regulate the sale of private securities to accredited investors and the disclosure of private securities offering information in certain cases. Tax law applies differently to equity compensation given to employees and executives of portfolio companies, and to the corporations themselves. By having their investments structured as partnerships, private equity firms are able to take advantage of favorable tax treatment for certain returns.
Corporate laws apply to all business activities, but are especially relevant to the internal workings of a private equity firm, including its organizational structure, governance, and compliance policies and procedures. Most private equity firms are organized as limited liability companies. The terms of limited liability companies (LLCs) and partnerships are generally defined through contractual agreements between their members or partners. Limited liability companies are managed by its members or a committee appointed by them. Under Delaware corporation law, a board of directors manages a corporation, including a Delaware corporation organized as a private equity fund. In the case of private equity funds, however, most of the significant decisions are made by the fund’s general partner, an active member of the firm.
Private equity law governs the complex relationships between the principal actors in a private equity transaction. At the beginning of the deal process, investors provide the funds – called "equity capital" – to a fund through a private placement. The fund finance attorney works with the corporation to structure the private placement, including the terms of a subscription agreement and limited partnership (or LLC) agreement. Because the fund will later be dissolved after its investments are either sold off or realized through an initial public offering (IPO), the attorney considers the tax implications for the fund itself and its investors. Depending on the size, sophistication, and the stated investment goals of the fund, it may be necessary to register the fund under federal investment regulations or to obtain exemptions from registration. The attorney will also help the fund identify and negotiate deals with portfolio companies, such as executing dividend recaps, participating in equity or debt recapitalizations, or pursuing opportunities to acquire or divest of portfolio companies. Once the investments are exited, the investor expects to receive a distribution of the proceeds, usually according to a formula in the fund’s contract.
Common Transactional Players in Private Equity
This section should provide an overview of the major players in the private equity world, what they do, and how the interplay between them affects legal obligations.
Private equity firms are the investment firms that manage the money for the private equity funds. They raise funds from investors, which they then invest into a variety of business with the goal of growing those businesses and eventually reselling them for a profit. Private equity firms are required to register with the SEC and they will typically only work with accredited investors and institutions. Private equity firms charge a management fee to help cover the expenses of portfolio management, and they also charge a percentage of the profits made by the funds that they manage. Exactly how much of a percent of the profits will go to the firm, and how much will go to the investors, has to be made clear before money is exchanged hands since this can vary between funds and firms.
A private equity fund is basically a pool of money made up from the accredited investors or various institutions, which the private equity firm manages. A fund will invest into one or multiple businesses in order to grow them.
Accredited investors are the range of people or businesses that the PE firm raises funds from. The SEC has a list of what class qualifies as an accredited investor, and the list includes natural people with an income in the previous 2 years of at least $200,000 (or combined for a married couple), or having a net worth of at least $1 million excluding the value of personal residence, as well as corporations, nonprofits, trusts, and other entities with at least $5 million in assets.
Portfolio companies – these are the companies that the PE firms invests into. The goal of the firm is to grow and improve on these businesses under its management so that they can get sold in the future for a profit. The PE firm will often have a seat on the portfolio company’s board of directors, which gives it an active role in the daily management of the business.
Common stockholders – this includes the CEO, CFO, and other majority shareholders of the business. Often times, the private equity firms will require that all existing common stock holders sell their shares to the firm as part of the investment deal. Often, in this case, the stockholders are also corporate insiders, meaning they have non-public information about the business, including its financial performance, business plans, economic condition, and estimated value.
Preferred stockholders – preferred stock is a type of stock that gives stockholders preferential treatment over common stockholders in repayment of dividends or in the event of a sale of the business. In this way, they ‘prefer’ their rights over the other stockholders. In many private equity deals, the preferred stockholders will be the investors themselves or the PE firm. Since they get paid out dividends before the common stockholders would, the preferred stockholders may have a slightly greater ability to influence the outcome of certain decisions, though they may not have full control of all of the decision making.
Common stock with a liquidation preference – this is similar to the above, with the key difference that the preferred stock with a liquidation preference must be paid out before dividends are paid to the common stockholders.
Minority stockholder – a corporation will often have many minority stockholders, who own small portions of the company. This can lead to some confusion in decision-making, and can sometimes become an obstacle toward making major changes or future investment.
Private Equity Fund Structures from a Legal Perspective
Private equity fund formation is oneself of the most important parts of the life-cycle of a private equity fund. It is necessary to have the proper compliance for the formation of a private equity fund. Investor agreements, subscription agreements, special purpose entities, and a myriad of other legal documents are necessary for the formation of a private equity fund. The legal structure of a private equity fund is determined by what type of investments the fund will be making. Funds which will perform roll-ups of companies must have a different type of structure than a company which plans to just make a few real estate investments. Public companies require significant different disclosures than private companies. Besides the type of fund, the procedures employed by the fund affect the legal structure necessary. Funds which actively manage their investments may need a different structure than those who passively manage their investments. The risk allocation model of the fund affects the legal structure. The complexity in determining the legal structure of a private equity fund ensures that good legal advice should be sought before committing to any type of fund structure.
Private Equity Fund Regulation Overview
Private equity is subject to a complex web of regulations that varies significantly by jurisdiction. In multiple jurisdictions, private equity funds are required to register as investment companies under securities laws or act as exempt reporting advisers. A growing area of regulation is the general anti-avoidance rules, which are being applied more often to private equity funds in the context of "deductions shopping" – when an investor seeks to deduct funds paid to an offshore investment manager against Australian-sourced income. The challenge for private equity fund managers is to remain compliant with dense and often ambiguous regulations while preserving an effective investment strategy.
United States: Private equity funds are organized based on tax considerations, relying upon certain provisions of the Internal Revenue Code to qualify as "pass-through" entities. These provisions prevent funds from being subject to double taxation on income at both the fund and investor levels. In order to preserve this pass-through tax status, private equity funds are generally organized as limited partnerships or limited liability companies. Under these forms of organization, general partners or managers of the fund do not share in the fund’s tax burden, and investors do not owe taxes concerning fund income until they take distributions from the fund, unless the fund is registered as an investment company under the Investment Company Act of 1940. All fund investors must be "qualified clients," which includes very wealthy individual investors and high-net-worth institutional investors. These entities lose their pass-through status if they issue more than three classes of equity securities, which includes debt instruments .
European Union: Further to the global financial crisis, the European Union implemented specific legislation governing private equity in 2012, addressing concerns regarding accountability and transparency. For example, under European Regulation 2011/91, limited partnerships and limited liability companies formed as private equity funds and hedge funds must be registered with EU regulators, comply with substantive rules and reporting requirements, and register for permission to market fund shares. In addition, Member States are given regulatory authority over private equity funds marketed within their borders. Particularly relevant to private equity funds registered within the European Union are the European Undertakings for Collective Investment in Transferable Securities Regulation 2003 and the European Alternative Investment Fund Managers Directive 2011. UK regulators have guidance documents and private placement memoranda clarifying their application of relevant laws and funds in certain industries, such as energy and real estate.
Asia: Australia has very similar rules to those described above in the United States and European Union, with funds requiring registration as investment companies. China, by contrast, falls somewhat outside of international norms with a disclosure regime that does not generally require fund disclosure or registration. However, China operates a "Panda Bond" market through Hong Kong, which permits investment managers to issue bonds with exposure to renminbi (RMB). This market permits offshore bond issuers to assist private equity firms in fundraising in RMB while providing an opportunity for private equity firms to diversify their investor base.
Key Legal Considerations in Private Equity Transactions
After the term sheet is agreed upon, the next logical step in the process is to work on finalizing the purchase and sale agreement. This is often called the "definitive" agreement and can be several hundred pages long. It is in this document that the representation and warranties are disclosed along with the obligations of the parties. The negotiation of this document is usually done by the lawyers of the respective parties, supplemented by the advice of each other’s respective business people. In some cases, the lawyers will propose a term sheet before any negotiations are done so that the deal can move more quickly. If there are a lot of changes to the "definitive" agreement, it may be appropriate to revisit the term sheet to make sure that the parties are still in agreement with the changes made.
The due diligence process usually takes about 60-90 days. In many cases the seller employs an "investment banker," someone who specializes in getting the best value for the shares of the company. Sometimes this process involves an auction – i.e., invited several companies to bid on the shares. Once the results are received, the deal is completed or not on that basis. More frequently, the company does not go through an auction but simply falls under the good graces of someone they know that wants to invest in their company.
Common Legal Issues Affecting Private Equity
Private equity law not only deals with company mergers and acquisitions but also has its own set of challenges that need to be navigated. Problems may arise from conflicts of interest during investments and negotiations, valuation disputes, and timely exit strategies.
One common area of conflict is in the payment structure of deals. For example, differences in opinions in how and when management will be rewarded for good performance or penalized for poor performance is a common dispute and may complicate the finalization of a deal. Another major consideration is valuation disagreements. In order to acquire a company and invest in private equity, proper valuation estimates must be determined for both the current assets and potential future growth metrics of the company. Strong investment partners have set criteria they look for when reviewing a business and will object to the deal if they did not achieve their minimum benchmarks. Valuation can be a sensitive topic as the owner of the target company may feel that these estimates place an unfair, low value on the business that they have worked so hard to grow and build. On the other hand, strong private equity firms understand how important it is for valuations to be conducted by a third-party in order to prevent any bias in the process. Finally, strategies for a profitable exit from investments can be a significant sticking point in finalizing a deal. The management team of the target company may have strong opinions on how and when they would like to exit from an investment while private equity partners may prefer a more aggressive schedule. Companies may be more open to clipping coupon type exit strategies for partial ownership if the investment is small, but these terms become less favorable when the investment is larger. A good attorney will advise you on these terms in order to best accomplish your investment goals.
The Future of Private Equity Law
As private equity continues to evolve, so too does the law governing it. One of the most notable prospective trends includes the growing focus on environmental, social, and governance (ESG) considerations. While traditionally, such factors were largely considered non-financial, the impact of ESG on long-term profitability is increasingly being recognized. The incorporation of ESG metrics into investment decisions may soon become commonplace, influencing which companies attract investment, and how they are governed post-acquisition. Legal obligations related to ESG issues such as climate change and human rights, for example , are already being examined in other jurisdictions such as the European Union and may influence private equity law in various ways.
Furthermore, increased regulatory oversight is anticipated in certain areas. The labelled "greenwashing" of funds, where the ESG credentials of a fund or investment thesis are overstated, has come under recent scrutiny by regulators. We can expect increased regulatory attention on how ESG is presented and reported in funds. In addition, data privacy and anti-money laundering legislation are both likely to cast a wider net over fund and investment structures, with increased investigation and reporting requirements for fund managers using complex or bespoke funds and vehicles.