Minority equity sell-down transactions

October 2023  |  SPECIAL REPORT: PRIVATE EQUITY

Financier Worldwide Magazine

October 2023 Issue

The general partner (GP)-led single asset continuation fund secondary transaction has become an important portfolio management tool for private equity (PE) sponsors seeking an alternative form of exit. A GP-led secondary enables a sponsor to continue to manage a trophy asset beyond the life of the sponsor’s current fund and to provide an element of liquidity for those limited partners (LPs) wanting it.

Although both the number and value of single asset GP-led transactions have boomed, the less common minority equity sell-down transaction can also be a valuable tool in the sponsor’s portfolio management toolbox.

The minority equity sell-down transaction is a partial exit by a PE fund through a direct sale of a minority interest in the relevant portfolio company to a third party PE fund (or other financial investor) in a traditional M&A process. Although a single asset GP-led transaction may be an attractive option for a sponsor seeking liquidity from a portfolio company, the minority equity sell-down transaction can have advantages in certain circumstances.

The minority equity sell-down transaction can be distinguished from a GP-led strip sale of a minority interest to a continuation fund, which has its own drivers, advantages and challenges.

The sale of a minority interest in a portfolio company by a PE fund to a new financial investor gives liquidity for all the selling fund’s LPs and provides them with a continuing exposure to the company through the existing fund on the same fund terms. On a GP-led transaction, LPs may not have the option of partially selling their interest and partially rolling into the continuation fund. Furthermore, the timeframe and other new terms of the continuation fund may not suit an LP’s own circumstances.

The minority equity sell-down transaction also provides third-party validation to the selling fund’s LPs of the current carrying value of the relevant portfolio company. Indeed, a sale of a minority interest can be a precursor to, or combined with, a GP-led secondary of the majority interest in the portfolio company. The third-party sale of a minority interest in an M&A process can give greater comfort to LPs on the pricing of the GP-led secondary than a professional valuation or bids from secondary investors.

From the perspective of a fund’s carried interest holders, if a carried interest payment is otherwise triggered by a disposal of a portfolio company to a GP-led secondary continuation fund, the sponsor’s executives entitled to the carried interest payment will be obliged to roll most, if not all, of it into the continuation fund. If a carried interest payment is triggered by a minority equity sell-down transaction in relation to a portfolio company, the rollover obligation does not arise.

The minority investor may also add value through access to new markets or expertise, and provide an obvious exit route, with the minority investor seeking to acquire the rest of the company in due course.

Issues to be considered

The terms of any minority sell-down transaction will be dependent upon relevant circumstances, including the requirements of the acquiring investor, and are negotiable within parameters. The main driver of the transaction terms will be the size of the shareholding to be acquired by the minority investor.

The key issues to be agreed include whether the new minority investor’s shareholding ranks in priority to that of existing shareholders, the governance and minority protection rights and the rights of the minority investor relating to share transfers and exit. Another key issue, which must be addressed at the outset, is the impact of the transaction on the members of the management team.

Preferential ranking. A financial investor which acquires a small minority equity stake of circa 10 to 15 percent from the majority shareholder will typically expect to receive its investment back before the majority investor participates in future returns. Whether an investor which acquires a larger minority equity stake of circa 20 to 30 percent is likely to achieve such a preferential ranking for its investment can depend upon a number of factors.

The greater the difference between the original majority investor’s entry price and the minority investor’s acquisition price, the greater the argument that the minority investor should have a preferential ranking.

The incoming minority investor’s rights in relation to the timing and value of an exit will also be a significant factor in considering whether the minority investor should have a preferential ranking for its investment. If the minority investor is unable to veto a forced exit at below its acquisition price in the early years of its investment it will have a stronger argument that it should have a preferred position.

Governance and minority protection rights. The minority financial investor will expect to receive a board seat or the possibility of appointing a board observer. An investor which acquires a large minority stake may want the right to appoint more than one director. Retention of the right to appoint a director may be dependent upon retaining a specified level of shareholding, with the investor losing the right if its equity stake falls below that level.

The minority investor will expect customary minority shareholder protection rights, including preemptive rights on new share issues. Consent (veto) rights in respect of the strategy and operation of the company’s business will be reserved to investors which acquire large minority equity stakes. Investors acquiring small minority equity stakes will have their consent rights limited to those designed to directly protect their shareholding.

An antitrust analysis will be necessary to assess regulatory filing requirements and whether governance rights for the new investor may raise significant influence or control issues resulting in increased deal execution risk.

Share transfers and liquidity. The minority investor will typically either not have the right to transfer its shares (other than in the case of customary permitted transfers) or be subject to a lock-up on share sales for an agreed period.

Pro rata tag-along rights are likely to be granted to the minority investor to cover the situation where the majority investor subsequently sells shares in the portfolio company making up less than a majority interest, with the minority investor having the right to sell the whole of its minority stake where a controlling stake in the company is being sold by the majority investor.

The minority investor will be concerned to ensure that it is not forced into a premature exit at a valuation below its acquisition price. An investor with a large minority stake of 20 to 30 percent might expect to negotiate that the majority investor’s drag-along right should not apply to the minority investor’s shares for an agreed period of years from completion of the investment unless the relevant exit delivers the minority investor an agreed minimum multiple of its invested capital.

Another principal concern of the minority investor will be that it is not able to exit its investment. This can be addressed partially by restricting the sales lock-up period applicable to the minority investor’s shares. Any share sales by the minority shareholder after the lock-up period would likely be subject to a right of first refusal, or first offer, in favour of the majority investor.

A minority investor with a large equity stake may also be granted the right to trigger a process for the sale of the whole company if no exit has been achieved by the end of a five-year period from the date of its acquisition. The majority investor may insist on the retention of a right of first refusal in respect of such a sale.

Management team issues. Management may not have tag-along rights in relation to the sale by the PE fund to the minority investor. It will, however, be important to ensure that the management team is supportive of the sale because their participation in the sale process will be needed. It will therefore be necessary to agree the extent of the sale of shares by the management team as part of the sale to the minority investor.

Another key issue for the management team will be the effect of the minority equity sale on any existing equity proceeds ratchet or other management incentive plan. The impact of the sale on any existing exit ratchet will need to be assessed alongside any proposals for a new ratchet based upon the higher valuation implied by the minority equity sell-down transaction.

The management team will need to give business warranties in relation to the sale to the minority investor. Any liability under these warranties would typically be backed by warranty and indemnity insurance.

Looking forward

The single asset GP-led transaction market will doubtless continue to grow apace because it provides both an alternative route to liquidity and the opportunity for a fund’s GP to continue to manage a highly performing asset beyond the life of the fund.

In comparison, the minority equity sell-down transaction may remain less common. Its popularity is, however, also expected to grow, with the approach being used as a standalone option or in combination with a GP-led. There have already been many examples of a direct minority sale being combined with a GP-led of the retained interests by the majority investor.

Other minority investment transactions such as primary buyouts involving the acquisition by a private equity fund of a minority (rather than majority) equity interest, co-investments and growth capital investments all have some common terms with the minority equity sell-down transaction. Minority equity sell-down transaction terms will, however, continue to have their own discernible guidelines, and be somewhat bespoke, dependent upon the circumstances of the relevant transaction.

 

Ed Harris is a partner, Cees Brouwer is a counsel and Graham Nicholson is a counsel knowledge lawyer at Hogan Lovells International LLP. Mr Harris can be contacted on +44 (0)20 7296 2809 or by email: ed.harris@hoganlovells.com. Mr Brouwer can be contacted on +44 (0)20 7296 5985 or by email: cees.brouwer@hoganlovells.com. Mr Nicholson can be contacted on +44 (0)20 7296 5852 or by email: graham.nicholson@hoganlovells.com.

© Financier Worldwide

BY

Ed Harris, Cees Brouwer and Graham Nicholson

Hogan Lovells International LLP

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