Private equity sponsors have increasingly been syndicating to their limited partners a portion of their equity commitments in leveraged buyouts. This has been driven partly by the desire of private equity sponsors to reduce their commitments in larger transactions to more prudent levels in light of their diversification objectives and partly by the desire of many limited partners to increase their level of direct co-investments as those co-investments are frequently made on a "no fee, no carry" basis. Syndications involving a large number of prospective co-investors raise a number of practical and legal issues and pitfalls for sponsors, particularly if the syndications are part of a coordinated sell down in a consortium transaction (commonly known as a "club deal").
The issues and pitfalls that a private equity sponsor should consider in any syndication to their limited partners is what information can and should be shared with prospective co-investors, how the investment should be structured and what kinds of rights should be offered to co-investors. In club deals where more than one sponsor is syndicating a portion of its commitment, there are additional issues regarding how to coordinate the syndication and how to handle prospective co-investors who are limited partners in the funds of more than one of the sponsors.
Sharing Information
The information provided to prospective co-investors in connection with a syndication to their limited partners varies from sponsor to sponsor and from syndication to syndication. Certain sponsors furnish prospective co-investors on a particular deal with little more than their investment committee memorandum and due diligence memoranda commissioned from third parties while others, particularly in larger syndications, prepare "teasers" and a detailed information memorandum specifically for purposes of the syndication and hold management "road shows" and advisor conference calls for prospective co-investors.
Whatever you do, a few basic rules of the road to be mindful of include:
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If the syndication is effected prior to the closing of the transaction, verify that you can furnish the information to prospective co-investors under your confidentiality agreement and investment documentation with the target and ask each prospective co-investor to sign an agreement acknowledging that it will be bound by your confidentiality agreement. If possible ensure that your confidentiality agreement allows you to share information with "prospective financing sources" to minimize the risk that you have to get the consent of the target company to share the information. However, you may still be faced with the prospect of seeking the consent of the target company if prospective co-investors want to seek modifications to the terms of your confidentiality agreement if it contains terms that they don't normally agree to or omits their standard carve-outs.
Depending upon the particular circumstances, target companies may have little incentive to consent to changes to the confidentiality agreement so this should be made clear to prospective co-investors up front to deter them from coming to you with their wish list of changes.
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Prior to sharing any third party diligence reports with prospective co-investors, check with the advisor who prepared the report to confirm that it will consent to the report being furnished to co-investors. Most advisers will consent to this assuming that the co-investors sign a "non-reliance" letter confirming that the report was not prepared for them or their purposes and they can't rely upon it. This issue becomes more complicated if, as in many European deals, the seller of the business has its advisors prepare "vendor due diligence reports" for all bidders as part of the sale process. In that circumstance, you will need to obtain the consent of the seller's advisors prior to furnishing the vendor due diligence reports to the prospective co-investors and the seller's advisors may be less motivated to consent than your own advisors.
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If you are preparing a teaser and an investment memorandum for the syndication, you should generally have the target company's management review, and approve the contents of the memorandum prior to using it. In the event that the deal does not turn out as well as anticipated, you want to have a record that the information furnished to prospective co-investors was diligently prepared and vetted by the appropriate persons.
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Also have your counsel review all syndication materials prior to furnishing it to your prospective co-investors. A syndication involves a securities offering and you want to make sure that there are no unfortunate statements that could be avoided in the syndication materials and that all risks and relevant issues are adequately presented.
In a non-control investment or an investment where you can't be assured of management's cooperation, you should consider providing in the investment documentation that management will cooperate with your syndication efforts and will participate in any required road shows and conference calls with co-investors.
Structuring The Investment
In structuring the co-investment you should find out upfront whether a co-investor has any particular tax or regulatory issues that will influence how a co-investor participates in an investment. These issues particularly arise with co-investors that need to qualify as venture capital operating companies under ERISA as well as co-investments in cross-border transactions. A good example of this is that special structuring may be required for co-investors that need to qualify as venture capital operating companies. Depending upon the structure of your investment in the target company, this could require you to either structure your investment vehicle so that it would qualify as an operating company itself to the extent that the target company is not wholly owned by your investment vehicle or, alternatively, you may need to set up a dedicated investment vehicle for the co-investor that would invest directly in the target company and have direct contractual management rights in the target company. To the extent that you are not making a control investment in a target company, you will need to make sure in your investment documentation with the target company that it will be required to issue "management rights letters" to your co-investors upon your request.
Few tax or regulatory issues are insoluble but it is important to identify them early and to determine the impact and additional cost that may arise from a particular co-investor's specific needs. This will minimize last minute problems prior to closing and allow you to discuss with the particular co-investor passing on the additional costs of any special structuring requirements to that co-investor.
Rights To Be Offered To Co-Investors
The approach followed by many sponsors in connection with a syndication to their limited partners is to treat prospective co-investors as passive investors and therefore give them little or no governance rights and limited liquidity rights in co-investment deals. This would include no board representation (although they sometimes are given the right to appoint an observer), limited access to information and management, lock-ups on transfers of securities that permit them only to sell prior to an IPO in a tag sale or a drag sale and sometimes limitations on their ability to sell their shares following an IPO other than in a process coordinated by the sponsor. Co-investors are also usually subject to confidentiality restrictions and some sponsors also seek to bind co-investors to non-compete provisions to the extent they are in possession of confidential information regarding the target company.
Coordinating Your Syndication In A Club Deal
Many of the more complicated issues arising from syndications to limited partners arise in the context of club deals where there is a sell down by more than one sponsor. These issues include (i) coordinating the sell down so that sponsors don't contact the same prospective co-investors, (ii) coordinating the information to be provided prospective co-investors and any potential road show meetings or conference calls to ensure consistency of disclosure and to reduce the burden of the syndication on management of the target company, (iii) allocation of syndication risk in the event that certain sponsors have more demand from co-investors than the amount they would like to syndicate and other sponsors have less demand than the amount they would like to syndicate and (iv) determining whether co-investors should participate through separate co-investment vehicles established by each sponsor or a common vehicle for all sponsors.
As can be expected, there are no hard and fast answers as to how these issues should be addressed and it will depend in many cases upon the dynamics of the particular sponsor group as well as the amount of the sponsor commitments to be sold down. However, one key issue that needs to be addressed in any coordinated sell down is for the sponsor group to identify and determine how to handle "shared limited partners" who are prospective co-investors. For example, in a large buyout involving multiple sponsors it is likely that the sponsors will have several of the larger pension funds in common. As most private equity sponsors jealously guard their limited partner lists and will not likely be eager to share those lists with each other, the sponsors will need to agree on a process by which they can provide the information regarding prospective co-investors to a third party, such as counsel to the consortium, to review the list of prospective co-investors and determine which ones are "singleton" limited partners unique to a particular sponsor and which ones are shared limited partners.
Once the singleton and shared limited partners are identified, the sponsor group will need to determine whether one of the sponsors will be responsible for contacting each prospective limited partner and coordinating the process or, more likely, they will allocate responsibility for contacting and managing the process with each limited partner. In most cases, each sponsor will be responsible for their singletons and the sponsors with shared limited partners will need to agree among themselves how to allocate responsibility for the shared limited partners.
A related coordination issue is that the sponsors will need to determine the contents of the "information package" to be provided to prospective co-investors to ensure consistency of disclosure and to schedule road show meetings and conference calls for the co-investors with the target company's management to minimize the disruption on management of the target company. As a practical matter, clubs often assign primary responsibility for this task to one of the sponsors to put together the proposed information package and to work with management on the content and scheduling of any road show meetings and conference calls to make the process as efficient as possible.
Another key issue to be addressed is how to allocate syndication risk among the sponsor group. In the best of all worlds where each sponsor receives more than sufficient interest from their prospective co-investors, this is a simple problem with the only issue being the extent to which co-investors are cutback on the amounts they wanted to commit and how each sponsor allocates that cutback among their co-investors. However, sometimes a sponsor group will agree in advance how co-investor demand is allocated in the event that there is not sufficient interest in the aggregate or there is sufficient interest in the aggregate but a particular sponsor comes up short.
The sponsors will also need to address whether the co-investors participate in the investment through separate investment vehicles set up by each sponsor for its co-investors or a common vehicle for all co-investors. Sponsors frequently prefer to establish separate investment vehicles for their own co-investors so they get "credit" for the equity provided by that co-investor as well as the ability to control the voting rights attributable to their co-investors' equity.
Conclusion
Syndications by private equity sponsors to limited partners are becoming increasingly larger and more complicated. In particular, club deals raise a number of practical and coordination issues for sponsors that need to be worked through. Private equity sponsors should think through these issues going into a deal so as to make the process as efficient and painless as possible and to maximize the likelihood of a successful syndication.
Published January 1, 2007.
