new ilpa principles: what has changed?

W H AT ’ S I N S I D E

3 Exposure to PensionLiabilities May BeExpanding

5 GUEST COLUMN

Greener Returns Are on the Horizon

7 No Fear of Commitment:Equity CommitmentLetters in UK Transactions

9 Exclusivity From theSeller’s Perspective

11 The 2010 Estate and GiftTax Law: A “Gift” forPrivate Equity EstatePlanning

13 Helping Private EquityPlay a Greater Role in theU.S. Insurance Market

15 ALERT

English High CourtUpholds Sponsors’ Rightto Buy and Vote PortfolioCompany Debt

17 Doing Business withSovereign Wealth Funds:SEC Launches ForeignBribery Probe

19 The Return of Sponsor-Backed IPOs: Getting theHouse in Order

21 Russia’s Massive NewPrivatization Plan MayCreate Opportunities forPrivate Equity Investors

Winter 2011 Volume 11 Number 2

D e b e v o i s e & P l i m p t o nP r i v a t e E q u i t y Re p o r t

New ILPA Principles: What Has Changed?

“That's the report. Now, would anyone like to carp?”

As most in the private equity industryknow, the Institutional Limited PartnersAssociation (“ILPA”) recently released anupdated and revised version (“version 2.0”)of its Private Equity Principles (the“Principles”), which discuss a number ofkey fund terms from the investors'perspective. ILPA is a non-profitassociation representing over 240institutional private equity investors whocollectively manage some $1 trillion ofprivate equity assets.

Like the original Principles, which werepublished in September 2009, version 2.0states that three guiding principles form theessence of an effective private equitypartnership: (1) alignment of interestsbetween investors (“LPs”) and fundsponsors (“GPs”); (2) good fund governance

and (3) appropriate transparency. Version2.0 of the Principles goes on to describe insome detail ILPA’s “preferred private equityfund terms and best practices” in each ofthese three areas, noting that version 2.0was developed after “reflecting on theextensive input” that ILPA solicited fromGPs, as well as LPs, in 2010.

Roughly 140 LPs and GPs have endorsedthe Principles, including most recently suchmarket leading fund sponsors as OaktreeCapital Management, L.P., ApolloManagement L.P., Kohlberg Kravis Roberts& Co. and Warburg Pincus LLC. Accordingto ILPA’s website, endorsement of thePrinciples means that the endorsing firmgenerally supports the efforts of ILPA andindustry supporters to strengthen the

CONTINUED ON PAGE 23

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It’s been a long and miserable winter, but perhaps less so for those inthe private equity industry, where the combination of a responsive IPOmarket, accessible financing and investors with available capital have

made the weather and the world political environment somehow not as

overwhelming as they might be. To celebrate the end of winter, we

have an issue packed with articles on some of the topics that will bemost relevant to the private equity industry in the coming months.

On our cover, we provide perspective on the latest version of ILPA’sPrivate Equity Principles. Although ILPA’s revised list of “preferredterms” demonstrates that ILPA is responsive not only to its members,

but also to the market and to the sponsor community, there are still anumber of controversial recommendations included in the Principles.Notwithstanding the endorsement of the Principles by a number of

leading sponsors, some of the proposed “preferred private equity termsand best practices” will continue to lead to vigorous debate andnegotiation between GPs and LPs in future fundraises.

Private equity is going green! In our Guest Column, theEnvironmental Defense Fund’s Audrey Davenport and Thomas Murraydescribe the successful efforts of several private equity firms and theirportfolio companies to develop strategies to improve energy efficiency,reduce waste and water use and cut CO2 emissions. In addition, theEDF and Ernst & Young have piloted a program with private equityfunds to expand the focus of environmental due diligence by lookingnot just at potential liabilities, but also at potential ways to create valueusing environmental cost savings and waste reduction measures.

Elsewhere in this issue, we discuss two possible avenues of futureprivate equity investment: the insurance sector and the newlyinvigorated Russian privatization program. Our new partner, EricDinallo, former Superintendent of Insurance for the State of New York,

explains that many private equity firms have shied away from insurancecompanies out of an aversion to significant disclosure to state regulatorsabout fund structure and control persons, as well as ongoing multi-

jurisdiction regulatory compliance. He suggests, however, that as a

result of the financial crisis, insurance regulators may be increasingly

receptive to, and flexible with, private equity investors as reliable andsophisticated capital sources. Members of our Russian private equityteam outline the Russian government’s interest in attractinginternational private equity capital to its current privatization programand its recognition that in order to do so it will need to adopt more

market-driven sales processes. Our new London private equity transactional partner, David Innes,

explores the evolution of equity commitment letters in the UK and

puts them in the context of their U.S. counterparts.We also have several articles focused on exits. We explore the issues

surrounding whether a private equity seller should grant exclusivity to apotential bidder under several different sales scenarios, and we remindyou of the intricacies and planning that go into preparing a portfoliocompany for an IPO.

In this issue, we welcome Kevin Rinker, who joins Steve Hertz asone of our Associate Editors. We also want to take this opportunity tothank Andrew Sommer who has served with Steve, as an AssociateEditor for the past four years, for his enormous contributions to thisPrivate Equity Report and the practice it reflects.

As always, we welcome your ideas as to how we can make thePrivate Equity Report your go-to guide for the latest legal guidance onissues of importance for the private equity industry.

The Debevoise & PlimptonPrivate Equity Report is apublication of

Debevoise & Plimpton LLP919 Third AvenueNew York, New York 100221 212 909 6000

www.debevoise.com

Washington, D.C.1 202 383 8000

London44 20 7786 9000

Paris33 1 40 73 12 12

Frankfurt49 69 2097 5000

Moscow7 495 956 3858

Hong Kong852 2160 9800

Shanghai86 21 5047 1800

Private Equity Partner /Counsel Practice Group MembersFranci J. Blassberg Editor-in-Chief

Stephen R. Hertz Kevin A. RinkerAssociate Editors

Ann Heilman MurphyManaging Editor

David H. Schnabel Cartoon Editor

Please address inquiriesregarding topics covered in thispublication to the authors orany other member of thePractice Group.

All contents ©2011 Debevoise& Plimpton LLP. All rightsreserved.

The Private Equity Practice GroupAll lawyers based in New York, except where noted.

Private Equity FundsMarwan Al-Turki – LondonKenneth J. Berman– Washington,D.C.Erica BerthouJennifer J. BurleighWoodrow W. Campbell, Jr.Sherri G. CaplanJane EngelhardtMichael P. HarrellDavid Innes – LondonGeoffrey Kittredge – London Marcia L. MacHarg – FrankfurtAnthony McWhirter – LondonJordan C. Murray Andrew M. Ostrognai – Hong Kong Gerard C. Saviola – LondonDavid J. SchwartzRebecca F. Silberstein

Hedge FundsByungkwon LimGary E. Murphy

Mergers & AcquisitionsAndrew L. BabE. Raman Bet-Mansour – ParisPaul S. BirdFranci J. BlassbergRichard D. BohmThomas M. Britt III – Hong KongGeoffrey P. Burgess – LondonMarc Castagnède – ParisNeil I. Chang – Hong KongMargaret A. DavenportE. Drew Dutton – Hong Kong Michael J. GillespieGregory V. GoodingStephen R. HertzDavid Innes – LondonJames A. Kiernan III – LondonAntoine F. Kirry – ParisJonathan E. Levitsky

Guy Lewin-Smith – LondonDmitri V. Nikiforov – MoscowRobert F. Quaintance, Jr.William D. RegnerKevin A. RinkerJeffrey J. RosenKevin M. SchmidtThomas Schürrle – FrankfurtWendy A. Semel – LondonAndrew L. SommerJames C. Swank – ParisJohn M. Vasily Peter Wand – FrankfurtNiping Wu – Shanghai

Leveraged FinanceKatherine Ashton – LondonWilliam B. BeekmanDavid A. BrittenhamPaul D. BrusiloffPierre Clermontel – Paris Alan J. Davies – LondonPeter Hockless – London

Letter from the Editor

Franci J. Blassberg

Editor-in-Chief

Exposure to Pension Liabilities May Be ExpandingThe last thing private equity firms need arenew concerns about potentially expandingliability for retired workers. Well-settledconclusions about the use of parallel fundstructures to protect private equity funds andtheir portfolio liabilities against the spread ofpension liabilities from one portfoliocompany to another, or to the fundsthemselves, have been called into question bya recent opinion out of the Eastern Districtof Michigan, Sheet Metal Workers’ NationalPension Fund v. Palladium Equity Partners,LLC. In addition, the case is the first inwhich a court decision has addressed theexpansive interpretation of ERISA liabilityput forth by the Federal pensions regulator,which has taken the position that a privateequity fund itself is a “trade or business” and,therefore, subject to ERISA liability. Inanother troubling development, the courtsuggested that exposure to ERISA liabilitymay even extend to a fund manager that hasno ownership interest in the portfoliocompany with the pension liabilities. Thedecision did not technically create new lawsince it was not a ruling on the merits, butrather a rejection of motions to dismiss, and

the parties have since settled the case withouta trial or appeal. However, the districtcourt’s reasoning will likely provideammunition to union pension plans and theFederal pensions regulator, the PensionBenefit Guaranty Corporation (or PBGC),in future negotiations with private equityfirms regarding controlled group liabilitiesfor pension underfunding.

“Controlled Group” Issues in Private Equity FundsERISA, the Federal pension statute, imposesjoint and several liability for certain pensionliabilities on the employer that sponsors thepension plan and on each member of its“controlled group.” In very general terms, acontrolled group consists of trades orbusinesses that are at least 80%-owned by acommon parent. The result is that, if, forexample, one member of the controlledgroup sponsored an underfunded definedbenefit pension plan that was taken over bythe PBGC, or if such member ceased tocontribute to a union pension plan (thustriggering a “withdrawal” liability), thosepension or withdrawal liabilities could be

enforced against any and all tradesor businesses within the controlledgroup.

In the private equity context,concern over controlled groupissues has been a fixture for yearswhere a single private equity fundacquires a greater than 80% interestin more than one portfoliocompany. In this context, thecontrolled group rules are generallyunderstood to potentially result in across-contamination of pensionliabilities among separate portfoliocompanies. (For example,arguments over “ERISA affiliate”issues in credit agreementnegotiations are commonplace, as

banks often try to protect against their creditto one portfolio company being eroded, oreven trumped, by pension liabilities at otherportfolio companies.) Most, but not all,practitioners believe that, while the portfoliocompanies may be at risk with respect toeach other’s liabilities, the private equity fundis not, because the private equity fund is nota “trade or business” for tax purposes, andcontrolled group liabilities can only beenforced against trades or businesses.However, the PBGC, which insures definedbenefit pension plans, takes the position thatthe private equity fund itself can be heldresponsible for these liabilities, along with its80%-owned portfolio companies, as set forthin a decision of the Appeals Board of thePBGC from 2007. Prior to the Palladiumdecision, the PBGC’s view had not beentested in a reported court decision.

Separate from the “trade or business”issue, affiliated fund families structured asseparate funds for onshore and offshoreinvestors, or for taxable or non-taxableinvestors, or for investors with specificregulatory concerns, have a second line ofdefense from ERISA liabilities. In thesefund structures, it is typically the case thatno single fund owns more than 80% of aportfolio company, even though they mayshare a common investment manager,general partner and investment professionals.A structure in which two or more funds eachown less than 80% of a portfolio company(even if their combined ownership is greaterthan 80%) has been considered “safe,” andan effective insulation from ERISA liabilities(both with respect to the potential spread ofsuch liabilities to other portfolio companiesand to the funds themselves), because theownership of each fund was insufficient tocreate a controlled group under ERISA. ThePalladium decision, however, is a triple

Winter 2011 l Debevoise & Plimpton Private Equity Report l page 3

Guy Lewin-Smith – LondonDmitri V. Nikiforov – MoscowRobert F. Quaintance, Jr.William D. RegnerKevin A. RinkerJeffrey J. RosenKevin M. SchmidtThomas Schürrle – FrankfurtWendy A. Semel – LondonAndrew L. SommerJames C. Swank – ParisJohn M. Vasily Peter Wand – FrankfurtNiping Wu – Shanghai

Leveraged FinanceKatherine Ashton – LondonWilliam B. BeekmanDavid A. BrittenhamPaul D. BrusiloffPierre Clermontel – Paris Alan J. Davies – LondonPeter Hockless – London

Alan V. Kartashkin – Moscow Pierre Maugüé Margaret M. O’NeillNathan Parker – LondonA. David ReynoldsJeffrey E. RossPhilipp von Holst – Frankfurt

TaxJohn Forbes Anderson – LondonEric Bérengier – ParisAndrew N. BergPierre-Pascal Bruneau – ParisGary M. FriedmanPeter A. FurciFriedrich Hey – FrankfurtAdele M. KarigRafael KariyevVadim MahmoudovMatthew D. Saronson – LondonDavid H. SchnabelPeter F. G. SchuurRichard Ward – London

Trust & Estate PlanningJonathan J. RikoonCristine M. Sapers

Employee Compensation & BenefitsLawrence K. CagneyJonathan F. Lewis Alicia C. McCarthyElizabeth Pagel SerebranskyCharles E. Wachsstock

The articles appearing in thispublication provide summaryinformation only and are notintended as legal advice. Readersshould seek specific legal advicebefore taking any action withrespect to the matters discussedherein. Any discussion of U.S.Federal tax law contained in thesearticles was not intended orwritten to be used, and it cannotbe used by any taxpayer, for thepurpose of avoiding penalties thatmay be imposed on the taxpayerunder U.S. Federal tax law.

CONTINUED ON PAGE 4

l Debevoise & Plimpton Private Equity Report l Winter 2011

threat: it calls these “safe” structures intoquestion, while also voicing support for thePBGC’s position on the trade or businessissue, as well as potentially expandingexposure even further to a fund managerwith no ownership interest.

The Palladium DecisionIn Palladium, the plaintiffs, two

multiemployer pension plans, sought toimpose the withdrawal liability of a groupof bankrupt companies against threeprivate equity limited partnerships andtheir common fund manager. The privateequity funds at issue were part of a multi-fund structure where no one fund ownedmore than 80% of the group of bankruptcompanies.

The plaintiffs argued that the limitedpartnerships and the fund manager werepart of a controlled group with thebankrupt companies and thus liable for thewithdrawal liability. In the plaintiffs’ view,the limited partnerships and the fund

manager, in their ownership and operationof the companies, constituted a single jointventure or partnership whose ownershipinterests should be aggregated for ERISApurposes. The plaintiffs also argued thateach member of the group was a trade orbusiness. Each side moved for summaryjudgment in its favor on the issues, and thedistrict court denied the motions, findingthat the factual record precludeddetermination of the issues as a matter oflaw, which suggests that the judge mayhave believed that (1) the funds should beaggregated for purposes of the 80% test,(2) the funds are trades or businessesand/or (3) the fund manager is notimmune to ERISA liabilities even though itis not in the ownership chain. The partiesreached a settlement several months later,and, therefore, the case never went to trialfor final resolution of these issues.

So the Palladium decision is significantin two respects. First, the decisionrepresents the only judicial suggestion thatthe multi-fund structure, long considered“safe” from a controlled group perspective,may not be impervious to a controlledgroup challenge. Perhaps even moretroubling is that the pension plans sued notonly the private equity funds, but also thefund manager itself, which had noownership stake in the portfolio companiesat issue. The district court accepted theinclusion of the fund manager in theliability analysis, noting that, although theprivate equity firm “did not engage in anyinvestment activities itself, it functioned asthe brain for the investment operations ofthe three [limited partnerships].”

Second, the decision reflects the firstjudicial endorsement of the PBGC positionthat a private equity fund with a standardorganizational structure can be classified asa “trade or business” under ERISA. Priorto Palladium, most practitioners discountedthe PBGC position because it was

inconsistent with relevant tax authority onthe meaning of trade or business. Inaddition, the PBGC has historically settledthese disputes, suggesting to somepractitioners that the PBGC was reluctantto test its position in court. Palladiumprovides a judicial endorsement of thePBGC position and may imply a judicialwillingness to reach a different result on thequestion of an entity’s status as a trade orbusiness for purposes of ERISA (as distinctfrom a general tax law analysis). Even ifPalladium is not a decision on the merits, itmay buttress the legitimacy of the PBGCposition, providing authority on which thePBGC and union pension plans may restfuture arguments in favor of controlledgroup liability in similarly structured funds.

Impact of the Palladium DecisionWe continue to believe that the multi-fundstructure should help to insulate portfoliocompanies from the ERISA liabilities ofother portfolio companies, and we alsostrongly believe that the fund manager, as anon-owner, should have no exposure undera controlled group analysis. Nevertheless,in the absence of a ruling on the merits bya court, private equity firms should expectthese challenges to become more prevalentthan in prior years, both in single-fund andmulti-fund structures. The Palladiumdecision suggests that such claims may beviable in a judicial action, which couldmake settlement of these claims harder ormore expensive.

Jonathan F. [email protected]

Alicia C. [email protected]

Exposure to Pension Liabilities May Be Expanding (cont. from page 3)

The Palladium

decision...is a triple threat:

it calls...“safe” structures

into question, while also

voicing support for the

PBGC’s position [that

standard PE funds can be

classified as a]...trade or

business...as well as

potentially expanding

exposure even further to a

fund manager with no

ownership interest.


Greener Returns Are on the HorizonG U E S T C O L U M N

There has been a distinct shift in theconversation over the past year betweenprivate equity firms and the Green Returnsteam at Environmental Defense Fund(“EDF”). The discussion no longer centersaround “why” the environment presents anopportunity for differentiation and valuecreation, but “how” a private equity firmcan take advantage of opportunities. Fromimproving energy efficiency to cuttingmaterial and packaging waste to reducingwater use, environmental managementoffers numerous opportunities to run leaner,greener companies.

Three diverse private equity-ownedportfolio companies all have one veryimportant thing in common — they aresaving millions in operating costs throughimproved environmental management.U.S. Foodservice, a premier foodservicedistributor, has saved over $22 million inoperating costs and avoided more than100,000 metric tons of greenhouse gasemissions since 2008 through improvedfleet and energy management projects.Diversey, a leading provider of commercialcleaning solutions, is developing data-driventools to make high return investments inenergy savings in order to meet ambitiousenergy reduction goals. And DollarGeneral, a leading discount retailer, hassaved over $39M since 2008 throughimproved recycling and waste managementpractices at its stores and distributioncenters.

These savings are particularly compellingin today’s changing economy. The privateequity industry has been plagued by anumber of challenges and so it may seem anunlikely time for the PE sector to embracenew thinking on environmental matters.However, a handful of industry leaders haverealized that environmental innovation canbe a powerful lever for value creation acrossthe PE investment process. Whenimplemented at scale across PE portfolios, acreative approach to environmental issuescan improve due diligence, boost portfoliocompany performance, present new growthand investment opportunities and buildstronger relationships with LPs and otherstakeholders (see graphic below). Since PEfirms own thousands of companies withmillions of employees, these opportunitiesare almost limitless — yet across theeconomy, remain largely untapped.

The Environmental Defense Fund’swork with the private equity industry beganin 2007 through a collaboration withKohlberg Kravis Roberts & Co. (KKR),Texas Pacific Group and Goldman Sachs toimprove the environmental terms of the$45 billion leveraged buyout of Texas-basedutility, TXU. This successful collaborationopened the door for further collaborationand led to our partnership with KKR todevelop the Green Portfolio Program.Launched in mid-May of 2008, the GreenPortfolio Program is designed to measureand improve environmental and business

performance across KKR’s portfoliocompanies in five key environmental areas— greenhouse gas emissions, waste, water,forest resources and priority chemicals.Based on a set of analytic tools and metricsdesigned to help companies identifystrategic opportunities in these categories,the program has been incredibly successfulto date.

For us, it was truly a “leverage play,”with the objective of systematicallyimproving efficiency, cutting costs andreducing environmental impacts at scaleacross a portfolio of companies. As of June2010, when we announced the two-yearprogram results, eight portfolio companieswere reporting environmental performancethrough the program and had adoptedinnovations that resulted in avoiding over$160 million in operating costs, 345,000metric tons of CO2 emissions, 8,500 tonsof paper and 1.2 million tons of waste. Atthe time of the announcement, KKRstrongly endorsed the business case forenvironmental management.

The momentum has not stopped withKKR, nor with post-closing operatingimprovements. In March 2010, weannounced a new partnership with TheCarlyle Group, focusing on identifying andunlocking upside opportunities for valuecreation during environmental duediligence. “Our goal is to increase returnsfor our investors while enhancingenvironmental performance,” said WilliamConway, managing director and co-founderof The Carlyle Group.

The initial result of the Carlylepartnership is an environmental duediligence screen — developed incollaboration with The Payne Firm — thatsystematically incorporates environmentalopportunities to improve operations andcreate value into the early stages of the

CONTINUED ON PAGE 6

}Differentiatedfundraisingstrategy

Environmental andfinancial resultsmultiplied acrossthe portfolio

Enhanced environmentaldue diligence

LIMITEDPARTNERS

PORTFOLIO COMPANIES

PEFIRM

l Focus on operationsl Scale best practices & innovationsl 5 year + time horizon


investment process. The typicalenvironmental due diligence processhistorically has tended to focus purely onenvironmental issues from a risk andpotential liability perspective. Carlyle andEDF’s updated approach aims to set a newindustry standard by expanding the narrowfocus of environmental due diligence fromquantifying downside risks and costs toinclude identifying upside opportunitiesand benefits.

Moving forward, Carlyle has committedto implement the new screen in its U.S. andEuropean buyout funds and to share lessonslearned with other leading firms. With dealflow beginning to improve, Carlyle expectsto put this tool to the test soon to helpidentify opportunities to improveoperations, reduce costs, and strengthen themarket position of target companiesthrough steps such as improving energyefficiency, reducing material inputs andwaste generation, and developing newenvironmental products and services.

The TXU deal, KKR’s Green PortfolioProgram and Carlyle’s new due diligenceprocess are a great start, but hopefully justmark the beginning of what might beachieved when best practices for

environmental management are rolled outacross the entire PE industry. Otherindustry leaders are already embracing thisopportunity and many more seem poised tofollow. Growing interest from limitedpartners (such as Alpinvest and CalPERS),voluntary investor initiatives, such as theUN-backed Principles for ResponsibleInvestment, and evolving regulatoryschemes (for example, the UK’s CRCEnergy Efficiency Scheme, which capturesPE-owned businesses) are pushing this topicto the forefront. Major industryconferences are including this as a key topicworthy of discussion, along with other moreconventional subjects, including creditspreads, rebalancing LP/GP relationshipsand the PE industry’s need to communicatebetter.

In an effort to transform this growinginterest in environmental management intoaction, we announced in January of 2011 anew effort with global accounting firmErnst & Young (E&Y). Together, EDF andE&Y are piloting a new offering for theindustry called Green Ops for PE. GreenOps for PE will offer participating PE firmsa tailored assessment of the size and natureof environmental opportunities across their

portfolio, and provide a clear roadmap forimplementation. The approach is intendedto help PE firms overcome the majorbarriers to systemic environmentalmanagement by drawing on EDF’s strongtrack record in the industry and E&Y’sdeep expertise and resources in both privateequity and sustainability services.

PE firms’ investments representapproximately 10% of the U.S. economy,and PE-backed companies employ morethan six million Americans. Imagine if all ofthose companies and employees recognizedthat environmental performance andbusiness performance go hand-in-hand? Webelieve the potential results could faroutstrip all our expectations, meeting boththe needs and demands of investors, whilealso helping safeguard the future of ourplanet.

Audrey DavenportProject Manager, Geballe Fellow,Corporate Partnerships ProgramEnvironmental Defense Fund

Thomas P. MurrayManaging DirectorCorporate Partnerships ProgramEnvironmental Defense Fund

Guest Column: Greener Returns Are on the Horizon (cont. from page 5)

Green Returns Project Timeline (2007-2011)

May: EDF & KKR announce the Green Portfolio Partnership to improve business and environmental performance across KKR’s portfolio

Oct: KKR & EDF begin exploring opportunities to measure, manage and improve performance at portfolio companies

March: EDF and The Carlyle Group announce the launch of the EcoValueScreen

Oct: KKR announces enrollment of four additional companies in the EU and Australia; total enrollment reaches 16 companies

Jan: EDF announces Green Ops for PE — a joint effort with global consulting firm, Ernst & Young, to develop and pilot an environmental offering for the private equity industry

Feb: KKR & EDF announce results from three pilot companies: U.S. Foodservice, PRIMEDIA and Sealy; i.e. $16.4M saved and 25k metric tons of CO2 avoided

2007 2008 2009 2010 2011

May: EDF advises KKR and partners on the $45B TXU buyout; plans for 8 coal-fired power plants withdrawn

June: Five additional U.S. KKR companies join the Green Portfolio Program following the successful pilot

July: KKR & EDF announce 2009 results for 8 companies, i.e. $160M saved and 345k metric tons of CO2 avoided

Jan: Carlyle releases the industry’s first corporate citizenship report, highlighting the EDF partnership and implementation of the EcoValueScreen

Feb: KKR & EDF announce enrollment of 4 more companies, including the first in Europe and Asia


Equity commitment letters have been awell-established feature of both public andprivate transactions involving private equitysponsors in the U.S. for many decades.Their arrival on the UK private deal sceneis much more recent and has developed intandem with changes in the lendingenvironment. This article examines theevolution of equity commitment letters inUK deals and current market practice forequity commitment letters in UK privatetransactions.

The Influence of Public DealsUnlike their public counterparts, closingsunder UK acquisition agreements forprivate companies were historically oftenconditioned on an anti-trust condition (the“Acquisition Condition”), a material adversechange condition (“MAC”) and otherprovisions mirroring the outstandingconditions in the related financedocumentation. Although, in practice, ifthe Acquisition Condition was satisfied,buyers would rarely fail to close a deal,there was a level of uncertainty in both thedebt and equity funding until monies wereavailable and closing actually occurred.

In contrast, the “certain funds” conceptwas long-established in bids for companiesgoverned by the UK Takeover Code, whichinclude companies publicly listed in the UKor which were listed in the UK in theprevious 10 years. Under the TakeoverCode, if the offer is for cash, or includes anelement of cash, an appropriate third party(in practice, the offeror’s financial adviser) isrequired to confirm that resources sufficientto satisfy the cash element of the offer areavailable to the offeror (termed the “cashconfirmation”). Since the party giving thecash confirmation can be required toprovide the cash itself, if it has not actedreasonably and responsibly in giving thecash confirmation, it has a vested interest in

ensuring that the financing of the offercontains as few conditions as possible andthat those conditions are, to the extentpractical, within the control of the bidder.Financing for UK public M&A transactionsis, therefore, on a “certain funds” basis.

Certain funds became available fromlenders to UK private M&A transactionsonly in the early 2000s, fueled by acompetitive lending market and the desireof private equity sponsors to increase thedeliverability of their bids by replicating thecertainty of debt funding available in publicM&A deals. This, in turn, led to thedecline of MAC conditions in privateacquisition agreements, because suchconditionality was no longer required inorder to mirror the outstanding conditionsin debt documents. In addition, and, moreimportantly, for private equity sponsors,increased demands for buyers to completethe funding picture by providing equitycommitment letters became more common.

Initially, many private equity sponsorsrefused to provide equity commitmentletters, usually on the basis that they had animpeccable track record of never failing tofund an agreed deal. However, influencedby U.S. practice and the relatively loose,formative manner in which such obligationswere documented, many sponsors graduallybecame less resistant to the idea. Whenequity commitment letters made their firstappearance in the UK market, they werebrief, often lacked clarity and almost alwayscontained a broad carve-out for the privateequity sponsor if debt funding was notprovided. In the intervening years, thedrafting of equity commitment letters hasbecome tighter and the terms increasinglyseller-friendly. In particular, the widespreaduse of auctions has allowed sellers to exploitcompetitive tension to achieve strongerequity commitment letters from private

equity bidders. It is now common, at thepenultimate stage in competitive auctions,for UK non-listed companies (where thenumber of bidders is reduced to amanageable number of, for example, 4-5)for bidders to be provided with a draftequity commitment letter (as well as a draftacquisition agreement) to mark up,negotiate and deliver with their finalbinding bids.

Equity Commitment TermsThe sellers’ aim is to ensure that, so far aspossible, the transaction is conditioned onlyupon the main Acquisition Condition.Once that is satisfied, the acquisitionagreement, together with the debt financeand equity finance documents (includingthe equity commitment letter) becomeunconditional. In those circumstances, if abuyer does not close, the sellers will, at thevery least, have an action for damages

No Fear of Commitment:Equity Commitment Letters in UK Transactions

CONTINUED ON PAGE 8

[T]he drafting of equity

commitment letters has

become tighter and the

terms increasingly seller-

friendly. In particular,

the widespread use of

auctions has allowed

sellers to exploit

competitive tension to

achieve stronger equity

commitment letters from

private equity bidders.


against the buyer (which will have assetsbecause it has received equity funding) orthe buying sponsor if it has failed to fundthe buyer.

To eliminate as much risk as possibleon the debt funding, the buyer is nowgenerally required to deliver to the sellers,at the same time the acquisitionagreement is signed, a letter from thefunding banks evidencing that allconditions precedent to the debt financinghave been satisfied, other than theAcquisition Condition in the acquisitionagreement and conditions within thecontrol of the buyer.

Similarly, to eliminate as much risk aspossible from the equity funding, theacquisition agreement and the equitycommitment letter will be entered into atthe same time and together provide thatthe buying sponsor will:

l on satisfaction of the AcquisitionCondition, provide the necessaryequity funds to the buyer (and notwithdraw them);

l on satisfaction of the AcquisitionCondition, require that the buyer takeall necessary steps to draw down thedebt financing. Occasionally, sellersalso ask for a power of attorney fromthe buyer to enable the sellers toenforce the debt financing documents,but that is usually rejected;

l require that the buyer fulfils itsobligations under the acquisitionagreement; and

l not take, or omit to take, any actionswhich are likely to prejudice the abilityof the buyer to close the transaction,including amending or terminating thefinancing documents.

These terms are broader than thetypical equity commitment letter in U.S.deals and incorporate provisions that in

current U.S. market practice would bemore commonly found in the acquisitionagreement and guarantee.

Financing Condition in EquityCommitment LettersThe most contested provision in an equitycommitment letter is the financingcondition, which, if included, permits theprivate equity sponsor an “out” from itsfunding obligation if the debt financing isnot available. The precise wording isgenerally fiercely negotiated, and is oftenthe last point on the table prior to signingthe transaction documents.

The outcome will depend on therelative bargaining position of the parties,any competitive tension generated in anauction, and the extent of conditionalityin the debt financing documents. In verycompetitive auctions, the financing “out”is often conceded, albeit very reluctantly,by bidders keen to seal the deal. If thisprovision is conceded, the private equitybidder is obligated, subject to any rarelyagreed liability cap, for the entire equitycommitment if the debt is not funded.

Credit CrunchContrary to expectation, the credit crunchand declining availability of debtfinancing did not reduce the need for“certain-funds” and equity commitmentobligations in private M&A transactions.In fact, auctions for desirable assets are ascompetitive as ever due to changes indebt/equity ratios, private equity sponsorswith large amounts of “dry powder” and ashortage of high-quality assets for sale.Buying sponsors eager to demonstrate thedeliverability of their bids continue tonegotiate certain funds from banks andprovide equity commitment letters tosellers.

RemediesWhile liability caps or reverse terminationfees have become common in the U.S.

market, such fees and liability caps are rarein the UK. However, some UK buyershave successfully argued for caps on thebasis that liability under equitycommitment letters should be limited toreflect the likely amount of damages thatwould be payable on a successful claim forbreach of contract for failure to close.

Under English law, loss for breach ofcontract is generally calculated as thedifference in value between what theclaimant receives, and what the claimantwould have received if the breach had notoccurred, and the contract had beenperformed. It is also subject to the dutyof a claimant to take reasonable steps tomitigate its loss. If a buyer refuses or isunable to close, the seller still retains theshares in the target and may be able to sellthe target to a different bidder. Thedamages available to a seller are, therefore,likely to be limited to the sale costsincurred by the seller and potentially theloss of profit or loss of value on analternative deal, which will be significantlyless than the consideration contained inthe acquisition agreement. Obviously,these amounts would potentially havebeen much higher when asset values weredepressed shortly after the credit crunchthan they are at present in a more stablemarket.

In addition, specific performance of acontract is a more difficult remedy toobtain in the UK than it is in the U.S. Itis a discretionary remedy which is usuallyonly available when the courts considerthat damages would be an inadequateremedy. That is only likely to be the casein unusual circumstances. As a result, theliability of a sponsor under an equitycommitment letter in the UK may be lessthan in the U.S., where a seller with third-party beneficiary rights against the equitycommitment letter would be able to sue

Equity Commitment Letters in UK Transactions (cont. from page 7)



Private equity buyers traditionally attach a lotof importance to proprietary deals or togetting exclusivity in potential transactions.Private equity sellers, however, do not alwaysthink that what is good for the goose is goodfor the gander. As private equity ownersthink about exiting their investments innegotiated transactions, they will often needto address the difficult and complicateddecision of whether to grant exclusivity atsome point in the process. That decision willhave implications in terms of deal dynamics,but may also have legal consequences. In thisarticle, we explore some of the issues thatprivate equity sellers should consider inhandling an exclusivity request, using threedifferent exit scenarios: (1) the sale of aportfolio company to a strategic buyer; (2) anauction process for a portfolio company; and(3) the sale of a public company in which aprivate equity firm holds a significant equityinterest.

Scenario #1A portfolio company has been approached by astrategic buyer offering a dazzling purchase priceand a request for an exclusivity period toconduct due diligence and negotiate a bindingpurchase agreement.

Assuming the time is right for a sale, theprivate equity firm must consider whetherthere are one or more buyers that might pay ahigher price and present the same or a betterdeal with respect to speed, certainty and riskallocation. This analysis involves consideringother potential strategic buyers, as well as asale to another private equity firm. If itseems unlikely that a better deal could behad, or the exercise of finding this out wouldbe unduly time-consuming and distractingfor the portfolio company management team,then the exclusivity request should beseriously considered.

First, exclusivity avoids the strain that anauction process can create for a managementteam, not just in terms of answeringquestions and providing information, but

also uncertainty regarding potential newowners. Second, limiting the negotiations toa single buyer reduces the chances of a leak.The public scrutiny that comes with “beingon the block” can lead to inquiries fromemployees, customers, suppliers and businesspartners about the company’s plans that mayprove distracting, even harmful, to thecompany’s operations and business.Moreover, running an effective auction mayrequire sharing competitively sensitiveinformation with multiple parties, whichcould likewise be harmful to the company’sbusiness and, potentially, have a deleteriouseffect on the initial bidder’s view of thecompany’s value. Finally, exclusivity providesthe benefit of establishing a moralcommitment by the buyer to the process andestablishes a concrete time frame for signing adeal, since the potential buyer will beincentivized to reach a binding agreementbefore the exclusivity period ends.

If, after considering all these variables, theprivate equity firm is inclined to grantexclusivity, it may want to consider whetherthe benefit to the buyer of a proprietarytransaction should come with a price tag —such as an increase in the buyer’s offer price— although any agreement on value at thisstage is, obviously, not binding.

Scenario #2The private equity firm has conducted anauction for a portfolio company. The highestbidder submits a bid letter which “requires” thetarget company to provide exclusivity as acondition to its offer.In this scenario, the seller obviouslyconcluded that the pros of an auction processoutweigh the cons. As a result, the primaryfocus of the exclusivity analysis should be theimpact on the seller’s negotiating leverage andits ability to maximize value. Agreeing toexclusivity would mean effectively freezingout the other bidders. While giving the highbidder exclusivity should incentivize thatbidder to work quickly toward signing, the

seller needs to be wary of the high bidderfeeling so empowered that it begins tonegotiate the outstanding deal points moreaggressively. (One way to mitigate thisproblem is to attempt to negotiate the keyterms of the transaction, in addition to price,before agreeing to exclusivity.)

On the other hand, while refusing toprovide exclusivity may keep the high bidderon its best behavior, it will also meanforegoing the benefit of a deadline that theexclusivity period provides. In fact, the highbidder may feel that time is on its side andtry to extend the negotiations with theknowledge that, at some point, the seller willbe reluctant to turn to the second-placebidder — either because the seller will haveinvested so much time with the high bidderthat it will want to avoid having to start overwith someone else, or because it knows thatthe second bidder will likely have enhancedleverage, knowing that the seller wasunsuccessful with the high bidder (assuming,in each case, that the seller has not beensimultaneously negotiating with bothparties).

Exclusivity From the Seller’s Perspective



If it seems unlikely that a

better deal could be had,

or the exercise of finding

this out would be unduly

time-consuming and

distracting for the

portfolio company

management team, then

the exclusivity request

should be seriously

considered.


In practice, the seller’s banker delivers amessage to the high bidder that writtenexclusivity will not be provided but, if thehigh bidder rebids at a certain level, thatbidder will become the front-runner andwill have de facto exclusivity until a specifieddate. During that period, the banker willtry to maintain a connection with the otherbidders so that there are fallback options forthe seller.

As both scenarios #1 and #2demonstrate, the response to an exclusivityrequest during the sale of a privately-heldportfolio company is driven by dealdynamics, not legal considerations. That isbecause, in the context of a sale of aprivately-held portfolio company, the legalexposure associated with granting exclusivityis usually not significant due to theportfolio company’s small number ofminority stockholders, if any. The analysisbecomes more complicated as we move tothe public company arena.

Scenario #3The private equity firm has a significant stakein a public company. A buyer has emergedwith an offer at a substantial premium overthe current trading price and a request thatthe target company work exclusively with ittoward the signing of a definitive deal.As with scenario #1, the private equity firm,or, more precisely, the portfolio companyboard, must consider whether the timing isright and the extent to which the offer isappealing when compared to the company’strading price, financial performance,prospects and long-term strategic plans. Inaddition, and unlike in the private companycontext, legal issues play a significant role inthe analysis regarding exclusivity. This isbecause the fiduciary duties of directors ofpublic companies, while not different fromthose of directors of private companies, raiseheightened risks if breached, due to the nearinevitability of the shareholder litigationthat accompanies public company

transactions. In short, if the board decidesthat the company will be sold, the directors’fiduciary duty is to seek the best pricereasonably available.

There are, of course, a number ofreasons why a board of a public companymight prefer to proceed without a pre-signing market check and negotiateexclusively with one buyer. Not unlike theconsiderations discussed in the privatecompany context, one of the biggestconcerns is the distraction to the business ofa public process and the strain on themanagement team of a protracted processwith multiple potential buyers. Theseconcerns are arguably heightened in thepublic company context where leaks andrumors get more air time and can havegreater consequences, such as an impact onthe trading price against which the dealprice will be measured. Proceeding quicklyand without the public spotlight decreasespotential disruption and distraction withemployees, customers, suppliers and otherbusiness partners.

While these are all good reasons forgranting exclusivity, they cannot be viewedin a vacuum. Granting exclusivity, even forcompelling reasons, comes with legal risksfor the target’s board as a result of thepotential for fiduciary duty claims bystockholders, or in reality, the plaintiffslawyers that represent them. This does notmean that a public company board cannotgrant exclusivity — as Chancellor Laster ofthe Delaware Chancery Court said in therecent Del Monte case, granting exclusivityis a tactical decision that courts “will rarelyhave cause to second guess” (assuming thatthe board is independent and active andassisted by non-conflicted advisors). Itdoes, though, mean that the company’sboard should consider carefully theadvantages and disadvantages of grantingexclusivity, and should build a record of itsevaluation. It also means that, until thecompany’s stockholders have voted on the

transaction, the board must be able toconsider competing proposals.

This is why public company mergeragreements contain “fiduciary out”provisions permitting the target’s board torecommend that stockholders vote against aproposed merger if a better deal comesalong. That is the case regardless ofwhether a pre-signing market check hasbeen conducted. However, grantingexclusivity is relevant to how easy the boardhas to make it for competing bidders toenter the process after a deal is signed. Atarget that chooses to negotiate exclusivelywith one buyer prior to signing may seek tomitigate its legal exposure by pressing forrelatively loose post-signing dealprotections. For example, it can (1) insiston a “go-shop” provision allowing activesolicitation of competing offers for someperiod after signing, (2) attempt to set thebreak fee at the low end of the range andprovide for an even lower fee during the go-shop period and/or (3) limit the buyer’smatching rights in the context of acompeting offer.

ConclusionThe decision to grant exclusivity is acomplicated one. We have attempted tocover a number of the considerations in afew different scenarios, but ultimately, thedetermination will require a careful analysisof the particular facts at hand and a gooddeal of judgment on the part of the seller.The good news is that private equity sellersand their advisors will have likely beenthrough this drill many times, including onthe buy-side, and are, therefore, well-positioned to make a judgment call under avariety of different circumstances.

Margaret Andrews [email protected]

Michael A. [email protected]

Exclusivity From the Seller’s Perspective (cont. from page 9)


The 2010 Estate and Gift Tax Law:A “Gift” for Private Equity Estate Planning The recent changes in the estate and gift taxlaw may have been an unanticipated “gift”from Congress to private equityprofessionals. The tax law adopted at theend of last year (the “2010 Act”)dramatically reduced transfer tax rates andraised tax exemption amounts beyond whatmost practitioners had expected, and

instituted some long hoped-for reform. Thisarticle summarizes the major provisions ofthe 2010 Act and the significant estateplanning opportunities it has created,focusing on those available to principals ofprivate equity funds who have transferredfund interests to family trusts in recentinstallment sales and for those who may wishto transfer fund interests down the road.

Major Provisions of the ActAmong other things, the 2010 Act:

l Sets the amount exempt from federal gift,estate and generation-skipping transfer(“GST”) taxes at $5 million perindividual, $10 million for marriedcouples (up from $3.5 million perindividual, $7 million for marriedcouples, in 2009).

l Reduces the rate of taxes on amounts

above the exemption amount to 35%(down from 45% in 2009).

l Allows for “portability” of the gift andestate tax exemptions between spouses, sothat a surviving spouse can now applyany unused estate or gift (though notGST) tax exemption of a deceased spouseto taxable transfers made by the survivorduring his or her lifetime or at death.

Absent further action from Congress, theexemption amount and transfer tax rate willrevert in 2013 to the levels they would havereached under pre-2001 law ($1 million and55%, respectively). Most practitioners

believe the new rate and exemption will beextended, but few are likely to bet on that —especially given how wrong many of us werein predicting that the temporary repeal ofthe estate tax in 2010 would never come topass. In the meantime, with the exemptionat an historic high and the tax rate at anhistoric low, taxpayers have a unique

opportunity (at least for the next two years)to make significant transfers to beneficiariesof multiple generations free of tax. Forprincipals of private equity funds, thesetransfers can take the form of gifts or sales offund interests or the forgiveness of debtincurred by family trusts in acquiring fundinterests.

Enhanced Opportunity for Tax-Free Lifetime GiftsThe increase in the gift tax exemptionmeans, of course, that larger lifetime giftscan be made to anyone free of gift tax — upto an aggregate of $5 million (up to $10million for married couples). With theincrease in the GST tax exemption, gifts canbe made completely free of federal transfertax to grandchildren, great-grandchildren orperpetual “dynasty” trusts. Taxpayers who

have used up the old gift tax exemption of$1 million now have an additional $4million they can give away tax-free, and evenif the old $3.5 million GST exemption hasbeen entirely used, there is now another $1.5million available for GST gifts (again,doubled for married taxpayers). Assumingthat the transferred assets rise in value, all theexcess appreciation belongs to the donee andis out of the donor’s eventual estate for estatetax purposes.

For New York residents, like residents ofmany other states, lifetime gifts at almost anylevel are more cost-effective than transfers atdeath. Many states, including New York,impose an estate tax but no gift tax. Thus,

lifetime gifts do not trigger transfer taxliability at the state level and also help toreduce the eventual federal and state estatetax by reducing the taxable estate.

Lifetime gifts, whether outright or intrust, have several potential non-taxadvantages as well. Recipients of lifetimegifts can enjoy the economic benefit while

the donor is still alive rather than waiting fora parent or grandparent to die (and in manyestate plans, it is the death of both spousesthat triggers benefits to younger generations,creating an even longer wait). A current giftalso allows the donor to see how children orgrandchildren handle a first installment ofwealth or how a trustee managesinvestments. A donor can then makeadjustments where warranted — forexample, by changing trustees, coaxingyounger family members to become morefinancially responsible (through the possibleuse of incentive arrangements) or protectingthem against creditors or mismanagementthrough longer-term trusts.


Exclusivity From the Seller’s Perspective (cont. from page 9)

[W]ith the exemption at

an historic high and the

tax rate at an historic

low, taxpayers have a

unique opportunity (at

least for the next two

years) to make

significant transfers to

beneficiaries of multiple

generations free of tax.


Application to Estate Planningwith Fund InterestsNew estate planning transfers. Estateplanning transfers of interests in privateequity funds have often taken the form ofinstallment sales to family trusts. Such aninstallment sale typically involves thefollowing steps:

l The fund principal contributes aportion of his or her interest in the fundGP (including a proportionate share ofthe principal’s interest in both carry andcapital) to a family limited liabilitycompany (“FLLC”) or family limitedpartnership (“FLP”).

l The principal sells the economic interestin the FLLC or FLP to a trust for apurchase price equal to the value of theFLLC or FLP interest, as determined byan appraiser, taking into account thepresent value of the expected future cashflows from the GP and any appropriatediscounts for lack of control and lack ofmarketability. (Although legislativeproposals had been made to restrict oreven eliminate valuation discounts inintra-family transactions, especially onpassive assets, no legislation has yet beenenacted. As a result, such discounts are

still available, although we do not knowfor how much longer.)

l The trust pays the purchase price in theform of a cash down payment and apromissory note. If the trust hasinsufficient resources at inception toengage in the transfer, the fundprincipal can provide the necessarycapitalization of the trust by way of agift.

l Over time, the trust uses distributionsreceived from the fund GP (via theFLLC or FLP) to pay interest andprincipal on the note. Principalpayments can be back-loaded to

accommodate the expected timing ofcarry distributions from the fund GP.Because the purchasing trust is designedas a “grantor” trust that is ignored forincome tax purposes, the interest on thenote is not taxable income to theprincipal, and no gain is recognized onthe initial sale to the trust.

In structuring installment sales,cautious planners advise that the trusthave net assets (including the downpayment) of 15-20% of the purchaseprice, although some advisors believe that10% is sufficient, based on ambiguousauthority. For those principals who didnot already have family trusts withfunding in place, the prior $1 million gifttax exemption amount effectively cappedthe (appraised) value of the fund intereststhat could be transferred free of gift taxesto $5-$6.6 million (under the cautiousapproach).

With a $5 million exemption, thevalue of fund interests or other assets thatcan be transferred via an installment salehas increased significantly. For example, amarried individual could now sell a $50million asset to a grantor trust, fundingthe trust with a tax-free gift of $5-$10million, out of which the trust would thenpay the grantor a $5 million downpayment along with a note for $45million at the relatively modest interestrates mandated by the IRS. Of course,there needs to be a realistic expectation offull payment of the note, collateral (oftena pledge of the purchased asset) and soforth. The key change after the new taxlegislation is that the scale of installmentsales can now be much larger byleveraging the larger gift tax exemption.

Alternatively, principals can forego thecomplexities of an installment sale (whichrequires, among other things, thepreparation of a security agreement andthe filing of UCC statements in one or

more states) and instead transfer theFLLC or FLP interest by gift. With themuch larger gift tax exemption amount, itis now possible that the entire gift couldbe sheltered from gift tax.

Prior estate planning transfers. Fundprincipals holding promissory notes issuedby trusts in prior installment sales maywish to consider using the additional gifttax exemption to forgive some or all of theamount outstanding. The forgiveness ofthe loan will be treated as a gift to thetrust, which will be sheltered from tax tothe extent of the available exemption.Forgiveness of the loan will result insignificantly more wealth remaining in thetrust for beneficiaries and reduce theamount that would otherwise be repaid tothe donor and ultimately included in hisor her estate. In addition, forgiving theloan helps to avoid possible adverseincome tax consequences that may arise ifa donor dies while an installment note isstill outstanding. Principals will need toweigh these benefits against the potentialdisadvantages — including the reductionin cash flow (to the extent principals werecounting on the debt service for lifestyleor other needs) and the use of the gift taxexemption on an unleveraged basis.

In considering whether to forgive aloan from a trust, donors should also bearin mind the expected future performanceof the trust’s assets. For example, if a trustholds only an interest in the GP of asingle fund that is unlikely to generateenough carried interest distributions toallow the trust to pay off its installmentnote, there is little benefit in forgiving theloan. Instead, the trust can be allowed todefault on the note, in which case, the GPinterest held by the trust will simply bereturned to the principal. In that case, theprincipal can use the gift tax exemption toforgive debt owed by a trust holding an

The 2010 Estate and Gift Tax Law (cont. from page 11)



The 2010 Estate and Gift Tax Law (cont. from page 11) Helping Private Equity Play a Greater Role in the U.S. Insurance MarketAlthough some U.S. private equity fundscontinue to focus on investments in theU.S. insurance space, many private equityfirms have historically shied away from suchinvestments. Since opportunities for suchinvestments are expected to increase as theeconomy improves, due, in part, to theuncorrelated risk opportunity on the liabilityside of the balance sheet and theopportunity to leverage investment expertiseon the asset side, it may be an opportunetime for private equity firms to reevaluatethe insurance sector.

While the market is not oversaturatedwith insurance private equity transactions,there are a number of significant recenttransactions, including the $230 millioninvestment by Warburg Pincus in Primerica.Other private equity investments in thebroader U.S. insurance space include theapproximately $3.1 billion acquisition bySilver Lake Partners and BC Partners ofMultiplan, Inc., the largest independent PPOin the U.S., and a $1.1 billion buy-out ofSedgwick Claims Management Services, Inc.by Stone Point and Hellman & Friedmanand the Sedgwick management team.

Part of the historical reluctance of privateequity firms to invest in insurance assets isthe regulatory environment. U.S. insurancecompanies are generally regulated by state,not federal, law and the acquisition of aU.S.-domiciled insurance company by aprivate equity fund can require significantdisclosure to state regulators about theacquiror’s fund structure and controllingpersons. In addition, the acquired insurancecompany will continue to be subject to acomprehensive state-based regulatory regimeby its state of domicile and, in certaincircumstances, the laws of other states wherethe insurer is licensed.

State regulation sounds more ominousthan is actually the case. Private equity

funds proposing well-structured transactionsneed not necessarily fear state insuranceregulation. Speaking from my experience asthe Superintendent of Insurance for theState of New York, I recognize that stateinsurance regulators (and regulatorsgenerally) are constantly worried aboutpreventing the next crisis and will generallybe appreciative of those interested inproviding capital to the industry, includingprivate equity funds. On several occasionsduring my time as the New York StateSuperintendent of Insurance, I was relievedto be able to turn to private equity funds aspotential solutions to perceived or existingproblems — and I was in good company inthe regulatory community.

Following the financial crisis, stateinsurance regulators are more focused thanever on preventing problems and will oftenbe incentivized to welcome private equityfunds to the industry as reliable and expertsources of capital. This is especially truewhen private equity is viewed as a potentialrescuer of troubled insurers (which mightinclude insurers in receivership proceedingsor close to it, those facing unresolvedregulatory issues or needing to shed non-core assets or businesses). In addition to thepotential for attractive valuations,transactions involving troubled insurers havethe potential to offer a private equity fund astreamlined approval process. The approvalprocess can be streamlined at the discretionof the key regulators. One relevant examplewas the ability of Berkshire Hathaway toform and nationally license a monolineinsurer in approximately 10 weeks, a muchshorter time frame than is typical.

Once a potential insurance opportunityhas been identified, a private equity investorwill face two primary legal and regulatoryconsiderations. The first concerns thestructuring of the acquisition itself, which

has been adequately covered by ourinsurance team elsewhere.1 The secondconcerns managing the regulatory approvalprocess for the acquisition, as well asunderstanding the regulatory regime underwhich the acquired insurer will operatefollowing the closing. The remainder of thisarticle will focus on strategies forsuccessfully navigating the applicableregulatory regime, both in terms of securingregulatory approval for the acquisition itselfand owning a U.S.-domiciled insurerfollowing the closing.

Getting from Signing toClosing: Strategies forNavigating the InsuranceRegulatory RegimeAcquiring “control” of a U.S.-domiciledinsurance company requires the prior


Following the financial

crisis, state insurance

regulators are more

focused than ever on

preventing problems and

will often be incentivized

to welcome private

equity funds to the

industry as reliable and

expert sources of capital.

1 See “Private Equity Investments in InsuranceCompanies,” by Paul S. Bird, Stephen R. Hertz,Jeremy Hill and Andrew L. Sommer, in Insurance andInvestment Management M&A 2010, Debevoise &Plimpton LLP (2010).


approval of the domestic state regulator ofthe insurer and can also require theapproval of other state regulators if theinsurer is “commercially domiciled” inanother state.

What is “Control?”“Control” for state insurance law purposesis generally defined as the possession of thepower to direct the management andpolicies of a person, through ownership ofvoting securities, by contract, or otherwise.Most state insurance codes contain arebuttable presumption that an acquirorwill control an insurer if it holds, directlyor indirectly, the power to vote, or holdsproxies representing, 10% or more of thevoting securities of the insurer.

What Must Be Filed?The application for approval is generallysubmitted on a “Form A,” which oftenrequires disclosure of an acquiror’scontrolling persons, directors andexecutive officers, financial statements andbusiness plan for the insurer (oftenincluding financial projections). Thesedisclosure requirements can include thefiling of biographical affidavits, and insome states, fingerprints, with respect todirectors and executive officers of theacquired insurer or controlling person. Inaddition, in the event that the controllingperson of an insurer will be an individual,personal financial statements or a networth affidavit may be required.

The source of these requirements vary.Some are derived from a state’s insurancelaws, while others are a function of aninsurance department’s standard practice.While these requirements may initiallyappear burdensome and intrusive, incertain cases, an insurance regulator willhave the power to exercise significantdiscretion as to whether a particular itemmust be submitted in connection with aForm A filing, particularly in connectionwith a transaction where a private equityfirm is stepping in to rescue a troubledinsurer. Additionally, confidentialtreatment for non-public informationsubmitted in connection with a Form Afiling is often available. Therefore, privateequity firms whose partners areunderstandably loathe to disclose personalfinancial information will want toapproach the applicable regulators prior toentering into a transaction to gauge thelevel of disclosure that will be required intheir particular case.

In addition to the Form A filing, whichis the primary acquisition of control filing,a potential acquiror will need to considerthe laws of other states in which theinsurance company is licensed to

determine what, if any, other filings will berequired.

What Will the Regulator Be Focused On?A potential acquiror of a U.S.-domiciledinsurance company will want to be sure toaddress the primary areas of concern to aregulator reviewing a proposed transactionin preparing the Form A filing and in allother communications with the regulator.The regulator will have a somewhatdifferent perspective on the transactionthan the private equity firm’s investmentthesis. Harnessing facts to address thoseparticular concerns will be essential inmotivating the regulator to approve thetransaction on a timely and flexible basis.The primary areas an acquiror will want toaddress in discussions with the regulatorare:

l How the proposed acquisition willprotect and benefit policyholders (asopposed to investors);

l The financial strength of the targetinsurer based on statutory valuationmetrics (as opposed to internal financialor actuarial models);

l The expertise and experience of theincoming management team (asopposed to the prior managementregime); and

l Sensitivity towards the protection ofjobs and employees (especially in theinsurer’s home state).

Additionally, a private equity firmshould be aware that many insuranceregulators are mandated to (and otherschoose to) hold a public hearing prior todeciding whether to approve a transaction.

While the regulatory approval processfor the acquisition of control of aninsurance company can be time-

Helping Private Equity Play Greater Role in U.S. Insurance Market (cont. from page 13)

These disclosure

requirements can include

the filing of biographical

affidavits, and in some

states, fingerprints, with

respect to directors and

executive officers of the

acquired insurer or

controlling person. In

addition, in the event that

the controlling person of

an insurer will be an

individual, personal

financial statements or a

net worth affidavit may

be required. CONTINUED ON PAGE 26


A recent decision by the English HighCourt demonstrates the importance ofcarefully crafted loan documents,especially to private equity sponsors whomay want to invoke equity cure rights or

purchase portfolio company debt in orderto prevent lenders from exercisingremedies against their portfoliocompanies. The court upheld the powersgranted to majority lenders under anEnglish law facility agreement,notwithstanding that they were affiliatedwith the equity sponsors. In recognizingthe rights of the affiliated lenders who hadrecently purchased a majority of the debtand then withdrawn a previously-delivered notice making a debt payable ondemand, without the consent of theminority lenders, the court explained thatit was upholding the “commercialpurpose” of the facility agreement. In thesame decision, the court held that theborrower could cure a violation of theinterest coverage covenant in the loandocument by invoking an equity cureclause and incurring additional debt fromwithin its corporate group, withoutinjecting new capital. These holdingsdemonstrate that English courts remaingenerally willing to uphold the powersgranted to majority lenders even wherethey are connected with the equitysponsors and the powers are beingexercised indirectly for the benefit of thesponsors.

In the transaction leading to the case, aLuxembourg borrower (the “Company”)entered into a facilities agreement, underwhich three entities constituted themajority lenders. Following a breach ofthe Company’s financial covenants, the

facility agent, on the instruction of themajority lenders, sent a notice to theCompany stating that the Company wasin breach and that the facilities were to beplaced on demand. The majority lenders

subsequently sold their interests to twocompanies affiliated with the sponsor ofthe Company. The new majority lendersthen instructed the facility agent towithdraw the notice and to waive anybreaches of the financial covenants.

Following this, Strategic Value MasterFund (“SVMF”), a minority lender,brought an action against the Company(and the sponsor affiliates) claiming thatthe purported withdrawal of the noticeand waiver were ineffective. SVMFargued that the withdrawal of the noticewas an amendment or waiver of a term ofthe facilities agreement, and moreover, thewithdrawal related to the extension of thematurity of the commitment of a lender,which under the facilities agreementrequired unanimous lender consent. Thecourt concluded that the majority lendershad not waived or amended a term of thefacilities agreement merely by waivingtheir rights and withdrawing the notice,and that, thus, the majority lenders couldreturn the loan to its original paymentrequirements without unanimous consent.

In addition, SVMF disputed whetherthe acknowledged breach by theCompany of an interest coverage covenanthad been cured, as argued by theCompany and its sponsor. The sponsorhad “round-tripped” funds within theCompany’s group to cure the interestcoverage violation, in essence byrearranging intra-group debt but notinjecting any “new money.” The court

held that this was permissible under theloan documentation, which did notrequire new money in thesecircumstances.

Finally, SVMF argued that the

Company was insolvent within themeaning of the English Insolvency Act1986, because the value of its assets wasless than the value of its liabilities, andthat, thus, there was an existing defaultunder the facilities agreement, whichprovided that insolvency under anyapplicable law was an event of default.Despite the facilities agreement beinggoverned by English law, it was held thatthe English law balance sheet test ofinsolvency was not relevant for thepurposes of the facilities agreement. The“applicable law” is generally thejurisdiction of incorporation (in this case,Luxembourg), but may also include thelaw of any jurisdiction with the power towind a company up or to initiateequivalent procedures. The law chosen togovern the documentation, however, maynot be “applicable” in this sense.

The case is of particular interestbecause the High Court analysed severalprovisions commonly found in Europeansyndicated loan agreements:

l Equity Cure rights: Equity cure rightsin the event of a borrower’s non-compliance with financial covenantsare now an established part of theEuropean leveraged financinglandscape and have survived theadverse market conditions of the pastfew years. In the U.S., equity cureprovisions are also enjoying aresurgence and are now commonly

English High Court Upholds Sponsors’ Rightto Buy and Vote Portfolio Company Debt

A L E R T



included in leveraged facility

agreements. It should be noted that, inboth the U.S. and Europe, the termsare usually heavily negotiated bylenders who are aiming to restrict theiruse. Although in this case it waspossible to “round-trip” the fundsbased on the terms of the loanagreement, it is not generally possibleto use equity cure provisions withoutinjecting new funds. In addition, thereare typically limits on both the numberof cures permitted over the life of aloan and the number allowed overconsecutive periods. Increasingly,lenders are also requiring that some, orall, of the new funds are used to prepaydebt, which should obviously beresisted by sponsors and borrowerswhere possible.

l Disenfranchisement of SponsorAffiliates: The Loan MarketAssociation (“LMA”) standard formfacilities agreement for leveragedfinancings now includes restrictions onthe voting rights of sponsors and theiraffiliates who purchase debt, effectively

disenfranchising them entirely with

regard to debt held by them. Lenderswill usually insist on these restrictions,so they are now generally included inEuropean leveraged financing facilities;the SVMF documentation is unusualin not imposing such restrictions. Asthis case demonstrates, in agreeing tosuch restrictions sponsors are giving upvery real flexibility to manage distressedsituations by acquiring and votingdebt. In the U.S., there are often capson the amount of debt that sponsors ortheir affiliates can purchase and,subject to certain limited exceptions,such sponsors or affiliates are alsousually disenfranchised with regard tothe debt purchased.

l Insolvency Defaults: From a sponsoror borrower’s perspective, it isimportant to ensure that an event ofdefault cannot be triggered by atechnical insolvency, such as balancesheet insolvency (assets being less thanliabilities). The Loan MarketAssociation leveraged form includes aninsolvency default based on balance

sheet insolvency. Although in the

current case the borrower was able tosuccessfully argue that no insolvencyevent of default had occurred withinthe meaning of the facilities agreement,this might not have been the case if thelanguage in the LMA form had beenused. Accordingly, sponsors shouldresist the inclusion of the balance sheetinsolvency default from the LMA form.If it is included, this should be onlyfollowing diligence and carefulconsideration of the risks of suchdefault being triggered.

Most importantly, this case demonstratesthe need for private equity sponsors to bemindful of their need to retain flexibilityunder loan documentation to be bestequipped to handle distressed situations.

Katherine [email protected]

Alan J. [email protected]

Julia [email protected]

Alert: English High Court Upholds Sponsors’ Right (cont. from page 15)

for specific performance of the fullamount of the commitment.

Conclusion In competitive auctions, sellers are able tonegotiate aggressive and tight equitycommitment letters from buying sponsors,who have, in turn, negotiated tight debtcommitments from their lenders.However, in other situations where thenegotiating power lies with the buyer, thecommitment is correspondingly weakerand, even in auctions, the precise terms of

an equity commitment letter will often besecondary in the mind of a seller to theprice offered, as long as the seller issatisfied with the overall deliverability ofthe bid. It is also worth noting that, inthe UK market, there have been no, orvery few, instances of private equitysponsors failing to close agreed deals.Sponsors active in both the U.S. and UKmarkets should understand the differentconsequences of their equity commitmentletters in each jurisdiction and how they

interact with the overall risk profile ofcommitting capital to a transaction.

David [email protected]



Doing Business with Sovereign Wealth Funds:SEC Launches Foreign Bribery ProbeIt may have come as a surprise to somepeople in the private equity community tolearn that the Boston Office of the U.S.Securities and Exchange Commission(“SEC”) had launched an investigation intopossible violations of the Foreign CorruptPractices Act (“FCPA”) by financialinstitutions, including private equity firms,that have sought investments from orpartnerships with sovereign wealth funds(“SWFs”). Subsequent reports make clearthat the SEC’s investigation also includes areview of relationships with state-ownedpension funds.

Public reports describe the investigationas being in its relative infancy. Somefinancial institutions have receiveddocument preservation letters from theSEC; others, however, have also receivedsubpoenas. These reports suggest that theSEC may be engaged in its latest industry-wide probe, on the heels of investigations ofthe oil and gas and pharmaceuticalindustries, among others.

Private equity firms are well-advised totake steps now to get out ahead of anypossible inquiry. Firms that have notalready done so should conduct a riskassessment to determine whether they havemade (or promised) payments, or conferredother benefits, including travel orentertainment, in connection with efforts totransact business with SWFs or foreign,state-owned pension funds. Firms shouldalso review their compliance policies andprocedures to ensure that they are designedto prevent violations of the FCPA, whetherdirect or through indirect dealings via theiragents.

General Scope of the FCPAThe FCPA has a far broader scope thanmany would expect and its prohibitionsextend to far more than bribes or classic“pay offs.” It prohibits, among other

things, payments to “any foreign official forthe purpose of inducing such foreignofficial to use his influence with a foreigngovernment or instrumentality thereof toaffect or influence any act or decision ofsuch government or instrumentality.” Thereach of the statute has been interpretedquite broadly to apply to, among others,individuals that are U.S. citizens orresidents and companies that are listed ororganized in the U.S. or that have aprincipal place of business in the U.S.

Although the FCPA has been on thebooks for nearly 35 years, in recent years wehave witnessed an explosive growth inenforcement of its provisions, with fines,penalties, and disgorgement payments in2010 totaling roughly $1.8 billion, as wellas in prosecutions of individuals. Inaddition, those under investigation oftenface regulatory inquiries in foreignjurisdictions, shareholder litigation,debarment proceedings, and other collateralconsequences.

Private equity firms planning to registeras Registered Investment Advisers (“RIAs”)as required by the Dodd-Frank Act orotherwise may be called upon tounderstand and report to the SEC on theirdealings with sovereign wealth funds andcould come under scrutiny by the SEC, theU.S. Department of Justice (“DOJ”), orboth, as a result. The SEC may share withthe DOJ information it receives throughthe RIA registration or reporting processthat is relevant to FCPA compliance.

So far, it does not appear from thepublished press reports that the DOJ hasopened its own independent investigationinto interactions with sovereign wealthfunds, but the DOJ often acts incoordination with the SEC and couldundertake such an independent review atany time.

Are Employees of SovereignWealth Funds or State-OwnedPension Funds “ForeignOfficials” Under the FCPA?According to the U.S. authorities, “Yes.”The FCPA defines a “foreign official” as“any officer or employee of a foreigngovernment or any department, agency orinstrumentality thereof.” The SEC and theDOJ have long interpreted this definition— specifically, who is an employee of agovernment “instrumentality” — broadly tocover not just government officials, but alsoemployees of state-owned entities, even ifemployees or entities do not perform whatwould commonly be perceived to begovernment functions. For example, theSEC and DOJ have applied the FCPA toemployees of a government-owned bank in


[Private equity] firms that

have not already done so

should conduct a risk

assessment to determine

whether they have made

(or promised) payments,

or conferred other

benefits, including travel

or entertainment, in

connection with efforts to

transact business with

SWFs or foreign, state-

owned pension funds.


Argentina, employees of state-owned oiland oil services companies in Nigeria andAngola, and, most recently, employees of atelecommunications company in Malaysiain which the government held a 43%ownership stake. Thus, employees of anyenterprise, organization, or firm controlledby a non-U.S. government entity in factare likely to be viewed as “foreign officials”under prevailing practice.

The Likely Focus of the SEC InquiryThe SEC appears to be investigatingwhether banks, hedge funds and privateequity firms, in seeking investments fromSWFs or state-owned pension funds,made or promised to make payments —directly or indirectly — to SWF andpension fund employees. Payments, asused here, include in-kind benefits, suchas travel or entertainment.1 Indirect

payments would include payments toplacement agents, consultants or otherthird parties, while knowing ordeliberately disregarding that the payeewould pass monies on to a foreignofficial to secure access to or benefits,such as an investment or an assetpurchase, from the SWF. Enabling aSWF or pension fund employee orrelated party to co-invest alongside aSWF or pension fund could also beconsidered a payment (or illicit benefit)to that employee.

Next Steps To the extent that they have not alreadydone so, firms should conduct animmediate risk assessment to determinewhether they have made or promised tomake payments or conferred benefits inconnection with efforts to transactbusiness with SWFs or pension funds. Ifplacement agents or other third partieswere involved in the transactions, furtherinquiry is likely warranted.

If transactions with SWFs are beingcontemplated but have not beenconsummated, it behooves firms toensure that (1) they have conductedsufficient due diligence with respect toany third parties engaged to assist in thetransaction, and (2) any third-partycontracts contain sufficient anti-

corruption representations, covenants,and audit rights needed to providecomfort that monies or other benefitswill not be improperly passed on to fundofficials.

Finally, firms engaging in transactionswith sovereign wealth funds (or otherstate-owned entities) should have robustcompliance programs, including clearly-articulated policies, training, and testing,to reduce the risk of FCPA violationsoccurring and mitigate any penaltiesimposed in the event violations dooccur.

Paul R. [email protected]

Sean [email protected]

Doing Business with Sovereign Wealth Funds (cont. from page 17)

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1 There is no de minimis exception under theFCPA with respect to travel and entertainment, butfor such expenses to constitute a violation, they musthave been made “for the purpose of inducing [a]foreign official to use his influence with a foreigngovernment or instrumentality thereof to affect orinfluence any act or decision of such government orinstrumentality.” Reasonable and bona fideexpenses incurred to promote or describe a productor to perform under a contract are entitled to anexplicit affirmative defense. The bottom line is thatfirms should avoid any splashy events that could beconstrued as a quid pro quo.


Doing Business with Sovereign Wealth Funds (cont. from page 17)The Return of Sponsor-Backed IPOs:Getting the House in OrderNotwithstanding the recent flurry oflarge-scale private equity-sponsored IPOs,there are still a host of private equityportfolio companies who are not quiteready to hit the market. Although thosecompanies may not have matured enoughto “go public,” if a public exit may be onthe menu, it is probably not to soon towork through IPO-related “to-dos.” Wehighlight below a handful of matters thatshould be on the list.

Auditor IndependenceThe rules for auditor independence can bea harrowing trap for the unwary. SECrules require a registrant’s audit firm to beboth currently “independent” and to havebeen independent during the auditengagement period (generally, the three-year period beginning with the firstincome statement required to be includedin the registration statement). The rulesregarding auditor independence arecomplex for any issuer. But, in the contextof a sponsor-backed portfolio companyIPO, there is an added twist: a registrant’saudit firm may not be independent withinSEC rules if it performed non-auditservices for an “affiliate” of the registrant,which under SEC rules includes entitiesthat control or are under common controlwith the registrant. Thus, if anaccounting firm audits the financialstatements of portfolio company A (theIPO registrant) and also provides aprohibited non-audit service (such asconsulting services regarding internalcontrols) for portfolio company B, ifcompanies A and B are controlled by thesame private equity firm, the accountingfirm may not be independent within SECrules with respect to portfolio company A.There is no “cure” for an auditorindependence violation, and the

consequences for such a violation arepotentially severe, because an IPOregistration statement would betechnically non-compliant, and investorscould have rescission rights with respect topurchased stock.

Publicity and CommunicationConsiderations Communications by a registrant and itsaffiliates before and after the filing of aregistration statement for the company’sIPO are restricted by the federal securitieslaws. Because offers of securities to be soldin the IPO may, as a general rule, bemade only via the offering prospectus, anynon-compliant offer can run afoul of thesecurities laws. The concept of whatconstitutes an offer is very broad andincludes most written or oralcommunications. Therefore, in manyinstances communications or publicitygenerated by, or on behalf of, a registrantor its affiliates before or after the filing ofthe registration statement for its IPO,could be viewed as an illegal offer(commonly referred to as “gun jumping”).The theory is that such communicationsare an attempt to arouse public interestin the company or in its common stock orto pre-condition the market for the sale ofthe common stock. The consequences ofgun jumping can include significantdelays in the proposed IPO, investorrescission rights and civil and criminalsanctions. With this in mind, sponsorsand portfolio company IPO candidatesshould develop communicationsguidelines that address the following areas:(1) relations with the media, (2) pressreleases, advertising and other company-related publicity, (3) relations with thefinancial analyst community, (4) relationswith employees, customers and other

third-parties, (5) the company websiteand (6) the use of social media websites.

Internal Control Over Financial ReportingAn annual assessment of internal controlsover financial reporting beginning withthe registrant’s annual report for its firstfull fiscal year following the completion ofthe registrant’s IPO is required to be madeby the registrant’s management underSEC rules implementing Section 404 ofThe Sarbanes Oxley Act of 2002 (“SOX”).In addition, registrants (other than thosewith a market capitalization of $75million or less) must also provide anattestation report of its audit firm on itsinternal controls over financial reporting.Internal controls over financial reportingare designed to provide reasonableassurance regarding reliability of financialreporting and the preparation of financialstatements in accordance with GAAP.These include those policies andprocedures that: (1) pertain to themaintenance of records that accuratelyand fairly reflect the company’stransactions and dispositions of assets inreasonable detail; (2) provide reasonableassurance that transactions are recorded asnecessary to permit preparation offinancial statements in accordance withGAAP, and that receipts and expendituresare being made only as authorized bymanagement and the board and (3)provide reasonable assurance regardingprevention or timely detection ofunauthorized acquisition, use ordisposition of assets that could have amaterial effect on the company’s financialstatements.

Given the scope of the work necessaryto implement effective controls, advance



work on internal controls over financialreporting is critical and should include:(1) consultation with the registrant’sauditor (taking care to avoidindependence issues), (2) engaging anindependent financial or accountingconsulting firm to advise on preparationfor SOX 404 compliance and (3)establishing robust systems and controlsand an appropriate “tone at the top” tofacilitate the development of effectiveinternal controls over financialreporting.

Disclosure Controls and ProceduresSOX and related SEC rules also requirepublic companies to maintain andevaluate the effectiveness of the designand operation of their “disclosurecontrols and procedures.” Disclosurecontrols and procedures are the controlsand other procedures of an issuer thatare designed to ensure that informationrequired to be disclosed by the issuer inits SEC reports is recorded, processed,summarized and reported, in a timelymanner. Disclosure controls andprocedures substantially overlap withinternal controls over financialreporting, with disclosure controls andprocedures likely subsuming thoseaspects of internal controls overfinancial reporting that relate to theaccuracy of financial reporting.

In addition to the suggested actionsregarding internal controls highlightedabove, to facilitate the development ofeffective disclosure controls andprocedures, the following steps shouldbe addressed: (1) management and theaudit committee should discuss andaffirm their commitment to full, fair,accurate, timely and reliable publicdisclosures, (2) the registrant should laythe groundwork for a disclosurecommittee to assist company executives

in evaluating and maintaining disclosurecontrols, (3) the registrant shouldconsider the respective roles its principalexecutive officers, audit committee anddisclosure committee will play inestablishing, maintaining and evaluatingthe company’s overall disclosurecontrols and procedures, including howthose roles might differ from the privateequity portfolio context) and (4) theregistrant should review its existinginternal controls to determine whetherthey fully and accurately reflect the waythe company operates and, ifdeficiencies are found, new guidelinesor procedures should be implemented.

Stockholder ArrangementsMost private equity-sponsoredcompanies embark on an IPO with amyriad of voting, tag-along and drag-along provisions contained in astockholders agreement entered into atthe time of the initial acquisition. Ifdue care is not exercised whenrestructuring these arrangements for acompany’s post-IPO existence, partiesto the stockholders agreement may findthemselves with unwanted reportingobligations under the SecuritiesExchange Act of 1934 (the “ExchangeAct”) by virtue of being part of a“group” for purposes of Section 13(d) ofthe Exchange Act. If the members ofthe group collectively hold more than10% of the issuer’s equity securities, theSEC takes the position that all membersof the group become subject to thereporting and short-swing trading rulesunder Section 16 of the Exchange Act.Section 16(a) requires the reporting ofmost share acquisitions and dispositionswithin two business days, and the short-swing trading rules under Section 16(b)require subject stockholders to disgorgeto the issuer any profits from anypurchase or sale that is effectuated

within six months before or after anopposite-way transaction. This canobviously be very problematic onceshareholders are free of holdbackrestrictions and can sell into the marketunder Rule 144.

The parties will frequently have alsoaddressed the issue of registration rightsat the time of the initial acquisition,commonly providing that sponsors willbe entitled to demand registration rightsand that minority stockholders will beentitled to piggy-back registrationrights. These arrangements should berevisited in anticipation of an IPO toensure that they still reflect the desiredapproach to post-IPO liquidity (andstill work as a technical matter,notwithstanding any changes in law orpractice).

Corporate GovernanceThe composition of the board andcommittees of the board after theoffering is of key importance andrequires attention to both the applicablestockholder arrangements and relevantstock exchange and Exchange Act rules.For example, stock exchange rules willrequire the establishment of an audit,compensation andnominating/corporate governancecommittee, with each such committeeand a majority of the registrant’s boardcomprised of “independent” directors(subject to applicable transition rulesfor IPO companies). The NYSE rulesprovide one notable exception to thisrule that is particularly useful to privateequity portfolio companies: if theregistrant will be a controlled companyfor purposes of New York StockExchange Rules (i.e., more than 50% ofthe voting power for the election ofdirectors is held by an individual, agroup or another company), then only

The Return of Sponsor-Backed IPOs: Getting the House in Order (cont. from page 19)


The sale of a large portion of the Russian state’s interests in adiverse group of Russia’s most successful companies is expected tooccur within the next one to three years. This highly anticipatednew phase of privatizations in Russia should provide significantopportunities for Russian and foreign investors alike. However,enticing foreign private equity firms to participate may require amore buyer-friendly process than the Russian government mightlike. Whether foreign investors, and private equity investors inparticular, will choose to participate will depend on a number offactors, including the way the sales processes are run and theamount of transparency provided to investors.

The recently adopted Russian privatization program specifies thecompanies and assets that are due to be privatized before the end of2013, as well as the size of the stake to be sold as part of theprivatization. Among those on the list are:

The exact timing and method of privatization of thesecompanies will be determined by the Russian Government at a laterdate, likely within the next 6-8 months. Most assets are expected

to be sold in public auctions, however, in order to make theprivatization process more flexible and investor-friendly, thegovernment may well utilize other methods as well.

For the first time, the Russian government has invited Russianand international investment banks to participate in theprivatization process as its advisors. It is expected that involvementof investment banks, especially internationally recognized banks,will increase the transparency of the privatization process and makeparticipation more attractive to foreign investors. Among theinvestment banks that are expected to assist with the sales areCredit Suisse, VTB Capital, Deutsche Bank, VEB Capital, MerrillLynch, Morgan Stanley, J.P. Morgan, Goldman Sachs andSyberbank.

The government sale procedures do not typically allow investorsto negotiate the terms of the transaction regardless of theprivatization method. Moreover, the handling of due diligence mayappear unusual to those more accustomed to sales in the privatesector. For example, the state may organize a due diligence dataroom, but it is not required to do so. And even if a data room isutilized, bidders would not typically have the opportunity torequest additional documents, ask detailed questions or visit thecompany’s premises and facilities.

The acquisition agreement will likely be governed by Russianlaw. While there is no explicit requirement that this be so, it is notexpected that the state would subject itself to foreign law. Theagreements are usually short, simple documents unlikely to includeany representations, warranties, indemnities or other protectionsthat would be anticipated by a foreign investor. In general, Russianlaw and practice is not very buyer-friendly and this is likely to beeven more true in the context of the planned privatizations. Thedocumentation will often be more akin to a simple transferinstrument than a full-blown purchase agreement in which theallocations of risks between the buyer and the seller is heavilynegotiated.

There is some hope though that the government will be a bitmore flexible in at least certain transactions. For example, in thesale of a stake in VTB Bank, which was the first companyprivatized under the new Privatization Program, there was someevidence that the government recognized the importance of makingthe process attractive to well-known foreign investors. The firstpotential investor to confirm its interest in VTB was Texas PacificGroup, which proposed to acquire (together with a number ofother funds organized by TPG) a 10% stake for approximately $3.5


Russia’s Massive New Privatization Plan May Create Opportunities for Private Equity Investors

Rosneft Oil Company (the largest Russian oil company, market capitalization approx. $85 billion) 25 percent stake

VTB Bank (one of the leading Russian state-controlled commercial banks, market capitalization approx. $30 billion) 35.5 percent stake

RusHydro (the largest Russian hydropower generating company, market capitalization approx. $15 billion) 7.97 percent stake

Federal Grid Company of Unified Energy System (the largest Russian electrical power transportation company, market capitalization approx. $14 billion) 4.11 percent stake

Sberbank of Russia (the largest Russian state -controlled commercial bank. Market capitalization approx. $80 billion) 7.58 percent stake

Russian Railways (Russian railways monopoly, not listed yet) 25 percent stake



billon. Presumably in light of the benefitsthat the participation of a sophisticatedinvestor like TPG could have in terms ofencouraging other foreign investors toparticipate, the Russian Governmentinitially considered an alternative, morebuyer-friendly sale process, which wouldhave allowed TPG to acquire the stake inVTB Bank without any auction andunder a share purchase agreementgoverned by English law. TPG was alsopermitted to conduct relatively extensivedue diligence (outside of the officiallyannounced privatization procedure) andwas also apparently allowed to negotiatethe terms of the potential acquisitiondirectly with the Russian Government.

However, after TPG conducted its duediligence, Merrill Lynch, the investmentbank chosen by the Russian state for theVTB Bank privatization, reportedlyadvised the Russian Government thatTPG was having trouble gettingcommitments from a sufficient number

of co-investors. As a result, the RussianGovernment apparently decided toconvert the process from a negotiatedtransaction with a single buying group toa public offering (SPO) (VTB’s shareprice fell 10% on the news).

With the help of Merill Lynch,Deutsche Bank and VTB Capital, theRussian Government managed to sellglobal depositary receipts representing10% of VTB shares for a total of $3.26billion, down a bit from the $3.5 billionnumber initially discussed with TPG.Among those who participated wereTPG, which bought approximately 1%of VTB shares, together with Generali,and a number of funds from the UnitedStates, Europe, the Middle East and Asia.

All in all, the Russian Government isplanning to raise approximately $60billion through the privatizationinitiative, creating a huge opportunity forforeign investors. And the sale of theVTB stake has illustrated that the

government may be willing to structure atransaction to be more appealing to suchinvestors. However, in any event, dealingwith the Russian Government and themore structured privatization process islikely to be a bit trickier than a typicalM&A transaction. Close consultationwith sophisticated advisors on the groundin Russia is therefore crucial to navigatingthese waters successfully.

Alyona N. [email protected]

Ekaterina A. [email protected]

Russia’s Massive New Privatization Plan (cont. from page 21)

interest in a fund that is more likely to besuccessful, or can save the exemption forestate planning with a new fund.

* * *For all the changes brought by the

2010 Act, most of the tax rules that drivethe structure of estate planningtransactions with private equity fundinterests remain the same. We still advisethat principals transfer a “vertical slice” ofall of their interests in a fund in order tosatisfy Section 2701 of the InternalRevenue Code, which applies to intra-family transfers of partnership or LLCinterests and can result in adverse gift taxconsequences unless certain exceptionsare met. Transfers of interests inmanagement companies remain

potentially problematic because of the“assignment of income” doctrine andother issues.

In recent years, practitioners havedeveloped new transfer techniques inorder to avoid some of the constraints ofSection 2701, including transfersinvolving derivative contracts. Althoughthese techniques are not widely used andraise some potential tax issues, they maybe useful in situations where particularfund structures make it difficult orimpossible to satisfy the “vertical slice”rule. In those cases where transferring a“vertical slice” is not problematic, theincrease in the gift tax exemption amountmakes the less exotic (but tried and true)gift and installment sale techniques more

attractive than ever.While decisions about estate matters are

never easy, the opportunities presented bythe 2010 Act are dramatic enough — andmay be short-lived enough — that privateequity professionals should take a closelook at their estate plans and considerpossible changes while they can.

Cristine M. [email protected]

The 2010 Estate and Gift Tax Law (cont. from page 12)


“alignment of interest” value proposition inprivate equity, although endorsement doesnot constitute a commitment to each andevery preferred term set forth in thePrinciples.1

Moving the MarketOverall the Principles seem to be anattempt to move the market in a more “LP-friendly” direction, incorporating a widerange of the comments on fund terms thatLPs and their counsel often serve up to GPswhen negotiating the terms of a privateequity fund. This effort is not surprising,given that ILPA represents the interests ofinstitutional LPs that provide a verysignificant share of the total capital investedin private equity funds. This also is not anew effort; readers may recall the “MercerReport,” sponsored by nine state retirementplans in 1996, which set forth the views ofthose LPs concerning preferred fund terms.Furthermore, the enumerated principlesaround which ILPA proposes that GP andLP discussions be organized — alignmentof interests, good fund governance andappropriate transparency and reporting —are not controversial.

As always, though, the devil is in thedetails. Many of the very specific“preferred” fund terms advanced in version2.0 of the Principles as furthering thesethree general principles are controversial.Vigorous discussion and debate betweenGPs and LPs over these terms can beexpected as private equity fund agreementsare negotiated in the years ahead. It iscertainly true that several of the preferredterms in version 2.0 are more “GP-friendly”

than in the original Principles, such as theacceptance in version 2.0 of the view thatGP clawbacks should be “after tax,” andthat GP clawbacks need not always bebackstopped by joint and severalguarantees. However, many of the ILPApreferred terms are still more “pro-LP” thanthe actual terms that we have seennegotiated and agreed upon by LPs andGPs over the past several years. Althoughdescribed by ILPA as best practices, thePrinciples continue to be seen by some GPsas a long LP “wish list.”

Different LP Perspectives. GPs are not the only market participantswho may take issue with some of thepreferred terms included in version 2.0 ofthe Principles. Not surprisingly, differentLPs have different views on certain of thepreferred terms. For example, infurtherance of the goal of good governance,version 2.0 of the Principles proposes aprominent role for the LP AdvisoryCommittee, which is described as a“sounding board” for the GP and also as a“voice” for LPs. Yet, some LPs that are notrepresented on LP Advisory Committeesmay prefer to rely on the judgment of theGP, or may want controversial matters to beput to a vote of all LPs. They may feel thatan overly strong and activist LP AdvisoryCommittee could exert disproportionateinfluence on the GP, to the potentialdetriment of the fund as a whole. Evensome LPs who do hold seats on LPAdvisory Committees may not wish toinvest the time and effort (or may not feelthey have the expertise) to assume all ofthe responsibilities described in thePrinciples, such as approving valuations orvaluation methodologies or reviewingallocation of investment opportunities.Other LPs who frequently hold seats onLP Advisory Committees may welcomean enhanced Advisory Committeefunction, so long as they can act solely in

their own interests and are not required tobe a voice for other LPs.

Another example of a “preferred” termthat might not be in the best interest of LPsin some situations is one of the mostcontroversial of the ILPA proposals, relatingto the timing of carried interestdistributions to GPs. Version 2.0 of thePrinciples states that LPs and GPs “must”recognize “as a best practice” a distributionwaterfall providing for the return toinvestors of all capital contributions, plus apreferred return, before any payment ofcarried interest is made to the fund’s GP.This approach, which is quite common inEurope, reduces the likelihood that the GPwill be required to make clawbackpayments and for that reason is favored bymany LPs and some GPs. On the otherhand, this “return all capital first” approach(as compared to the “deal by deal”distribution model that has been themarket standard in the United States forover three decades) has the effect ofdelaying distributions of carried interest toGPs, often for many years. Such a delayaffects GP incentives and could adverselyimpact the ability of some private equityfirms — particularly small and mid-sizedfirms that do not have multiple products orlines of business — to attract and retainthe most talented investment professionals.It also could have the perverse effect ofencouraging a more rapid disposition ofinvestments than is appropriate. Some LPsand many GPs could well take the viewthat, at least for certain firms, the modelthat ILPA says “must” be recognized as abest practice is not necessarily consistentwith the goal (unstated by ILPA) ofmaximizing investment returns.

What Else Does Version 2.0Recommend?Version 2.0 of the Principles recasts some of

New ILPA Principles: What Has Changed? (cont. from page 1)


1 Version 2.0 of the Principles can be found atwww.ilpa.org. For more background on the originalPrinciples, see “Institutional Limited Partners AssociationReleases Private Equity Principles Report Listing PrivateEquity Preferred Terms” in the Summer 2009 issue of theDebevoise & Plimpton Private Equity Report. For moreinformation on ILPA, see “LPs and the Role of ILPA” inthe Spring 2006 issue of the Debevoise & PlimptonPrivate Equity Report.


the terms included in the original Principlesto be more GP-friendly, but also adds newpro-LP terms. Set out below are some ofthe notable changes proposed in version 2.0as compared to the original Principles:

l After-tax GP clawbacks: The originalversion of the Principles stated that theGP clawback (i.e., the GP’s obligation toreturn overdistributions of carriedinterest) should be gross of tax. ILPAnow states that an after-tax GP clawbackis acceptable. However, the calculationof the after-tax amount subject to beingclawed back from the GP must be basedon the actual tax situation of theindividual GP member and should takeinto account loss carryforwards andcarrybacks, the character of fundincome, deductions attributable to statetax payments, any loss resulting from theclawback contribution and any changein taxation between the date of thepartnership agreement and the clawback.The use of a single assumed tax ratebased on the highest hypotheticalmarginal tax rate in a designatedlocation, an approach adopted by manyprivate equity funds, is discouraged.Thus, ILPA concedes that after-taxclawbacks are acceptable, but then

proposes a clawback calculation that isquite complex and is still moreaggressive than the approach agreed toby a majority of LPs in the past decade.

l Guarantees of the GP’s clawbackobligation: The original version of thePrinciples took the off market view thatindividual GP members must guaranteethe GP clawback obligation on a jointand several basis. Version 2.0acknowledges that a creditworthybackstop (such as a substantial parentcompany guarantee or guarantees by asubset of GP members) may be anacceptable substitute for joint and several

guarantees, but does not go so far as toaccept the market practice of GPmembers guaranteeing only their prorata shares of the GP’s clawbackobligation.

l Interim GP clawbacks: Version 2.0recommends that, if a “deal by deal”carried interest distribution waterfall isused in a new fund, then the GPshould be subject to interim clawbacks(as compared with a clawbackobligation that only applies at the endof the term of the fund), triggeredboth at defined intervals and uponspecific events, such as a key personevent or in the event that a fund’s netasset value is less than 125% of cost(NAV coverage itself being a newconcept for the Principles, and not onegenerally used for private equity fundsother than some venture funds).Interim clawbacks were not discussedin the original Principles and are notcustomary in today’s market.

l Limits on all-partner clawbacks:Version 2.0 states that so-called “all-partner clawbacks” (i.e., the obligationof all partners to return distributions toindemnify the GP), which became

quite common in the 1990s, should becapped so that the amount subject toclawback does not exceed 25% ofcommitted capital. Version 2.0 alsostates that only amounts distributed toLPs in the preceding two years (orsome other “reasonable period”) maybe clawed back by the fund. This 25%cap and the “two years afterdistribution” limitation have beenfrequently requested by LPs over theyears. However, these terms have beenvigorously (and often successfully)resisted by many GPs, who argue thatsuch restrictions make it much lesslikely that the all-partner clawback will

work as designed (i.e., to protect theGP from bearing more than its share offund liabilities). Instead, GPs havefrequently obtained agreement tohigher caps on amounts subject toclawback (e.g., up to 50% ofdistributions) and to longer periodsduring which such amounts are subjectto clawback (e.g., until the second orthird anniversary of the end of thefund’s term). All-partner clawbackswere not discussed in the originalversion of the Principles.2

l GP contribution to be in cash: Version2.0 states that the GP’s commitment toa fund should consist entirely of cash,as opposed to being contributed inwhole or in part through amanagement fee offset mechanism.The original version of the Principlesrequired a “high percentage” of the GPcommitment to be in cash.

l Required vote for no fault suspension ofinvestment period: Version 2.0proposes that the investment period ofa fund may be suspended orterminated on a “no fault” basisfollowing a vote by two-thirds ininterest of LPs, compared with the

majority in interest vote in the originalversion of the Principles. This pro-GPchange will be embraced, we expect, bysome LPs who disliked the priorformulation because it allowed only asimple majority in interest of the LPs,without any showing of cause, to shutdown the fund’s ability to invest.



2 For more information on the clawbacksdescribed in this and the preceding three bulletpoints, see “Clawbacks: Protecting theFundamental Business Deal in Private EquityFunds” in the Fall 2000 issue of the Debevoise &Plimpton Private Equity Report.


l Required vote for no fault GP removal:Version 2.0 proposed that the GP maybe removed, or the fund may bedissolved, on a “no fault” basis followinga vote by three-quarters in interest ofLPs, compared with the two-thirds ininterest vote in the original version ofthe Principles. Like the changediscussed in the preceding bullet point,we expect that this pro-GP change willbe embraced by some LPs who dislikedthe prior formulation because it allowedonly two-thirds in interest of the LPs totake the extraordinary step, without anyshowing of cause, of removing the GPor dissolving the fund.

l GP removal, or fund termination, forcause: Version 2.0 provides that amajority in interest of LPs should havethe ability to vote to remove the GP, orterminate the fund, for cause. This issuewas not addressed in the original versionof the Principles, although for causeremoval provisions (often with amajority or two-thirds in interest LPvote requirement) are standard in fundagreements.

l Disclosure of certain LP conflicts: Version2.0 states that if a member of the LPAdvisory Committee has a conflict ofinterest, that conflict should be disclosedto the other LPs on the AdvisoryCommittee. The following are given asexamples of conflicts of interest: (1) ifthe LP is co-investing with the fund, (2)if the LP holds an interest in the GP oran affiliate or (3) if the LP has receivedpreferential economic terms. This issuewas not addressed in the original versionof the Principles.

l Notice of liabilities, breach: Version 2.0states that the GP should immediatelynotify the LPs if there is a breach of thefund’s limited partnership agreement, or

if any material contingency or liabilityarises. It appears that the Principles arereferring to fund-level liabilities orcontingencies, although this is notexplicitly stated. Version 2.0 does notaddress situations where such disclosurewould be contrary to the best interest ofthe fund, nor does it address thepotential liability of the GP to the LPs ifthe GP’s judgment as to materiality or

the existence of the breach, contingencyor liability is made in good faith butproves to be incorrect. This is a newterm.

l Annual reports, focus on risk management:Version 2.0 states that annual reportsshould be provided to LPs within 90days after the end of the relevant annualperiod, rather than within 75 days asprovided in the original Principles.Version 2.0 also adds a new reportingrequirement: annual reports shouldinclude information on material risksand how they are managed, at both thefund and portfolio company level. Suchrisks include concentration risk, foreignexchange risk, leverage risk, realizationrisk (e.g., change in exit environment),reputation risk and ESG(environmental, social and governance)risk.

l Quarterly projections: Version 2.0 statesthat the GP should provide estimatedquarterly projections for capital calls anddistributions. This is new.

l Approval of term extensions: Version 2.0proposes that extensions of a fund’s termmust be approved by a majority of theLP Advisory Committee or by the LPs;the GP may not unilaterally extend afund’s term. The original Principles didnot discuss the approval process forextensions.

l Liquidation timing: Version 2.0 providesthat a fund must be fully liquidatedwithin a year after the fund’s term hasended, unless LPs otherwise consent.This is a new term, and addresses LPconcerns that dispositions are too oftendelayed and/or that management fees arecharged during the extended liquidationperiod. However, this requirement alsocould require GPs to dispose of assetsmore quickly than they believe isprudent.

StandardizationAlong with version 2.0 of the Principles,ILPA published standardized forms ofcapital call notices and distribution notices.ILPA has announced that it plans to releasemore such templates in the future,including proposed standardized reportingpackages that tie into the recommendationscontained in the Principles.


[O]ne of the most

controversial of the ILPA

proposals...states that

LPs and GPs “must”

recognize “as a best

practice” a distribution

waterfall providing for

the return to investors of

all capital contributions,

plus a preferred return,

before any payment of

carried interest is made

to the fund’s GP.



consuming, it need not inhibit privateequity funds from considering investmentsin the U.S. insurance space. In manysituations, concerns about obtainingregulatory approval can be minimized byapproaching the regulator prior to signingto discuss potential transaction structures,required disclosures and any potentialpitfalls. An early and proactive approachcan provide the state insurance regulatorswith the information needed to properlyconsider the proposed transaction and canresult in a smoother regulatory approval

process that can then yield a strongrelationship between the acquiror and stateregulators going forward.

Post-Closing: Understanding the ApplicableRegulatory RegimeIn addition to the regulatory approvalprocess, a potential acquiror of a U.S.-domiciled insurance company will want to focus on the regulatoryregime applicable following the closing.U.S.-domiciled insurance companies aresubject to a range of state regulations, butthe most critical from the perspective of aprivate equity investor are often theinvestment rules and dividend restrictions.

Additionally, following the financial crisis,the National Association of InsuranceCommissioners (the “NAIC”) has recentlyadopted amendments to its model lawsthat, if enacted into law by the states,would give state insurance regulatorsadditional powers to regulate affiliates ofan insurance company. Thoughpotentially burdensome to private equityfirms, as discussed below, these newrequirements may also provide an openingfor private equity firms to work withregulators to educate them in an area in

which many regulators will have littleexpertise.

What Are the “Investment Rules?”State insurance investment laws may be ofparticular concern to private equity funds andother potential acquirors looking to maximizevalue through aggressive management of adomestic insurer’s assets. Generally speaking,these laws require an adherence to a prudentinsurer standard when making investments andalso contain limitations on investments, both incertain types of assets and in single issuers.Additionally, if an insurer will seek to engage inderivative or similar transactions, additionalrestrictions may apply. State insuranceinvestment laws are specific to U.S.-domiciled

insurance companies and generally do not applyto a private equity owner or an insurer’s otheraffiliates.

In many cases, state insuranceregulators retain the flexibility to permitan insurer to make investments that areeither not contemplated by, or wouldotherwise be prohibited by, the insuranceinvestment rules. Therefore, establishing adialogue with the regulator with respect toproposed investment strategies, bothduring the initial Form A approval processand after the closing, is key.

Finally, investment management orsimilar agreements entered into betweenthe acquiror or an affiliate and theacquired insurance company must be fairand reasonable and are generally subject toprior regulatory approval. This may be ofparticular concern if a private equityinvestor also has portfolio companies orother related parties which are investmentmanagement businesses.

What Are the “Dividend Restrictions?”State insurance laws generally restrict theamount of dividends a domestic insurercan pay without prior regulatory approval.


What’s Next? The Principles have been the subject ofmuch discussion in the industry and areoften mentioned in the context of GP/LPnegotiations of fund terms. Some of theterms that the original Principles advanced(for example, the insistence that largerpercentages of transaction fee incomeaccrue to the benefit of the LPs, and severalof the terms concerning the role of the LPAdvisory Committee) have been adoptedby a number of GPs. We expect that

certain of the version 2.0 proposalsconcerning clawbacks (e.g., the use ofinterim clawbacks) and fund reporting willalso be adopted (or increasingly adopted) byGPs. We also expect, however, that GPswill continue to resist strongly a number ofthe ILPA preferred terms, and that LPs willcontinue to hold differing views on therelative importance of certain of thepreferred terms and their impact on fund

performance and governance. Private equity firms, of course, come in

many shapes and sizes; one size does not fit

all (as ILPA acknowledges in theintroduction to version 2.0 of thePrinciples). We will continue, as we havefor the past 30 years, to engage with ourclients and with other industry participants— including both GPs and LPs — on theseissues, watching with interest as the privateequity fund market continues to evolve.

Michael P. [email protected]

Gavin [email protected]




Dividends subject to regulatory approvalare referred to as “extraordinarydividends.” Typically, regulatory approvalis required to pay a dividend ordistribution of cash or other propertywhose fair market value, together withother dividends and distributions, madewithin the last 12 months exceeds thegreater of (lesser of in New York): (1) 10% of the insurer’s policyholders’surplus as of the preceding December 31,or (2) the net income of the insurer for the12-month period ending the precedingDecember 31. These dividend restrictions,together with other factors, including thesubordination of lender claims to policyclaims in an insurance receivershipproceeding, restrictions imposed by NewYork and some other states on an insurer’sability to pledge its assets and restrictionsin respect of insurance companies directlyissuing debt or guaranteeing debt issued byaffiliates, has generally led to U.S.insurance sector buyouts being lessleveraged than is the case in otherindustries.

What Are the Recent “Holding CompanyAct Developments?”As noted above, the NAIC has recently

adopted amendments to its model lawsthat, if enacted into law by the states,would give state insurance regulators newpowers to regulate not just insurers, butmembers of insurance holding companies.Among the amendments most relevant toprivate equity acquirors of U.S.-domiciledinsurers are new requirements thatacquirors of a U.S. insurer file reportsidentifying and describing risks that couldpose “enterprise risks” to the acquiredinsurer. Although these developments dohave the potential to require additionaldisclosure, private equity funds active inthe U.S. insurance space also will have anopportunity to be proactive and to educateinsurance regulators about how thestructure of their funds can mitigateenterprise risk.

Other Transactions in the U.S.Insurance SpaceThe requirements outlined above applyonly to the direct or indirect acquisitionand post-closing operation of a U.S.-domiciled insurance company. There are,of course, many other ways for a privateequity investor to access the U.S.insurance markets through businesses thatinvolve less regulatory oversight. These

include forming or acquiring an offshorereinsurer that would assume U.S.-originated business, acquiring insurancedistributors or other insurance-relatedbusinesses, acquiring a minority stake in aU.S.-domiciled insurance company thatdoes not result in the direct or indirectacquisition of 10% or more of the insurer’svoting securities or investing in insurancesidecars, catastrophe bonds or otherinsurance-based capital markets-basedtransactions.

* * *Private equity funds seeking to invest in

the U.S. insurance market will want to beproactive in formulating a plan to bothnavigate the regulatory approval processand comply with applicable post-closingregulatory requirements. The continuedincrease of private equity participation isrecognized by U.S. insurance regulators asan important source of capital, and privateequity firms will benefit from workingwith regulators to reinforce thatperspective.

Eric R. [email protected]


Recent and Upcoming Speaking Engagements February 11, 2011Michael P. Harrell“Private Equity Funds — Terms and Trends”Maples Investment Funds Forum 2011Maples and CalderGrand Cayman, Cayman Islands

March 22, 2011Alan V. Kartashkin“What Opportunities Are There For LargerDeals?”Private Equity and Venture Capital inRussia Forum BVCALondon

June 9-10, 2011Kevin M. Schmidt“Special Issues Involved in AcquiringDivisions or Subsidiaries of LargerCompanies”Acquiring or Selling the Privately HeldCompany 2011Practising Law InstituteNew York

For more information about upcoming events, visit www.debevoise.com


the audit committee need be fullyindependent. There are also taximplications related to committeecomposition. In order to maintain thedeductibility of performance-basedcompensation for named executiveofficers that exceeds $1 million, suchcompensation must be approved by acommittee comprised if at least two“outside directors.”

Since a classified board is one of themost effective anti-takeover techniques,careful thought should be given as towhether to create a classified board (aswell as how to create “classes ofdirectors”). Another topic of crucialimportance is determining whether toopt out of the anti-takeover provisionsof Section 203 of the Delaware GeneralCorporation Law, which is perceived togive a board more control overmanaging an ultimate exit to anunfriendly suitor.

Cheap StockOne accounting issue that frequentlycauses problems for sponsors and theirportfolio companies is the so-called“cheap stock” issue. Under applicableaccounting rules, the fair value of anequity award is recorded as a non-cashcompensation expense. This is mostrelevant where there is a largediscrepancy between option exerciseprices and the IPO price, and the optionhas been granted with an exercise priceof less than the grant date fair value ofthe underlying common stock. TheSEC has historically carefully scrutinizedthe sufficiency of non-cashcompensation expenses, particularly forawards granted within the year-periodpreceding the filing of the IPOregistration statement with the SEC.Disagreements with the SEC over the

non-cash compensation expense maylead the registrant to have to restate itshistorical financial statements. Thereare a number of things that a registrantcan do, short of eliminating equityawards prior to the IPO filing, to help itsteer clear of cheap stock issues,including (1) having an independentvaluation firm contemporaneously valuethe equity awards at the time of grant,

(2) disclose the process and substancerelated to the registrant’s equity awardsin the registration statement and (3) maintain a file of valuation materialsand information regarding the grantsthemselves, which may be helpful inresponding to any SEC comments.

Non-GAAP FinancialMeasuresWhile not quite as controversial as theyonce were, non-GAAP financialmeasures included in IPO prospectusesand other public disclosure are still afocus for the SEC. The SEC willtypically comment on disclosureregarding non-GAAP financial measuresand request additional and/or clarifying(1) disclosure as to the reason for theirinclusion (i.e., why does managementbelieve the disclosure is important forinvestors) and (2) footnote disclosurearound the line-items that comprise thereconciliation of those measures to themost closely-related GAAP measure.Registrants and sponsors, in consultationwith underwriters and counsel, shouldcarefully consider what non-GAAPfinancial measures the company intendsto disclose, ensure that the measures areadequately defined so that that they willremain useful to the company andinvestors going forward and anticipateSEC comments by including fulsomedisclosure to address potential concerns.

Management/ConsultingAgreement ArrangementsIt is common for a private equityportfolio company to have entered intoa management or consulting agreementwith the sponsor at the time of theinitial acquisition. Under thesearrangements, a sponsor will typicallyprovide, among other things, advisory,consulting and other services to theportfolio company in exchange for aperiodic fee. These arrangements mayterminate by their terms at the time ofthe IPO or may be terminable by theCompany at its option. Sometimes, thetermination involves the payment of afee. It is also important to note that feespaid under these arrangements and thesize and terms of the fee and the relatedarrangements may have an impact onthe independence of the sponsor’s boarddesignees under applicable stockexchange rules.

* * *The IPO process is a long one, and is

often complicated by foreseeable issuesthat create speed-bumps. By getting ahead-start on IPO preparation, theuniverse of such issues can be reducedsignificantly, thus shortening thetimeline and increasing the chances of asuccessful offering.

Matthew E. [email protected]

Steven J. [email protected]

The Return of Sponsor-Backed IPOs: Getting the House in Order (cont. from page 20)

new ilpa principles: what has changed?

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