Buying to sell

The private equity world, and its disruptive influence in global markets, are throwing up more controversies than ever before. So much so that many leading law firms flatly declined the Gazette’s interview requests for this article. Other commentators spoke only on condition of anonymity.

The revolution in law

US law firms ‘have blown the market up’, according to one private equity partner. This has been aided by a shift in the source of financial power since the 2008 financial crisis. Now, private capital is a key source of deal finance, encroaching on the territory of investment banks.

With their formidable work ethic, aggressive hiring tactics and focus on growth through a highly commercial take on law firm management, firms such as Kirkland & Ellis and Latham & Watkins dominate high-end deals as advisers to coveted private equity businesses at the top of the market. This is either a triumph of successful dealmaking or, according to one commentator, ‘a hollow, brutal, commoditised process’, depending on your pecking order in the market.

‘Magic circle firms have mostly been pushed into acting for the lenders,’ says Trevor Clark, a law lecturer at the University of Leeds who was a partner at Linklaters for 16 years. ‘It is now a highly bifurcated market.’

The financing of private equity deals is complicated, with tiers of mezzanine equity and debt. With deal power concentrated in the hands of private equity rather than lenders, contracts have become covenant-light, rather than covenant-heavy as they were before the financial crisis. Lenders compete aggressively for work, vying with each other to offer the most-tempting terms to private equity businesses in auction processes.

The imbalance in parties’ power has raised questions in the financial press and elsewhere over the referral relationship between US law firms and the magic circle (‘the designated counsel relationship’), and the service that the lenders, which are usually bunched into a consortium represented by one firm, ultimately receive.

‘The balance of power swings backwards and forwards in this business, depending on who has the whip hand – the debt or the equity guy,’ says one private equity partner. At the moment, despite hurdles such as the fallout from the war in Ukraine, inflation and high interest rates, private equity still has that whip hand.

Mid-market buyouts certainly seem a happier place for some, as UK firms are more likely to be in their sweet spot of advising the private equity business, or if not, the management team for whom this may be their one big-ticket transaction.

‘At the high end, private equity tends to focus on businesses as assets to be managed, whereas in the mid-market the approach is potentially more personalised and focused on the incumbent founders and management team,’ says Sean Scanlon, a UK corporate law partner in the London office at Arnold & Porter Kaye Scholer, a US firm.

The definition of mid-market varies wildly, but loosely encompasses deal sizes of roughly £20m-£250m in the lower mid-market, and £250m-£500m in the upper mid-market.

‘As a private equity lawyer, you are the key enabler to getting a deal done,’ says Mike Hinchliffe, head of private equity at Addleshaw Goddard, who has over 25 years of deal experience. ‘Many of the terms you negotiate are deal-critical and bespoke, informed by your own and the investor’s experience working side-by-side.’

In mid-market buyouts, the relationship with the client – often a private equity funder or chief executive – is usually held by only two or three key partners, making each deal a satisfying personal achievement. Lawyers work with their clients throughout the life cycle of their investment, from buyout to subsequent exit strategy through sale or flotation. Given the fast pace of the sector, there is always the opportunity to be instructed on more deals once a relationship has been forged with a private equity client.

A few years ago, a wide range of law firms was active in the private equity market. But the field has narrowed as more private equity businesses turned to panels to meet their varying needs on transactions and provide options in the case of conflicts.

With a glut of dry power (funds raised but not yet invested) and investors chasing very few deals, mid-market deal size has grown significantly in the past year. Buyouts are also more likely to have an international element, as investors widen their search for growth.

‘Before the financial crisis, many private equity businesses were doing stupid deals in silly amounts of time, but now that exuberance has died and the market is more sensible,’ says one private equity partner.

With more deal flow than some of the participants at the top of the market are experiencing, the role of law firms focused on mid-market buyouts includes not just ‘getting the deal done’, but thought leadership as well.

That can mean highlighting regulatory concerns that may affect clients, such as environmental, social and governance (ESG) disclosure requirements, or pinpointing trends in the market.

Growing pains

Private equity has also matured. This brings greater layers of complexity to deals which are often still executed to punishingly short timescales.

‘Private equity businesses are still extremely agile, with many exempt from the financial disclosure rules required from banks and other publicly listed companies,’ says one private equity lawyer. ‘They are also in the business of making the best return for their investors. This means that the government and regulation are always a few steps behind.’

That said, some of the largest private equity businesses, such as Apollo, Blackstone, Carlyle and KKR, are listed, so they face similar transparency pressures to other public companies.

‘Inspired by their own pitchbook’

Although in-house teams are now part of the picture, external advice is not sought only on the nuts and bolts of a private equity transaction. Tax law advice is integral to the deal, to ensure that the management team receives a tax-efficient equity stake, with the aim of paying capital gains tax rather than income tax.

Competition law advice is more frequently required, as well as specialist input from regulatory lawyers for the specific sector in which the fund is investing; healthcare and technology are particularly attractive targets for investment at present.

Obtaining certainty on warranties insurance so that the fund does not have claims hanging over it as it moves to the next phase is also important. The need for clearance under the UK’s National Security and Investment (NSI) Act plays to the strengths of larger, full-service firms.

Another emerging trend is private equity fund managers being approached by strategic investors looking to take a minority stake in the fund manager itself. In the past six months, Hunter Point Capital announced minority investments and strategic partnerships with mid-market firm Inflexion, secondaries specialist Coller Capital and consumer specialist L Catterton.

‘It is interesting to see good-quality PE firms being inspired by their own pitchbook, and benefiting from the support and additional liquidity that strategic investors like Hunter Point can offer,’ says Hinchliffe.

Reputation and the establishment

Established private equity businesses are highly cognisant of Warren Buffett’s quote on reputation: it takes 20 years to build it, but five minutes to ruin it. Even so, with thousands of private equity businesses globally, there are numerous, less well-known players which will put profit before reputation.

‘They all want to make money, but the well-known private equity businesses do not want to take unnecessary risks with their reputation. The big names do not want to feature in the Daily Mail, and take business measures to avoid such exposure,’ says Scanlon.

‘This may mean making a strategic decision to avoid certain emotive sectors, or performing deep due diligence on various aspects of the companies they are targeting. They are very prepared to kill a deal, even at a late stage, if they find a significant reputational risk.’

It is not just about bad publicity. The Financial Conduct Authority (FCA) has made it clear that its remit is not just financial misconduct, but extends to behaviour that has the potential to cause harm to individuals or the reputation of an organisation. This includes bullying, discrimination and sexual misconduct.

'Private equity is perfect for an investment in restaurants, but maybe not so much in care homes, where there are very different consequences if the business fails'

Anonymous private equity lawyer

In the public eye, private equity will always make a great story. Think of the headlines about private equity investment in Chelsea or Manchester United football clubs; the outcry that met the purchase of high-street chemist Boots; the Southern Cross care-homes scandal; and the current furore over Thames Water.

Given the overriding goal of making money for investors while remaining agnostic on industry sector, it is probably unsurprising that private equity is a major participant in controversial fossil-fuel investments around the globe, according to Private Equity’s Dirty Dozen, a report by LittleSis and the Private Equity Stakeholder Project.

‘There is no doubt that private equity investment is ideally suited to some sectors, but perhaps not others,’ says one private equity lawyer. ‘It is perfect for an investment in restaurants, for example, but maybe not so much in care homes, where there are very different consequences if the business fails.’

The key question, they point out, is who would step in and fill the investment void, if not private equity?

ESG

As the business world wakes up to the fact that ignoring ESG has the potential to hit the bottom line, private equity is no exception.

The business model has always benefited from strong governance – the G in ESG. With control of portfolio companies and the advantage of speedy decision-making processes, there is potential for yet another private equity reinvention.

A strong push towards ESG by institutional investors such as pension and sovereign wealth funds has led some funds to pivot to a portfolio of sustainable investments. This is a calculated strategy that aims to continue providing the high returns the industry is used to.

Also, although far from the norm, some private equity firms, such as KKR, offer substantial ownership to all employees on some of their investments, together with financial education. This ‘spread the wealth’ notion fits squarely into the ESG mindset.

Regulation is another major driver. In Europe, private equity and venture capital fall under the definition of alternative investment funds of the Alternative Investment Fund Managers Directive (AIFMD or directive 2011/61/EU). This applies regardless of whether they are located in the EU or meet the minimum threshold.

The directive applies directly to private equity fund managers with assets under management (AUM) of more than €500m. While those with less than €500m in AUM are exempted from the full AIFMD requirements, they still have to comply with a simplified registration and reporting regime.

The EU’s Sustainable Finance Disclosure Regulation (SFDR) requires disclosure on how a business integrates sustainability risks into investment decisions, considers sustainability risk and provides sustainability information on financial products. The requirements took effect in January. As Deloitte pointed out in the October issue of its Performance Magazine: ‘The complexity of the legislation, as well as the difficulty of gathering the required data, means private equity firms are facing a lot of uncertainty with regard to SFDR reporting requirements of their limited partner (LP) firms.’

The Corporate Sustainability Reporting Directive (CSRD) is also relevant. It expands the scope of entities that have to apply the EU sustainability standards to all large companies and those listed on EU-regulated markets (with the exception of micro-enterprises).

The CSRD is a data challenge for private equity, in terms of companies having to obtain relevant ESG data on investees’ companies for reporting purposes.

Finally, there is diversity – hardly a hallmark of an industry that continues to be dominated by the familiar white male demographic that has dominated since the 1980s. As its track record improves, however, this agile and adaptive asset class is very likely to turn the ESG challenge into another highly lucrative revenue stream, with reputational benefits to boot.

As it does so, lawyers will profit too.

 

Katharine Freeland is a freelance journalist