Achieving a successful exit through an auction process in today’s market

October 2024  |  SPECIAL REPORT: PRIVATE EQUITY

Financier Worldwide Magazine

October 2024 Issue

A few years ago, in a seller-friendly environment driven by the availability of low interest third-party debt, it was relatively straightforward for a private equity (PE) fund to sell a portfolio company via an auction process.

A typical auction process would involve: (i) the PE fund or the portfolio company engaging a financial adviser to oversee the process, and due diligence providers to conduct vendor due diligence (VDD) covering financial, commercial, tax and legal matters and, depending on industry sector, specialist matters such as data protection or environmental, social and governance; (ii) due diligence providers spending two to three months carrying out VDD; (iii) the financial adviser and management preparing a confidential information memorandum (CIM) as an overview of the business; (iv) non-disclosure agreements (NDAs) being sent out to potential bidders; (v) interested parties being given four weeks for ‘phase one’, with access to the commercial and financial VDD reports on the basis of hold harmless or non-reliance letters, to submit an indicative bid; (vi) a smaller group of around four to five bidders being invited into ‘phase two’ and given four to six weeks to complete their due diligence and provide mark-ups of transaction documents; and (vii) after receipt of ‘binding’ bids at the end of phase two, a preferred bidder being given 24 to 48 hours to sign binding documentation.

In today’s market, however, with high interest rates and greater scepticism on valuations, together with a growing number of PE funds looking to exit from their more mature investments, bidders have been selective about the opportunities that they pursue. PE sellers and their advisers need to be nimbler, and often they will have to work a lot harder, in pursuing an exit. However, there are steps that PE sellers can take to put themselves in the best possible position to achieve a successful exit through an auction process.

What constitutes a ‘successful’ exit?

The primary goal of a PE seller is normally to achieve a ‘clean’ exit, meaning there is limited or no recourse to them, particularly if warranty and indemnity (W&I) insurance is used for all warranties, and solely for cash consideration, with no earn-out, deferred consideration or escrow provisions. To ensure the best chance of achieving a clean exit, it is important to ensure that there is competitive tension between multiple bidders, and therefore a PE seller needs to keep more than one bidder engaged in the auction process, and get them all to make a bid, on an equivalent basis and at the same time.

Preparing for an exit

Preparation for an exit should start, not months before the launch of an auction process, but as early as during the PE fund’s acquisition of the portfolio company. In other words, when negotiating the shareholders’ agreement and constitutional documents of the portfolio company, the PE fund should have its exit plans in mind and ensure that it has sufficient control and exit rights (including board control, veto rights, drag-along rights, and the right to ‘force’ an initial public offering when it decides to explore an exit).

Similarly, management incentives are essential for a successful exit and should be put in place at an early stage. Such incentives should be designed with the overall objective of aligning the PE seller and management’s interests in relation to the exit and encourage key individuals (particularly for ‘people’ businesses such as wealth management, insurance broking and public relations) to stay with the portfolio company following the exit.

Planning the exit

Once the PE seller has decided to explore an exit, preparation is critical to the success of the auction. As part of the planning, the PE seller should consider taking the actions outlined below.

First, identify (with financial advisers) the most credible buyers of the business being sold, and if they are a mixture of strategic, PE and family offices, assess the different motivations and objectives of the different categories of bidders and consider how its objectives for the exit would align itself with such buyers. For example, is the PE seller interested in maintaining a minority position in the business? If so, a strategic buyer may not be the right buyer for the exit as they tend to prefer 100 percent control of the acquired business.

Second, assess which VDD reports should be commissioned, and whether there should be a particular focus for specific buyers. Strategic buyers will be interested in how the target business could be integrated with, or otherwise complementary to, its existing businesses. A strategic buyer may be willing to pay more for the business than a PE buyer if it can be provided with information about the likely synergies with its existing business, but of course there may also be merger control issues to consider. The PE seller should also consider whether certain buyers, for example strategics, should be given ‘early access’ to information to entice them into a process and provide more time for internal decision making, that can be more involved as compared to a PE buyer.

Third, with legal and tax advisers, analyse how the PE seller’s investment in the target company was structured, what rights it has to facilitate the exit (specifically, whether management shareholders are required to participate and assist in the sales process, including providing business warranties in the transaction documents, assisting on the CIM and participating in management diligence sessions) and what rights minority investors or management have in this process (whether they have consent or consultation rights over the exit, whether there is a minimum returns threshold or time period before the drag can be exercised). All this should be factored into the auction process, both from an execution and timing perspective, to minimise the risk of the process falling apart in particular due to the exercise of such minority rights. The transaction structure and auction draft share purchase agreement should take this all into consideration.

Fourth, identify potential commercial, legal and tax issues with management and advisers so that these issues can potentially be resolved before the formal commencement of the auction process. The goal here is to reduce the list of issues that a bidder could use to lower the purchase price, or which might result in a delay to the process while parties attempt to understand, resolve or quantify the risks of any such issues. VDD is helpful here as professional advisers can conduct an objective analysis of the business and report on, and offer recommendations to address, such issues as opposed to allowing multiple bidders to propose multiple solutions. Specifically, transaction insurance can be used as a solution for some of these issues. For example, there could be a known tax issue that would not be covered by W&I insurance which bidders could use to lower the purchase price in negotiations. If a robust contingent risk insurance policy (for ‘known’ risks) is put in place to address such issue (which requires more time to put in place as compared to W&I insurance), the negotiations would then shift from the quantum of the tax liability exposure to who should bear the premium for the policy (which would be a smaller amount).

Fifth, engage with management on the process – understand their motivations and existing incentivisation package and assess what needs to be done to incentivise them for the process, particularly if there are different categories of buyers. Are they looking to stay with the business following the exit or do they want to exit as well? The motivations of management in place since the PE fund acquired the business may be very different from that of a management team recently put in place to facilitate an exit. This has to be assessed alongside the buyers for the process – there is likely to be tension between a management team that wants to stay with the business following the exit and a strategic buyer that is looking to put in place a new management team from one of its business divisions or between a management team that wants to exit and a PE buyer that wants the team to continue running the business.

Finally, there are preparatory steps designed to maximise the price that the PE seller can get from bidders and to ensure a swift sale of the portfolio company, that are often taken for a UK or European auction process, but less commonly seen in a US-focused process.

Typically, the sell-side will commission advisers to prepare VDD reports. The use of the VDD report is meant to speed up the bidders’ processes by highlighting key due diligence issues that warrant focused further investigation by bidders and their advisers, or that go to price. In theory, they also reduce the cost of participating in a process for buyers and allow sellers to reach out to a greater number of potential buyers without overburdening management.

The sell-side will often engage an insurance broker to put together a W&I package for bidders to consider alongside the transaction documentation. Specifically, the broker will prepare a report that presents a non-binding indication (NBI) of terms (including details of premium, policy limit and retention amounts) from several insurers based on the auction draft of the transaction documents. The NBI is then shared with potential bidders. The NBI allows the PE seller to take the approach of limiting meaningful recourse against it under the transaction documents, while at the same time offering some recourse to a buyer. The PE seller will hope that by stapling insurance coverage to a set of warranties that it (or management) is happy to provide, it will succeed in minimising the extent of any negotiation of the same by potential buyers.

The sell-side may also prearrange and agree acquisition financing packages (‘stapled financing’) with third-party banks or alternative lenders for the successful bidder in the auction. Stapled financing helps to speed up the bidders’ processes for obtaining acquisition financing for the transaction, as a considerable amount of the preparatory work, including diligence by the debt providers, would be done by the PE seller on behalf of potential bidders.

All these steps will involve additional upfront time and costs for the PE seller and management. The PE seller will have to undertake a cost/benefit analysis on the above – balancing ‘wasted’ costs if the sales process is aborted against the benefits it brings to an exit.

Phase one of the process

Once the PE seller and its financial adviser have agreed on the list of potential bidders to approach for the auction, NDAs will have to be executed before confidential information is provided to them at the beginning of phase one. In addition to imposing confidentiality obligations, NDAs can be used by the PE seller to control the auction process. Specifically, a PE seller will be keen to maintain control of the sale process and will not want bidders to disrupt its process by sourcing its own acquisition financing and W&I insurance and requiring such financing and insurance providers to work with them on an exclusive basis. Bidders should be asked in the NDAs to agree not to contact such providers. Similarly, collusion between bidders or between a bidder and the management team can be harmful to the competitiveness of the sale process. The NDA would also impose restrictions on the bidders in this regard.

Once the bidders participating in the process are confirmed, legal advisers should be asked to scrutinise the likely antitrust, foreign direct investment and regulatory clearances required for the exit, and which bidders would be affected by them. Strategic buyers, unlike PE or family office buyers, may have significant competitive overlaps with the business. Selling the business to such buyers may therefore pose greater execution risk and a longer timetable for the closing of the transaction.

Phase two of the process

During phase two of the auction, confidential information will be shared with the remaining bidders through access to a virtual data room. Bidders will also be granted access to management through management presentations and diligence sessions. The control of the scope and flow of information to bidders is particularly important and PE sellers would be well-advised to appoint an experienced internal team to populate the data room and to stage the release of commercially sensitive information to bidders. Bidders’ access to management will have to be tightly controlled with the financial adviser chaperoning any contact to ensure that management treat all bidders (whether they are strategic or PE) in a consistent manner and do not jeopardise the competitiveness of the process by favouring one bidder over another, while attempting to ensure they all reach the finish line at the same time.

Bidders should be encouraged to provide a preview of their legal advisers’ markups of the transaction documentation prior to final bid submission so that the PE seller’s legal advisers are given an opportunity to test them on how important their clients’ positions are on the proposed amendments to these documents and guide them in producing a competitive markup for the final bid while the balance of power is still in the hands of the PE seller. Once exclusivity is granted to the preferred bidder at the end of phase two, competitive tension will naturally be reduced. For that reason, PE sellers should resist granting exclusivity and only do so when all key commercial points have been agreed; a short exclusivity period would then be granted to the preferred bidder for the legal advisers to go through the process of finalising the transaction documentation.

Conclusion

A PE fund is only as successful as its exits. Careful planning, a comprehensive understanding of the existing business and the motivations of its management team, and awareness of the perspectives of the potential buyers of the business, are all crucial for a successful exit.

Gordon Milne and Will Pearce are partners and William Tong is counsel at Davis Polk & Wardwell London LLP. Mr Milne can be contacted on +44 (0)7418 1086 or by email: gordon.milne@davispolk.com. Mr Pearce can be contacted on +44 (0)7418 1448 or by email: will.pearce@davispolk.com. Mr Tong can be contacted on +44 (0)7418 1089 or by email: william.tong@davispolk.com.

© Financier Worldwide

BY

Gordon Milne, Will Pearce and William Tong

Davis Polk & Wardwell London LLP

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