Trends in infrastructure shareholders’ arrangements

September 2022  |  SPECIAL REPORT: PRIVATE EQUITY

Financier Worldwide Magazine

September 2022 Issue

Infrastructure deals in Europe have undergone significant change in the past couple of decades. Many of the market trends in infrastructure shareholders’ arrangements have arisen due to infrastructure investors in earlier vintage deals experiencing difficulties when wishing to sell their stakes.

Early consortium arrangements in Europe were saddled with exit and transfer restrictions, which made it near impossible for selling shareholders to sell to anyone other than an existing shareholder, severely impacting value on exit. In addition, the trend of mega-deals in this sector necessitates large consortia being formed, adding to the complexity of the arrangements.

This article explores some key themes that have emerged more recently in such arrangements and important considerations when negotiating them.

Terminology

As an industry, we do not always use consistent terminology when describing the multiple layers of shareholders’ arrangements within an acquisition structure. However, generally speaking, shareholders arrangements can be categorised as follows. First, shareholders’ arrangements with a strategic, founder or just one other shareholder where each party has an equivalent size stake are known as ‘joint ventures’, and are usually structured closest to the underlying asset. Second, arrangements with infrastructure sponsors and some active financial co-investors (such as pension plans and sovereign wealth funds) are known as ‘consortium’ or ‘co-sponsor’ arrangements, and are typically structured at least one level above the acquisition vehicle investing in the target (or joint venture). Lastly, arrangements with passive financial co-investors with smaller, more passive stakes (e.g., limited partners, sub debt lenders and smaller pension plans) are known as ‘co-investment’ or ‘syndication’ arrangements, and are structured at least one level above a consortium or co-sponsor arrangement.

Marketability of stakes

On large infrastructure deals, the sheer scale of the enterprise value of the business may mean that exits are more likely to be achieved by way of multiple stake sales, as no one buyer is likely to be able to buy the whole. In addition, the different investment horizons of consortium members – where closed-end funds invest alongside permanent capital vehicles and pension funds – mean they need to exit at different times. Even a long term hold investor may sell some or all of its stake to reduce its exposure to the asset or recalibrate its portfolio in light of market factors. This means that transfer provisions need to permit some degree of stake sale liquidity. To ensure investors are able to maximise liquidity, some governance should be afforded to smaller stakes to make such stake size marketable. Confidentiality provisions should also enable a shareholder to market its stake and facilitate due diligence by a third-party buyer.

ROFOs

Typically, existing shareholders will have a preferential right to buy another shareholder’s interest ahead of a sale to a third party. Historically, rights were often structured as a right of refusal over stakes being sold. This significantly impacted liquidity and price on sales and even resulted in many abortive sale processes, as potential purchasers would not commit time and money to a process knowing incumbent shareholders could trump their offer by matching terms.

As a consequence, protection for incumbent shareholders is now typically structured as a right of first offer (ROFO), where the other shareholders set the price at which they are willing to buy, and if the selling shareholder does not take up this offer, such price will set the floor price for a sale to a third party.

Drag and tag rights

Drag rights (the right to require other shareholders to sell their shares on the same terms) and tag rights (the right of other minority shareholders to sell alongside the selling shareholder on the same terms) are an essential feature of private equity deals, helped by the fact that private equity funds are typically closed ended and thus most private equity sponsors will be generally aligned on the timing of exit. These provisions are also always included in the equity arrangements with management shareholders.

On infrastructure deals, this is less common. Pro rata drag and tag rights are often used in passive co-investment structures between the main sponsor and minority co-investors, who are often also limited partners in the fund, in line with the ‘in together out together’ principle. This enables the fund to deliver an exit for 100 percent (or its entire stake).

In joint ventures or other consortium arrangements, drag rights are unusual and where they are included there is often a minimum return hurdle included, often both internal rate of return (IRR) and multiple of invested capital (MOIC) hurdles.

Pro rata tag rights are sometimes included in consortium arrangements, but they can act as a significant impediment to liquidity: the seller may need to scale down the stake it sells to accommodate the tagging shareholder, resulting in a selling shareholder retaining a stub portion of its stake, which may itself have very limited governance. Care should also be taken to ensure the timing for the exercise of any ROFO and tag right works effectively.

Affiliate transfers

Shareholders’ arrangements will typically permit transfers to affiliates without restriction, but the definition of affiliate is carefully negotiated. Normally, an ‘affiliate’ is broadly defined to give maximum flexibility to investors to transfer stakes to related parties. In the past year or so it is increasingly common for the range of ‘permitted’ affiliates to exclude an affiliated continuation fund (or similar vehicle). This is to avoid a situation where the main sponsor effectively exits and makes an exit-like return on a sale, without affording tag or ROFO protection to the other shareholders. More minority shareholders want to tag in such situations as if it were a sale to the third party, given it represents the ability for the initial fund to exit and achieve its exit returns. Ensuring that transfers to continuation funds are treated as third parties and not affiliates therefore requires careful drafting.

Governance

A detailed overview of typical governance regimes is beyond the scope of this article and therefore we are focused on how to implement governance effectively at multiple levels, and the interaction between governance and liquidity. Strategics and founder shareholders will often require special governance rights that might be disproportionate to their stake. If they need to consolidate the joint venture company for accounting purposes, they will require vetoes over strategic matters such as business plan, budget and senior management appointments.

Financial sponsor investors, on the other hand, will typically seek governance that is commensurate with stake size. Most will require the right to appoint a director with a stake size of 10 to 15 percent. In addition, there will be certain ‘reserved matters’ that require consent of investors that together have a minimum threshold shareholding.

Look-through provisions

A number of high-value transactions now involve multi-layered shareholders’ arrangements. These arrangements exist for a number of reasons, such as a strategic partner not wanting to interact with more than one other shareholder group, or the equity cheque being so large that a combination of different investor profiles is required to fund the acquisition, with each financial sponsor syndicating its own equity exposure higher up in the structure.

There are also governance and other regulatory requirements which must be considered for certain shareholders, such as Canadian pension funds which must ensure they comply with the requirements of the 30 percent rule. A key feature for all structures will be tax efficiency to minimise tax leakage for investors at each level of the structure.

On deals with multi-layered structures, shareholders will need to ensure the governance, pre-emption and transfer provisions interact effectively on a look-through basis.

Where consultation or veto rights exist at multiple levels, shareholders’ arrangements for a holding company should allow investors at the holding company level to implement the consensus view, or exercise their vetoes, at the subsidiary level below in an efficient manner. This should be achieved through the use of aligned approval deadlines (typically with sunset provisions that deem consent is given after a fixed deadline) and ensuring there is enough flexibility for approvals to be delivered through multiple channels (at board meetings or between investor directors in writing). Outside the documentation, it is important that in practice, board meetings are scheduled in advance conveniently and sequentially to facilitate these flow-through governance arrangements.

On many deals, governance arrangements for different levels may be agreed at different times. For example, a sponsor may be raising equity to fund a joint venture with a strategic. The sponsor should make clear at the term sheet stage that it cannot give other co-investors or co-sponsors governance rights that it does not itself enjoy at the joint venture level. For example, a co-investor cannot have a veto right over litigation involving the target group exceeding €10m, if the veto at the joint venture level only applies to litigation exceeding €20m.

The pre-emption regime for new equity issuances must also be structured so as to allow individual shareholders to enforce their rights on a look-through basis. If some but not all co-investors choose to follow their money on a new equity issuance, those who have opted in will need to be in a position to force the vehicle through which they invest to exercise its pre-emption rights at the level below.

Similarly, ROFO and tag rights will need to be structured in a way which allows an individual shareholder in a consortium vehicle to exercise its pro rata right at the joint venture level, and where appropriate, take up any excess rights that are not exercised by its co-shareholders. This requires specific mechanics: the information requirements must match and the time periods for exercising tag rights or ROFO rights must be aligned correctly to facilitate exercise through the different levels.

 

Amy Mahon and Jiaying Zhang are partners at Simpson Thacher & Bartlett LLP. Ms Mahon can be contacted on +44 (0)20 7275 6595 or by email: amy.mahon@stblaw.com. Ms Zhang can be contacted on +44 (0)20 7275 6187 or by email: jiaying.zhang@stblaw.com.

© Financier Worldwide

BY

Amy Mahon and Jiaying Zhang

Simpson Thacher & Bartlett LLP

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