September 10, 2020
Financial sponsors, including private equity, venture capital, and hedge funds encounter situations where the financial fairness of a corporate transaction is in question. The main drivers behind these issues stem from conflicts of interests, regulatory requirements, and other legal considerations.
Engaging a qualified financial advisor to provide a fairness opinion is a best practice that helps mitigate risk and supports an independent process that leads to successful transactions.
Private Equity — Common transactions where an independent fairness opinion is obtained
For most private equity-led acquisitions in the middle market, the need for an independent fairness opinion is not required. Typically, a buyout fund or growth equity fund negotiates with a privately-owned business and settles on a mutually agreed upon transaction price and structure. Both parties are independent and willing to engage in a transaction, and thus a fair value is established through the deal process.
There are other private equity transactions that may involve affiliated parties with potentially divergent objectives. In the case where a conflict of interest exists and a participant has an interest in the outcome of a deal, obtaining a fairness opinion can help protect a company’s directors from liability. In the private equity context, either an actual or perceived conflict of interest exists that could have an impact on the fairness of a transaction.
Whether the need for obtaining a fairness opinion is required from a legal or regulatory perspective or is driven by best practice, private equity firms should work with their legal counsel and a financial advisor to help mitigate risk and support an independent process that leads to successful transactions. The most common private equity transactions that require a fairness opinion include the following:
- Down Round financings
- PIPEs and other public securities transactions
- Take-private transactions
- ESOP transactions
- Portfolio transactions
A fairness opinion is a letter prepared by a financial advisor that states whether a transaction – from a financial point of view – is fair. The opinion focuses significantly on the process conducted in the execution of the transaction as well as assumptions regarding the target, market conditions, and specific valuation metrics. Furthermore, the opinion speaks only to fairness from a financial point of view. This limitation is important as it serves to define the scope of the work and make clear the relevant experience and professional qualifications of the financial advisor providing the opinion.
Down Round Financings
A down round financing is common in venture capital and private equity. Down rounds often occur when a new investor group participates in a later investment round (Series B, C, or D) and certain or most existing investors may not be funding at their pro-rata share level. The reason for the down round can be performance-related (for example, the company missed certain operational and financial benchmarks that were previously projected in earlier rounds) or it can be a result of an overall slowdown in the market or industry sector that causes a material decline in valuation multiples. In either case, the new investor group generally benefits from a lower valuation and more favorable funding terms.
Complexities in a down round financing arise when conflicts of interests exist, especially where appointed directors or private equity-backed majority owners of a portfolio company have financial interests that are not the same as all stakeholders. This dynamic is magnified when founding shareholders, management or other early stage investors feel like they are being “crammed-down” (i.e. they are being forced or subject to significant dilution or loss of certain preferential rights, such as liquidation preferences) or have to give the new investors preferences such as participating preferred stock. These transactions are subject to heightened legal scrutiny.
Boards that are asked to approve down round transactions cannot solely rely on the protections afforded by the business judgment rule and will have the burden of proving the “entire fairness” of the transaction. The entire fairness standard is more onerous and entails both the negotiation process (i.e., fair dealing) as well as the economic terms of the transaction (i.e., fair price).
PIPE’s and other Public Securities Transactions
A Private Investment in Public Equity (PIPE) is a privately-negotiated placement of a public issuer’s equity or equity-linked securities, where the sale is conditioned upon a resale registration statement being filed with and declared effective by the SEC. Although there is a significant amount of cash in the system, there has only been a moderate increase in private equity fund activity in PIPE transactions, mainly due to the lack of available credit for issuers seeking to grow their businesses through highly leveraged acquisitions. In distressed periods, there could be increased private equity fund-PIPE activity, as larger funds can invest directly from their own balance sheets and take stakes in companies that are trading at market lows or valued at distressed prices. Conflicts may emerge when the PIPE transaction is combined with debt financing coming directly from the PE sponsor or an affiliated fund or partner. Minority stakeholders might challenge whether the terms of such financing are fair to all parties.
The distressed pricing context may also be an issue that boards need to take into consideration, given that litigation risk may be heightened depending on the structure of the transaction. There may be approvals required for this type of transaction, such as shareholder consent, depending upon the requirements of the respective securities exchange and potential conversion terms that may be set at a discount to the market.
80% Test: SPAC fairness opinions often have additional language opining that the de-SPAC transaction is with one or more target businesses that together have an aggregate fair market value of at least 80% of the assets held in the trust account.
Another public investment structure that is rising in popularity with private equity sponsors are Special Purpose Acquisition Company (SPAC) transactions. SPACs are public entities formed with the immediate purpose of acquiring one or more operating companies pursuant to a business combination (essentially a “blank check” or shell company). Unlike a PIPE transaction, which is geared towards minority stake deals with public issuers, private equity funds can raise capital through a SPAC to do larger deals with a controlling interest. SPACs also provide private equity sponsors a permanent capital solution to access public markets and the possibility of having the transaction structured to permit it to co-invest side-by-side using more equity and less leverage.
Not all SPAC transactions require a fairness opinion, however they can be beneficial to the SPAC’s board of directors (or special committee of the board) when it is deciding whether to approve a specific business combination proposed by the SPAC management (i.e., a private equity sponsor). In the case where there is a potential conflict of interest, i.e., that target entity is affiliated with an insider of the SPAC, then obtaining a fairness opinion is suggested.
Take-private (or Rule 13, E-3) transactions refers to a transaction or series of transactions that convert a publicly traded company into a private entity. The company’s shares are no longer traded publicly when the process concludes, resulting in the company becoming de-listed from a securities exchange. In recent years, there has been a significant increase in private equity sponsor-led take-private transactions, fueled by the record amount of capital raised as well as easy access to low interest financing. Like conglomerate breakups, where an issuer is under pressure to divest certain assets or business divisions, uncertainty will generate additional turn-around/distressed opportunities, especially with those issuers that have an urgent need for capital.
Although regulations like Rule 13, E-3 do not specifically require a fairness opinion on a take-private transaction, there are certain jurisdictions where the application of the entire fairness standard is required. Best practice militates toward the board (or special committee) retaining a financial advisor to deliver a fairness opinion during take-private transactions. Frequently, there are conflicts-of-interest in these transactions when the existing management team is involved with the newly formed private company. In those situations, it is required to form a special committee and obtain a fairness opinion to protect the board of directors. The presentation to the special committee usually includes, an analysis of the financial structure of the transaction, specific details about the deal process, and whether strategic alternatives were considered, including go-shop provisions.
Entire fairness is Delaware’s most onerous standard: “Once entire fairness applies the defendants must establish ‘to the court’s satisfaction that the transaction was the product of both fair dealing and fair price.”
Employee Stock Ownership Plans (ESOP) have increasingly been used by private equity sponsors as a creative mechanism to structure deals. ESOPs are employee benefit plans that give workers ownership interest in the company, while also providing tax benefits to the subject company, the selling shareholder, and participants. Common transactions where ESOPs may have an impact on deal structure include:
- Acquisition: Implementing an ESOP for management and other key employees to align interests
- Acquisition: Buying a company with an existing ESOP
- Exit: Selling a portfolio company to management via an ESOP
- Exit: Selling a company with an existing ESOP to a strategic buyer (or other private equity fund)
There are layers of complexity to these transactions that have implications for a fairness opinion. In some instances, members of management who participate in the ESOP might have distinct executive compensation arrangements that present conflicting incentives (i.e. management may have been awarded shares previously of the company at a lower price than the ESOP is being structured at and thus may have conflicting interests). In addition, ESOPs receive various tax benefits, making them qualified plans and subject to IRS and DOL oversight. While a fairness opinion is not specifically codified, given heightened scrutiny, ESOP Trustees are inclined to obtain a fairness opinion.
There are two types of private equity portfolio transactions that necessitate the use of a fairness opinion. The most common scenario is when a private equity firm sells a portfolio company out of one fund to another fund within the investment complex. This inter-fund transfer, akin to a cross-trade, has conflict of interest issues at the General Partner level, especially if the investor groups differ between the funds. It can also arise when a Limited Partner tenders an offer to acquire control of a portfolio company.
Another situation is a private equity sale of illiquid funds or assets where the carrying value is significantly written down. For some private equity sponsors, these circumstances occur in older vintage funds with residual investments or highly distressed holdings. Alternatively, the conditions are manifest in instances where a fund holds assets beyond the intended holding period, usually because managers were unsuccessful in seeking exit opportunities.
A fairness opinion from a professional, independent financial advisor can be an important element of diligence for a board of directors, special committee, or company to manage risks in a transaction particularly if there is any potential or perceived conflict of interest from parties involved and can be a component of an overall process to ensure that the transaction is completed efficiently with recognized risk.