In the “circle of life” of private equity investing, the acquisition of a portfolio company eventually leads to the exit from the portfolio company. There may be twists in the ownership journey along the way—a transfer to a successor or continuation vehicle, a minority sale to a new investor, one or more “add on” acquisitions, the sale of a division or a business unit, or an IPO (leading to liquidity over an extended period)—but, at some point, a full exit will occur.

Often, the timing of the exit does not fully align with the sponsor’s original investment horizon. Financing conditions, management transitions, competitive disruptions, and a myriad of other events may lead a sponsor to accelerate exit and kick-start a sale process. Sale processes can move quickly. Without proper preparation and organization, a selling sponsor may fail to find the best buyer for its portfolio company, face delays in deal execution and may need to compromise on key deal terms Although many factors affecting sale process are outside a sponsor’s control, it pays to be prepared. A sponsor will therefore want to take stock of key sell-side issues prior to beginning a sale process. (These considerations assume the sale of an entire portfolio company in a single transaction; for sell-side issues associated with carve outs, such as the sale of a division or business unit, see the Spring 2023 issue of the Private Equity Report). Keep in mind that several of the items on this list take significant time and resources to pull together, so plan to get started sooner rather than later.

1. Structure/Optimizing Tax Planning. Whether a portfolio company is a partnership or a corporation for tax purposes will have material tax implications for both the selling sponsor and buyer, so the selling sponsor should be clear from the start about expectations regarding the entity or entities being sold and allocation of tax-driven value. A buyer typically is able to amortize purchase price attributable to an interest in a partnership for U.S. federal income tax purposes, which creates additional tax shield and value. Sponsors will want to ensure that potential buyers factor this benefit into their price when marketing the portfolio company. However, a partnership may also present pitfalls, as sponsors will often have investors at several levels, including investors participating via blocker corporations, and may have either agreed to or otherwise want to exit in part through a sale of those blockers. It’s best to make this intention clear at the start of the process, so that a buyer is not led to believe it is acquiring entirely partnership interests, only to be later asked to buy at a different level.

If the portfolio company is a corporation, the sponsor should consider whether there are tax attributes, including net operating losses or deductions attributable to compensation and transaction expenses, that the portfolio company will be able to access after closing. If there are, the sponsor should seek to have the existence of such attributes factored into the purchase price, or otherwise seek payment for the benefit of such attributes when they are realized by the portfolio company post-closing.

2. Equity Arrangements. Over the lifetime of an investment, the equity structure of a portfolio company may evolve—whether through an issuance of stock to a new primary investor, as consideration for one or more “add on” acquisitions, to implement a management incentive plan or for other reasons. A buyer will want to verify that any such issuances were validly authorized and documented at the time, and that the capital structure presented by the seller is accurate and complete. Ensuring the portfolio company’s corporate books and records are readily accessible, accurate and up-to-date will save time and headache down the line.

3. Employee Entitlements/Retention Considerations. There are generally two key employee-related considerations for selling sponsors and buyers in connection with a sale transaction, early attention to which will lead to a smoother transaction. First, the sponsor will need to understand what management and other key employees will be paid as part of the transaction, (e.g., as a result of equity incentives of transaction bonuses). Second, the parties will need to determine the portfolio company’s liabilities to all employees after the transaction closes, including pensions, deferred compensation and retention bonuses.

A buyer will be keenly interested in the amounts to which the management team is entitled in a deal, because that will inform the management team’s incentives to get the transaction done and will help the buyer determine what types of additional long-term incentives will be needed to keep the executive team properly motivated going forward. Will there be a substantial payout for a chief executive who is near retirement age, meaning the buyer will need to begin a leadership search sooner rather than later? Will the selling sponsor’s incentive plan fully vest and be cashed out in the transaction, or will awards remain outstanding, thereby providing some built-in retention value for the buyer? For a private equity buyer, the answers to these questions will also determine the amount of skin in the game the management team will be asked to keep in the business via an equity rollover or reinvestment of proceeds, and understanding the structure will allow the buyer to determine if a tax-deferred rollover of equity interests can be offered to the management team in order to make their commitment as efficiently as possible. Specificity around these payment details is difficult to obtain earlier in a sale process where equity value is not locked down, but even rough estimates are helpful for purposes of framing a buyer’s discussions with management.

The seller should also be ready for the buyer to scrutinize the potential economic effects of the employment agreements and employee benefit plans that the portfolio company will retain following the closing. A buyer may wish to negotiate new employment agreements with some or all of the senior management team, reflecting new economics regarding cash compensation or severance benefits, new restrictive covenants or other changes to the status quo. A buyer often looks to treat unfunded pension and other deferred compensation liabilities as indebtedness of the portfolio company, which reduces the equity value ultimately paid by the buyer.

Lastly, treatment of annual bonuses, long-term performance cash incentives and retention bonuses that will become payable after closing are often the subject of negotiation in terms of which party to the transaction will bear those costs and whether some of them should be allocated between buyer and seller.

4. Debt Review. The portfolio company’s existing debt financing arrangements will receive considerable attention from both sides. Sellers and buyers alike will be keen to understand how a proposed transaction may affect a portfolio company’s existing financing arrangements, including whether these financing arrangements can remain in place post-transaction. The possibility of investing in a company with existing financing arrangements at low interest rates, whether through portability provisions in those debt agreements or by structuring the percentage of equity sold in a transaction to avoid triggering a change of control provision, is particularly relevant for buyers in the current high interest rate environment. In recent years, some sponsors, looking ahead to a future sale, added portability provisions to portfolio company debt agreements in connection with a refinancing transaction. In most cases, though, that option does not exist, so a private equity buyer must obtain new debt financing to consummate the transaction and repay the company’s existing financing arrangements at closing. In that case, prior to commencing a sale process, a seller should confirm whether any prepayment penalties or other breakage costs may be required to refinance the company’s existing debt, and plan to account for these amounts to reduce the consideration received at closing. The seller may wish to investigate whether a slight delay in transaction timing could lead to a lower prepayment penalty being required.

5. Diligence Process. Prior to conducting comprehensive due diligence, potential bidders typically receive a teaser and a confidential information memorandum providing a high-level overview of a portfolio company’s business. Any potential buyers moving forward after reviewing that preliminary information can be expected to conduct detailed due diligence on the portfolio company. Thorough preparation for the diligence process by the seller will greatly affect how time- and energy-intensive this process is for both sides, and make the seller better prepared to negotiate any issues that may arise from the diligence process.

As a first step, selling sponsors should ask their advisors to provide sample due diligence request lists of the documents and information buyers can be expected to request. Identifying and organizing that information is often a time-consuming exercise, so it is advisable to get started as early on in the sale process as possible. Two areas warrant particular attention:

• Data Room Set Up / Staging. Sponsors will need to arrange for due diligence materials to be posted in a virtual data room, and should consult with legal counsel to determine the scope and timing of information being provided. For example, if any bidders are competitors of the portfolio company, certain information may need to be redacted, held back, or disclosed only to a “clean team” of that bidder. It may also be advisable to hold back certain information for strategic reasons. For example, if the portfolio company has engaged in any add-on transactions, the sponsor may want to hold back the underlying purchase agreements for those transactions to avoid a scenario where buyers attempt to leverage those agreements when negotiating the definitive documentation for the portfolio company sale.
• Preparation of Disclosure Schedules. An early start on sell-side diligence also facilitates preparation of the disclosure schedules to the purchase agreement. Initial population of the disclosure schedules can begin based on the selling sponsor’s auction draft purchase agreement, even before the agreement is provided to or negotiated with potential buyers.

6. Significant Contingent Liabilities - Environmental. Portfolio companies that own real property or conduct chemically intensive operations should assess whether there are actual or potential environmental issues related to their properties or operations ahead of a sale process. Environmental issues may bring regulatory, litigation and reputational risks, reduce the value of the property to the business, or affect the property’s future usability or saleability. Identifying whether any environmental studies or reports (e.g., Phase I assessments) have been prepared in the past, and/or whether any such studies or reports may be required by a buyer, will help a selling sponsor determine whether to commission or update such studies or reports as well as help frame any investigative or remedial actions that may need to be taken, any potential costs and the timing implications on the transaction itself.

7. Significant Contingent Liabilities – Litigation/Disputes. Sellers need to have a firm grasp on any pending litigation matters and outstanding litigation liabilities, which will be closely scrutinized by any potential buyer. Buyers will expect a summary of any pending and historical matters (typically within a five-year look-back period), and will endeavor to understand whether the matters are ordinary course (and non-material) or whether they could lead to material liability in the future. Sellers should be prepared to explain the current status of any litigation, the merit of the underlying claims, an estimated amount of any potential or outstanding liability, and whether the matters are covered by the portfolio company’s existing insurance plans. Likewise, buyers will be interested in ongoing disputes (particularly with key customers or suppliers) that may result in legal proceedings. In certain cases where the post-closing liabilities are either particularly significant or uncertain, a buyer may request a special indemnity. Having a handle on the details of the underlying matters will be helpful in defending against—or at least effectively negotiating—any such requests.

8. Third Party Consents. In addition to identifying material contracts as part of the diligence process as outlined in Item 5 above, sellers will need to review those contracts to determine whether the transaction would trigger any notice or consent requirements. If any third party consents are required, sellers will be expected to have a view on the likelihood of receiving those consents, the potential cost of obtaining consent, and alternatives if consent cannot be obtained.

9. Governmental / Regulatory Approvals. Regulatory approvals and other regulatory filing and notice requirements often drive the timing of the deal’s consummation, so it is essential to determine what regimes and requirements may apply to the proposed transaction, as well as what information is needed to finalize that determination and is to be provided in connection with any applicable approvals or filings. The existence or extent of certain requirements will hinge on the particular buyer, but there is a lot the selling sponsor and portfolio company can do to make meaningful headway even before a buyer is identified.

• Regulated Industries. If the portfolio company operates in a regulated industry, parties will need to determine whether the transaction will require notice and/or consent from the applicable regulator. Having a head start on this analysis will increase a seller’s credibility with those regulators and allow both buyer and seller to have better-informed expectations regarding potential roadblocks, and the anticipated timeframe, for completing the proposed sale.
• Antitrust. Transactions exceeding a certain deal value ($111.4 million for 2023) are generally reportable under the Hart-Scott-Rodino (HSR) Act unless an exemption applies (e.g., due to the structure of the buyer or limited U.S. nexus of the portfolio company). Whether antitrust filings will be required in any non-U.S. jurisdictions will ultimately depend on the identity of the buyer, but sellers should work with antitrust counsel in advance to ensure that the portfolio company’s revenue and other required data is segmented as appropriate to allow potential buyers to determine if antitrust filings are required in any non-U.S. jurisdictions. Sellers should also work with antitrust counsel to determine whether there is potential antitrust risk with any of the likely bidders due to competitive overlap with the seller.
• CFIUS/Foreign Direct Investment Filings. If the potential buyer could be a foreign company (or a U.S. company controlled by a foreign person), then the sponsor will want to conduct advance diligence to determine whether the transaction would be within the jurisdiction of the Committee on Foreign Investment in the United States (CFIUS). If the buyer might be foreign, then the seller will want to determine whether the transaction might be subject to a mandatory CFIUS filing, which may be the case if the business deals in “critical technology” or if the buyer is foreign government controlled. Even if a CFIUS filing is not mandatory, however, if the business is one that would be categorized under CFIUS regulations as a “T[echnology]I[nfrastructure]D[data] U.S. business,” or if the acquisition might otherwise plausibly implicate national security concerns, a foreign buyer may wish to make a voluntary CFIUS filing and then have CFIUS approval be a closing condition. The seller should remember that the CFIUS process can be time consuming and could delay closing unless there are other, longer post-signing regulatory processes that need to be completed. Apart from CFIUS, if the business has operations outside of the United States, the seller and buyer will need to determine whether foreign direct investment filings are required in any non-U.S. jurisdictions.

10. Outside Advisers / Other Third Parties. Investment banks and legal counsel are often the first advisors that a sponsor hires in connection with a portfolio company sale, but getting ahead on identifying other potential advisors and third parties that may require engagement will help to ensure a smoother process.

• Local Counsel. If the portfolio company has operations outside the United States, it is likely that the sponsor will need to engage local counsel in those jurisdictions. Non-U.S. jurisdictions often have more onerous notice and consent requirements for sale transactions and the seller should have a firm grasp on those requirements—and how they may impact timing of the transaction—before buyers begin diligence in earnest. For example, companies in certain jurisdictions have government-mandated works councils dedicated to protecting employee rights; requirements relating to and negotiations with a works council can be time consuming and directly affect the transaction structure and definitive agreements.
• Accountants/Tax Advisors. Bringing on board accountants and tax advisers early will enable sellers to identify any potential financial and/or structural issues that may need to be addressed as part of the transaction, as well as any vendor-side due diligence issues that may need to be disclosed during the buyer’s due diligence.
• Consent Parties. Once a seller has identified any required third-party consents (see Item 8 above), it should consider the appropriate time for notifying those parties of the transactions. Given confidentiality concerns, sellers typically try to limit the number of third parties that are made aware of a transaction before signing, but depending on the materiality of the consent required, it may be advisable to gauge the counterparty’s likelihood of cooperation earlier on in the process.

The Private Equity Report Fall 2023, Vol 23, No 3