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What’s Inside

Catching the Secondary Wave:Opportunities and Risks

Secondaries generally fall within two categories of deals. In the first category, the seller transfers a limited partnershipinterest in an existing partnership thatcontinues its existence undisturbed by thetransfer. In the second category, the sellertransfers a portfolio of private equityinvestments in operating companies. Thebuyer of such operating companies is oftenan entity managed by the former managersof the seller’s private equity portfolio. Thisarticle will focus principally on the practicaland legal issues associated with the firstcategory, although we will briefly discusssome issues raised by the second category.

Buyers of secondary interests includeincreasingly large pooled investment fundsas well as institutional investors. Secondarybuyers of partnership interests are oftenable to purchase partnerships with substan-tially invested portfolios which allow thebuyer to evaluate the actual underlying port-folio (as opposed to primary investmentswhere the buyer is purchasing a “blindpool”). In addition, expenses and earlylosses may cause a seller’s aggregate capitalaccount to be lower than its aggregatecapital contributions, allowing a buyer pur-chasing at a price equal to seller’s capitalaccount to purchase effectively at a dis-count. Not surprisingly, opportunities likethese usually come with some risk.

The PlayersIn addition to the seller and buyer, thegeneral partner is a crucial participant in secondary transactions. In nearly all cases, the consent of the general partner is required in order to transfer a partner-ship interest.

The seller may seek to clear prospectivebuyers or classes of prospective buyerswith the general partner to save valuabletime. Sometimes a general partner willactually supply a seller with names ofpotential buyers that are acceptable to it.Particularly in the case of a defaultinglimited partner, the general partner willactively participate in the sale process.Involving the general partner at the verybeginning of the process will greatly facil-itate legal and business due diligence, as well as the actual transfer of the part-nership interest.

Understanding the Existing DocumentsOneof the first steps inanalyzinga secondary purchase of anexisting partnership is to iden-tify the relevant documentsgoverning the GP/LP relation-ship, including the originalprivate placement memoran-dum (and any supplements),

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Volume 4 Number 2 Winter 2004

P r i v a t e E q u i t y Re p o r t

“I bought my L.P. interests on eBay – why, did you guys pay retail?”

The size of the secondary market for private equity funds has exploded in recent years. Banksand other financial institutions are actively selling their private equity portfolios in an attempt toreduce the volatility of their earnings and rebalance their portfolios. Individuals and corporationsexperiencing financial difficulties are also active sellers of limited partnership interests often, inthe case of defaulting limited partners, with the help or at the insistence of the general partner.

continued on page 16

3 Managing General PartnerLitigation Risk

4 The Pitfalls of Using anEnglish-Language, U.S.-StyleAcquisition Agreement inTransactions Governed byFrench Law

6 Guest Column: The New Opportunity for Private Equity

8 M&A in Wonderland: What You Don’t Know About Bankruptcy M&A Will Surprise You

10 Alert:German Fund Legislation

11 Alert:It Was All a Bad Dream –Private Investment Funds NoLonger Subject to Tax ShelterReporting Requirements

12 Exiting With IDSs: A New Way Out

14 Alert:New Safe Harbor Provisionson Italian Leveraged Buy-Outs

15 SEC Sends Message to Private Fund Advisers: Adopt Compliance Policies and Procedures Now!

24 Alert:NASD Relaxes Ban on Use of Related Performance Information

letter from the editor

Private Equity Partner/ Counsel Practice Group Members

The Debevoise & Plimpton Private Equity Report l Winter 2004 l page 2

Franci J. Blassberg Editor-in-Chief

Ann Heilman Murphy Managing Editor

William D. Regner Cartoon Editor

Please address inquiries regardingtopics covered in this publication to the authors or the members of the Practice Group.

All contents ©2004 Debevoise&Plimpton LLP. All rights reserved.

The articles appearing in thispublication provide summaryinformation only and are notintended as legal advice.Readers should seek specificlegal advice before taking anyaction with respect to thematters discussed herein.

The Private Equity Practice GroupAll lawyers based in New York, except where noted.

Private Equity FundsMarwan Al-Turki – LondonAnn G. Baker – Paris

Kenneth J. Berman–Washington, D.C.Jennifer J. BurleighWoodrow W. Campbell, Jr.Sherri G. CaplanMichael P. HarrellGeoffrey Kittredge – LondonMarcia L. MacHarg – FrankfurtAndrew M. Ostrognai – Hong KongDavid J. SchwartzRebecca F. Silberstein

Mergers and Acquisitions/ Venture CapitalAndrew L. BabHans Bertram-Nothnagel – FrankfurtE. Raman Bet-Mansour

Paul S. BirdFranci J. BlassbergColin W. Bogie – LondonRichard D. BohmGeoffrey P. Burgess – LondonMargaret A. DavenportMichael J. GillespieGregory V. GoodingStephen R. HertzDavid F. Hickok – FrankfurtJames A. Kiernan, III – LondonAntoine F. Kirry – ParisMarc A. KushnerLi Li – ShanghaiRobert F. QuaintanceKevin M. Schmidt

The Debevoise & Plimpton Private Equity Report is a publication ofDebevoise & Plimpton LLP919 Third AvenueNew York, New York 10022(212) 909-6000

www.debevoise.com

Washington, D.C.LondonParisFrankfurtMoscowHong KongShanghai

The past year turned into an exciting time for the

private equity community, and 2004 is off to a busy

start. Financing for new deals is readily available,

exits are increasingly viable in a variety of forms and

new markets for fund interests have emerged for

those who have overcommitted to the asset class.

For private equity firms, this new environment can

be challenging, but it certainly looks and feels better

than it has in awhile. In this issue, we provide some

guidance on the opportunities and risks of the cur-

rent landscape.

First, on our cover, we discuss the exploding

market for secondary interests in private equity

funds and outline the unexpected pitfalls for buyers

used to open negotiations and full due diligence.

In an effort to focus on new exit opportunities, Jeff

Rosen, Andrew Bab and Peter Furci introduce you

to the income deposit security, a new capital market

product that we have helped develop over the past

year and which is poised to provide an attractive

new exit strategy for private equity sponsors. In our

Guest Column, Alan Jones, Managing Director and

Co-Head of Global Financial Sponsors of Morgan

Stanley, argues that while the improving equity mar-

kets may increase the competition for deals from

strategic buyers, private equity firms need not be too

worried: the combination of plentiful debt financing,

robust equity capital reserves and the unique and

adaptive strategies that private equity firms bring to

deal structure and post-acquisition operations will

ensure that private equity firms are active buyers.

From the European perspective, Antoine Kirry

warns investors in France to be wary of blithely

adopting U.S.-style, English-language acquisition

agreements for use in French deals without first

clarifying which U.S. terms of art may be construed

differently by French negotiators and by French courts.

We also report on recent legislation in Germany

and Italy that should make doing deals in those two

countries easier for private equity firms.

Elsewhere in this issue, Sarah Fitts outlines some

of the unusual and procedural differences that buyers

contemplating acquiring a troubled company in a

bankruptcy sale may face. And Rebecca Silberstein

and Tim Bass describe how general partners can

minimize the potential litigation risk from disgrun-

tled limited partners.

We look forward to any comments you might have

on our publication or questions you might have about

our global private equity practice.

Franci J. BlassbergEditor-in-Chief

One effect of the recent economic down-turn: many private equity funds havesuffered significant losses, includingfunds that were top performers just afew years ago. Some investors havelooked to litigation to recoup some oftheir capital losses, particularly wherethey believe the losses are attributable toa breach of duty by the general partner.For example, in February 2002, a lawsuitwas filed by the attorney general of theState of Connecticut against ForstmannLittle & Company following a write-downof investments in XO CommunicationsInc., although that case has not yetresulted in a decision on the merits ofConnecticut’s claims. Although lawsuitsby limited partners against general part-ners of private equity funds are still notcommonplace, even funds that are well-managed and have honest generalpartners can lose money; thus, generalpartners have become increasinglyfocused on ways to avoid the reputa-tional and financial damage of litigationby investors.

Litigation exposure will depend tosome extent on the type of entitiesinvolved and the terms of the organiza-tional documents. General partners ofprivate equity funds and their principalsmay act both on behalf of the funditself, ordinarily a Delaware limited part-

nership, and also as directors of publicor private portfolio companies. The firstpart of this article examines some of therisks and relevant standards of conductthat apply to general partners and theirdesignees. In the second part of thearticle, we suggest some guidelines tohelp reduce these risks.

The Relevant Duties: A ReminderPrivate equity funds customarily organizeas limited partnerships (although thisdiscussion generally applies to limitedliability companies as well). The DelawareRevised Uniform Limited PartnershipAct provides that a partnership agree-ment may expand or restrict the generalpartner’s fiduciary duties. If the partner-ship agreement does not establish anexplicit standard, the fiduciary dutiesrelevant to directors of corporationsapply to general partners by default –namely, the duty of loyalty (the director’sactions are solely motivated by the bestinterests of the corporation and itsstockholders) and the duty of care (thedirector exercises the degree of careand prudence that would be expected ifthe director managed his or her ownaffairs). Generally, if directors of a Dela-ware corporation observe their dutiesof loyalty and care to the entity and itsstockholders, they will be entitled to rely

on the business judgmentpresumption, which isintended to preventliability for losses causedby business decisionsthat turn out to be wrong,so long as they weremade on an informedbasis and in the honestbelief that they were inthe best interests of thecorporation and its stock-holders. However, if a

director (or its affiliate) is on both sidesof a transaction, the entire fairnessstandard may apply, requiring both afair price and a fair process, which may include a determination made by “independent” directors.

Under the default duties applicable togeneral partners (absent modification inthe partnership agreement), the generalpartner’s decisions should be shieldedby the business judgment presumptionif it complies with the duties of loyaltyand care. However, in a transaction wherethe general partner has a personal finan-cial interest in the result, the enhancedduty of entire fairness may apply. The dis-tinction between directors and generalpartners is that general partners cannotbe truly “independent.” Although theeconomic interests of a general partnerthat invests its own capital in its privateequity fund are in part aligned with theinterests of the fund’s limited partners,there are inherent conflicts of interestbetween a general partner and itslimited partners that cannot be entirelyeliminated given the economic andbusiness deal common to private equityfunds – among other things, the generalpartner’s carried interest and the otheractivities of the general partner or itsaffiliates. Fortunately, unlike a corpora-tion, as stated above, a partnership canmodify the default fiduciary duties byclearly providing for it in the partnershipagreement – this freedom of contractprinciple is critical to allow a fund toprovide a reasonable approach to deal-ing with conflicts that may arise. Forexample, partnership agreements forprivate equity funds often have provisionsallowing for allocation of investmentopportunities that might be appropriatefor the fund or other entities or affiliates,or setting out specific guidelines to be

Managing General Partner Litigation Risk

Thomas Schürrle – FrankfurtAndrew L. Sommer – LondonJames C. Swank – ParisJohn M. Vasily Philipp von Holst – Frankfurt

Acquisition/HighYield FinancingWilliam B. BeekmanCraig A. Bowman –LondonDavid A. BrittenhamPaul D. Brusiloff Peter Hockless – LondonA. David Reynolds

TaxAndrew N. BergRobert J. Cubitto

Gary M. FriedmanPeter A. FurciFriedrich Hey – FrankfurtAdele M. KarigDavid H. SchnabelPeter F. G. Schuur–LondonElizabeth Pagel Serebransky

Employee Compensation & BenefitsLawrence K. CagneyDavid P. Mason

Estate & Trust \PlanningJonathan J. Rikoon



The growing use of English-language, U.S.-style acquisition agreements in transactions governed by French law poses new challengesto French M&A practitioners, and requires that they be extremely careful in using words and clauses that were initially intended tooperate under a different legal system.


If one looks back at the evolution of theM&A practice in France (and indeed inmost of Europe) over the past 15 years,one of the salient features is the muchbroader acceptance of English-languagelegal documentation, certainly for cross-border transactions on the Continentand even for purely domestic transac-tions. There are several reasons for this.First, a number of major French indus-trial and financial groups, especiallythose with a sizeable presence outsideFrance, have adopted English as theirworking language. Second, interest byinternational investors in transactionsinvolving French companies has con-tinued to grow steadily, making Franceone of the principal countries in theworld for international investment. Third,most CEOs, general counsel and CFOsof large French companies, as well astheir legal and financial advisors, havebecome familiar with U.S.-style dealmanagement methods and draftingtechniques, and tend to use them evenfor purely domestic transactions.

As a result, more and more agree-ments are being negotiated andexecuted in English, and include inmany instances legal, financial andaccounting words and clauses that arederived from the U.S. practice. Thiscarries with it the risk that there mightbe a disconnect between the words andclauses used and the rules of Frenchlaw, if not the actual intention of theparties to the agreements. The poten-tial for difficulty is made even greaterby some of the French Civil Code ruleson the construction of contracts, partic-ularly the rule under which the parties

to an agreement are not supposed toinclude in their agreement words andclauses which are not intended to pro-duce some legal effect. There would beno room, therefore, for disregardingcertain words and clauses as irrelevantin a French law agreement just becausethey would be the “usual U.S. legalverbiage.” Several examples illustratewhat the resulting difficulties might be.

Terminology IssuesIt is not uncommon in U.S.-style legaldocuments to see series of words ofclose if not identical meaning. Many ofthese “word chains” owe their originsto the course of U.S. corporate litiga-tion and case law, the explanation ofwhich is beyond the scope of this article.Take, for example, the classic transferwording contained in a U.S.-style acqui-sition agreement, in which the sellerwill usually “sell, transfer, convey, assignand deliver” the shares or assets to thebuyer. Finding a distinct meaning foreach of these words under French lawis a tricky exercise, yet one that must befaced if one has adopted without cautionthe standard U.S.-style wording. UnderFrench law, one would be tempted tothink that things are somewhat simpler:the seller sells. Selling, by law, impliesseveral obligations, one of which is to deliver the item sold; another is toprovide certain warranties with respectto this item. There is no point, there-fore, restating in a contract what theseller undertakes to do when this is allprovided for by law, except where theparties want to expand or narrow thescope of the seller’s obligations. Usingthe “sell, transfer, convey, assign and

deliver” wording in a French law agree-ment may lead to uncertainties becauseeach of these words may not have adefinite meaning under French law.

Similar comments can be madeabout series of words such as “agree-ments, commitments, arrangementsor understandings” or “mortgage,pledge, deed of trust, hypothecation,security interest, encumbrance, liens.”In each case, there is certainly a validreason why these words are used in aU.S. agreement: each of them musthave a distinct meaning, and the prac-tice of expressing them in series isintended to cover all meanings. UnderFrench law, this is usually unnecessarybecause there is a generic word with a meaning that, by statute or pursuant to case law, covers all the variousaspects that the U.S.-style series isintended to capture.

Other terminology issues can befound in the use of words and expres-sions that cover U.S. legal, financial oraccounting concepts that may or maynot have counterparts on the Frenchside (and, if they do, these counterpartsmay or may not convey exactly the samemeaning as in the U.S.)

An obvious example is the notion of“authorized capital stock,” which seemsso basic to most U.S. lawyers that theyfind it difficult to believe that a similarconcept does not exist under Frenchlaw. Indeed, it does not, so that a repre-sentation made about the “authorizedcapital stock” of a French corporation(or many corporations of other Euro-pean countries) would not make muchsense. However, just like in the U.S., it

The Pitfalls of Using an English-Language, U.S.-Style AcquisitionAgreement in Transactions Governed by French Law


is important in a French law transac-tion to obtain assurances as to theactual and potential capital of a targetcompany. These assurances are usuallyobtained on the basis of French lawconcepts of corporation law, so thatbeyond the terminology issue, thisissue is substantively covered to thesame extent as it would be in a U.S.transaction. There are scores of otherexamples of this nature, posing asmany traps to the inadvertent user ofU.S.-style agreements: references to“share certificates” for instance, since,for a French corporation, shares onlyexist in book entries, or references tothe “delivery” of an agreement, whichis a concept that is wholly alien toFrench law.

Elements of Deal StructureBeyond terminological issues, there area number of clauses or techniques thatare commonly used in U.S.-style acquisi-tion agreements that do not work well inthe context of a French law transaction.

A striking example is the referenceto “GAAP.” The issue in France hasbeen largely due to a common beliefamong French practitioners that FrenchGAAP was a comprehensive body ofaccounting rules that could be refer-enced to resolve accounting disputes,particularly in the context of priceadjustment mechanisms using param-eters based on financial statements.While there is some danger in pro-ceeding on the basis of a similar beliefin the context of a U.S.-style agreement,doing so in the context of a French lawagreement is even more risky because,in most cases “French GAAP” offerslittle guidance to resolve “real-life” issuesthat may arise in the context of thesedisputes. Therefore, in a French lawtransaction, providing in a clause thatany accounting issue that may arise inconnection with such clause should beresolved “in accordance with GAAP”

does not help. “GAAP consistentlyapplied” or another formula that wouldmean “consistent with past practiceexcept when such practice is inconsis-tent with GAAP” is much better, butthis wording leaves open the questionof what the accountants should do ifone or more of the past practices arefound inconsistent with GAAP, withoutaffecting the entire transaction orgiving rise to a claim for indemnifica-tion under the representations andwarranties covering financial state-ments. In practice, one comes to theconclusion that the reference to GAAPis not really helpful in this context, andthat parties would be well advised toagree on a set of detailed accountingrules addressing the key accountingissues that may arise in light of theparticular business involved (e.g., in a distribution business: how to charac-terize and reserve for slow-movingitems? When and to what extent toreserve for customer receivables?).Most accounting firms seem to favorthis approach, which facilitates theirwork and avoids endless discussionsabout what options should be takenwhen existing accounting practiceshave to be modified.

Another example in a similar vein is the potential impact of the manage-ment restrictions that buyers typicallyimpose on sellers for the periodbetween the signing of an acquisitionagreement and the completion of thetransaction. These restrictions often gointo the detail of day-to-day manage-ment and include approval rights forhiring employees, making investmentsor expenditures in excess of specifiedamounts, etc. One easily understandsthe rationale for those restrictions: thebuyer legitimately wants to avoid thatactions taken in this interim periodadversely affect the value or prospectsof the proposed investment.Yet, becauseof specific rules of French bankruptcy

law, overly tight restrictions may have apotential for backfiring in the event thatthe transaction is not completed andthe target company files for bankruptcyat a later stage. In the context of bank-ruptcy proceedings, if there is anyshortfall of assets vis-à-vis liabilities,the persons who have acted as man-agers of the bankrupt company may be ordered to pay for all or part of thisshortfall. This applies also to de factomanagers, i.e., the persons or entitieswho have been involved in the manage-ment of the target company withouthaving legal authority to do so. Negoti-ators for buyers should be very careful,therefore, not to satisfy themselveswith having obtained from sellers verytight management restrictions of thetype one sometimes sees in U.S.-styleacquisition agreements for the periodbetween signing and closing. While theexistence of these contractual clausesalone may not be conclusive, they maybe regarded as indications that theprospective buyers had the right to par-ticipate in the management of the targetcompanies following the execution ofthe acquisition agreements. Wheneverthese indications are confirmed byactual involvement in the management


It is not uncommon in U.S.-

style legal documents to see

series of words of close if not

identical meaning... Finding a

distinct meaning for each of

these words under French law

is a tricky exercise, yet one

that must be faced if one has

adopted without caution the

standard U.S.-style wording.


The New Opportunity for Private Equityguest column

In 2003, the rebounding capital marketshelped to provide a real boost to thefinancial sponsors in the private equityworld. The high-yield market, arguablyas robust as it has ever been, fueledsponsor activity in a number of impor-tant ways. With yields for new LBObonds plummeting into the 8% – andeven 7% – range, and with senior loanspricing off near-historic low LIBORrates, “other people’s money” hasnever been cheaper for private equityfirms. As a result, sponsors have beenable to push debt-to-EBITDA levels torecord highs. Businesses that as recentlyas a year ago might have struggled to achieve debt levels of 5x EBITDA, forexample, can finance today at levelsnorth of 6x EBITDA.

Just as savvy consumers have takenadvantage of low mortgage rates to refi-nance their homes, private equity firmssimilarly have availed themselves of themore-than-accommodating high-yieldmarket to refinance and to extend thematurities of their portfolio companies’debt. Pushing the exercise to its logicalextreme, sponsors also have taken goodadvantage of the robust debt markets torecapitalize many of their portfolio com-panies and pay themselves handsomedividends that have often returned all of the firm’s original investment, and insome cases many multiples on thatoriginal investment.

Perhaps most important, however,the robust debt markets have onceagain made private equity firms fiercecompetitors in the market for corporatecontrol. While the inflated asset values of the technology and communicationsbubble years kept many financial spon-sors from their traditional pursuit ofbuying companies outright, today’senormously robust high-yield market

has enabled private equity firms to buybusinesses at multiples of EBIDTA that once were available only to strategicacquirers with significant synergies.Additionally, private equity firms’ increas-ing willingness to partner with each otherin “club deals” has permitted sponsorsto set their sights on much larger targets.Simply put, LBO firms can pay big pricesfor big companies.

Many students of private equity warn,however, that this golden era of compet-itive advantage for sponsors is about to end. While the argument takes manydifferent forms, a common themeemerges. Strategic buyers, they contend,have been sidelined of late by a combi-nation of an uncertain economic outlook,which has made valuing acquisitiontargets tricky, and by their own depressedstock prices, which have dampened the confidence of would-be corporateacquirers and reduced the attractivenessof their own stock as an acquisitioncurrency.

More recently, however, with goodnews of economic growth that borderson stunning, sharply improving corporate profits and concomitantimprovement in many potentialacquirers’ stock prices, strategic buyersfind themselves twice blessed. Thesedual forces have given corporate chieftains both the weapon of a morevaluable acquisition currency and the courage of their convictions withrespect to bold strategic moves.

Not only will strategic acquirers be tougher competitors for financialbuyers, the argument continues, but the improved public equity market itselfwill again “compete” against financialbuyers. That is, even as financial buyershave benefited from their own ability tosell the equity of their portfolio companies

into an improving equity market, thepublic market also serves, in effect asanother competitive buyer for non-corebusinesses or other assets that corpo-rates seek to monetize. A healthy equitymarket is a double-edged sword forprivate equity firms, who are, of course,both buyers and sellers of businesses.

While all of this is, of course, true, noone should assume that the improvedcompetitive position and emboldenedanimal spirits of strategic acquirers willbe sufficient to enable corporates tobeat financial buyers at the acquisitiongame they have been playing so success-fully of late. Why not?

First, the Federal Reserve has indicatedthat it will endeavor to keep interest rateslow for some time. Since private equityfirms typically borrow two-thirds tothree-quarters of the value of the com-panies they acquire, continued lowborrowing costs provide them with anobvious boon. So, absent an unexpectedcredit crunch or some broader disloca-tion in the leveraged finance markets,debt financing for LBOs should continueto be cheap and abundant.

Second, there is no risk that privateequity firms will run out of equity capitalany time soon. With more than $100billion of committed but uninvestedprivate equity waiting to be put to workworldwide, there is, in fact, too muchmoney chasing too few deals. (More onthat below.)

Third, and most important, financialbuyers have always been quick to adaptto changes in the environment, and thecurrent environment offers no exception.Faced with looming competition bothfrom strategic acquirers and the publicequity market, and with a supply/demand imbalance that has loweredachievable returns, private equity firms

have pursued at least four successfulstrategies to buy assets in ways that willenable them to compete effectivelyagainst strategic acquirers and still gen-erate attractive returns.

Three of these strategies principallyaim to avoid the intense competitionfostered by auctions, where the problemof too much money chasing too fewdeals may cause potential acquirers toview any victory as a Pyrrhic one. The“auction-avoidance” strategies includeinvesting in distressed debt securitiesto gain control of businesses, partneringwith corporate sellers in joint-ventureLBOs or similar structures that permitsellers to retain a portion of the upsideof divested assets and taking a contrar-ian approach by buying assets that areeither out of favor with most investorsor that bring with them sufficient com-plexity or “hair” to scare most would-beacquirers away and thus render anauction untenable.

The fourth strategy assumes thathotly contested auctions are a fact oflife, and instead attempts to enable abuyer to pay a full price, but to improvethe operations of the acquired businessin a way that will make it appear cheapex post. In deploying this fourth strategy,private equity firms typically utilizeoperating partners, experienced man-agers – often former CEOs – who canbe either permanent members of thefirm or ad hoc partners who work onselect projects to identify cash flowimprovement opportunities that purefinancial bidders may miss.

Each of these strategies has its merits:

1. Distressed debt investing. While anumber of successful private equityfirms have used investing in thedistressed debt market as a way toacquire assets for years, many otherfirms who historically have not availedthemselves of this opportunity have

recently begun to see it as a chance toacquire assets cheaply and potentiallyas a way to avoid auctions. Additionally,firms pursuing this stratagem reasonthat even if an auction does ensue oranother firm succeeds in acquiring thebusiness in question, the result of thatacquisition simply will be a higher pricefor the bonds the firm bought at dis-tressed levels – not a bad outcome. Not for the faint of heart, playing the dis-tressed debt market differs markedlyfrom traditional private equity investingand requires specialized skills includinga clear understanding of both bank-ruptcy law and out-of-court restructuringdynamics. Perhaps more important, private equity firms accustomed to thein-depth due diligence opportunitiesafforded them in highly structuredauctions may find the notion of making a big investment based solely on publicinformation daunting, if not an anathema.

2. Corporate partnering. The nightmarethat haunts the typical private equityinvestor is discovering after the fact thathe has overpaid for an acquisition. Thenightmare for a CEO selling a majorcorporation’s asset on the other hand,is discovering ex post that he has soldtoo cheaply. In its most painful form,this latter nightmare manifests itself in a private equity firm quickly “flipping” a recently acquired asset at an enor-mous profit to the obvious chagrin ofthe prior owner. In the hopes of strikingdeals designed to avoid these night-mares, a number of private equity firmshave persuaded corporates to retain an ownership stake in a divested asset.In some instances, tax or accountingconsiderations determine the percentageretained. In others, it will be a matter of simple negotiation, and structuresrange from fairly simple joint venturesto reasonably complex exchanges ofoptions to buy or sell ownership at future

times, often based on triggering events.Corporate sellers benefit in these dealsfrom avoiding embarrassing future “flips”(i.e., having sold at too cheap a price);financial buyers benefit from maintainingaccess to corporate expertise inherent in a long-time owner’s experience and,in many cases, by avoiding a full-blownauction. (The complexity and time-con-suming nature of structuring a JV or a corporate partnership often means aseller will choose a single financial buyerwith whom to work.)

3. Contrarian investing. “The time to buyis when the blood is in the street,” asRothschild once wisely advised. By defi-nition, contrarian investors invest whenconventional wisdom suggests that oneought not to. Through careful, in-depthstudy of an industry or company, con-trarian investors find worthy assets withvalues that may be obscured temporarilyby industry fundamentals the investorsperceive will change or by contingent



While the inflated asset values

of the technology and commu-

nications bubble years kept

many financial sponsors from

their traditional pursuit of

buying companies outright,

today’s enormously robust

high-yield market has enabled

private equity firms to buy

businesses at multiples of

EBITDA that once were avail-

able only to strategic acquirers

with significant synergies.

During the recent economic rough patch, many M&A professionals of all stripes found themselves engaging in a new type of M&Atransaction: a sale or purchase of assets of a troubled company pursuant to Section 363 of the bankruptcy code. Private equity firmsare likely to find some interesting targets among these offerings. At first blush, these transactions look and feel a lot like a regularM&A transaction, and many jumped in with both feet, only to be surprised by some of the unusual legal and anthropological differ-ences in completing a transaction under these circumstances.


Troubled Co.Let’s set the stage with a fairly commonsituation. Assume there is a medium-sized U.S.-based company with publicshareholders called Troubled Co., andthat its business would be profitablebut for its heavy debt service burden.Let’s also assume that the debt is inthe form of private notes held by agroup of conservative insurance com-panies. The notes are secured bysubstantially all the assets of TroubledCo., but even still, the best estimatesare that the value of the secured assetsis less than the unpaid principal andinterest on the notes. Troubled Co. had a small working capital line of credit,secured parri passu with the notes, butit has been tapped out and is not avail-able. In terms of scale, the amount ofthe line of credit is dwarfed by the out-standing notes, so it is the noteholderswho are calling the shots with the banksoccasionally asserting themselves on afew issues. Lets also assume that priormanagement may have made some badbusiness judgments and that TroubledCo. may have had some bad luck, butthere isn’t evidence that managementincludes any crooks either, so there areno criminal investigations or significantlitigation.

Now, let’s assume that Troubled Co.recently informed the secured creditorsthat it will not make its scheduled inter-est payments under the notes or line ofcredit. The noteholders contacted each

other in a fluster, appointed two orthree of the larger holders to an ad hocsteering committee, and selected afinancial advisor and a law firm to reviewoptions. On reflection, the securedlenders conclude that the business isreasonably sound, that they are mostlikely to recoup most of their initial loan,and perhaps some interest, if TroubledCo. were sold through a bankruptcysale. Troubled Co., the noteholders andthe bank entered into a forbearanceagreement where, among other things,the noteholders agreed to waive theirrights to accelerate the payments underthe notes for a few months and TroubledCo. agreed to various affirmative andnegative covenants relating to its oper-ation of the business and to commencea process for selling the company.

Section 363 in a NutshellHere is where you come in. You receivea short offering circular from TroubledCo. informing you that Troubled Co.will be sold and asking you to make anoffer. The offering circular includes adraft agreement which provides thatpromptly after signing the agreement,Troubled Co. will voluntarily file forbankruptcy. This does not seem veryauspicious, but your legal advisor givesyou the following thumbnail explana-tion of procedures under Section 363 ofthe Bankruptcy Code:

• Troubled Co. and purchaser enter intoan asset purchase agreement pursuantto which the purchaser agrees to buyall or a portion of the assets of Troubled

Co. as part of a bankruptcy sale.Troubled Co. then files for bankruptcyvoluntarily under Chapter 11 of theU.S. Bankruptcy Code.

• The bankruptcy court is asked toapprove various procedural mattersrelating to the sale, including ordersrelating to Troubled Co.’s ability touse cash that is pledged to the note-holders between signing and closing,and the rights of the purchaser toreceive certain payments (describedbelow) in connection with certaincontingencies described in the assetpurchase agreement.

• The court will require a “fair auction,”a part of which includes an invitationto third parties to make higher orbetter offers.

• The court approves the sale of theassets to the winning bidder. Estimatedtime from start to finish: 60 to 90 days.

Why Bankruptcy M&A is Different: The Anthropological PerspectiveBankruptcy M&A is different fromother M&A deals for obvious reasons.The target admits to being a troubledcompany, which is sometimes but notusually the case. There are also severalprocedural and substantive issueswhich make negotiating these deals a challenge, even for the seasonedprivate equity professionals.

The bankruptcy world is small. You willdiscover that in the bankruptcy world,the top professionals who work as

M&A in Wonderland: What You Don’t Know About Bankruptcy M&A Will Surprise You


financial advisors, lawyers and workoutconsultants always seem to know eachother from other transactions. Reputa-tions matter. It’s like a club, and as thenew arrival you will discover that theytalk to each other in code. This can bean enormous aid in getting a deal donebecause advisors may not need toestablish their credibility or trust withthe others, and can get to the meatquickly. It is also daunting to the new-comer, and you may well feel like anoutsider who speaks a foreign language.

Ambiguous lines of control. In the factpattern that we outlined above, whichis not unusual, the amount of the debtexceeds the value of Troubled Co.’sassets. This means that if every pennywere to be squeezed out of a sale, it isstill improbable that there would be asingle penny to distribute to the publicshareholders. This raises the obviousquestion – for whom is managementnow working? This is a deep question.The noteholders want it to be clear thatthey are not managing the company –that carries a risk of their being deemedinsiders and not being treated as seniorsecured creditors in the bankruptcy –but they are in fact the only party ininterest, or very nearly. The purchasermay try to bring the noteholders to thetable, but the noteholders may not beinterested. Think back to high schoolwhen you were making Saturday nightplans with friends, knowing that noneof them would work unless mom agreedand loaned you the car. That’s the note-holders’ role in this transaction. Thenoteholders are unlikely to know thenuts and bolts of the company, butthey will have very set views on issuesthat go to the bottom line of the deal.Negotiating with Troubled Co. is fineand appropriate, but if the noteholdersaren’t happy with the results, you willhave to try again.

Aren’t the noteholders in a hurry to get thisdone? Maybe not, unless the companyis truly deteriorating. True, most individ-uals would like to have this unpleasanttask behind them, but remember, inthis case Troubled Co. would be healthyif it didn’t have to pay interest on itsdebt and the secured creditors or for-bearing on enforcement, so it is actuallycash positive. And remember also thatthe secured creditor is king. There isalways a chance that if the noteholdersdo nothing at all, Troubled Co. will getits act together sufficiently and weatherthe crisis, or that in the meantime, abetter deal will come along. Any arrange-ment to which creditors agree mayactually reduce their rights to take action.The most sensible thing for noteholdersto do in this case may well be to sit ontheir hands until the deal Troubled Co.brings them is the one that they wantto do. Add to this the fact that the note-holders are often a group of companiesthat don’t normally do business witheach other (although many of the indi-viduals are likely to be acquaintedthrough prior, similar workouts), thatthis is one of several similar projectsfor them, and that often unanimous orsupermajority approval by the note-holders (voting based on percentagesof senior secured debt held) is requiredunder the relevant agreements, and itsimply is difficult for them to act quicklyto get necessary internal approvals andmake decisions.

Why would anyone voluntarily be thestalking horse? If you are the buyer underthe asset purchase agreement, youmay become a “stalking horse,” but itcan have its advantages. The stalkinghorse buyer gets to do due diligence inmore depth than the other bidders, andgets to have a bigger hand in shapingthe deal. If there is a real auction, thestalking horse may be in a better posi-tion to determine whether to raise the

initial offer or to walk away. In addition,and not unimportantly, the stalkinghorse buyer is also often entitled to asignificant payment for its trouble if itis not the winning bidder in the end,including reimbursement of expensesand a break-up fee if another partysuccessfully purchases the company.Courts often limit the break-up fee to3% of the purchase price, but in a largetransaction this still is a big number. In fact, prudent creditors and companymanagement will be concerned thatthe stalking horse bidder is looking at,say, a cool $10 million break-up fee aspreferable to actually winning theauction in the end, and will try to nego-tiate around that possibility as much as possible. Accordingly, the partieswill negotiate the timing of payment(termination of the purchase agree-ment versus consummation of the newsale), under what circumstances it ispaid (only if the stalking horse buyer isnot the high bidder versus terminationof the purchase agreement for anyreason), and how easy it is for sellers to terminate. This is different from thecase in a public deal where a break-upcontinued on page 19

The noteholders are unlikely

to know the nuts and bolts

of the company, but they

will have very set views on

issues that go to the bottom

line of the deal. Negotiating

with Troubled Co. is fine and

appropriate, but if the note-

holders aren’t happy with

the results, you will have to

try again.

German Fund Legislationalert


Over the course of last year, in a seriesof articles appearing in The PrivateEquity Report, we have followed theprogress of German legislation tomodernize the regulation and taxationof funds and discussed the climate forprivate equity investment in Germany.1

The legislation, known as the Invest-mentmodernisierungsgesetz, has nowbeen enacted. And, as of January 1,2004, new German Investment andInvestment Taxation Acts are in effect.

For our private equity clients, there are some helpful changes embodied inthe new laws. For example, investmentmanagement companies regulated inanother EU member state and complyingwith the UCITS regime can now providefund management services, includingdiscretionary investment advice, distribu-tion and depositary services, to clients inGermany. So non-EU based private equitysponsors with a subsidiary located, forexample, in London, can provide cross-border investment services in Germany.

OutsourcingGerman investment managers can retainnon-German advisers to provide discre-tionary advice to German funds andother clients. As a result, non-Europeanprivate equity managers, for example,can import their investment manage-ment services into Germany throughoutsourcing arrangements with a man-agement company licensed in Germanyor licensed in another EU country andhaving a German “passport.”

Distribution of Hedge Funds in GermanySingle hedge funds (both German andforeign) can now be sold to individual

investors as well as to institutions, but,in both instances, only through privateplacements. German (but not foreign)hedge funds of funds that meet certaindiversification and other requirementscan be sold to the public in Germany.

Investments Permitted for German Hedge FundsGerman single hedge funds can investup to 30% of their net assets in unlistedsecurities, including interests in non-EUprivate equity funds. German hedgefunds of funds can invest in non-EUtarget hedge funds. However, the capitalgains derived from a target fund willonly benefit from German preferentialpass-through tax treatment (for individ-uals, only 50% of dividends and capitalgains will be taxable and institutionalinvestors will be tax-exempt) if thetarget fund complies with reportingrequirements. It is currently unclear if the target fund has to publish therequired information or if it is sufficientthat it provides the information to thefund of funds in order to comply withthe reporting requirements. In anyevent, non-EU hedge fund managerscan be expected to be unwilling toconform with any strict German taxreporting requirements, which wouldcompel them to disclose, among otherthings, the degree of leverage, amountof short sales and other proprietarytrading strategies.

Taxation of FundsThe new Investment Taxation Act onlyhas two classifications of funds: trans-parent (white) and non-transparent(black) funds. The scheme that produced“gray” funds has been abolished. Whitefunds must comply with detailed taxreporting requirements to the Germanauthorities in order to qualify for the

preferential tax treatment mentionedabove. The extent to which underlyingtarget funds would be required to makereports to German authorities is atpresent unclear. Funds that fail to meetthe reporting requirements are non-transparent, or “black” funds, subjectto full taxation and a penalizing tax.

Status of Private Equity and Venture FundsAlthough earlier drafts of the legislationprovided some guidance, the legisla-tion as enacted failed to clarify whattypes of commingled vehicles are“funds” that must meet the Germantax reporting requirements in order toavoid penalizing taxation in Germany.As a result, the private equity industrywill continue to rely on a circular issuedby the BaFin (German SupervisoryAuthority) in 2001. According to the2001 circular, private equity and venturefunds that assume an active role withrespect to portfolio companies are notregarded as “funds” for purposes ofthe Investment Taxation Act. As a result,they are not subject to the penalizingtax regime, even if they do not complywith the reporting requirements.

The new laws are an important stepin the right direction for the Germaninvestment management industry. Butmany practical issues need to beresolved through the interpretative andimplementation processes. — Marcia L. [email protected]

— Patricia [email protected]

— Christian R. [email protected]

1 See “Alert: Germany to Modernize Fund Laws” in the Fall2003 Private Equity Report, “Alert: German Funds MadeEasier” in the Spring 2003 issue and “Minority Investmentsin German Companies” in the Winter 2003 issue.


Upcoming Speaking Engagements

March 4-5 Franci J. Blassberg, Program Co-ChairSpecial Problems When Acquiring Divisions and SubsidiariesNegotiating the Acquisition of the Private CompanyThe 19th Annual Advanced ALI-ABA Course on the Study of Corporate Mergers and AcquisitionsSan Francisco, CA

March 8 Paul D. BrusiloffGregory H. WoodsLender Liability Issues and Answers10th Anniversary Conference of the Community Development Venture Capital AllianceNew York, NY

April 21-22 Marwan Al-TurkiConvergence of PE Fund Terms in Europe and U.S.How to Negotiate Lower Fees, Carries and Other Favorable TermsPrivate Equity Analyst Limited Partners Summit EuropeZurich, Switzerland

It Was All a Bad Dream – Private Investment Funds No Longer Subject to Tax Shelter Reporting Requirements

alert

On December 29, 2003, the IRS drasti-cally modified the Treasury Regulationsrelating to “confidential transactions” thathad been causing great angst among pri-vate equity fund sponsors and investorsalike since their adoption in early 2003.

The old Regulations, part of an arrayof IRS and Treasury activity directedagainst abusive tax shelters, were writtenso broadly that they required limitedpartners in ordinary private equity fundsto report their investment in the fund to the IRS Office of Tax Shelter Analysis(and, possibly, subject the funds and theirlimited partners to IRS scrutiny), unlessthe fund’s confidentiality provisionspermitted its limited partners to disclosethe tax structure and tax treatment ofthe fund and its investments.

The old Regulations left fund spon-sors with an unpleasant choice: eitherthey could subject their investors to thereporting rules (which included record-

retention requirements as well), or theycould allow their investors to disclosethe “tax structure” and “tax treatment”of the fund. The problem was, “tax struc-ture” was defined so broadly that fundsponsors risked having the economicterms of their funds and portfolio invest-ments (and other provisions sponsorsrightly felt were and ought to remainproprietary or confidential) disclosedwithout penalty by limited partners.

The new Regulations generally excludeprivate investment funds (as well as mostM&A and other commercial transactions)from their ambit. Happily, taxpayers mayapply the new rules retroactively to Jan-uary 1, 2003, the effective date of theoriginal regulations. Accordingly, exceptin unusual cases:

• Fund sponsors. You can take those pesky“tax carve-outs” out of any pendingprivate placement memoranda, part-nership agreements and other docu-

mentation (and consider amendingexisting partnership agreements todelete the tax carve-out).

• Fund investors. You don’t have to file.

We wouldn’t be tax lawyers unless weended on a cautionary note: unfortu-nately, it is still possible that a privateinvestment fund (or a transaction under-taken by a fund) may be or becomesubject to IRS reporting requirementsunder another category of transactionscovered by the tax shelter rules, forexample, if the fund has certain types oflosses (such as foreign-currency lossesor losses on operating partnership invest-ments). But for most private investmentfunds, it was all just a bad dream. — Adele M. [email protected]

— David H. [email protected]


Exiting with IDSs: A New Way Out

Two issuers filed registration state-ments with the Securities and ExchangeCommission for offerings of incomedeposit securities in the first half oflast year, VSA and American SeafoodsCorporation, which is represented byDebevoise & Plimpton LLC and isawaiting audited 2003 numbers beforegoing to market. We have been inti-mately involved in the development ofthe product and are active participantsin the recent flurry of activity as bankersemerge with their own versions of theIDS product and seek promising poten-tial issuers for new deals.

Basic ConceptsAn IDS is a unit of common stock andsubordinated debt marketed as a yield-oriented hybrid security. The debtcomponent of the unit pays monthlyor quarterly interest and the issuerespouses a dividend policy underwhich monthly or quarterly dividendswill be paid on the common stocksuch that substantially all of the freecash flow is distributed to the IDSholders. At a time when three- andfive-year equity returns have been, toput it charitably, disappointing, andwhen yields in the 9-10% range arenot readily available, markets appearripe for such a security. Indeed, thevaluations apparently available appearto exceed conventional exit transac-tions by two or more EBITDA turns.

IDSs were initially developed byCIBC as a derivative of Canadianincome trusts (CITs) that own bothdebt and equity of a company. CITshave been extremely popular in

Canada (with over C$60 billion of CITsecurities outstanding) as both a retailand institutional monthly yield secu-rity. Although some U.S. companies(perhaps seven or eight) have issuedsecurities in the CIT market in Canada,CITs have not had nearly the samesuccess with U.S. issuers, and recentlya cloud has hovered over the U.S.company version, because severalaccounting firms have announced thatthey are reevaluating key tax issues.

IDSs have a number of features incommon with CITs – the units arelisted on an exchange and trade in unitform, they are priced on a composite-yield basis, covenants in the seniorindebtedness as well as the IDS debthave expansive restricted paymentprovisions that allow the cash flow ofthe issuer to be paid out in subordi-nated interest and dividends absentperformance problems and the consum-mation of an IDS offering likely shiftsmanagement’s and the company’sfocus from earning and growth tostable cash flow generation. However,there are important differences as wellthat result from U.S. tax and marketconsiderations – differences in capital-ization, unit structure, intercreditorarrangements, retained interest provi-sions and other matters.

In part because of its beguilingsimplicity, and in part because of theCIT legacy, the IDS product tendsalready to be the subject of somedegree of mythology and misconcep-tion. Understanding its potentialrequires a measured look at the currentfrenzy and an understanding some of the complexities.

The Fine Print

The Tax Play An obvious feature of an IDS offering is that interest deductions on the IDS debt are intended to reduce theissuer’s taxable income, but theseofferings are not tax gimmicks and donot and cannot eliminate corporateincome tax. The fact that the IDS debtand equity are held pro rata is a “nega-tive” factor in determining whether theIDS debt should be characterized asdebt rather than equity for tax purposes.This necessitates conservatism in devel-oping the company’s capital structureand care in designing debt and inter-creditor terms to make sure that theattorneys and accountants can reachthe desired level of comfort on thedebt-equity question (the VSA andAmerican Seafoods deals both have“should”-level tax opinions). In conse-quence, leverage and coverage ratiosare set at about historical levels for the issuer or the sector. The resultingimpact on taxable income depends inlarge measure on what other shelter –depreciation from recent basis step-ups,NOLs, breakage costs – is available;but it will be a rare IDS issuer that willnot have some tax “leakage.” The taxtreatment of the IDS debt is furthersupported by causing the units to bereadily separable and registering theseparate components under the secu-rities laws. Both the relatively conser-vative debt-to-equity and EBITDA ratiosand the ready separability are featuresabsent from the majority of CITs.

The success late last year of the initial public offering of Volume Services America Holdings, Inc. (VSA) using a new capital marketsproduct known as an Income Deposit Security (IDS) has caused a buzz in investment banks and private equity shops across thecountry – the former eager to demonstrate their prowess in structuring and marketing the new securities and the latter wondering if the indicative valuations are too good to be true.

The Intercreditor PuzzleThe infancy of the IDS product makesnegotiation of the senior debt portion ofthe capital structure a bit of a challenge.On the one hand, for the right credit,the senior portion should be prettyattractive because target senior leverageis only about two times cash flow. Butthe senior lender is not offered any prin-cipal amortization prior to maturity and,indeed, is expected to let cash flow thathe might have expected to receive asprincipal payments go out to the equityowners as dividends. Getting all thatagreed to thus far has taken a fairly intri-cate series of provisions including apre-funding of initial interest and divi-dend payments, interest deferral featureson the IDS debt, dividend stoppers that kick in prior to a senior default andacceleration forbearance arrangements.It is to be hoped that as the productmatures, a more robust senior marketwill develop that tolerates more fluidand less Byzantine provisions.

The Valuation EquationBankers and sponsors structuring anIDS deal can’t tarry long before gettingto the central valuation issues – howmuch free cash flow is there and what is the likely yield that the market willrequire? The latter question is largely acapital markets matter, but the formerhas numerous structuring and negotia-tion nuances. Obviously the quest is fora cash flow number that can be “prom-ised” to investors with a high degree ofconfidence. That requires developmentof a cash flow number (EDITDA, lesscapex, incremental administrativeexpenses, senior interest and otherdeducts), an understanding of historicalnumbers and cash flow risks, and also acombined marketing, pricing and struc-turing metric that creates some form of cushion. Basically, four approachesseem to be available: (1) price the offer-ing at a prescribed 5-10% “holdback”or haircut off of expected cash flow, (2)

persuade the sponsors to “subordinate”their rights to cash on their retainedinterest to the IDS equity, (3) derive acushion from the amount by whichcurrent-year cash flow is expected toexceed trailing cash flow, or (4) marketthrough whatever volatility risk exists.All are being talked up these days.

The Retained InterestVSA, American Seafoods and most ofthe other transactions of which we areaware are sponsor portfolio transactionsin which an IDS offering is proposedas an exit. Typically, however, it is aphased exit and one of the more com-plex groups of structuring (and capitalmarkets) issues surrounds the “retainedinterest” held by the sponsor and man-agement after the offering. The firstissue is what security the retaineesshould hold – converting their stake toIDS may create substantial tax liability(to the extent of the debt component)while failing to do so leaves them in an inferior credit and cash flow position.The second is what governance and/orboard representation rights to give theretainees, and that is an issue renderedconsiderably more complex in theaftermath of Sarbanes-Oxley and thevarious independent director require-ments prescribed by the SEC and theexchanges. And the third issue is howto structure their rights to roll into IDS and exit in subsequent offerings – a path fraught with tax and securitiesissues that are, with one exceptiondescribed below, beyond the scope ofthis article.

Subsequent Issuances and FungibilityA central feature of the IDS product is the need to permit subsequentissuances of units that will trade as asingle issue with the securities origi-nally offered. This is necessary toensure the sponsors an orderly exitand also because it safeguard’s theissuers future access to capital. The

problem is that while the terms of thecommon stock and notes underlyingfuture IDSs will be identical to those inthe initial offering, changes in interestrates or the issuer’s credit spread couldcause the notes issued in a subsequentIDS offering to have “original issuediscount”or “OID” for tax and otherpurposes, and OID securities will notbe fungible with non-OID securities. To deal with this problem, the IDS noteindenture provides that a portion ofthe new OID notes will automaticallybe exchanged for a portion of the oldnotes, so that all holders end up withthe same mix of OID and non-OIDsecurities. While this is expected toachieve the desired goal of fungibility,it puts the original buyers in the posi-tion of possibly having OID (andphantom income) imposed on themwhenever the issuer – or the privateequity sponsor – decides to effect asecondary offering.

So Now What?At this writing, as acronyms for IDS-type securities proliferate (to date wehave heard tell of EISs, Bells, Cougarsand Yous, in addition to IDSs), it’s far from clear what the future holds forunits of this sort. Are they a creaturesolely of today’s yield hungry markets? Could they become a permanent andsubstantial feature of the landscape asCITs have in Canada? Or will they be-come a niche product for sectors withstable cash flow and modest growthprospects that might otherwise havedifficulty accessing public equity mar-kets? Whatever the case, in the shortrun we seem to be in for a wave ofthese transactions, and they are not as simple as they seem. — Andrew L. [email protected]— Peter A. [email protected]— Jeffrey J. [email protected]



New Safe Harbor Provisions on Italian Leveraged Buy-Outsalert

Many European jurisdictions, includingItaly, have adopted rules that preventor limit any form of financial assis-tance by a corporation to third partiesin connection with the purchase orsubscription of the corporation’s shares.These financial assistance rules, bytheir express terms or pursuant to theirinterpretation by local courts, oftenresult in the prohibition of a quickmerger between a leveraged vehicleand the acquired target, thus pre-cluding the maximization of tax andfinancing efficiencies.

Recent legislation, enacted in Italy aspart of a large reform of company law,and applicable as of January 1, 2004,has created a general safe harbor forleveraged acquisitions. Mergers betweena leveraged vehicle and the acquiredtarget, where the target acts as a generalguarantee for, or the source of reim-bursement of, the debt incurred by thevehicle, will now be permitted, subjectto certain requirements.

These requirements include:

• That the merger plan must contain(in addition to the customary items,such as the new articles of associa-

tion, the exchange ratio for shares ofeach company, etc.) a description ofthe financial resources expected to beused by the merged company to fulfillits obligations;

• That the report customarily preparedby the directors of each merging com-pany must specifically indicate thereasons justifying the merger, a busi-ness and financial plan identifying the expected financial resources, andthe objectives that are expected to beaccomplished as a result of the merger;

• That the financial expert’s opiniondelivered in connection with a merger,customarily focused on the fairnessof the share exchange ratio, mustalso confirm the reasonableness ofthe directors’ reports; and

• That a report prepared by externalauditors, if either or both of themerging companies are subject toexternal audit (i.e., in the case oflisted companies or companies thathave shares held by a large number of investors), must substantiate the directors’ report and be annexed to the merger plan.

The company law reform alsoincluded the streamlining of proce-dures for mergers between a parentcompany and a 90%-to-100% directlyowned subsidiary. These procedures,however, will not be applicable tomergers between a leveraged vehicleand the acquired target.

One note of caution should beadded. The new rules introduced newprovisions on “group misdirection”:controlling companies may be heldliable for damages caused to minorityshareholders and creditors of controlledcompanies as a result of breaches, atthe controlling-company level, of theduty of proper corporate and businessmanagement. While it is true that thenewly enacted rules largely reflect pre-vious Italian case law, which was basedon general principles of civil liabilityand conflict-of-interest rules, the intro-duction of specific language on thematter into Italian company legislationwill likely increase the level of scrutinyof all corporate reorganizations, includ-ing intra-group mergers.

In addition, certain new specificlanguage extends liability for “group mis-direction” to those who have participatedin the alleged misconduct or have know-ingly profited from such misconduct.This could affect the level of scrutiny ofall parties to the transaction, arguably,including private equity sponsors.

All in all, however, the recent legisla-tion is a positive step towards the furtheropening of the Italian marketplace forprivate equity investments. — Giancarlo Capolino [email protected]

— Dante [email protected]

Mergers between a leveraged

vehicle and the acquired

target, where the target acts

as a general guarantee for,

or the source of the reimburse-

ment of, the debt incurred

by the vehicle, will now be

permitted, subject to certain

requirements.


Last December, the SEC set a new enforcement precedent and sent a strong message to all private fund advisers by bringing its firstfailure-to-supervise action under the Investment Advisers Act against the principal of an unregistered hedge fund adviser. Previously,the SEC had brought such actions only against registered advisers. The SEC also proceeded against the adviser’s director of investmentsfor fraud under various federal securities laws.

The director of investments materiallymisrepresented the funds’ performance– even reporting a year-to-date gain fora fund with a year-to-date performanceof negative 28% – and misrepresentedthe funds’ management structure andrisk management techniques. He alsoredeemed the investments of two sub-stantial investors at inflated valuesfollowing dramatic fund losses withoutdisclosing the losses to other investorsuntil months later. The principal of thehedge fund adviser shared office spacewith the director of investments andhad an ongoing opportunity to super-vise his activities. However, the principalfailed to do so and instead relied entirelyon the director’s representations withno independent oversight.

The SEC found not only that theprincipal had failed to take reasonablesupervisory actions, but, more impor-tantly, that he had failed to create orimplement procedures to independ-

ently verify the director’s representationsor detect violations of the securitieslaws. Such procedures could haveincluded: maintaining accurate recordsof investments and redemptions,reviewing trade confirmations andstatements, and properly and indepen-dently calculating fund performance.

This action suggests that the SECexpects all investment advisers – registered or not – to develop andimplement compliance policies andprocedures consistent with their fidu-ciary obligations and appropriate fortheir advisory firms, particularly thosethat advise private funds. Given thatthat the SEC has recently adopted arule requiring registered investmentadvisers to maintain compliance poli-cies and procedures, annually reviewsuch policies and procedures anddesignate a chief compliance officer,unregistered advisers might be wise totake these standards into considerationwhen gauging the adequacy of their

own compliance system. Although theSEC does not have inspection authorityover unregistered investment advisers,this action is a reminder to all privatefund advisers that the SEC takes veryseriously registered and unregisteredadvisers’ responsibilities to superviseemployees with a view toward pre-venting federal securities law violations.

If you have any questions about this recent action or about the adequacyof your own oversight or complianceprogram, please feel free to contactany of us. — Kenneth [email protected]

— Marcia L. [email protected]

— Jennifer Anne [email protected]

This action suggests that the

SEC expects all investment

advisers – registered or not

– to develop and implement

compliance policies and pro-

cedures consistent with their

fiduciary obligations and

appropriate for their advisory

firms, particularly those that

advise private funds.

SEC Sends Message to Private Fund Advisers: AdoptCompliance Policies and Procedures Now !


Catching the Secondary Wave: Opportunities and Risks (cont. from page 1)

the partnership agreement (and anyamendments), the management andadvisory agreement, the subscriptionagreement, any personal guarantees ofthe general partner’s clawback obliga-tions, side letters, corporate, tax andother opinions issued in connection withthe original investment, and financialinformation (such as audited financialstatements and tax returns).

Key Points to ReviewIdentify transfer restrictions. In nearly allcases, a partnership interest may not betransferred without the consent of thegeneral partner. Occasionally, all of thelimited partners will have rights of firstrefusal and, very rarely, partnership agree-ments will require that all the limitedpartners of the fund approve a transfer.In connection with transfers of portfoliosof investments in operating companies,the buyer also needs to consider whetherthe proposed transaction will raise opera-tional level consent issues, such as thosearising under credit agreements orexecutive employment arrangements ortrigger rights of first refusal or co-sale.

Liability issues. It is important to deter-mine whether the partnership agreementrequires the limited partners to returnall or a portion of prior distributionsreceived from the fund. If the partnershipagreement contains such a limited part-ner “clawback” and there have beensignificant distributions, a buyer whoassumes all the liability of a seller maybe liable to return distributions it hasnever received. Even if the partnershipagreement does not contain a contrac-tual right to clawback prior distributions,the general partner may use currentassets of the fund to pay liabilitiesincurred with respect to transactionsthat occurred prior to the transfer of the partnership interest. As discussedbelow, the buyer will likely require an

indemnity from the seller against such a liability. However, especially in a caseof a distressed seller, such an indemnifi-cation is of questionable value. Sales ofunderlying portfolio companies, eitherpublic offerings or private sales, recap-italizations of portfolio companies indistressed situations or simply sittingon the board of directors of portfoliocompanies may generate liabilities forwhich the fund ultimately will be respon-sible. While it is important to identifythe contractual obligations, such as alimited partner clawback, it is equallyimportant for the buyer, through discus-sions with the general partner and areview of the financial statements andthe general activities of the fund todate, to identify contingent liabilities.

Size of uncalled capital commitment.Partnership agreements often allow the general partner to recall the capitalportion of distributions relating to invest-ments sold within 12-18 months ordistributions relating to bridge invest-ments. One cannot simply subtract the drawdown capital from the originalcapital commitment to determine theunfunded capital. Buyer’s counsel shoulddetermine whether the partnershipagreement contains such reinvestmentrights, so that a prospective buyer mayquantify the actual amount of capital sub-ject to call by the general partner. Thebuyer should also determine whethermanagement fees are paid out of thepartnership assets or by the limitedpartners in addition to their capitalcommitments. If the latter, the buyer’spotential obligations will be increasedby projected management fees.

Economics. The prospective buyer willneed to determine the amount of thegeneral partner incentive fee – thecarried interest – which may be of theratio 80/20 or 75/25 or even 70/30

between the limited partner and generalpartner, respectively, as well as the sizeof the management fee in order to deter-mine the purchase price.

Regulatory issues. Each buyer has itsown set of unique regulatory issues. Forexample, a U.S. private pension planmay only purchase investments in part-nerships that are “venture capitaloperating companies” or otherwise“ERISA-safe.”

Business due diligence. While the lawyersconduct legal due diligence on the privateequity fund, the buyer will conduct afinancial review of the underlying port-folio companies and often attempt tomeet with management of the moreimportant portfolio companies. Suchreviews and meetings with managementare nearly impossible without the activecooperation of the general partner.Generally, the seller has access to verylimited information regarding portfoliocompanies and no direct access to man-agement. Often the general partner willdecline to make management availableto a prospective transferee of a limitedpartnership interest and the buyer isforced to make its investment decisionwith incomplete information.

Documenting the Deal

Confidentiality AgreementThe first document to be negotiated,often even before the names of thefunds are revealed by the seller, is theconfidentiality agreement. Generally, a seller is required (under the relevantpartnership agreement) to keep thefund’s financial and underlying portfolioinformation (the information a buyerwill request as part of its due diligence)confidential without the prior consentof the general partner or the agreementby the recipient to keep such informa-tion confidential.


Term Sheet and Letter of IntentOften the parties will dispense with a term sheet, especially in an auctionwhere the seller will submit a form of purchase agreement as part of thebidding process. In an individuallynegotiated sale, the prospective buyeroften requires a letter of intent, whichincludes a provision restricting the sellerfrom offering the relevant partnershipinterests to other persons (a “no-shopclause”) for a specified period of timewhile the prospective buyer completesits due diligence and the parties nego-tiate a purchase agreement.

Purchase AgreementThe purchase agreement will generallycontain the following:

Purchase price. The stated purchase priceis generally based on the seller’s capitalaccount and is adjusted upward by theamount of any capital contributionsmade by the seller since the valuationdate and reduced by the amount of anydistributions (valued at the valuationassigned by the general partner in thecase of in-kind distributions) since thevaluation date.

Representations and warranties of theseller. The seller’s representations willtypically include, among other things,due authorization and authority to enterinto the purchase agreement; good titleto the partnership interest, free of anyencumbrances other than transferrestrictions contained in the partnershipagreement; size of the seller’s capitalcommitment and amount contributedto date; and confirmation that the sellerhas funded all capital calls when due,has not opted out of or been excusedfrom any portfolio investment and isnot in default under the partnershipagreement. In addition, a prospectivebuyer often will require a representationthat the seller has supplied completecopies of the partnership agreements,subscription agreements, side letters,

opinions and other agreements appli-cable to the transferred interests. Whilethe list may appear rather straightfor-ward, it is often very time consuming forthe seller to gather all these documents,especially where multiple partnershipinterests are being transferred. Repre-sentations regarding the underlyinginvestments themselves are unusual if only limited partnership interests willbe transferred to the buyer.

Representations and warranties of thebuyer. The buyer’s representations willtypically be more limited, includingamong other things, due authorizationand authority to enter into the purchaseagreement and a series of private place-ment representations.

Closing conditions. Generally at closingthe representations are brought up todate by both the seller and buyer. If thereis expected to be a significant time periodbetween the signing of the purchaseagreement and actual closing, the pros-pective buyer often requests the inclusionof a closing condition that no materialadverse change has taken place withrespect to any partnership being trans-ferred during this interval. If multipleinterests are being purchased, the sellerand buyer need to determine whether allinterests are to close at the same timeor transfers may take place serially asgeneral partner consents are obtained.

Indemnification. The seller usually willindemnify the purchaser against liabilitiesarising out of events prior to the transfer,including clawback of distributions madeprior to such date, breaches of any obli-gations or representations made by theseller under the purchase agreement, thepartnership agreement or ancillary docu-ments, and any transfer fees. The buyerwill typically indemnify the seller againstliabilities arising out of events after thetransfer and breaches of any obligationsor representations made by the pur-chaser under the purchase agreement.

Expenses. The purchase agreementgenerally provides that each party will beresponsible for its own costs (includinglegal fees) in connection with the pur-chase, sale and transfer as well aswhich party will be responsible for anytransfer costs in connection with thefunds themselves. General partnerssometimes expect either the seller orbuyer to cover their expenses (includinglegal fees) in connection with transfers.

Assignment and Assumption Agreement.Pursuant to the assignment and assump-tion agreement, the seller transfers it’s interest in the partnership and thebuyer assumes the obligations of theseller with respect to the transferredinterest. From the buyer’s perspective,it is important that it only assumeseller’s obligations as a limited partnerunder the partnership agreement (acopy of which was supplied pursuant tothe purchase agreement) and specifiedancillary documents. A broad assump-tion of all obligations of the seller withrespect to the transferred interest couldtechnically include, for example, obli-gations to third parties such as taxingcontinued on page 18

While the lawyers conduct legal

due diligence on the private

equity fund, the buyer will con-

duct a financial review of the

underlying portfolio companies

and often attempt to meet with

management.... Such reviews

and meetings with manage-

ment are nearly impossible

without the active cooperation

of the general partner.


authorities. The general partner willgenerally require that the buyer agree tobe bound by the terms of the partner-ship agreement and to make customaryrepresentations (such as to the statusof the buyer and money launderinginformation). In addition, the generalpartner may ask that both the seller andthe buyer indemnify the general partneragainst any liabilities resulting from thetransfer. Each of the seller and buyerusually will only agree to indemnify thegeneral partner against liabilities result-ing from the actions or omissions ofsuch party and not for the actions oromissions of the other or of the generalpartner. This compromise is usuallyacceptable to general partners.

Occasionally, and particularly if only one asset is being transferred, theparties will dispense with a purchaseagreement and sign and close simulta-neously by executing an assignmentand assumption agreement. In suchcase, such agreement will contain manyof the representations and indemni-fication provisions normally found inthe purchase agreement.

General Partner ConsentAs discussed above, the buyer cannot be admitted to the partnership withoutthe consent of the general partner of such partnership. Such consent isdocumented in the assignment andassumption agreement or in a separateconsent letter. In addition to receivingthe written consent of the generalpartner to its admission as a limitedpartner of the partnership, the buyerwill often ask the general partner toconfirm that all transfer conditionshave been satisfied or waived and theamount of the seller’s original capitalcommitment and uncalled capitalcommitment. The seller may ask the

general partner to release it from anyand all liabilities under the partnershipagreement; otherwise, if the buyerdefaults on a capital call, the partner-ship may still have a claim against theseller. Finally, if the seller has defaultedon a capital call, the buyer will ask thegeneral partner to confirm that, uponpayment of the missed capital call, it will be in good standing and notsubject to any default penalties withrespect to such missed capital call.

Tax ConsiderationsThe principal tax issue in secondarytransfers is whether the transfer willcause the fund to become a “publiclytraded partnership” taxable as a corpo-ration for U.S. federal income taxpurposes. A fund would be a publiclytraded partnership if interests in thefund were traded on an establishedsecurities market (such as the New YorkStock Exchange or Nasdaq) or wereregularly traded on a secondary market(or the substantial equivalent thereof)unless 90% or more of the fund’sincome for each year consists of certaintypes of passive income. In most cases,the secondary transfer will be a privatetransfer negotiated between the sellerand buyer and would not be considered a trade on a prohibited public or quasi-public market. In addition, there are a number of regulatory “safe harbors”protecting against interests in a fundbeing considered to be regularly tradedon a secondary market (or the substan-tial equivalent thereof). These safeharbors include transfers of interests in funds where interests were issued in a private placement and that do nothave more than 100 partners (which isfrequently applicable), and funds thathave transfers of interests in capital orprofits totaling less than 2% of totalinterests in capital or profits per year.

A second tax issue is the method of allocating the fund’s taxable items ofincome and loss for the taxable yearbetween seller and buyer. The “closing-of-the-books” method allocates all of theitems through to the date of transfer tothe seller and all of the items after thedate of transfer to the buyer. Alternatively,the seller and buyer each can take a prorata share of all of the fund’s income andloss based on the portion of the taxableyear that has elapsed prior to the transfer,or determined under any other methodthat is reasonable. If the fund has had asignificant gain prior to the date of trans-fer, the buyer may request the “closing-of-the-books” method in order to avoidphantom income.

Secondaries Involving a Transfer of Operating CompaniesAs noted above, an increasinglycommon form of secondary involves thetransfer of a seller’s interests in severaldirect private equity investments to anewly formed partnership that is oftenrun by the former managers of theseller’s private equity portfolio. Thesetransactions present several issues inaddition to those raised above.

Co-investors in the direct investmentsbeing transferred to the new partnershipmay have rights of first refusal or co-sale.Additionally, the transaction may triggerdefaults under a variety of operationalagreements relating to the underlyingportfolio companies. Identifying theseissues may be difficult, especially if the seller has limited access to the doc-uments of the portfolio companies.Although the former managers of theseller’s private equity portfolio may be aware of certain material consents,this will be of limited comfort to theprivate equity investor supporting themanagers in their acquisition.

Catching the Secondary Wave: Opportunities and Risks (cont. from page 17)


Additionally, the buyer may want toobtain representations and indemnitiesregarding the portfolio investments.Most sellers should be willing to pro-vide representations that the sellerowns a specified number of shares inthe portfolio investment and perhapsthat the shares represent specifiedpercentages of the portfolio companies.These matters clearly go to the heart of the buyer’s investment decision. Thebuyer will also likely seek representa-tions regarding third-party consents.But if the representations sought by the buyer extend to other operationalmatters involving the portfolio invest-ments, such as financial statements or

material, contingent liabilities, the sellermay well resist. This is especially thecase if the seller is a financial institutionwhich has relied on the managers (whonow may be associated with the buyer)to monitor the portfolio or if the seller’sinterest in the portfolio companies isonly a minority position. The buyer willcertainly negotiate these issues with the seller but, in the end, it may to somedegree be left to its own business, finan-cial and legal due diligence to obtaincomfort on certain matters (recognizingthat the parties may or may not havecomplete access to the management ofthe underlying portfolio companies).

While the above issues are beingnegotiated with the seller, the former

managers may be engaged in struc-turing the new investment partnershipto serve as the buyer and negotiatingthe terms of such partnership withprospective investors who are financingthe acquisition.

As this brief discussion should indicate, buyers seeking to catch thesecondary wave should realize that theyare wading into an area with uniqueopportunities and risk. Advance plan-ning and understanding of the potentialpitfalls is essential to executing thesetypes of transactions. — David J. [email protected]

M&A in Wonderland: What You Don’t Know About Bankruptcy M&A Will Surprise You (cont. from page 9)

fee might be paid if the board or share-holders reject a contract or accept abetter offer, if only because an auction iscertain to occur and so there is a higherchance of the break-up fee being owed.

Why Bankruptcy M&A is Different: The Deal That Isn’t a Deal, MaybeA negotiation for an asset purchaseagreement in anticipation of a Section363 sale is also likely to take on differentcharacteristics than a more typicalM&A negotiation.

The deal isn’t a deal. The most obviousdifference in negotiating the asset pur-chase agreement in a Section 363 saleis that it might not be a real deal. Itmight be only a starting point for futurenegotiations. A key element in theSection 363 sale is that others will beinvited in to make higher and betteroffers. Therefore, a prudent seller orsecured creditor will be looking to keepthe provisions simple, straightforwardand capable of being bid against. Pricein the stalking horse deal, for example,

is evaluated not only in terms of dollarsbut also in terms of whether others willbe encouraged to enter the fray and tryto raise it. But this situation naturallylimits the amount of time a sensiblebuyer will invest in the deal and encour-ages the buyer to protect itself bybuilding into the agreement reimburse-ment of its expenses and the payment of a break-up fee if another party winsthe auction. Now, given that the assetpurchase agreement, like any othercontract, could be rejected by the debtorin bankruptcy, none of this will work ifthe court doesn’t generally approvethese arrangements, and there is a lotof lore and law on when and whatshould be acceptable to the court. All of this needs to be weighed and evalu-ated as part of negotiating the assetpurchase agreement.

Due diligence: how much and what’simportant? One reason to run a com-pany through bankruptcy is to shedunpleasant contractual obligations andliabilities. Under Section 365 of the

Bankruptcy Code, contracts that requirefuture performance (so-called executorycontracts) can be “rejected” by TroubledCo, meaning that Troubled Co. can electnot to perform under that contract, andthe other party is then left with a claimfor damages as a consequence of suchnon-performance. This right of thedebtor to reject contracts applies in thecase of sales pursuant to Section 363 aswell. Contracts that are unattractive canbe left behind, including any claims fordamages for breach. Environmentallycontinued on page 20

The most obvious difference

in negotiating the asset pur-

chase agreement in a Section

363 sale is that it might not

be a real deal. It might only

be a starting point for future

negotiations.


contaminated pieces of real property,unless posing an immediate threat tohuman life, can be abandoned. Theseopen issues need to be sorted out aspart of winding up the bankruptcy pro-cess, but the buyer doesn’t need toworry about them. Therefore, while thebuyer may do the usual due diligence as to cash flow and the business, thedue diligence on contracts, leases andenvironmental matters is often limitedto just enough research to say: do wewant or need this, and could we nego-tiate something better when we own thecompany after the bankruptcy? And thereis always a question about how much ofan investment the buyer wants to makewhen ultimately the deal might notactually be his. Even if some or all of theout-of-pocket costs are reimbursed aspart of the break-up fee agreement, thetime spent on this project that could havebeen spent differently is gone forever.

What are the hot issues in the assetpurchase agreement? Price and closingconditions. A seller and its creditorsshould focus on two things: what is therecovery and what is the risk that theydon’t get it? Just about the worst casescenario for the creditors would be to have the stalking horse buyer taggedby the court as the winner, but thenhave the stalking horse refuse to closebecause closing conditions have notbeen satisfied. This could give thebuyer the opportunity to try to renego-tiate the deal at a time when TroubledCo. is already in bankruptcy, alreadyhas completed the auction process andmay have very few other alternatives.On the other hand, a sensible buyershould realize that if something goeswrong, if Troubled Co. is not in thecondition represented or similar issuesarise, the buyer will have no recourseother than not to close. Troubled Co.

will already be in bankruptcy and unlessspecial provision is made for an escrowor representation and warranty insur-ance, there will be no practical way tobe made whole.

Exclusivity. A sensible buyer might seekan exclusive right to negotiate withTroubled Co. for a period of time. Priorto filing for bankruptcy, Troubled Co.can oblige to the same extent any otherseller could. It is simply a matter ofcontract. Once Troubled Co. files forbankruptcy, however, exclusivitybecomes elusive. The auction process is built into the 363 sale procedure, soclearly once the auction process startsthere is no exclusivity. But what aboutthe period between filing and start of the auction? It is not clear what theanswer to this question is until thebankruptcy court tells you. But a sensiblebuyer should not count on exclusivityafter the filing even if it is set forth inthe purchase agreement.

Financing. One of the hot issues innegotiating these types of acquisitionsfor the buyer is financing. Obviously, the seller and its creditors would preferthe certainty of a transaction with no“financing out.” But the reality is that alot of buyers will need some sort offinancing, and it is also the reality thatbanks don’t make ironclad commit-ments to provide financing in advance.As already noted, sellers and creditorsare looking for certainty, and the ques-tion about when the ability to obtainfinancing ceases to be a condition tobuyer’s obligation to close will be negoti-ated: At the time of the filing of TroubledCo. in bankruptcy? At the conclusion of the auction process? At closing? Alsoto be negotiated, what if the buyer islooking to the public markets for finan-cing, for example in a high-yield offering?Certainly the buyer may be reluctant to

begin work on a debt offering memountil it knows it is the successfulbidder, and it will not know if it is thesuccessful bidder until the end of the auction. Given the time necessary to launch the public debt offering, this will delay the closing for at least 30 days after the end of the auction. Delay shifts some risk to the seller and its creditors that something couldgo wrong, and if something does gowrong, that the transaction will notclose and the creditors and TroubledCo. will be we be where they do notwant to be – in bankruptcy without abuyer or a clear way out. All of theseconcerns will need to be addressedcarefully in the purchase agreement.

ConclusionThis article only touches on some of the issues that you will run across if you step into a Section 363 saleprocess. The point, though, is this:M&A in the bankruptcy context isdifferent from regular M&A in a lot of subtle and not so subtle ways.Understanding the M&A issues and the anthropology of the parties, as you would in any deal, is of courseimportant, but equally important isunderstanding the variables that thebankruptcy process creates and howthe relative weight of important andunimportant issues and deal driversshifts as a consequence. And perhapssurprisingly, that buzz you get whenyou have successfully completed anegotiation just isn’t the same – thepurchase agreement is signed, thehand shakes are done but instead ofclinking champagne glasses, TroubledCo. goes to the courthouse and files for bankruptcy. It just isn’t the same. — Sarah A. W. [email protected]

M&A in Wonderland: What You Don’t Know About Bankruptcy M&A Will Surprise You (cont. from page 19)


followed during transactions with affili-ates. While it is not clear that fiduciaryduties can be entirely eliminated, theyclearly may be restricted, and someclaims can be barred by a well-draftedpartnership agreement.

Several important principals governany restriction of a general partner’sfiduciary duties. First, the provisionsmust be clearly drafted and explicitlyoverride the default fiduciary duties ofcare and loyalty. One recent case, Millerv. American Real Estate Partners, L.P.,held that a real estate partnershipcontrolled by Carl Icahn was subject to fiduciary duties because the sole discretion provision in the partnershipagreement did not expressly supplantthe default fiduciary duty standards. A related point is that courts tend tointerpret ambiguities in the partnershipagreement against the general partner.This is particularly true where thelimited partners took no part in draftingthe limited partnership agreement.

Guidelines for Minimizing RiskThe second step in minimizing thelegal risks is to implement safeguards.Of course, business practices such asmaintaining good relations with yourlimited partners and enabling assign-ments of limited partners interests canalso help avoid lawsuits. Following is alist of suggested safeguards:

Draft organizational documents clearly.The key provisions dealing with generalpartner duties in the partnership agreements need to be clearly drafted.Traditional fiduciary principles will besupplanted only by express provisionsthat cannot be reconciled with theapplication of the default fiduciary prin-ciples. These include the standard for duties owed to the partnership andlimited partners set forth in the limitedpartnership agreement; exculpation

and indemnification provisions, wheredefault duties of loyalty and care maybe modified; and conflict provisions,where certain actions can be permittedand procedures established. The generalpartner will be protected from liability ifit acts in good-faith reliance on the pro-visions of the partnership agreement.

Comply with relevant standards. The gen-eral partner must carefully considerwhich provisions of the limited partner-ship agreement govern a particularaction and comply with the relevant stan-dards of conduct. The general partnershould consult with counsel to ensureit is following the standards set forth in the agreement and should interpretany ambiguities in the language ingood faith (and not to its own benefit).

Process counts. The general partner mustestablish the proper level of care inmaking its determinations.This involvesbeing fully informed of all materialinformation reasonably available (andfully informing other decision-makersas well) and deliberating over a reason-able period of time. As a practicalmatter, courts will be far more inclinedto support the judgments of decisionmakers who act with appropriate care.

Use more care with conflicts. Conflict ofinterest transactions attract scrutiny andlitigation. If the entire fairness standardunder Delaware corporate law applies,directors bear the initial burden ofproving that both the process and theprice were fair to minority stockholders.Likewise, if the limited partnershipagreement does not restrict the standardof care, a general partner and its directorsmay be required to show that a conflicttransaction was fair to the partnershipand the limited partners. A market check,third-party fairness opinion or consulta-tion with the fund’s advisory committeemay help to establish that the processand/or price were fair.

Maintain a record. A corollary to goodprocess is the ability to prove it. Minutesshould indicate when and for how longdecision-makers met and generallywhat was discussed. However, minutesshould not editorialize or enumeratethe details of discussions.

D&O insurance. Premiums haveincreased significantly over the pastfew years in the wake of numerouscorporate scandals, but most fundsconsider it advisable to insure againstthe risk of investors’ claims. Insuranceis not a replacement for good corpo-rate governance, however, for severalreasons. In addition to the negotiateddeductibles and policy limits, D&Opolicies typically have important exclu-sions for bad acts such as willfulviolations and gaining an improperprofit or advantage.

Full disclosure. Remember that certainstandards of behavior cannot be nego-tiated away. For example, a claim ofmisleading statements or omissionsunder the anti-fraud provisions (Rule10b-5) of the Securities Exchange Act of1934 can apply to disclosure providedin the private placement memorandum,notwithstanding any modification ofduties in the partnership agreement.

— Rebecca F. [email protected]

— Timothy S. T. [email protected]

Managing General Partner Litigation Risk (cont. from page 3)

Of course, business practices

such as maintaining good rela-

tions with your limited partners

and enabling assignments of

limited partner interests can

also help avoid lawsuits.


The Pitfalls of Using an English-Language, U.S.-Style Acquisition Agreement (cont. from page 5)

through the exercise of the rights result-ing from such clauses, the prospectivepurchaser may be seriously at risk if thetransaction collapses and the target com-pany then goes bankrupt. In practice,this risk can be controlled to a greatextent by focusing on the managementrestrictions that really matter, and byhaving information rather than veto oraffirmative authorization rights.

Other clauses in U.S.-style agree-ments would technically work underFrench law, but they are not regarded as market practice, and sometimes are difficult to “sell” to the other sideprecisely because they are believed tobe derived from the U.S. practice. Atthe top of the list is the sort of “10b-5”representation that a buyer often wantsto receive from the seller, under whichthe seller represents that the acquisitionagreement and generally all documentsfurnished by the seller do not containany untrue statement of a material factor omit to state a material fact necessary,to make other statements made in theagreement and these documents, notmisleading. Even though this sort ofrepresentation may not be very commonin private transactions in the U.S., it hassomehow become a popular requestamong buyers in French transactions.However, while the existence of fairlydetailed representations and warrantiesin acquisition agreements has nowbecome standard practice in France,there is still a lot of resistance to addingthis sort of catch-all representationwhose effect, incidentally, is untested inFrench courts. In the same category arethe representations and warranties thatare sometimes expected from a buyer.In a cash transaction, buyers will veryoften sneer at sellers’ requests for theserepresentations and warranties, on thetheory that cash has an objective valuethat hardly needs to be protected by

contract. In addition, a buyer will typi-cally say that if the real concern relatesto the buyer’s ability to pay the acquisi-tion price, the buyer’s representationsand warranties would be redundantwith the buyer’s commitment to pur-chase and pay the agreed upon pricethat is the essence of the agreement. In practice, however, buyers’ repre-sentations and warranties are oftenreluctantly accepted by buyers withcomments to the effect that they do notreally understand what sort of benefitthe sellers are expecting from them.

Best EffortsBest efforts is an obligation qualifier thatwas virtually unknown in French M&Apractice 20 years ago, and has met withremarkable success. It is a very populartool for the ultimate concessions thatexhausted negotiators often make whenthe sun rises after a night-long session,thinking that they are not giving out toomuch after all since “best efforts” wouldessentially mean a less stringent stan-dard than for an unqualified obligation.

Yet, under French law, the analysis ofa “best effort” obligation may not quitematch this vision. In essence, Frenchlaw recognizes two standards for legalobligations: one is where the obligorcommits to procure a defined result,and is liable even without a fault on hispart if this result is not procured (e.g.,the safety obligation a public transporta-tion carrier owes to the passengers),and the other is where the obligor onlycommits to use all possible means toprocure the desired result, withoutcommitting to achieving it, and is liableif it can be shown that he did not usethe means a reasonable man in a similarsituation would have used (e.g., thistype of standard is used for medicalmalpractice cases). In legal terms, thefirst type is called obligation de résultat,

and the other obligation de moyen. Inmany ways, an obligation de moyen is a sort of statutory reasonable effortsobligation. What is then the effect ofadding the “best efforts” wording to anobligation de résultat? While this doesnot seem to have been tested in Frenchcourts, the likely answer is that thewords “best efforts” set a slightly higherstandard of obligation than for a simpleobligation de moyen, because this expres-sion tends to set an absolute standard(“best”) for the means the obligor isexpected to use to procure the desiredresult, whereas in the absence of thisexpression the standard would defaultto what a reasonable man would do.“Best efforts” would therefore be theexact opposite of what most users maythink this expression means. It is defi-nitely not a wording that should be usedcasually on the belief that there wouldbe no real consequences to a “bestefforts” obligation.

At the risk of stating the obvious, a contract does not exist in a vacuum,but it draws its legal effect from thelegal system on which it is based. Thislegal system also underlies to somedegree virtually all the words and clausesin a contract. While U.S.-style acquisi-tion agreements have brought a lot tothe French M&A practice in terms ofdeal techniques and detailed drafting,French practitioners should bear in mindthat these benefits can only exist if theymake the effort of adapting these agree-ments where necessary to make themoperational under French law. Similarly,U.S. investors in France should not expectthat because all parties have agreed to use English-language agreements for a transaction, the respective agreementsare going to be identical to those that areused to for U.S. transactions. — Antoine [email protected]


The New Opportunity for Private Equity (cont. from page 7)

liabilities that the investors understandor perhaps can contain better than others.

4. Use of operating partners. Recognizingthat an auction still represents the salemechanism of choice for many sellersof corporate assets, private equity firmsthat employ operating partners still tryto avoid auctions wherever possible,but have concluded that financial engi-neering, while a necessary feature ofany LBO, may no longer be sufficient.Good operating partners, steeped inthe real-world experience of runningbusinesses, afford private equity firmsadvantages both before buying an assetand after. Prior to purchase, operatingpartners can help buyers to do betterdue diligence. Sometimes experiencedoperating partners uncover subtle risks,hidden costs or underestimated liabili-ties that cause their firms to bid less foran asset than a pure financing engineermight, but, equally often, operating part-ners see opportunities for cost cuttingor better cash flow management thatencourage their firms to pay more. Inboth cases, the firms employing oper-ating partners believe they have madegood, informed decisions: avoidingover-paying in the first instance andpaying up to capture an asset theyknow will appear cheap in hindsight in the second.

Skeptical market observers and par-ticipants alike may dismiss all of thesestrategies as insufficient to overcomethe overarching supply/demand imbal-ance of too much money chasing toofew deals. Even for these skeptics, how-ever, there is reason for optimism, for a number of important trends are con-spiring if not to overcome the supply/demand problem then at least to amelio-rate it. Each of these trends has increasedthe availability of assets suitable for pur-chase by private equity firms.

First, many public-company CEOshave decided that the costs of being apublic company (recently exacerbatedby the demands of Sarbanes-Oxley)outweigh the benefits. Many small- andmid-cap companies have begun to feel“orphaned” by the public equity markets.Their public float simply may be toosmall to attract investors with a predilec-tion for liquid stocks or too small toencourage broad interest among anincreasingly cost-conscious equity-research community. Whatever thereason, many public companies recentlyhave turned to LBO firms to help themgo private, and many more like-mindedcompanies are in various stages of the process of going private. Of course,by putting themselves “in play” throughthe going-private process, these firmsmay put themselves at risk of beingacquired by competitors, but the recentexperience of successful public-to-privates including Nortek, Dole andQuintiles should give courage to manage-ment teams that may be contemplatinggoing private.

Second, a renewed focus on corecompetencies (and core businesses)among corporates continues togenerate a steady supply of non-coreassets for the divestiture market, par-ticularly in Europe, where the advent of the EU has helped spur the kind ofrestructuring that many U.S. compa-nies went through in the 1980s and1990s. Suez’s divestiture of Nalco andVivendi’s sale of Houghton-Mifflin arebut two recent examples of Europeanbusinesses divesting significant assetsto private equity firms. Even in the U.S., however, tectonic shifts occurringacross a number of industries con-tinue to spur significant asset sales. As an example, within the last year or so,private equity firms acquired virtually

the entire global yellow-pages industrylargely as a result of pressures on theirerstwhile owners in the telecommuni-cations industry.

Third, secondary buyouts (where oneLBO firm buys a business from anotherLBO firm), once believed to be taboo inthe private equity world, are becomingcommonplace. In years past, LBO firmstypically would not buy a business from a competitor, presuming that theprevious owner would have “squeezedall the juice out of the lemon” bywringing out whatever cost savings orcash flow improvements were available.In today’s environment, however, the wildly ebullient high-yield marketpermits a new buyer to finance a pre-owned asset – to borrow a handyeuphemism from used car dealers – at more aggressive levels than wereavailable to the prior owner. This happyfeat of financial engineering means thatthe new buyer can pay a higher multipleof cash flow than the prior owner did without necessarily having to makeheroic assumptions about improvingthe business. Equally important, how-ever, recent signs of incipient economicrecovery have given financial buyers the courage to assume that, in buying a business from another LBO firm, theywill be riding a new wave in the eco-nomic cycle. Valuations that seem priceytoday, these buyers reason, will lookcheap in hindsight if the economy con-tinues to improve as sharply as currentindicators imply it will.

Some wags have suggested thatsecondary buyouts may solve the pri-vate equity supply/demand imbalanceforever by creating the investmentanalog of a perpetual motion machine,with LBO firms constantly trading thesame small group of companies amongthemselves ad infinitum. At a minimum,continued on page 24


Last fall, the National Association ofSecurities Dealers, Inc. threw a wrenchin fund sponsors’ marketing activitieswhen it formally advised NASDmembers they could not use “relatedperformance information” – that is,performance data of a predecessor orsimilar fund – in hedge fund sales mate-rial, including flip books. Following aflurry of informal communications withthe NASD prompted by its formaladvice, most understood the prohibi-tion to apply to private equity funds as well as hedge funds, although not to apply to related performance infor-mation that appeared in private place-ment memoranda.

Although the NASD has long prohib-ited the presentation of such informationin mutual fund “sales literature” – label-ing such presentations as potentiallymisleading – it came as a real surprisewhen the NASD imported this prohibi-tion into the private fund context, firstinformally through spot checks of mem-ber firms’ marketing materials andthen formally through interpretive guid-ance issued October 2, 2003.

Just in time for New Year’s celebra-tions, the NASD retreated from thisposition. Responding to a letter sub-

mitted on behalf of CSFB, the NASDstated that, as a general matter, it wouldnot object if an NASD member (e.g., afund placement agent) included relatedperformance information in sales mate-rials for Section 3(c)(7) funds, providedthat the member “ensures that all recip-ients of such sales material are ‘qualifiedpurchasers’” within the meaning of theInvestment Company Act. Most largeprivate funds raised today in fact relyon the exemption from InvestmentCompany Act registration provided bySection 3(c)(7) of that Act. Accordingly,this is meaningful relief and such fundsmay now include the track records ofpredecessor funds in their flip booksand other sales materials.

However, some private funds, suchas so-called “friends and family” funds,still rely on the Section 3(c)(1) exemp-tion under the Investment Company Act.The letter does not, however, provideany general relief for these Section3(c)(1) funds. (Note that some of thesefunds may not necessarily be marketedusing an NASD member (e.g., a place-ment agent)).

The recent advisory letter expandssomewhat on the concerns underlyingthe NASD’s October letter, noting in

particular its concern that related per-formance information would be used“where the audience for such salesmaterial could be retail investors.” It isunclear whether the NASD will expandon the types of investors (e.g., institu-tional investors in Section 3(c)(1) funds)to whom related performance informa-tion may be provided.

The NASD also took the opportunityin its year-end letter to remind membersthat private fund sales materials remainsubject to the applicable standards ofNASD Rule 2210, as well as applicablesecurities laws and regulations. Com-munications with the public must, asbefore, among other things, be basedon principles of fair dealing and goodfaith, be fair and balanced, and may notpredict or project performance or implythat past performance is any indicationof future performance. — Jennifer Anne [email protected]

— Michael P. [email protected]

— Kenneth J. [email protected]

NASD Relaxes Ban on Use of Related Performance Informationalert

The New Opportunity for Private Equity (cont. from page 23)

secondary buyouts represent a sourceof assets once thought unavailable tobuyout firms.

Finally, for those with an outlooklong enough to span the inevitableebb and flow of the business cycle,today’s aggressive high-yield market,in a perverse sense, may well becreating tomorrow’s distressed debtopportunities for private equity firms.

This view will hold particular appealfor cynics, but history has taught us toexpect that some meaningful portionof those companies enjoying the fruitsof a more than bountiful high-yieldmarket inevitably will turn out to haveincurred more debt than they couldsupport. Be assured that private equityfirms will be waiting to take advantageof the opportunities inherent in thosecompanies’ misfortunes.

2004 looks promising for privateequity investment. All indicators seem to point to a resurgence of M&Aactivity. With private equity firms’unique strategies and special compe-tencies, financial sponsors are wellpositioned to avail themselves of thesenew market opportunities. — Alan K. JonesManaging Director & Co-Head of GlobalFinancial Sponsors, Morgan Stanley