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Since the financial crisis private equity houses have increasingly focused on specific strategies to enhance the value of portfolio businesses. One of these strategies is the “buy and build” strategy; that is, acquiring a target company with the specific intention of making a series of add-on acquisitions in the same sector.
Buy and build strategies give rise to a number of legal and commercial considerations that would not necessarily be present in a standalone transaction.
One of the key issues to be considered when embarking on a buy and build strategy is how the add-on acquisitions will be financed. It may be possible to arrange an extra credit line at the time of the original transaction to finance all or most of the consideration payable for the add-on acquisitions.
However, flexibility needs to be built in to equity and debt documents to allow this financing to take place. Where private equity investors subscribe for further equity, this gives rise to issues relating to the dilution of management's equity (see below), which need to be carefully considered.
As further equity funding is likely to be needed by the original acquisition vehicle to make add-on acquisitions, its funding structure will have to change during the period of the buy and build strategy. Where such further equity funding is subscribed for by the private equity investors, the equity held by the management team is likely to be diluted.
Even though the equity documents will usually contain rights for management to subscribe pro rata, they are unlikely to have the financial resources available to subscribe for their relevant proportion of further equity.
The level of dilution will depend on the price paid for the add-on acquisition, at what stage it becomes earnings enhancing for the original target company, and the extent to which the acquisition enhances the overall value of the group.
It may be impossible to predict the level of dilution of management's equity stake unless the parties have identified in advance the add-on acquisitions, finalised the structure of the additional funding and agreed the anticipated contribution of each of the add-on acquisitions to the enlarged group.
We have seen investment term sheets for buy and builds which list add-on targets and approximate valuations, so that management and the investors are agreed in principle as to specific targets, methods of funding and levels of dilution.
Unless flexibility is built into the equity documents at the outset, a material renegotiation of the equity terms between the investors and management may be necessary. Therefore, private equity investors should seek this flexibility, where possible, to accommodate the additional funding for acquisitions.
To protect management's position, their lawyers may seek to ensure that the key terms of such further funding are prescribed upfront.
If there is a ratchet (that is, a provision increasing management's percentage of proceeds if certain targets are achieved on exit), this may need to be amended to take into account the additional funding; for example, money multipliers may be more difficult to achieve on equity subscribed later.
Also, if the management of the add-on acquisitions will be invited to take equity in the original acquisition vehicle, they will need, at the very least, to adhere to the existing equity documents and their equity participation may have knock-on effects on the terms of the equity documents themselves.
There may be significant time, cost and disruption involved in integrating the add-on acquisitions into the group, especially if an acquisition results in relocating parts of the business, substantial re-branding or significant redundancies.
As a result, holding periods are often longer for buy and builds than standalone transactions, particularly if integration is especially difficult or takes longer than expected.
The principal goals behind the buy and build approach are to consolidate a particular sector and/or to create a larger enterprise which benefits from economies of scale.
When selecting a potential buy and build platform, it is clearly important to be confident that the add-on acquisitions in the relevant sector are likely to be available for acquisition, in order to achieve the anticipated returns.
As with any acquisition strategy, compliance with applicable competition law will need to be taken into account. Given that buy and build strategies are likely to contribute to the consolidation of particular sectors, for larger transactions or targets with a high market share, input from competition specialists will be required at an early stage to ensure that the correct strategy is followed.
Achieving a tax efficient structure is clearly one of the most important considerations when structuring a buy and build transaction. Ultimately, it is a matter of determining the structure that minimises, so far as possible, tax leakage on the flow of profits from the group companies (for example, to service debt), and any tax leakage on the realisation of profits and gains from investments.
Investors setting up a pan-European group need to identify the jurisdiction that provides the best holding company structure. There is unlikely to be a "one size fits all" answer to this as it will depend on the location of the management team, the investors and, of course, the prospective target companies and where they operate.
A Luxembourg holding company structure is commonly used for a pan-European buy and build strategy. The Luxembourg structure provides for a participation exemption for gains on the sale by the holding company of qualifying investments.
Also, if a share tracking mechanism is used, proceeds can be distributed to investors in capital form following the partial liquidation of the relevant class of shares in the holding company without any Luxembourg withholding tax.
Alternatively, in certain situations, a UK holding company structure can be a straightforward yet tax efficient solution for a pan-European buy and build. Changes to the taxation of corporate vehicles on dividend receipts mean that now a UK company can usually receive dividend income from UK or offshore subsidiaries without incurring a tax charge on the income.
The need to think long-term and the consequence of doing so for the structure of financing, the position of management, and the structure of the group for tax purposes, mean that these issues should be considered at an early stage.
This article was written by Malcolm MacDougall.
For more information contact Malcolm on +44 (0)20 7427 4544 or email@example.com