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Private equity and public procurement contracts: please don’t be misunderstood!

20 March 2014

When investing in businesses that sell to the public sector, it is especially important for private equity backers to know their rights under procurement law.

A particular concern (and misconception) among public authorities is that private equity investors do not represent sustainable, stable and reliable sources of finance in the long-term.

This can lead to knee-jerk reactions from contracting authorities seeking to exclude private equity-backed bidders under the criteria for financial standing within the applicable pre-qualification questionnaire.

There appears to be a perception among contracting authorities that the shareholder debt element of private equity investments is akin to third party debt from commercial debt providers and should therefore be taken into account as debt when assessing levels of gearing/indebtedness on a bidding entity's balance sheet.

It pays to be keenly aware of this misconception, since probing an awarding body on its reasoning for exclusion can often expose a breach of its duties under the public procurement rules. If you find this is the case, it may be possible to get an exclusion overturned or, if not, damages by way of compensation.

Contracting authorities are permitted to set minimum levels of financial standing in their selection criteria, provided these are clearly set out in the contract notice and documentation and are proportionate to the works or services being provided.

The first thing you should do if a public authority questions the financials of a business you have invested in is to seek advice on whether they are relying on clear, transparent criteria that have been made known from the outset, and whether the authority are relying on a sound, logical calculation which follows the methodology set out in those criteria.

If not, the authority's decision could be open to challenge for a lack of transparency, which is required under EU procurement law.

Very much connected with this duty of transparency is that of equal treatment. This often comes to the fore when public authorities seek to interpret the financial metrics in the PQQ criteria in a private equity context.

Typically, the error they can be prone to make is to conflate private equity finance with commercial debt finance and add PE funding to the business' overall debt levels on its balance sheet.

Taking this line unsurprisingly can lead the public authority to conclude that the bidder carries "unacceptable levels of risk" (to paraphrase the commonly-used wording of selection criteria). However, this interpretation wrongly assumes private equity backers view their investment in the same way as, say, a lending bank would.

Of course, the reality is that private equity investment is bound up with the growth and expansion of the business in which the private equity house is invested.

The private equity creditor wants a proper return on its investment, by ultimately enhancing the value of its equity share; rather than seeking to recall any debt instruments at the first sign of potential default, it will almost always seek to maximise the business's opportunity for long term success before doing so.

This contrasts sharply with the position of a third party debt provider, whose main concern is to recover the principal and interest on its loan.

The fact private equity backers' interests are very much aligned with those of the business means they should not be classed in the same category as third party creditors. This is particularly true of loan stock and preference shares as opposed to, say, a revolving credit facility with a financial institution.

To conflate these forms of investment can put a public authority at odds with official procurement guidance which says the public authority should exercise a more rounded, "business judgment" when deciding whether to exclude a bidder on financial grounds. 

Likewise, this guidance specifically promotes an appreciation of the unique nature of intra-group debt and the need for the wider resources of a corporate group (ie including the private equity funds that have invested in the relevant business) to be taken into consideration. 

In some circumstances it might be the case that the funds can inject further finance to support the underlying business, which would bolster the bidder's financial standing in line with this guidance. However, irrespective of the funding arrangements, the private equity funds' shareholder loans should never be regarded as akin to third party institutional debt finance.

Get the authority to explain itself

If you come across an exclusion on financial grounds for an investee business it pays to request the authority's reasoning and evidence for making its decision. This will expose any flaws such as those described above, and help you get clear advice on your rights.

It could prove the difference between your investee company getting its big public sector jobs and not!

This article was written by Paul Henty.

For more information contact Paul on +44 (0)20 7427 6506 or paul.henty@crsblaw.com