Introduction

When PE sponsors propose a public to private takeover bid (P2P), this has material implications for the current board in terms of fiduciary duties, possible conflicts of interest and all the stakeholders in the business. This article builds upon part 1 of the series, which was primarily focused on the perspective of the PE sponsor, and considers the following areas from the perspective of the board and management of a listed company which may be the target of a P2P offer:

• the different types of P2P transactions;
• how P2Ps arise;
• what preparation can be done in advance to defend an unwelcome approach;
• reacting to an approach once made;
• dealing with due diligence requests from a bidder;
• how the formal sale process runs;
• whether an offer should be recommended to shareholders;
• how to deal with future management incentive arrangements; and
• completing the takeover.

Types of P2P transaction

Generally speaking, there are two types of P2P: those that are primarily instigated by or will closely involve the existing management team from the outset, so called “MBO P2Ps”; and those that are proposed by PE sponsors as pure financial investors where the management team which will operate the business under new ownership will likely comprise a mix of existing and new management, so called “investor-led P2Ps”.

This distinction can prove quite important, as it affects how the Takeover Code applies and also has important implications for the board of the target plc and what conflicts of interest may arise. However, it should be appreciated that this is not a precise distinction and the facts and circumstances will determine how the rules and laws apply.

How P2Ps arise

Public listed companies are always for sale, that’s part and parcel of being publicly listed. Normally of course, investors are only buying small stakes or gaining exposure to the share price using derivatives or other mechanisms. However, activists or investors with more ambitious plans may also be investing as a precursor to a bid.

Investment banks are constantly assessing whether listed companies might be takeover targets. This might be with a view to positioning to help advise on defending a takeover (in addition to other normal corporate finance advisory services) or pitching the listed company as an attractive takeover target. Meanwhile, strategic competitors or PE sponsors might be carrying out their own independent research into the listed company.

No company (other than the really enormous listed companies) are out of reach of PE sponsors and it is not possible to summarise the characteristics of a company attractive to PE sponsors save that they will be attracted to companies which may be undervalued by the public markets.

Initiating an MBO P2P

Unlike in some jurisdictions, it is generally not possible for existing management (especially those who are directors of the listed company) to use confidential information belonging to the company to formulate and develop an MBO proposal with a PE sponsor without express authority and consent from the company (i.e. the non-involved directors) to do so. There are two basic reasons for this:

• employment terms of executive service contracts will customarily provide that the executive should devote full time and attention to their employer’s business (which does not leave room for working on an MBO); and
• as directors, the executives have fiduciary and other duties and responsibilities which are owed to the company which include the duty to promote the success of the company and avoid conflicts of interest (unless the conflict has been authorised). A director who is considering an MBO P2P, has an obvious and direct conflict of interest as someone who will personally be financially motivated as a buyer of the company from the shareholders who currently own the company (to which fiduciary duties are owed).

For this reason, existing management teams need the consent and authority of the company to work on a possible MBO P2P. When that consent is given, it is customary and advisable to set prescriptive guidelines so that the company is aware of all meaningful steps which are taken and, in particular, to stipulate that no confidential information is shared with a PE sponsor or financing banks without a non-disclosure agreement being signed.

Initiating an investor-led P2P

Investor-led P2Ps tend to be the larger P2Ps and are customarily carried out by major PE sponsors, which are highly sophisticated investors. The potential opportunity may have been pitched to them by an investment bank or generated internally. The PE sponsor might have approached the CEO of the listed company or vice versa. The origination of it does not really matter to the regulation of the transaction unless the PE sponsor decides that it wants to work closely with the existing management from the outset, in which event the Code rules for MBO P2Ps will largely apply.

Pre-approach defence

Well run and advised listed companies are highly attuned to their shareholder base. They employ financial PR consultants, proxy advisers and other experts to enable to them to have a constant dialogue with their shareholders, prospective investors and the analysts, market research or and other organisations and the media.

Companies should consider instituting a regular programme of sending out notices under s.793 of the Companies Act to shareholders. These reveal who the ultimate beneficial holders are, who have interests and who may be acting in concert with one another in contemplation of an offer. It is better to have such a system in place rather than try to establish one only after there have been multiple unusual trades in the company’s shares.

There are other steps companies can take before a surprise takeover approach which they often cannot easily take after a takeover approach. By way of example:

• it may be advisable to amend non-executive appointment terms to provide for enhanced remuneration if a takeover offer arises. After all, the non-executive directors might suddenly find they are almost full time during a takeover (especially an MBO P2P where they lose input from the executives); or
• there may be changes that could legitimately be made to executive director service contracts and share incentive schemes. We have seen situations where the option scheme does not properly operate after a takeover, e.g. putting significant discretion into the hands of the Remco which may feel it cannot exercise that discretion in the face of an unwelcome offer.

Under the Code, these types of changes cannot easily be made if the listed company has been approached about a possible offer or if there are reasonable grounds to consider a bona-fide offer might be imminent. However, subject to normal corporate governance considerations, they can be made in normal circumstances.

It can also be useful to review of the D&O insurance policy and ensure that run-off cover will be possible, so that directors get protection for historic events after they leave the company.

Reacting to an approach

The first 24 hours after an unsolicited approach

Some companies will develop a full defence manual but over the years we have found that these gather dust on shelves and get out of date. In our experience it is more impactful to have a short fire drill of key dos and don’ts for the first 24 hours and contact details of key officers and advisers. The most important things to know are:

• when approached by a potential bidder, the listed company has the obligation to monitor its share price and news media and to release a possible offer announcement immediately upon a leak, unless the Panel agrees otherwise or unless it is unequivocally rejected (in which event announcement obligations in case of a leak revert to the potential bidder);
• an approach should be made to the chair of board but could be made to another director or possibly a retained financial adviser. The board should normally be notified promptly and a process established for considering the approach and whether to reject it outright (i.e. if it is manifestly unattractive) or enter into discussions;
• generally, boards of target companies will try their best not to have a leak since it can unsettle the business and encourage speculation in the company’s shares. Most PE sponsors will also not want an early leak, as that will result in a 28 day deadline for the bidder to: announce a fully financed offer; obtain an extension of time to do so; or make a no intention to bid statement (whereupon it will be restricted from bidding for 6 months) – the so called “put up or shut up” rule or “PUSU”; and
• sometimes a listed company will put out an announcement disclosing the approach, say it undervalues the company and that therefore the company is refusing to enter talks and give due diligence access. This way, the board can impose a 28 day PUSU knowing that this will likely mean that the PE sponsor will be timed out and will have to walk away. It is a confident move as the shareholders will often be aware of the potential value of cash offer which is not being made available to them and may pressure the board to relent.

Entering talks

This is a very significant step and is generally undertaken only after the target has decided that the indicative offer price is recommendable and the PE sponsor is a credible counter-party which can execute the transaction.

There is therefore often a fairly formal exchange of letters which leads up to the decision to engage. The target will often reject higher and higher approaches on the basis that the indicative offer is materially, significantly or fundamentally undervaluing the company and see how high it can push the PE sponsor. An understandable concern from the perspective of the target board is that the price may only go down rather than up in due diligence and giving access to due diligence heightens leak risk.

Before entering into the formal talks and giving any non-public information in due diligence on the basis of an indicative offer, a well-advised target will also generally insist that the PE sponsor enters into a non-disclosure agreement with a standstill restricting the prospective bidder from buying shares, making a hostile bid or contacting target shareholders.

These NDA’s can be heavily negotiated but ultimately most PE sponsors will agree a standstill because in reality most PE sponsors will not go hostile anyway. A point to note is that these types of restrictions can only be imposed upon the first potential bidder which makes an approach. If after the first NDA is signed, a second potential bidder makes an approach, the company cannot force the same terms on the second bidder (which has the right to the same information see below).

Due diligence

Public listed companies are required to disclose very significant levels of information in order that the market can price the shares. Also, the Code requires a target company to give equal access to other potential bidders (even if they are competitors).

Consequently, a listed company will often insist that the due diligence request is limited only to those matters which are essential to validate the valuation and transaction assumptions. Sometimes, a target board may agree to extensive due diligence if the PE sponsor insists that this is required before it will announce its offer which is highly attractive to target shareholders.

The formal sale process

A listed company can decide to put itself up for sale. An announcement is released stating that it has done so and an investment bank will then customarily run a private auction process to select the preferred bidder. Any participants in the formal process can be required to sign NDA’s with a standstill and the target can, as an exception to the normal prohibition, agree to pay the preferred bidder a break fee if its bid is not successful.

Any potential bidder which does not participate in the formal process cannot be denied the same information but cannot get a break fee. The offer by the preferred bidder which announces the offer after the formal sale process has concluded carries the normal risk that an interloper will make a higher offer and win but it can at least be compensated by being paid the break fee.

Some companies will make strategic review announcements which do not qualify as formal sale processes. This can often lead to the same outcome but break fees cannot be offered.

Independent financial adviser

Under the Code, a target company must retain an independent adviser to provide advice on whether the financial terms offered by the bidder are fair and reasonable. That advice must be disclosed to the target shareholders in the offer documentation. In addition, if the transaction is an MBO P2P, the financial adviser must also give an opinion that the management incentive terms are market standard.

Where PE sponsors are involved it can often be difficult for the target company’s usual financial adviser to satisfy the Panel that they are independent. This is because many PE sponsors will have significant commercial relationships with the leading investment banks and the Panel’s independence rules are strict. In view of this it is not uncommon to find that an independent boutique financial adviser is brought in alongside a normal financial adviser to give the independent opinion.

A target financial adviser will customarily be rewarded on a success fee basis, i.e. assuming that the P2P succeeds. This has attracted some criticism in the past because it has been alleged that the financial adviser has a conflict of interest, since it is effectively being paid to give a fairness opinion when payment for that opinion depends upon the transaction which it is judging to be fair succeeds. Conversely, the Code does not allow a fee to be contingent upon an unwelcome takeover offer failing, the logic being that the financial adviser (together with a target board) may be incentivised to defeat an offer which would be beneficial to shareholders. Given that the success or failure of a takeover offer ultimately depends upon whether shareholders accept the offer, not what the board and the financial adviser say they should do, it is arguable that this does not make sense. However, the system seems to work and of course financial advisers are motivated to give objective and good advice as otherwise they would not get hired again. This does however underscore the importance of choosing a good financial adviser.

Whether to recommend an offer

Historically, this decision was almost exclusively a financial and economic question, i.e. does the offer fairly value the company having regard to its prospects such that the board can recommend it to shareholders for acceptance. The financial adviser would assist the board in reaching a view using a number of different valuation models.

However, the Companies Act 2006 introduced a new definition concerning directors’ duties which suggests that it is not just about money in the pocket of shareholders. Specifically, section 172 references the need to act in good faith to “promote the success of the company for the benefit of its members as a whole” but (emphasis added) having regard to: long term consequences of decisions; interests of employees; relationships with suppliers and customers; impact of operations on community and environment; maintenance of high standards of business conduct; and the need to act fairly between members.

Moreover, the current focus on ESG and the purpose of the company has caused boards to think more deeply about the social contract involved in managing a substantial business which has other stakeholders, in addition to shareholders (some of whom may have already sold out in the market to merger arbitrage funds speculating on the outcome of the offer).

To assist boards, the Code now requires the bidder to be more explicit about its intentions for how the business and operations will be managed after the takeover. These intentions statements are binding for 12 months (save in exceptional circumstances). The Code also provides a mechanism for binding undertakings to be given which can last for longer and be more explicit.

In other words, boards have a choice where they are unsure about whether to recommend an offer which looks attractive from a financial point of view but which in their view is really quite unattractive for non-financial reasons. They can:

• decline to recommend the offer but not actively oppose it and explain the reasons for the equivocal position being taken. That effectively puts the decision in the hands of shareholders. One can imagine a board might be criticised for taking such a position (since it is expecting a lot for shareholders to ignore their own interests for the greater good); and the Panel would expect to be consulted on the form of wording;
• recommend the offer notwithstanding some misgivings on the basis that the financial case is so overwhelming for shareholders that, having regard to how section 172 (1) is worded, it is indefensible not to recommend it to shareholders;
• simply reject a financially attractive offer on the basis that in the proper exercise of their fiduciary duties they do not consider that it will best promote the success of the company and inform the PE sponsor that the Code allows them to make a hostile offer direct to shareholders and prevents the board from frustrating that offer being made. However, it should be appreciated that such a course of action could be very controversial and its lawfulness should be very carefully examined having regard to all the facts and circumstances at the relevant time. In particular, the PE sponsor may be unable to make an offer which is not recommended by the target board (which the investment documents in some PE funds will provide) such that this means no hostile offer could be made unilaterally;
• closely examine the future intentions of the PE sponsor and maybe work with the sponsor to adjust those intentions so that the board is comfortable recommending the offer; and
• go further and make the recommendation conditional upon binding post-offer undertakings being given which will impact how the PE sponsor will in future be able to operate the business. An example of this arose in Advent’s £4bn bid for Cobham in 2019, where post-offer undertakings (for a 5-year duration) were given to: maintain headquarters in the UK for certain business units (including mission services, aviation services and communications); maintain R&D spend of each of the key business units based on a fixed percentage of aggregate sales of each business unit; and maintain the “Cobham” name in the registered name of each entity.

It should be noted with regard to the above that PE sponsors have been proven to be effective custodians and business owners. Most successful PE sponsors will have a strong track record of investing in and growing the businesses they own which will often compare favourably with the track record of public listed companies. Also, large private businesses are also now subject to considerable governance and the directors will have the same fiduciary duties when owned by the PE sponsor. As such we would regard the dilemma referenced above to arise on rare occasions indeed and certainly not simply because the bidder is a PE sponsor.

There may also be other reasons why a board would not recommend an offer, e.g. if they consider that the offer carries significant execution risk and that it is not in the best interests of the company to live with that uncertainty for an extended period of time. There have been occasions where a target board has declined to take forward an opportunity to interact with a potential bidder offering a higher offer because it has come so late in the timetable for an existing offer which now carries little or no execution risk.

In most cases the decision on whether to recommend is fairly straightforward, but where it is not it is useful to have strong independent thinkers on the board and experienced advisers.

Management incentive arrangements

Code implications

In an MBO P2P, the PE sponsor will normally pre-agree the management incentive arrangements. In this event:

• the details of the arrangements must be disclosed in the offer documentation;
• if existing management own shares and/or options in the target company (which they often do) and they are then offered ongoing equity incentives in the Bidco which are not being made available to all shareholders, that is a so called, “special deal”;
• ordinarily, one shareholder cannot receive a special deal unless all shareholders are offered the same special deal;
• however, the Code allows such a special deal to be offered to management provided the target’s financial adviser gives an opinion that the terms are market standard and provided the terms are subject to a confirmatory vote of approval by the target shareholders; and
• if the special deal is offered to any non-management shareholder, then it cannot normally be offered (or sanctioned by a confirmatory vote of approval) save in certain exceptional circumstances where the shareholder qualifies as a so called, “joint offeror”.

Where target management are provided such a special deal, there are normally other consequences under the Code and company law:

• the management directors will have a conflict of interest and a special committee of the unaffected directors will normally be formed to consider the offer; and
• if the management directors contribute to the PE Sponsor’s business plan, that plan may be discloseable to the special committee.

Increasingly on P2P transactions, the management incentive scheme discussions are deferred until after the transaction has closed. From the perspective of the management team, this deferral can affect their negotiating position with regard to the terms of the MIP.

Customary incentive arrangements

Management incentive arrangements in a PE structure are primarily designed to create alignment between the interests of management and the PE sponsor in delivering the business plan and ultimately an exit. Fundamentally, the economics of the PE management incentive plan (or MIP) in a P2P are unlikely to differ from a conventional MBO.

The key components of a MIP are:

• Sweet equity: Sweet equity is a class of ordinary shares reserved for management and senior employees. The ordinary shares sit at the bottom of the capital structure behind the third party debt and the preferred securities. The ordinary shares will only participate in value once all of the third party debt and preferred securities have been repaid (plus all accrued interest). This effectively creates a performance hurdle and depresses the value of the ordinary shares at acquisition but allows the holder to benefit disproportionately from the upside once the performance conditions have been met.
• Institutional strip: The institutional strip (sometimes referred to as the “co-invest”) is a mixture of ordinary shares and preferred securities (which may be preference shares or shareholder loan notes) that accrue interest at a fixed amount per annum. The ratio of ordinary shares to preferred securities will usually be in the region of 1:99 or 2:98 (or similar). Management will hold their institutional strip securities in the same proportions and on the same terms as the investor.

Most senior executives will own shares and have unexercised share options over shares in the target company. As such they will receive cash upon the takeover completing. Management will generally be asked to rollover or reinvest a proportion of the consideration they receive in the P2P into the sweet equity and institutional strip. Management who are not receiving material proceeds in the offer may be offered a limited recourse loan by the company to help them to fund their investment.

The purpose of the sweet equity in particular is to incentivise management to deliver growth and to remain with the business through to an exit. The sweet equity is therefore issued subject to certain terms and conditions.

There will, for example, be restrictions on the ability of management to transfer their shares without the consent of the PE sponsor. There will also be “leaver provisions” which apply where a manager ceases to be employed by the company prior to an exit. In those circumstances, the company will be entitled to require a manager to hand back their sweet equity and, in many cases, their institutional strip. The price the manager receives for their sweet equity will depend on the circumstances in which they have become a “leaver”. If a manager has resigned or been dismissed for cause, they will typically be classed as a “bad leaver” and will receive the lower of acquisition cost (i.e. the amount they originally paid for their sweet equity) and market value. If a manager leaves as a “good leaver” (for example, if they retire or leave as a result of ill health or death), they will typically receive market value for some or all of their sweet equity. A leaver will generally receive market value for their institutional strip (on the basis that this represents a real investment by the manager in the company) but in certain circumstance they may forfeit that value, for example, if they have been dismissed for cause or breached their restrictive covenants.

The “leaver provisions” will be amongst the most heavily negotiated provisions of the MIP.

The shares held by management will also be subject to customary drag along and tag along rights.

As noted above, where the MIP is agreed before the P2P, the Rule 3 adviser to the target company must state publicly that in its opinion the MIP arrangements are fair and reasonable and these arrangements will therefore be compared against MIP’s in place in comparable public and private transactions. Where the MIP is agreed before the P2P, the managers may be expected by the PE sponsor to warrant the P2P business plan.

On an exit, management will sell their ordinary shares and preferred securities alongside the PE sponsor. Management will be expected to give warranties to the buyer about the business and operations of the group. The PE sponsor will not give business warranties.

MIPs are designed to be tax efficient for management such that the gains on their ordinary shares will be subject to capital gains tax and the gains on their preferred securities will be subject to tax at the dividend rate.

Completing the offer

Our first article on P2P transactions summarised the mechanics by which P2P transactions are customarily executed. From the perspective of the target directors, the following points are noteworthy:

• most P2P transactions are completed using a scheme of arrangement entered into by the target company and its shareholders. Target directors have a particular responsibility towards the company and its shareholders to ensure that all information relevant to that decision and as required by the law and regulation (especially. the Code) is contained in that documentation;
• up until the scheme has been sanctioned by the court and the court order has been filed, the directors can delay or withdraw the scheme at any stage if in the exercise of their fiduciary duties they think this is in the best interests of shareholders, i.e. because a higher potential offer has arisen; and
• a well advised bidder may however have insisted on the key milestones happening by target long stop dates (e.g. post of scheme circular, shareholder meeting being held and court sanction hearing). If one of these dates is missed (i.e. whilst the target board explores a potential competing bid), the PE sponsor may walk away and the certain offer would be lost.

Conclusions

P2P transactions offer target shareholders a cash exit. They raise particular issues where they involve an MBO. However, these issues are well understood and do not present insurmountable hurdles. Perhaps the most meaningful issue for the target board is ensuring that the board does not recommend an offer which undervalues the company. This issue is particularly challenging in an MBO where the non-executives lose the input of the executive management team whose allegiances switch to the PE sponsor since future incentive arrangements depend upon the P2P succeeding. In this event, the non-executive directors will have a particular responsibility as will the independent financial adviser.