This article was written by Heath Lewis and Mark Joss.
As we all know, a defining feature of private equity investment is alignment between the sponsor's strategic objectives and the managers of the business.
This is usually achieved through financial incentives.
For public to private deals, ensuring that equity-holding managers will be appropriately motivated and aligned post-transaction gives rise to particular issues in connection with the principles of fairness and equality of treatment that underpin takeover bids and schemes of arrangement.
It is one of the reasons why private equity will, more often than not, pursue public to private deals via a scheme of arrangement – there is greater flexibility in the scheme route.
However, a scheme of arrangement is not a panacea for the sponsor seeking deal certainty. In fact, a decision to pursue a scheme of arrangement will usually lead to a trade-off decision - deal certainty versus management lock-in certainty.
Ultimately, how sponsors face into the challenge of equitizing and locking in management of listed companies will very much depend on the circumstances at hand, including the composition of the target share register, the prospect of counter-bidders, the extent of equity held by management and the "key person risk" represented by existing management. But the bottom line is – there's only the best answer in the circumstances, and not a complete, risk-free answer.
The trade-off is well demonstrated by the recent scheme of arrangement undertaken by Zenith Energy. Pacific Equity Partners was the initial bidder, offering cash to target shareholders generally plus an equity roll-over alternative to certain members of Zenith's management team, including its founders.
The exclusivity of the equity roll-over opportunity afforded to specified members of management saw ~23% of the target's equity quarantined in a separate class for voting purposes on the basis that, in accordance with the classic class formation principle, the roll-over managers' rights under the scheme were too dissimilar to the shareholder group at large to sensibly permit them "to consult together with a view to their common interest". As a result of the dual class formation (which saw the main class reduced to a pool of ~77% of all Zenith shares) and usual voter turn-out for Australian schemes (in the range of 60% to 80% of all shares on issue), the threshold for a blocking stake was set at a significantly reduced 11.5% to 15.5%.
And so it transpired that this structural vulnerability was exposed. Firstly by a consortium of OPTrust and Infrastructure Capital Group, who cleverly levered themselves into the bidding consortium with PEP after acquiring a 17.5% stake on-market. And then by an existing shareholder of Zenith Energy, WestOz Funds Management, which increased its stake to around 12% (following the main voting class shrinking even further to ~60% of all Zenith shares when OPTrust / ICG joined the management roll-over class) and subsequently benefitted from a price bump.
The Zenith scheme was ultimately approved on a timeline that, for all of the distractions, was not outrageously longer than originally envisaged by PEP and Zenith Energy. Nevertheless, it is a good example of the structural vulnerability that arises when management (or indeed any shareholders) are afforded an exclusive opportunity to participate in the bidder's equity into the future to the exclusion of shareholders generally.
A similar situation transpired in the 2016 scheme of arrangement pursued by Ausenco, albeit the structure involved "retained equity" rather than "roll-over equity", and the risk of a rejected scheme emanated from existing shareholders.
The Ausenco scheme was unusual in the sense that it excluded management equity holders and a substantial shareholder, collectively holding (together with the bidder Resource Capital Fund VI L.P.) around 40% of all Ausenco shares. The scheme itself only operated upon those shareholders who had not contractually committed to retain their equity in Ausenco – ie. the 60% balance of all Ausenco shares.
Although there was only a single class and a single scheme meeting (with the committed shareholders who would retain their equity not getting a say on the scheme proposal), similar to the Zenith Energy scheme, the threshold for a blocking stake was substantially reduced by the structure that was adopted. On voter turn-out of between 60% and 80%, shareholders holding between 9% and 12% could vote down the scheme.
On this occasion however, it was not an interloper or a potentially competing bidder that brought the structural risk into focus, but rather minority shareholder discontent with the proposal. Ultimately the scheme was approved, but by margins that no doubt left the parties to the transaction nervous in the lead up to the scheme meeting – 83% by value of shares voted (when 75% is required) and 54% by number of shareholders voting (when 50% is required).
Very recently, a similar dynamic played out when disgruntled shareholders were able to leverage a blocking stake into a materially higher offer ($3 versus $2.40) on BGH Capital's (ultimately successful) proposal to take Village Roadshow private.
So, what's the solution?
For sponsors intent on securing reassurance pre-scheme that management will remain engaged and equitized post-scheme, unfortunately there's no complete answer, and everything has a trade-off.
Locking in a management equity roll-over gives rise to the structural vulnerability explained through the examples discussed above – the transaction becomes vulnerable to an interloper or to minority shareholder veto.
There are two main alternatives that are usually considered (and not uncommonly implemented):
No management roll-over equity proposal
Under this approach, the extent of management participating in the equity of the business in the future is largely left to be dealt with post-transaction. The Pacific Energy scheme involving QIC as the financial sponsor is a recent example of this approach.
Both the sponsor and the management shareholders may derive comfort from preliminary discussions that do not result in any sort of commitment as to future equity arrangements.
However, from the sponsor's perspective, there is always a risk that management could "take the money and run", leaving the sponsor without part of the management team. How reliant the business is on key personnel will dictate how tolerable this approach may be. Compared to a management equity roll-over proposal, this approach will also cost more in acquisition funding as cash will be required for the acquisition of management's equity.
From management's perspective, taking at least some cash "off the table" is usually attractive. And often they will get some pre-scheme flavour for the parameters to be applied to the sponsor's post-transaction management equity arrangements. However, the impact of personal tax can be significant and influential, and depending on an individual's circumstances, the financial position and performance of the target and the value of the scheme proposal, often there is real value in avoiding the tax leakage of a process which sees the manager cashed out and then subsequently re-equitised.
Another alternative is to turn to private equity's old friend, "stub equity". The distinction between the management equity roll-over or retention proposals discussed above and an offer of stub equity is the universe of offerees of the bidder equity – a stub equity proposal sees all shareholders (and not just specified management shareholders) being offered the opportunity to retain equity (directly or indirectly) in the target business.
There's a long history of financial sponsors making use of stub equity in Australian schemes of arrangement, with the "stub" equity usually being an offer of shares in an Australian proprietary (non-public) company or a foreign incorporated company, in each case with a view to minimising the BidCo's compliance and regulatory burden post-transaction.
In order to manage the prospect of every target shareholder electing for stub equity, limitations are always applied to the stub equity offer, including the maximum overall participation of target shareholders in the equity of BidCo. In addition, the terms and conditions of the shareholders agreement which governs the operation of and, importantly, the share capital structure of, BidCo post-transaction are usually sufficiently onerous and unattractive for most non-management shareholders to form the view that the cash alternative is preferred.
Recent ASIC guidance (see our recent article "To stub or not to stub? ASIC hands down its view") has slightly added to the burden for stub equity bidders by requiring offers to be made by public companies (rather than Australian proprietary companies), and preventing the conversion of a BidCo to a proprietary company without dismantling the custodian arrangements which are commonly used to make life easier.
Nevertheless, the self-evident downside for a sponsor of using stub equity rather than a targeted management roll-over structure is that the sponsor could end up with scores of outside shareholders holding equity in the post-transaction vehicle. A stub equity scheme also adds complexity and cost to the transaction – even more now following ASIC's updated guidance.
Ultimately, how sponsors face into the challenge of equitizing management will very much depend on the circumstances at hand. The composition of the target share register, the prospect of counter-bidders, the extent of equity held by management, the relative cash value being offered, the "key person risk" represented by existing management and a variety of other considerations will influence how best to deal with the issue of management equity. But the bottom line is – there's only the best answer in the circumstances, and not a complete, risk-free answer.
[KWM acted for the OPTrust / ICG consortium on the Zenith Energy scheme of arrangement, and for Resource Capital Fund VI L.P. on the Ausenco scheme of arrangement.]