Enter any store or restaurant, and you might be greeted with signs specifying acceptable forms of payment — cash, credit cards, checks and so on. But private equity funds don’t have the same luxury: Often, when they sell portfolio companies to public companies, they may be required to accept stock as payment. In those cases, PE funds want to turn around and sell those securities “as soon as humanly possible,” said Ramey Layne, a Mergers & Acquisitions and Capital Markets partner at V&E.
“Private equity funds typically have a total life of 10 years, with a plan to be in and out of each investment within five years,” Layne explained. Because of funds’ limited duration, he said, it’s inevitably in their interest to sell off stock for cash.
Selling shares in a public company can come with a host of complications. Yet, for many PE funds, the hassle is worth it — in recent years, funds have found that selling off their portfolio companies to public companies has offered better chances for successful exits than relying strictly on the volatile IPO market or selling privately for cash. Examples of the trend include sales of upstream firms in the Permian Basin in Texas and New Mexico, said Shamus Crosby, a Mergers & Acquisitions and Capital Markets partner at V&E. “In late 2016 and the first half of 2017, PE funds abandoned a series of potential Permian upstream IPOs to pursue sales to public companies with large stock components,” Crosby said. “For most of those sellers, the sooner they were able to exit the stock, the better.”
Here’s a look at six things any PE fund must consider when accepting and selling stock from a public company.
1. Lock-up agreements require delays in public or private sales.
Lock-up agreements, which prohibit the sales of stock for a set amount of time, are a fairly typical feature of equity deals between PE funds and public companies. “Lock-up agreements are common in the M&A context when the seller is taking a particularly large stock position in the issuer or the issuer is conducting an equity financing to fund the cash portion of the purchase price,” explained Crosby. A lock-up may only prohibit public sales, and could either be limited to actual sales or be broad enough to prohibit derivative transactions as well. The devil may be in the details of the specific lock-up, both in terms of what is prohibited and when it is prohibited, so it’s important to pay close attention to the lock-up agreement in negotiating the transaction.
2. Registration for public resale may require delay.
A lock-up may only prohibit public sales, and could either be limited to actual sales or be broad enough to prohibit derivative transactions as well. The devil may be in the details.
Even without a contractual lock-up, selling stock publicly quickly after a deal is often not possible. That’s because public sales require registration with the Securities and Exchange Commission. The registration process can take several months to complete, requires participation by the public company and the public company may be unwilling to spend the time and effort to complete the registration process. Even when the company is a willing issuer, it may be required to delay beginning the registration process until necessary financial statements are available. Beyond registration, issuers are also often reluctant to participate in the road shows necessary to garner interest in the stock or even to participate in diligence exercises certain underwriters will require.
Moreover, funds will find many investment banks have internal policies and procedures that limit their ability to execute block trades of the shares without conducting the same diligence that the issuer desires to avoid in connection with underwritten deals. Layne said, “the banks, even if they’re only acting as brokers, technically are exposed to liability under the securities laws.” These policies and procedures effectively require the same or greater due diligence typical of underwritten offerings. In practice, adhering to bank rules may result in stock sales being delayed six months or more after the deal. As a result, a PE fund may need to find smaller, more flexible brokers to handle registered block trades and other brokerage transactions.
For these reasons, private resales may be preferable … if not necessarily easy.
3. The rules change after six months.
After a private equity fund holds shares for six months, the fund may sell the shares publicly, as allowed by the SEC’s Rule 144. The rule offers a “safe harbor” to those participating in the sales, including any banks acting as brokers, protecting them from liability. However, Crosby explained that, even after six months, a PE fund’s status as an “affiliate” of the issuer may result in certain volume limitations on the shares that may be sold. “The resulting volume limitations will make it more difficult to exit the stock via Rule 144,” Crosby said. “This status as a potential affiliate should be considered when negotiating to require the issuer to cooperate with underwritten public offerings.”
4. Sometimes issuers are hostile to private placements, too.
Although a private resale provides an alternative to registering a public offering, issuers don’t always cooperate with those, either. “Sometimes we’ve even seen it where a private issuance is difficult because the issuer won’t share information with the prospective buyer, who may want to do more diligence than just looking through what’s already been publicly filed,” Layne said. But such incremental diligence, added Crosby, is more likely to be necessary when funds are unloading very significant blocks of common securities or certain structured preferred instruments. If that may be an issue on eventual resale, it’s important to avoid such a complication from the get-go, he said. Doing so means ensuring that the sale agreement between the PE fund and the issuer includes the right to provide confidential information to a prospective buyer. “If you don’t have that right, you’re kind of stuck if you can’t find anybody who’s willing to buy your stake without incremental diligence,” Layne said.
5. In-kind distributions provide only a partial solution.
A PE fund may also engage in in-kind distributions, transferring shares directly to the fund’s limited partners. Funds typically are only permitted to make in-kind distributions where the shares are “freely tradable,” meaning they can be sold without limitation. Some limited partners, for various reasons, don’t want to hold stock, so a fund would still have to sell its leftover shares and distribute the cash back to the limited partners who didn’t take securities. “You sort of whittle it down,” Layne explained. “If you hold securities in a company that is, let’s say, $100 million, you may be able to distribute two-thirds of that out to LPs who are willing to take freely tradable securities in kind. Then you only have to do an offering of $33 million for those who insist on only receiving cash.”
6. Derivatives offer another work-around.
Derivative transactions, such as forward sales, allow PE funds to enter into early contracts to sell their shares, meaning they can potentially lock in sale prices on their shares before the six-month holding period is complete. In accordance with internal bank procedures, such agreements are often struck after the PE fund has held the shares for about two months. “They may enter into a contract with the bank that says, ‘In another four months and a day — so one day after the six-month period for 144 — I will deliver shares at X price,’” Layne explained. “After the six-month period has lapsed, they close out the derivative by buying shares on the market and delivering them in that sales transaction. They then sell the shares that they’ve held for six months as allowed by Rule 144.” But Layne noted that such transactions must be structured very carefully to avoid running afoul of SEC rules or conflict with lock-up agreements. “There’s a right way to do it and there’s a wrong way to do it, ” he said.
Whether or not SEC rules would require the fund to publicly disclose the derivative may also factor into the attractiveness of such a transaction. Whether it’s through derivatives, relying on the SEC’s six-month rule or pushing ahead with SEC registrations, more and more private equity funds are intent on finding the right way to sell stock after making a deal with a public company. As they work through their options, it’s critical that they have experienced attorneys at their side.