Excerpt from Practical Guidance

Using The M&A Slowdown To Prepare A Portfolio Co. For Sale

By Michael Gilligan and Caitlin Cornell
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Law360 (May 26, 2020, 6:14 PM EDT) --
Michael Gilligan
Michael Gilligan
Caitlin Cornell
Caitlin Cornell
The process of preparing a portfolio company for sale by a financial sponsor is time consuming and involves significant preparation and coordination from multiple internal and external resources and advisers. A failure to fully prepare for a sale process can delay the process and otherwise adversely impact its results.

Given that deal activity has dwindled as a result of the COVID-19 crisis, dealmakers and their advisers may want to consider using this period to prepare for sale processes to be undertaken when the deal market eventually picks back up.

This article offers guidance on the timing and scheduling of steps in preparation for sale, including specific considerations in light of COVID-19, and advice regarding coordination of the sale process once it begins.

To maximize the return on a sponsor's investment, it is critical that the sponsor be in a position to sign a definitive sale agreement when the competitive tension among potential acquirers is at a peak, without delays arising from unanswered due diligence questions, unfinished negotiations with management or other administrative loose ends.

Always Be Thinking About the Exit

The fact that every portfolio company will eventually need to be marketed, investigated by bidders and sold should inform every material decision taken by the sponsor from the time of the acquisition forward, including:

  • Financing decisions, such as flexibility to roll to a new sponsor/obligation to provide parent/sponsor guarantees, etc.;

  • Structuring decisions, including having a clear view of what will be sold and the consequences to both the sponsor, as seller, and the acquirer as a result of the chosen structure; and

  • Commercial decisions, including whether that bolt-on acquisition, growth capital investment or joint venture is really worth the costs and restrictive covenants it may impose on the business.

Sponsors should attempt to avoid decisions that, while potentially beneficial in the short term, may materially complicate a future sale process and distract a potential buyer's focus from the company's core businesses. In short, always be thinking about the exit.

Advance Action Items

All members of the team that will ultimately be responsible for managing key aspects of a sale process should be identified early, and they should be introduced to each other.

The external teams that are expected to be involved in the sale process — including financial advisers, lawyers, accounting and tax advisers, with others as needed — should be identified and stay relatively familiar with the company's business and operations.

Below are action items that should form the initial part of the preparation for a sale process. All these items will eventually be requested by bidders or their advisers in the due diligence process.

If the current slowdown in the deal market allows, all of the following steps can be started now, well in advance of any sale process, so as to limit the lead time before any sale process can start and allowing sponsors to take advantage of limited windows during which sale processes may be successful.

Many of these items are, in fact, simply matters of good management practice. The sponsor, with assistance from management, should:

  • Prepare annual budgets and projections, including a wide variety of sensitivities to account for the uncertainties around COVID-19;

  • Maintain contract databases, including summaries of material contracts and charts highlighting which contracts contain change of control provisions, confidentiality provisions, renewal/termination rights, most favored nation provisions and other provisions that companies should be monitoring compliance in the ordinary course;

  • If applicable to the business, prepare form contracts that include the company's position on key terms, e.g., indemnification obligations;

  • Maintain an updated capitalization table with detailed management incentive equity and vesting information;

  • Maintain readily accessible records regarding employment and separation documents, and know who will be owed a payment, and how much, subject to the ultimate purchase price) in connection a transaction;

  • Maintain a litigation log along with key dates and copies of all applicable documents;

  • Track outside legal spending and responsibilities of each external law firm;

  • Maintain copies of key transaction documents of any follow-on investments — including a copy of the data room and diligence memorandum prepared in connection with such acquisition — or divestitures, and consider preparing summaries of the key transaction terms highlighting any ongoing obligations or contingent liabilities;

  • Maintain title documents for owned real properties and lease documents for leased spaces;

  • Maintain reasonably current environmental assessments of material properties/sites;

  • Consider maintaining a relatively current data room or other structured repository of company-specific documents (this can be also useful for financings, refinancings, etc.); and

  • Make sure to obtain an electronic copy of the data room used in the initial acquisition process.

There is also utility in conducting a relatively complete self-diligence review to identify potential roadblocks, so a plan can be implemented to address each of these self-identified issues when the sale process is commenced.

The COVID-19 era is unprecedented and businesses may be operating outside the ordinary course and as a result, management should be maintaining a log of any material actions or inactions that are atypical for their business, as it may be necessary to disclose these items to a potential buyer under the terms of the sale agreement.

When deal activity resumes, sponsors should be wary of closing risk due to an additional wave of COVID-19 cases or lingering effects of the pandemic and resulting market volatility. These risks should be appropriately addressed under the terms of the sale agreement.

The Sale Process

Once it has been determined that the appropriate time to exit has come and the sale process begins in earnest, the following steps should be taken.

Select a Financial Adviser

When considering strategic alternatives — mainly, a sale — the first step is typically to select the financial adviser. In selecting a financial adviser, sponsors should not fail to consider:

  • The benefits of sector expertise vs. process expertise;
  • Potential conflicts of interest; and
  • The ability of the adviser to assist in connection with financing issues.

Understanding the Universe and Concerns Related to the Identity of Potential Acquirers

The financial adviser should be able to provide insight into the universe of potential acquirers and, from a preparation perspective, it is important to understand whether potential buyers are likely to be strategic bidders, sponsors or a combination of both.

Due to antitrust and other concerns, sponsors should be cautious regarding sharing certain detailed information with strategic bidders or with sponsors that own portfolio companies in competitive industries.

There may be a need for a clean team process and different data rooms for different bidders, and, therefore, the relevant members of the deal, including management and M&A/antitrust counsel, should begin reviewing, flagging and redacting key documents as may be necessary well in advance of the bidders' intensive due diligence review to ensure that addressing these competitive concerns will not delay the process.

The legal team should also work with the financial advisers to examine the list of potential buyers from a regulatory perspective (e.g., which bidders may create antitrust or Committee on Foreign Investment in the United States concerns).

Preparing the Teaser/Confidential Information Memorandum

The financial advisers are largely responsible for the preparation of the teaser/confidential information memorandum, or CIM, but these documents require significant data to be provided by management, including commercial/market assessments and detailed and thoughtful projections.

If this information is not readily available, the preparation of the CIM will take significantly more time. It is important that lawyers review a relatively early draft of the CIM to ensure that it does not contain statements that are problematic from the perspective of antitrust or securities regulation.

Nondisclosure Agreement Process

As a threshold matter, the sellers must decide whether the bankers or lawyers, internal or external, will run the negotiation process.

In most cases, there is limited benefit to having an overly aggressive nondisclosure agreement and, if it is too aggressive, many bidders (especially acquisitive strategic bidders and large institutional buyout shops) may simply substitute their own form of buy-side NDA in lieu of editing the draft they initially receive.

If there are more than a handful of NDAs being negotiated, the primary consideration should be getting through the process relatively quickly and painlessly while bringing as many bidders into the fold as possible.

It is generally helpful to have the lawyers prepare an aggressive buy-side markup of the form NDA and discuss it with the sponsor deal team and key members of management to anticipate potential issues and have clear views on what points are acceptable and what points aren't acceptable.

As soon as a definitive agreement is signed with the winning bidder, the company's legal team should instruct the losing bidders to return or destroy all of the confidential information in their possession that they received access to as part of the due diligence process.

Data Room

Virtually all sale processes involve a virtual data room of due diligence materials. As mentioned above, consider maintaining a periodically updated current data room, using the initial acquisition's data room as a base.

Again, this is a step that could be started, and, possibly, largely completed, during the current lull in the deal market. In addition to the typical buckets of information provided in a data room, below are other various items to consider when preparing the data room that can further streamline the diligence process:

  • Prior to opening the data room, aim to have the draft auction purchase agreement, draft disclosure schedules and other key ancillary agreements in a shareable form.

  • Before the sale process starts, determine whether new environmental Phase I assessments are needed and, if so, have a consultant engaged to prepare them so they are ready when the data room opens.

  • Consider whether there are any issues with the company's title to any of its owned real properties that need to be cleaned up.

  • Consider obtaining commercial/market diligence reports ahead of time.

  • Consider engaging an accounting firm to prepare a sell-side quality of earnings report.

  • Consider whether multiple data rooms, or restricted access clean team folders within the same data room, need to be maintained for different acquirers (i.e., considering any competitive or regulatory sensitivities).

Every document proposed to be posted in the data room should be reviewed from a legal and commercial standpoint before being made available to bidders, as no one should be surprised by what documents are in the data room.

Sellers should also consider providing bidders with an executive summary of the materials in the data room as well (e.g., an entity-by-entity overview). The goal should be to make review of the data room as quick and easy as possible.

Representations and Warranties Insurance

In today's market, it is common for sellers to insist that the buyer obtain a representations and warranties insurance policy, and to rely on that insurance policy as a primary source of recovery for breaches of representations and warranties, rather than offering up a robust traditional indemnification/escrow package.

Although it would be rare that a deal would not be insurable, obtaining representation and warranty insurance policy quotes will be helpful to understand what terms insurers will offer and if there are material exclusions.

If there would be material exclusions, then the sellers can consider whether to get ahead of the issue and provide for a limited special indemnity in respect of such excluded items. Sellers should also obtain and provide such quotations so bidders can prepare their markups on the auction draft based on the quotations.

Management

Key members of the management team should be aware that the sale process is going to be a significant distraction from running the business and should have a plan for managing their time and their duties accordingly. At the highest level, management should understand that, in connection with a sale to another sponsor, they will likely be requested to roll over a significant amount of equity, although they will likely receive additional equity or bonus opportunities from the new sponsor as well.

If management needs to be additionally incentivized to get the deal done quickly and conscientiously, arrangements to otherwise compensate management (i.e., transaction bonuses) can be considered, with the understanding that these payments will be borne by the selling sponsor.

Management should be encouraged to hire separate counsel to negotiate new arrangements with a financial buyer — the seller's law firm should not be negotiating on behalf of management.

Resolution of these management-related issues must also be considered as part of the overall timetable to get a transaction signed, and there shouldn't be any remaining issues to solve between signing and closing — otherwise, management will possess hold-up value.

Conclusion

To maximize the return on a sponsor's investment, it is critical that the sponsor be in a position to sign a definitive sale agreement when the competitive tension among potential acquirers is at a peak, without delays arising from unanswered due diligence questions, unfinished negotiations with management or other administrative loose ends.

As a result, a well-designed and implemented sale process is critical and advanced preparation is vital to ensuring a streamlined sale process. The current lull in the deal market provides dealmakers and their advisers an opportunity to get a head start on this process of maximizing the value of the sponsor's investment.



Michael Gilligan is a partner and Caitlin Cornell is an associate at Schulte Roth & Zabel LLP.

This article is excerpted from Lexis Practice Advisor®, a comprehensive practical guidance resource that includes practice notes, checklists, and model annotated forms drafted by experienced attorneys to help lawyers effectively and efficiently complete their daily tasks. For more information on Lexis Practice Advisor or to sign up for a free trial, please click here. Lexis is a registered trademark of RELX Group, used under license.

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The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

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