Editor: How do you define private equity?
Hagan: I define private equity very broadly. Private equity can be both venture capital investments or providing financing for the buyout of a company or its recapitalization.
Editor: Please tell us about your practice. How has it evolved over the course of your career?
Hagan: My practice is a middle-market private equity practice focused primarily on leverage buyouts, build-ups and recapitalizations. I also do a small amount of venture capital transactions. I have been working on leveraged buyouts and build-ups for my entire career.
Editor: During the course of your career, how has the private equity marketplace changed?
Hagan: It has changed dramatically. First, there are a number of new players in the industry. 20 years ago, there were 50 or 60 major private equity funds in addition to an equal number of venture capital funds. Now there are literally thousands of private equity funds of all sizes and types. In addition, there are alternative investors such as hedge funds and business development companies that periodically will invest in private equity as well. As a result, this has caused the explosion of private equity transactions that we are seeing now. Many of the biggest private equity funds today like Bain Capital and the Carlyle Group were not doing multibillion dollar deals ten years ago. Thus, private equity investing can range from $1 million venture investments to multibillion dollar transactions. Private equity is now so large that many companies are now more often being sold by one private equity group to another.
Other factors have helped private equity grow as well. Sarbanes/Oxley has helped private equity funds because it makes it harder for smaller companies to go public owing to the cost of compliance and the rigors of regulation. In addition, the IPO market is much more difficult for businesses unless they are either high technology companies or energy companies. Many smaller companies simply do not want the risks of being public. A private equity buyout can sometimes also focus more on long-term growth where there is less pressure for having to demonstrate quarterly results.
Editor: How is the private equity practice positioned within your firm? What other legal disciplines come into play?
Hagan: Our firm's private equity practice has three main components: (1) working on behalf of hedge funds, business development companies or other specialty investors, (2) representing venture capital investors, and (3) representing buyout funds. To each of these groups we provide a wide range of services. In addition to the investment side, we are among the top law firms in the United States in fund formation work. We also do a lot of tax planning as well for private equity and hedge funds. One of the great things about doing leveraged buyouts is that you tend to involve many legal disciplines in different fields. In purchases of a public company you need securities lawyers, you might also need tax, real estate, environmental, employee benefits, intellectual property, antitrust or regulatory lawyers depending on the type of transaction. Editor: Do you follow the companies once the deal is done?
Hagan: Absolutely. This is one of the areas that differentiates Goodwin Procter from many other top private equity law firms which are frequently more transaction-focused. We like to provide advice to portfolio companies of private equity firms. A number of my clients are now public companies which have been clients since they were originally backed by a private equity fund.
Editor: Has there been a change in deal terms and deal structures?
Hagan: Deal terms have changed dramatically in a lot of ways. Until the late summer of 2007, the deals had become very pro-seller. The larger sellers could essentially sell themselves without having to put a lot on the line in terms of representations and warranties or future indemnities or escrows. The financial markets were also very liberal, particularly with bigger deals, in terms of giving private equity buyers very attractive financing terms, including limited restrictions which are often referred to as "covenant light." Many investment banks also offered "staple financing" to buyers on auctioned deals. However, the market has changed since the summer of 2007. The credit crunch has hit the larger-sized deals (over $1 billion) particularly hard. The larger deals have been more impacted by the credit crunch than the middle market deals because that is where the higher leverage and covenant-light terms were more prevalent. The long and short of it is that the financing market is reverting back to stricter, more customary terms as the markets are exercising more discipline.
Deal structures have also changed as many private equity buyers now take advantage of limited liability company or partnership structures for tax reasons.
Editor: In your experience do private equity firms use a platform technique - that is, buy one company in an industry and then layer on other companies in the same industry?
Hagan: Many firms employ the strategy of buying one strong company (called a "platform") and then building it out with acquisitions. For these platform transactions, private equity firms often bring new management teams to the table, as frequently the management of the platform companies lack the experience or drive to take their companies to the next level. The new management team and the private equity group can frequently take a company that might have been a nice mid-sized company and help it grow substantially through joint ventures and acquisitions as well as organic internal growth.
Editor: Do you see Club Deals to any great degree?
Hagan: Club Deals are generally used primarily for the larger sized deals, but sometimes can be found in smaller deals as well. I think that there is a misconception about Club Deals. Recently, some pundits in the media have suggested that Club Deals are a way of joining competing groups together to reduce the competition for a deal. But in my experience that is not the case - typically their purpose is to spread the risk in very large deals. Most private equity funds have limits or guidelines as to the size of each equity investment, thus a club deal can be the only way a group of funds might be able to acquire a larger company that they could not acquire alone.
Editor: If the deal goes south, is it customary for there to be some mechanism among the fund partners for a buyout of all the equity players?
Hagan: That feature is found in some deals, but certainly not in all. Many deals have "drag-along" rights to force a sale of a company to a third party but typically don't have the right to buy out minority fund investors. As more Club Deals occur, dispute resolution buyouts (which are more prevalent in small family enterprises), may become more common.
Editor: How does your practice go about protecting its fund clients from fraud and other problems?
Hagan: It is important to make sure that as a buyer you have strong indemnification rights against the seller. In addition to strong representations and warranties, utilizing hold-back arrangements on sale proceeds such as escrows, seller notes, earn-outs or stock claw-backs can help ensure a buyer get compensated for any indemnification claims. Seller notes are also a great way to partially finance a deal through deeply subordinated debt. I also like to protect my clients by making sure that they have strong working capital or net worth adjustments that last for a period of more than 90 days after closing. I find by doing that I protect my clients much better than just by an indemnity claim alone since most adjustments don't have the limitations that indemnity claims do. Since most claims against a seller are uncovered in the first few months following an acquisition, this is a great mechanism to protect a buyer. To a limited extent indemnity insurance is useful if there is a major potential claim that is highly speculative. In the case of most public company acquisitions, once the deal closes, the buyer generally has no recourse other than to sue the former directors and officers of the public company for fraud. As a result, proper due diligence on each transaction is critical.
Editor: What do you see today by way of credit availability for your larger companies?
Hagan: The good news is the credit crunch has not eliminated financing for private equity transactions. While the financing terms may not be as favorable, in addition to banks, there are a number of alternative debt financing sources for transactions such as hedge funds and insurance companies. Nevertheless, there is no question that financing is tighter and obtaining the higher leverage ratios seen a year ago is a problem. Staple financing where investment banks used to provide debt financing as part of a sale process, has also been greatly reduced or eliminated by many investment banks.
Editor: What type of industries today are attractive to the private equity funds?
Hagan: Most venture capital funds are technologically focused on areas such as biotech, software or clean energy. On the private equity buyout side, any company that has strong cash flows as well as an upside for growth is of strong interest. The third area where you will start to see more deals in 2008 and 2009 is what I would describe as the turn-around deal. This is where private equity funds might come in, in a bail out or bankruptcy situation, to buy the company or certain assets at a discounted price.
In terms of specialized industries - healthcare and alternative energy are hot industries, but any company with strong growth and cash flow would be of interest to private equity.
Editor: There have always been distress debt funds.
Hagan: In fact, many hedge funds have always been in the distressed securities market. I work with one of the largest hedge funds in the country and they think of 2008 as a great opportunity for them because they really like distressed turnaround situations. They want something they can own for 24-36 months, turn it around and then resell it. Going back to the savings and loan crisis of seventeen or eighteen years ago, the groups that bought the distressed assets from the S&Ls made a fortune. Many of these same investors believe they will find bargains again in the current turbulent market.
Editor: It shows the shrewdness of these management groups.
Hagan: While not all private equity groups are doing well, a lot of them really know what they are doing. They really investigate the companies they are buying, the industries they are in and they develop detailed plans for future growth and synergistic follow-on acquisitions. Sometimes the best companies to buy are corporate orphans. As many corporate in-house counsel can attest, many companies have divisions that have been under managed or capitalized since they don't fit into their company's core focus. A private equity buyer, by installing a more focused management team, can frequently turn these "corporate orphans" around.
Editor: Why should in-house counsel be informed about private equity?
Hagan: Most companies, whether public or private, will encounter private equity in one way or another. Your company could be acquired by a private equity fund. Even if that is not a possibility your company might wish to acquire a portfolio company of a private equity fund or sell a division to a private equity fund. Further, many public companies often act as venture capitalists themselves by investing in promising technologies of smaller companies. As a result, it is important to understand how private equity works and how it can affect your business. Even if your company is among the Fortune 500 companies, you will still likely encounter private equity in one form or another in the course of your career.
Editor: I should think that buying a portfolio company would be a very attractive purchase because the equity investors would have stripped out so much of the fat.
Hagan: Yes, most portfolio companies are generally run very leanly. However, when competitors buy each other there can be duplications that result in layoffs.
The last point I would make is that is important for you to understand who the private equity investors are and what are their limitations. For example, if your company is selling a business to a private equity fund, there may be a financing contingency risk on a sale. Until recently, a Fortune 500 company could sell a division to a private equity fund and that fund might be able to buy it without a financing contingency. Those days are starting to end and the financing contingency is coming back in again. As a result, it is important for corporate counsel to be able to advise their management or board of directors on exactly how these types of transactions are structured and what the critical risks are.
Published February 1, 2008.
