CULS: a value-sharing solution?

Around 80% of public-to-privates (PtPs) considered by buyout houses fall through at some stage of the process. There are a number of different reasons for this, but a recurring one is the unwillingness of some listed investors to support the transaction. Consequently, private equity firms are running up significant abort costs, depleting returns to investors and dampening ongoing interest in this type of transaction. Advisory firm Kinmont and law firm Travers Smith Braithwaite think they have come up with a structural solution.

Their structure involves part of the private equity house’s bid consideration being in the form of a convertible unsecured loan stock (CULS), which would allow institutional investors unwilling to accept pricing offers on public-to-privates to stay in the company when it delists and, if all goes to plan, benefit from private equity level returns.

The arrival of the CULS structures is particularly timely given the fall off in PtP activity as institutional investors find themselves of the opinion that the economy is on the right track, which is a view bolstered by the stock market recovery. So, cashing out to private equity players at this point has questionable value. With such a mindset some of these institutions have already tried to block their companies from being delisted in the event of a takeover by a private equity firm.

The institutional investors unhappy with an unsatisfactory cash offer might be appeased by this new structure, which is being defined as a “partial private”. The premise is that if shareholders are given an opportunity to maintain an equity interest in the target company, with the potential for upside if the target’s business is a success, they will be more willing to support the take-private.

As to when a CULS structure could be introduced Spencer Summerfield of Travers Smith Braithwaite says: “CULS are not so much of a last resort, but more a means to an end. Public-to-privates have reached a bit of a stalemate. There is a whole host of public-to-privates that haven’t got off the ground because the institutional investors have said the price which the VC is prepared to offer is not acceptable.”

He adds that if a private equity house can engage listed investors in a proper value and risk sharing discussion, the same volume of profit may be created through a smaller amount of risk equity exposure. “At a time when, increasingly, we hear private equity houses talk in terms of a minimum volume of profit required in money terms rather than just an IRR hurdle or minimum money multiple, the potential value of risk sharing comes through strongly,” he says.

The CULS is basically a quoted debt instrument with a conversion right that represents an equity return. It wouldn’t be introduced late into the deal as a means of securing acceptances, but would probably go into the deal at the front end. Instead of the VC simply offering cash to the target company’s shareholders with a possible loan note alternative (which is the usual consideration offered on a take-private) the VC would offer the CULS alternative.

These are issued by the bidder and listed on AIM and will therefore be a security that the listed investors should be able to hold under their investment policy rules. Household names in the listed equity market such as Gartmore and Schroders are often not permitted to hold unquoted investments in their funds preventing them from simply refusing to sell out and remaining a shareholder in a delisted company. But that does not prevent them holding listed securities in unlisted companies, which is what the CULS will enable such investors to do.

There have nevertheless been a number of recent cases where the minority shareholders have refused the offer made by the VC and have decided to remain shareholders in a company – see EVCJ September 2003, page 19. In instances where less than 90% acceptances are received although the VC cannot enforce the squeeze out whereby the remaining shareholders have to accept the offer price, the VC can still move to delist the company with the minority shareholders in tow.

Deutsche refused to accept the Cinven offer from Fitness First, increasing its stake from 7.2% to 10.2%; Fidelity and M&G refused to accept the Capricorn Ventures offer for Pizza Express and as a result own 10% of the delisted entity; and most recently Standard Life has stated it will not accept the current private equity offers for Debenhams.

The classic premium to offer on a take private is between 30% and 40% of current price but where the company’s current share price is a quarter of what it was when the institutional investors first invested this is irrelevant and is unlikely to be acceptable to the institutional investor, says Summerfield. “This new CULS structure is a way to enable the institutional investors (and indeed any other target shareholder) to retain some value in the company post-privatisation.”

“We have spoken to a number of VCs and institutional investors and they are excited by this idea. They see this as a way of getting through the log-jam. When we first thought of it we were thinking of it as an anti-embarrassment clause for the institutional investors where they would get a small participation in any upside post privatisation,” says Summerfield. But he adds that there may be circumstances where it might be appropriate for a much smaller cash payment to be offered up front with a much bigger post privatisation value sharing participation.

“Ultimately the ball is in the court of the VCs,” says Martin Bolland of Alchemy Partners, an active PtP player. “The deal can be structured in any way so that there is some sort of upside for the institution in the future, but not necessarily the same return as the VC.”

The precise terms of the CULS will be a matter for negotiation each time. They will normally be interest bearing and the size of the coupon will depend on the ability of the target company’s business to service that coupon.

The CULS will usually only be convertible into ordinary shares of the bidder on an exit. The conversion price can be at the same entry price for the private equity house in the shares of the bidder or at a premium to that price. It can also be subject to adjustment if the management’s ratchet kicks in (assuming there is a ratchet). This will ensure that the private equity house is not the only one that has its equity interest diluted if the management’s ratchet is triggered.

The CULS should have a long enough maturity date to ensure a good chance of achieving an exit before maturity. In any case, the maturity date is likely to extend beyond the maturity date of the acquisition bank finance and any shareholder loans. Earlier redemption might only occur in the event of an insolvency of the bidder.

As far as management fees are concerned, Kinmont doesn’t envisage this will be an issue. The private equity house would look at the CULS as another part of the debt structure and just as the management fee wouldn’t be payable on mezzanine for example, nor would it be payable on the loan note.

“The idea is that they’d stay in as long as we did and when we get an exit they’d get a similar return but it would depend on the structure of the investment,” says Kevin Reynolds of Bridgepoint Capital.

He adds: “This is a structure the VC would offer as an incentive to get the institutional investor onside and would be used to bridge a valuation gap that could not be bridged in a more conventional manner.” Ideally, a player such as Bridgepoint would want to avoid this scenario and control the buyout vehicle. “Having minority shareholders in a buyout vehicle is messy and not something you want,” says Reynolds. “In an ideal world you’d have had conversations beforehand with the institutions involved in the deal to make sure they’re onside.”

“This structure is probably only applicable to a limited number of institutional shareholders and if institutional shareholders as a class don’t like it, it won’t happen,” says Reynolds. He adds that most of the less sophisticated retail investors would look to take the cash option as there is less risk involved. “I think conceptually, it’s quite interesting. The proof of the pudding is finding a real life situation where it works. We’re actually looking at deals now where it might be applicable,” he says.

Martin Bolland says: “We would consider using this structure if needed. But it’s more useful for the larger transactions because it’s the larger ones where there tends to be more uncertainty from institutions.”

The introduction of the CULS alternative into the PtP equation will undoubtedly impact the economics of the deal for the private equity house, but the partial private can still generate an appropriate return for the private equity house while enabling the institutional shareholders who elect for the CULS alternative to retain an economic participation in the target company’s business post PtP.

Spencer Summerfield says: “If a bidder is prepared to offer a very healthy premium, I’m sure at the end of the day cash is king. But where the share price of the target is completely bombed out this is unlikely. A partial privates structure might be the way through.”

And with transparency and performance being a hot topic among private equity investors at the moment it might be that the idea of a publicly traded CULS acting as an indicator of the performance of an investment is a potential turn-off for VCs.

For table of UK private-equity backed PtPs see EVCJ September 2003, page 21.

Completed UK PtPs over £10m 1997-2003

Year Number Value £m

1997 4 284

1998 24 2,922

1999 34 5,011

2000 35 8,938

2001 28 6,256

2002 14 2,705

2003 (half year) 8 569

Source: KPMG

Average UK PtP deal size

1997 £71m

1998 £122m

1999 £147m

2000 £255m

2001 £223m

2002 £193m

2003 £71m

Source: KPMG