Much has been written about the impact of the Alternative Investment Fund Managers Directive (the “AIFMD”) on the marketing and management of private equity and other alternative investment funds, but the impact of the AIFMD is much deeper than this – it is also set to have a profound effect on the way in which private equity M&A transactions will need to be structured, and may indeed make it considerably more difficult for certain types of deals to take place. This article focuses on two themes in the AIFMD that should be of particular interest to PE transactional professionals - a new disclosure regime and the so-called “asset stripping” provisions.
Recent years have seen criticisms levelled at the private equity industry from a number of sources and for a variety of reasons - some of the industry’s detractors have argued that it is responsible for job losses and the stripping of assets from portfolio companies. In reality these arguments are often too simplistic – there is an equally strong body of evidence that shows that private equity is responsible for a growth in employment, value creation and the generation of returns through strategic and operational transformation. The private equity-focused provisions in the AIFMD may go some way to answering some of the criticisms that have been levelled at the industry.
Timing and Scope of the AIFMD
Whilst the AIFMD came into force across the EU on 22 July 2013, many member states have provided for a one-year transitional period which means that these provisions (and the remainder of the AIFMD) will not bite until July 2014 for existing investment managers.1
By way of reminder, the AIFMD will apply to any EU alternative investment fund manager (referred to as an “AIFM” in the AIFMD) that manages an alternative investment fund (referred to as “AIF” in the AIFMD) irrespective of whether or not the AIF is located in the EU. It will also apply to any non-EU AIFM that is:
marketing one or more AIFs to investors in the EU; or
managing one or more EU AIFs.
The new Portfolio Company Disclosure Regime
The AIFMD portfolio company disclosure regime applies only to holdings in companies whose registered office is in the EU. However, the provisions differ between portfolio companies that have securities admitted on an EEA regulated market (referred to as issuers) and non-listed portfolio companies securities (which for these purposes includes portfolio companies' with securities traded exclusively on markets which are not EEA regulated markets, such as AIM).
The disclosure obligations do not apply to small and medium sized enterprises (“SMEs”) or special purpose vehicles formed with the purpose of purchasing or administering real estate.2
Disclosure Obligations for AIFMs managing AIFs that acquire "Control" of non-listed EU Companies and Issuers
The AIFMD sets out two tests for determining when control has been acquired, depending on whether the portfolio company is an issuer or not.
“Control” of a non-listed EU company occurs where more than 50% of the non-listed EU company’s voting rights are held.
“Control” of an issuer is determined by reference to the threshold for a mandatory bid under the EU Takeover Directive. This figure is not consistent across the EU member states, but in many is set at 30% of the issuer’s voting rights.
The disclosure obligations are triggered where:
the AIF (including any of its subsidiaries) acquires control (as described above) of a company;
multiple AIFs managed by the same AIFM operate under an agreement designed to acquire control of a company (i.e. the AIFs are acting in concert); or
where an AIFM cooperates with one or more other AIFMs on the basis of an agreement whereby it is intended that the AIFs managed by those AIFMs jointly acquire control of a company.
When the AIF takes control of a company, either individually or jointly, the AIFM must notify the company’s board of directors and the shareholders (to the extent that the details of those shareholders are available) and the regulator of the AIFM’s home member state of the following:
the identity of the AIFMs managing the AIFs that have acquired control;
the AIFM’s policy for preventing and managing conflicts of interest, in particular between the AIFM, the AIF and the company, including information about the specific safeguards established to ensure that any agreements between the AIFM and/or the AIF and the company are concluded at arm’s length; and
the policy for external and internal communication relating to the company, with particular regard to employees.
Notification of the Acquisition of major Holdings and Control of non-listed Companies
These provisions only apply to non-listed companies and do not apply to issuers.
An AIFM is required to notify its home regulator (for example, the Financial Conduct Authority in the UK) of the proportion of voting rights of the non-listed company held by any AIF (which it manages) at any time when the proportion of those voting rights held by the AIF exceeds or falls below 10%, 20%, 30%, 50% and 75%. The notification should be made as soon as possible but no longer than 10 working days after the date on which the AIF has reached, exceeded or fallen below the above thresholds.
If an AIF takes control (as described above) of a non-listed company, the AIFM must notify:
the non-listed company;
the shareholders of the non-listed company whose identities and addresses are available; and
the competent authorities of the home member state of the AIFM;
as soon as possible, but no longer than 10 working days after the date on which the AIF has acquired control of the non-listed company, of the following:
the resulting situation in terms of the voting rights;
the date on which control was acquired; and
the conditions subject to which control was acquired, including information about the shareholders, any natural person or legal entity entitled to exercise voting rights on their behalf and, if applicable, the chain of undertakings through which voting rights are effectively held. This final point can mean that significant information about, for example, any financing structure would require disclosure, which can be commercially extremely sensitive.
Furthermore, an AIFM must use its best efforts to ensure that an annual report of the non-listed company setting out certain prescribed information is prepared and made available to the employees' representatives, or where there are no representatives, to the employees of the non-listed company themselves.
Some parallels can be drawn when comparing the disclosure and notification requirements under the AIFMD with the disclosure and transparency rules that already apply in the EU to listed securities, and also require notification to be made when certain voting thresholds are met.
The asset stripping requirements were adopted in direct response to instances (whether perceived or actual) of private equity acquirers using the assets of portfolio companies to secure debt financing that was then used to make distributions to shareholders, leaving the underlying portfolio group with an increased level of third party debt. The asset stripping requirements apply to both non-listed companies and issuers.
Where an AIF individually or jointly acquires control of a non-listed company or an issuer, then the AIFM of that AIF shall, for the two years following acquisition of control of the company by the AIF:
not be allowed to facilitate, support or instruct any distribution, capital reduction, share redemption and/or acquisition of own shares by the company;
not vote in favour of a distribution, capital reduction, share redemption and/or the acquisition of own shares; and
in any event use its best efforts to prevent distributions, capital reductions, share redemptions and/or the acquisition of own shares by the company;
if as a consequence thereof:
any distribution to shareholders has the result that the net assets of the portfolio company are lower, or would become lower, than the amount of the company’s subscribed capital, plus its undistributable reserves;
any acquisition by the company of its own shares would reduce its net assets below the limit stipulated in the immediately preceding paragraph; and/or
any distribution to shareholders would exceed the amount of the profits at the end of the last financial year (plus any profits brought forward and sums drawn from reserves) less any losses brought forward and sums placed in undistributable reserves.
As is the case with the disclosure obligations, these provisions do not apply to SMEs or special purpose vehicles formed with the purpose of purchasing or administering real estate.
What does this mean for Private Equity M&A Transactions?
The asset stripping provisions are likely to have a significant impact on future deal structuring and exits – for instance, it would appear that the payment of special dividends within the first two years of the acquisition of control will either no longer be possible, or be subject to additional restrictions.
Structuring that would involve the AIF taking equity in the form of preference shares, with the intention of redeeming/liquidating such shares within two years, may also be caught, although the redemption of shareholder debt (i.e. loan notes) would appear to be permissible.
The asset stripping provisions apply for two years from the acquisition of control and apply to the AIFM. However, the AIFMD is silent on what would occur if the AIFM no longer manages the AIF in question, or the AIF ceases to have control of the portfolio company in question. As a consequence, on any sale of a portfolio company to which the asset stripping provisions apply, it may be advisable to require a buyer to covenant not to effect any measures that would constitute asset stripping until the two year anniversary of the initial acquisition of control. This may help to would demonstrate that the AIFM has used its “best efforts” (which is the standard required by the AIFMD).
As a practical issue, AIFMs will likely want to conduct increased due diligence on target companies, in addition to ensuring that (i) they put in place arrangements with portfolio companies dealing with actual or potential conflicts of interest, such that all arrangements between the company and the AIF are at arm’s length terms and (ii) employees (or their representatives) are notified of shareholder changes where required. Private equity asset managers caught or likely to be caught in the future by the AIFMD would be advised to be proactive in putting in place reporting procedures and deal questionnaires to ensure that these requirements are addressed correctly.
These provisions may mean that AIFMs caught by the AIFMD will be at a significant competitive disadvantage when compared to other providers of capital such as high net worth individuals, pension funds, sovereign wealth funds and private equity funds that are not subject to the AIFMD (for instance, because they are not AIFs, or are not marketing to EU investors).
Careful planning will be needed when considering the structuring of private equity M&A transactions to ensure that AIFMs do not fall foul of these provisions. AIFMs need to understand, and be prepared for, the notifications and disclosure regime and appreciate that they have a relatively short space of time in which to make such notifications and disclosures once they become due. The asset stripping requirements are in force for a period of two years from the acquisition of control and then fall away. This means that private equity acquirers planning to use the assets of recently acquired portfolio companies to secure debt financing (with the intention of rewarding shareholders through dividends) will need to wait until this period has expired. The provisions do mark a significant change in the way that certain types of PE transaction may be structured. Whilst it is too early to discern any market trends, both the industry and regulators will be keen to see the impact of the provisions on what is already a difficult M&A market.