Over the years, we have represented a number of investors, target companies and management teams in minority transactions. The market for “GP stakes” and similar non-controlling transactions with asset managers has grown considerably over the last 10 years, and while much of the investment activity continues to be with larger firms ($10 billion in AUM or more), there is growing interest and activity in the middle market as well. Current owners are looking to outside capital providers for liquidity – cash to take off the table and funding for future general partner commitments to sponsored funds, for growth capital, and to facilitate succession planning. Investors may also offer distribution support and future capital commitments. In the middle market, many prospective investors are already limited partners in the manager’s funds or clients of the manager.
Below are some of the important factors to be considered by a target company and its management team in connection with a proposed minority investment.
Customary deal preliminaries include entering into a non-disclosure agreement with the investor to limit the use and disclosure of the company’s confidential information. If the company does not already have outside transactional advisors, it should select them. Experienced deal counsel is a necessity, and an investment banker, while not always required, can be helpful in negotiating financial terms and validating customary practice and valuation.
The investor and the company will typically enter into a letter of intent or agree on high-level terms (valuation, amount, basic structure and governance) in a term sheet. Once basic terms are agreed, the company will need to open and populate a data room to support the investor’s due diligence. The company should confirm that the transaction will not require notice or consent of investors, lenders or others under fund agreements (including side letters), joint venture agreements, lending arrangements, leases and vendor contracts (property management, pricing services, etc.), and that no regulatory approvals will be triggered by the investment.
The letter of intent is also a good opportunity to reach business agreement on important terms for how the company will be run after the investment closes – including minority protections and management arrangements (both discussed in more detail below).
What is being sold, and what is the investor paying for it? The investment may represent a share in all sources of the manager’s income, or just certain of those sources. For example, a private equity fund manager may sell to an investor an interest in future management fee income and capital and carry of future funds, but not in management’s share of capital and carry of existing funds. A firm may have substantial balance sheet assets that it is warehousing or that represent undistributed profits of the legacy owners. Balance sheet assets are usually addressed through a cash and working capital adjustment, with the company agreeing to maintain a net working capital reserve (which is usually relatively low, given the simple balance sheets of most asset managers).1
The economics of a minority investment can be structured as a share of top-line revenue, a common or preferred equity stake, or even as a combination of debt and warrants or other equity-linked instruments. Tax-exempt investors may invest through blockers to avoid unrelated business taxable income, and non-U.S. investors may seek to block effectively connected income. Particular care must be taken in structuring the allocation and distribution waterfall in the company’s operating agreement so as to avoid unintended shifts in value or timing of recognition of income or gain.
What percentage of the business is to be sold to the investor? The answer to this depends on a number of factors and will be informed by the purposes of the transaction. This percentage will generally be lower in the case of a simple capital raise for growth capital or partial management liquidity, whereas a substantial stake may be sold if the parties want the initial investment to serve as the first step in an eventual buyout of all or substantially all of the interests in the firm.2
When is the purchase price paid? Many large market transactions involve large investment amounts that may be made over several years in order to avoid having too much cash sit on the company’s balance sheet. In the middle market, it is more common to see the purchase price paid up front, sometimes with a deferred or contingent portion that represents a relatively small percentage of the purchase price.
Establishing and executing on a tight plan for external and internal communications is critical. The company may wish to implement internal information barriers so that the transaction is on a “need to know” basis within the firm and prevent leaks. If the investor is a public company, the target firm should confirm that the investment will not trigger a Form 8-K or other public announcement. The parties should agree upon the form and substance of a notice to clients and investors and of any press release.
If the company is raising capital for a fund, it will need to determine whether the transaction is material and must be disclosed to investors before their commitments are accepted (or the company should delay the next fund closing until after it has announced the transaction).
CHANGES TO THE OPERATING AGREEMENT
A minority transaction usually involves the restatement of the target company’s operating agreement to reflect the economic and other terms of the investment. Equity rights will be negotiated, including allocation and distribution provisions; exchange or conversion rights; transfer restrictions; preemptive rights; future capital call obligations and related enforcement mechanisms; rights of first refusal or first offer; tag-along rights; drag-along rights; and forced-exit rights (for both investors and management owners).
In addition, governance rights and minority protections will be negotiated. The precise form and effect of those rights and protection is the subject of intense negotiation. The minority investor may request a board seat or observer rights. A strategic investor may also seek representation on the firm’s investment committee. Minority investors typically do not sit on management or operating committees.
In addition, minority protections customarily sought by investors include approval rights over related party transactions with the owners and their affiliates; liquidity events; change in line of business; issuances of senior equity; and redemptions of equity. If the transaction is structured as a sharing of bottom-line profits rather than top-line revenues, additional protections around expense management will be sought, such as budgets and business plans, management compensation, and travel and related expenses.
One of the principal attractions of a minority investment versus a change in control transaction is that the management team remains in place and the investor typically has no say in day-to-day governance of the business. The firm’s investment process, lines of reporting, product approval and pricing, marketing and branding, and compensation practices remain unchanged.
Firm management and the investor may use an outside investment as an opportunity to update arrangements among the management owners and implement a succession plan, including by cashing out or buying down senior management or outside investors and increasing the ownership stakes of the next generation of firm leaders. Investors may be able to assist with the financing of equity recycling to support the succession plan.
In addition, the investor will require that management enter into or renew covenants regarding confidentiality, trade secrets, non-competition and non-solicitation of clients and employees. These covenants may be in the amended operating agreement, in new employment agreements, or both. The enforceability of non-compete covenants in particular has been the subject of recent legislative and judicial activity, and depends in large part on the jurisdiction in which the manager operates.
CERTAIN TAX CONSIDERATIONS
Additional considerations for individual members of management include the tax implications of the investment. The firm’s owners may be able to defer the recognition of gain on some or all of a minority investment, depending on when they wish to take cash proceeds out of the business. If the company is owned solely by natural persons, an investment by an institutional investor may cause the owners to switch from the cash method to the accrual method for federal income tax purposes, which can result in an acceleration of taxable income to the owners. Owners should re-visit their estate plans to determine how the transaction will affect them. Funds and joint ventures managed or owned by the company should also be reviewed for transfer and related taxes.
CAPITAL RAISING AND OTHER RELATIONSHIP FACTORS
The company will need to assess the expected impact of the transaction on existing relationships with investors, clients and vendors.
Most strategic minority investments include a capital raising component. The investor may offer distribution support for future fund raising, and may also commit to invest capital in future funds and to share business opportunities with the company. In connection with securing these commitments, the company should look to protect the confidentiality of its clients, portfolio management strategies and other sensitive information, and to identify and address potential conflicts of interest with the investor, as well as evaluating the potential reputational and other risks associated with a long-term relationship with an outside investor.
1 The owners of asset management firms are sophisticated managers and traders, but given the complexity of many firms and the valuation process, management teams should consider retaining an investment banker to independently confirm the deal valuation and to assist with the negotiation of other financial terms.
2 Minority transactions are typically structured so as not to trigger the need to obtain consents from clients, investors or other third parties, but sometimes consents are required, particularly where loan covenants are affected by the change in ownership. If third party consents are required, the company should take into account the cost of obtaining those consents in negotiating with the investor (and may want to ask the investor to bear a portion of those costs).