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After the unprecedented boom of the immediate post-COVID era,
European M&A activity has slumped in recent months. Indeed,
recent market intelligence from Dealogic showed that Q1 of 2023 in
EMEA saw a 68% decline in M&A volume year-on-year and the
lowest Q1 level since 1997 (worse still than during the global
financial crisis). Against this backdrop, private equity sponsors
looking to create liquidity for their funds may need to consider
more bespoke and structured solutions at asset level rather than
simply selling their portfolio companies in full to third parties.
As a consequence, lenders in the European market will be looking to
understand what exactly constitutes a “change of control”
in their credit documentation and what rights they have in the
event that a “change of control” is deemed to have
occurred.
This deep dive with Daniel Hendon (Partner) and Phil Anscombe
(Associate), lawyers in Proskauer’s Private Credit Group in
London, will explain the philosophy behind “change of
control” protection and what it is intended to achieve, how
the trigger events are typically described and what effects they
have within the documentation, and how common loopholes and
exceptions may be particularly relevant in today’s market.
When performing its due diligence on a prospective financing
opportunity, a lender will typically speak to both the shareholders
(or persons who will acquire the shares, if an acquisition
financing) and management to discuss and assess their business plan
and financial projections for the business. As a result, when
lenders commit to such a financing, they are in essence backing a
particular vision and strategy for the business going forward. The
underlying principle behind “change of control”
provisions in loan agreements is that, if there is a change in the
persons controlling the business (and those persons are in theory
able to use their control to change that business strategy), then
there has been a fundamental change in the dynamics of the
investment and the lender should have the option of exiting the
deal and being prepaid in full. There are a number of different
concepts that feed into both how a “change of control” is
defined and what its consequences are for the parties (and how
these concepts are treated vary depending on the size of the deal,
the sponsor involved and the commercial context of the deal)
– the ways in which such concepts are treated can broadly be
described as follows:
- What constitutes a “change” –
Traditional loan documentation operates so that if a specified
group of permitted controlling investors ceases to exercise control
over the group, then that is considered a “change” in the
control of the group. However, the traditional approach in the
world of high-yield bonds is for this to be constructed so that it
is only when a certain new investor or new investors acting
together in concert (which are, in each case, not permitted
controlling investors) attain control of the group that a
“change” is considered to have occurred. This is a subtle
yet important distinction – the latter construct would allow
multiple minority equity stakes to be sold (which in aggregate mean
the original investors no longer control the operations of the
group), while the former construct would consider this a
fundamental “change” in the controlling composition of
the shareholder group. The latter construct has increasingly
pervaded the syndicated loan market, but private credit firms have
generally been resistant to this and insisted upon the more
traditional loan formulation. - What constitutes “control” –
The most sponsor-friendly documents will solely define
“control” as being the beneficial ownership of a simple
majority (being more than 50%) of the issued voting equity in the
parent company of the banking group. The rationale for this is
that, while there will likely be some jurisdiction-specific
factors, this is typically the level of equity ownership required
in order to exercise key shareholder rights in order to maintain
operational control (in particular, the right to pass resolutions
to hire/fire board members). However, it is not necessarily the
case that beneficial ownership will always carry these rights
– for example, proxy voting rights may be granted, or
contractual arrangements may be entered into that give such rights
to other persons. Traditional LMA-style loan documentation would
therefore state that “control” means the ability, whether
by ownership of shares, proxy, contract, agency or otherwise, to
have the power to: (i) cast, or control the casting, of a majority
of the maximum number of votes that might be cast at a general
meeting of the shareholders of the parent company, (ii) appoint or
remove the majority of the board of directors of the parent
company, or (iii) give directions with respect to the operating and
financial policies of the parent company, with which the directors
or equivalent officers are obliged to comply. Certain private
credit providers have insisted on retaining the traditional
formulation (including in US loan documents), while others have
been more willing to rely on the test looking solely at voting
share ownership (on the basis that sponsors are perhaps unlikely to
give away such control rights while they still hold a voting
majority). It should be noted that this is ordinarily expressed as
being “direct or indirect” control – the reason
being that in most structures the equity vehicle will be above the
level of the senior banking group, and so what is really being
referred to is being able to exert these powers by way of indirect
control down a chain of wholly-owned subsidiaries sitting below the
equity vehicle. - Are there additional triggers – Certain
other trigger events commonly seen in the loan market are as
follows:
- While often not described as a “change of control”
for the purposes of the definition itself, a sale of all or
substantially all of the assets of the Group typically constitutes
a trigger event in the same way as a “change of control”
for the purposes of the loan documentation. This is to cater for a
scenario in which the shareholders elect to exit their investment
by way of an asset sale rather than a share sale. - A common feature on almost all European loan financings is a
limb within the “change of control” definition that
protects the “single point of enforcement”.” In
contrast to the US (where there is a common insolvency regime
across all states that is well understood by market participants
and well tested on prior transactions), due to the diversity in
insolvency regimes across Europe, transactions are typically
structured so as to ensure there is a robust and protected security
interest granted to lenders at the top of the banking structure
that would facilitate an enforcement and sale of the entire group
as a going-concern, on an out-of-court basis, in a downside
scenario. To ensure the sanctity of this share security through the
life of the deal, it typically constitutes a “change of
control” if the chargor/pledgor ceases to hold (directly) the
entirety of the issued equity in the entity over which it is
granting security. Note that US deals will still typically include
a requirement that the topco “holdings” entity retain
ownership of 100% of the issued and outstanding equity of the opco
/ borrowing entity. In lower middle-market transactions or in
structures where there are material operating entities that sit
underneath the primary borrower, US lenders may push for ownership
prongs with respect to those subsidiaries as well, but that is a
negotiated point and atypical in larger deals. - Certain lenders take the view that, in addition to ensuring
that the original shareholders maintain operational control, the
“change of control” definition should also look to ensure
that those original investors maintain sufficient economic
“skin in the game”. The purpose of this would be to
ensure that the sponsor cannot materially reduce the extent of
their financial investment and realise value (e.g., by way of a
secondary sale to a third party) by disposing of non-voting equity
or equity-like instruments, so as to circumvent the “change of
control”, e.g., a disposal of loan note instruments or
preference shares. To achieve this, such lenders would require that
a “change of control” be considered to have occurred if
the original investors cease to own the majority of all equity
(voting or non-voting) or cease to own the majority of any
quasi-equity instruments (e.g., loan note instruments accruing
roll-up interest) that were issued at the outset of the deal, the
latter formulation of which is not common in the US. This has
generally remained a feature of the European mid-market only and
some sponsors are resistant to this on the basis that they consider
it to unduly inhibit their portfolio management. They would also
argue that it is not practically likely that a new investor would
acquire the majority of the economic capital in a deal without
requiring voting control at the same time.
- While often not described as a “change of control”
- Who is a permitted controlling investor
– Traditionally, the permitted controlling investors (that
were required to retain control at all times) under loan agreements
were the sponsor funds invested in the transaction at closing of
the deal. However:
- In recent years, it became common for this to be extended to
affiliates and related funds of those initial funds (i.e., so as to
include any other vehicles established now or in the future,
provided they are managed and controlled by the same sponsor). The
thesis behind this is that lenders are backing that sponsor’s
vision for the business, so provided the sponsor as an institution
remains in control, that should be sufficient from the lender’s
perspective to remain in the deal. This is particularly topical in
the current market as, given the subdued M&A environment, there
has been an increase in GP-led secondary trades as a method of
generating liquidity for sponsor funds. What this means is that,
where a particular fund is nearing the end of its life cycle and
requires liquidity (but conditions are not optimal for a widely
marketed sale process of a particular asset), the sponsor may set
up a new and separately capitalised vehicle to acquire the asset
from the original fund, so it can continue to be managed and sold
at a later date. Although the sponsor remains in control of the
business, an exit has nonetheless been achieved for the original
fund (and value/upside realised by the investors in that fund)
– in this context, certain lenders have queried whether in
fact this should constitute a “change of control”, so
that lenders can recover value concurrently or otherwise discuss
new terms to reflect the new sponsor vehicle’s new investment
horizon. In the US, the market has largely accepted that the
“Sponsor” for purposes of the “change of
control” definition will include a hardwired fund and its
“controlled investment affiliates” to account for this
flexibility, but this remains a hot topic of discussion and it will
be seen in due course whether these sensitivities prompt a change
in the approach taken by the wider market. - On more aggressive transactions (particularly on larger deals),
sponsors commonly request a more expansive list of permitted
controlling investors. They will often push for all institutional
equity investors at closing (for example, any seller that is
rolling over all or a portion of its investment into the new
structure but as a minority shareholder, or any other new minority
co-investor introduced by the sponsor) and all management
shareholders to be included in the numerator of the calculation.
This evidently does not require that the sponsor itself retains
control and calls into question what happens if the sponsor itself
reduces below 50% and subsequently has a fall-out with management
(for example) over the future strategy of the business. This could
lead to a dead-lock situation that would be value destructive
– a situation that lenders would look to avoid. Sponsors
would argue, however, that they are entirely aligned with lenders
in protecting their controlling voting rights going forward. Where
it is requested that co-investors (or, more generically, limited
partners of the sponsor) be included, lenders will often request
that they be explicitly named in the documentation to ensure it is
clear who has been approved. Where that is not possible (for
example, where the sponsor intends to syndicate a portion of its
equity post-closing or between commitment and completion) and
lenders are willing to accommodate that flexibility, they will
generally offer a time-capped period only in which such
co-investors can be brought in (e.g., 6 months from closing) or, in
the US, a pre-agreed “white” list of investors who may
come in. Lenders also sometimes agree for LPs/co-investors to count
as permitted controlling investors but only to the extent all of
their voting rights are at all times controlled and exercised by
the sponsor (i.e., they are fully silent and passive co-investors
only). The purpose of these various parameters is to ensure that
there are no significant loopholes in the construct – given
the diversity of the LP base in many private equity funds (many of
which LPs may well also have a direct investment arm themselves),
it would otherwise be difficult to regulate whether this
flexibility could inadvertently permit what would otherwise be
considered a true third-party sale.
- In recent years, it became common for this to be extended to
- Is it a control investment – It should
be noted that the above analysis assumes that the relevant
transaction is a regular “control” majority equity
investment by a private equity sponsor. If it is a sponsor-less
transaction, there will clearly need to be a more bespoke analysis
undertaken and reflected in the drafting (perhaps by reference to
the shareholdings of key founders/members of management). If the
transaction in question still represents an investment of private
equity capital but on a minority basis, lenders (including in the
mid-market) are generally more amenable to including specified
co-investors or members of management as at closing alongside the
sponsor in the “permitted controlling investors”
definitions. However, lenders may look to supplement this by
requiring an additional limb of the definition, stating that the
sponsor itself must retain a certain proportion of its own equity
investment. They may also require that a limb be inserted requiring
that the sponsor must retain all of the minority rights it has
under the shareholders’ agreement as at closing. A sponsor
investing on a minority basis may negotiate with the other
shareholders so that it has certain step-in rights upon the
occurrence of trigger events pertaining to underperformance
(possibly including swamping rights, facilitating the sponsor to
take control of the board) and lenders may seek to ensure that loss
of such fundamental rights (whether due to the sponsor selling its
stake below a certain ownership threshold or otherwise) would also
constitute a “change of control”. In certain US deals
where specific individuals are important to the ongoing business,
lenders may sometimes push for prongs requiring that such
“key” individuals either retain some portion of the
equity or retain certain positions or responsibilities. This is
particularly relevant where a lender’s underwriting is focused
on an individual officer’s relationships with customers or
vendors, for example. - Is there a portability concept – While
still an uncommon feature in the market, occasionally loan
documents will contain a “portability” concept. This is
effectively an exception to the “change of control”
regime, such that the debt can be “ported” and remain in
place notwithstanding the sale of the group to a new sponsor.
Clearly, this feature is very attractive to sponsors, as in theory
it would make a sale of the business easier to manage (as an
incoming buyer would not need to arrange its own package of debt
financing). Given the current difficult environment for raising
debt finance, it may be that sponsors in fact look for portability
features more frequently than they did when credit markets were
buoyant. Where the concept is seen in the European and US private
credit markets, it is usually subject to tight parameters, which
may include a time limit (e.g., the loan is only portable for the
first 2 years following closing, which should ensure any incoming
sponsor’s investment horizon is not wildly out of kilter with
the tenor of the loan), a limited list of incoming sponsors that
may benefit from the portability option (typically sponsors with
which the lender has a good relationship or which have strong
experience in the sector), a condition requiring that the option is
subject to a pro forma leverage test (e.g., set at opening leverage
from the original deal, so the deal cannot be ported in a downside
scenario) and that a specified minimum equity condition must be met
(e.g., a pro forma equity cushion of 50% following the new
sponsor’s investment) and that a fee must be payable at the
time of the portability option is exercised (somewhat akin to an
origination/underwriting fee, though sometimes with a discount to
regular new money fees). In the US, lenders will also limit the
number of so-called “permitted” “change of
control” transactions, such that only one can occur over the
life of the facility, to avoid a situation in which the company
changes hands repeatedly. Call protection would also typically be
re-set once the debt has been ported and on some transactions
lenders might offer a tenor extension in connection with the
exercise of the portability option. Requests for portability are
most commonly seen on refinancing transactions, where a sponsor
already owns the asset and expects to exit within a relatively
short period of time after the refinancing deal (and has at least
some visibility as to likely buyers) and is looking to simplify
and/or reduce the cost of the debt-raise process for prospective
buyers. In the US, portability historically has been limited to
upper market deals, particularly in prior years where sponsors had
more bargaining power given the historic level of M&A activity
and related competition. However, the US market has since largely
pushed back on this concept, and as of now it remains rare in true
middle market transactions. That being said, this may become a
trend in the current market, as difficult M&A conditions have
meant many sale processes have been postponed until the market
recovers (but refinancings/dividend recaps may still be proceeding
in the meantime). It is worth noting that, even where portability
features are included, it remains relatively uncommon for them to
be utilised in practice. Whilst the existence of the feature
clearly means the lender has to come to the table if an eligible
transaction has been proposed, in practice, most incoming sponsors
will have their own views on appropriate terms and structure and
will prefer to refinance the existing facilities under a new
document, rather than rely on the prior sponsor’s negotiated
terms. - What is the result of a “change of
control” – Traditional European loan
documentation operates so that a “change of control”
causes all amounts outstanding under the finance documents
(including principal and all accrued but unpaid interest) to become
immediately due and payable. A “change of control” will
constitute an event of default in US credit agreements, but will
not trigger automatic acceleration (or an automatic “mandatory
prepayment”) outside of older lower middle-market
transactions. In addition, the significant majority of private
credit transactions in the European market require that call
protection be due in connection with a “change of
control” transaction – as such (and if within the call
protection period), such a premium would also crystallise and
become due and payable at that time. However, on European large cap
transactions (where there have commonly been very large and diverse
banking syndicates where debt investors may have varying views on a
new incoming sponsor) it has become more common for the result of a
“change of control” to be structured as a lender put
option. The way that this works is that the group must notify the
agent of the proposed “change of control” (and the agent
then promptly notifies the lenders) – each individual lender
will then have a certain period in which to confirm whether it is
electing to exercise its “put” and be prepaid in full (in
the same way as set out above) or whether it is happy to continue
to remain a lender to the group. While the outcome should be
substantively the same if the lender wishes to be prepaid, it puts
the procedural risk (albeit a small risk) of an issue in the agent
failing to notify a lender (or the lender missing such
notification) or the lender failing to notify the group, onto the
lender in question. Clearly the ramifications for a lender that
wishes to exit but is not ultimately able to do so may be
significant – however, private credit lenders on larger
transactions have increasingly become comfortable with this. In the
US, because a “change of control” will not necessarily
trigger a prepayment requirement as noted above, a related
prepayment will instead constitute a “voluntary” or
“optional” prepayment, which will be subject to the
applicable prepayment premium. However, the market has moved toward
incorporating a discount on prepayments in connection with changes
of control. As such, the company will only owe 50% of the premium
that would have otherwise been payable in connection with a typical
voluntary prepayment. It should be noted that, irrespective of
which formulation is used, it is important that a “change of
control” itself cannot be waived by the majority of the
lenders and that the definition and operative provisions cannot be
amended by the majority of the lenders (as these matters should
always be sacred all-lender matters).
Given the difficult environment for raising new finance and the
likelihood of private equity sponsors pursuing bespoke
opportunities to realise liquidity for their funds, it seems highly
likely that “change of control” provisions will remain in
sharp focus for lenders and borrowers alike during the course of
2023.
Private Credit Deep Dives – Change Of
Control
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guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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