Private equity funds are becoming increasingly decisive in Italy. At the level of mergers and acquisitions, their role in the last five years has risen sharply, from a share of 24% to 35% of total deals (data from SDA Bocconi, PE LAB). In the first six months of 2022, private funds reconfirmed themselves as key drivers of the M&A in our country, completing 214 transactions out of a total of 617. An analysis of private equity activity and its main document, namely the Share Purchase Agreement (SPA), would help to understand the potential and critical points of this form of investment.
Private equity activity and its steps
The private equity activity involves investing in unlisted companies' risk capital with the goal of increasing its value over a period of three to seven years. This activity is carried out by specialized financial operators that raise capital from institutional investors and private individuals, to subsequently invest it in the share capital of the target company. Thus, the private equity operator becomes a partner of the company, but a temporary one. Once value creation has been reached, his shares must be sold, through a process of disinvestment.
There are various steps involved in a Private Equity Transaction Timeline. The process begins with a preparatory phase aimed at researching investment opportunities. During this phase, a company is presented to a private equity operator, usually by sending an extract of the business plan. If the investment proposal is evaluated positively by the investor, the negotiation phase can start. After repeated informal contacts, the actual negotiation comes to a head with the conclusion of an agreement - term sheet - through which the parties set the milestones on which the subsequent more detailed negotiations will be based. This document is non-binding for the finalization of the transaction, which is, instead, generally conditional on the successful completion of the planned due diligence activity. The latter is crucial because when someone acquires all, or a significant portion, of the shares of a target company, that investor also acquires its liabilities. Thus, in M&A transactions, extensive due diligence is conducted to understand what liabilities, if any, will be borne by the acquirer. Moreover, it clarifies the strengths and weaknesses that could have an impact on the success or otherwise of the investment.
At the end of this investigation, the buyer, and its professional advisers (typically lawyers and accountants) should be able to decide whether to enter or not into a share purchase agreement.
What is a share purchase agreement?
At the heart of the SPA is the agreement that the seller will sell, and the buyer will purchase, the shares of the target company. The seller normally agrees to sell the shares “with full title guarantee” which implies that there are no third-party rights or restrictions attached to the shares. In this respect, SPAs may also be controlled or affected by existing shareholders’ agreements between the shareholders of the target company which may have imposed some conditions on the circulation of the shares.
Important clauses in the share purchase agreement
A share purchase agreement is likely to be long and consists of the main document and various schedules or annexes containing details of the transaction. While a SPA could be in any format, it typically contains the main following clauses:
· Definitions and interpretations: defining terms up-front in the document helps avoid future disputes about what they mean.
· The agreements governing the acts to be performed at the time of the closing (i.e., the activity using which the parties proceed to the formal and final registration of the social participation)
· Transfer of shares and purchase price: type and amount (or the formula to determine it), post-closing adjustment mechanisms, and terms of payment.
· Representations and Warranties on the economic, financial, and management situation of the target company. This type of clause is aimed at protecting the buyer against “unexpected liabilities” after the company is sold.
· Choice of law: a selection made by the parties to use the law of a specific jurisdiction to regulate their respective rights and obligations.
· Resolution of Dispute and Arbitration
Focus on: Resolution of Disputes and Arbitration
A distinction between the governing law clause and the dispute resolution clause must be made. The former regards substantive law governing the agreement, while the latter establishes how any controversies should be resolved. When drafting a dispute resolution clause, firstly, it is necessary to specify the country where the resolution of any issue arising under the agreement should take place. There are several options and parties can either elect one forum or a combination of different forums. Moreover, the parties could determine whether court litigation or arbitration is more appropriate. Those are pivotal aspects in defining the terms of a dispute, strongly affecting its economic results. Nonetheless, this decision requires an understanding of the advantages and disadvantages of the different forums as, in each case, the transaction will be better suited to one or the other.
Overall, there are several advantages related to the decision of referring to an arbitrator. Firstly, arbitration awards are easier to enforce than court judgments. Moreover, parties are generally free to agree on a suitable procedure, hold hearings in a neutral country, and appoint arbitrators who are of a different nationality compared to the parties. Arbitrators can also be empowered to decide a dispute under different substantive and/or different procedural rules than the rules which a court is compelled to observe. Another fundamental advantage regards the confidentiality of arbitration resolution. In a lot of cases, litigation that is held before a court is public, and, for a lot of companies, this could be a significant problem. They want to keep their privacy, avoiding making the dispute public.
Last but not least, the speed of the proceedings is much more elevated, and it ensures a quick definition of the controversy, extremely important also for the costs that it requires.
The monitoring phase of the target company
Once the acquisition of the shares is concluded on the closing date, the delicate phase of the management of the target company opens. At this stage, the investor’s task is to support the management in generating addictive value for the company. The investor usually requires access to corporate information to keep track of the company’s performance and identify any problems at an early stage.
The disinvestment
After the time for value creation has expired, the disinvestment process should begin. In successful cases, the investor sells his shares when the value of the company has increased. On the contrary, in the case of failure, disinvestment occurs when the conviction matures that it is no longer possible to resolve the crisis.
Final consideration
The intervention of private equity operators could have several benefits for the growth of the company. Firstly, the company could raise financial resources without recourse to debt. Furthermore, it allows the enhancement of the company’s visibility, also on an international level, and the expansion of its network of commercial and financial relations. Looking at the Italian entrepreneurial situation, there are several small and medium-sized companies, which need to grow. PE funds that see further value creation can accompany the company, by promoting stable and lasting business development.
Despite the undisputed benefits for the target company, private equity presents several specific challenges for the investor. Firstly, target companies have fewer disclosures, as they are unlisted companies, and so it is more difficult to obtain information that will aid decision-making. The balance sheet, for example, is not published as that of a public company and so the investor has to work together with the board to have it.
Furthermore, it may be complicated to liquidate the investment because it is not always possible to perfectly match the needs of sellers and buyers. A private equity company must necessarily undertake “a search” for a buyer in order to sell its investment.
To sum up, a private equity investment requires valuable accounting competencies, to analyze and evaluate the financial statements of the target company, and the ability to figure out its potential future income, taking into consideration the assumption in its financial model.
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