What protections are available to investors on minority deals?
Dr Hendrik Röhricht
Partner, Ginting & Reksodiputro in association with Allen & Overy
Jasper de Jong
07 July 2022
There was a time when many private equity firms would only invest in a business if they could take full control. Not so anymore. Over the past five years, we have seen a marked increase in deals where investors take only partial ownership of a company.
Minority investing offers new opportunities for private equity firms and institutional investors to put money to work in high-performing companies – and we expect these deals to be a permanent fixture of the M&A landscape in the years to come. However, our experience has shown that investors need to take particular care to ensure that their rights are adequately protected throughout the lifecycle of the minority deal.
Minority deals happen across a range of different sizes of businesses, investors and sectors. The common thread that runs through all these transactions is a hot deals market, which has made it harder for firms to deploy capital and forced them to look at new types of transactions. The pandemic also made businesses more willing to accept minority investments from external shareholders, as many companies struggled to survive lockdowns and a radically altered trading environment.
There are now a range of private equity firms that target mid-market minority deals, with some even raising stand-alone funds for such transactions. For instance, Inflexion raised GBP1bn for its second ‘Partnership Capital’ fund in 2018.
Over the past two years, we have seen a particular increase in the popularity of partial exits, where a private equity firm sells down a minority stake in a portfolio company but holds on to the rest. For instance, private equity firm Bridgepoint first sold a minority stake in Element Materials Technology Group Singaporean investor Temasek in 2019, before agreeing to sell the company to it in 2022. We have also seen more prospective buyers use minority stakes as a way to differentiate themselves during competitive auction processes, offering the seller the chance to retain a minority stake in a company rather than fully exiting the business.
Deal levers for minority investors
Minority deals throw up new challenges for private equity firms and institutional investors, who need to find ways to protect their interests throughout the duration of their investment and during the exit process.
From our experience with clients, we have identified a number of levers that enable minority shareholders to exercise control over the deal:
The minority investor will typically gain one seat on the portfolio company’s board if they own over 15% of the shares. In some transactions the private equity owner may also request a limited amount of control over the management team, for instance being consulted on key C-suite appointments – although this is less common. Sometimes, minority investors can gain more board representation if the company performs poorly.
The minority investor will also typically have a limited set of veto rights when it comes to issues that are material to the business, such as related party transactions or excessive levels of debt financings. However, the minority investor will not usually be able to veto day-to-day managerial issues or key strategic matters, such as changes to the business plan.
How and when an exit occurs is a particularly important issue that needs to be addressed in deal documentation. We find that exit rights typically vary based on the investment horizon of the majority owner.
If the majority owner is a closed-end private equity fund, who typically seeks to exit investments within five years, the minority investor tends to be unable to choose when they sell down their stake. The private equity fund will also usually have ‘drag along’ rights that can force a minority shareholder to sell their stake when they deem the time is right, thereby allowing a control premium to be realised. The minority investor may also have ‘tag along’ rights that give them the right to have their shares purchased on the same terms as the majority shareholder.
If the majority owner is a founder or investor with a longer investing horizon, there tends to be more debate around whether a minority shareholder can independently sell down their position or initiate an IPO. We find in these cases it very much depends on the type of asset and the group of investors. However, the minority investor is often required to give other shareholders a right of first refusal on the sale of their shares.
Minimum return protections
In some instances, minority investors insist on introducing minimum return protections into deal documentation, particularly when investing at a later stage into a well-performing asset. This ensures that the minority investor cannot be forced to sell their stake in a company until they have made a certain return on the deal. Clients often ask us if there are market norms when it comes to typical minimum returns, but it is still very much deal dependent and will alter depending on the return expectations of the investor, the asset and the market conditions.
Protections ever more important
The importance of these different deal levers will alter depending on the type of minority transaction that is occurring, as well as the market context. But with economic headwinds likely to severely affect trading conditions in the year ahead, investors will need to take ever more care to ensure they properly understand what rights they may or may not have in a wide range of circumstances.