PRINT THIS PAGE Going semi-private19/09/2007. Source: Weil, Gotshal & Manges. Doug Warner and Michael Cubell 
Private equity sponsors have used so-called stub equity in a number of recent going private transactions, says Weil, Gotshal & Manges, including the acquisitions of Clear Channel Communications and Harman International Industries in the United States and Countrywide in the United Kingdom. In a going private transaction involving stub equity, target shareholders are offered the opportunity to retain a minority stake in the newly private company and thereby participate in its future growth. It is not clear whether the few stub equity deals that we have seen so far are a flash in the pan to address unique circumstances or whether this structure has legs. As sponsors have increasingly seen resistance to their proposed buyouts from activist hedge funds, institutional investors and shareholder groups, stub equity may turn out to be a useful tactical tool to bridge valuation and funding gaps in certain going private transactions. However, private equity sponsors should be aware of the advantages and drawbacks of stub equity before contemplating its use in a particular transaction.
Why Stub Equity May Win Votes
In Clear Channel and Harman, target shareholders were offered the opportunity to elect to either receive cash, shares in the acquisition vehicle or a combination of cash and shares subject to a cap on the amount of shares that could be owned in the aggregate by target shareholders (30% in Clear Channel and 27% in Harman). To the extent that target shareholders elect to receive shares that are, in the aggregate, greater than the percentage at which they are capped, they will be cutback pro rata to the capped percentage.
From a target shareholder’s perspective, stub equity has certain advantages over an all-cash deal. First, target shareholders gain access to what would otherwise be an exclusive investment without having to pay any management fees or carried interest. Second, the exchange of target shares for shares of the newly-formed acquisition vehicle should generally qualify as a tax-free exchange, which allows the shareholders to defer tax on that portion of their investment.
On the other hand, stub equity also has certain disadvantages to target shareholders. First, private equity sponsors have not to date been required to list the stub equity on any exchange. Consequently, there may be limited liquidity in the stub equity. Target shareholders may be able to sell through market makers, but there is no guarantee that any kind of liquid market for the stub equity will develop and there is a strong probability that this limited liquidity will adversely affect pricing for the stub equity.
Second, in both Clear Channel and Harman, the sponsors have only committed to filing SEC reports for the acquisition vehicle for a two-year period post-closing. Therefore, target shareholders have the risk that the acquisition vehicle ceases to file SEC reports after two years and goes “dark”, which will further damage liquidity and affect pricing (under applicable SEC rules the acquisition vehicle could go dark if it has fewer than 300 shareholders). Third, target shareholders may have no or very limited governance rights attached to their stub equity.
For example, in Harman, there was no guarantee of any independent directors on the board of the acquisition vehicle post-closing. However, in Clear Channel, the target board and shareholders negotiated for certain limited governance rights and minority protections, including the right of the former target shareholders to appoint two independent directors to the board of the acquisition vehicle and approval rights over certain future transaction and monitoring fees paid to the sponsors. Fourth, assuming the stub equity will be registered, a going private transaction with a stub may not close as quickly as a typical all-cash merger transaction because of the obligation to register the stub equity under the Securities Act. As a result, target shareholders could experience a delay in the receipt of any cash proceeds. This could be a particular concern if the target’s shareholder base consists of many arbitrageurs.
Advantages of Stub Equity to Sponsors
In most cases, stub equity is not the structure of first choice for private equity sponsors due to some of the significant disadvantages to the structure discussed below and the fact that, in today’s environment, most private equity sponsors do not need the equity funding provided by the stub to close a deal. However, stub equity may be a useful tactical tool for sponsors in the following situations:
Convincing Recalcitrant Shareholders to Support the Transaction - If a sponsor cannot get the required vote for a merger from target shareholders due to a valuation gap or due to the desire of certain large target shareholders to own a continuing equity interest in the target, a stub equity structure may help bridge that gap. In determining whether to offer stub equity, a sponsor should analyze the target shareholder base to determine its receptivity to a stub equity interest. For example, many institutional investors have a limited ability to own unlisted equities and therefore offering them stub equity may not push them over the edge in favor of supporting a transaction.
Getting Boards to Yes - A stub equity structure may provide a sponsor with a competitive advantage in an auction or other pre-signing market check where insiders want to rollover some of their equity and the target board is concerned about disparate treatment of insiders compared with other target shareholders. In a competitive bidding situation, an offer of stub equity may also be an effective strategy in differentiating that sponsor’s bid from other bids by permitting target shareholders, who so elect, to participate in the future upside of the business.
Additional Equity Capital - Stub equity may reduce the need to club with other sponsors or to syndicate down a portion of its commitment, although stub equity is not “committed” and therefore it is possible that all target shareholders will elect to take cash and not rollover any of their equity. Sponsors will also be cognizant of the fact that they will not be able to charge a carried interest or management fees to the target shareholders on the equity they hold.
Increase Post-Acquisition Earnings - A sponsor that employs a stub equity structure may in certain cases benefit from recap accounting for the target, which would favorably impact the acquisition vehicle’s future net income.
Drawbacks of Stub Equity to Sponsors
Sponsors should consider the following drawbacks in connection with offering a stub equity structure to a target:
Enhanced SEC Disclosure Obligations - Sponsors will be subject to enhanced SEC disclosure obligations due to the stub equity structure. The stub equity will generally need to be registered under the Securities Act and the acquisition vehicle will need to prepare a prospectus that complies with the Securities Act to be mailed to target shareholders in connection with their decision as to whether to rollover all or a portion of their equity. The acquisition vehicle (and the sponsors as control persons) will also be subject to potential liability under the Securities Act for any misstatements or omissions of material fact in the prospectus. In addition, as noted above, the acquisition vehicle will need to be an SEC reporting company for at least some period of time post-closing and will need to comply with a number of Sarbanes-Oxley requirements applicable to SEC reporting companies.
Minority Board Representation - As in Clear Channel, the target may negotiate for certain governance rights for the target shareholders, including the right to appoint independent directors to the board of the acquisition vehicle. The presence of independent directors may very well change the dynamic in the board room of the acquisition vehicle and may prove a nuisance to the sponsors.
Limits on Affiliate Transactions - As in Clear Channel, the target may negotiate for limitations on transaction and management fees benefiting the sponsors, as well as other limitations on affiliate transactions. Even without these limitations, the sponsors will have to be cautious, considering the public nature of the shareholder base, that the acquisition vehicle does not enter into any transactions with them or their affiliates that could be challenged in court.
Speed to Closing - As noted above, a going private transaction with a stub equity structure may not close as quickly as a typical all-cash merger transaction because of the obligation to register the stub equity under the Securities Act.
Conclusion
It is not clear whether the stub equity structures recently seen in Clear Channel and Harman will be the start of a trend or will become footnotes in recent deal history. Going semi-private is probably not the ideal result for sponsors, particularly in a time when equity capital is abundant. In any event, sponsors should be aware of the advantages and drawbacks of stub equity structures before contemplating their use.
Weil, Gotshal Manges is a leading legal specialist in private equity services, with dedicated private equity lawyers in major financial centres throughout the world. For more information please visit www.weil.com.
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