Download Private Equity Investment in Latin America

Private Equity Investment in Latin America
November 2007
Peter V. Darrow
Randall R. Gibeau
www.mayerbrown.com
Mayer Brown LLP is among the 10 largest law firms in the world, with more than
1,500 lawyers practicing in 14 cities around the globe. In addition, Mayer Brown has
an independent correspondent relationship with Jáuregui, Navarrete y Nader, a
prominent law firm in Mexico City.
Mayer Brown offers a broad range of services to clients conducting business in Latin
America. We have extensive experience in private equity investments, joint ventures
and mergers and acquisitions, debt and equity security offerings in the international
capital markets, acquisition financing, advice concerning disclosure obligations
under the U.S. federal securities laws, securitization and structured financing,
corporate and project finance, and real estate investments and financing. The
attorneys in our Latin America practice work with local counsel to find innovative,
cost-effective solutions to various investment objectives when advising private
equity funds, portfolio companies, management teams and financial institutions in
connection with fund formation, investment/ exit transactions and related financing
activities.
In private equity, Mayer Brown acts for traditional private equity funds, captive
funds, venture capital funds, portfolio companies, management teams and financial
institutions in connection with private equity transactions. We are experienced in
representing private equity clients in management and leveraged buyouts, follow-on
acquisitions, public-to-private transactions, private investments in public companies,
seed and venture capital investments and all forms of exit transactions, including
auction sales, recapitalizations and IPOs. Our firm-wide team provides corporate,
securities, tax, employment, antitrust, environment and other regulatory skills to
efficiently structure and close the most complex transactions.
For more information, please contact:
Peter V. Darrow
Randall R. Gibeau
1-212-506-2560
1-212-506-2532
[email protected]
[email protected]
Mayer Brown LLP
1675 Broadway
New York, New York 10019-5820
Tel:
1-212-506-2500
Fax:
1-212-262-1910
Copyright © 2007 Mayer Brown LLP. This Mayer Brown publication provides information and comments on legal
issues and developments of interest to our clients and friends. The foregoing is not a comprehensive treatment of the
subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before
taking any action with respect to the matters discussed herein.
Private Equity Investment in Latin America
Introduction
There has been an exponential growth in private equity investment in the United
States over the last decade, and private equity investors – both private equity funds
and hedge funds – attracted by the prospect of high returns, have started to increase
their investment activity in Latin America, especially in Brazil and Mexico, the two
largest and most mature markets in the region. In addition, a number of private
equity funds have been organized throughout the region in response to the longstanding demand for, and inadequate supply of, capital. These developments,
together with the perception that asset values in Latin America generally are low in
relation to asset values in the U.S. and Europe, have led to an acceleration in the
growth of private equity investments in Latin America.
Latin buyout funds
generated one-year
gross returns of 31%
in the year to June,
2006, according
to the Emerging
Market Private
Equity Association.
According to Venture Equity Latin America, during the period 2001-2005 over $4
billion in private equity investments were made in Latin America, while over $4.5
billion in private equity funds was raised for investment in the region. Latin buyout
funds generated one-year gross returns of 31% in the year to June, 2006, according to
the Emerging Markets Private Equity Association. In addition, Dealogic reports that
leveraged buyouts more than doubled in Latin America in 2006, with 36 deals worth
$2.4 billion, compared with three deals in 2003 worth $363.5 million. The relative
economic stability of the region, combined with strong economic growth and
increasingly sophisticated capital markets, has also made Latin America an attractive
market for private equity investment.
The types of Latin American companies that may be in search of private equity vary
widely. For example, there are many companies in the region that have grown and
matured in their respective industries that need to recapitalize their balance sheets in
order to obtain debt financing upon competitive terms to either consolidate their
position in the local market or meet the competitive challenges arising from
increasing economic globalization. In addition, there are a large number of less
mature companies in the region that are investing in growth sectors, such as housing,
commercial real estate, and consumer goods and services. These companies are
capital intensive, and require significant ongoing capital infusions in order to
continue their growth and expansion.
Successful venture capital and private equity investments in the region can prove to
be very beneficial for the companies in which the investments are made, as well as
the economies in which the companies operate. A successful private equity
investment in a target company will reward the investor with an attractive rate of
return while allowing the target company access to the capital, skills and technology
it needs in order to sustain growth and profitability. Furthermore, Latin American
economies benefit from an influx of private equity which aims to achieve profits
through the long-term growth of target companies, as opposed to more traditional
investments in local capital markets which have proven all too often to be
speculative and short-term in nature.
PRIVATE EQUITY INVESTMENT IN LATIN AMERICA
Characteristics of Private Equity Investments in Latin America
Broadly, private equity investments often share the following characteristics: (i) the
investment is made in a company (the “Company”), the equity securities of which
are either held by a small group of shareholders (the “Original Shareholders”) who
founded the company or are publicly listed in a capital market that, because of
liquidity or pricing issues, is unable to support the Company’s access to public
capital; (ii) the investment is often made by professional venture capitalists, strategic
investors, or by funds organized for the purpose of making private equity
investments (“Investors”) who are likely to assume that their participation in the
investment will add value to the Company, and will, therefore, expect to be granted
some degree of participation in the management or, at a minimum, oversight of the
Company; and (iii) such investments are not intended to be held indefinitely, but for
a limited period of time (usually 3-6 years). Due to their limited time horizon,
Investors generally seek Companies that are perceived to enjoy high-growth
potential over the long term, whether because they are industries with long-term,
high-growth potential, because they are developing new products or services that
when introduced are likely to garner a significant market share, because they are an
active force in a rapidly consolidating industry, or because of any combination of
these characteristics.
Many Latin
American Original
Shareholders are
family members
who have
historically opposed
selling any equity in
their company and
who are, as a rule,
unwilling to
surrender control.
These general characteristics must, however, be viewed in a Latin American context.
For example, many Latin American Original Shareholders are family members who
have historically opposed selling any equity in their company and who are, as a rule,
unwilling to surrender control. As a result, private equity investments in Latin
America often involve the acquisition of lesser percentages of the equity of the
Company than is common in the United States. Furthermore, depending on the
sector and the local jurisdiction, there may be legal restrictions on the percentage of
foreign ownership allowed in the Company.
For the reasons discussed below, the Company’s capital structure will customarily
include both common and preferred stock. Private equity investors normally expect
their investment to be in the form of preferred stock, which will enjoy certain
important preferences in relation to the common stock, will be convertible into
common stock, and may (depending upon the bargaining power of the Investor and
the Company’s need for capital) be redeemable at the option of the holder.
Risks of Private Equity Investments
Private equity investments pose risks for both the Original Shareholders and the
Investors, in addition to the business and valuation risks that all companies face.
Past experience has shown that the more significant factors which have given rise to
problems in private equity investments in Latin America have included, among
others (i) disagreements on the value of the Company, the sales price of the
Investors’ participation and the appropriate valuation procedures; (ii) disagreements
on exit formulae; (iii) the conflicting objectives of the Original Shareholders and the
Investors; (iv) the resistance of the Original Shareholders to permitting the Investors
to exercise significant influence over the management and direction of the Company;
and (v) where the investment is made in a Company incorporated in Latin America
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PRIVATE EQUITY INVESTMENT IN LATIN AMERICA
(as opposed to an offshore jurisdiction), the potential lack of a clear and reliable legal
framework to enforce minority rights, and the potential inability of the local judiciary
system to resolve controversies efficiently.
As in any direct investment, there is the risk of changes in or disagreements with
regard to either the goals of the Company or the interests and expectations of the
Original Shareholders and Investors. Therefore, it is important that the parties
negotiate clear and effective mechanisms to regulate the relationship among all
shareholders, especially the terms and conditions dealing with governance, financial
decisions, day-to-day management, dispute resolution, and exit strategies.
With respect to the Original Shareholders, a private equity investment will often
involve having to learn to manage the Company with certain restrictions on
decision-making. Investors frequently request representation on the board of
directors and rights to veto actions relative to certain key management and operating
issues. In some cases, the Investors will even seek direct participation in the day-today management of the Company. While these restrictions may seem burdensome
and restrictive to the Original Shareholders accustomed to exercising unfettered
control of the Company, they are nevertheless important to protection of the interests
of minority shareholders.
An additional risk faced by the Original Shareholders is the potential for dilution of
their interests. Private equity investment is often attracted to businesses and
industries with strong prospects for growth. As a result, Investors often make an
investment in a Company in anticipation of the pursuit of an aggressive growth
strategy, which may impose significant and continuing capital needs on a Company.
Depending on their resources, the Original Shareholders may experience dilution as
Investors or other capital sources make contributions in excess of their ratable
interest. As a result, Original Shareholders should seek to include antidilution
provisions in the agreements documenting the private equity investment.
With respect to the Investor, the relative illiquidity of the Company’s shares (the
“Shares”) purchased by the Investor generally represents one of the most significant
risks in any private equity investment. Accordingly, in order for the Investor to be
able to realize an acceptable return on its investment, the Investor will insist upon
negotiating an acceptable exit strategy at the outset of the investment. Such
strategies, discussed in greater detail below, may include taking the Company
public, selling the Company to a third party, selling the Shares back to the Company
(pursuant to a put provision in the agreements documenting the private equity
investment) or selling the Shares to a third party.
Engaging Legal Advisors
Prior to entering into negotiations with private equity investors, the Original
Shareholders will need to engage a law firm that is experienced in advising
companies in connection with private equity investments. The law firm will have
responsibility for reviewing and negotiating with private equity investors the terms
and conditions of any investment, while seeking to protect the interests of the
Original Shareholders. The Original Shareholders may be unfamiliar with this
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PRIVATE EQUITY INVESTMENT IN LATIN AMERICA
process and are often more focused on obtaining adequate private equity financing.
As a result, the Original Shareholders may not take (or have) the time to fully
understand and properly evaluate the significance of investment terms proposed by
private equity investors, and may make concessions that have the consequence of
reducing their future rights and equity interest in the Company. Support from
knowledgeable counsel can be important to the Original Shareholders in “leveling
the playing field,” elevating their awareness about the implications of proposed
investment terms and preventing them from making significant – and avoidable –
concessions.
The Process of Obtaining a Private Equity Investment
Formulating a Business Plan
Once the Company has decided to seek private equity, the first step will be the
preparation of a detailed business plan that describes the Company’s business and
operations, summarizes its business strategy, describes the relevant market, includes
financial statements, if available, and includes detailed financial projections. If the
Company is a development stage entity, the Original Shareholders will be more
likely to prepare the business plan, since there is no significant role for investment
bankers to play in early stage financing. If the Company is a more mature business,
it may be desirable to engage an investment banker to assist in preparing the
business plan, identify prospective investors and assist in implementing the
investment. In either case, before entering into the various stages of negotiation, the
Company should obtain the services of a law firm with experience in private equity
investments to negotiate and document the terms and conditions of the investments
and to advise the Company on legal issues arising from the search for private equity.
Confidentiality and Due Diligence
Through contact with the Company’s management or investment bankers (if they
have been retained) and review of the business plan, Investors with interest in the
Company will identify themselves and ask to undertake an in-depth due diligence
review of the Company. The due diligence review is essential to formulating a
valuation by potential investors and for verifying the assets, liabilities and
contractual obligations (including any existing or potential contingent liabilities) and
financial condition of the Company. Before further discussion is held with
prospective Investors or additional material is distributed or made available to them,
a Company ordinarily requires that a confidentiality agreement be executed. In
order to prepare for the due diligence to be carried out by interested Investors, the
Company, with advice from its legal counsel, will be responsible for selecting,
organizing, and making available for review all relevant documents. In addition, the
Company will typically arrange for Investors to meet at length with management
and tour the Company’s facilities.
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Term Sheets and Letters of Intent
Typically, after a potential Investor has performed its due diligence and has
indicated a serious interest in making an investment, the parties will want to
negotiate a term sheet or equivalent letter of intent which sets forth, in detail, the
principal terms and conditions on which the investment will be made. (However, it
is not uncommon for a term sheet to be negotiated prior to the performance of due
diligence by a potential investor.) Those terms and conditions will be influenced by
the amount to be invested, the level of ownership the investment represents, the type
of business the Company operates, the Company’s financial situation, and the type
of investment (development stage, strategic investment in an ongoing business,
recapitalization, or troubled company turnaround).
The shareholders’
agreement should be
drafted in such a
way so as to protect
all shareholders,
represent their
interests, and
anticipate any kind
of controversy by
providing an
adequate mechanism
for its resolution.
The single most important issue to be addressed in the term sheet is determining the
value of the Company. This issue is the most sensitive matter at the initial
negotiation stage, and the Investors will generally not go forward with a proposed
investment upon the failure to reach agreement. Other important issues relating to
the financial terms of the investment, including the schedule on which capital is to be
invested and the nature of the investment (convertible debt, debt with warrants,
common stock, preferred stock, etc.), are resolved at this term sheet stage.
In most cases, the term sheet also addresses issues relating to Company governance
and the relationship between the Investors and the Original Shareholders. The
amount of negotiation on these issues and the extent of the detail included in the
term sheet or letter of intent will influence, in an important fashion, the negotiation
of the relevant agreements. To the extent the parties are able to reach a detailed
agreement at the term sheet stage concerning these issues, there will be a
corresponding reduction in the amount of time required to negotiate the
documentation of the investment.
Typically, there is significant negotiation between the principals that occurs at the
term sheet stage. Once the terms and conditions have been agreed to by all the
parties, legal counsel will incorporate the terms into draft documentation. This
generally includes both a securities purchase agreement (containing the price, the
nature and terms of the Shares, the conditions to closing the investment, the
representations of the parties and any indemnity obligations), and a shareholders’
agreement, which regulates all aspects of the relationship among the Company’s
shareholders, including the resolution of any controversies that may arise among the
parties. Therefore, because of the pivotal role it plays in the success of the
investment, the shareholders’ agreement should be drafted in such a way so as to
protect all shareholders, represent their interests, and anticipate any kind of
controversy by providing an adequate mechanism for its resolution. Where
registration rights are contemplated, they will either be incorporated in the
shareholders’ agreement, or contained in a separate registration rights agreement. It
will be the lawyers’ responsibility to produce documents that set forth, in a clear
manner, all the terms and conditions negotiated by the parties and provide a
workable arrangement for the management of the Company.
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PRIVATE EQUITY INVESTMENT IN LATIN AMERICA
What Form of Capital Structure Should be Used?
The Original Shareholders will want the Company to have a capital structure that
allows them flexibility in financing, recognizing that not all Investors will receive the
same rights, and that different classes of Investors will have different investment
expectations.
Private equity
investors will
Private equity investors will typically expect to receive preferred stock, convertible
into common stock, that enjoys preferential treatment in any liquidation of the
Company, and may enjoy other preferences, including the right to receive dividends.
Private equity investors may also expect to receive warrants.
typically expect to
receive preferred
stock, convertible
into common stock,
that enjoys
Typical Preferred Stock Provisions
Preferred stock issued to private equity investors will generally have some or all of
the following features:
•
The preferred stock will be convertible at any time, at the option of the
holder, into common stock of the Company, at a specified price per share.
The conversion ratio will generally be on a one-for-one basis, adjusted for
stock splits, stock dividends, recapitalizations and similar events. Also
typically included would be antidilution rights discussed below.
•
In addition, the preferred stock will automatically convert into Shares of
common stock, at the then applicable price per share, upon the
completion of a “Qualified Public Offering” that meets certain specified
criteria, which typically include a minimum of proceeds and a per share
price which is a specified multiple of the original purchase price.
•
The preferred stock will customarily vote with the common stock on an
“as converted” basis (i.e., as if it has already been converted).
•
The preferred stock will vote as a class (separately from the common
stock) on certain issues of importance to the holders of the preferred
stock, including (i) changes in the capital structure, (ii) the issuance of
additional preferred stock which is pari passu with or senior to the
existing preferred stock, (iii) mergers and business combinations, (iv)
changes of control, (v) the adoption of any stock option plan and (vi) any
IPO.
•
Preferred stock will often carry a fixed dividend payable at regular
intervals, which may or may not “cumulate” in favor of the holder if not
declared for any reason. Cumulated dividends must be paid to holders
of preferred stock before any dividend may be paid to holders of
common stock. However, since many companies either lack the cash
with which to pay dividends, or are in industries where the practice is
generally to pay no dividends, holders of preferred stock will
preferential
treatment in any
liquidation of the
Company….
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PRIVATE EQUITY INVESTMENT IN LATIN AMERICA
customarily be entitled only to dividends and distributions equivalent to
those paid on the Shares of the common stock, based upon the number of
Shares of common stock into which the preferred stock could have been
converted on the record date for the declaration of dividends.
•
The preferred stock will enjoy a liquidation preference, so that upon any
liquidation, dissolution, merger, or sale, the holders of preferred stock
will be entitled to receive an amount equal to the purchase price, plus
any declared but unpaid dividends, before any payment is made to
holders of the common stock. The amount payable to holders of
preferred stock upon liquidation or sale may also include some form of
return on invested capital or “participation” in the increased value of the
Company. Often, a “liquidation” is deemed to occur upon a change of
control entitling the preferred stockholders to a purchase price at least
equal to the liquidation preference and, possibly, higher than the price
paid to common stockholders.
In order to provide themselves with an exit strategy (which is discussed generally
below), Investors receiving convertible preferred stock will often negotiate for a right
of redemption at the option of the holder, which typically will be exercisable after the
lapse of a specified period of time in which no initial public offering has been
successfully implemented. Like the liquidation price, the redemption price will be
the purchase price, plus any declared but unpaid dividends, and may include some
form of return on invested capital.
Antidilution Protection
As mentioned above, the Original Shareholders will expect to experience dilution as
new Investors are brought in, but will nevertheless hope to retain control of the
Company. The Original Shareholders may negotiate for preemptive rights, giving
them the right to purchase their pro rata share of any new Shares issued by the
Company, before Shares may be offered outside of the existing group of
shareholders. However, since the Original Shareholders may lack the financial
resources to exercise their preemptive rights – but will need additional capital – they
may expect to be diluted.
Investors will expect to be protected against dilution arising from the future issuance
by the Company of Shares at a price below the price which they paid for their Shares.
There are two common antidilution formulas: a “weighted average” antidilution
formula, and a “full ratchet” antidilution provision. Under “full ratchet” provisions,
the conversion price of existing convertible preferred stock automatically decreases if
one share of stock is issued at a price lower than the existing conversion price. In
that event, the conversion price of the preferred stock automatically “ratchets down”
to the lower price, entitling the holders of the preferred stock to receive a higher (and
possibly much higher) percentage of the common stock upon conversion, even
though the Company may have only raised a nominal amount of additional
financing. Obviously, this type of antidilution is much more Investor-friendly.
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PRIVATE EQUITY INVESTMENT IN LATIN AMERICA
In contrast, a “weighted average” antidilution provision moderates the rate at which
existing shareholders suffer dilution. Under this approach, where the Company
issues new Shares at a price below the conversion price of existing convertible
preferred stock, the conversion price is reduced, but to a number that takes into
account how many new Shares are being issued by the Company. Thus, where only
a limited number of new Shares are issued by the Company at a price below the
existing conversion price, the conversion price of the existing convertible preferred
stock will be reduced (entitling the holders thereof to acquire more Shares of
common stock) only slightly.
Corporate Governance Rights
Minority Investors
will … generally
Set forth below is a description of the principal issues that will arise in any
negotiation with potential Investors.
expect to have a right
Board Representation and Observer Rights
of approval in
Investors will expect representation on the Company’s board of directors, typically at
a level proportionate to their investment. Board representation allows an Investor to
review all important managerial decisions relating to the Company and to
participate in all decision-making that occurs at the board level. Typically, the board
representative selected by an Investor will have experience in the industry in which
the Company is involved, or will be experienced with companies at a similar stage of
development. By having one or more appropriate representatives on the board of
directors, together with the veto rights referred to below, the Investor feels that it has
the ability to influence the Company’s business and to protect its investment. If a
private equity investor is unable to obtain a seat on the Company’s board, it may
request observer rights, which give the Investor the right to receive all materials sent
to the Board and to participate (though not vote) at board meetings.
relation to a variety
of matters that are
important to the
capitalization,
growth, financing
and management of
the Company.
Veto Rights of Minority Investors
Minority Investors will, dependent upon the level of their investment, generally
expect to have a right of approval in relation to a variety of matters that are
important to the capitalization, growth, financing and management of the Company.
In the case of actions requiring shareholder approval, veto rights in favor of a
minority Investor are created either by explicitly granting an Investor these rights in
the organization documents of the Company (including by creating a separate class
of securities held only by the Investor and requiring the approval of holders of that
class of securities, voting as a separate class), or by requiring the approval of a supermajority of the stockholders that cannot be obtained without the participation of the
Investor. If the organizational mechanisms are unavailable or impractical, the
Investor may seek from the Company a covenant (to be contained in the
shareholders’ agreement) that such actions will not be taken without the prior
consent of the Investor.
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PRIVATE EQUITY INVESTMENT IN LATIN AMERICA
The nature of the Company will also have an effect: generally, the more established
the Company, the fewer of these issues require Investor approval, while in
development-stage companies, Investors generally seek approval of a broader
segment of these issues. Issues requiring approval by a minority Investor are often
divided between those actions that require approval at the level of the board of
directors, and those actions requiring shareholder approval. However, while there is
no prevailing convention for allocating in any particular fashion those actions that
are taken at the board level and those actions that are taken by the shareholders, in
practice these actions are often divided along certain logical lines.
Minority Investors
will usually request
that most
Minority Investors will usually request that most fundamental changes of the
Company, its business and direction, and its organic and capital structure, which
normally require the approval of shareholders, be subject to a favorable vote by such
Investors. These matters typically include the following:
•
issuance of additional stock, bonds, debentures, Shares or any options or
warrants to purchase stock, the reclassification of stock, or an initial
public offering;
Company, its
•
redemption of stock;
business and
•
amendments to the charter and bylaws of the Company;
direction, and its
•
increases or reductions of the capital stock of the Company;
•
extension of the duration of the Company;
•
change of the corporate purpose of the Company;
•
effecting a merger, spinoff, consolidation or business combination of the
Company or a sale or conveyance of all or substantially all of the
Company’s assets;
•
liquidation or dissolution of the Company or filing for bankruptcy or
insolvency proceedings; and
•
changing the number and composition of the board of directors or of any
special committee of the board.
fundamental
changes of the
organic and capital
structure … be
subject to a
favorable vote by
such Investors.
The issues that minority Investors typically identify as requiring their approval
generally include changes to the capital structure of the Company and, particularly
in the case of development-stage companies, changes in the management or
operations of the Company’s business. Board actions commonly requiring the
Investor’s approval include, among others, the following:
•
appointment and removal of the CEO of the Company;
•
approval and amendment of the Company’s business plan;
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PRIVATE EQUITY INVESTMENT IN LATIN AMERICA
•
approval and amendment of the Company’s annual operation and
capital investment budgets;
•
incurrence of debt;
•
creation of liens and encumbrances;
•
sale, lease, conveyance or purchase of assets outside the ordinary course
of the Company’s business;
•
entering into any merger, consolidation or business combination;
•
payment of dividends;
•
appointment and removal of the Company’s external auditors and
statutory examiners;
•
entering into agreements involving expenditures or commitments in
excess of a determined amount or outside the ordinary course of
business;
•
approval of any agreement with related parties to the shareholders or
directors or officers or their respective relatives;
•
initiation of any litigation or consent to the settlement or admission of
liability with respect to any litigation;
•
approval of employment contracts and severance agreements with key
management; and
•
any of the above-mentioned issues with respect to any of the Company’s
subsidiaries.
Management
The Investor may require that certain changes be made in the management of the
Company, and may seek involvement in the day-to-day management of the
Company, especially where the Investor has acquired at least a majority of the
Company’s voting securities. The resolution of this issue will depend on the
financial situation of the Company, the level of the investment, and the degree of
expertise of the existing management to meet projected goals, and other factors.
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General Transfer Restrictions on the Company’s Shares
Preemptive Rights
Preemptive rights give shareholders the right to purchase, out of new securities to be
issued by the Company, their pro rata share of such securities. This provides to each
shareholder a right to maintain its proportionate interest in the Company and
thereby avoid the dilution that will occur upon the Company’s issuance of securities
to other shareholders or to third parties. Investors will typically insist on having
preemptive rights to protect themselves against any possible dilution.
Right of First Refusal
Investors will
typically insist on
having preemptive
rights to protect
themselves against
Shareholders’ agreements typically include rights of first refusal, allowing
shareholders to purchase their pro rata portion of Shares that are offered by any
selling shareholder to a third party, at the price and on the terms that have been
offered by the third party. If any shareholders elect not to purchase their ratable
portion of Shares to be sold, the remaining shareholders have a subsequent
opportunity to acquire their pro rata portion of the unpurchased Shares. Once all
shareholders have exhausted their right of first refusal, the original selling
shareholder is free to sell the remainder of its Shares to the third party, at the
tendered price, for a specified period of time.
any possible
dilution.
Tag-Along Rights
In the situation where the shareholders have successfully negotiated to sell their
Shares to a third party, tag-along rights require, as a condition of the sale, that the
other shareholders be permitted to sell their Shares to the purchaser (i.e., to “tag
along” with the majority shareholders) on the same terms and under the same
conditions of the offer. This provision discourages competition among shareholders
to sell their Shares to a potential buyer. Often, tag-along rights apply only to sales of
a majority of the outstanding Shares, in which circumstance the tag-along right
prevents a third party from offering to purchase from the majority shareholders at a
premium price only that number of Shares sufficient to obtain a majority of the board
of directors.
Drag-Along Rights
Drag-along rights, which are common in shareholders’ agreements, permit majority
shareholders to negotiate the sale of the Company to a third party, and then compel
(or “drag along”) the minority shareholders to sell their Shares to the third party on
the same terms and conditions that have been negotiated by the majority
shareholders. Drag-along rights allow majority shareholders to force uncooperative
or complacent minority shareholders to participate in an exit strategy. Drag-along
rights can be very coercive to minority shareholders, compelling them to sell their
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Shares in an entire sale of the Company in circumstances where they would prefer to
remain as minority investors.
Exit Strategies
One of the most important issues to be negotiated between the Original Shareholders
and any minority Investor(s) is the exit strategy. A private equity Investor does not
make an investment with the intention of retaining its investment for an indefinite
period of time. As a result, exit strategies play a key role when an investment has
matured (or the Investor believes the Company has achieved a sufficient level of
growth or profitability) and the Investor wishes to “exit” the Company by selling its
Shares. The exit procedure set forth in the shareholders’ agreement will depend on,
among other factors, the size of the Company and its business, as well as market
conditions.
The shareholders’ agreement will usually anticipate that the Company will be taken
public through an initial public offering (an “IPO”). However, it is possible that at
the desired time the international markets may prove inaccessible for an IPO by a
Latin American company, so an Investor is likely to require that an alternate exit
mechanism is provided. An alternative would be for the Investor to be able to cause
the Company to be sold to a strategic buyer, such as a larger local company wishing
to expand or a foreign company interested in entering the local market. The
shareholders’ agreement may also provide the Investor with the option to “put” its
Shares back to the Original Shareholders or to a third party (i.e., require that they
purchase the Investor’s Shares) that is acceptable to the Original Shareholders either
at the then “market price” of the Company or at a price intended to provide the
Investor with an acceptable rate of return on its investment.
If an exit provision such as a “put” has been triggered, the valuation procedures set
forth in the shareholders’ agreement will be of critical importance in determining the
value of the Company. Therefore, a detailed procedure should be negotiated and
documented in order to avoid any conflict or complications among the shareholders.
This provision should be carefully structured so as to complement, and not conflict
with, the exit strategies and dispute resolution measures also provided for in the
shareholders’ agreement.
Initial Public Offering and Demand Registration Rights
To many Investors, registration rights are an important issue in making their initial
investment decision. The Company can engage in a public offering only with the
support of the Company’s board of directors and its management, meaning that a
minority Investor in a nonpublic Company is effectively subject to decisions made by
the majority shareholders. Therefore, negotiating in advance the circumstances
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PRIVATE EQUITY INVESTMENT IN LATIN AMERICA
under which the Company will cooperate in a public offering of its Shares is critical
to a minority Investor.*
In order to insure their ability to sell their Shares publicly, minority Investors secure
in advance the consent of the majority shareholders to cooperate — and to cause the
Company to cooperate — in the preparation and filing of a registration statement
that will comply with all of the SEC’s requirements (referred to as “registration
rights”). As a practical matter, an IPO is only likely to be successful where the
Company itself is issuing Shares, although at the discretion of the underwriters the
IPO may also include all, or some portion, of shareholders’ Shares among those
Shares that are to be registered with the SEC. Accordingly, minority Investors will
negotiate for registration rights that will permit them to include their Shares in any
future public offering by the Company.
An IPO is only
likely to be
successful where the
Company itself is
issuing Shares ….
There are two types of registration rights; “demand” rights and “piggyback” rights.
“Piggyback” registration rights allow shareholders to have their Shares included in
any suitable registration statement that the Company is planning to prepare and file
with the SEC on behalf of itself or other shareholders. “Demand” registration rights,
on the other hand, require that the Company initiate and follow through with a
registered offering (and pay the costs associated with preparing and filing a
registration statement) and include in that offering Shares held by the Investor
making the demand. Typically, Investors will seek the right to make up to a
negotiated number of demand registration rights within an agreed-upon period.
Dispute Resolution
There will be many issues throughout the existence of the investment that may give
rise to conflict between the Original Shareholders and the Investor. These issues will
generally encompass key financial or managerial decisions such as capital
contributions, dividends, budgets, business plans, acquisitions, sales of assets,
indebtedness and appointment of key officers. Since disagreements among the
parties will inevitably arise, it is essential to the existence of the Company and for the
protection of the Investor’s investment to have a clear and effective procedure
pursuant to which any type of controversy may be addressed and resolved fairly and
efficiently.
Controversies involving issues to be addressed at the board of directors’ level may
be resolved in a variety of ways. One alternative involves giving the President-ofthe-board the decisive vote and having the Presidency change among the
shareholders from year to year. This procedure guarantees that the President,
knowing that the following year another shareholder will have the power to elect a
successor, shall make a careful and conscientious decision. Another alternative for
resolving disputes among the members of the board is to present the issue to the
board on two separate occasions. If the board is unable to resolve the dispute during
*
For a useful discussion of registration rights, see Equity Finance Venture Capital, Buyouts,
Restructurings and Reorganizations, Joseph W. Bartlett (John Wiley & Sons, Inc., Second Edition,
1995).
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PRIVATE EQUITY INVESTMENT IN LATIN AMERICA
that time, the issue will be presented to the shareholders for resolution at a meeting
convened precisely for that purpose.
If any issue to be addressed at the shareholder level, including any disputes
originating at the board of directors’ level, cannot be resolved in two consecutive
shareholder meetings, the dispute may be resolved through an arbitration procedure
with as much formality and procedural specificity as the parties may agree. The
shareholders’ agreement normally sets forth the scope of this arbitration procedure,
which may range from a “mini-arbitration” procedure set forth in the shareholders’
agreement to a more formal procedure conducted under the rules of an arbitration
organization, such as the American Arbitration Association or the International
Chamber of Commerce.
When disputes arise among the shareholders, certain unrelated events may be
triggered under the shareholders’ agreement. For example, put and call rights
embedded in the shareholders’ agreement may be triggered which would force the
shareholder in disagreement to either sell all of its Shares to the remaining
shareholders or to purchase the Shares of all the other shareholders. It is in such
situations where a carefully structured valuation procedure would prove valuable in
attempting to avoid any further controversies among the shareholders.
Amendments to the Company’s Charter and Bylaws
In most circumstances, the Company’s charter and bylaws will have to be amended
to reflect the terms and conditions agreed to by the Investors, the Company and the
Original Shareholders. The most significant changes affecting these documents will
probably involve changes to the description of the economic and voting rights
appurtenant to the Shares being purchased, the structure of the board of directors,
the procedures for appointing and removing directors, key management and
auditors, and the voting requirements for the board of directors and general and
special shareholders’ meetings.
Stock Purchase Agreement
In addition to negotiating a shareholders’ agreement, the parties will also negotiate a
detailed stock purchase agreement, which is generally prepared by counsel for the
Investor. This agreement will, in addition to containing the terms regarding the
purchase of the Shares, include extensive and detailed representations and
warranties concerning the business, assets, liabilities and financial condition of the
Company and its subsidiaries, their compliance with all applicable laws and
regulations, and their possession of all required governmental permits,
authorizations and licenses and may also include representations about the selling
shareholders.
It will also include covenants applicable to the Company and, in many cases, the
selling shareholders, conditions to closing (including receipt of any required
governmental authorizations or approvals), provisions allowing for termination of
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PRIVATE EQUITY INVESTMENT IN LATIN AMERICA
the agreement, and a broad indemnification in favor of the Investor for any damages,
losses or claims (including fees and expenses) arising from any breach by the
Company or the selling shareholders of any representation or warranty or covenant
contained in the stock purchase agreement.
Inaccuracy of the
representations and
warranties by the
Company will allow
the Investor to assert
a claim for postclosing indemnification against the
Company (and
typically the selling
shareholders).
In order to ensure adequate disclosure to the Investor concerning the condition of the
business of the Company, the stock purchase agreement will typically include
numerous disclosure schedules that require management of the Company and its
counsel to furnish detailed, itemized information concerning all of the Company’s
assets, liabilities, material contracts, real estate owned and leased, information
systems, insurance coverage, licenses and similar information. Inaccuracy of the
representations and warranties by the Company will allow the Investor to assert a
claim for postclosing indemnification against the Company (and typically the selling
shareholders), and obtain a downward adjustment in the price paid by the Investor
for the investment.
Tax Considerations for Private Equity
Investments in Latin America
Tax considerations will typically have enormous importance to Investors,
particularly U.S. Investors. For U.S. Investors, the primary goal is to reduce the
aggregate of the taxes imposed by the local country and by the United States. A
secondary goal is to defer the payment of U.S. taxes on the foreign income. As a
general matter, the primary goal is achieved by reducing foreign taxes to the largest
extent possible and maximizing the ability to take a credit against U.S. taxes for any
foreign taxes paid. In many cases this requires that the foreign entity be eligible to be
treated as a pass-through entity for U.S. federal income tax purposes or that the
investment be made through a jurisdiction with which the foreign entity has a
favorable tax treaty. In other instances, the investment is made in part with debt or
provides that the U.S. Investor receives fees for providing services. In any event, the
legal team assembled by the Company should include an experienced international
tax lawyer familiar with the U.S. tax issues present in equity investments, and local
counsel conversant with the local tax regime, and the availability of pass-through
entities, such as limited liability companies and partnerships, which are likely to
minimize potential tax liability.
Conclusion
For Latin American companies, private equity investment often represents an
attractive source of capital. As the discussion above makes clear, there are a number
of important considerations that require careful review and negotiation by the
parties in relation to any private equity investment. The discussion set forth above
relating to these issues is not intended to be comprehensive, but rather is designed to
highlight certain matters to which Latin American companies, and their private
equity investors, need to be sensitive when considering private equity as a source of
financing.
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