11 July 2012
Hong Kong has seen very few private equity sponsored MBOs and privatisations. We believe this may change as private equity is getting increasingly active and as family shareholders of Hong Kong listed companies (some of which are in the second or third generation) wish to pass on control to or team up with outside investors.
This briefing looks at the legal framework for carrying out MBOs and privatisations in Hong Kong in partnership with existing shareholders or management.
The Hong Kong Code on Takeovers and Mergers (Takeovers Code) does not define a management buyout (MBO) but for the purpose of this briefing it isassumed to have the following characteristics:
- a cash offer is made by a vehicle formed for the purpose of the transaction by a financial sponsor (Bidco);
- the retention of Bidco's equity in private hands;
- Bidco being leveraged (e.g. bank debt to equity of say 2:1);
- it being key that the management hold an equity interest in Bidco in order to incentivise them; and
- the expectation by the financial sponsor (and management) that an exit will be achieved through a trade sale or IPO within a defined timeframe (say three to five years).
The characteristics of an MBO are generally that the existing shareholders (other than the professional management team) are expected to exit their investment in the underlying business by accepting the cash consideration. In other words, there is no significant shareholder in the target which will roll over its investment into Bidco rather than exit for cash.
A privatisation may share many (or all) of the characteristics listed above but there may also be a major shareholder (perhaps a founding family shareholding block) which does not wish to exit the business and instead wishes itself to make the offer or to join the consortium making the offer by rolling over its shares to become a shareholder in Bidco.
As further set out below, the general principles and rules of the Takeovers Code treat MBOs and privatisations by (or involving) a material shareholder differently in some important respects.
Takeovers Code background
General Principle 1 of the Takeovers Code provides:
"All shareholders are to be treated even-handedly and all shareholders of the same class are to be treated similarly".
The point is underscored by Rule 25 which prohibits special deals by a bidder (or its concert parties) with target shareholders before, during or for six months after a takeover offer closes. The mischief that these provisions are seeking to prevent is some shareholders being offered financial or other benefits (not offered to all shareholders) in order to encourage the selected shareholders to accept the offer.
Accordingly, where a person who is a shareholder in the target company is to acquire an interest in Bidco (directly or indirectly) and that opportunity is not being extended to other target shareholders, the question arises as to whether this constitutes a special deal contrary to Rule 25.
There are, however, two basic scenarios where some target shareholders can legitimately be treated differently by the Bidco under the rules:
- a management incentive arrangement falling within the exemption contained in ote 3 to Rule 25; and
- where a target shareholder is itself the offeror or is a "joint offeror".
MBOs: management incentive arrangements
Note 3 to Rule 25 recognises the practicalities of business life by acknowledging that it can be beneficial for a bidder to be able to retain the services of existing target management but that management may need to be given an incentive to stay on in the form of a continuing financial involvement in the business. Where the management are also other shareholders, this inevitably will mean that they are offered a deal overall which is different from that being offered to other shareholders. Provided certain safeguards are met, Note 3 sets out parameters which can make the difference acceptable, essentially by balancing out any favourable aspects of the management's retained interest with appropriate risks.
The following needs to be taken into account in order to fall within the exception set out in Note 3:
- it will need to be demonstrated that the risks as well as the rewards associated with an equity shareholding should apply to the management retained interest;
- an independent financial adviser to the target will need to give a fairness opinion on the arrangements; and
- where the Bidco and the management together have more than 5 per cent of the equity of the target, a vote of independent shareholders is required.
As regards the requirement that the management will be exposed to the risks as well as the rewards of equity, there are several different ways in which the management incentive could be structured.
In Hong Kong, investment income and capital gains are generally not subject to tax. Therefore, if the arrangement is structured in such a way that what the management receive is a return on an initial investment, it may be possible for the management to obtain payments tax free. By contrast, income from employment is subject to salaries tax and income is broadly defined and can catch share awards which are granted in connection with employment (i.e. under share option plans). Generally, the managers will get the best tax treatment if they are co-founders of the Bidco from the start rather than given options.
Although it is not stated on the face of the Note itself, there is one other very important requirement likely to be insisted upon by the Takeover Executive, namely that the managers being offered the incentive arrangements should be "full time managers". In other words, the Note is not suitable for situations where family members in a family-controlled listed company wish to roll over their shareholdings where they have no (or a limited) management role. Instead, they would need to qualify as a joint offeror (see "Privatisations: joint offerors" below) or the offer would need to be extended to all shareholders on the same terms (see "Privatisations: roll-over offers" below).
Privatisations: joint offerors
A genuine offeror is a person who, alone or with others, seeks to obtain control of a company and who, following acquisition of control, can expect to exert a dominant or at least significant influence over the company, to participate in distributions of profits and surplus capital and to benefit from any increase in the value of the company, while at the same time bearing the risk of a fall in its value resulting from the poor performance of the company's business or adverse market conditions. There may, however, be situations where two or more parties join together to make an offer and they should therefore be considered to be joint offerors.
In order to assess whether a person is a joint offeror, the following questions are likely to be considered by the Takeover Executive:
- what proportion of the equity share capital (equity) of Bidco will that person own after completion of the acquisition – a person who holds less than 30 as a joint offeror;
- even if the person holds 30 per cent or more of the equity, the Takeover Executive may determine he is not the offeror and that one or more of the other capital providers is in fact, economically speaking, the offeror in view of the risk to which his capital is exposed and the returns to which he is entitled. This will typically be the case where the equity is disproportionately small in relation to the value of the offer/the enterprise value of the company andthat person's total contribution is relatively insignificant;
- where a consortium comprises more than three investors, each of whom has a roughly equal interest in the equity of the Bidco, the Takeover Executive may regard each of them as a joint offeror (even though he holds less than 30 per cent of the equity); and
- if the person's share of the equity is liable to significant dilution as a result of the exercise of rights attaching to options, warrants or convertible securities, the Takeover Executive may consider the fully diluted percentage interest as well as the initial interest of the putative joint offeror.
Will the person be able to exert a significant
influence over the Bidco?
- what percentage of voting rights exercisable at general meetings will that person hold or control;
- will that person be represented on the board of Bidco and, if so, what proportion of the voting rights exercisable at board meetings will his representatives hold; and
- what veto /minority protection rights will that person enjoy.
Will the person be in a position to influence
significantly the conduct of the bid?
In particular, is that person's approval required for:
- the announcement and posting of the offer;
- the fixing of the terms of the offer;
- any revision of the offer;
- any extension of the offer; and
- the waive down of the acceptance condition.
What contribution is that person making to Bidco
apart from his shareholding in the target?
If the person is partially funding the offer for the remaining target shares or contributing significant assets to Bidco, rather than just rolling over all or part of his shareholding, he is more likely to be viewed as a joint offeror.
What arrangements exist
for the person to exit
While it is common in private equity transactions to state as an objective that exit will be achieved within a certain timeframe by flotation or trade sale – and there may be "drag-along" provisions ensuring that the majority shareholders can deliver ownership of the whole company – a joint offeror should not be entitled to exit when other equity investors cannot, for example pursuant to a put option or a redemption right.
The Takeover Executive is likely to weigh up the responses to the questions set out above in determining whether the party in question is a joint offeror. In some exceptional cases, the Takeover Executive may determine that the only offeror is Bidco.
Rule 25 does, on the other hand, apply to special deals extended to target shareholders who are merely concert parties of the offeror as opposed to joint offerors. In this case, a roll-over offer will have to be made (see below).
Privatisations: roll-over offers
If the parties cannot fall within Note 3 nor qualify as joint offerors, then any "special deals" will have to be offered to all target shareholders. In other words, an opportunity to invest into Bidco equity would have to be offered to not only the target shareholders who Bidco wants to retain (e.g. a family block) but also general shareholders (e.g. retail and/or institutional shareholders).
It may be possible to structure the arrangement so that the general shareholders hold a different class of equity with the same economic rights but without the opportunity to participate in management. This would, however, require detailed discussion with the Takeover Executive.
There have been several MBO transactions in the UK based upon the UK equivalent exemption to Note 3 to Rule 25. Such transactions are rare in Hong Kong. While there have been joint offeror transactions in the UK, we are not aware of any private equity sponsored examples in Hong Kong. The principles set out in "Privatisations: joint offerors" above are based upon the UK Takeover Panel practice which was applied in the high profile takeover of Canary Wharf in 2004 by a joint offeror consortium.
There have been privatisations in Hong Kong by major shareholders (e.g. Hutchison privatisation of Hutchison Telecom in 2010). There have also been some notable failures (e.g. PCCW attempted privatisation in 2009). The attempted privatisation by CVC of Natural Beauty in 2008/9 was a high profile attempt by private equity to effect an MBO-style privatisation. In that case, a roll-over offer was made. Carlyle subsequently effected an alternative transaction. This was after a
restructuring of Natural Beauty's family shareholdings into a single holding company.
It is very important to consider carefully whether the proposed MBO is likely to fall within the exception set out in Note 3 to Rule 25. To do so, the proposal should be structured to incentivise the full-time professional management team rather than to enable a significant shareholder to roll over into Bidco. MBOs under Note 3 to Rule 25 have been rare in Hong Kong, possibly because most listed companies have a major controlling shareholder which is unwilling to exit the business.
If the proposed MBO will not fall within Note 3 (i.e. due to a proposed roll-over by a family shareholder) then the relevant parties need to consider whether they could be considered to be joint offerors. It is very important to review the criteria referred to in "Privatisations: joint offerors" above which are likely to be applied by the Takeover Executive to judge whether joint offeror status will be granted. This should be done before entering into detailed discussions and structure with other relevant stakeholders. Joint offeror status may be denied where the Takeover Executive suspects that the parties have artificially structured the proposal to meet the criteria, particularly if the structure is amended later to try to fall within the joint offeror exemption. Also, it remains to be seen whether the Takeover Executive will follow UK practice and consider the parties joint offerors rather than simply concert parties.
For further information, please contact:
Robert Ogilvy Watson, Partner, Ashurst
Lina Lee, Partner, Ashurst
Jackson Woo, Partner, Ashurst
Jonathan Hsui, Ashurst