(Article from Registered Funds Alert, February 2018)
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Below is an overview of some key considerations for buyers and sellers in an asset management M&A transaction, including critical regulatory considerations. Many outside advisers will aid in assessing these considerations. Legal specialists focus on aspects of deal structure such as tax, employee benefits and intellectual property. It is critical in the asset management space to also involve regulatory specialists who focus on 1940 Act and Advisers Act issues. Certain deals also involve regulatory specialists from other areas, such as antitrust or banking regulations.
Identifying a counterparty
An obvious first step is identifying a seller or buyer. This does not necessarily need to be a formal process. Some transactions will be privately negotiated after one party approaches another with a potential deal in mind. In those instances the target company and the prospective buyer may reach agreement in principle on the key terms of the deal before beginning the process of due diligence, disclosure and drafting the merger agreement. It is common practice for the parties to have legal counsel record these terms in writing as a term sheet, which is also sometimes referred to as a memorandum of understanding or a letter of intent.
In other circumstances, the seller may opt to engage in an auction process to identify a buyer or investor. A public company looking to maximize the value of the asset or business being sold may use an auction process. Here, the seller is firmly in control the auction and will often engage legal counsel and an investment bank to quarterback the auction before any level of negotiations with a potential counterparty begin.[1] An auction could be publicly announced, which allows interested parties to approach the seller, or an auction could be private, in which case the investment bank would approach potential buyers directly.
An auction begins with the solicitation of initial indications of interest (IOI) from potential buyers. Sellers often provide a two-to-five page summary, known as a “teaser,” that describes the target, its business and the potential transaction. The IOI typically is a simple letter outlining a bidder’s intention to pursue a purchase and often includes an initial, non-binding proposed purchase price and other key terms and conditions.
The seller typically requires a potential bidder that submits an IOI to sign a non-disclosure agreement (NDA). After obtaining a bidder’s NDA, the seller provides a confidential information memorandum (CIM) and a bid process letter to the bidder. The CIM contains more detailed information about the target company [2] than the teaser and is intended to elicit meaningful, well-informed bids. The bid process letter lays the groundwork for the auction process and explains the rules and procedures of the auction.
The seller’s investment banker ensures that no bidder becomes aware of the existence or identity of any other bidder or the terms of any other bid. In the absence of information about other bidders, each bidder must balance its desire to win the bid with its need for favorable terms.
After providing an initial indication of interest, the seller will invite some bidders to participate in the next stage of the process. The next stage could involve bidders meeting with management of the seller, conducting initial diligence on the seller and discussing a term sheet. This stage could go so far as to involve bidders reviewing and commenting on a draft of the transaction agreement provided by the seller. A seller typically will then choose one bidder and enter into an exclusivity agreement with that bidder. At this point, robust due diligence and negotiation of definitive transaction documents will commence.
Defining the scope of a transaction
Once the parties decide to pursue an M&A transaction, the next step is to clearly identify what is being bought, sold or otherwise bargained for. This is relatively straightforward for a sale of a minority, non-controlling stake, a joint venture or a fund adoption. The buyer alternatively may consider an acquisition of a stake in one or more general partners affiliated with the adviser, which typically house an adviser’s carried interest in private funds. These types of transactions are referred to as GP-stakes deals, and have grown in number in recent years. For other deal structures, this process can be more complicated.
A majority or controlling stake acquisition—by a financial or strategic buyer—generally will use one of two structures: a stock deal or an asset deal. In a stock deal, a buyer acquires one or more legal entities outright, including all of the associated assets and liabilities. In an asset deal, a buyer only acquires certain assets and usually does not take on some or all of the liabilities associated with the business being sold.
Whether a deal will involve a stock or asset sale depends on a number of factors. A stock sale is generally simpler and quicker to accomplish. This can be attractive to parties wishing to move quickly, with little complication. An asset deal may be more appealing to a buyer if a seller has pending litigation or regulatory issues. This is because the liabilities stay with the seller. It is possible to apportion certain of these liabilities in a stock deal to some extent through indemnification provisions, but indemnities are typically limited in scope and dollar amount.
Due diligence
The goal of due diligence is to give a buyer comfort that it has the key information needed to fully evaluate and negotiate a transaction. In certain types of M&A transactions, both parties may engage in due diligence. This would be the case with a merger of equals, a joint venture, a minority stake deal or a majority stake deal if the seller will maintain an interest in the company.
Where the merging parties are significant competitors of one another, there may also be antitrust-related diligence. Before one party shares sensitive information with the other, often the parties will put particularly sensitive data into a “clean” room available only to certain screened personnel of the other party. For particularly sensitive information, such as documents related to an ongoing regulatory examination or investigation, an exclusivity agreement also may be a prerequisite.
Parties typically provide and review due diligence information using electronic data rooms. In addition to, or in lieu of, an electronic data room, a party with particular security concerns may require that sensitive documents be reviewed on-site/in-person in a physical data room. Knowledgeable personnel, such as a portfolio manager or a chief compliance officer, may be made available to the other party to participate in detailed diligence discussions and answer questions.
Naturally, there are limitations on the diligence process. Time, cost and other commercial considerations require the parties to prioritize some types of information over others, and may leave one party feeling unsatisfied with the information it has received on certain topics. One way to address this issue is for the transaction documents to include representations and indemnities that serve to provide the unsatisfied party with some comfort on the topic(s) in question. However, not every transaction has indemnities for breaches of representations and warranties.
Negotiating consent rights
In a minority stake deal, an economic investor typically will seek consent rights over certain material transactions or decisions that might impact the value of their economic investment. Partners in a joint venture, to the extent the governance of the joint venture is not split equally between the parties, may agree to give a minority partner similar consent rights over significant actions. In majority or controlling stake deals, a buyer usually seeks similar consent rights over important decisions for the duration of the post-signing/pre-closing period (i.e., while seeking approvals/consents from funds/investors and/or any required governmental approvals).
In any scenario, consent rights should not go so far as to give the consenting party extensive control over an investment adviser and its day-to-day operations. If consent rights go too far, those rights could be deemed to create “control,” resulting in an inadvertent assignment of an investment adviser’s advisory contracts without the requisite approvals/consents having been obtained (see discussion below for assignments of advisory contracts).
The SEC Staff has issued guidance related to the types of facts and circumstances that would or would not be deemed to result in such an assignment. The most well-known guidance, a no-action letter issued to American Century Companies, Inc. in 1997, outlined a number of consent rights that the SEC Staff blessed as not amounting to control for purposes of determining whether an M&A deal triggered an assignment. The American Century consent rights are primarily related to protecting a party’s economic investment—including consent rights over material transactions such as mergers, significant sales of assets, incurring additional debt, issuing additional equity, initiating bankruptcy, or other material events outside the ordinary course of business, such as terminating key senior executives. Having experienced counsel review the proposed consent rights in any transaction is critical to avoid a premature pre-closing assignment or if the parties are trying to avoid trigging an assignment and the related approval/consent process altogether.
Assignments and client consent requirements under the 1940 Act and Advisers Act
The 1940 Act and Advisers Act impose certain requirements for investment advisory clients to approve or consent when an M&A transaction will result in an “assignment” of an investment adviser’s advisory contracts. These client consent requirements are particularly important for a majority or control stake transaction.
The definition of an “assignment” is similar under the 1940 Act and Advisers Act, and includes a direct or indirect transfer of a contract, or of a controlling block of the assignor’s outstanding voting securities of the assignor. Under the 1940 Act definition of “control” and related SEC guidance, there is a presumption that transferring more than 25% of an adviser’s voting securities constitutes a transfer of a controlling block and would result in an assignment.[3] Under the Advisers Act, many practitioners take the view that the threshold is slightly lower, and that a transfer of exactly 25% of the adviser’s voting securities is sufficient to trigger an assignment, based on the definition of “control” in Form ADV. These definitions and interpretations mean that an assignment could occur under the 1940 Act or Advisers Act even if there is no transfer of an advisory contract to an assignee. Again, there is a substantial body of SEC guidance regarding whether a given set of facts results in an assignment, but the 25% thresholds are significantguideposts.
Registered Funds
Under the 1940 Act, a registered fund’s contract with its investment adviser is required to terminate automatically upon its assignment. This requirement makes it technically impossible for an investment adviser to transfer an advisory contract for a registered fund. Therefore, instead of a buyer acquiring the existing contract for a registered fund, the buyer pays a seller for their efforts in obtaining approval from the fund’s board and shareholders for a new advisory contract.
A registered fund’s board must fulfill its obligations under Section 15 of the 1940 Act in connection with its consideration of a new advisory contract, which include requesting information from the buyer (and seller) as may reasonably be necessary to evaluate the terms of a new advisory contract. Typically, a board’s independent legal counsel assists in the preparation of an information request letter and reviews the adviser’s responses with the board. Information request letters typically focus on the potential impact of the transaction on the services provided to the registered fund, and may inquire about possible changes in personnel, resources, compliance infrastructure and other day-to-day implications of the M&A deal.
Section 15(c) of the 1940 Act also requires that the board meet in person to approve the new contract, and that the independent board members separately approve the new contract. The board also needs to call a meeting of the registered fund’s shareholders and approve the filing of a proxy statement. The default 1940 Act voting standard requires that a “majority of the outstanding voting securities” of a fund approve the new advisory contract, which means the lesser of (a) 67% of shares present at the shareholder meeting if more than 50% of the shares are voted or (b) more than 50% of all outstanding shares. This standard essentially imposes a quorum requirement of 50% of shares for a shareholder meeting to vote on a new advisory contract. It is possible for a particular fund’s organizational documents to impose a higher quorum or voting requirement.
Non-Registered Funds
For advisory clients other than registered funds, the Advisers Act requires that an advisory contract include a provision that the investment adviser cannot assign the contract without the consent of the client. The Advisers Act does not specify the form of consent that an investment adviser is required to seek from clients. As a result, there are two ways in which a client could consent to an assignment of an advisory contract, affirmative consent or “negative” consent.
Affirmative consent may be required depending on how the assignment provision of an advisory contract is worded. An example of where affirmative consent from a client would be required is if an agreement requires the client’s prior written consent to an assignment. Many advisory contracts, however, are silent as to the form of consent required for an assignment. If that is the case, the investment adviser typically will provide a client with notice of an assignment and state that if the client does not object, the client will be viewed as having consented to the assignment.
As a result of the 1940 Act and Advisers Act assignment requirements, asset management M&A deals (other than non-controlling minority stakes deals) are unable to sign and close on the same day. Instead, there is a post-signing/pre-closing period in which the required approvals and consents are sought.[4] For further discussion regarding consents, a recent article written by our practitioners can be found here.
Section 15(f) of the 1940 Act—a critical safe harbor for sellers
Under common law, it is illegal for a person to sell a fiduciary office for compensation (e.g., a trustee of a trust cannot sell their position to another person). Because an investment adviser is a fiduciary to its clients, this prohibition poses an issue for an adviser seeking to sell its business for a profit. Congress addressed this problem for advisers to registered funds when it adopted Section 15(f) of the 1940 Act as part of the 1975 amendments to the statute, but imposed certain conditions. Compliance with these conditions is critical because failure to do so opens up the possibility that compensation received by an adviser for selling its business could be clawed back by a registered fund.
Section 15(f) imposes two requirements:
- For a period of three years from the date of an assignment, at least 75% of the board members for a registered fund must not be “interested persons” (i.e., independent) of either the prior or then-current investment adviser, and
- There is no “unfair burden” imposed on a registered fund as a result of the assignment.
Compliance with these conditions requires cooperation from a buyer, and usually requires a buyer to provide assurances that it will not take any action to cause non-compliance with these conditions.
A word on unfair burdens—the 1940 Act does not provide a definitive definition of the term “unfair burden,” but it does state that that term includes any arrangement during the two-year period after an assignment that results in the new or old investment adviser receiving compensation other than bona fide underwriting or advisory fees. Many practitioners take the view that this means that the registered fund should not bear the costs of any proxy solicitations resulting from an M&A transaction by the investment adviser and that, notwithstanding the express language of 15 (f), advisory fees for the registered fund should not increase for two years after an assignment occurs.
[1] Both buyers and sellers often engage investment banks in other contexts as well.
[2] Note that non-public information about registered funds managed by an adviser generally cannot be disclosed without permission from the boards of the funds.
[3] This presumption can be rebutted. For example, SEC guidance has permitted a merger of two widely held public company advisers to proceed without deeming it to be an assignment as, among other factors, no person controlled either adviser before the transaction and no person would control the combined adviser after the transaction.
[4] In addition to client approvals/consents, governmental filings may be required for an M&A transaction. These could include seeking approval from the Federal Trade Commission under the Hart-Scott-Rodino Antitrust Improvements Act or filing a Continuing Membership Application with the Financial Industry Regulatory Authority if a transaction involves a broker-dealer.