Investor Expectations
and Regulatory Scrutiny Rise as Sovereigns
Co-Sponsor Deals

Last week’s collapse of the $30bn Aon – Willis Towers Watson merger is a reminder of how difficult strategic mega-deals can be to pull off. When the DOJ sues to prevent the deal on the grounds that it will diminish competition, there’s not much that can be done but walk away. (And, in Aon’s case, pay a $1 billion termination fee.) In theory, the risk of such an outcome should be lower for acquisitions by private equity groups and institutional investors, which should have fewer competition law issues and therefore be easier to close. That may explain why a year ago, thyssenkrupp ended up selling its prized Elevator business to a consortium of PE firms and sovereign wealth funds, despite strategic bidder Kone reportedly offering more money¹.

Yet, large private equity deals need ever larger amounts of equity capital and frequently cannot go it alone. The return of multi-billion dollar deals globally as the pandemic eases is requiring private equity firms to join forces with fellow sponsors, as well as (from the outset of the deal) sovereign wealth funds and other large institutional investors with the capacity to write sizeable equity cheques. The thyssenkrupp Elevator deal was one example; the current Medline deal is another. These alliances create new demands for governance and company access from increasingly active investors. At the same time, bringing together investors from multiple countries can complicate the regulatory analysis and require discussion of how to manage any potential regulatory scrutiny that may arise from large investments in often sensitive industries.

Megadeals Require Increasingly Large Equity Cheques; Co-Sponsors are needed to cover them

The buyout of U.S. medical supplies business Medline for $34 billion set a new high watermark for post-financial crisis deals. While the group of Blackstone, the Carlyle Group and Hellman & Friedman has echoes of consortiums formed in 2006 and 2007, it has a slightly different flavour. The buyers are reported to be funding about half the purchase price with equity and the remainder with debt, well below the leverage levels typically attributed to pre-financial crisis deals². In addition, investing alongside the sponsors are a number of global sovereign investment funds, including Singapore’s GIC.

Large buyout firms continue to raise ever-larger pools of capital, with all three sponsors involved in the Medline transaction deploying – or in the process of raising – funds in excess of $20 billion. While there are positive arguments for investing sizeable amounts into a single deal with the potential to deliver strong returns, there are counterarguments about de-risking investments by sharing the equity burden with other investors.

In many cases, sponsors can underwrite relatively large deals and syndicate equity after closing to a range of co-investors. However, in the case of megadeals (especially in competitive auctions), sellers want certainty that buyers can execute, and are therefore demanding that the entire equity commitment – along with the financing package – be guaranteed when final bids are submitted. As a result, sponsors need large co-investors not only to fund deals, but also to share the risk upfront.

Large Co-Sponsors Want More Rights

Over the years, the increasing sophistication of sovereign investors and their earlier involvement in transactions has led to the historical role of passive co-investor evolving into one of more active co-sponsor. As they have grown, sovereign wealth funds in the Middle East and Asia and public pension plans in North America have brought in private equity professionals to oversee expanding private capital portfolios. As a result, they are also taking a more active approach to investment – 2020 was a record year for sovereign wealth fund direct deals, with investment almost doubling to $65.9 billion from $35.9 billion.

While, in some countries, more capital went into supporting domestic companies through the pandemic, many investment funds continued to target international opportunities throughout 2020 and with increasing pace, frequency and size into 2021. Most recently, Canada Pension Plan Investment Board, which has around one-quarter of its assets in private equity, is working alongside U.S. firm Fortress on its accepted bid for British supermarket Morrisons.

For private equity firms, co-sponsorship brings much-needed capital commitments, but also increased demands from their fellow investors. In addition to a share of the economic benefits of the deal, sovereign and public pension investment funds are seeking enhanced rights, such as greater access to information, and involvement in the decision-making process, either as a director or an observer, and/or through robust consent rights. Private equity firms must therefore tread a fine line, balancing the desire to protect their preferential rights as deal originators and strategic and operational control over companies, with the need to accommodate co-sponsors who are often large investors in their funds.

Tensions will inevitably arise when PE sponsors try to treat the large/early co-sponsors the same as smaller/later co-investors, or treat the co-investment as a fund and group all co-investors together, using the LP/GP structure to offer co-sponsors similar rights to those that they have as LP investors in the sponsor’s fund. From the perspective of the sovereign wealth fund or institutional investor, there is less incentive to get involved in a co-investment early (and often pay a share of deal expenses and fees) if the rights on offer are on a par with those given to investors who come into the deal later through the syndication process, or no better than those obtained in their original fund investment.

Managing the Risk of Regulatory Scrutiny

On the other hand, large deals, particularly those involving foreign investors, can invite greater regulatory scrutiny and in some industries, even more so in the wake of the pandemic as governments seek to protect domestic companies seen as essential to national security or public health.

While in the past FDI restrictions or review processes were only a factor in a handful of jurisdictions (notably the US (CFIUS) and Australia (FIRB)), in recent years numerous other countries, especially in Europe, have tightened up powers to investigate mergers and takeovers, potentially capturing foreign investment into fields including healthcare and advanced technologies. (For example, the UK government’s current “active interest” in Parker Hannifin’s bid for Meggitt and Cobham’s bid for Ultra Electronics is part of a growing trend of focus on foreign involvement in defence sector takeovers.) Some jurisdictions are particularly liberal in their interpretations of what constitutes public interest to block deals. Earlier this year, Canadian convenience store operator Alimentation Couche-Tard dropped its €16 billion bid for French retailer Carrefour after opposition from the French government over food security.

A consortium of investors from several different countries may find that the investment into a large multinational target is treated as “foreign” by more than one country’s regulator. For example, CFIUS may view the target company as a U.S. business, while the German regulator will be focused on the German part of the group. This is a challenge that can require creative solutions, especially in a competitive auction scenario where deal certainty is paramount, and it is in everyone’s interest to ensure that their consortium does not fall foul of FDI rules. A balance may have to be struck between enhanced rights as a reward for being a risk-sharing co-sponsor and reduced rights in certain areas to reduce regulatory attention on the “foreign” influence in the consortium.

However, not all FDI regulatory regimes are equal and not all foreign investors are equal, and sovereign investors will welcome a thoughtful, tailored approach. Modified governance and information rights to mitigate regulatory risk might make sense in some circumstances, while a clause allowing the lead sponsor to unilaterally pare back the economic or voting rights of investors to address potential regulatory issues may face opposition, especially from sovereign investors who have never in practice come up against objections from regulators.