Approaching a restructure

A common feature of the private equity transactions concluded over the last few years was the provisions built in by investors to allow for a conversion of their investment into Initial Public Offering shares upon a resulting IPO.

The hope for many would have been that 2009 would be the year that they would realise significant gains from their investments. Much time and effort would have been spent documenting the transaction to deal with, among other things, the calculation of the formula for conversion of the investment into IPO shares; the liquidation preferences; and protective provisions and drag along and tag along rights.

What were not considered or negotiated in as much detail, however, were the distressed issues currently being faced by investors. What we find now is a need for a comprehensive analysis of how to restructure investments.

In relation to many of the pre-IPO type transactions in Asia, the role played by Cayman Islands and BVI counsel is key to these restructurings. Many of these types of investments are structured through BVI and Cayman Islands entities (in particular Cayman Islands companies, which offer an attractive exit via NASDAQ, NYSE and HKSE listings), especially many of the acquisition finance transactions in the People’s Republic of China.

Restructuring offshore
Restructuring often takes the form of a further infusion of capital in the structure to – on the whole – preserve the integrity of the existing structure. It is often the case that an injection of new capital is needed to meet urgent existing financing obligations. In short, cash is required quickly and typically the investor is seeking to improve its present position through the cash injection. The financing may be by way of a straight or convertible loan. The investor package would usually include security over corporate assets and stronger corporate control. Other than the usual security taken over the downstream PRC assets and bank accounts, charges will be taken over the shares of all Cayman/BVI companies within the structure. The investor will want to increase its shareholding or acquire a shareholding in the respective offshore company. It may be that the shareholding is insufficient to afford the investor real voting clout, however, what it does provide the investor with is a seat at the table. This is coupled with additional or majority board control of the company, which is critical given it is the board that exercises control over the company.

Directors’ duties
The investment may give rise to certain corporate issues. It may well be the case that the investor already has representation at board level. The investor will want to consider his role as a director during the approval process. Will there be conflicts of interest issues? Will the directors be acting in the company’s best interest by approving the transaction?

It is important for the directors to be reminded that their fiduciary duty is to act in the best interest of the company and not in the interest of the investor whose interest they may have been notionally appointed to “represent” – it is on those restructuring transactions where the tension between the “investor director’s” duty to the company and supposed loyalty to the investor are acute. The law is clear – the duty is owed to the company. To alleviate this tension, it may be that the investor director simply decides it is best not to vote on any resolutions relating to the restructuring, although this does not preclude involvement in discussions or his voice being heard.

Preference shares
Although the entrenched shareholding position may not carry with it significant voting influence, what it may carry is the right to take part in the sweeping up of any cash that resides in the company following redemption of the loan and payment out to any secured, unsecured or preferred creditors in priority to other shareholders in the company.

Voidable transactions – solvency
At the heart of the investment is the preservation of the company’s solvency and consequently the sustainability of the investment. Whilst attempting to sustain the company’s solvency through the capital injection, it is important the investor does not expose his investment. Where the investor takes security over the company’s assets – the result being that the investor receives good security – the danger is that the security package created would be subject to claw-back where the company becomes insolvent within six months of the transaction. In such a case, the presumption would be that the transaction is voidable. Offshore counsel should always be consulted prior to finalising any such arrangement.

Conclusion
What is important is that measures to restructure private equity transactions should be considered from the outset and not simply as an afterthought. The lessons which will be learnt from the current wave of restructurings will perhaps become entrenched in deals going forward and recalled when things improve as there will no doubt be more “bad times” ahead.

Everton Robertson is a Hong Kong-based partner in the Private Equity Group at Walkers, an offshore law firm which works with many GPs managing private equity firms domiciled in the Cayman Islands, the British Virgin Islands and Jersey.