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Patience: A virtue even in deal-making

In the deal world, speed is prized and often, a key tool in establishing a competitive advantage.  A quick response can signal the extent of a party’s interest, and executing a transaction expeditiously can be beneficial and sometimes, necessary to protect one’s leverage position (e.g., sellers in an auction setting).

However, patience can also be a valuable tool, particularly for family offices and the unique benefits that arise from their more “patient capital.”

As anyone involved in a recent auction process can attest to, it is a seller’s market. With all the “dry powder” waiting in the wings, rising multiples and seemingly shrinking supply of quality assets, the current environment for deal-making has become intensely competitive. Along with that, the question of – how to win deals and/or source proprietary deals – has grown in prominence, not only for traditional sponsors but also for family offices, given the growing trend of family offices making direct investments.

Much ink has been spilled on the answer to this question, and a comprehensive answer is beyond the scope of this article. Suffice it to say, the answer lies in a combination of different factors including the fundamental economics (i.e., being the highest bidder), existing relationships, and specialized or industry knowledge.

That said, one key competitive advantage for family offices is the more patient or long-term nature of their capital. Traditional sponsors typically have a four- to seven-year holding period that’s driven by the need to deliver a return within that timeframe to their limited partners. However, family offices are able to invest with substantially longer holding periods because their capital does not face the same kind of expiration date, and their investment goals stretch well beyond the next four to seven years.

Often, sellers will have concerns regarding the long-term legacy of the business, retention of the employees and “slash and burn” approach of compromising long-term growth for short-term gains – even when they don’t have a vested interest in the business after the transaction. It is in these types of situations that “patient capital” can play a key role in alleviating these types of concerns. This is especially true in smaller, low- to mid-market transactions, where the parties frequently have a more-personal relationship with the business (e.g. founders, multi-generation family owners) and ascribe a greater value to the “intangibles” involved in a transaction.

Ultimately, the fundamentals will still be the fundamentals. The highest bidder will typically carry the day, and an appeal to “patient capital” is not likely to overcome a substantial difference in purchase price. Nonetheless, “patient capital” is a unique competitive advantage for family offices, which they can use to differentiate themselves and open the door to transactions that may otherwise be closed.

Minority investors beware, Delaware courts will not rewrite your operating agreement
A recent decision from Delaware’s Court of Chancery (the “Court”) makes clear that parties entering into an operating agreement for a noncorporate entity have wide discretion when structuring the rights of controlling and minority investors. It is possible for parties to waive fiduciary duties they might otherwise be owed, or to empower boards to engage in conflicted or self-interested transactions, and rarely will the implied covenant of good faith and fair dealing be available to a party seeking relief from onerous or unfair terms to which it expressly agreed. This freedom when contracting underpins the attractiveness of limited liability companies and limited partnerships; however, investors need to be mindful of potential outcomes permitted by a target entity’s governing documents in order to avoid a bad deal. The Court will not save them.
In Miller v. HCP, decided by the Court on February 1, 2018, a minority investor in a limited liability company challenged its board’s decision to sell the company without an auction process. The majority of the board was allied with a controlling shareholder entitled to the bulk of the modest sale proceeds due to the particulars of the entity’s operating agreement, whereas the minority investor who filed suit would receive very little compensation unless the company was sold at a much higher price. The board had little incentive to seek bids beyond what would satisfy the controlling shareholder and in fact did not pursue a fulsome auction process despite indications that other bidders might have been willing to pay significantly more for the company. The minority investor raised objections during the sale process and later claimed that the board breached its implied covenant of good faith and fair dealing by failing to try to maximize the sale price.
Significantly, under the terms of the operating agreement, the parties waived all fiduciary duties and granted the board sole discretion in pursuing a sale with an unaffiliated third party. The Court reasoned that the implied covenant of good faith and fair dealing—which is available to address contractual gaps the parties did not anticipate when negotiating the operating agreement —could not be invoked by the minority investor given there was not in fact a contractual gap implicated by the sale. Rather, since the operating agreement included an express waiver of fiduciary duty and a grant of authority to the board with respect to a sale process, and the slanted waterfall provision in black and white, the minority investor was stuck with the deal.
This unbending contractual overlay on the noncorporate form is in contrast to the world of corporations, where different standards of judicial review apply and boards have fiduciary duties to other investors that may not be waived. While the case remains subject to appeal, minority investors in LLCs or limited partnerships should be cautious since they choose to forego the statutory and common law protections tied to the corporate form and therefore must live with the operating agreement bearing their signature.
Hot topics: what’s next for private equity investing in health care

On February 8, 2018, the Los Angeles office of Nixon Peabody LLP hosted a Hot Topics in the Middle Market event entitled Private Equity Outlook: What is Next for Investing in Health Care. NP partners Stephen Reil, Jill Gordon, and Matt Grazier moderated a discussion featuring the following speakers:

-          Len Anderson, Managing Director, LHA Capital Partners

-          Jonathan Bluth, Sr. Vice President & Head of the Healthcare Group, Intrepid Investment Bankers

-          Steven Shill, Partner/National Leader, BDO Center for Healthcare Excellence & Innovation

-          Srin Vishwanath, CEO and Co-Founder, GreenWave Health Technologies

A summary of the panelists’ observations on the current state of the health care industry and investment opportunities is as follows:

Trends and Opportunities: In today’s health care market, private equity investors increasingly have the option to invest in patient-centric, cash-pay companies rather than providers that primarily rely on government and third party reimbursement models. The panelists agreed that behavioral health, including the areas of addiction, autism, and other mental disorders, represents a new frontier in the health care industry and has become increasingly viewed as an exciting area of investment.  Growth in the behavioral health industry is being driven by an increasing awareness of, and a lessening of the historical stigmas associated with, mental health issues.  Coupled with the sense of urgency that often accompanies patients seeking behavioral health treatment (who are increasingly connected to behavioral health communities via the internet and social media), the industry has transformed into a high cash pay, high volume and high growth sector. In addition, the panel recognized that there has been a stratification of the behavioral health field, with certain areas migrating toward in-network coverage while others remain out-of-network and primarily cash-pay.  This has created a dichotomy in the sector which presents opportunities for investors.  Going forward the question of whether behavioral health will be able to demonstrate patient outcomes and value will remain the critical questions for the industry and its investors.  Finally, the rise of digital health has led to an explosion of international investment and medical tourism, with international investors, often from China, exporting diagnostic and digital medicine models to their home countries.

Dedicated Health Care Funds:  The panel discussed the recent rise of health care specific private equity funds that not only have a high level of understanding of the field’s regulatory concerns, but also strong relationships with regulatory agencies. In the past, less-sophisticated investors have had difficulty understanding health care business valuations and deal structures due to an inability to economically quantify the industry’s risks. Now, industry savvy investors are differentiating themselves through depth of reach and connectivity.  Coupled with their newfound regulatory expertise, many health care-centric private equity investors are able to not only identify appropriate targets and close deals but, post-closing, they are able to fundamentally change the growth trajectory of the target business and drive the value needle.

Digital Apps and Devices: There was general consensus among the panelists that investors are increasingly looking outside of the four walls of the hospital to alternative investment opportunities in patient-centric care. Specifically, ancillary services have become a primary area of focus as a way to identify and eliminate adverse events, and ultimately as a means to reduce the overall costs of care. In particular, investment in companies providing health services digitally through digital apps and devices and through telehealth and telemedicine (the panel used the example of rural hospitals accessing physician specialists through web and phone conferencing applications).  These companies are disrupting the industry, blurring the lines of how and where care is provided and effecting how providers are paid.  This growing portfolio of health care / technology hybrids has created ample opportunity for private equity investors looking for targets and, ultimately, returns.

Hope springs eternal: private equity M&A in 2018
2017 was a year of some apprehension for dealmakers. Political uncertainty in the United States and the Eurozone dampened the global economic outlook and many dealmakers remained hesitant to pull the trigger on potential transactions. In the end, however, many of these fears proved unfounded. 2017 saw steady economic growth in the United States, an economic recovery in the Eurozone, economic resilience in China and a bullish stock market (all buoyed by supportive monetary policy from central banks). As 2018 gets underway, Deloitte reports that 68 percent of surveyed executives at U.S.-headquartered corporations and 76 percent of leaders at domestic-based private equity firms believe deal flow is set to increase in the next 12 months. For the private equity industry, this may mean that, at least in the near term, good times are ahead.
As with other dealmakers, private equity mergers and acquisitions activity in 2017 lagged behind past years due to political and regulatory uncertainty and sky-high asset valuations. Though these concerns may carry over into 2018, a massive stockpile of dry powder (a result of years of strong fundraising activity) and continued macroeconomic growth will compel private equity sponsors to seek out and close new deals. At the same time, private equity mergers and acquisitions activity in 2018 will be heavily influenced by high transaction multiples, a continued lack of high quality assets in the market and competition from strategic buyers. To maneuver in this environment and still generate the returns expected from their asset class, private equity sponsors will seek to be creative in how they approach deals in 2018. Some will look to an increasingly diverse set of transaction structures beyond the traditional buyout model, including minority investments, joint ventures and other partnerships between private equity sponsors and strategics. Additionally, private equity sponsors will continue to hone their sector expertise as a way to differentiate themselves in an overcrowded market, drive deal value and compete with rival strategics. Finally, the middle-market will remain particularly attractive for private equity mergers and acquisitions as even large sponsors will move down market in search of quality assets and add on acquisitions to drive growth in their existing portfolios.
On the wary side, private equity sponsors will likely experience increased competition in 2018 from strategic players as organic growth remains elusive. A raging stock market coupled with the newly reduced corporate tax rate will (presumably) augment corporate balance sheets and provide strategics with even more ammunition for acquisitions. In the middle-market private equity space sponsors will face increased competition from direct investors and family offices. Family offices in particular can offer long-term investing strategies, patient capital and a more personalized message to those family owned businesses that are looking to take chips off the table rather than completely exit.
Regardless, 2018 is poised to be a strong year for private equity mergers and acquisitions. Political uncertainty in 2017 proved to be little match for the resolve of dealmakers, and there is little reason to believe 2018 will be different. Despite an increasingly crowded field of competitors, private equity sponsors that are able to take advantage of sector specializations and craft creative deal structures will be well positioned to ride the tail winds of the current macroeconomic growth cycle and find returns for themselves and their limited partners.
Nixon Peabody releases 16th Annual Material Adverse Change Survey
This week, Nixon Peabody issued its 16th Annual MAC Survey, which reviews the material adverse change provisions in M&A deal documents to gauge what is market in terms of the deal protections afforded by MAC clauses. The survey analyzed over 200 publicly filed M&A agreements involving deals with values ranging from $100 million to over $85 billion. 

Our annual review of MAC clauses in acquisition agreements over the past 16 years has evinced a dealmaking climate highly sensitive to developments both in the United States and globally. Each year, the survey provides a renewed opportunity to examine the market’s responses to shifts in the myriad economic, geopolitical and societal forces that shape the manner and environment in which M&A transactions are executed. With each survey we conduct, we capture a more robust picture of M&A trends.

We hope you enjoy reading this year’s survey.  We will continue to monitor closely how the dealmaking market responds to these and other developments in the years to come.  The survey can be found on Nixon Peabody’s web site by clicking this link

16th Annual MAC Survey Infographic 
Tax reform: boon or bust for private equity dealmaking?
As the Republican tax reform bill moves closer and closer to becoming law, private equity dealmakers are scrambling to analyze its impact on their business models. This comes at a time when private equity firms in North America are under pressure to deploy more than $500 billion in dry powder, according to the Wall Street Journal.
The boon: lowering of the corporate tax rate
If the tax reform bill successfully passes in its current state, the effective tax rate for U.S. corporations will be reduced from 35% to 20%. This reduction may, for a variety of reasons, lead to increased private equity deal activity in 2018 and beyond. First, the reduction would have an obvious positive impact on the rates of return private equity firms would realize in future deals. As private equity firms scrutinize their models, deals that would have been non-starters in light of the current corporate tax rate may suddenly become viable. Additionally, strategics looking to divest underperforming and non-core business units may look to accomplish these divestitures through outright sales rather than tax-free spinoffs, potentially bringing additional quality assets to market, thus lowering current valuations. Finally, a reduction in the corporate tax rate will be a boon for private equity portfolio companies, leading to, potentially, increased exit opportunities.
The bust: capping interest deductions
The tax reform bill also proposes reducing companies’ ability to deduct interest payments. Though the calculation is subject to change, the bill’s current form would cap the amount of interest expenses companies can deduct from their taxes at 30% of EBITDA. Private equity dealmakers worry this cap on interest deductions would stifle private equity dealmaking going forward. First, a cap on interest deductions would limit the amount of debt private equity buyers could pin to target companies, curbing potential returns. Second, the cap may reduce the type and quality of assets private equity firms will be willing to pursue. For example, companies in highly cyclical industries (such as construction or heavy equipment, which see significant shifts in EBITDA and are prone to particular suffering during recessions) may become unappealing targets or see their valuations plummet. The current Senate proposal is even less forgiving and proposes capping the interest deduction at 30% of earnings before interest and taxes, but not depreciation and amortization. This would make capital-intensive businesses (such as oil and gas or telecommunications) less attractive. Overall, capping the interest deduction amount could force private equity dealmakers to rethink the leverage-heavy buyout model and may lower the amount of potential targets, raising valuations for those targets that do come to market.
There can be no doubt that if the tax reform bill becomes law the private equity industry will experience some degree of upheaval. Private equity dealmakers will have to run the numbers individually to see if the benefits of a lower corporate tax rate offset the negative effects of capping interest deductions. However, as with any upheaval, those dealmakers who are able to get ahead and adjust to a shifting regulatory landscape will find opportunities.
Fundraising at highest point since 2007 — middle-market opportunities
It's no secret that 2017 has seen a “boom” in the fundraising space, with capital raised at an all-time high since 2007.  While this is a positive for fund managers and investors, alike, both should keep in mind the impact this increased activity has on the market, specifically with respect to fund managers’ ability to attract investors and what this increase means when it comes to eventually deploying available capital.
Competition to attract investors
Despite an increase in the number of funds being raised, including first-time funds, the vast majority of fund managers have expressed that there is more competition than last year to attract investors to their funds. Many fund managers rely on a solid base of repeat-investors who have been satisfied with the fund’s prior key terms and economics. But, with the increase in the number of funds, fund managers may need to pay more attention to the terms they offer investors and be more willing to negotiate such terms in order to maintain their historical investor base and attract new investors. In this regard, investors (and fund managers) may want to be mindful of the investment limitations given the larger fund sizes and increase in available capital.
Available capital
Along with the increase in the number of funds, there is a significant increase in the amount of available capital, which could lead to greater competition for deals, and, in turn, higher pricings for such deals. Therefore, investors should consider middle-market exposure—which could preclude  potential overpriced valuations—by targeting companies not typically on the radar of the mega funds and not as likely to go through an auction process. And, while the mega funds have seen an increase in the overall size of such funds, middle-market funds account for a greater number of final closes, thus far, in 2017, so there are ample opportunities for investors.


Searching for bigger returns? Think smaller.
As the private equity industry matures and competition for middle-market acquisition targets becomes super heated, some private equity firms are moving downstream into the lower brackets of the middle market in search of additional opportunities and higher returns. Though not without risks, the lower middle market provides opportunities for outsized returns to those private equity investors willing to roll up their sleeves and take a hands-on approach to operational improvements.
First and foremost, the lower middle market simply offers a greater number of potential targets. There are approximately 350,000 companies with annual revenues between $5 million and $100 million, while there are only 25,000 companies with annual revenues between $100 million and $500 million, and only a few thousand companies with annual revenues in excess of $500 million. The lower end of the middle market also has the most new entrants. New companies are constantly being formed, maturing, and looking for growth capital.
The lower middle market presents opportunities for smaller, more specialized private equity investors who focus on specific industries and have significant operational experience. Lower middle-market deals can be difficult because target companies often lack sophisticated infrastructure, operational experience, and/or experienced management teams—all of which are critical for a business’ ultimate success. Private equity investors (with management and operational experience in specific industries) are able to leverage their industry knowledge to grow these companies, scale up operations, and increase revenue. Private equity investors in the lower middle market must be willing to step in as CFO, or CEO, and must recognize that these investments are operational partnerships, not just financial transactions.
In part, this shift toward the lower middle market is being driven (as are other recent trends in the private equity industry) by structural changes in the private equity industry itself. As first-generation private equity firms mature and the original general partners look to retire or limit their contributions, some are branching out and opening up their own smaller and more specialized shops. These general partners already have a track record of successful deals and often focused much of their career on a specific industry. The lower middle market offers abundant opportunities for these newer, smaller shops to buy attractive assets at potentially lower multiples.
Transactions in the lower middle market are not, of course, without risk. Competition remains high and valuations, currently around seven times EBITDA, are the highest they have ever been—according to the alternative asset analysis firm Preqin’s 2017 report on the lower middle-market. Additionally, low EBITDA-generating companies face difficulties entering the market and are often too small to retain an investment bank to run a full auction process. Lower middle market deals often use a compressed deal process—offering limited exposure to the seller and management and limited opportunities for diligence. If multiple suitors are involved and transaction expenses spiral out of control, the economics of the deal may become unworkable. Finally, because of their smaller size it can be difficult for lower middle-market private equity firms to provide the significant management, operational, and back-office support their targets often require.
Despite these challenges, acquisitions of lower middle-market targets can be an attractive alternative for private equity firms looking for increased deal opportunities in today’s highly competitive market.
Middle-market PE firms selling minority stakes to outside investors
In the past, large bulge bracket private equity firms like the Carlyle Group, the Blackstone Group and Providence Equity Partners sold minority stakes to outside investors as a method of raising capital and fueling growth. Recently, this phenomenon has migrated down to middle-market private equity firms, with those firms increasingly selling minority stakes in the firms themselves (as opposed to limited partnership interests in their fund vehicles). Why?
Capital to grow
Middle-market private equity firms, especially those with smaller portfolios and less operating history, generally do not keep a lot of cash on hand. Sale of a minority stake gives private equity firms a balance sheet boost and instantly deployable capital, providing the resources to pursue deals they otherwise could not take on. Furthermore, similar to firms in other industries that recently struggled to grow organically, private equity firms struggled to grow solely from returns at the fund level. The capital raised by selling a minority stake allows private equity firms to seek add-on acquisitions for portfolio companies, explore other business lines, test novel investment ideas that they can later apply at the fund level and acquire other private equity firms. Finally, by selling a minority stake, private equity firms can raise capital without the headache and expense of a public offering.
Generational transfers
As the middle-market private equity industry matures, the general partners of firms founded in the 1980s and 1990s are transitioning out. A minority stake sale at the firm level provides these general partners with liquidity and lowers their risk profile. Moreover, as the old guard general partners transition out of the firm, younger general partners may have trouble covering their capital commitments at the fund level. Selling a minority stake can supply the capital necessary for the next generation of general partners to raise new funds.
Deepening ties with investors and limited partners Historically, minority investors in private equity firms have been current or former fund limited partners. Selling a minority stake in the firm to a long-time fund limited partner allows both the private equity firm and the limited partner to develop a deeper institutional tie. Private equity firms look for minority investors with industry expertise, deal sourcing networks and value beyond their capital. Limited partners are attracted to minority investments in private equity firms because their investment maintains a steady stream of income from profits and distributions and avoids the fees associated with investments at the fund level. Becoming a minority investor at the firm level could also open up additional investment opportunities at the fund level. Minority investors must be aware, though, that capital invested at the firm level may be tied up for long periods of time and, unlike investments in a fund, there is no express future liquidity event to look forward to.
As the middle-market private equity industry becomes increasingly competitive, more and more middle-market private equity firms will look to raise capital through minority sales. This capital will help the next generation of general partners raise funds, close deals and grow their firms.
Cannabis businesses and investors march forward at NP roundtable event
Significant challenges and opportunities in the recreational and medicinal cannabis industry, including the legal and regulatory status of cannabis, banking problems and investment activity, were identified and discussed at Nixon Peabody’s June 13 Hot Topics event in Boston. Panelists leading this interactive roundtable event included Shanel Lindsay, Ardent Cannabis; William Luzier, Marijuana Policy Project; David Rheins, Marijuana Business Association; and Roger Tilton, full_tiltON ventures, llc. After a roundtable discussion several marijuana businesses looking for investments pitched their businesses to the attendees. Nixon Peabody’s Philip Taub and Rudy Salo led the discussion.
Legal & regulatory status
While eight states have legalized marijuana sales to adults for recreational purposes, and over a half a dozen states (and counting) have legalized sales of medical marijuana, marijuana remains illegal federally under the Controlled Substances Act and under international treaties executed by the United States. Although federal regulation of illicit drugs rests primarily with the Justice Department, the Federal Health and Human Services Secretary also holds powers that restrict marijuana and the rescheduling of it under the Controlled Substances Act. 
When President Donald Trump appointed Jeff Sessions as U.S. attorney general, Sessions’ well-known stance against marijuana cast uncertainty over the marijuana industry. However, despite his stance, Sessions hasn’t done anything concrete to pump the brakes on the marijuana industry. In addition, Congress’ amendment to the federal spending bill prevents Sessions’ department from cracking down on legal medical marijuana programs.
Nevertheless, the Trump administration has taken an adversarial stance toward marijuana, which has brought a chill to the burgeoning cannabis industry. Still, investors, including attendees of our event, are willing to invest in the industry.
The inability to use traditional banks continues to hamper the cannabis industry, though state chartered banks and credit unions have been able to moderately fill the banking gap. Banks that were considering banking in the industry and trying to follow the Treasury Department’s Financial Crimes Enforcement Network, or FinCEN, guidelines for banking marijuana, have been concerned that the attorney general’s opposition may increase enforcement against the banks that do provide services to the industry.
Investment activity
During the pitching round of our panel, several businesses shared their proven success and their need for additional capital to get to the next level. The businesses that pitched were from all over the United States, including Washington, Colorado, New York, California and Massachusetts.
It was made clear that investors must have a pretty high risk tolerance because there are plenty of challenges unique to the marijuana industry. On the other hand, legal marijuana sales in the U.S. are projected to surpass those of ready-to-eat breakfast cereal in 2019, according to estimates by certain industry group.
With nearly sixty people attending the event, interest and activity in this sector are undoubtedly growing. If you are interested in attending our ongoing Hot Topics in the Middle Market series, contact
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