The current market for infrastructure assets is characterised by high valuations, a paucity of assets, mounds of dry powder, new entrants and increasing recycling (rather than disposal) of fund assets. As a consequence, we are seeing a continued increase in competition for assets, the expansion of what is considered core infrastructure and, ultimately, serious return compression.
In this context, pre-emption rights on asset transfers are a continuing challenge for buyers and sellers. In this article, we focus on key issues associated with these rights, how and when they are valuable and what they mean for infrastructure market deal makers.
WHAT ARE PRE-EMPTION RIGHTS ANYWAY?
In an industry dominated by consortia, it is common practice for infrastructure assets to be owned by a joint venture company or holding company (the JVC), which is in turn owned by the consortium members. The consortium members will then enter into a shareholders’ agreement, under which they regulate the management and control of the JVC.
In this shareholders’ agreement, the consortium members will often include pre-emption rights, which will apply where a member wishes to sell its shares in the JVC. The effect of the pre-emption rights is that existing consortium members will have the opportunity to purchase the shares of the exiting member in preference to any third-party purchaser.
In many cases, any shareholder debt (e.g. loan notes or Eurobonds) will be stapled to the shares in the JVC and accordingly will be subject to the pre-emption rights in the same way.
WHEN DO WE LIKE PRE-EMPTION RIGHTS?
When we’re not the original buyer or seller in the transaction: for the most part, pre-emption rights suit the purposes of consortium members who are not the original buyer or seller in the transaction. They enable these consortium members to:
Pick off deals they think are good value, without investing the time and effort to negotiate and agree those deals in the first place; and
Avoid potentially unknown or undesirable third parties entering the consortium.
Where the underlying asset is performing well, these rights can be incredibly valuable as they provide a way for existing consortium members to increase their exposure with minimum transaction cost and risk.
When we’re selling (sometimes!): While sometimes a major source of difficulty for sellers (see below), pre-emption rights can work to their benefit in some circumstances:
First, where the pre-emption clause allows the seller to activate the clause without having first received a bona fide third-party offer and instead based on terms proposed by the seller. In such a case, the seller may find a buyer among the existing consortium members with relatively little risk and cost, on terms it likes and without having to go to the market. Existing consortium members can feel significant pressure to buy in these circumstances as, if they do not, the seller will typically be permitted to sell to a third party (on the same or more favourable terms for the seller) within the next three to 12 months;
Second, even where a bona fide third-party offer is required, the ability to sell to a known consortium member can be a great benefit for sellers, significantly reducing transaction risk and cost.
WHEN ARE WE NOT SO KEEN ON PRE-EMPTION RIGHTS?
When we’re buying: Pre-emption rights are almost universally troublesome for buyers. The buyer enters the sales process, does its initial due diligence, puts in a competitive offer, becomes preferred bidder and then spends even more time and money negotiating the terms of the sale and purchase agreement and finalising its due diligence.
Then, the buyer waits… and waits… to see if the time and expense has been worth it, or if there is pre-emption and it has all been for nothing; the buyer having paid handsomely in time and costs for the privilege of being stalking horse and valuer.
This is a major risk for buyers and one that has led many not to enter sales processes where pre-emption rights apply. There are no perfect solutions to manage this risk, but there are some things buyers may consider.
When we’re selling (most of the time!): A major risk of pre-emption rights for sellers is that buyers, aware of the rights, may be unwilling to come into sales processes.
This can put sellers in a difficult position, particularly in cooling markets. They may have a great asset, but their pool of buyers may be limited by the pre-emption rights with a consequent impact on price competition and their ability to realise full value. In addition, the added complexity of the pre-emption process can add significant transaction cost and risk.
WHAT CAN WE DO TO MANAGE THESE RIGHTS?
For almost as long as lawyers have been drafting pre-emption provisions, lawyers have been thinking up ways to get around them and to mitigate their risks. This can sometimes include:
Pre-emption avoidance structures, such as use of “affiliate transfer routes”, sales of shares in upstream special purpose vehicles and “unmatchable” or “package” deals;
Creating an upstream consortium with one of the existing consortium members and “piggy-backing” on their pre-emption rights;
Creating economic or derivate rights;
Requiring the seller to clear the pre-emption process prior to completion of detailed due diligence; and
Break or due diligence fees.
Pre-emption rights come in a myriad of forms. Some are absolutely watertight, leaving no room for manoeuvre, while others are less robust, leaving scope for structuring. Depending on your position in the transaction, they may be of significant value or they may expose you to significant cost and risk.
It is important to review the detail of the relevant provisions at the beginning of a transaction to understand what they mean for your structuring options. This can then be considered together with the attitudes of counterparties (or potential counterparties) and the level of competition for the particular assets. Then, a decision can be made as to which approach to pre-emption makes the most sense.
Similarly, when setting up consortia, it makes sense to give detailed consideration to pre-emption provisions to ensure they are valuable for you. They are not mere boilerplate and an ‘off the shelf’ approach can be dangerous. A few final questions to consider include:
Do you want pre-emption rights at all? Could you afford to pre-empt? Could you take more of the asset in your portfolio?
Should they be watertight or have a little bit of flexibility?
What time periods for pre-emption are appropriate? How long would you need to access or raise funds? How long to make the investment decision?
Should a bona fide third-party offer be required to trigger the rights?