Considerations for directors and supervisory board members in LBOs

The judgment relates to childcare organisation Estro Group (formerly named Catalpa), which was acquired by the private equity investor Providence in 2010. The acquisition was carried out through a leveraged buyout (LBO). This transaction structure is commonly used in private equity deals and is characterised by financing a significant portion of the acquisition with debt. In this case, the total financing consisted of (i) a EUR 230 million loan from a consortium of banks, (ii) a EUR 225 million shareholder loan by Providence, and (iii) a capital injection of EUR 66 million by Providence. As is customary in LBO transactions, the target group assumes, guarantees and/or secures the acquisition financing provided by third party creditors. In this case, to avoid financial assistance rules, a legal merger between the bid company (as acquiring entity) and Estro (as the disappearing entity) was set up, resulting de facto in both the bank financing and the shareholder loan becoming liabilities at target company (Estro) level.

Estro went bankrupt in 2014 because of revenue losses due, at least in part, to government cutbacks of subsidies. The bankruptcy trustee filed a petition for an inquiry into the policies and affairs of Estro in relation to the acquisition. Following the investigation results, the Enterprise Chamber has now determined that there was mismanagement at Estro. The court's ruling provides significant insights into the responsibilities of directors and supervisory board members in LBO transactions. So, what are the main take-aways?

1. Correct and complete disclosure to the works council is key

An important aspect in the Enterprise Chamber judgment was the disclosure of information to the works council. The directors are responsible for keeping the works council correctly and fully informed during the advisory process. If it turns out that the information used by the works council is not correct, this should be corrected and, if appropriate, the works council should be given the opportunity to issue a further advice. If certain deal aspects only become clear at a later stage in the transaction process, the works council should be updated. To ensure that the works council and management are aligned in terms of the manner and timing of the works council’s involvement, it may be appropriate to agree on process arrangements. In this case, the directors had not made clear (or rectified once they became aware) that the equity portion to be provided by Providence was provided to a large extent under a shareholder loan which, due to the merger, became a liability for the target company. In addition, the reasoning for the merger was misleading. It was labelled as a simplification of the holding structure whilst the predominant reason was to comply with the conditions of the banks to grant guarantees/security for the acquisition financing (without any financial assistance restrictions).

2. Provide for transparent and responsible decision-making

Given that an LBO is often accompanied by a significant financial burden on the target company, directors must carefully consider the (financial) pros and cons. The corporate interest analysis should not only consider the continuity of the target company following the LBO, but also whether the LBO contributes to the sustainable success and execution of the strategy of the target company after the LBO has taken place. During the entire process, the board must consider whether the LBO and its conditions can still be aligned with the interest of the target company, or whether these conditions require adjustments. The target company management board must adopt a proactive approach and, when necessary, challenge the parties involved in the process (including the private equity investor). In doing so, directors should provide for an accessible paper trail to ensure transparency on decision-making processes. In the case at hand, Estro had negotiated with Providence that it could finalise its corporate benefit analyses after the deal closing but – according to the Enterprise Chamber – that seemed contradictory to the factual situation where Estro already acceded to the bank financing under which it was agreed that the merger had to be effectuated (pursuant to which the shareholder loan would also become a liability for Estro).

3. Engage an independent expert

In making the corporate benefit analysis, directors should seek assistance of independent experts to determine any issues and risks associated with the LBO. If certain red flags are identified, the board should quantify these and, if necessary, take measures to address any possible consequences. If recommendations for further investigation are made, the board should consider whether any such further investigation is necessary to gain sufficient knowledge of the potential impact of the LBO on the target company (thus effectively balancing interests). In this case, no or insufficient consideration was given to, or action was taken, on the remarks of the independent experts in respect of (a) the level of deductibility of interest on the shareholder loan (which could potentially have a major impact on the cash flow with a risk to breach the financial covenants under the bank financing), (b) the (other) default scenarios under the bank financing and (c) any refinancing risks in respect of the bank loans and the shareholder loan. The directors therefore risked becoming too dependent on the banks and consequently the continuity of Estro and the execution of the strategy would be jeopardised.

4. Carefully consider (the conditions of) shareholder loans

Directors should be aware that, while shareholder loans do not often have a negative impact on the company’s cash flow (due to high PIK interest and bullet repayment), such loans can weigh heavily on the balance sheet of the company and negatively impact the company’s solvency (especially as the principal of these subordinated loans may increase substantially over time as a result of PIK interest being added to the principal). As a result, the position of unsecured creditors (whose claims are not subordinated to the shareholder loan) is weakened and the deteriorated balance sheet may put the target company in a difficult position in the ordinary course of its business or in case of refinancing. In this case, due to the merger, the target company became the borrower under the shareholder loan. As Providence had the option to be paid in kind or in cash, Providence could, in case of non-payment, accelerate the shareholder loan resulting in Estro losing control. There was also no conversion right (into (cumulative preferred) share capital) for Estro or any other arrangement with Providence to mitigate this risk. Finally, the interest deductibility was questionable, which could result in a material cash impact and potential financial covenant default under the bank financing. In any case, the shareholder loan for the interest deductibility did not have to be this high to maximise tax efficiency. Although these risks were also pointed out by the independent expert, they were not - or not sufficiently - considered or acted upon by the directors.

5. Enhanced duty of care may apply if personal or public interests are involved

Directors should keep in mind that an increased duty of care may apply due to personal financial interests, such as entitlements to exit bonuses or management participation incentives. In their decision-making, the board should consider the potential effects of such personal interests and demonstrate that these do not conflict with the interests of the target company. Therefore, Estro could only commit to the LBO after all concerns were properly addressed and the risks were considered in light of Estro’s sustainable success probability (especially taking into account the public nature of Estro).

As the largest childcare company in the Netherlands, Estro was heavily reliant on childcare subsidies from the government. The company's interest was therefore also influenced by the public interest in the continuity and accessibility of high-quality and affordable childcare. As such, these interests had to be considered in the board’s decision-making, and whether the board has done so is relevant when considering if mismanagement took place.

6. Supervisory board members should actively monitor directors

Supervisory board members need to ensure that directors who are subject to an enhanced duty of care, observe that duty of care in the preparation, decision-making and execution of the acquisition. When recommendations are made by experts, the supervisory board should urge the management board to act upon these. Private equity delegates appointed as board observers in the supervisory board, should be aware that an enhanced duty of care may also apply to them due to conflicting interests from involvement in the preparations or execution of the LBO.