T
HEE
UROPEAN PROVISION AGAINST ASSET STRIPPING:
W
HATABOUT THE PROTECTION OF VULNERABLE STAKEHOLDERS
?
Master’s program in Law and Finance, LL.M Student: Bart Warringa
Student number: 12436941
Supervisors: J.E (Jeroen) Ligterink, and F. (Fatjon) Kaja Submission date: July 2020
ABSTRACT
In private equity, asset stripping has been a highly a controversial topic. The European legislator made its first attempt to regulate asset stripping in article 30 of the Alternative Investment Fund Managers Directive. The purpose of this thesis is to analyze the effectiveness of this asset stripping provision for stakeholders, and by extension for the society at large. Against this background, the present thesis seeks to answer the following research question: “Is the regulation against “asset stripping”, as formulated in article 30 of the European AIFMD, an effective and desirable provision to protect the corporation’s stakeholders and the society as a whole? This thesis aims to give an answer to this question through the examination on the international empirical studies in order to conceptualize asset stripping. By means of the empirical findings, the judicial analysis regarding the AIFMD, and the related Dutch national rules, we analyses whether the current regulatory framework is sufficient to protect the company’s stakeholders.
This paper argues that the European legislator does not well seem to understand the conceptualization of asset stripping in practice. Moreover, this paper argues that one seems to have forgotten the position of vulnerable stakeholders of the company. In this spirit of the addressed shortcomings, this paper provides suggestions for further enhancement of the stakeholder position of stakeholders in buyouts.
Keywords: Asset stripping – AIFMD – Stakeholders – Shortcomings of the AIFMD – Regulatory amendments
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ABLE OFC
ONTENTS1.1 The relevance and background ... 1
1.2 What is PE? ... 2
1.3 Outline of this thesis ... 4
CHAPTER 2 - GENERAL LITERATURE REVIEW AND THEORY ON ASSET STRIPPING ... 6
2.1 The concept and term “asset stripping” ... 6
2.2 Activity-based definition of asset stripping ... 8
2.2.1 Transfers from portfolio companies ... 9
2.2.2 Sale & leaseback ... 13
2.3 The agency theory of debt covenants ... 15
2.3.1 Analysis of the empirical literature on the use of covenants in PE ... 16
CHAPTER 3 - RELATED ASSET STRIPPING LITERATURE AND THEORY ... 18
3.1 Asset stripping in PE backed transactions ... 18
3.1.1 Disposition of assets ... 18
3.1.2 Dividend distributions ... 20
3.1.3 PE & short-term bias ... 21
3.2 Wealth transfers from stakeholders in an asset stripping transaction ... 22
3.2.1 Expropriation of debtholders ... 22
3.2.2 Expropriation of employees ... 23
3.2.3 Expropriation of suppliers ... 24
3.3 The case for regulating asset stripping ... 25
CHAPTER 4 –THE REGULATORY RESPONSES TO ASSET STRIPPING ... 28
4.1 Background and introduction to the asset stripping rule under AIFMD ... 28
4.2 The AIFMD asset stripping rule under scrutiny ... 29
4.3 How is the of position of stakeholders safeguarded under AIFMD and Dutch national law in an asset stripping transaction? ... 31
4.4 What can we learn from abroad? ... 34
4.5 Case studies ... 35
4.5.1 Case study 1. The VendexKKB and the HEMA ... 35
4.5.2 Case study 2. Aldel ... 37
4.6 The way forward: a new regulatory approach to the asset stripping rule ... 38
4.6.1 The revised asset stripping rule ... 40
CHAPTER 5 - CONCLUSION ... 42
References ... 44
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I
NTRODUCTION1.1 The relevance and background
The past decade, private equity (hereinafter abbreviated to “PE”) experienced a tremendous growth, recently deploying a volume of investors’ capital worldwide of roughly $180 billion in 2000 to over $1.47 trillion in 2019.1 Each year, PE invests in thousands of companies
(Brown et al., 2020). At this point, accumulated evidence suggests that PE investment strategies has been outperforming the public stock markets since the 1980s (Harris et al. 2014, 2016). Other existing work suggests that PE has not beaten the stock market since 2006 (Appelbaum & Batt, 2019). While one more recent paper, written by Phalippou (2020), points out that PE funds have similar returns as the stock market since at least 2006. Thus, studies give a mixed picture on PE’s performance. As such, PE firms are considered to generate high returns over the companies they invest in. However, in some cases it remains unclear how PE generates these revenues.
The impact of PE and how they affect their portfolio companies (hereinafter abbreviated to “PC(s)”) and stakeholders have therefore become a popular topic. Moreover, PE continues to be in the center of public debate (Appelbaum & Batt, 2020). Proponents, on the one hand, point out the important role of PE in the merger & acquisition (M&A) market, transforming poor performing companies into better performing capital-efficient firms, the so-called “bright side view” (Heed, 2010). Critics, on the other hand, amongst other things, accuse PE of solely stripping companies bare, the so-called “dark-side view” (Wood & Wright, 2010). In other words, selling of the valuable corporate assets for short-term profits. These asset stripping transactions have become a controversial topic in the financial world, because these actions may undermine the interest of other market participants.
The first regulatory response to asset stripping came in 2013, from the European legislator. It made its first attempt to formulate anti-asset stripping rules through the adoption of article 30 of the Alternative Investment Fund Manager Directive (hereinafter: “AIFMD”). In the
academic literature and the judicial practice, the application of this provision is welcomed with sharp criticism. Several scholars and law practitioners have argued that the directive represent poorly addressed regulation that does not deal with the chief practical elements of asset stripping (Barneveld, 2013; Hodge, 2014; KMPG, 2018; AFM, 2020). Therefore, in this thesis we will underline the shortcomings of the AIFMD, in order to make recommendations for further regulatory improvements. In short, the ultimate goal of this thesis is to propose regulatory framework under the AIFMD in which all stakeholders are sufficiently protected. In order to continue, and to explain how we contribute to the existing literature, we first briefly clarify how PE works.
1.2 What is PE?
What is PE? As the name of the asset class suggest, PE investments consist of equity investments that are typically private, not being publicly traded, or listed on an exchange (Jenkinson et al., 2020). PE is used for investments and specialist management assistance, often related to highly leveraged acquisitions of companies (Heed, 2010). A PE firm incorporates a pool of capital from investors in the “investment fund” from which it raises equity capital (Kaplan & Strömberg, 2009). PE investments can take many forms. The most important forms are to finance the acquisition is by venture capital (VC) fund or buyouts fund (Kaplan & Strömberg, 2008). The former compromises of equity invested in start-ups or young emerging companies, usually without obtaining the majority of control (Kaplan & Strömberg, 2008). The latter consists of PE firms that buy a majority stake in later-stage growth companies, either public or private (Jenkinson et al., 2020). If the company is public, the firms will be delisted from the stock exchange, the so-called “public-to-private transaction” (Kaplan & Strömberg, 2009).
The PE-model is considered as an extreme form of shareholder-value capitalism (Morris & Phalippou, 2020). PE owners have great financial incentives to look for every single source of return in the companies they invest in. Some of these sources may very well be thought of as socially useful, others are neutral, while some are thought to have a negative social impact (Morris & Phalippou, 2020).
From a legal point of view, the PE fund is organized in a partnership or a limited liability corporation, with limited partners (“LPs”) and general partners (“GPs”) (Kaplan & Strömberg, 2008). This fund consists of equity capital, typically 98% committed by the LPs and 2% from the GPs (Appelbaum & Batt, 2020). Formally, the PE fund has no formal power in the PCs, besides from being the major shareholder. However, there is a high level of commitment from the PE fund to their PCs. In that sense, GPs, typically the PE firm, are considered to be “active investors” (Kaplan & Strömberg, 2008). Commonly, taking seat and controlling the PCs’ board of directors (Kaplan & Strömberg, 2008). Moreover, GPs manage all other important decisions (e.g. the capital structure, investments, divestments, and operational changes) (Lopez-de-Silanes et al., 2015). The LPs, on the other side, are considered to be “passive investors”, that commit capital for the long-term. In principle, they have no say in PCs (Appelbaum & Batt, 2014). LPs include institutional investors, pension funds, endowments, insurance companies, and wealthy individuals (Kaplan & Strömberg, 2008).
PE tends to focus on optimizing the company’s capital structure, minimizing the after-tax cost of capital (“financial engineering”) (Morris & Phalippou, 2020). Typically, acquisitions are financed by a mixture equity and a substantial amount of debt. Commonly arranged with 70% debt, and 30% equity provided by the PE fund (Appelbaum & Batt, 2020; Morris & Phalippou, 2020). This debt percentage may be lower for smaller companies with fewer assets (Appelbaum & Batt, 2020). Debt funding is provided on the basis of the PCs’ assets and its future cash flows, serving as security (Gillian & Wright, 2014). A critical role is played by the providers of debt finance; as comes from a number of resources. The debt component is typically provided through the syndicated loan market, ultimately funded by a large number of lenders (Axelson et al., 2008). The nature of debt financing typically consists of tranches with levels of seniority, lending terms, and interest rates (Kaplan & Strömberg, 2008). Chunks of senior and secured funding, and an unsecured part, including high yield bonds or mezzanine debt2 (Kaplan & Strömberg, 2008). Large fractions of these loans are typically re-sold within
a short period of time to intuitional investors, such as hedge funds or collateral loan obligation (“CLO”)3 managers (Kaplan & Strömberg, 2008).
For the firm, the obligation to service debt can be viewed from a positive or a negative outcome. The use of debt magnifies both outcomes. On the positive side, the value gains from the tax shield are considered to be the “lifeblood” of the PE firm, i.e. the tax deduction on interest payments on debt (Kaplan, 1989b). On the negative side, high debt levels may induce financial distress or bankruptcy risks (Kaplan & Stein, 1993).
1.3 Outline of this thesis
As formerly mentioned, this thesis examines the effects of the anti-asset stripping provision under AIFMD. This thesis contributes to the existing literature and the ongoing debate in three ways. Our first contribution is that we define “asset stripping” on the basis of a conceptual framework that comprehensively incorporates the existing theorical literature and the financial empirical studies. The second contribution is that this thesis aims at bridging the gap between empirical findings and the current regulatory response in the AIFMD and the Dutch regulatory framework. In order to detect regulatory implications, we investigate the effectiveness of these rules. Thus far, this interaction has not yet been well explored. Finally, the third contribution is that we provide an alternative approach to regulate asset stripping under the AIFMD, in which we provide recommendations for further improvement of the current framework.
In this light, the research question in this thesis is:
“Is the regulation against “asset stripping”, as formulated in article 30 of the European AIFMD, an effective and desirable provision to protect the corporation’s stakeholders and the society as a whole?
3 A CLO is an asset-backed security issued by special purpose vehicle (SPV). The leading bank arranges the loan syndicated and earns a fee, while
the leading bank sales to the loan to CLO. CLO securities (“notes”) are collateralized against the underlying loan portfolio. See for more information: Shivdasani & Wang (2011).
This thesis is divided into five sections, the structure is as follows: In Chapter 1, we have briefly introduced the concepts and legal practice of asset stripping and the mechanisms of PE. In Chapter 2, we will analyze the conceptualization of asset stripping based theorical framework (§2.1). Hereafter, we discuss the case for regulating asset stripping (§2.2), the historical background (§2.3), and the activity-based definition from a shareholder-debtholder agency perspective (§2.4). Finally, the last paragraph (§2.5) builds on the previous ones, discussing the rationales for the use of covenants, from the perspective of the borrower, the macroeconomic trends, and the lenders. In chapter 3, a comprehensive overview of all existing literature following my literature search will be discussed. In the first part of this chapter (§3.1), we will focus on the activity-based features of asset stripping, the second part (§3.2) will provide insights into the effects of redistribution of value from other stakeholder to the PE investors. Chapter 4 builds on the previous ones, as we study the interaction between our asset stripping framework and the current asset stripping provisions under AIMFD and Dutch national law. Moreover, we discuss the shortcomings of the current regulatory framework and make suggestions for further improvement. Chapter 5 concludes.
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G
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ITERATURER
EVIEW ANDT
HEORY ONA
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TRIPPINGThe aim of this chapter is to provide a comprehensive overview of the academic theory and literature on the conceptual features of asset stripping. In order to give the reader a clear understanding of asset stripping and the potential implications for the company’s prospect, stakeholders, or for the society at large.
2.1 The concept and term “asset stripping”
It is important to properly conceptualize the term “asset stripping”, since recent survey research done by KMPG (2018), among fund managers, national competent authorities (“NCAs”) and stakeholders in the European Union, showed great inconsistencies regarding the general features of asset stripping (KPMG, 2018).4 After all, this is not surprising, since the term asset stripping,
as we use it today, comes within a multitude of forms and appearances. For regulation to be effective, a consistent definition is crucial.
To be clear, in this thesis we conceptualize “asset stripping” in PE as a practice of intentionally disposing or harming the company’s assets, in order to improve the return for equity investors; the PE fund (Gillian & Wright, 2014; Wright, 2009). Typically, asset stripping adversely affects the company’s prospect, the position of stakeholders, or the society at large. In this context, asset stripping can be thought of as a form of rent-seeking behavior.5 It is not generating “real” value
but rather creating negative externalities (i.e. negative effects for which entities are not compensated) (Appelbaum & Batt, 2014). Following this definition, a number of important questions remain to be pending. For instance, what kind of assets may be stripped? What kind of negative externalities can we think of? Who are these stakeholders?
As a starting point, to further define asset stripping, we examine the features of “assets” and the verb “stripping”. The term “stripping” has many shades of meaning. In our context it refers to actions of removing, disposing, depriving, separating, or leaving something bare
(Merriam-4 KPMG (2018), p. 74-100.
Webster Dictionary). An asset is defined as a: “recourse controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity “(IASB 2010, § 4.4). In general, there are two types of assets, i.e. tangible and intangible assets (Berk & DeMarzo, 2017). Tangible assets are resources of physical nature, such as property, plant and equipment (IAS 2003, §3). Intangible assets are sources of non-physical nature, such as trademarks, copyrights, or patenting, but, most notably, also consist of the company’s stakeholders, such as employees and suppliers (IAS 38, §9).
With regard to harming the company’s prospect, one could think of transactions in which underlying assets are sold at expenses of the company’s future legitimate interest (“value extractions”). Or transactions that steer to the company towards future distress. In general, PE enjoy better bargaining power, negotiating skills, and superior information relative to inexperienced investors. Therefore, PE excels in transferring value out of companies they invest in (Tykvová & Borell, 2012).
As indicated, asset stripping transactions could also adversely affect the companies’ stakeholders. A stakeholder is further defined as someone “who has commitment to a corporation that stems from the fact that they work for it, supply it, purchase from it, live near it, or are affect in some way by its activities” (Mayer, 2013). To further endorse, Shleifer & Summers (1988) argued that wealth gains in LBOs are ascribed to the breach of implicit and explicit contracts with the company’s stakeholders, adversely affecting their position. Moreover, Perotti & Spier (1993) describe that LBOs may be used as a bargaining tool to the non-financial stakeholders to make concessions at cost of company’s stakeholders, by the renegotiation of contractual terms, which further induces value redistribution effects. With this grasp, examples causing negative externalities are extensive. An example includes employees that face repercussions in the form of layoffs or wage cuts. While suppliers may face a deterioration of their claim or are forced to make concessions, and debtholders encounter wealth expropriations from certain transactions that affect the company’s capital structure.
Against the negative connotation of asset stripping, other academics argue that asset stripping may also expose hidden value, and increase the value of the businesses, creating more efficient
allocative financial markets (Berg & Gottschalg, 2003; Gillian & Wright, 2014). In addition, Gillian & Wright (2014) stress that, if the current owner is not using the asset’s full potential, selling an asset to a third party that will use its full potential instead, will increase the overall economic efficiency. This is simplistically illustrated below.
Figure 1: Asset value discrepancies. Source: author.
As such, one may also think of asset sales, in order to reduce the corporate scope, thereby increasing strategic focus (Berg & Gottschalg, 2003). Besides the framework of pursuing value maximalization, opportunities of selling assets come about when the cost of maintaining the assets are lower than the benefits of selling it, which is consistent with the value discrepancy theory (Weir et al., 2008). This is similar to the controversial “quick flips”, i.e. transactions that rapidly ensure high returns. Quick flips may very well unveil “hidden value” in companies. But when the PE investors disregard the above-discussed interest, it is viewed as asset stripping.
2.2 Activity-based definition of asset stripping
This paragraph dives into the activity-based definition of asset stripping. Activities related to asset stripping, are commonly linked to targeting “cash cow companies” and employing a number of controversial strategies, in order to generate liquidity, and cash out the proceeds to shareholders. Broadly speaking, there are two main strategies to extract value from companies,
by: i) sale & leaseback, and ii) leveraged dividend recapitalization. These features will be discussed below.
2.2.1 Transfers from portfolio companies
This section contains an agency-theorical observation of asset stripping in PE. As indicated below, in figure 2, the agency relationship comprises the red line drawn from the equity holders to the debtholders. In this agency relationship the PE fund acts as “agent” and the debtholders as “principals”.
Figure 2: Simplified acquisition structure. Source: author.
2.2.1.1 The leveraged dividend recapitalizations
A well-known example in the PE industry, to extract value from PCs, is through a dividend recap (Phillips & Hope, 2013). Recent anecdotal evidence from the Netherlands suggests that it is not
uncommon for PE-investors to pay out such a special dividend.6 So, how does the recap work? A
recap changes the capital structure with the issuance of new debt, thus increasing leverage, for the sole purpose of paying out this amount as a special dividend (Eckbo & Thorburn, 2008). This is unusual to say the least, since dividends are usually paid from the company’s earnings. The recap is schematically depicted below.
Figure 3. The dividend recap. Source: author.
In order generate financing for the recap, debt will be provided against the company’s future cashflows (Eckbo & Thorburn (2008).7 Typically there several debt instruments that can be issued.
For instance, low-grade bonds (“junk bonds”), syndicated loans, or secured debt (Appelnaum & Batt, 2020; Phillips & Hope, 2013; De Weijs, 2018). As we will discuss below, the nature of the debt is important for the dilution effects for initial debtholders.
PE critics often worry about recaps (Morris & Phalippou, 2020). In particular, they argue that recaps have a “plundering effect” on the company, draining its liquidity (Morris & Phalippou, 2020). This is partly true, because PE changes the capital structure, without changing the company’s underlying operations. Therefore, critics argue that the increase in leverage (and thus
6 See, for example, in the Netherlands: Financial Times, ‘TenCate again lends to private equity for dividend’ April 3th 2019. TenCate issued again
additional amount of debt of 130 million and pay out €90 in the form of dividend. Two years ago, it also issued €125 million in debt to pay out a dividend. Moreover, there are often lawsuits in relation to recaps. Other anecdotal examples are Mervyn’s (Malenko & Malenko 2017)
7 The dividend recaps count for 28% of the middle market loans, therefore being a substantial part of the granted loans, according to the Standard
interest payments) relative to the company’s earnings, creates a potential inability to respond to unanticipated economic downturns (Phillips & Hope, 2013). Academics have investigated the effects of recaps on PCs; empirical studies do not seem to support this view. In contrary, bankruptcy risks even seem to decrease after recaps. We will further elaborate in paragraph 3.1.3. On the flipside, it is true that recaps impact the future company’s prospect. The money is borrowed and accordingly represents a burden on the PC’s balance sheet. This money is not invested to let the company grow, to create jobs, or to increase the economic social welfare within the company (Fürth & Rauch, 2012).
From the shareholders’ perspective, the recap is interesting for a bunch of reasons. First and foremost, shareholders can maximize their internal rate of return (“IRR”) through paying out recaps during their holding period. Second, instead of the more traditional exit scenario’s, such as the (partial) initial public offerings (“IPOs”), recaps immediately achieve liquidity (Phillips & Hope, 2013). Third, and lastly, more debt boosts the company’s tax shield.
From the debtholder’s perspective is the increase in leverage less advantageous, as it magnifies agency problems (Myers, 1977; Jensen & Meckling, 1976). For instance, debtholders can find their claim diluted by the issuance of the new debt, leading to (uncompensated) credit downgrades; adversely affecting the initial claim value (“bait and switch”) (Modigliani & Miller, 1988). This effect is illustrated in figure 3. And besides, claim value can be affected when the firm’s current cashflows or operational results do not match with the debt load (De Weijs, 2018). Certainly, as briefly indicated, the dilution effect is stronger if the new debt is of a more senior ranking than the initial debt, as this will lower its priority (Tirole, 2006). A possible example of these effects has been described in the Colt Industries case in the 1980s. They did a recap in which debtholders found their claim value diluted for $34 million (Schmeits, 2007). Therefore, recaps may referred to as “outright theft”, leading to “uncompensated wealth transfers” to shareholders (Modigliani & Miller, 1988).
Figure 4: Simplified illustration for claim dilution after recap. Source: author with reference to Jensen, 1989.
Besides claim dilution, the issuance of more debt may induce the underinvestment problem (Myers, 1977). The “underinvestment” or “debt overhang problem” is the situation of a company being “underwater”. With substantial amounts of debt financing, this is very well imaginable, as higher leverage exacerbates this issue (Jensen & Meckling, 1976) The dilemma with debt overhang lies in that profits contributed by the new investments end up immediately in the pockets of the debtholders, rather than to the shareholders (Welch, 2011). Myers (1977) demonstrates that a company financed with (risky) debt, creating the debt overhang problem, incentivizes managers into inefficient investments. According to this theory, shareholders will be motivated to ignore positive NPV projects (Myers, 1977) and sell-off assets to pay out cash via a dividend distribution,
leaving debtholders with an empty shell (“cash in and run” and “let the roof leak”).8 (Tirole, 2006).
However, such behavior would heavily damage the reputation of the PE firms, which will enable them to finance future deals. Therefore, as we will discuss later on in this thesis, in the empirical studies, we do not find support on this view.
To conclude, debtholders may face expropriation risks as a result of recaps. So, one may wonder, why do debtholders accept this increase in leverage in the first place? An answer can be found in that, as a matter of fact, PE has become a sophisticated customer of debt, borrowing substantially more than normal stand-alone companies (De Fontenay, 2013). In that sense, debtholders may experience an internal pressure to earn fees or expand their market share in the PE debt market. Another, less obvious explanation may be that debtholders inadequately management their risks. Either way, it must be clear that the benefits for debtholders funding PE, outweighs expropriations risks from recaps.
2.2.2 Sale & leaseback
Another common way to generate cash inflows is by means of a sale & leaseback construction (“SLB”). The SLB is a construction in which the PE investors sell the assets, to eventually lease them back. Typically, the proceeds of the asset sale will be paid to shareholders in the form of a dividend. As indicated in figure 4, SLB works as follows: the PE splits up the company into an operating company (the “OpCo”) and a property company, often holding its real estate (the “PropCo”) (Batt & Appelbaum, 2009). The PropCo part will be sold told a third party that becomes the future “lessor” (Batt & Appelbaum, 2009). Afterwards, the OpCo leases back the real estate under a long term-lease agreement. Sometimes, even at inflated rates9 (Batt & Appelbaum, 2009).
8 Black (1976) states in this context: “There is no easier way for a company to escape the burden of a debt than to pay out all of its assets in the
form of a dividend, and leave the creditors holding an empty shell”.
9 Research done by Hordijk et al. (2010) report that 60% of the sale-and-leaseback transactions are concluded against higher rents than the usual
Figure 5: The sale & leaseback construction.
Source: author with reference to Gillian & Wright (2014).
After the SLB, the company has a new lease charge on their profit and loss account. This means, in fact, more risks and liabilities; therefore, lease is often considered to be a form of “hidden leverage”. However, SLBs are not always deemed to extract value from companies and may very well take place for other sensible motives outside PE. For instance, for certain companies being “asset light” became a business strategy (Page, 2007). In the hotel industry, one observes a growing trend to dispose real estate assets to lease them back, in order to focus on hotel management rather than owning real estate (Page, 2007).
From an agency perspective, the SLB may have a similar affect as the principle of claim dilution. There may very well arise dilutive effects, because the selloff will result in an higher claim on the remaining assets, that serve as collateral for providers of debt (Iskandar-Datta & Emery, 1992; Renneboog & Szilagyi, 2008).
2.3 The agency theory of debt covenants
As described in the previous sections, debtholders may face wealth expropriations due to a change in the capital structure. Lenders have several remedies to reduce these agency conflicts. For example, simply restrict the supply of debt financing (“credit rationing”) (Stiglitz & Weiss, 1981) or pledge a specific asset as collateral (so-called “secured bonds”). Another remedy for lender is to impose covenants on the borrower, to reduce the agency costs ex ante (Smith & Warner, 1979). Covenants are contractual clauses (in personam right) that grant some control over the corporate assets and decision-making in case of an “event of default”, therefore differing from security rights that give a proprietary right over the asset (in rem right) (Kraakman et al., 2014). Covenants have their theorical fundamentals in the contracting complexity due to asymmetric information between debtholders and equity holders (Hart, 2017). Broadly speaking, there are three types of covenants. First, the “affirmative” covenants that require the borrower to take certain actions. For instance, to provide information on time (Kraakman et al., 2014). Second, the “negative covenants” prevent the borrowers from taking certain actions, such as disposing assets, paying dividends, or changing control over the company (Kraakman et al., 2014). Third, the “financial covenants” are accounting-based restrictions on risks and performance, for instance, to maintain an amount of leverage or earnings (Kraakman et al., 2014).
The costs involved writing and enforcing covenants are substantial (Smith & Warner, 1979). Having too many covenants may also induce monitoring costs on the lender. Moreover, covenants may restrict the flexibility of the firm to make certain investments, divestments, or dividend decisions. It would therefore be possible to limit managerial behavior with covenants, although this would evidently reduce value of credit (Jensen & Meckling, 1976).
Hence, debtholders can protect themselves against wealth expropriations from an increase in leverage or asset sales. As indicated, they may ask for collateral, restrict lending, or impose covenants. Nonetheless, in practice, these remedies are not often used (De Fontenay, 2013). Quite the opposite, covenants are generally not imposed on the borrower. In the next section we elaborate.
2.3.1 Analysis of the empirical literature on the use of covenants in PE
This subsection builds on the previous sections. The academic literature on the use of covenants in LBO loans will be central. The majority of the leveraged loans are typically “covenant-light” (“cov-lite”)10 (Kaplan & Stein, 1993; Kaplan & Strömberg, 2009; Ivashina & Vallee, 2020).
Meaning that, as the terms suggests, loans are borrower friendly with typically fewer restrictions on the borrowers and fewer protections for the lender (Acharya et al., 2007). Cov-liteness has been interpreted as a sign of easy credit conditions, and besides seems to be a feature of leveraged loans (Whitehead, 2009). In this spirit, a natural question arises: why do debtholders, that may very well can suffer wealth losses due the above-mentioned agency problems, grant loans for LBOs on a cov-lite basis? The literature constituted serval theoretical arguments explaining why PE accesses debt finance against less restrictions.
First, creditors are more willing to grant loans to GPs that received reputation, proxied by historical performance of the PE company (Demiroglu & James, 2010). Diamond (1989) describes that value in generated by having a sound reputation. Reputation is considered to be a valuable asset, which could easily drop with a single default. The overall idea is that good reputation lowers the incentive for PE to engage in risk-shifting or to expropriate, as this would not allow PE to finance future deals. The fear of losing reputation is a strong disincentive. Reputational damage is an important sanction on corporate misconduct (Mayer, 2013). Second, LBOs are mostly financed in the form of syndicated loans. Syndication implies a selection of financiers, the so-called participating lenders, that provide debt together, in order to spread credit risks, which eventually leads to looser lending terms. Third, macroeconomic conditions are very relevant. After the financial crisis, banks were willing to provide capital for LBOs against very favorable terms. Ligterink et al. (2017) describe that this led to an intensified deal competition amongst banks and other financiers with “race to the bottom” lending conditions.11 Lastly, a recent paper written by Ellias & Stark (2019)
explains that there is no perfect contractual solution to foresee shareholders’ control opportunism to harm creditors. Particularly, when the financial distress potential deepens. Even the best drafted
10 Becker & Ivashina (2016) report a percentage of 70% 2005. Other, recent anecdotal comes with a percentage of 85% (J. Edwards, Business
Insider ‘The risky ‘leveraged loan’ market just sunk to a whole new low’ 17th of February 2019).
covenant contracts will contain some loopholes. Thus, the authors argue that the use of covenants is an insufficient remedy in case of the borrower’s default or expropriation practices.
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R
ELATEDA
SSETS
TRIPPINGL
ITERATURE ANDT
HEORYIn this chapter we discuss the negative effects of PE in relation to asset stripping. Over the past decade, international empirical studies explored the impact of PE on PCs. In relation to asset stripping, this section will highlight and explain their essential findings. This section is divided into two subsections. The first section contains work regarding divestments, dividend recaps, and PE’s investment horizon. The second section investigates the redistribution effects of asset stripping on stakeholders.
3.1 Asset stripping in PE backed transactions
In this section we study asset stripping in PE-backed transactions. As a starting point, we start with work done by Boot in 1992. In his paper, Boot wonders if value enhancing divestures are not induced by the management of a target company itself. Boot argues that self-interest managers are, in general, reluctant to divest. Divesting is seen as a bad signal because managers acknowledge their choice for an inappropriate project or worse, a failed acquisition. By the same token, Lang et al. (1995) argue that managers may be disinclined to sell assets to promote operating efficiency, for the sake of reducing in their scope of control. These scholars indirectly support the “bright side view” on PE. PE, as skilled value finders, dare to make divestment decisions that an incumbent management would not make.
3.1.1 Disposition of assets
This subsection aims at bridging the gap between asset disposals and the investment horizon of PE and is divided two parts. The first part deals with the literature on divestures in relation to asset stripping. In the second part we discuss a less obvious way in which PE may strip companies bare. In this section we will discuss how PE negatively affects a company’s prospect by starving PCs of their necessary investments, in order to extract short-term profit (Morris & Phalippou, 2011). Below we discuss the main empirical findings.
We start off with the first PE wave in the 1980s. During this LBO boom, acquisitions were mainly focused on selling inefficiently overdiversified conglomerates into pieces (Bhagat et al.,1990).12 Studies describe that firms lost averagely 30-50% of their book value of assets, often
already within 2 years (Bhagat et al., 1993; Ravenscraft & Scherer, 1988; Set & Easterwood, 1993; Kaplan 1991).
In more recent work, Guo et al. (2009) study a sample of 94 US LBOs between 1990-2006. Over their sample, the authors report that 36% (34 of the 94 deals) sell assets in a 3-year period after the buyout. The proceeds are equal to roughly 22% of the initial purchase price. In relation to the SLB construction, Wright et al. (2007) report that the proceeds from asset sales form a great part of realized value for the PE fund, accounting for 1/3 of the total value in 2001, and 1/4 in 2005. Evidence worldwide further indicates that asset disposal following a buyout is limited, and is mainly involving the larger LBOs (Strömberg, 2008; Wright et al., 2007).
Other evidence comes from Acharya et al. (2008) studying a sample of LBOs in the UK between 1996-2004. The authors describe that 19% (13 out of 66 deals) sold assets, although they found no evidence of asset stripping. Overall, the authors note that the divesting companies have lower IRRs than companies that do not divest. Their evidence seems to be contradictory to the critique that high divestment levels lead to the highest returns. Correspondingly, work done by Ayash et al., (2017) pinpoints that buyouts focused on sustainable value creation, i.e. buy-and build (“B&B”)13,
ultimately produce the highest exit returns. In §3.1.4 we will further substantiate.
As briefly indicated above, another popular charge is that PE strips companies bare by starving them of investment, thereby negatively affecting the company’s prospect and long-term growth opportunities (Morris & Phalippou, 2011). Morris & Phalippou (2020) note, for example, that GPs may have clear incentives to cut back investment in financial distress, to gain short-term profits and keep control at expense of other stakeholders. Apart from financial distress situations, evidence in this context is mixed. Several studies do support this view, reporting significant
12 See: de Jong et al. (2007) or Cheffins & Armour (2007) for an extensive description of the PE history.
13 This strategy is best explained as a scale up strategy by horizontal mergers, i.e. merging with companies operating within the same
reductions of overall patenting and citations after the buyout (Hitt et al., 1996; Cumming et al., 2018; Ayash & Egan, 2019; Bertoni, 2017). And other studies report positive effects on patenting activities and innovation after the acquisition (Kortum & Lerner, 1998; Popev & Roosenboom, 2009; Lerner et al., 2011; Bernstein et al., 2020).
To conclude, recent evidence seems to suggest that there is no systemic evidence for asset stripping as to asset disposals. Instead, PE has an incentive to expand businesses for higher returns. With respect to R&D, if PE investors prevent companies from making the necessary operations for future growth this may cause negative externalities. Such as, adversely affecting the company’s prospects or its stakeholders; this is considered to be asset stripping.
3.1.2 Dividend distributions
In this subsection we will explore the empirical main insights on dividend distributions by PE. As formerly mentioned, a popular charge is that PE extracts value from acquired companies by loading them full of debt, draining their financial resources with high dividends. Overall, the empirical studies are straightforward.
Empirical studies report that recaps are relatively common in PE and is observed in roughly 20%-55% of the buyouts. On average, evidence suggests that there is no correlation between recaps and financial distress. Moreover, in some specifications, recaps are even associated with lower default probabilities (Hotchkiss et al., 2010; Hotchkiss et al., 2014; Harford & Kolasinski, 2014; Ayash et al., 2017;). This evidence suggests that companies only pay out a dividend if they are sufficiently liquid.
Research done by Cohn et al. (2014) reports that PE-backed companies pay very little dividend. They observe that 90% of the highest dividend payouts account for 0.1% of the transaction value in the first year, and for 1.7% the year after. Which makes the payout rates actually lower than before buyout.
To sum, on average, the formerly mentioned evidence contrasts the narrative of the PE industry. Although evidence indicates that it is common for PE to pay out dividends, this does not lead to higher probabilities of financial distress.
3.1.3 PE & short-term bias
Does PE lead to heavier focus on the short-term? In this section we will substantiate the basis of the main empirical findings. In general, there seems to be very limited support that PE leads to excessive short-term focus.
In this spirit, Strömberg (2008) studied 21.000 buyouts between 1970-2007. Strömberg observes that during the first buyout wave in 1980s, PE’s holding period seems to increase over time, averaging approximately 6-7 years, and only 8% of the buyouts are less than 2 years. To continue, Kaplan & Strömberg (2009) study a sample of 17.171 transactions worldwide (1970-2007), reporting an average holding period of roughly 6 years, where also 6% of the acquisitions went bankruptcy. More recently, Lopez-de-Silanes et al. (2015) examined over a sample of 7.453 buyouts of which 10% goes bankrupt and 25% is considered to be a quick flip. The authors report that quick flips produce the highest IRRs, averagely equal to 79%, while investments longer than 4 years have an IRR of 10%. Besides excessive occurrences, the authors report an average holding period of roughly 4 years. To be complete, most recent work, executed by Brown et al. (2020) report an average holding period of 5 years. The results of these papers are in line with the recent B&B strategy (i.e. value creation is to let the company grow) (Hammer, 2016). Yet this evidence also suggests that incentives for asset stripping and quick flips exist under the short-term pressure to generate cash for funds.
In sum, the empirical results report a median holding period variating between 4 and 6 years, suggesting a more medium-term focus than a short-term focus. All the more, this focus can be well explained from the fund structuring, in which completing the investment typically takes 5 years for a 10-year fund (Hüther et al., 2020). Therefore, the question whether the time horizon of PE creates a negative externality for involved parties is hard to answer. If PE’s short-term orientation
affects involved parties or the society as a whole, causing negative externalities to people that cannot protect themselves, it may very well be considered to be asset stripping.
3.2 Wealth transfers from stakeholders in an asset stripping transaction
In this section we explore the redistribution effects of asset stripping at stakeholders’ expenses. The structure of this section is made up in threefold. We start with the position of debtholders, next we discuss employees, and lastly, suppliers.
3.2.1 Expropriation of debtholders
In this section we discuss the position of debtholders. Wealth expropriation effects on bondholders, i.e. the transfer from bondholder value to shareholders, has been observed in several corporate events. The wealth effects have been examined around the announcement of certain corporate events on the return of debtholders. In general, debtholders that are not protected by covenants suffer moderate wealth losses. While covenant protected debtholders experience a surge in wealth.
As briefly indicated, debtholders without covenants suffer moderate losses (averagely -0.5-2.5%) as a result of carve-outs, spin-offs, asset selloffs, and dividend recaps (Datta & Iskandar-Datta, 1994; Easterwoord, 1998, Datta, Iskandar- Datta and Raman, 2003; Maxwell & Rao, 2003; Murray et al 2017; Huang et al. 2016).
While on the other hand, protected debtholders experience an increase in wealth (averagely +0.5-2%) in the above-described events (Acquith & Wizman, 1990; Walkers 1991; Cook et al. 1992; Warga & Welch, 1993; Baran et al. 2010; Travlov & Cornett, 1993; Okamoto, 2011; Billet et al. 2004, 2010).
Furthermore, after the 1980s, one detects that the change of control covenants (“CoCs”) got introduced in the PE-industry (Billet et al., 2010). CoCs allow investors to put (sell) their bonds back to the company at 101% or par (i.e. at equal value) when a specific event has changed the ownership or control of the firm (WesternAsset, 2011). Debt covenants offer optimal protection against an increase in leverage or other corporate events.
To conclude, with the use of covenants, debtholders may very well protect themselves against asset stripping and potential wealth expropriations.
3.2.2 Expropriation of employees
In this subsection we explore the position of employees. Employees may lose their job, experience wage cuts, or face adverse effects on human resource management (“HRM”) related matters. The results from empirical studies are not ambiguous.
By way of illustration, we start with evidence from the first US buyout wave in the 1980s. This period was known for major layoffs after the acquisition. Evidence reports that, on average, workforce got reduced with 20-40%, mostly within 2 years (Bhagat et al.,1993; Wright & Coyne, 1985; Kaplan 1989; Muscarella & Vetsuypens, 1990; Robbie et al.,1992).
More recent evidence is somewhat mixed. Several studies do not observe a significant decrease in workforce (Amess & Wright, 2007; Bacon et al. 2013; Wilson et al. 2012; Acharya et al., 2008; Amess & Wright 2007; Bernstein et al. 2016; Agrawal & Tambe, 2016). Furthermore, evidence reports an increase in wages and “employment prospect benefits”, such as more trainings or safety improvements on the workplace (Wright et al., 2007; Amess et al., 2008; Boucly et al.,2008; Bruining et al., 2005; Agrawal & Tambe, 2016; Cohn et al., 2019).
Nevertheless, results from other studies are more worrisome. Studies report that, where workforce shrinks after the acquisition, it substantially expands the years after. These effects are often referred to as the process of “creative job destruction” or “job reallocation” at firms taken over by PE (Wright et al., 1992; Weir et al., 2009; Cressy et al., 2007; Boucly et al., 2011; Davis et al., 2008, 2014, 2019). Employees suffer from these reorganizations. To illustrate, the most recent work done by Davis et al. (2019) report a decline in the number of employees, equal to -13% in the first 2 years. Thus, for employees there is a fair chance that some of them will lose their job by virtue of a buyout. In addition, studies report lower wages and work intensifications. Furthermore, employees have trouble finding a new job, particularly the employees that are older or low educated (Amess & Wright, 2007; Work Foundations 2007; Lichtenberg & Siegel; Antoni et al. 2019; Davis et al., 2019).
In short, studies give a mixed picture of how PE affects the position of employees. Yet one must bear in mind that PE, as skilled investors, change lagging companies, which includes the composition of employees. Evidently, it is therefore inevitable to reduce the number of employees after the buyout. Studies further show that PE promotes “creative destruction”, “job reallocation”, work intensification, and downward pressure on salaries, which cause negative externalities to employees and the society at large. These effects cause negative externalities to employees and by extension to society as at large.
3.2.3 Expropriation of suppliers
More vulnerable creditors, suppliers (as trade creditors), may suffer the effects from PE’s optimized working capital management (“WCM”).14 These WCM adjustments improve the PCs’
performance, while negatively influencing the suppliers’ position relative to the company (Morris & Phalippou, 2011). Indeed, several studies observe that PE-backed companies, significantly improved their WCM (Smith, 1990; Wright et al. 1992; Wilson et al., 2012; Weir et al., 2016). Moreover, Brown et al. (2009) describe that suppliers usually experience negative effects from LBOs as a result of PE’s bargaining power. In particular, suppliers that are economically dependent on, or that made specific investments in relation to that company, suffer losses in terms of stock returns and reduced profit margins (Brown et al., 2009).
A common strategy to improve WCM at expenses of suppliers, is by postponing invoice payments to suppliers (Niemeyer & Simpson, 2008). To illustrate, a fictitious example: a company extends its payment from 60 to 200 days. Thus, suppliers are forced to wait longer for their invoices to be paid. Over this claim, suppliers do not receive any interest, and therefore this amount becomes non-interest-bearing, being an important part of the debtor’s balance sheet (De Weijs, 2018). Ultimately, the company “borrows” this money against 0% interest from trade-creditors to fund its operations. This forms a substantial amount of leverage in the company, thus boosting the company’s return on equity (“ROE”). 15 According to the European Commission, yearly thousands
14 Working capital management is strategy which involves taking all required actions to maintain an optimum balance of working capital -
receivables, inventory, and payables, which enables value creation (Blanco, 2017)
of SMEs, acting as suppliers, go bankrupt waiting for their invoices to be paid. 16 Although, this
statement is not fully applicable to PE, it does give an indication of the problem.
Anecdotal evidence of this strategy is given in several papers. For instance, Roosenboom (2009) describes that Maxeda (previously VendexKBB) extended its payment to suppliers from 30 to 60 days. In addition, De Weijs (2016, 2018) mentions that Hema, V&D, and Douwe Egberts increased their payments period from 60 to 200 days, without interest compensation. Moreover, Action and Hunkemöller recently changed their payment period from 30 to 90 days.17
To sum up, all these examples support the evidence that suppliers suffer wealth losses as a result of PE’s improved WCM.
3.3 The case for regulating asset stripping
This paragraph focuses on the rationale for regulating asset stripping in PE. The central question will be how to deal with the direct and indirect features of asset stripping causing negative externalities. As extensively illustrated above, the negative effects of asset stripping are often shifted to vulnerable market participants that cannot protect themselves against these risks. In this section we discuss the array of important stakeholders in the following sequence: debtholders, employees, and suppliers.
Typically, in relation to the shareholder-debtholder agency conflict, debtholders can protect themselves for the detrimental effects of asset stripping and a potential (unexpected) decrease in value. For instance, debtholders can demand for covenants, grant rights over the company’s assets when defaulting on loans (collateral) or restrict lending. Overall, debtholders discipline their credit risks and may able to estimate the risk of their investments. As long as debtholders’ expropriation not become excessive, this will not create systemic risks; this will not create negative externalities on the society. Moreover, PE investors have an incentive to build up a sustainable relationship with their lenders to increase their reputation. However, if, for example, the PE-backed company enters into financial distress, ending up in the hand of the debtholders18, this may lead to negative
16 See: https://ec.europa.eu/growth/smes/support/late-payment_en.
17 Den Brinker, G, Dutch Financial Times, ‘Private equity club cracks approach crisis owners Action and Hunkemöller’, 23th of May 2020. 18 One may think of the recent HEMA case. This will be discussed later in the case studies.
externalities on society. For instance, this could result in an adverse effect on company’s prospect, repercussions for employees and suppliers. If these repercussions become excessive and cause negative externalities to the stakeholders or the society, then additional regulation should be introduced. At this point, this is not the case.
A second major stakeholder are the employees of a company, the so-called “human capital” of the company. Asset stripping transaction restructure firms and may reduce employment, replacing employees, or wages cuts, i.e. the “creative job destruction” arguments. This can cause negative effects on the employees and by extension on the society at large. For instance, replaced employees may not find new employment. This may cause problems for society. For example, old low uneducated workers that cannot easily find a job elsewhere and remain unemployed. In sum, the position of employees has become extremely vulnerable in a buyout. Usually, employees cannot protect themselves very well against asset stripping.
Lastly, suppliers (or “trade creditors”) may be put at disadvantage as a result of asset stripping transactions. Within their relationship there is a significant imbalance in bargaining power, which may lead to unfair trading practices. For instance, suppliers may be forced to accept payment extensions (and, therefore brought in the position of suppliers of creditor)19 or force payment
concessions. Ultimately this boosts the company’s profits and thus the returns to PE investors. Likewise, late payments adversely affect the suppliers’ liquidity, competitiveness, and their profitability. 20 Especially, if they need to obtain external finance to compensate these effects To
conclude, suppliers are poorly protected against asset stripping, they cannot properly protect their interest in buyouts.
Asset stripping & Externalities
It must have been clear that asset stripping is method to reinforce the so-called “shareholder primacy” at expenses of stakeholders and the society. The classic view of the role of a corporation has traditionally rested on the assumptions that that corporations must maximize their shareholder value, i.e. the “shareholder primacy”, within the boundaries of the contracts and regulations
19 We will elaborate extensively on this mechanism in §3.2.3. 20 Directive 2011/7/EU, recital 3.
(Friedman, 1970). This vision has been criticized by several scholars for being morally too lax, disregarding the interest of the companies’ stakeholders or creating social welfare (Freeman, (1983); Jensen (1989); Hart & Zingales (2017); Mayer (2013, 2018).
In this spirit, Hart & Zingales, (2017) argue that money making activities are inextricably connected with damage or potential other negative externalities. The authors argue that shareholders, in general, also care about reducing these externalities and aim at pursuing ethical and social goals. Therefore, the corporate goal should not be maximizing market value but rather shareholder welfare. To conclude, we agree with Hart & Zingales and argue that stakeholders that cannot protect themselves, should be protected regulation against asset stripping. With this assumption we will discuss the regulatory response to asset stripping in the next chapter.
C
HAPTER4
–T
HE REGULATORY RESPONSES TO ASSET STRIPPINGThe previous section concluded that PE can lead to redistribution of value among stakeholders. Against this background, of interest in this chapter is the effectiveness of current regulatory framework as a response to asset stripping. More specifically, whether additional regulatory mechanism should be in place to control looming negative externalities. The primary objective of the chapter is to analyze whether the asset stripping rule, as codified in article 30 of the AIFMD, offers an adequate protection for stakeholders. Likewise, in this context, we will evaluate the current Dutch regulatory framework.
In this chapter we will first introduce the AIFMD regulatory framework. Next, we will discuss its shortcomings, and continue with what we can learn from regulation from abroad. Hereafter, we discuss case studies, to continue with opportunities for regulatory improvement. In the last section we make suggestions for regulatory amendments.
4.1 Background and introduction to the asset stripping rule under AIFMD
In the aftermath of the financial crisis, the regulation of PE gained public attention in Europe Union (“EU”) (Payne, 2011). The asset stripping rule is a reaction to the recommendation of the European Parliament (“EP), that European regulation must aim at regulating “unreasonable asset stripping in companies”.21 Correspondingly, the European Commission (“EC”) stressed to introduce rules
that forbid companies to “plunder”.22 With the adoption of the AIFMD, the EU introduced rules
for a sector that has been largely unregulated. 23
AIFMD’s scope
The AIFMD pursues two objectives. First, it encourages the stability and integrity of the financial markets24, and second, it strives to improve investor protection.25 The directive applies to
alternative investment fund managers (“AIFMs”), which regular business is to manage one or more
21 Report EP (2008), p. 5. 22 Report EC (2007), p.11. 23 See Ferran (2011) for details. 24 AIFMD 2011, recital 51. 25 Ibid, recital 29.
alternative investment funds (“AIFs”) established in an EU member state.26 The AIF may be open
or close ended;27 PE funds can be both closed and open-ended (Heed, 2010). With regard to the
scope of the AIFMD, there are several exceptions. First, the directive shall not apply to AIFMs that manage an AIF whose asset under management is below €500 million.28 Moreover, the
directive shall not apply to firms that qualify as a “small and medium-sized enterprises” (“SMEs”).29 The AIFM itself does not give a SME definition, but the Recommendation30 explains
that this includes companies with less than 250 employees that have an annual turnover lower than €50 million or companies that do not exceed the balance sheet total of €43 million.31 To put is
perspective, roughly 86% of the deals are carried out in the SMEs sector.32 Lastly, special purpose
vehicles (“SPVs”) operating in the real estate, are excluded.33 Hence, the workings of the AIFMD
should not be overestimated, as rules will not be applicable for a predominant part of transactions.
4.2 The AIFMD asset stripping rule under scrutiny
As mentioned in the introduction, the application of the asset stripping rule raised concerns among scholars. Recently, the European commission clarified that the AIFMD must be amended to better accommodate the protection of company’s stakeholders.34 Moreover, it is remarkably that, thus
far, there has not been a single case where the asset stripping rule got invoked. Also due to a lack of available data, it is not possible to determine the rules’ added value, yet. To shed more light on the AIFMD, KPMG conducted an empirical research in 2018 among AIFMs, national competent authorities (“NCAs”), and stakeholders on the effectiveness of the AIFMD.
In this regard, feedback was overwhelmingly negative. Broadly speaking, the AIFMD was regarded as “unnecessary”, “overtly burdensome”35, or mainly an “administrative annoyance”.36
In survey, researchers asked their interviewees whether the current asset stripping is considered to
26 Art. 1, 2, and 4 (a) AIFMD. 27 Art. 2 (2) (a) AIFMD. 28 Art. 3(2) (a-b) AIFMD. 29 Article 26 (2) (a) AIFMD.
30 Commission Recommendation 2003/361/EC of 6 May 2003. 31 Annex, article 2 (1), AIFMD.
32 Investing in Europe: Private Equity activity 2019, p. 8. 33 Article 26 (2) (b) AIFMD.
34 Report Commission (2020). 35 KPMG (2018), p. 98. 36 Ibid, p. 234.
be effective. Interviewees answered the following: 0% “fully agreed”, 20% “somewhat agreed”, while the majority answered with “no opinion, neutral, somewhat disagreed, or fully disagreed”.37
In addition, 58% of the interviewees did not have an idea on how to apply the asset stripping rules in practice.38
KPMG’s (2018) research further points out that there are great discrepancies in the practical use of the term “asset stripping” within the EU.39 Within member states, several legal experts gave
different unequal interpretations to the concept “asset stripping”. 40 While approximately 70% of
the respondents reported that there were no comparable rules regarding asset stripping under their national laws.41 Together, this could create uncertainty regarding the legal and practical use of the
term, and thus different interpretations among member states. Moreover, this may result in different supervisory practices at national level, potentially causing regulatory arbitrage, in which intuitions avoid regulatory costs by engaging their activities in the least regulated ways. This would undermine the AIFMD’s objective of a coherent approach and “level playing field”.42
The Dutch Authority for Financial Markets (“AFM”) (2020) commented on KPMG’s research. The AFM notes that there are great uncertainties regarding the applicable laws that constitute asset stripping. For instance, in cross-border buyouts, is this the applicable law of the PC or the manager?43 This remains unclear. In addition, with regard to above noted level playing field
argument, the AFM states that this could be best achieved by regulating “asset stripping” under national corporate law of the member state, with application guidance on EU level. 44
KMPG’s research (2018) further describes that employees are concerned about their treatment in buyouts. Employees do not experience comparable protection rights as in normal acquisitions.45
In addition, employees experienced that the existing regulatory framework does not sufficiently addresses the cross-border character of PE transactions. For example, as regards disclosure rights,
37 Report European Commission by KPMG (2018), p. 99. 38 KPMG (2018), p. 231. 39 EU Council (2020), p. 9. 40 KPMG (2018), p. 116. 41 Ibid, p. 99-225. 42 AFM (2020), p. 6. 43 Ibid, p. 7. 44 AMF (2020), p. 7. 45 KPMG (2018), p. 120.
industry codes, and information rights; interviewees note that disclosure after the acquisition, on how PE will affect their position, is important. 46 In the next section we will discuss how the
stakeholder rights are safeguarded under AIFMD.
4.3 How is the of position of stakeholders safeguarded under AIFMD and Dutch national law in an asset stripping transaction?
Article 30 AIFMD contains a temporary measure to counter asset stripping controlled by AIF. The rule formulates features that collectively characterize.
That is, fund managers are not be allowed to facilitate, support or instruct any distribution (the payment of dividends or other interest related to shares), capital reduction, share redemption and/or acquisition of own shares by the company within the period of 24 months following the acquisition where the AIFMs acquires control47 in the company, where:
1. The distribution exceeds the assets as stated in the financial account and would become lower than the amount of the subscribed capital; or
2. The distribution exceeds the amount of the profits at the end of the last financial year plus any profits that brought forward.48
This provision is codified in Dutch law in article 4:37v and 4:37z of the Dutch Financial Supervision Act (“Wf”). To shed some more light on this matter, we will discuss the position of stakeholders under article 30 AIFMD in the following order: debtholders, employees, and suppliers.
Debtholders
To start off with the debtholders. It is important to note that, despite the intention of the AIFMD and in contrary to the term used, the rule does not directly prohibit the sale of valuable assets and thus “asset stripping” in companies. This rule does constitute a barrier to certain distribution transactions to shareholders, such as dividends. In that sense, the provision restricts asset sales to payout the proceeds directly to the shareholders in the form of a dividend in the first two year.
46 KPMG (2018), p. 222-224.
47 Control is described as 50% of the voting rights of a non-listed company (EU Takeover Bids Directive, 2004/25/EC). 48 Art. 30 AIFM-directive 2011.
Nonetheless, as indicated in paragraph 3.1.3, most recent evidence on dividends and superdividends describe that these are no structural occurrences in PE-backed companies, therefore the value of this part of the provision will be low.
The liberty to, inter alia, sell asset after the acquisition is not restricted. This is also noted by Barneveld (2013). Barneveld explains that the asset stripping rule is not regulating the “asset side” of the balance sheet but only the “liability side”. The impact of this provision will therefore be very limited in practice. Moreover, in broad terms, the provision correlates for a great deal with asset stripping rules worldwide.
Asset stripping and dividends payments have already been considerably restricted under national law. In the Netherlands, asset stripping falls under the directors’ liability of article 2:105 and article 2:216 sections 2 and 3 of the Dutch Civil Code (“BW”). This provision restricts profit distributions, based on a realistic forecast, i.e. a balance sheet test, based on whether the dividend distribution may lead to continue problems for the company. More specifically, stipulated in case-law: “if the director knew or should have reasonably have foreseen that the corporation would not be able to continue to pay its due debts after the distribution.”4950 Recently, the Court of Amsterdam further
explained this provision in the PCM-case.51 Without going too much into detail, the rule ensuing
is that under certain conditions the distribution of dividends, although complied with the rules cited above, may be undesirable in regard to company’s interest and the protection of creditors. 52 This
makes the former rule even stricter. In that sense, leeway for asset stripping has been has restricted.
Employees
Under Dutch national law, we observe several provisions that somewhat protect the interest of employees in a buyout. In this section we analyze the Social and Economic Council’s Resolution Concerning the Merger Code 2015 (“SFG) and the Work Council Act 1950 (“WOR”).
49 As formulated in Nimox/ Van den End (Court of Cassation (Hoge Raad) 8th of November 1991, NJ 1992, 174 m.nt. Maeijer. 50 For more information about liability on dividend payments, see Barneveld (2009).
51 Court of Amsterdam (CC) 27th of May 2010, LJN BM5928 (PCM). 52 For a further analysis of this case see Barneveld (2009).
