Hedge Fund Managers Undertaking a Portfolio Company IPO: A Primer

The strong capital markets have recently led to record numbers of initial public offerings. Often, the principal investor in a company going public is a traditional private equity firm, whose investment manager will be familiar with IPOs as a standard portfolio company liquidity event. On occasion, though, a key pre-IPO investor will be a hedge fund, or other pooled investment vehicle not meeting the traditional PE profile, that has deployed capital to the portfolio company as part of the fund’s illiquid or “side pocket” investment program. In contrast to a classic PE sponsor, the hedge fund manager may have only infrequent contact with the IPO process and thus be less conversant in the key issues surrounding such a transaction.

This article is a brief primer for the hedge fund manager who is invested in a portfolio company undertaking a Securities and Exchange Commission-registered IPO, but for whom the transaction is not business as usual. We describe key issues the manager should be prepared to address. These issues include the type of securities the hedge fund will hold post-IPO; board representation; legal risks associated with the company’s disclosure to investors; planning for post-IPO liquidity; and securities law regulatory matters following closing. For purposes of this article, we assume the hedge fund has a significant (though perhaps minority) equity interest in the pre-IPO company and will retain a meaningful minority equity position following the offering. We refer to the hedge fund and its manager together as the “Fund,” and to the side pocket portfolio company undertaking the IPO as the “Company.”

Securities Pre- and Post-IPO

The Fund’s pre-IPO investment in the Company—especially where the Fund is a minority financial investor—often will have taken the form of convertible preferred stock. Committing capital as a convertible preferred investor generally enables the Fund to limit downside risk through the preferred stock’s liquidation preference, while permitting the Fund to capture upside potential through conversion into the Company’s common stock.

The preferred stock’s terms may provide for automatic conversion upon a “qualifying” IPO. ¹Generally, a “qualifying” IPO means an IPO satisfying an agreed upon minimum aggregate offering size (e.g., $200 million) or price per share. If not, the treatment of the preferred stock upon the IPO—e.g., being redeemed with cash, converted or remaining outstanding—will be a subject of discussion among the Company, the Fund and other members of the working group. While the Fund may favor retaining its preferred stock, the Company may advance reasons in favor of conversion. These reasons might include the likelihood of additional SEC comments during the registration process if convertible preferred remains outstanding; potential accounting issues (e.g., equity vs. liability treatment); and possible adverse market perceptions due to overhang or Company obligations to pay preferred dividends. Outstanding warrants and options can raise analogous concerns and thus may be candidates for exercise in connection with the IPO.

Board Representation

Pre-IPO, many hedge funds making a material investment in a portfolio company will negotiate for the right to appoint one or more Company directors. Generally, the right to board representation is set forth in a shareholders’ agreement. The shareholders’ agreement typically terminates upon an IPO, however, which means the Fund must consider whether and how its director-appointment rights will continue after the Company goes public. ²There are certain provisions of the shareholders’ agreement that are intended to survive an IPO but generally such provisions are moved to a new stand-alone agreement (e.g., a registration rights agreement) and the shareholders’ agreement is terminated in its entirety when the IPO closes.

When it is determined that Fund-affiliated directors will remain on the Company’s board post-IPO, the working group will need to consider the mechanism by which these individuals will be nominated and elected as directors. The Fund, other shareholders and the Company could enter a voting agreement providing that the Company and the other parties will support the nomination and election of directors proposed by the Fund. While this type of arrangement is possible, it could complicate the disclosure contained in the prospectus and the agreement would need to be filed publicly with the SEC as an exhibit to the registration statement. A simpler approach for nominating directors to the newly public Company is to rely on the nominating committee of the board. To the extent that Fund-affiliated directors can substantively contribute to the success of the Company through their industry expertise and long-standing involvement with the Company, the nominating committee likely will be disposed to re-nominating those individuals to the board.

Another issue requiring attention is whether and on what basis the Company can conclude that a Fund-affiliated director is “independent.” Subject to certain phase-in relief for newly public issuers, the NYSE and NASDAQ listed company rules require that the Company’s board have a majority of independent members and that the board’s audit, compensation and nominating committees be entirely independent. While a discussion of independence criteria is outside the scope of this article, we note that a director’s affiliation with a significant shareholder is not, by itself, a bar to an independence finding. ³See, e.g., Commentary to NYSE Rule 302A.02.

Liability Issues

The Fund and its employees potentially have liability under the U.S. federal securities laws for material misstatements or omissions in the Company’s IPO registration statement and related prospectus. Generally, liability can arise either because the Fund or its personnel are deemed to be “controlling persons” of the Company or because an individual affiliated with the Fund serves as a Company director. This risk of liability must be addressed even when—as is normally the case—the Company and its own counsel will be primarily responsible for drafting the registration statement and prospectus.

Controlling Person Liability.

Section 15(a) of the Securities Act of 1933 and Section 20(a) of the Securities Exchange Act of 1934 provide in similar fashion that a person who “controls” a primary violator of either statute may have secondary, joint and several liability for that violation. The term “control” means the power to direct or cause the direction of the primary violator’s management and policies, whether through share ownership, by contract or otherwise.

Section 15(a) of the Securities Act potentially imposes joint and several secondary liability on a controlling person if the Company incurs primary liability under Section 11(a) and/or Section 12(a)(2) of the Securities Act. Under Section 11(a), the Company would incur strict liability to investors if the IPO registration statement, at the time it was declared effective by the SEC, contained a material misstatement or omission. Under Section 12(a)(2), the Company would incur liability if the IPO prospectus (or related oral communication), at the time the investor committed to the underwriters to purchase shares, contained a material misstatement or omission of which the investor had no knowledge. If the Company were found liable to investors under Section 11(a) or 12(a)(2), a controlling person could avoid secondary liability under Section 15(a) by demonstrating that it did not know and had no reasonable ground to believe that the Company’s IPO disclosure was materially flawed.

Section 20(a) of the Exchange Act potentially imposes joint and several secondary liability on a controlling person if the Company incurs primary liability under any provision of the Exchange Act or its related rules. In the context of an IPO, the most relevant of these provisions are Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, which the Company could violate by including a material misstatement or omission in the registration statement, prospectus or related communication. A plaintiff under Rule 10b-5 must prove its reliance on the misstatement or omission and must establish scienter on the Company’s part. If the Company were found liable to investors under Rule 10b-5, a controlling person could, however, avoid secondary liability under Section 20(a) by establishing that it acted in “good faith and did not directly or indirectly induce” the Company’s disclosure violation.

Determining “controlling person” status is highly fact-sensitive and expressed in somewhat fluid case law. Judicial rulings do, however, provide at least a basic framework for considering whether the Fund might be considered a controlling person of the Company. Factors that courts have found relevant fall into three main categories. First, while not necessarily dispositive, percentage equity ownership of the issuer is typically an important factor in determining control, especially if other indicia of control are present. Second, courts have found evidence of control in an entity’s representation (or right to representation) on the issuer’s board. Control may be further exhibited if an entity’s director designee sits on a significant board committee (e.g., the compensation, audit or governance committee). Third, participation (or the right to participate) in the management or daily operations of the issuer, either generally or with respect to specific matters, may indicate control, particularly if coupled with significant equity ownership. For the above reasons, if the Fund has a significant ownership interest in the Company, board representation and/or operational influence, it would be prudent for the Fund to assume it is a controlling person and thus potentially liable for any IPO disclosure violations the Company might commit.

While worded slightly differently, the defenses to controlling person liability provided in Section 15(a) of the Securities Act and Section 20(a) of the Exchange Act amount to essentially the same thing: the Fund can avoid liability for any actionable IPO disclosure violations the Company might commit by showing that the Fund has acted in good faith, did not induce the Company’s violation and had no reasonable grounds to know that the disclosure was materially flawed. In general terms, this means the Fund should satisfy itself, through active review of the registration statement, that the Company’s disclosure is reasonable, factually supportable and not misleading or incomplete. While each issuer is unique, as a general matter we would suggest that the Fund and its counsel pay particular attention to the following elements of the registration statement: the historical and pro forma financial statements and their related notes; descriptions of the Company’s business relationships with significant customers, suppliers and service providers; the accuracy and adequacy of the risk factors disclosure; the basis for, and the adequacy of, the protective language used in connection with any “forward-looking statements”; the management discussion and analysis (MD&A) disclosure; and the disclosure concerning corporate governance arrangements and related-party transactions.

Director Liability.

The most likely basis for a claim against a director would be Section 11(a) of the Securities Act. Unlike the Company (which has strict liability), a director has a defense to Section 11(a) liability under Section 11(b)(3)(A) of the Securities Act. The director may rely on this defense by showing that he conducted a reasonable investigation into the registration statement’s disclosure and that, after the investigation, he had reasonable grounds for believing that the disclosure was not false or misleading. ⁴With respect to “expertized” disclosure contained in the registration statement (e.g., the audited financial statements), Section 11(b)(3)(C) of the Securities Act requires the director merely to show that he had no reasonable grounds to believe the disclosure was false or misleading. We recommend that each Fund-affiliated director maintain a record of having actively reviewed and questioned the content of the IPO registration statement in order to better secure this due diligence defense.

Other Risk Mitigation Techniques for Directors.

If the Fund will have a director on the Company’s board, the Fund should ensure that the Company’s articles include customary director indemnification provisions that cannot be retroactively amended, and that the Company obtains directors and officers liability insurance (D&O) featuring reasonable policy terms, deductibles and coverage amounts. Directors also should consider entering into indemnification agreements directly with the Company. While an indemnification agreement will overlap to some degree with the substance of the Company’s articles and D&O insurance, the agreement has the benefit of establishing clearly the specific contractual rights and mechanics associated with a director’s claim for indemnification.

Law of Domicile.

The Fund and its affiliated directors also must educate themselves about the liability of directors and shareholders under the laws of the jurisdiction in which the Company is organized. While most Funds are reasonably familiar with Delaware law, they may know less about the laws of other states or foreign countries. We recommend that the Fund and the directors take written advice from local counsel setting forth the obligations and duties of members of the board and shareholders.

Liquidity

The Fund may be subject to both contractual and legal restrictions on its ability to sell its shares following the IPO. Contractually, if the Fund’s post-IPO equity position will be significant enough—at least three to five percent is probably a good rule of thumb—the Fund should expect to be subject to an underwriter-imposed lock-up agreement that prohibits sales by the Fund for 180 days following the IPO. Once the lock-up expires, the Fund’s ability to resell in the public market will hinge on any registration rights the Fund has negotiated, as well as on the operation of Rule 144 under the Securities Act. Registration rights and/or Rule 144 are important routes to public-market liquidity because the shares held by the Fund will be restricted securities for purposes of the Securities Act.

As noted above, because the shareholders’ agreement will terminate upon the IPO, any registration rights of the Fund likely will be moved (possibly following renegotiation) to a new stand-alone registration rights agreement that takes effect when the IPO closes. Whether the Fund actually needs registration rights often depends in large part on whether the Fund—by virtue of the size of its equity position or some other indicium of control such as board representation—will be an “affiliate” of the Company post-IPO. ⁵A Fund that owns 10 percent of more of the Company’s common stock is presumptively considered an affiliate of the Company. If the Fund will not be an affiliate, registration rights may be less critical because the Fund likely will be free to sell its restricted shares into the public market under Rule 144 as soon as the underwriters’ 180-day lock-up expires. By contrast, if the Fund will be an affiliate of the Company, registration rights are more important because Rule 144 imposes selling limitations on affiliates, including volume restrictions.

Securities Regulatory Matters

Depending on the size of its post-IPO equity position, the Fund may need to adhere to the beneficial ownership- and transaction-reporting regimes set forth in Sections 13 and 16 of the Exchange Act. If the Fund beneficially owns more than five percent of the Company’s common stock, it will need to disclose on Schedule 13D its ownership position and any “plans or proposals” it may have in respect of the Company. ⁶A Fund with a certifiably passive investment posture may be eligible to report instead on the less detailed Schedule 13G. At or above ten-percent beneficial ownership, the Fund will be subject to transaction reporting and short-swing profit disgorgement under Section 16 of the Exchange Act. If the Fund is subject to Section 16, it will be extremely important to time purchases and sales so that opposite-way transactions in a single six-month period do not give rise to profit disgorgement under Section 16(b). In addition, a Fund-affiliated director will be personally subject to Section 16 by virtue of his director status.

A Fund with board representation or other close involvement with Company management also may need to monitor its purchases and sales of Company stock from two other perspectives. First, a Fund with an affiliated director will need to understand the Company’s insider trading prevention policy, including in particular the structure and scope of any trading blackout periods and pre-clearance policies and whether those policies apply to the Fund as well as to the director personally. Second, to the extent the Fund expects to receive confidential Company information from an affiliated director or otherwise through interaction with management (or perhaps through information obtained by a “sister” credit fund of the Fund), the Fund will need to ensure that it has adequate information management procedures to prevent potential insider trading issues. In the case of receiving information from an affiliated director, it also may be advisable for the Fund to enter into an agreement with the Company clarifying that such information-sharing, if subject to agreed confidentiality procedures on the Fund’s part, does not violate Company or board confidentiality policies.

Conclusion

Successfully participating in a portfolio company’s IPO can be a challenging process for a hedge fund manager, and requires both thoughtful planning and careful execution. Hedge funds, their lawyers and the other IPO participants need to be particularly attentive to:

• the post-IPO capitalization of the portfolio company;
• the degree and manner of the fund’s ongoing involvement in the portfolio company’s management;
• post-IPO liquidity issues; and
• potential securities laws reporting obligations.

Hedge funds and their managers also need to ensure that they are demonstrably involved in the preparation of the portfolio company’s IPO registration statement in order to better secure available due diligence defenses. The foregoing process can be made easier and less risky with the assistance of experienced legal counsel.