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5.4 Investor protection provisions in shareholder agreements
BOX 5.4
In minority transactions, strategic investment funds must protect themselves against downside risks arising from lack of control through proactive engagement with the majority owner and careful negotiation of the shareholders agreement. minority private equity owners need to invest in building a relationship with the majority owner, understand its motivations, anticipate potential areas of misalignment, and plan for both the ownership and exit phases (Schneider and Henrik 2015). In addition, several provisions of the shareholders agreement—the main contractual document disciplining the relationship between shareholders of a company—can be negotiated to ensure alignment of interests between minority and majority owners. general investor protection provisions in shareholders agreements include the following.
• right to approve key actions: – minority shareholder’s right to approve board actions in critical areas, for instance, issuing stock, incurring debt, and acquiring or selling significant assets.a For practical purposes, this veto right should not extend to the day-to-day operation of the company. – Supermajority provisions requiring a portion of the minority shareholders to also approve corporate actions such as a merger or the sale of substantially all of the company’s assets.
– Subjecting amendments of the shareholders agreement to the approval of some or all minority shareholders. • restrictions to the transfer of shares, including – Right of first refusal, allowing any nonselling shareholders to buy the stake of a selling shareholder on the same terms offered by a third party; – Tag-along right, allowing the nonselling shareholders to force the selling shareholder to include their equity in the sale to a third party, on the same terms; – Drag-along right, allowing the selling shareholder or the board to require the other shareholders to sell their stakes to a third party;b and – Put and call provisions, giving a shareholder the right to sell its stake to the company or other shareholders (put), or allowing the company or certain shareholders the right to buy another shareholder’s stake (call). • Preemptive rights in case of issuance of new equity, giving shareholders the ability to maintain their proportionate stakes by buying additional shares at the same price offered to other shareholders or third parties.
Sources: Greenberger 2001; Hewitt 2021. a. The approval may be unanimous or include a percentage vote of the minority shareholders. b. This provision is usually required by the controlling shareholder as a counterbalance to the tag-along right, as a way to prevent minority shareholders from jeopardizing the sale of the company by refusing to participate (see Greenberger 2001).
raises new capital through the primary issuance of shares. minority deals are more common in emerging market and developing economies, an important consideration for SIFs that operate there.27 minority deals have several attractions for SIFs. First, when minority deals result from new equity issuance,28 SIFs have the opportunity to support companies in their growth trajectory (Schneider and Henrik 2015). Second, minority deals allow SIFs to participate, together with other investors, in larger transactions that they would not be able to finance exclusively.29 Third, they may facilitate co-investments in the target company, fulfilling the SIF’s crowding-in objective30 and mitigating the risk of crowding out private investors.31 Fourth, if a SIF catalyzes the involvement of a majority co-investor with strong operating expertise and industry track record, it can improve
the performance of the portfolio company, leading to higher financial and economic returns.32 Fifth, minority deals are less likely to have hidden flaws given that other investors take or maintain an economic interest in the company (Schneider and Henrik 2015). Finally, even as minority investors, SIFs can act as troubleshooters in investments that require a heavy interaction with the local government, in particular in the infrastructure sector (for example, see the meridiam thematic review in appendix B).33
For sellers of minority stakes, minority investors can be attractive for their specific expertise and credibility, beyond their infusion of capital.34 A professional minority investor, for instance, can bring knowledge of adjacent industry sectors or new growth markets, and support the professionalization of portfolio companies’ governance. In addition, SIFs—as well-recognized investors with high-level government affiliations—can credentialize their portfolio companies with commercial and financial counterparts, such as clients in new markets or future providers of capital. For instance, ACP considers its affiliation with the AdB, uK department for International development, and Japan International Cooperation Agency (its main public backers) a strong advantage for fast-growing portfolio companies that seek credentials to expand to new countries and that may consider, down the line, an initial public offering. The required compliance with the AdB’s eSg standards also enhances the credibility of ACP’s portfolio companies.
• Individual investment size. The SIF’s investment strategy may also provide an indicative size for individual investments, sometimes referred to as “ticket size.” Ticket size varies widely across funds, reflecting several factors, including (1) typical target company size in the sectors and geographies of focus or, for indirect investments, the typical size of an investee fund; (2) the SIF’s size (total capital committed by its investors); (3) the SIF’s focus on majority or minority deals; and, importantly, (4) the SIF’s portfolio diversification strategy, which is a core component of risk management, as discussed in the next section. marguerite II, for instance, targets €20 million to €100 million tickets, which—depending on sector, geography, and leverage—translate into project sizes of €50 million to €2 billion (see the case study in appendix A). • Co-investment/joint investment strategy. given that the raison d’être of a SIF typically hinges on attracting commercial capital, the investment policy or investment strategy highlights the importance of co-investments and joint investments with external investors. A key element of ISIF’s investment strategy, for instance, is to attract co-investment from third-party investors, with the original target being 2.0x (ISIF 2019). The crowding-in of capital is viewed as particularly important because it leverages ISIF’s finite resources to significantly increase the economic impact in Ireland. Article 41.4d of the nTmA Act 2014 permits nTmA wide flexibility in entering partnerships and joint ventures using ISIF funds. In tandem, ISIF’s July 2015 investment strategy highlights its focus on attracting co-investment partners to multiply the impact of investments in Ireland’s economy.35 Likewise, the nSIA
Act 2011 (Article 46.1) allows nIF funds to be used to develop infrastructure projects in nigeria via co-investment strategies. nSIA’s investment policy elaborates that nSIA will set up vehicles to attract international and domestic capital (nSIA 2019, Article 4.3) and gives wide flexibility to the manager
to co-invest with infrastructure players or enter into joint ventures as it deems appropriate (nSIA 2019, Article 7.1). • Vehicles for strategic alliances between sovereigns. Although not usually included in the investment strategy, as sovereign funds, public capital
SIFs in particular operate within the realm of geopolitics and can serve as convenient vehicles for strategic and commercial alliances between sovereigns. In december 2016, for instance, the governments of morocco and nigeria agreed to finance a regional gas pipeline project through their respective SIFs, Ithmar Capital and nSIA-nIF (Ithmar Capital 2016).
Between 2017 and 2018, the Abu dhabi Investment Authority and
Singapore’s Temasek agreed to invest in nIIF’s master Fund to finance
Indian infrastructure (see the case study in appendix A). Academic research has also shown that, when compared with global institutional investors in general, SWFs tend to invest noticeably more in countries with which they have a cultural affinity, perhaps because they find less information asymmetry when investing in what is familiar (Chhaochharia and Laeven 2008). Such alliances are, however, deal-specific and not usually part of the investment strategy. • Direct versus indirect investing and internal versus external management. SIFs can choose to provide capital directly to companies (direct investing) or indirectly, by investing in third-party funds that provide capital to companies (indirect investing). A SIF’s investment strategy should specify to what extent and according to which criteria the fund can engage in direct or indirect investing. In addition, the Santiago Principles recommend that SWFs disclose information on funds being managed either internally or externally, including the selection and monitoring process for managers.36
direct investing gives funds greater control over investment decisions and management of portfolio companies, which is important for funds that focus on domestic economic development, and allows SIFs and SWFs alike to avoid the fees charged by third-party fund managers and the dilution they cause to ultimate investor returns (Wright and Amess 2017).
Indirect investing, by contrast, allows SIFs and SWFs alike to benefit from the skills and established systems of third-party managers in specialized instruments and markets, and to manage or reduce the costs of maintaining an asset management function in a particular market or instrument. To capture opportunities in specific markets and instruments, SIFs—like some private equity funds of funds—may act as cornerstone investors for new and emerging fund managers (Preqin 2017). In addition, the presence of other commercial investors in the SIF’s portfolio funds can amplify the capital multiplier effect, as discussed in chapter 2. SIFs engaged in indirect investing should determine whether and under which conditions they are allowed to co-invest in portfolio companies alongside their investee funds.37 A SIF that engages in indirect investing needs to ensure that its investee funds comply with its policy mandate and apply the same or equivalent eSg criteria. For instance, nSIA-nIF evaluates all direct and indirect investments against the same list of key performance indicators (financial and development impact related). Similarly, in order to qualify for an ISIF investment, third-party funds must comply with ISIF’s statutory requirement of commercial return and economic impact. note that SIFs run by an external fund manager, already remunerated with fees levied on the SIF’s returns, may be disinclined to pay further return-diluting
