Inside Arbitration: Exits only – How investors can get put calls right

Despite a bullish year for private equity in the Asia-Pacific, exit disputes remain a risk. We assess the safest ways to exercise your put option

Despite major geopolitical and financial headwinds, Asia-Pacific investment in 2022 remained robust, with a particularly strong flow of private capital driving activity. According to data published by EY, during the first half of 2022 private equity (PE) activity surged in the region with a 47% increase ($47 billion) in M&A deal value against the pre-pandemic five-year average. Even though capital market conditions tightened, PE firms retained large amounts of cash that needed to be deployed. In July 2022, for example, dry powder in Asia-Pacific funds stood at $455.2 billion while across the year PE and venture capital investments in the Asia-Pacific region excluding Japan reached 208 transactions valued at $35.4 billion, according to S&P Global.

In simple terms private equity refers to investments in the shares of companies that are not publicly traded. PE investors and PE funds typically provide financing by purchasing a controlling stake or minority shareholding in a private company. Notwithstanding the recent surge in activity, however, the effect of a fragile global economy means that PE investments often underperform against expectations or become distressed. This can be exacerbated by the high levels of debt used to fund PE investments and limited timelines for generating returns. This, coupled with an increasingly competitive Asia-Pacific market where company valuations have been at all-time highs, has led to a steady increase in PE disputes and related arbitrations, which is the preferred method for resolving such disputes.

Although PE disputes can emerge at various points along an investment's life cycle, exit disputes – which arise when a PE house seeks to exit its investment by choice or compulsion – are among the most common. This article focuses on the first of these exit mechanisms, namely where the shareholders' agreements between the investor and controlling shareholder give the investor the right to exit by selling its shareholding at a stipulated price if certain conditions are not fulfilled, usually known as a put option.

Put options are found in almost every PE shareholders' agreement. They are important because they provide the investor with a contractual right to exit when certain pre-agreed triggers are met. Perhaps the most common trigger is when the target company does not achieve an initial public offering (IPO) within a certain period, usually five years after the investment. In those circumstances, the investor will usually want an alternative form of exit which matches its own internal investment timeframe. Other triggers include where the company does not achieve a certain level of financial performance, or where the controlling shareholder commits a material breach of the agreements.

Put disputes are common

What should on paper be a relatively straightforward contractual right to exit is often far from easy in practice, especially in a distressed market. Again, the position in Asia is often exacerbated. Company valuations remain artificially high, the investment is in an emerging market, and often the put requires the co-operation of the founder shareholder, who did not anticipate returning the investment and is willing to do whatever it takes to avoid having to pay.

Disputes relating to put option mechanisms can arise for a variety of reasons. Here, we focus on three main types of disputes we have seen recently in Asia and explain how potential pitfalls might be avoided in the future.

Triggers and conditions:

A common battleground between the parties is whether the trigger for the exercise of the put has been met or not. While this might seem simple in some cases, it can have disastrous consequences for the investor if it gets it wrong. In one recent case where we acted for the controlling shareholder, the investor issued its put notice on the basis the company had not achieved an IPO within five years from closing. The investor, however, issued its notice on the fifth anniversary of the date of the shareholders' agreement, whereas the trigger required five years from closing to have elapsed. In other words, the notice was premature. By the time the investor realised its mistake, the company was in liquidation, which threw up a host of complicated issues about whether it was possible for the investor to re-issue its notice and rectify its earlier mistake. Moreover, the investor also failed to follow the formal requirements for the content and format of the notice.

Both mistakes could easily have been avoided. Nevertheless, by not strictly following the contractual requirements, the controlling shareholder had significant ammunition to argue the put was not valid in the first place, and that it was too late to remedy. Ultimately, this led to settlement on extremely favourable terms for the controlling shareholder, and the investor exited without achieving a return on its investment.

Lesson 1: Make sure the put option can be exercised and the exercise notice has been properly issued.

Valuation and mechanics:

Another common theme is what value should be ascribed to the put, and how this might be calculated. In some cases, the put is valued by reference to an internal rate of return on the amount of the investment made. Although this is more straightforward than assessing market value, disputes can arise in relation to the interest rate applied (and whether this might operate, or be construed, as a penalty), and how the value of the put should be calculated where a price rebate on the investment made is also due. In our experience, giving more thought to these questions, and the interplay between different remedies under the contract at the time of drafting, would always save significant cost and time in the event a dispute arises in the future.

Where the contract is silent on the valuation basis, questions also arise as to whether the price should be calculated by reference to market value and, if so, how this value should be ascertained. Even where the agreement contains sophisticated valuation mechanisms, involving both sides appointing valuation experts, the process can break down completely if one party does not co-operate, and the contract does not provide what should happen, and how the shares should be valued. Again, we have been involved in several disputes where significant time and cost would have been avoided if the agreements had been clearer on the valuation exercise and the role of experts in that process. In more extreme cases, tailoring the drafting to anticipate a recalcitrant shareholder can be the difference between success and failure.

Lesson 2: Ensure your valuation method and process for resolving valuation disputes are set out clearly in the shareholders’ agreement.

Enforcement: 

Unsurprisingly, the last area of contention we want to focus on relates to enforcement: what remedies should be sought, how such remedies can be enforced and on what terms. 

A common debate is whether specific performance is available, and how this might be achieved practically. Some savvy PE clients have started attaching pro forma share transfer contracts to their agreements, to mitigate the risk that a tribunal finds that the terms of any share transfer are too uncertain to enforce. Another consideration is whether the governing law of the agreement permits specific enforcement of a put in the first place, and whether it is going to be possible to enforce an arbitration award in the place where the shares that are being transferred are registered, so that the transfer – and more importantly payment – can be achieved. Again, in circumstances where damages – repayment of the investment with interest – are likely to be the key goal, one way to address this upfront is to build contingency scenarios into the agreements, for example, a guarantee. We have seen this work to great effect and achieve quicker and simpler outcomes. Otherwise, it is important to think about how to structure the relief so a damages payment can be achieved, irrespective of what happens to the shares. Fortunately, tribunals and courts are increasingly willing not only to order specific performance, but also to find ways to assist investors who have a clear right to repayment of their investment, and to structure the relief granted accordingly. A good strategy is to engage the tribunal early about this issue and, of course, appoint an experienced tribunal in the first place.

Lesson 3: Consider how to enhance your chances of successful enforcement.

Conclusion:

Although investment agreements invariably provide for put options, investors may not always be able to exercise their rights under the contracts successfully or quickly, particularly if the controlling shareholder is unwilling to, or cannot, repay the debt. Some challenges originate from questions of law or fact (eg, conditions that trigger the put option, the proper valuation), others come from practical considerations (eg, what remedies to seek). These all have important implications on the strategies that PE houses deploy in formulating their exit. While the recent trends from tribunals and courts are encouraging and indicative of a pro-enforcement approach, the exercise of put options – at both the drafting and enforcement stages – continues to require careful consideration. Getting dispute counsel involved at the deal stage, rather than only at the disputes stage, can itself pay dividends.