Unlike listed bidders, private equity funds cannot offer a conventional share alternative to cash or loan notes as consideration on a takeover. This can make it more difficult to win shareholder support for a bid if shareholders in the target company (the target) want to retain an interest in the enlarged group after the takeover.

Stub equity is intended to go some way to addressing this difficulty. The term refers to equity offered by bidders as part of the consideration on a takeover. In practice, it tends to form only a small part of the consideration, hence the name.

There are various different ways of structuring stub equity offers, but classic stub equity takes the form of shares in a company that is to own part of the target after the acquisition and is to be listed on the Alternative Investment Market (AIM). It typically gives the holders only limited voting rights in relation to the underlying target.

AIM-listed stub equity has been offered on a number of deals, but is still rare. A working example is the Class B shares in Songbird Estates plc (Songbird) offered by the Morgan Stanley fund-led consortium as part of the consideration on its May 2004 acquisition of Canary Wharf Group plc (Canary Wharf).

Unsuccessful offers of AIM-listed stub equity alternatives include those by Brascan Corporation (Brascan) in its competing bid for Canary Wharf and by the Grupo Ferrovial SA consortium in its June 2006 bid for BAA plc (BAA). Brascan lost out to the Morgan Stanley consortium on Canary Wharf and the BAA alternative lapsed as an insufficient number of shareholders elected to receive it (for background, see feature article, “A turbulent takeover: the battle for BAA” www.practicallaw.com/6-206-1989).

Listings were sought in each of the above examples to make the stub equity attractive to institutional shareholders, such as pension funds, which typically have investment criteria that would prevent them investing in unlisted securities.

AIM is more appropriate than the main market for all the reasons one might expect. The entry criteria for AIM make it possible to gain admission for the stub equity company, typically a newly formed special purpose vehicle, without a trading record. Unlike the main market, the AIM Rules impose no requirements relating to the company’s level of capitalisation (unless the company is an investing company, as defined in the AIM Rules) or number of shareholders.

In terms of continuing obligations, AIM companies benefit from a less onerous regulatory environment. They have to comply with the AIM Rules, but are not bound by the UK Listing Authority’s Listing Rules. What this means in practice, according to Mike Francies, a partner at Weil Gotshal & Manges who advised on the Songbird stub equity issue, is that the bidder still has much of the flexibility to manage the target that it would have if it was unlisted.

For example, shareholder consent is required under the AIM Rules only for reverse takeovers or disposals resulting in a fundamental change of business (Rules 14 and 15). While other substantial transactions must be announced, there is no requirement for shareholder approval or for a circular to be issued, unless these are required for other reasons.

However, even a listing on AIM is costly and time-consuming to put in place. It adds an additional layer of complexity to the deal and leaves a legacy of structural and corporate governance issues to be addressed.

Unlike the stub equity offered on the BAA bid and the Class B shares offered on the Canary Wharf bid, the stub equity offered to shareholders of Countrywide was unlisted (the Songbird stub equity also included an unlisted alternative).

The decision to offer unlisted, rather than listed, stub equity will depend principally on which population of shareholders the stub equity is designed to appeal to. “Unlisted securities are problematic for many institutions and so are not appropriate when you are trying to appeal to a broad spectrum of investors. However, they may not present the same problems for some other investors, such as hedge funds with appropriate side pockets, which typically have much more flexible investment perameters,” says Charles Martin, a partner at Macfarlanes.

The offer has to be made on the same terms to all the target’s shareholders (General Principle 1 and Rule 16, Takeover Code) (the Code). However, in practice, hedge fund investors are the main audience for an unlisted stub equity alternative. Indeed, it was reported that some bought shares in Countrywide after the offer was launched at a premium to the offer price, in an effort to increase their potential holding (LBO newswire, 12 March 2007).

By structuring what are, in essence, special terms for hedge fund participation through stub equity, the bidder can allow hedge funds to participate but avoid the need to make the hedge funds joint offerors under the Code, as those terms are available, if not appealing, to all shareholders.

The Takeover Panel determines whether a person is a joint offeror on a case-by-case basis in accordance with the criteria developed in the context of the Canary Wharf bid, where the special terms given to Simon Glick were held not to contravene Rule 16 of the Code, as he was a joint offeror with the Morgan Stanley funds (www.practicallaw.com/0-102-6117).

In addition to unlisted shares, the Countrywide alternative also includes unlisted debt securities, again reflecting the intended audience for the offer.

“To make an offer appealing to hedge funds, the bidder essentially has to let the hedge funds into the deal on broadly similar terms to itself,” says David Higgins, a partner at Freshfields Bruckhaus Deringer. “This means to some extent replicating the bidder’s own investment, which will typically include an element of shareholder debt.”

A similar approach was adopted in the August 2006 public to private bid by Apax Partners Worldwide LLP (Apax) for Incisive Media Plc. Certain eligible shareholders in the target elected to reinvest their cash consideration in various unlisted interests in the limited partnership holding the bidding vehicle, for a combined interest of 25%.

The interests included interests in income or capital paid on payment-in-kind (PIK) notes. PIK notes, a common form of debt funding for private equity investors, accrue interest that is payable either in cash or, at the borrower’s option, by the issue of additional notes. The interest rate is typically more attractive than that on conventional debt (15.75% per annum in the case of the Apax PIKs).

Stub equity is still rare and that does not look set to change, though it has been reported that it is under consideration in relation to a number of current bids, including by Kohlberg Kravis Roberts in connection with its possible offer for Alliance Boots (The Daily Telegraph, 11 April 2007).

“It means a huge amount of additional work for the bidder, both initially and on an ongoing basis, and that makes it very unattractive,” says Francies. “However, there will be situations where bidders want to offer stub equity to encourage the target board to recommend the bid.” Higgins agrees, but adds: “Private equity funds typically spend a long period and invest significant resources putting a bid together. It is just not economic for them to give away too big a slice of that to opportunistic investors who bought their shares the week before.”