Corporate | Energy & Infrastructure | Private Equity
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For this month's episode of Murabaha Monthly, Karl Bradford, a Legal Director in our Corporate team shares his insights on the nuances that both investors and financial institutions ought to be mindful of when structuring and executing deals where real estate is being acquired by way of a corporate acquisition.
As HMRC levies stamp duty land tax (SDLT) on the transfer of real estate in England, it is often attractive to hold real estate assets in special purpose vehicles that can be sold through a corporate transaction, which will attract little or no direct transfer tax (depending on the holding structure used). Islamic banks in the UK are familiar with such acquisition structures and routinely provide senior debt terms to their customers who wish to transact on the basis of a corporate acquisition. This article applies equally to Islamic and conventional investors and financial institutions.
When acquiring the target entity the buyer inherits all of the asset and liabilities of that target entity, including, for example, historical tax liabilities, disputes or outstanding contractual obligations. It is therefore necessary to be able to first identify any liabilities that exist in the target entity and then look at ways to remove or minimise the risks to ensure that the initial SDLT saving is not overshadowed by the liabilities that are inherited.
Below is a summary of some aspects to consider when looking at a corporate real estate transaction.
Early consideration should be paid to which entity within the structure will be the obligor of any senior debt that may be utilised to fund the acquisition, with tax considerations often being the driver here. Sellers may prefer not to become seemingly embroiled in the Buyer's funding mechanics on completion by suggesting that any senior debt should not come in at Target/Propco level. Agreeing completion mechanics at an early stage can often get parties comfortable that the funding mechanics will not compromise the underlying corporate acquisition nor result in any additional risk to the Seller. If funding is being provided by an Islamic bank, the Buyer should ascertain whether any additional completion steps may be required from that bank's shariah supervisory board. For example, certain Islamic banks in the UK require the share acquisition to occur momentarily before the commodity trade (explained further in Episode 1 of Murabaha Monthly).
This is important in any deal but much more extensive in a corporate transaction as the buyer is acquiring all assets and liabilities of the target. The scope of the due diligence will depend on the holding structure and operations of the target entity. The scope of due diligence would, for example, likely be more extensive on a student accommodation asset that is held offshore and has employees than due diligence on a site that has planning permission for a small development. Tax due diligence will be key and should be started as soon as possible to understand the current tax position (for example, capital allowances, transfer pricing) and also future taxes which may become payable (for example, capital gains tax). Buyers should be mindful that any senior debt provider will require reliance on tax and other professional reports that are commissioned as part of the due diligence process.
Warranties are a key component of the due diligence exercise. The seller is asked to provide warranties (that is, assurances about past or present facts or a future state of affairs relating to the target). For example, a buyer may request confirmation that there are no employees of the target. If this turned out to be untrue and the target had employees then the buyer may have a claim for damages against the seller for breach of the warranty (as well as being in breach of its financial covenants in the senior facility agreement), if the seller did not properly disclose the facts and a loss arises as a result. Of course, it is never quite as simple as this. There are usually extensive negotiations on the level of disclosure, buyer knowledge and limitations on claims.
An indemnity is designed to cover a specific risk that has been identified by the buyer during due diligence and that the buyer wants to be protected from. This is usually a risk of an unquantified amount or a quantifiable risk that may or may not crystalise. Under an indemnity the buyer would be able to bring a claim for the pound for pound loss incurred (subject to limitations such as caps and time limits). If the amount of a liability is known and the risk of such liability being realised is high then a price renegotiation or retention may be more appropriate.
Sellers do not wish to be indefinitely at risk of a claim for breach of warranties and indemnities. Time limits will be negotiated but if the seller wishes to have more of a clean break then the parties could discuss the possibility of Warranty & Indemnity ("W&I") insurance. W&I insurance is now common in corporate real estate transactions although its advantages and disadvantages need to be clearly understood by the parties (please click here for our brief overview of W&I insurance).
How should the purchase price be calculated and what adjustments will be made (for example, a locked box mechanism vs. a completion accounts mechanism)? Consideration also needs to be given to any amount of the purchase price that may be deferred or held in escrow for a period of time after completion. Escrow arrangements are now commonplace and relatively easy to arrange. Escrow agents are purely administrative in function and so the contractual terms of when and how monies are released (and how interest should be treated, if senior debt is being provided by an Islamic bank) from an escrow account will be the part that takes time to agree!
Will there be an exclusivity agreement? Will there be a split exchange and completion? A period of time between exchange and completion may be necessary if there is an element of conditionality (for example, planning permission or merger clearance). The parameters around a split exchange and completion can often become heavily negotiated to ensure the various risks are properly apportioned between the buyer and the seller. It should also be noted that W&I insurance does not usually cover issues that occur between exchange and completion and so there is a potential gap in cover for a buyer which will need to be carefully considered.
That concludes this episode of Murabaha Monthly – join us next month when Leena Payyappilly, an Associate in our Islamic finance team will provide insights into which conditions precedents in commodity murabaha facilities can prove to be problematic and how commercially minded investors can go about resolving common sticking points.