Beware minority shareholders: lending to the professional services

Typically, the professional and holdco shareholders will hold two classes of shares in the subsidiary. This affords the flexibility to allocate differing levels of control, rights and obligations to shareholders, reflecting their different roles in the capital structure and the operations of the business. These will be governed by the subsidiary’s articles and, most likely, a shareholder agreement. The latter varies in form and content but is useful for setting out any matters that the shareholders prefer to remain private, whereas the articles will (for a limited company, at least) be publicly available. It is here that the key controls over the non-wholly owned subsidiaries will be set out.

For example, as these entities will be part of the “Group” for the purpose of the Finance Documents, the obligors will want to ensure that they remain compliant with the relevant representations and undertakings. This may entail amending the shareholder agreement to include “reserved matters” around incurrence of debt, granting of guarantees and other matters subject to negative undertakings in the facilities agreement.

Depending on a balance of commercial factors, including the maturity of the individual practices and the structure as a whole, financing requirements, exit considerations and the balance of power between the shareholders, it is not unusual for the non-wholly owned subsidiaries to be restricted from giving guarantees and security for third party debt. This may also extend to restricting either or both sets of shareholders from charging their shares in the non-wholly owned subsidiary.

Lenders will also need to understand the extent to which the co-operation of minority shareholders could be required to vote on certain matters, even where such matters are not prohibited by the company’s constitution.

Given this landscape, how should lenders approach the collateral package?

As a starting point, lenders seek to ensure they hold guarantees and security from the most valuable companies within the group. This is typically tested with reference to EBITDA, and potentially also turnover and assets, depending on the nature of the business. This fundamental tenet is challenged in a non-wholly owned group. The value is likely to be concentrated at the non-wholly owned subsidiary, trading company level. Whether lenders can take security and guarantees at this level will depend upon what is permitted in the shareholder arrangements, and it is not uncommon for the granting of collateral by, and sometimes also over, the non-wholly owned subsidiaries to be prohibited.

All is not lost. Lenders can still benefit from credit support granted by the holding companies. Whilst the value in the business sits below, having security from holding companies allows the lenders to enforce over the subsidiaries. If shareholder arrangements restrict the immediate holdco shareholder from charging its shares in the non-wholly owned subsidiary, security may need to be taken from such holdco shareholder’s parent. Moreover, provided that security is also taken from such parent entity, this will provide the lenders with a clean, single point of enforcement.

Lenders should give particular consideration to how enforcement of security would operate in the context of the non-wholly owned subsidiaries, including a detailed review of the shareholders’ agreements. For example, would the enforcement of security over shares in a holdco or the subsidiaries themselves trigger a change of control terminating the shareholder agreement or triggering other undesirable consequences? If so, the security package shouldbe pared back accordingly or an exception agreed as regards the enforcement of security.

Such non-wholly owned structures sometimes entail the professional shareholders having a “put option”, ie the right to require the holdco to buy all or a portion of their shares, subject to specified conditions. There may also be a “drag along right” allowing the holdco shareholder to “drag” the professionals to sell all or a portion of their shares as part of a sale of the business, with parameters around how consideration is calculated in this scenario. Any “put option” and the consideration requirements for a “drag” right need to be switched off where the group’s lenders are enforcing transaction security.

Scrutiny of a business’ cashflows is particularly important with a non-wholly owned structure, given the potential for cash to flow to the professional shareholders, and therefore out of the lenders’ collateral net. Lenders will want to understand how (and how much) funds flow to the professional shareholders, whether by way of dividend, fee or otherwise. Lenders will be alive to the risk of minority shareholders receiving preferential treatment. Typical leveraged finance documents offer ample controls on permitted payments, but they will need to be adapted to block or limit payments to the professional shareholders, particularly when the business is underperforming.

Leveraged loans typically allow additional shares to be issued to minority shareholders at the same time as its majority shareholders. However, in the context of professional services, lenders will wish to understand (and potentially curtail) any bespoke share issuance to professional shareholders. Such provisions are likely to be commonplace in any such business, as core professional stakeholders join and leave the firm.

As outlined already, lenders may need to accept a lighter collateral package than normal for a non-wholly owned group. If lenders do not have the benefit of direct credit support from the main profitgenerating entities in the group, is it still reasonable for their revenue contribution to nonetheless be included for financial covenant purposes? The analysis on this point will largely depend on an understanding of the cashflows, protocols for permitted payments and other shareholder controls within the group. Provided that the cashflows to the holdcos from the non-wholly owned subsidiary and protections against leakage are robust and the required shareholder controls are adhered to, it may be appropriate and necessary to include the non-wholly owned subsidiary’s EBITDA when calculating leverage, for example.

Some of the concerns regarding minority shareholders could be alleviated by such stakeholders signing up to intercreditor agreements, but this is generally not acceptable, nor practical. Deals involving professional services firms can also give rise to complications due to the presence of unusual entity types (eg limited liability partnerships) within the group structure. Such entity types will operate very differently from a limited company in terms of decision-making mechanics, protocols for transfer of ownership and lack of publicly available information on the constitution of the entity. Where the borrower group operates in certain regulated professions, this may further limit options for enforcement and the transfer of membership interests.

These considerations will impact on the due diligence required for such deals and on information undertakings throughout the lifecycle of the deal.

A non-wholly owned structure, where professionals hold shares alongside holding companies, requires lenders to rethink guarantee and security coverage, leakage and financial covenants. Restrictions on subsidiaries providing security compel reliance on holding companies for collateral, making shareholder arrangements and enforceability crucial. Additionally, managing cashflows to prevent leakage and adapting covenants are essential for risk mitigation. Despite these complexities, the professional services sector’s potential for consolidation and stable models offers promising opportunities. Therefore, tailored financing strategies and flexible approaches will be key in successfully navigating and leveraging the benefits of nonwholly owned groups.