Few private equity firms have established shared service centres and outsourced the operations of those centres, and few related portfolio companies have entered into multiparty outsourcing agreements. This is a reflection of the generally held view that outsourcing the needs of multiple companies in a single transaction would be too complex, and would potentially hamper the exit of any individual portfolio company, effectively turning an IPO or sale of a standalone business into something like the carve out of an operating division.
However, outside the private equity context, affiliated companies often use common outsourced information technology and business process platforms – realising the benefits of internal economies of scale and other benefits of outsourcing. Given this, and the sluggish state of the economy, it is time to challenge the prevailing private equity view.
Issues that may concern GPs include:
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Kevin Boyle |
What happens if some of the portfolio companies require different services, or services at different service levels, than do the other portfolio companies?
How would the sale of a portfolio company impact the other portfolio companies that continue to receive the outsourced services?
Would an ex-portfolio company be in a position to operate on a stand-alone basis? Would implementation of stand-alone operations be costly?
How should a GP assess the risk that sharing support functions could make it easier for a plaintiff with a claim against a portfolio company to ‘pierce the corporate veil’ and reach the GP’s assets?
FACILITATING AN EASY EXIT
An ex-portfolio company would be in a position to operate on a standalone basis if the outsourcing agreement is structured so as to facilitate easy exit. In such an agreement:
The scope of the services provided to a portfolio company would be determined by such company based on its business needs. Some portfolio companies might elect to receive all of the services while others would elect to receive different combinations of only part of the services;
The services would be provided to the different portfolio companies at service levels reflecting their different business needs where technically and economically feasible;
The pricing would be unit based reflecting each portfolio company’s consumption of the services taking into account the level of service actually received by each company;
The services would be provided using non-proprietary hardware and software where technically and economically feasible;
During the, say, two-year period following the sale of a portfolio company or the remainder of the term, whichever is less (the “post-disposition service period”), the service provider would be obligated to service the ex-portfolio company or its successor, and would charge the ex-portfolio company on the same basis and using the same rate structure as before the sale or other disposition. In addition, for purposes of determining volume-based charges, the ex-portfolio company’s volumes would be aggregated with the remaining portfolio companies for the duration of the post-disposition service period; and
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Allen Klein |
During the post-disposition service period, the service provider would be obligated to provide the ex-portfolio company assistance required to transition the services to other platforms, including platforms implemented by the ex-portfolio company and the platforms of the service provider’s competitors.
By structuring an outsourcing in this fashion, the ex-portfolio company would (i) be in a position to continue to operate without interruption or degradation of its systems for an extended period (e.g., 24 months), and (ii) have such extended period to transition to stand alone operations, whether supported internally or by another third party outsourcing services provider, which should be sufficient to transition without interruption or degradation of the services. Moreover, operating costs would be stable during such period.
Finally, there would be no unbundling process; from and after the effective time of the disposition or, if the portfolio company requests post-disposition services, once the period expires, the remaining portfolio companies would continue to receive the services from the service provider, although, in the case of volume-based charges, the applicable per unit rate may increase unless the ex-portfolio company’s volumes are replaced by the volumes of other newly-acquired portfolio companies or by growth in volumes consumed by the remaining portfolio companies. Even if the ex-portfolio company’s volumes are not replaced, the per unit cost to the remaining portfolio companies would likely remain lower than if the portfolio companies continued to operate or outsource on a stand-alone basis. Indeed, it should be possible to negotiate an arrangement such that, in the worst case, their costs would never exceed what they would have been on a stand-alone basis.
PIERCING THE CORPORATE VEIL
Another concern is that shared support functions across the portfolio could make it easier for a plaintiff with a claim against a portfolio company to ‘pierce the corporate veil’ and reach the sponsor’s assets.
Under Delaware law, the corporate veil is likely to be pierced where the corporate structure is used to perpetrate a “fraud, contravention of law or contract, public wrong, or where equitable considerations among members of the corporation require it”; and that the veil may be pierced where “those in control of the corporate enterprise have not treated it as a distinct entity – have ignored the corporateness of the corporation and have themselves treated it as their instrumentality.”
Formation of a shared services center and/or an outsourcing to achieve economies of scale and other business benefits does not, by itself, appear to provide a basis for piercing the veil under either of these theories. Even so, given the potential, GPs should be careful that there are few if any other factors that indicate that the piercing of the veil is appropriate so that the use of a common outsourced information technology and/or business process platform is not ‘the straw that breaks the camel’s back’. The law varies by state and GPs should conduct a state-by-state analysis early in the contracting process.
A FEW CAUTIONARY NOTES
The outsourcing process is likely to require the transition of some or all of the affected portfolio companies to one or more platforms maintained by the service provider. Although the outsourcing service provider typically takes responsibility for this transition, the private equity company and portfolio companies will inevitably be required to devote skilled internal resources to this process – that is, resources with deep knowledge of the portfolio company’s business, platforms and processes. Moreover, depending on the complexity of the transition, the service provider’s transition charges may be significant.
Allen Klein and Kevin Boyle are partners in Latham & Watkins corporate department. Both are based in the firm’s Washington DC office.
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