Define the relationship: lifecycle of a PE investment

1. Align on structure and tax treatment early

When structuring a PE acquisition, there is rarely a single best structure. Rather, each option requires balancing competing priorities: a stock deal may be simpler to execute, but brings with it historical liabilities; an asset deal may better isolate unwanted liabilities, but can create consent and operational separation issues; and a merger may help a seller wrangle a diffuse shareholder base, but introduces statutory process, notice, and potential appraisal-rights considerations.

The key is to make those tradeoffs deliberately at the outset, selecting the structure that best protects the sponsor’s downside risk, while preserving a practical path to closing, and positioning the business for value creation during the hold period and eventual exit.

In acquisitions involving S-Corporations (S-Corps), a pre-closing reorganization known as an F-Reorg may help bridge the gap between competing tax and corporate interests. Buyers of S-Corps typically prefer an asset sale, where they can receive a fair market value step-up in tax basis—whereas for corporate purposes, sellers and buyers often prefer an entity sale.

In a pre-closing F-Reorg, the shareholders of the S-Corp form a new holding company and contribute their existing S-Corp ownership interests to it. The holding company then wholly owns the original company as a subsidiary, which may elect to be treated as a disregarded entity for tax purposes. The new holding company, which stays behind with the sellers, is treated for tax purposes as the continuing S-Corp, and its sale of its subsidiary to the buyer can be treated as a sale of assets for tax purposes, while being a sale of stock for corporate purposes.

Due to the unique pass-through nature of an S-Corp, this structure will typically produce tax results for the seller similar to those of a transaction treated as a sale of the shares of the S-Corp for tax purposes, while still allowing the buyer to acquire the existing corporate entity for non-tax purposes. Torys’ bulletin, Before you buy that S-Corp, discusses these considerations and more.

2. View litigation diligence as a value-creation tool

When approached strategically, mapping risk during litigation diligence, and effectively allocating that risk during contract drafting and negotiation, are effective ways to preserve and generate value.

Litigation risk assessment. A key responsibility for litigators during the acquisition process is to evaluate pending and threatened litigation involving the target company. This assessment spans several critical areas, including regulatory and antitrust risk—such as FTC/DOJ scrutiny, Hart-Scott-Rodino filings, CFIUS reviews, and sanctions or anti-corruption concerns—and the target’s direct liability exposure from existing or threatened lawsuits. Additional areas to map include employment and operational issues, such as wage claims and supplier contract disputes, risks associated with distressed assets and restructuring scenarios, and any unresolved data breaches or concerns around data privacy compliance and AI tools.

Contingent liabilities. Beyond existing litigation, litigators must assess the target’s contingent liability landscape—potential future financial obligations arising from uncertain events such as litigation, tax disputes, and environmental risks. To manage, mitigate, and allocate these risks, buyers commonly employ deal-structuring tools such as earn-outs, escrows, and holdbacks. Earn-outs tie a portion of the purchase price to the target, meeting future financial benchmarks, while escrows and holdbacks reserve funds to cover specific identified liabilities such as pending litigation.

Representations, warranties, and indemnities. Litigators can also play a central role in negotiating the representations, warranties, and indemnities in the purchase agreement, which serve as critical risk allocation mechanisms. Reps and warranties should be tailored to the target’s specific industry and risk profile. Indemnities function as the primary enforcement mechanism for the reps and warranties, establishing protection for breaches, claims procedures, damage calculation methodologies, and potential remedies such as specific performance. Other key negotiation points include materiality thresholds, knowledge qualifiers, limitation periods, baskets, and overall caps. The use of Representations and Warranties Insurance (RWI) to further mitigate risks is increasingly common, providing an additional layer of protection that can facilitate more aggressive or atypical deal structures.

3. Maximize the value of the real estate portfolio

Private equity firms often see real estate holdings within target companies as untapped assets that can be optimized for value creation by using a variety of strategies, such as the following:

• Sale-leaseback transaction. This is a fundamental PE strategy related to real estate. It involves selling owned properties to third-party investors and leasing them back long-term, usually over 20 years, to extract equity for acquisition costs. These transactions typically offer better cap rates than acquisition debt, and impose minimal operating covenants on tenants, providing upfront financial benefits that outweigh lease payments’ drag on EBITDA. The structure allows PE firms to free up cash to reinvest into operating businesses for better returns.

• Highest and best-use analysis. Sponsors should evaluate whether properties are used optimally. They might consider relocating warehouses from gentrifying neighborhoods to lower-cost sites, or selling excess parcels. This analysis, often done by appraisers, can reveal opportunities to dispose of assets at premiums and leverage tax benefits.

• Lease rationalization and consolidation. Identifying negotiation opportunities relating to long-term leases, especially if landlords face distress or market vacancies, can unlock value. Strategies include “blend and extend” agreements (averaging the current rent with a new market rent in exchange for extending the lease term), providing guarantees to secure better terms, and considering subleasing or assignments to manage space efficiently. These financial maneuvers do not affect operations, but they improve lease economics and exit perceptions.

4. Carefully craft restrictive covenants to avoid pitfalls

Thoughtfully drafted restrictive covenants for key employees can be critical to preserving the value of the acquisition. The first step in this regard during the acquisition phase involves identifying key employees and reviewing their existing restrictive covenants, which may be found in standalone agreements, employment agreements, and equity documents. The scope of these covenants and their enforceability often vary, so they should be evaluated holistically.

If the target’s key employees are not bound by adequate restrictive covenants, the PE sponsor will likely want to enter into new restrictive covenants at the time of acquisition. In many states, continued employment is not adequate consideration for restrictive covenants, and an M&A transaction provides an opportunity for increased base salary, new equity awards, or transaction bonuses, all of which could serve as adequate consideration for entering into new restrictive covenants.

When considering enforceability of the various types of restrictive covenants, PE sponsors should pay close attention to state law requirements. There has been an increasing divergence in how states treat employment-based non-compete and non-solicit covenants. Some states ban non-compete agreements altogether, and other states impose various procedural requirements for a valid non-compete. An increasing number of states also impose statutory penalties for violating their non-compete laws, such that the consequence of entering into a non-enforceable non-compete or non-solicit is not just the lack of enforceability, but could involve statutory penalties, attorneys’ fees, and monetary damages.

5. Prepare during the hold period with exit in mind

Finally, the holding period should be managed as though a buyer—or underwriters and investors in an initial public offering (IPO)—will eventually scrutinize every corporate action, equity issuance, acquisition, significant contract, and governance decision taken during ownership. Maintaining disciplined documentation and an accurate, current cap table in real time—not as an exit clean-up exercise—helps preserve buyer confidence and/or facilitate IPO preparation, and ensures the value created during the hold is not undermined at exit. In addition, careful attention should be given to developing robust investor rights for the PE sponsor in the event of a public company exit, including post-IPO board and management rights, information rights, participation rights as well as registration rights, the last of which is important to ensure the ability to resell the PE sponsor’s retained interest in the public company over time. PE sponsors should also be mindful of agreements between the portfolio company and third parties whereby the company has agreed to issue equity in connection with an IPO or as consideration in other circumstances, as these can create equity overhang for a potential public offering.

To the extent that an IPO exit becomes likely and more imminent, PE sponsors should also start getting organized for the portfolio company to become public. To go public, the portfolio company will need financial statements that are audited by an independent accounting firm in accordance with applicable securities laws, depending on the legal status of the issuer and the jurisdiction in which it goes public. Companies going public in the United States may also need to lay the groundwork for compliance with the auditor attestation requirements of internal controls under Sarbanes-Oxley, although all newly-public companies automatically get a one-year grace period (and certain other issuers have an additional on-ramp). Portfolio companies will also need to assemble a public company board and board committees, as well as public company-oriented management and other employees, and public company directors and officers (D&Os) will need to obtain public company D&O insurance.

Lastly, the portfolio company will need to be prepared for public company disclosure – not just in the IPO prospectus, which will extensively describe the business and its risks – but also public company reporting on a periodic basis after the IPO, which generally requires real-time disclosures of material developments (whether good or bad), for which the company—and its D&Os—will be liable under applicable securities laws. Accordingly, a PE sponsor seeking to take a portfolio company public—with the help of the IPO investment banks and other financial and legal advisors—should do its best to clean up its corporate structure, simplify its debt, resolve third-party litigation and other potential disputes, secure long-term contracts and hone its business strategy ahead of the IPO to ensure that it can best present itself to public company investors going forward.