Private Equity Investments: Legal Framework and Contractual Structure

Private equity refers to long-term equity investments in companies whose shares are not traded on a stock exchange, generally made with the aim of exiting after a certain period. In Turkey, such investments are mostly carried out by foreign funds or by investment companies established by them, through the acquisition of part or a majority of the shares of a Turkish company. What is decisive for the investor is not merely the acquisition of the shares, but also the ability to have a say in the management of the company throughout the investment period and to transfer its shares on the envisaged terms at the end of the investment. Structuring these objectives in line with the mandatory provisions of the Turkish Commercial Code (Türk Ticaret Kanunu, TTK) on joint stock companies largely determines the legal structure of the transaction.

Contents

• Through which structures are private equity investments made in Turkey?
• Do foreign investors require approval?
• Why does the legal form of the target company matter?
• Is the investment made by share transfer or by capital increase?
• How are the investor's rights secured in the articles of association?
• What function does the shareholders' agreement serve?
• How are share transfer restrictions and exit rights regulated?
• Through which routes is an exit from the investment achieved?
• Is Competition Board approval required?
• Which special rules apply to venture capital investment funds and companies?
• Conclusion

Through which structures are private equity investments made in Turkey?

In practice, private equity investments are made by the investor acquiring minority or majority shares in a company operating in Turkey or by contributing new capital to the company. Foreign funds frequently invest through an investment company they have established abroad, whereas within Turkey venture capital investment funds (girişim sermayesi yatırım fonları) and venture capital investment companies (girişim sermayesi yatırım ortaklıkları), which are subject to the regulations of the Capital Markets Board (SPK), may be used as a separate investment vehicle.

The type of investment also has a direct impact on the contractual structure. In transactions in which majority shares are acquired, the purchase agreement and the guarantees relating to the target company's past come to the fore, whereas in minority investments the investor's participation in management, veto rights over important decisions and exit opportunities become decisive. Practice shows that a considerable proportion of the disputes arising in minority investments stem from exit provisions that were not regulated in sufficient detail at the time of the investment.

Do foreign investors require approval?

Under Foreign Direct Investment Law No. 4875, foreign investors are, as a rule, subject to equal treatment with domestic investors and are not required to obtain prior approval in order to establish a company in Turkey or to acquire shares in an existing company. After the investment, however, the information obligations provided for in the legislation must be fulfilled.

Nevertheless, in regulated sectors such as banking, insurance, energy, electronic communications and media, share acquisitions exceeding certain thresholds are subject to the approval of, or a notification to, the relevant regulatory authority. With regard to the target company's real estate, the provisions of Article 36 of the Land Registry Law (Tapu Kanunu) concerning the acquisition of real estate by companies with foreign capital must also be taken into account.

Why does the legal form of the target company matter?

In private equity investments, the joint stock company (AŞ) structure offers clear advantages over the limited liability company. In limited liability companies, the transfer of a share in a limited company must, pursuant to Article 595 TTK, be made in writing and the signatures must be notarised; unless otherwise provided in the articles of association, the transfer is moreover subject to the approval of the shareholders' meeting. In addition, the shareholders of a limited liability company may, under Article 35 of Law No. 6183 on the Collection of Public Receivables, be held liable in proportion to their capital shares for public receivables (tax and other public debts) that cannot be collected from the company in whole or in part or that evidently cannot be collected, while, in the case of a share transfer, the transferor and the transferee are jointly and severally liable on the same basis for the payment of public receivables relating to the period before the transfer.

In joint stock companies, by contrast, the transfer of shares is subject to a more flexible regime, and the shareholders bear no personal liability for the company's debts. Furthermore, instruments that protect the investor, such as preferred (privileged) shares, the right to board representation and qualified quorums, can be used more extensively in a joint stock company. For this reason, in target companies structured as limited liability companies, a conversion into a joint stock company by way of a change of legal form is frequently considered before the investment.

Is the investment made by share transfer or by capital increase?

The investment may be made by purchasing shares from the existing shareholders, by contributing new capital to the company, or by combining these two methods. In a share transfer the purchase price is paid to the selling shareholders, whereas in a capital increase the investment amount flows directly into the company and is used to finance its growth plans.

In investments made by way of a capital increase, the pre-emptive (subscription) right (rüçhan hakkı) of the existing shareholders must be addressed separately. Pursuant to Article 461 TTK, each shareholder has the right to acquire newly issued shares in proportion to its existing shares in the share capital; this right may be restricted or excluded only where there are just causes and with the affirmative vote of at least sixty per cent of the share capital. In practice, a written declaration by the existing shareholders that they will not exercise their pre-emptive subscription rights is also a common solution. Where it is planned to use the assets of the target company to finance the purchase price, Article 380 TTK, which, subject to statutory exceptions, deems null and void transactions concerning the granting of advances, loans or security for the purpose of acquiring the company's own shares, must also be taken into account.

How are the investor's rights secured in the articles of association?

Pursuant to Article 340 TTK, the articles of association of a joint stock company may deviate from the provisions of the Code on joint stock companies only where the Code expressly permits this. The rights to be granted to the investor must therefore be structured within the framework of the instruments provided for by the Code. Foremost among these instruments are the preferred shares regulated in Article 478 et seq.; privileges may be granted in respect of rights such as dividends, liquidation proceeds, pre-emptive subscription rights and voting rights, while multiple voting rights may, as a rule, be granted by attaching a maximum of fifteen votes to one share.

Pursuant to Article 360 TTK, the articles of association may grant certain share groups the right to be represented on the board of directors, and this right qualifies as a privilege. With regard to important decisions, the articles of association may provide for meeting and decision quorums that are stricter than the statutory quorums; indeed, the Code already requires the affirmative vote of at least seventy-five per cent of the share capital for certain amendments to the articles of association, such as the creation of preferred shares and the restriction of the transfer of registered shares. However, multiple voting rights cannot be exercised in resolutions such as amendments to the articles of association, the discharge of directors and the filing of liability actions; this limit must be taken into account when designing veto rights.

What function does the shareholders' agreement serve?

In practice, the details of the relationship between the investor and the existing shareholders are regulated in a shareholders' agreement (pay sahipleri sözleşmesi). This agreement covers matters such as the appointment of board members, the investor's consent to important decisions, information rights, non-compete obligations, restrictions on share transfers and exit mechanisms. However, as a contract under the law of obligations, the shareholders' agreement binds only its parties; it does not bind the company or persons who are not party to it, and a resolution of the general assembly adopted in breach of the agreement does not, for that reason alone, become invalid.

For this reason, the key provisions of the shareholders' agreement should also be reflected in the articles of association to the extent permitted by the Code. For provisions that cannot be transferred into the articles of association, sanction and security mechanisms such as a contractual penalty applicable in the event of breach, call and put options and a share pledge should be provided for. Experience shows that inconsistencies between the two documents lead to serious disputes as to which provision is to apply, particularly at the exit stage.

How are share transfer restrictions and exit rights regulated?

For registered shares not traded on a stock exchange, the articles of association may provide, pursuant to Article 492 TTK, that the shares may be transferred only with the approval of the company. Under Article 493, the company may refuse the request for approval only on the basis of a significant reason provided for in the articles of association or by offering to acquire the shares at their real value at the time of the application; the articles of association cannot make the conditions of transferability more stringent beyond this. For this reason, arrangements such as the right of first refusal (önalım hakkı, a pre-emption right on the transfer of existing shares), the tag-along right and the drag-along obligation are, in practice, contained primarily in the shareholders' agreement.

The drag-along obligation is of particular importance in enabling the investor to transfer the company in its entirety to a buyer upon exit. Since this obligation remains one under the law of obligations, its enforceability should be strengthened by supporting mechanisms such as a call option, authorisations for the transfer granted in advance and a contractual penalty. With regard to put options and exit rights granted at the end of certain periods, how the price is to be determined, the valuation method and the payment terms should be clearly regulated.

Through which routes is an exit from the investment achieved?

An exit from private equity investments is mostly achieved by selling the shares to a strategic investor or to another fund, by taking the company public through an IPO (public offering), or by transferring the shares to the existing shareholders. In the case of an IPO, the regulations of the Capital Markets Board and Borsa İstanbul apply; for this reason, in investments in which an IPO is envisaged as an exit option, bringing the company's corporate governance structure into line with these regulations should be planned in advance.

The repurchase of the investor's shares by the company, on the other hand, is a limited option. Pursuant to Article 379 TTK, a joint stock company may not, subject to statutory exceptions, acquire its own shares for consideration in an amount exceeding one tenth of its share capital or issued capital; the acquisition is moreover subject to authorisation by the general assembly and to conditions relating to the company's net assets. For this reason, in structures in which the exit is based on the company's resources, alternative routes such as a capital decrease should also be considered.

Is Competition Board approval required?

The acquisition by a private equity fund of control over the target company, whether alone or jointly with other shareholders, is subject to the approval of the Competition Board if the turnover thresholds set out in Communiqué No. 2010/4 are exceeded. Since, in minority investments as well, veto rights granted to the investor over strategic decisions may result in joint control, the notification obligation should not be assessed solely on the basis of the shareholding percentage.

It should be borne in mind that the turnover of other portfolio companies under the fund's control may also be taken into account when calculating the turnover thresholds. A transaction requiring approval does not become legally valid without approval having been obtained; for this reason, the approval requirement should be specifically addressed in the transaction timetable and in the closing conditions of the agreement.

Which special rules apply to venture capital investment funds and companies?

Venture capital investment funds established in Turkey are subject to the Capital Markets Board's Communiqué No. III-52.4 on the Principles Regarding Venture Capital Investment Funds. These funds are pools of assets without legal personality, established by portfolio management companies that have obtained an operating licence from the Board, and their participation units may be sold only to qualified investors. Venture capital investment companies, by contrast, operate as joint stock companies whose shares are subject to capital markets legislation.

From a tax perspective, the earnings of venture capital investment funds and companies established in Turkey are exempt from corporate tax pursuant to Article 5/1-d-3 of the Corporate Tax Law, provided that the statutory conditions are met. In addition, corporate taxpayers may deduct from their corporate income, pursuant to Article 10/1-g of the Corporate Tax Law, the amounts they set aside as a venture capital reserve (girişim sermayesi fonu) under Article 325/A of the Tax Procedure Law, provided that the reserve amount set aside in the relevant year does not exceed ten per cent of the declared corporate income and the total reserve amount does not exceed twenty per cent of equity, that the amount set aside is invested in venture capital investment funds or companies by the end of the same year, and that the other statutory conditions are met. The use of these instruments in an investment structure should be assessed separately under capital markets and tax legislation.

Conclusion

In private equity investments, the investor's participation in management and its exit opportunities must be structured within the framework of the mandatory provisions of the Turkish Commercial Code on joint stock companies. While preferred shares, the right to board representation and qualified quorums can be secured in the articles of association, arrangements such as rights of first refusal, tag-along rights and drag-along rights are contained primarily in the shareholders' agreement and bind only its parties.

For this reason, when determining the investment structure, the legal form of the target company, whether the investment is made by share transfer or by capital increase, the consistency between the articles of association and the shareholders' agreement, Competition Board approval and the exit scenarios should be assessed together at the outset of the transaction.

GEMS Schindhelm advises on private equity investments with regard to determining the investment structure, legal due diligence, the preparation and negotiation of share transfer and investment agreements, shareholders' agreements and articles of association, and Competition Board approval procedures. This article is for general information purposes only and does not constitute a legal opinion or legal advice; each transaction must be assessed separately according to the circumstances of the specific case and the legislation in force.