PRINT THIS PAGE A Rock and a Hard Place07/11/2007. Source: Weil, Gotshal & Manges. 
Deal certainty is important to both buyers and sellers of corporate businesses. A buyer wants certainty as to both the circumstances in which it can terminate the acquisition agreement if the assumptions on which it agreed to buy the business have materially changed and the maximum amount of potential recourse that a seller has against it if it terminates. A seller wants certainty that a buyer cannot terminate the acquisition agreement in the absence of a material adverse change in the business and wants meaningful remedies against a buyer for wrongful termination, say Doug Warner and Christopher Machera of Weil, Gotshal & Manges. In large leveraged buyout transactions recently, this desire for certainty and the competing demands of a buyer to cap its potential liability and the seller to have meaningful remedies found a balance to this tension in commonly used deal terms.
In a typical deal, a buyer would be required to close or otherwise pay a reverse termination fee unless it could establish that the business had suffered a material adverse change (MAC). As the buyer would typically not have a financing out, it would usually not sign the deal unless it had firm commitment papers for debt financing with conditions that mirrored the conditions, including the MAC condition, in the acquisition agreement. Deals would vary in terms of whether there was a one-tier or two-tier reverse termination fee, whether the reverse termination fee was the exclusive monetary remedy or whether there was a cap for provable damages above the reverse termination fee and whether the seller could seek specific performance against the buyer.
All of this worked well until the credit bubble began unwinding in the summer of 2007. Whether or not directly related to the turmoil in the credit markets, a number of recent transactions, including Accredited Home, HD Supply, Axciom, Harman and Sallie Mae, began running into trouble and exposed flaws in the architecture of this typical deal. A number of lessons can be learned from these transactions. This article highlights some of those lessons and describes a few changes in typical deal terms that have appeared in certain of the sponsor-backed going private transactions announced since the credit bubble ended.
MACs May Not Provide Adequate Protection to Either Buyers or Sellers
MAC definitions tend to receive a high degree of focus from deal professionals and their lawyers. Despite how heavily engineered these definitions have become, most are still glaringly ambiguous.1 The law on MACs is also startlingly undeveloped with only a small number of decided cases that provide any guidance to practitioners. The combination of ambiguous definitions and undeveloped law means that neither the buyer nor the seller will usually be certain as to a buyer’s ability to terminate the acquisition agreement due to a MAC. This can lead to a complicated dance between buyers and sellers if an adverse change happens to the target between signing and closing and the buyer wants to terminate or recut the deal. The buyer will assess not only whether it has the right to terminate but also the negative consequences, such as a seller claim for the reverse termination fee, other damages or specific performance, of being wrong in its conclusion that it has the right to terminate. The seller will assess whether the buyer can terminate and what remedies it has against the buyer if the buyer alleges, contrary to the seller’s belief, that a MAC has occurred. The seller may also assess whether it makes sense to cut a deal with the buyer to reduce the purchase price to get the deal done or settle a potential claim by the buyer that a MAC has occurred by agreeing to a reduced termination fee to avoid protracted, expensive and uncertain litigation.
The lesson to be learned is that deal professionals should consciously consider whether they will likely benefit or suffer from the traditional MAC and its ambiguity. If their conclusion is that they will likely not benefit then they should consider whether to include more objective criteria either in the MAC definition or in the conditions to closing that will provide them the certainty and protection they need.
Reverse Termination Fees May Not Be All That They Are Cracked Up to Be
Reverse termination fees started as a delicate compromise between public target companies and private equity sponsor buyers. Historically, when a private equity sponsor bought a public company the typical structure involved the use of a newly-formed special purpose company as the acquisition vehicle and a merger agreement that included a financing out and did not provide for any recourse directly against the private equity sponsor if the special purpose company failed to perform under the merger agreement. In the going private boom that started a couple of years ago, public target boards of directors became uncomfortable with this structure. This was particularly the case as target companies generally had full recourse against the assets of a strategic buyer in the event of a breach of the merger agreement and also usually had the ability to seek specific performance (i.e., force the buyer to close the acquisition) by the strategic buyer.
The two key concessions target boards began to typically demand were that the private equity sponsor had to close whether financing was available or not and that the private equity sponsor had to stand behind the special purpose company so that the public target company had a meaningful remedy in the event of a breach. Private equity sponsors usually agreed to this construct but insisted upon capping their liability and eliminating the ability of the target company to seek specific performance of the merger agreement. The cap was typically a reverse termination fee that mirrored the break-up fee paid by the target to the buyer in the event that it terminated the merger agreement in favor of a superior competing offer. However, a number of variations on this structure developed in the market, including two-tier reverse termination fees where one tier applied to the failure to close due to lack of financing and another higher second tier where the target retained the ability to seek greater damages subject to a cap in the event that there was a willful breach and the target could prove that they incurred damages greater than the reverse termination fee. Occasionally, private equity sponsors also agreed that the target could seek specific performance of the merger agreement.
The recent stress testing of this compromise has provided certain lessons for targets and buyers. The lessons for targets are that (i) a reverse termination fee may not provide an adequate remedy to targets in the event that the buyer fails to close and (ii) it may be difficult to collect the reverse termination fee from the buyer if the buyer has a reasonable good faith argument that the target has suffered a MAC or has failed to comply with its obligations under the merger agreement. The lessons for private equity sponsor buyers are that (i) they need to make their financing commitments as bulletproof as possible if they agree to a reverse termination fee and (ii) they may be in the unfortunate position of having to issue a capital call to their limited partners to pay the reverse termination fee if they want to terminate and can’t prove the target suffered a MAC or that they are otherwise not required to close under the merger agreement.
In light of the recent wrangling on certain transactions it seems reverse termination fees may not be all they were cracked up to be in terms of allocating risk between targets and buyers. For private equity sponsors, the limitations of reverse termination fees from a target’s perspective may reduce their competitiveness against strategic buyers in future auctions.
Bank Commitment Papers May Not Be as Tight as They Seem
As part of the increasing willingness by private equity sponsors to do deals without financing outs, they insisted that their bank commitment papers be drafted in a way so that there was no “daylight” between their commitment to the target company and the banks’ commitment to finance the deal. As a result, “market MACs”, syndication conditions, “no new information” conditions and other traditional protections to the banks disappeared, “business MACs” were conformed to the MAC in the underlying acquisition agreement and details frequently left to the definitive documentation, such as representations, warranties and covenants, were frequently qualified by reference to “based on existing sponsor precedent” or similar language.
Despite the tightening of the terms of bank commitment papers, the recent stress testing of these papers have indicated they were not 100% bulletproof and offers certain lessons to sponsors. These lessons include (i) make sure that the amount of the available financing is absolutely certain, particularly in asset-based lending where advances are based on the quantity and quality of available assets, as the amounts available for advance could be subject to downward interpretation, (ii) be wary of language such as to “to be determined” and “sponsor precedent” as those terms can give banks latitude to tighten terms on the borrower in a tough lending environment and (iii) strictly comply with all of your obligations under the commitment papers to avoid any possibility of an allegation of breach, including even technical “foot faults”, which would excuse the banks from performance.
Recent Deals
Based on an admittedly unscientific sampling of seven sponsor-backed going private transactions announced since the credit bubble ended (3Com, Radiation Therapy Services, Goodman Global, Puget Energy, Deb Shops, Midwest Air and Covad Communications), some of the typical terms previously seen in going private transactions may be changing. In particular:
- Two of the transactions had an express condition to closing tied to trailing EBITDA rather than relying exclusively upon the MAC and another transaction modified the typical MAC definition to include a presumption that any change that has a materially disproportionate adverse impact on the industry in which the target operated compared to other industries would be a MAC.
- One of the transactions had a higher reverse termination fee for failure to close due to being unable to obtain financing than for other breaches by the buyer. Two of the transactions had no reverse termination fee and no express cap on damages and permitted the target to seek specific performance in the event of a breach by the buyer. Another transaction had a reverse termination fee which was approximately four times the size of the break-up fee and the sponsor was required to place the reverse termination fee in escrow when the merger agreement was signed.
- None of the transactions had a financing out and the sponsors in two of the transactions agreed to fund the entire purchase price with equity.
It is too early to determine whether any of these changes will become a trend but we will report on this more fully in our annual January issue of Private Equity Alert focusing on trends and developments in the industry.
Conclusion
The recent unwinding of the credit bubble exposed flaws in the architecture of the typical large leveraged buyout transaction by private equity sponsors. Some of the lessons learned involved the limitations of MACs and reverse termination fees to both buyers and sellers and that bank commitment papers were not as bulletproof as commonly believed. As a result, both buyers and sellers are likely to take a fresh look at these typical deal terms.
Weil, Gotshal Manges is a leading legal specialist in private equity services, with dedicated private equity lawyers in major financial centres throughout the world. For more information please visit www.weil.com.
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