Buyers back out

When a JC Flowers-led group agreed to buy Sallie Mae in April, a capital-intensive financial services business, the deal was looked on as a harbinger of things to come: Companies previously off-limits to buyout shops had become fair game.

Now that the buyout consortium has said it would not go through with the buyout at the existing price, owing to changes in the “legislative and economic environment”, the transaction may be indicative of another trend: buyers exercising material adverse change clauses to renegotiate or back out of LBO agreements.

That famous stockpile of hundreds of billions of LBO-backed debt is still intimidating. And after already losing money on many of their agreements, banks without a doubt will have to tend to it. But banks and sponsors are proving that not all deals are alike and are trying to back out of, or amend, the least savoury of them by claiming material adverse changes (MAC) have occurred to target companies since they signed agreements.

As such, deals for Sallie Mae, Harman International Industries and PHH Corp, among others, are in limbo.

Included in most buyout and financing commitment agreements is a MAC clause that governs how and why a buyer may back out of an agreement without paying the break-up fee.

The flexible nature of these clauses make them difficult and costly to prove through litigation, explaining why they are rarely used to walk away from a transaction. And when they are brought up they often function as a bargaining chip that the buyer uses to renegotiate terms, betting that shareholders would rather renegotiate than go down the value-sapping path of litigation.

“The world of M&A and LBOs has changed,” an M&A lawyer said. “Even though you don’t want to call a MAC, there might be few options and sellers understand in some cases that this is a predicament for renegotiating. The seller often realises that there are more negatives (with contesting it) than with renegotiating.”

Sallie Mae’s predicament is specific, but still difficult to prove, analysts say. The buyout group has made it clear it believes that changes in the legislative and economic environment since it agreed to buy the lender are significant enough to nullify the US$60.00-a-share, or US$25bn, buyout agreement signed in April.

Almost all pending buyouts have been significantly disturbed by the slumping debt market, but Sallie Mae’s deal, in particular, will be affected by Congress’s passage of the College Cost Reduction and Access Act of 2007. Sallie Mae expects the Act, which the president signed into a law last week, would reduce net income by about 2% annually over the next five years.

The investor group knew about the imminence of the legislation when it agreed to the deal. Yet, the fact that it became a law made the difference: “We have told representatives of the Sallie Mae board that we are open to discussing a revision of the transaction that reflects this new environment,” the group said in a press release.

There was a quick response from the seller: “Sallie Mae firmly believes that the buyer group has no contractual basis to repudiate its obligations under the merger agreement and intends to pursue all remedies available to it to the fullest extent permitted by law.”

JC Flowers and Friedman Fleischer & Lowe had planned to invest US$4.4bn and own 50.2%, as per the merger agreement. Bank of America and JPMorgan were each to invest US$2.2bn and each own 24.9%. The two banks have acted as advisers, equity investors and debt arrangers.

The debt package was supposed to include US$16.5bn divided between loans and bonds. The arrangers were also providing Sallie Mae with a US$30bn asset-backed CP conduit facility until the purchase was completed, the agreement stated.

It is unclear what the next step will be, but the deal is indicative of a growing LBO market trend. Two weeks ago, KKR and GS Capital Partners pulled out of their plans to buy Harman International on the same grounds as JC Flowers, stating that a MAC had occurred. Other deals, including PHH and Reddy Ice Holding, might also have to be amended before completion, owing to significant market changes.

Bank of America, Credit Suisse, Goldman Sachs and Lehman Brothers had committed to provide the debt financing for the buyout of Harman International. Kohlberg Kravis Roberts and GS Capital Partners have agreed to buy Harman in a transaction valued at about US$8bn.

Harman shareholders can receive US$120.00 in cash for each share they own, or they can elect to exchange some or all of their shares for shares in the new company (up to 8.3m shares, or about US$1bn). Harman makes audio products and electronic systems for the automotive, consumer and professional markets.

Should these deals get officially nullified, there are implications for banks and buyout shops, neither party wanting to be known to wiggle out of legally binding agreements. That said, there are market participants – beyond lawyers – who laud the development. “I’m not surprised that is it happening,” an investor said. “I think there will be less supply coming to market than people fear, either with banks stuck holding or deals not getting done. That’s a good thing.”

And it is not only the equity investors who are questioning their existing agreements. GE Capital Solutions’ plans to purchase PHH Corp for about US$1.8bn in cash is under threat because of banks. Agreed to in March, the deal has PHH stockholders getting US$31.50 per share in cash, a 13.3% premium to the announced price.

While that part of the transaction is clear enough, the acquisition is also contingent upon the Blackstone Group’s ability subsequently to purchase PHH’s prime mortgage operations from GE. That is anything but certain.

JPMorgan and Lehman Brothers, which had provided Blackstone a debt commitment letter on March 15, recently sent Blackstone “revised interpretations as to the availability of debt financing under the debt commitment letter”, the firm stated in an SEC filing.

Blackstone has revealed to GE that the revisions could result in a shortfall of as much as US$750m in debt financing. Blackstone is exploring its financing options.