Targets Apply Lessons Learned In Take-Privates

The going-private market in 2010 had some good news and bad news for private equity sponsors.

The good news was that deals were back with almost 40 going-private transactions announced in the United States with an enterprise value of more than $100 million in 2010 compared to only 14 in 2009. This was largely attributable to relatively generous leveraged financing markets and the attractive valuation levels of many public companies. The bad news was that target companies and their counsel learned a number of lessons from the busted going-privates of the credit crisis and have increasingly squeezed more attractive deal terms from sponsors in these transactions.

Some of the lessons learned by target companies and their counsel included ensuring that the sponsor does not have a “pure option” to terminate the transaction and that the target company has a meaningful remedy against the sponsor in the event of a breach, making more effective use of go-shop provisions and tightening up a sponsor’s financing obligations. As this article highlights, these changes in deal terms have generally allocated more risk to the sponsors than they typically bore in pre-credit crisis going privates.

Closing Certainty And Remedies

The issue most frequently encountered during the credit crisis in going-private transactions was that of closing certainty and remedies (and in particular the interplay between specific performance and reverse break-up fees). With twenty/twenty hindsight, it became clear as broken deals were litigated that the deal terms for going-privates often gave sponsors the option whether to close or not, frequently for a relatively modest reverse break-up fee. This “mispriced” option gave sponsors significant leverage not only to terminate but also to renegotiate terms of announced transactions.

Target companies have since attempted to address that perceived imbalance through a construct referred to as “specific performance-lite” and through more expensive reverse break-up fess. A vast majority of sponsor-backed going-privates over the last year have included specific performance-lite provisions. Under this construct, the target company may specifically enforce a buyer’s obligation to consummate the transaction if the debt financing is available. Target companies have also successfully negotiated for the right in some cases to specifically enforce the buyer’s other covenants (including those relating to using commercially reasonable or reasonable best efforts to obtain debt financing).

If the debt financing is not available and the buyer is unwilling to close, the agreement can be terminated upon the payment of a reverse break-up fee, which now routinely exceeds the previous norm of around 3 percent to 4 percent of equity value (most recent deals have ranged from 5 percent to 10 percent of equity value and one approached 20 percent). The increased reverse break-up fee is intended by the target company to ensure that a decision to walk away from a deal will truly be a painful one for the buyer. Another interesting trend in this area has been the use of two-tiered reverse break-up fees, where a buyer pays a higher reverse break-up fee if it has debt financing but refuses to close or it materially breaches the acquisition agreement. The buyer still has an option not to close a deal it may have lost interest in but it is an expensive option.

More Effective Use Of Go Shops

Another area that target companies and their advisors have focused on over the past year has been go-shops. Several recent decisions by the Delaware courts have looked with scrutiny at the manner in which some public company boards have conducted sales processes, with go-shops being at the center of many of those decisions. While some studies have cast doubt on the effectiveness of go-shops in eliciting competing bids, others have maintained their usefulness, with Justice Strine of the Delaware Chancery Court remarking recently that “among the top [private equity] firms, the difference between a go-shop and no-shop is a meaningful signal.”

And as courts have looked more closely at go-shops, so too have target companies and their advisors. Interestingly, and perhaps reflecting the conflicting views as to the effectiveness of go-shops, there were fewer go-shops employed over the last year than in previous years, but when they were used they tended to be more target-friendly. For example, go-shop periods have been longer and there has been a greater use of a reduced break-up fee payable by the target company during the go-shop period. In 2006, 50 percent of go-shop periods were between 20 and 29 days, but in 2010 only two go-shop periods were between 20 and 29 days and the vast majority were in excess of 40 days (with the J. Crew settlement resulting in a go-shop period of 85 days). Similarly, in 2006, 50 percent of go-shops had reduced break-up fees, as compared to over 60% percent in 2010. These target-friendly provisions theoretically increase the chance that the target will receive a superior proposal during the go-shop period.

Target companies have also attempted to bolster the efficacy of go-shops by negotiating to expand what constitutes an “excluded party” (i.e., a party that makes an offer during the go-shop period and enables the target company to pay the reduced break-up fee if it signs up a deal with that party). Historically, buyers have argued for a “hard-stop,” which cuts off a party from being an “excluded party” within a proscribed period from the end of the go-shop period. Recent deals have broadened what constitutes an excluded party. For example, in The Carlyle Group’s acquisition of CommScope, not only could a person who submitted a superior proposal during the go-shop period remain an excluded party indefinitely, but the agreement also permitted any group that includes a person who had made a superior proposal during the go-shop period (regardless of the percentage of equity value that person has in such group) to constitute an additional “excluded party.” By expanding the situations in which the reduced go-shop break-up fee would be payable, target companies are attempting to increase the likelihood of a superior proposal from a competing bidder.

Another device that target companies have focused on recently is the matching right, which gives the buyer the ability to match any potentially superior proposal made by a competing bidder. Most larger recent deals have a match period of three days or less as opposed to an average of three and a half days in 2009 (and almost five days in previous years). Though still in the minority, some recent deals have eliminated the buyer’s matching rights if there is a proposal by a competing bidder that exceeds a certain percentage of the initial offer.

Financing Certainty

Target companies have also been taking a harder look at debt financing commitment papers and have been tightening the terms of their acquisition agreements in response. As discussed above, target companies are increasingly seeking the ability to specifically enforce a buyer’s covenant to use commercially reasonable or reasonable best efforts to obtain the debt financing required to close the deal and are attempting through two-tier reverse break-up fees to extract a higher reverse break-up fee from the buyer if the transaction doesn’t close due to a breach by buyer of this covenant.

In addition, target companies are refocusing on the “marketing period” concept in acquisition agreements. The marketing period is designed to ensure that a buyer cannot be forced to close an acquisition until the banks financing their acquisition have had sufficient time to syndicate bank debt or market bonds. The marketing period (typically at least 20 business days) commences only upon the delivery by the target company to the buyer of the “required information” for the syndication or marketing effort. Traditionally, required information was defined in a way that gave buyers the opportunity to claim that the period had not in fact started based upon management’s alleged failure in providing this information. In the past year target companies have sought to reduce the opportunity for disputes over whether the marketing period had started by more precisely defining the required information and by providing that the marketing period started once the target company delivered notice to the buyer confirming that it had provided the required information.

What is clear based on these recent trends in going-private transactions is that target companies went to school during and after the credit crunch and learned a number of lessons which have migrated into the new generation of deal documents. For sponsors, these changes in deal terms have generally allocated more risk to sponsors than they typically bore in pre-credit crisis going privates.

Doug Warner is a senior partner with Weil Gotshal’s Private Equity practice and Co-head of the Firm’s Hedge Funds practice. Christopher Machera is a corporate associate, focusing on private equity. Both are based in New York