In acquisitions of new platforms, private equity funds typically use a newly formed corporation or limited liability company to make their acquisitions. These “Newcos” typically have no money or resources until they are funded at the closing of an acquisition. Consequently, a key issue in these transactions is what happens if the Newco commits to purchase a business, but fails to do so.
Newcos can agree to pay “reverse break-up fees” to protect sellers against the failure to close. The “sponsor guarantees” are the guarantees of the private equity fund to support the obligations of its Newco. The terror, of course, arises from the prospect of a private equity fund having to make a large payment concerning a transaction that never closes.
Prevalence
In the context of the acquisition of a public company by a private equity fund, it is rare for a public company target to provide the private equity fund with the ability to walk away from the transaction without any liability. Also, in transactions involving debt financing, private equity funds rarely agree to the remedy of specific performance, which is the requirement that a party fulfill its obligations under a contract. Accordingly, reverse break-up fees provide a typical compromise for the buyer to provide the target public company compensation for the buyer’s failure to perform and simultaneously limit the buyer’s liability to an amount below the full purchase price of the transaction.
A recent study of public company acquisitions during the period beginning with the first quarter of 2009 through the first quarter of 2010 by the Practical Law Company, “Reverse Break-Up Fees and Specific Performance: A Survey of Remedies in Public Deals,” found that transactions involving financial buyers provided for a reverse break-up fee in approximately 75 percent of the transactions included in the study. Typically, the reverse break-up fee is equal to or greater than the break-up fee payable by seller.
In the context of the acquisition of a private company by a private equity fund, the approach to remedies in the event that the private equity fund fails to close a transaction is more varied. The remainder of this article will focus on three general strategies that private equity funds employ in private transactions to address a seller’s concerns regarding the buyer’s ability to close.
Avoidance
From a private equity fund’s perspective, the best way to handle reverse break-up fees and sponsor guarantees is to avoid them entirely. This approach works best when the parties agree to a simultaneous sign and close. To do so, the parties need to obtain any third-party or governmental consents or approvals prior to the signing. For example, if the transaction is subject to Hart Scott Rodino filing requirements, this approach typically involves the parties making the Hart Scott Rodino filings based on a letter of intent and then waiting for the full 30 day response period to expire, rather than requesting early termination. While requesting early termination could accelerate the timing, notice of early termination is posted in the Federal Register and could thereby lead to the premature disclosure of the transaction.
Another approach to avoiding reverse break-up fees and sponsor guarantees is for the private equity fund to convince the seller that they are not necessary. Commitment letters from lenders help demonstrate the ability of the private equity fund to close the transaction. Also, private equity funds can argue that they would not have spent the money and time to sign a transaction that they did not intend to close and that their reputation would preclude them from backing out of a deal. In times of greater certainty, this argument frequently prevailed. However, it is less persuasive since the 2008 upheaval in the credit markets and the adverse impact of the recession on numerous industries. In short, sellers are more concerned about the prospect of external forces killing their transaction than they were in decades past.
Ultimately, a seller signing a purchase agreement with a Newco, without a sponsor guarantee, is similar to granting an option. As the period between signing and closing in private transactions tends to be relatively brief, sellers are often willing to assume this risk. Frequently, a seller’s assumption of this risk occurs when no bidders are willing to step up with a sponsor guarantee because of uncertainties in financing, such as due to turmoil in the credit market or customer concentration concerns. In addition, if a private equity fund has offered a higher price than other potential buyers, the higher price may outweigh the risk of the transaction not closing from the seller’s perspective.
However, in a well run robust auction process, the key for a seller is to shorten the time between selecting a bidder and the bidder entering into a definitive agreement. Having a signed agreement with significant remedies in the event of a default deters the bidder from attempting to renegotiate its price. Also, avoiding a delay in time makes it easier to move to the second place bidder if the leading bidder starts to falter or renegotiate deal points. Where private equity buyers desire to obtain third-party financing to close and need time to complete the related documentation with their lenders, sellers usually prefer obtaining a binding agreement before closing and the discussions regarding a reverse break-up fee and sponsor guarantee will likely be unavoidable.
Mitigation
In private transactions, the reverse break-up fee is usually the sole and exclusive remedy in the event that a buyer fails to close under any circumstances and specific performance is disallowed. This approach limits buyer’s liability to a specific mutually agreed-upon amount of liquidated damages and the private equity fund provides a guarantee limited to the agreed upon amount. An alternative approach is to provide a reverse break-up fee as the seller’s sole and exclusive remedy only in the case of a buyer’s inability to obtain its debt financing, but to provide the seller with the right to seek damages or specific performance if the buyer fails to close for non-financing related reasons.
A private equity fund buyer can attempt to mitigate its risk in other ways as well. The private equity buyer should try to ensure that its lender’s walk-away rights under the commitment letters match the buyer’s walk away rights under the acquisition documents. Also, where time permits, the buyer can enter into a definitive credit agreement at the same time it signs the acquisition agreement.
A buyer should also try to obtain favorable conditions to closing, such as requiring that the seller’s representations and warranties be true as of the closing in all material respects. A seller would prefer to have this “bring down” closing condition be deemed to be satisfied unless the failure of its representations and warranties to be true would cause a “material adverse effect,” or MAE on the seller. However, as was demonstrated again recently in the Hexion Specialty Chemicals, Inc. v. Huntsman Corp. (September 29, 2008), MAE is a very high standard. In the Hexion case, the target experienced a 32 percent decline in its projected EBITDA. The court found that this did not constitute an MAE because the downturn was temporary in nature and noted that no Delaware court had ever found an MAE in the context of a merger. While an MAE standard is typical in a public company deal, a materiality standard is more common in the acquisition of a private company. According to the American Bar Association’s “2009 Private Target Mergers & Acquisitions Deal Points Study,” a seller’s “bring down” condition was qualified by “in all material respects” in 58 percent of the deals included in the study and by “MAE” in only 34 percent of the deals included in the study.
Going All In
Although a reverse break-up fee can soften the blow to a seller of a busted deal, the amount is not sufficiently large to allow an individual seller to recognize his financial bonanza or for a private equity seller to significantly move the needle in delivering a strong IRR to its investors. Consequently, in the context of a robust auction for a high quality company, sellers sometimes require that private equity funds commit to fund the entire amount necessary to close. Under this approach, the seller is entitled to specifically enforce the transaction so that the seller can be assured that the closing will occur if all conditions to the closing have been met.
Private equity funds that guarantee the money required to close typically have the ability to fund the entire transaction without the support of a third party lender. Frequently, the private equity fund simply bridges the debt and then refinances the debt with a third party lender at a later date. Of course, under this approach, there is no option for the buyer, so the private equity fund needs to get comfortable that if all the conditions to close are met that it will in fact close the transaction.
Conclusion
In light of the large amount of equity chasing a limited number of transactions, private equity funds will continue to be pushed to step up to the plate with significant money to back their Newco commitments. Reverse break-up fees and sponsor guarantees are not for the faint hearted, but then neither is private equity investing.
William Simpson serves as chair of the the Global Private Equity practice at Paul Hastings. Brandon Howald is a partner in the Corporate practice.
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