The string of failed deals and related litigation that followed the financial crisis that commenced in 2008 sharpened the focus of private equity (PE) buyers, target companies and their advisors on deal terms surrounding acquisition financing risk and deal certainty, with a resulting combination of provisions designed both to make a buyer’s exit from a deal more painful and to state more clearly under what circumstances a buyer can walk from a deal with well-defined limits on damages. Parties to PE buyout transactions need to be keenly aware of their contractual rights and obligations when the economics surrounding a deal and the financing for the deal deteriorate after signing and closing becomes less certain.
In the 1990s and earlier, PE buyers often negotiated “financing outs,” allowing them not to close if they were unable to obtain financing for the transaction. Sellers signed up to these deals relying in part on a reasonable perception that buyers and their financing sources would take steps required to close on the financing and acquisition or face dire reputational risks. This deal framework began to change in the 2000s as sellers in an active M&A market began requiring that buyers pay a price — a so-called reverse break-up fee — for walking away if the financing failed. When the financial crisis hit in 2008, some PE buyers looked to their contractual rights to exit deals whose value proposition no longer made sense and where obtaining the requisite financing had become a real challenge. Some simply paid the negotiated reverse break-up fee while others sought to avoid the break-up fee by claiming a breach by seller or the occurrence of a MAC (the merits of which surely varied from deal to deal). Some sellers were caught off guard as provisions designed in part to prevent failed deals began to be viewed at times as option agreements by buyers.
In the wake of the financial crisis, PE buyout terms retained the key features of reverse break-up fees. However, the challenges of busted deals during this period led to drafting modifications of related specific performance provisions, exclusive remedy provisions and financing representations, warranties and covenants, designed to set forth more precisely the parties’ rights and obligations relating to financing risk. In this article, we will examine how these provisions are typically structured, and look at some common variations. We will also survey key financing risk deal terms in 2012 year-to-date private equity buyouts of public companies and, where the terms have been made public, private companies or divisions of public companies, in each case where a substantial portion of the purchase price was funded through debt financing (see table on pages 6-7). Overall, financing risk deal terms in 2012 remain on the now familiar course that has been set over the past several years. Note that most of the transactions we surveyed were public merger transactions. For purposes of this article, the target company is the company being acquired in a public deal and the seller is the seller of a division or subsidiary in a private acquisition.
Shell Company Buyer with Limited Guaranty from Fund
In a PE buyout transaction, the purchasing entity that signs the acquisition agreement will typically be a newly formed shell company of the PE buyer with no assets. The sponsor will arrange for acquisition financing through financing commitments from third party lenders and equity commitments from the PE fund. Additionally, the PE fund will typically provide the seller with a limited guaranty covering certain obligations of the shell buyer, including the payment of the reverse break-up fee. This structure provides a fundamental backdrop to the discussion of key risk allocation terms below, as the buyer party to the definitive agreement itself has limited resources. This structure has been and continues to be part of the reality of selling to a PE buyer that sellers have accepted.
Financing Representations, Covenants and Conditions
When a private equity buyer relying on third party acquisition financing enters into an acquisition agreement, sellers require some comfort regarding the terms of the equity and debt commitments that will form the basis for funding the purchase price. The buyer will typically represent and warrant to the seller that buyer has provided seller with true and complete copies of the debt and equity commitment letters and that they are in full force and effect.
In addition, private equity buyers typically will covenant to take certain actions to consummate and obtain the financing under the commitment letters. Under these provisions, buyers will most commonly agree to use “commercially reasonable efforts” or “reasonable best efforts” to take actions needed to essentially make the financing happen. (In the 2012 deals we surveyed, 64% included a “reasonable best efforts” standard and 36% included a “commercially reasonable efforts” standard.) Buyer’s financing covenant typically includes maintaining the commitments, negotiating definitive agreements, satisfying financing conditions and causing the lenders and equity financing providers to fund at the closing. As sellers have insisted on specific performance provisions allowing them to seek specific performance of buyer’s covenants (short of forcing a closing if the financing ultimately is not available), the buyer’s financing covenant is a critical provision. Seller’s contractual right to force performance of buyer’s financing covenant may be the ultimate path to closing on the needed financing.
As such, seller’s counsel will often insist on robust financing covenants including (i) an obligation to promptly notify seller of any defaults or disputes with the financing parties or of any reason buyer in good faith believes it will not be able to obtain the financing, (ii) an obligation to keep seller updated on status of the financing efforts, (iii) a right to consent to any modification to or replacement of existing financing commitments that have a material impact on the transaction, and (iv) an obligation to use reasonable best efforts to obtain alternative financing if the initial financing becomes unavailable.
In addition, some sellers have successfully negotiated a provision requiring the buyer to commence litigation against financing sources to compel funding, although buyers are usually successful in resisting such an affirmative obligation in part because their lenders object to its inclusion in the purchase agreement. In the 2012 deals we surveyed, while 43% included an express covenant of the buyer to enforce its rights under the debt financing commitment letter, only 14% included an express obligation to commence litigation.
With respect to closing conditions, while express financing conditions were commonplace in LBOs years ago, they became much less common in the 2000s and remain rare. From a practical standpoint, the combination of reverse break-up fees and limited specific performance remedies still means that PE buyers can exit a deal if the debt financing does not materialize; however, doing so will come with a price tag. PE buyers need to be mindful of their covenant to use an agreed upon level of efforts to obtain financing (and seller’s related specific performance remedy).
Enforcing Buyer’s Obligations
What rights does a target company have to enforce the buyer’s obligations under the agreement in the event of a breach? Suing for damages is a possibility, but of course the buyer is a shell company and, as discussed below, buyers often negotiate caps on damages and/or payment of a reverse break-up fee as an exclusive remedy provision. Sellers then look to the availability of specific performance as a remedy for breach. In the pre-financial crisis era, sellers often agreed to limit or eliminate any right of specific performance which, together with a reverse break-up fee as an exclusive remedy, resulted in so-called “pure option” deals for PE buyers — they could simply decide not to close and opt instead to pay the reverse break-up fee without the seller having the contractual hammer of specific performance. Post-financial crisis and cringing from the late 2007 United Rentals/Cerberus decision (where the Delaware Chancery Court held that the target company could not seek specific enforcement in light of ambiguous and conflicting provisions in the agreement), sellers and their counsel focused hard on drafting provisions designed to strengthen specific performance as a pre-termination remedy.
Deals today still vary in terms of how extensive the seller’s specific performance right is, with sellers sometimes agreeing (although this was not the case in any of the 2012 deals we surveyed) to waive this remedy entirely. Sellers have been increasingly insistent that they have the right to seek specific performance of all of buyer’s covenants under the purchase agreement, with the exception of the obligation to close or seek the equity financing in the event the debt financing is not available. In most recent deals (including the 2012 deals we surveyed), the target company will be entitled to an injunction to enforce the terms of the agreement, but will not have the right to seek specific performance of the buyer’s obligation to cause the equity financing to be consummated and to close the acquisition unless (1) all closing conditions have been satisfied, (2) the debt financing has been funded or will be funded at closing if the equity financing is funded and (3) the target company confirms it will close if the equity financing and debt financing is funded.
The upshot of all this is that target companies can seek specific performance of the buyer’s financing covenant to use “reasonable best efforts” or “commercially reasonable efforts” to obtain the financing and, as discussed above, in some cases to commence litigation against financing sources to compel funding. Of course, the buyer’s obligation to obtain financing is not absolute and the measure of “reasonable best efforts” or “commercially reasonable efforts” is not always clear, but having this remedy in addition to a reverse break-up fee puts some teeth in a PE buyer’s financing covenants.
Damages — The Reverse Break-Up Fee
As discussed above, while PE buyout transactions funded with third party debt financing typically do not contain financing outs, they almost always contain a reverse break-up fee payable by the buyer in the event the agreement is terminated as a result of buyer’s material breach or failure to obtain the financing. More often than not, PE buyers will also successfully negotiate terms providing that upon payment, the fee is the sole and exclusive remedy of the target company and capping damages at the amount of the fee even in the case of a willful breach. Importantly, the PE fund will typically provide a guaranty of the shell buyer’s obligation to pay the reverse break-up fee.
In some deals, target companies have required different treatment for “willful breach,” with some PE buyers agreeing to uncapped damages in the case of willful breach (in which case the financial backing of a shell buyer’s obligations will be an obvious point to consider) or a two-tiered fee structure with a higher fee, or damages capped at a higher amount, payable in the event of a “willful breach.” Some of these deals have attempted to define willful breach so as to distinguish deliberate acts from actual knowledge that the act would constitute a breach of the agreement. The two-tiered structure began to appear several years ago as target companies sought to punish more harshly buyers who willfully breach their obligations under the agreement and walk away. However, the structure has not taken hold in recent deals, with only 14% of the 2012 deals we surveyed containing a 2-tiered fee structure.
What has happened since the financial crisis is a clear shift in the size of the reverse break-up fee from the typical 3-4% of deal size when these fee structures became common in the mid-2000s to 5-7% of deal size in the post-financial crisis era. Target companies recognized that steeper fees were needed to incentivize buyers to push hard for financing needed to close. In the 2012 deals we surveyed, the average reverse break-up fee was 5.32% of deal value (not taking into account one outlier transaction with an exceptionally low reverse break-up fee). It should also be noted that the same “fiduciary duty” concerns that constrain the size of break-up fees payable by sellers do not apply to reverse break-up fees payable by buyers, so sellers are free to negotiate the higher fees that we have seen over the last several years.
In 2012, the approach of capping damages at the reverse break-up fee as an exclusive remedy is still the norm for PE led buyouts, with all of the deals we surveyed providing that the fee is the exclusive remedy if paid (and with 42% expressly providing that damages for willful breach are also capped at the reverse break-up fee amount). As noted above, only 14% of the deals employed a 2-tiered structure.
The contractual interplay between specific performance and the reverse break-up fee is an important area of focus for deal lawyers. If the parties intend that the target company has specific performance remedies (short of forcing a closing or funding of the equity commitment unless the debt financing is there), target company’s counsel needs to ensure that the exclusive remedy language of the reverse break-up fee only applies in the circumstances where the fee is payable and does not foreclose the target company from seeking injunctive relief to compel compliance with the financing covenant before the reverse break-up fee is payable by the buyer. On the other hand, PE buyers that do not wish to enter a transaction with any recourse beyond the reverse break-up fee in all cases, need to ensure that seller’s remedy of specific performance is appropriately limited, and avoid confusing and dueling provisions that can lead to differing interpretations as was the case in the Cerberus/United Rentals dispute. And in any event, if the buyer pays the reverse break-up fee, buyer will want the language to be clear that at that point there is no further recourse against the buyer for either damages or specific performance.
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Lenders Continue to Want a Say on Certain Acquisition Agreement Terms
As lenders became entangled in litigation surrounding PE buyouts following the 2008 financial crisis, they began to insist on the inclusion of certain protective provisions in merger and acquisition agreements designed to limit their exposure to litigation attacks by sellers in the event of a failed transaction. These provisions are sometimes referred to as “Xerox” provisions, named after the 2009 Xerox Corporation/Affiliated Computer Services, Inc. merger agreement in which they first appeared. Xerox provisions now commonly seen in acquisition agreements include some or all of the following:
- Limitation on Damages: As is the case for the buyer, the agreement will provide that payment of the reverse break-up fee is also the sole and exclusive remedy of the target company against the buyer’s financing sources.
- Exclusive Jurisdiction in NY and Waiver of Jury Trial: Lenders frequently require that the agreement expressly provide that any actions relating to the financing be brought exclusively in NY courts. In addition, the agreement will often provide for an express waiver of jury trial in any such actions.
- Third Party Beneficiary/Amendments: The agreement may provide that the lenders are express third party beneficiaries of these provisions, and in some cases will also provide that these provisions cannot be amended without the consent of the lenders if the amendment would have an adverse effect on the lenders.
The chart on page 4 indicates that many of these provisions remain market in 2012 merger and acquisition agreements. PE buyers, sellers and their counsel should be aware that lenders will want to review the merger or acquisition agreement and will likely request inclusion of some or all of these provisions if not already provided for.
Chadbourne Summer Associates Yisroel Cohn and Chukwudi Udeogalanya assisted with the research for this article.