Slip out the back, or make a new plan?

In his 1975 hit song about ways to end a stale relationship, Paul Simon told his audience that there were 50 ways to leave a lover.
These days, many sponsors wish that Simon’s lyrics could be readily applied to private equity transactions signed prior to the credit crunch.
But, as many have learned, breaking up is not always easy. True, many pre-crunch deals effectively are structured to give sponsors the option to abandon the transaction upon payment of the reverse breakup fee (though, technically, most contracts provide that the reverse breakup fee is triggered by the target’s termination of the contract following the sponsor’s refusal to close). Others, however, prevent an easy exit by granting the target a specific performance remedy. Yet others, such as the Cerberus-United Rentals transaction include contradictory provisions that require a court to decide whether there is a walk-away right or not.
What’s more, even where the contract permits a sponsor to “slip out the back” (after depositing the fee check on the counter), several considerations weigh against a decision to terminate. Firstly, exercising a walk-away right, or attempting to reduce its price tag by involving a target in litigation over whether or not there has been a material adverse effect, or MAC, may leave a sponsor’s name tarnished. Concerns about reputation have begun to fade as an increasing number of private equity firms go down the termination route. But, ultimately, the jury is still out on this issue and will not be in until deal activity levels surge again. Secondly, even where the contract with the target is clearly structured as an option, different members of a buy-out consortium may have different appetites for exercising the termination right. And thirdly, paying a reverse breakup fee is, euphemistically put, not an ideal deployment of capital and the reaction of limited partners to the payment of these fees has yet to be fully tested.
Given these considerations, it is perhaps not surprising that, so far, sponsors have exercised the walk-away right in only a relatively small number of pre-crunch transactions. And it is likewise not surprising that, in many of these abandoned transactions, sponsors did not get stuck with payment of the full fee. Instead, sponsors often were successful in negotiating a reduction of the fee with the target (typically in situations where the sponsor was able to make a strong case that a MAC had occurred despite the many exceptions to MAC provisions that private equity firms have come to accept over recent years) or in getting the lenders to share in the fee.
Where “staying together” is not feasible economically and “breaking up” is hard to do, the focus turns to a third category of transaction: those that were renegotiated. Here is a look at some examples:

Getting everyone to give a little (or a lot)
With targets falling behind projections and industry comparables declining, perhaps the most logical angle for renegotiation is to seek better pricing terms from the target.
Such was the outcome in the acquisition of Home Depot Supply by Bain Capital, Carlyle and CD&R. The sponsor group believed it had a plausible argument that a MAC had occurred, but rather than taking the MAC battle to court, terms for the acquisition were modified.
The aggregate transaction price was reduced from $10.3 billion to $8.5 billion and Home Depot agreed to acquire a 12.5% equity stake in the surviving entity and to guarantee a portion of the acquisition debt. Some of Home Depot’s concessions were passed through to the lenders: the debt package was reduced by approximately 30% to $5.9 billion and restructured to take the form of an asset backed loan with higher interest rates on portions of the debt. The buyout consortium, in turn, increased its equity stake.
A similar compromise, also with a price reduction as its core, was reached in the acquisition of subprime mortgage lender Accredited Home Lenders by Lone Star Funds. In this transaction, the dispute over whether or not there had been a MAC did make it to the courts, but the parties settled the litigation and struck a new deal, including a reduction in purchase price (from $400 million to $296 million), an interim loan provided by Loan Star and intended to keep Accredited Home Lenders afloat, and a deletion of the no-MAC condition. The new agreement also permitted Lone Star to actively solicit better of fers and to terminate the agreement upon the emergence of a superior offer at half of the originally contemplated break-up fee.
A variation on the price-reduction theme can be seen in the August amendment of the (now terminated) acquisition of Reddy Ice Holdings by GSO Capital Partners. Reddy Ice agreed, along with other amendments, to cap the dividends Reddy Ice could pay until closing, thus reducing total cash to shareholders. As with the Home Depot Supply transaction, the reduction in price came in tandem with an equity roll-over, in this case by a minority shareholder of Reddy Ice.
Reddy Ice also granted GSO Capital Partners an extended period to market the debt.
Two factors, both interesting from a sponsor perspective, contributed to the Reddy Ice transaction ultimately failing despite the August amendment. For one, the debt financing sources threatened to withdraw from the deal, claiming that the August amendment required their consent. Reasonable minds may have different views on whether the Reddy Ice amendment was in fact adverse from the lenders’ point of view, but the position taken by the banks demonstrates a crucial point that sponsors should bear in mind when planning to renegotiate pending transactions: financing sources may, at least as long as current market conditions prevail, seek to leverage any amendment to the terms of a pending transaction to extricate themselves from the original commitment or, at least, improve its terms. A case in point, further illustrating the current interplay between renegotiation and lender commitments, is the law suit brought by one of the debt financing sources following Providence’s and Clear Channel’s agreement to reduce the price tag for the acquisition by Providence of Clear Channel’s television Group (the law suit is now settled and not to be confused with ongoing litigation regarding the financing of the Clear Channel buy-out).
For another, GSO’s termination right survived the August amendment of the merger agreement permitting GSO to walk from the transaction for a fee payment of $21 million. This illustrates another important point, i.e., the enormous bargaining power that comes with a clean walk-away right. While GSO managed to preserve the option character of its agreement, sponsors should be aware that those provisions may not always survive renegotiation. In any renegotiation, target boards may seek to prevent sponsors from having a second bite at the “walk-away apple” or to significantly reduce the appeal of the walk-away right by increasing the economic pain associated with its exercise (the reverse break-up fee) or by limiting the circumstances in which it is available.

A closer look at the existing debt
Renegotiation does not necessarily have to involve pricing concessions on the part of the target. The lenders for BC Partners’ contemplated acquisition of Intelsat initiated an amendment of Intelsat’s existing debt that permits leaving the debt in place after BC Partners takes control. To make the proposition appealing, Intelsat’s existing lenders were promised higher spreads, tighter covenants, call premiums and an amendment premium of 500 bps. Rolling-over a target’s existing debt, as in the Intelsat transaction, is no doubt an appealing alternative when new financing is not readily available although doing so will often require an amendment, and, along with it, possible negotiation of an amendment fee and increased interest rates, among other concessions.
Sponsors may thus want to explore with counsel whether a particular transaction can be structured—at least on an interim basis until the financing markets improve —to fit within the confines of the change of control, restricted payments, and other covenants of a target’s existing debt. Such a structure may be possible, for example, where the transaction includes a significant target shareholder who constitutes an exempt person for purposes of the change of control definition.
However, sculpting a transaction around a target’s pre-acquisition debt may necessitate major changes to the envisioned equity and governance arrangements and those changes may or may not be palatable from the sponsor’s perspective. In addition, even the most careful structuring around a target’s existing debt documents may not eliminate all risk that the target’s banks will seek to accelerate the loans, whether at closing or at a later point in time, if they have a different view.

Buying time
In lieu of seeking a reduction in deal price—directly from the target or via enhanced financing terms—two transactions reflect another strategy: buying time.
The first of these two is Goldman Sachs Capital Partners’ proposed acquisition of Myers Industries – a transaction that was called off for good in April.
Shortly before the contract’s original “dropdead” date in December of 2007, GSCP obtained an amendment that permitted it to delay closing until 15 days after delivery by Myers of its first quarter 2008 financials. To get this extension, GSCP agreed to make a nonrefundable $35 million payment to Myers (an amount not coincidentally equal to the reverse breakup-fee) and conceded that there had not been a MAC as of the amendment date. The amendment also included a renouncement by Myers of its right to seek specific performance, a waiver of any further rights to the reverse breakup fee, and a consent to GSCP terminating the limited guarantee (curiously, effective as of the date of the amendment, i.e., before the actual payment of the $35 million). Myers, in turn, was permitted to shop the company and to terminate the contract upon emergence of a superior proposal without payment of a break-up fee though GSCP retained an express six-day matching right. Myers was also freed from many of the restrictions of the interim covenant. Finally, Myers was granted the right to pay a special $10 million dividend to its shareholders and given the green light to repurchase its shares at prices lower than the merger consideration.
Dubbed “The Goldman Sachs No-Fault Divorce” by the Wall Street Journal, the Myers approach could just as aptly be characterized as a “friends with benefits” arrangement. Assuming that GSCP would not have been able to successfully assert a MAC, GSCP would have been required to pay the reverse breakup fee upon passage of the debt marketing period in any event. Rather than merely a payment for release from its obligations, the fee payment thus effectively bought GSCP time to make up its mind, including on whether or not to ask for a price reduction in the future. Permitting Myers to effectuate repurchases while the transaction remains in limbo adds an interesting twist to this compromise. Had the deal gone through, repurchases below the deal price could have made the overall economics sweeter from GSCP’s perspective. Now that the deal is off, repurchases may well be a plausible strategic alternative from Myers’ perspective.
That said, sponsors should be mindful that share repurchases by a public target during a pending transaction present their own legal challenges. Firstly, they confront the target board with a conundrum, i.e., whether permitting the shareholders to effectively make a bet on the fate of a pending buy-out constitutes an appropriate discharge of the board’s fiduciary duties. Secondly, where Rule 13e-3 applies, any repurchases will likely be viewed as an initial, integrated part of a control transaction, requiring the filing of an information statement with the SEC or an amendment to an existing Schedule 13E-3.
Thirdly, repurchases may expose a target (and the sponsor) to claims of trading on the basis of material nonpublic information (e.g., assertions that the target and its officers had information about the state of the acquisition financing that was not public at the time of the repurchases) or market manipulation claims. While the securities laws exposure can be managed to some extent with careful legal planning, including by adopting a 10b5-1 plan and bringing repurchases inside the safe harbor provisions of Rule 10b-18, such structuring may have its own drawbacks (such as the volume limitations of Rule 10b-18) and may not fully insulate the parties from litigation risk.
Another renegotiated acquisition that could be viewed as reflecting a play for time, on the sponsors’ part, is the acquisition of Harman International. In lieu of commencing litigation over whether or not there had been a MAC, the parties agreed to convert the KKR and GSCP-led going-private transaction into a $400 million PIPEs (private investment in public equity) investment in the form of convertible debt. As in Myers, the proceeds of the $400 million investment were earmarked, among other things, to permit Harman to conduct share repurchases.
The debt securities will pay out 1.25% interest annually. They can be converted into Harman shares should Harman trade up to $104 per share in the next 5 years, a number well below the $120 deal price but significantly higher than the current hare price.
KKR also was given a board nomination right.
PIPEs transactions raise a host of legal and strategic issues. But a threshold concern is feasibility. Whether or not a particular PIPEs investment is permissible under a target’s organizational and debt documents should always be carefully reviewed with counsel. Where practicable, though, acquiring a minority stake in a public target may prove an interesting play for time and can give a sponsor a leg up with respect to a control transaction at a later juncture.

The outlook
As of early April, more than 40 private equity transactions with an aggregate transaction value of in excess of $60 billion involving North American targets that were signed prior to the credit crunch were pending. While it is safe to predict that the next weeks and months will bring more “slipping out the back” and more “making new plans,” it remains to be seen whether the credit crunch will show us 50 different ways (or at least 40) for sponsors to get themselves free. A separate question is how the changed economic environment will impact deal terms going forward. We expect that meaningful answers to this question will likely remain elusive until more sizeable, precedent-setting transactions make a comeback.

Stefan Stauder also contributed to this article

Franci J. Blassberg is a partner and Stefan P. Stauder is counsel at Debevoise & Plimpton LLP. This article originally appeared in the Winter 2008 edition of the Debevoise & Plimpton PER.