Jack Bodner and Peter Schwartz are both partners at law firm Covington & Burling LLC in New York. Bodner is in the firm's mergers and acquisitions, corporate governance and securities groups, while Schwartz focuses on corporate finance, mergers and acquisitions and private equity. Bodner can be contacted at firstname.lastname@example.org and Schwartz at email@example.com.
From early 2005 until the middle of 2007, the market witnessed a dramatic increase in private equity-led LBOs of public companies, culminating in a number of ?mega? deals. The increase in LBO activity and dollar size of transactions was fueled in part by private equity sponsors under pressure to invest much larger funds and aggressive lending by banks and institutional and overseas investors with rising corporate profits. At the same time, many public companies were motivated sellers, looking to escape the burdensome regulatory environment of being a public company in the post-Enron Sarbanes-Oxley world. Finally, LBO valuations were high, with sponsors able to achieve higher leverage multiples and pay more while funding less equity. This perfect storm saw more robust competition among financial sponsors for the target company with lenders easing terms of their commitments to vie for a larger piece of the financing pie. Empowered target companies negotiated for greater deal certainty and higher takeout prices, and the credit markets, buoyed by lower default rates and the emergence of collaterized loan obligations (CLOs) which allowed lenders to access even more cash to finance the LBOs, provided cheaper financing with less conditionality.
Below are examples of deal terms that became more prevalent or took on a greater level of importance in going private LBOs over the last few years.
Buyers, sellers and lenders will approach negotiations and drafting with a heightened sensitivity to terms affecting deal certainty.
Go-Shop Provisions – Go-shop provisions give a target company some period of time (typically 20-45 days) following the signing of the merger agreement to seek higher offers and pay an agreed upon break-up fee to the buyer if a higher offer is accepted. While these provisions were pervasive in public company LBO transaction documents over the last two years, there were few examples where the go-shop provision actually resulted in a higher offer, most notably Community Health's $6.8 billion topping offer for Triad Hospitals. Prior to 2005, it was almost invariably the case that a public merger agreement involving a private equity buyer would contain a no-shop provision prohibiting a target company from soliciting third party interest in acquiring the target following the signing of the merger agreement.
Financing Condition – One term that disadvantaged private equity buyers as compared to corporates was that private equity buyers would typically insist on a financing condition in the acquisition agreement. However, with intense competition among bidders to offer more deal certainty to a target company, coupled with a willingness on the part of the banks competing to finance the acquisitions to forgo previously standard conditions to funding (such as ?market-outs?) and instead mirroring the conditions in the acquisition agreement, private equity sponsors in large LBO transactions no longer insisted on financing conditions. That is, buyers were willing to take the risk that they would be in breach of the acquisition agreement if the financing were not available at closing because of their view of the strength of their financing commitments.
Material Adverse Change/Material Adverse Effect – Material adverse change conditions and material adverse effect definitions have been included in acquisition agreements for years. However, in an attempt to obtain more certainty to closing, target companies have more recently been successfully negotiating for broader exceptions to what constitutes a material adverse effect. Some typical exceptions include changes in general economic, legal, regulatory or political conditions, changes in the industry in which the target company operates, effects resulting from the announcement of the agreement, changes in law, failure to meet projections and any increase in cost or availability of buyer financing.
Reverse Break-up Fees – Sponsors typically use a newly formed ?shell? company to enter into the acquisition agreement with the target company and make the acquisition. The reverse break-up fee, guaranteed by the fund sponsor itself and not just the acquisition company, which made one of its earliest appearances in the merger agreement involving the $11.4 billion acquisition of SunGard Data Services by a consortium comprised of seven private equity sponsors, was meant to compensate the target company in situations where the buyer could not otherwise obtain the financing necessary to complete the acquisition. In many cases, the reverse break-up fees served as a cap on all damages against the sponsor or acquisition company and in effect an option on the target company. However, the language was not always crystal clear, and the target companies often viewed the reverse break-up fees not as an option on the company, but as a payment of last resort after the buyer complied with its obligations to try to obtain the financing.
Specific Performance – Until recently, specific performance clauses were viewed by many as mere legal boilerplate in merger agreements. However, the interplay between the reverse break-up fee and specific performance has made headlines with the recent fracas involving United Rentals and Cerberus. Absent unambiguous language that a target company is entitled to specifically enforce the acquisition agreement, at least one court has concluded that the sponsor may choose to voluntarily breach the merger agreement (for example, by refusing to borrow the debt financing necessary to complete the acquisition) and instead pay an agreed upon reverse break-up fee representing its maximum exposure to the target company for such breach.
PIK/Toggle Notes – Payment in kind notes do not require cash outflow as there is no amortization and interest is rolled up into additional principal. Toggle notes allow the issuer to elect whether to make interest payments in cash or in kind. These types of debt instruments, which were popular during the late 1980s buyout boom, but fell out of favor in the 1990s, reappeared in the last few years and provide significantly greater flexibility to the issuer.
Covenant Lite – Indebtedness with ?covenant lite? packages contain minimal or no, previously customary, requirements on the part of the issuer to meet certain financial maintenance metrics (e.g., debt/EBITDA or interest expense to EBITDA ratios) to avoid defaulting. This lack of maintenance covenants took away the comfort lenders previously had that they could exercise remedies against the issuer or renegotiate terms if it looked like the issuer's financial condition was deteriorating.
Market Flex/Reverse Flex – Market flex refers to the right of the lenders to change the structure, terms or pricing of the debt in part to achieve successful syndication of the debt. Over the past few years, borrowers benefited from market flex language that was often very narrow, limiting the lender's ability to change interest rates only to certain specified terms, such as increasing pricing by an agreed upon number of basis points. In additional, with the strong appetite for LBO debt, many deals saw ?reverse flex,? where competition by investors for the loans resulted in pricing even lower that that agreed in the bank commitment letters.
Over the past six months, the meltdown in the subprime market has created significant instability in the credit markets and chaotic times in leveraged finance. In addition, although dwarfed by the size of the subprime market losses, banks have suffered significant losses funding LBOs, with the banks, rather than the LBO sponsors, taking the losses because they had provided firm commitments at much different prices than the current market would bear. Despite that, there is still a fair amount of unallocated equity among private equity funds, lenders are still in the lending business and private equity M&A and LBOs are continuing, albeit at a reduced pace and at lower valuations than experienced at the height of the buyout boom.
Given the change in the current landscape, what should buyers and sellers in LBO transactions involving public companies expect in regards to key deal terms? The simple answer is that we are likely to see deal terms similar to those terms that existed in 2004, before the private equity buyout boom went into high gear. Issuers who enjoyed covenant lite packages and PIK/toggle notes as a fairly common occurrence are seeing little or no appetite from investors for these types of provisions. Leverage levels are coming back down to earth. While lenders are not universally insisting on ?best efforts? commitments or syndication conditions, the recent difficulty in syndicating deals will likely continue to cause lenders to negotiate for broader flex language allowing lenders to reset all key provisions. Although the ?mirroring? of conditions between the debt financing and the merger agreement served to increase certainty of closing and made a sponsor's bid more attractive to a target company, lenders are likely to negotiate for market-out conditions to protect them from changes in the credit markets, with LBO sponsors wanting to pass this risk on to sellers.
On the acquisition agreement front, while financing conditions have not yet re-emerged, buyers and sellers are expected to focus even more attention on provisions for reverse break-up fees, specific performance and go-shops, with sponsors trying to cap their exposure in the event of a breach or failure to obtain financing and targets continuing to push for deal certainty. In light of some recent deals faltering due to allegations of a MAC, parties to merger agreements will place particular importance on material adverse change conditions and definitions of material adverse effect in an effort accurately reflect the agreed upon carveouts in as clear and unambiguous manner as possible while still not applying a specific dollar threshold to the definition. Lastly, given the lower levels of leverage that will be available to finance acquisitions, sponsors who will have to put up more equity may revert to club deals comprised of a greater number of sponsors as was the case a few years back. Sponsors will likely also look to put funds to work in more traditional PIPES transactions and other non-control situations.
Whatever the terms of a financing commitment or acquisition agreement ultimately may be, one thing is certain. In a more difficult and uncertain financing market, with recent experience of deals getting renegotiated and other deals failing due to allegations of a material adverse change or lack of financing, buyers, sellers and lenders will approach negotiations and drafting with a heightened sensitivity to terms affecting deal certainty.