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Slip out the back, or make a new plan?

Some recently renegotiated private equity deals reveal the complexity of changing terms after the ink's dry.

Franci J. Blassberg is a partner and Stefan P. Stauder is counsel at Debevoise & Plimpton LLP. For more details on the firm, visit www.debevoise.com.

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 offers 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.

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

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.