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Private equity-led buyouts of public companies have reemerged over the past year or so, with at least 19 announced deals since November of 2009. Although this may not signal a return to the pace of the market in 2006-2007, it has provided an opportunity to test the durability of some of the key paradigms under which PE deals were done during that period. This article focuses on the state of play in recent deals with respect to one of the most heavily scrutinized constructs of that era--the suite of provisions that address the target's remedies in the event the buyer fails to close. These provisions are increasingly important in today's market, as private equity buyers are pressured by sellers to tighten the terms of their acquisition agreements while at the same time as lenders are attempting to loosen their financing commitments.
At the peak of the PE deal market in 2006-2007, "reverse termination fees" (or "RTFs") and waivers of the target's right to seek "specific performance" (a court order requiring the buyer to perform its obligations) often combined to effectively give the buyer an "option," i.e. , the ability to walk from the deal with its liability capped at the amount of the RTF. RTFs during this period were typically in the range of 2-4% of the deal's equity value, although in some instances the buyer was potentially liable for a higher amount--in the range of 6% --if the target could prove that its actual damages exceeded the amount of the RTF. And the target was often prevented from seeking specific enforcement of the buyer's obligations, leaving collection of the RTF as its sole remedy.
In the second half of 2009, in the middle of the deep freeze of the credits markets, three non-leveraged public-to-private transactions (two of which were structured as tender offers) deviated from this paradigm. In July of 2009, Apax Partners agreed to a reverse termination fee of $570 million, or 100% of the value of the transaction, in its acquisition of Bankrate, Inc. In September of 2009, Advent International and Harbinger Capital Partners each signed up deals with no RTF or other cap on damages in their acquisitions of Charlotte Russe and SkyTerra Communications, respectively. But these three deals were unique for a variety of reasons, most importantly the absence of debt financing, which eliminated the primary risk that led to the RTF-based remedies regime in the first place.
After the Freeze: A New Model?
Demonstrating the unique circumstances surrounding these deals, the trend in the all equity-financed Bankrate, Charlotte Russe and SkyTerra deals has not carried over to the leveraged deals now being done by PE firms as we emerge from the credit freeze. Indeed, as the more recent sponsor-backed public company buyouts show, what constitutes "market" for remedies provisions in leveraged deals appears to have largely returned to the paradigm established during the height of the PE deal market, albeit with higher RTFs and an increased focus on specific performance in most, but not all, deals.
Almost all of the recent public-to-private transactions surveyed have included an RTF in the range of 5% to 8% of the equity value of the transaction--double or triple the fees typically seen previously. As was the case at the height of the PE deal market, the RTF in these transactions is the target's exclusive remedy for the buyer's failure to close when required to do so, except where specific performance is permitted.1 This increase in the size of RTFs suggests that the market has concluded that the size of RTFs prior to 2008 (i) caused buyers insufficient "pain" to deter them from walking from deals (see, for example, Cerberus' eventual payment of a 2.5% RTF to avoid the acquisition of United Rentals), (ii) failed to compensate sellers for their likely harm if buyers did walk and/or (iii) gave buyers too much leverage to re-cut deals if circumstances changed between signing and closing. But while the size of RTFs has increased in today's market, the RTF construct itself has clearly survived and appears here to stay for the foreseeable future.
It is worth highlighting two departures from the one-tier 5-8% RTF structure--Cerberus' buy out of DynCorp International, Inc., announced on April 12, 2010, and GTCR's acquisition of Protection One, Inc., announced two weeks later. In both the DynCorp and Protection One transactions, the buyer's liability for a "financing failure" was capped at the amount of an RTF, but at much higher levels than previously seen--10.0% of equity value in the case of DynCorp and 12.6% of equity value in case of Protection One. In addition, both deals provide for a higher second-tier RTF (29.9% of equity value for Cerberus and 31.6% of equity value for Protection One) in the event that the purchase agreement is terminated as a result of the buyer's "willful breach," defined in both agreements as a material breach of a material provision resulting from action taken with knowledge that such action would cause a breach.
The terms of the DynCorp deal may be best viewed not as evidence of an emerging market trend, but rather as the price Cerberus was required to pay in order to get back into the public company buyout market after its very well-publicized and contested jilting of United Rentals. The elevated RTF amounts and two-tiered structure in Protection One is not as easily distinguished. One possible explanation is that it is simply the price GTCR had to pay for a "pure option" since Protection One completely waived its right to seek specific performance and therefore the RTF was the target's sole recourse for a failure to close. However, as discussed below, Protection One is not the only recent deal in which the target's ability to obtain specific performance was compromised or eliminated entirely, and none of the other deals had an RTF even approaching the first-tier RTF in Protection One or the much higher "willful breach" fee.
As to whether these two deals are truly idiosyncratic or instead suggest a trend, our view is that they are likely outliers and that a one-tier structure with a single digit percentage fee of equity value will continue to prevail for the time being. While the two-tier structure is inherently logical in that it places a greater penalty on a willful breach than on a financing failure beyond the buyer's control, sophisticated buyers realize that targets would be very tempted to seek the higher fee by alleging willful breach, which would then force the buyer to litigate the issue or settle somewhere in the middle, neither of which would be very attractive outcomes.
Specific Performance: A Shift to a Spectrum
While the market continues to embrace the RTF structure for dealing with the buyer's monetary exposure in the event it fails to close, the recent PE deal market has seen some qualitative changes to the specific performance construct in sponsored deals. Of the 19 recent public-to-private transactions, 16 permit the target to obtain specific enforcement of the buyer's obligations under the merger agreement, but to varying degrees. While the availability of a specific performance remedy may not have always been a focus during the '06-'07 period, most deals back then reflected a binary approach--targets either had a right to seek specific performance of all relevant obligations or, quite often, no right at all. But more recently, particularly in the wake of United Rentals and other busted deals, specific performance has been an area of intense focus in the negotiation of sponsored deals.
At one end of the spectrum are three deals in which the target waives entirely its right to seek specific performance. On the other, weightier end are thirteen deals in which the target essentially has a right to seek specific performance of all (or nearly all) of the buyer's obligations (we'll refer to this as "Full Specific Performance"). And in the middle are three deals in which the target is permitted to seek specific performance of the buyer's obligation to draw on the sponsor's equity commitment and close the transaction (if all conditions to closing have been satisfied and the debt financing is available), but is not permitted to specifically enforce any of the buyer's other obligations (we'll refer to this as "Limited Specific Performance"). Since many of these obligations, such as the obligation to pursue the financing needed for the transaction, are predicates to the buyer's obligation to draw on the sponsor's equity commitment and close the transaction, the Limited Specific Performance regime may well undermine the target's ability to utilize its specific performance remedy to force the buyer to close.
A transaction that many view as kicking off the post-disruption wave of larger public-to-privates--the acquisition of IMS Health by TPG Capital and the Canadian Pension Plan--permitted Full Specific Performance. As in the other deals featuring Full Specific Performance, IMS had the right to seek specific performance generally but could only seek specific performance of the equity commitment letter and the buyer's obligation to actually close the deal if (i) all of the buyer's closing conditions had been satisfied, (ii) the debt financing had been funded or would have been funded if the equity was funded, and (iii) the target had confirmed that the closing would occur if the equity financing was provided.
The Limited Specific Performance construct seems to have first appeared in Apollo's agreement to buy Cedar Fair. Under this approach, the target does not have the right to seek specific performance generally. Instead, specific enforcement is permitted only with respect to the obligation to enforce the equity commitment and close the transaction, and only after satisfaction of essentially the same conditions noted above to the obligation to draw down the equity and close in transactions with Full Specific Performance. So, unlike Full Specific Performance, Limited Specific Performance strips the target of any right to obtain a court order requiring the buyer to perform its other obligations which could cause such conditions to be satisfied, e.g. , pursuing the debt financing and satisfying closing conditions, such as the receipt of governmental approvals. The target may seek a court order requiring the buyer to close only if all conditions have been satisfied and the debt is available, notwithstanding the target's inability to ensure that those events occur.
The "Value" of Specific Performance
Full Specific Performance
While Full Specific Performance provides the target with a useful alternative to simply seeking the RTF where an unwilling buyer is attempting to abandon or modify a deal, it must be considered, and perhaps loses a bit of its luster, in the context of a buyer's actual obligations under a typical PE purchase agreement. For example, a buyer's covenant to obtain its debt financing in a leveraged transaction is not (and cannot be) absolute, but rather is limited to some specified level of efforts, usually "reasonable best efforts" or "commercially reasonable efforts." This introduces a substantial level of subjectivity to the implementation of a specific performance remedy. And where the buyer's commitment papers will expire 60-120 days after signing, as is often the case in today's market, the target simply does not have much time to litigate the matter, obtain the court order and then actually get the buyer to obtain the financing. Still, these hurdles are not insurmountable, particularly in a fast-moving jurisdiction like Delaware, and thus Full Specific Performance provides targets with what many perceive as a meaningful remedy to complement the RTF.
Limited Specific Performance
Because a target with only Limited Specific Performance cannot seek specific performance until the buyer's debt financing is available, and cannot require the buyer to perform its covenant to obtain the debt financing, Limited Specific Performance seems at first blush to essentially give the buyer a "pure option." That is, a buyer can apparently refuse to seek its debt financing, with the target's only remedy being to terminate for breach and collect the RTF.
Still, there are several reasons why Limited Specific Performance may be of more value to targets than is initially apparent. One falls under the general rule that something is better than nothing. Even if the remedy is exercisable only once all of the other conditions to closing have been satisfied, there is some value to the target in knowing that it does not face the risk of doing all of the work to get to closing only to have the buyer walk away at the last minute. Another is that it is a potential source of leverage to the target in the event the buyer seeks to re-cut the deal. While it would be an uphill battle, the target could conceivably arrange the debt financing without the buyer's involvement, particularly where the financing relies solely on the target's assets and business. As much of a stretch as that may be, if the target can make a plausible showing that it is willing and able to go down that road, the buyer--knowing that it will have to close if the target succeeds and will have to live with the financing terms negotiated by the target--will have less leverage to renegotiate the deal. A third reason may simply reflect a judgment in certain deals that the imperfect nature of Full Specific Performance discussed above makes a compromise approach acceptable.
In looking at the recent wave of private equity transactions, it is clear that the basic remedy paradigm established during the height of the market in 2006-2007 is alive and well, although evolving. There are now three predominant variations of the RTF structure: (i) no specific performance or a "pure option", (ii) Limited Specific Performance and (iii) Full Specific Performance. Full Specific Performance has clearly become the dominant regime in recent months, but we expect that parties will continue to negotiate these provisions heavily and that, depending on leverage and other circumstances, will end up at different points on the spectrum.
Kevin A. Rinker is a partner, and Michael A. Diz and Luke T. Sternberg are associates, in the New York office of Debevoise & Plimpton LLP.
1. The buyer's monetary exposure for other breaches is typically capped at the same amount as the RTF, although the circumstances in which this would come into play are likely limited. It is difficult to imagine a situation in which the target would sue the buyer for a breach other than one that resulted in the closing not occurring (and in that circumstance, the RTF would be payable). Perhaps in recognition of this, a number of agreements provide that if the target is not entitled to the RTF, then it has no monetary remedy.