It looks as though private equity buyers better get used to seeing reverse breakup fees and other seller-friendly provisions in their merger agreements.
TheDeal.com details how reverse breakup fees are becoming industry-standard provisions in private equity LBO deals in a new article called “Desperately Seeking Certainty:”
Starting with the 2005 sale of Neiman Marcus Group Inc., LBO merger agreements often included a “two-tier” breakup fee, in which a buyer would pay a lower percentage in the event it couldn’t obtain financing and a higher one if it decided to walk from the deal in the absence of a contractual right to do so, such as a so-called material adverse effect at the target.
The McDermott and Debevoise lawyers found that those provisions remain standard. “All of the going-private deals signed since last October have explicitly provided that the seller will have no right to force the closing,” Schmidt wrote. “At least one deal did allow the seller the right to seek specific performance of the financing covenant, but for most, the only remedy if a buyer refuses to chase its lenders would be a claim for damages.”
Paul Shim, an M&A partner at Cleary Gottlieb Steen & Hamilton LLP, agrees: “The merger agreements in the deals that have been done since the bubble burst have largely followed the reverse break fee, no-financing condition, no-specific-performance paradigm.”
The article also mentions these deals are now coming with a greater level of contractual clarity regarding the buyer’s right to specific performance (i.e., forcing the private equity firm to close the deal) thanks to the decision in the collapsed buyout of United Rentals Inc. Although the Delaware Chancellor ultimately found in favor of the buyer (Cerberus Capital Management, LP), private equity firms are now making sure their deal documents clearly state the target does not have a right to specific performance:
The run of collapsed deals has led some observers to predict that sellers would demand greater contractual certainty from PE shops in merger agreements, but so far that hasn’t happened. Instead, sellers have gained some of the certainty they seek from more secure debt and equity financing arrangements while PE buyers have become more vigilant in rooting out dangerous ambiguities in contracts.
Of course, reverse breakup fees and other seller-friendly provisions may fall out of favor with the LBO market once the credit situation comes around. But until then, get used to them.
Read the entire thedeal.com article here.
As the credit crunch continues, many buyers may have to pay a fee for not being able to close an acquisition due to a provision called a reverse breakup fee.
What is a “reverse breakup fee?”
A reverse breakup fee is paid to the target company when the buyer backs out of acquiring the target. If the acquirer fails to close the acquisition because it can’t obtain financing, the reverse breakup fee provision is triggered. (Traditionally, acquirers insisted on including “financing out” clauses allowing them to decline to close acquisitions–without penalty–if they couldn’t obtain the necessary financing.)
What’s the reasoning behind reverse breakup fees?
Target companies believed that acquirers should share the risk that the proposed (and public) deal did not go through. These risks for target companies include:
(1) securities class action lawsuits;
(2) disruption of business operations; and
(3) the potential for an unstable set of management/employees.
Therefore, as acquisition targets gained bargaining power relative to their acquirers over the past few years, reverse breakup fees were increasingly inserted into acquisition documents to re-allocate such risks. According to Factset MergerMetrics, 76 percent of all going private deals involving U.S. target companies included a reverse breakup fee provision.
How much are typical reverse breakup fees?
Reverse breakup fees usually range between 1 to 3 percent of the acquisition price. That may seem like a nominal amount, but keep in mind 3 percent can be a massive dollar amount for private equity deals.
Do reverse breakup fees have any place in smaller acquisition deals?
While reverse breakup fees are found in private equity/leveraged buyout deals, they have a place in smaller deals. At a minimum, small targets also risk that a proposed acquisition will disrupt business operations and negatively affect management/employees (2 and 3 above). And one could argue that a smaller target would suffer more on the operations and personnel side compared to a larger company. Additionally, its inclusion could help entice smaller targets to enter into a proposed acquisition. The tradeoff is that increased language in acquisition documents may scare off the buyer or seller.
A leveraged buyout (“LBO”) is a strategy where someone acquires an existing company using a significant amount of borrowed funds. Typically, the assets of the company being purchased are used as collateral for the borrowed funds. This allows someone to acquire a company without having to outlay a lot of personal or business capital. Then, the purchased company’s cash flow is typically used to repay the debt.
It may not seem natural to include LBO talk in this Startup Lawyer Blog, but I believe every entrepreneur should be aware of such a strategy. LBO transactions can be a way to grow your companies–or sell them.