Until recently, the financing markets had been fueling a robust M&A market, with strategic and financial buyers easily able to obtain credit on very favorable terms. However, the collapse of the credit markets in the middle of 2007 has acted to put the brakes on M&A activity. While M&A has not disappeared altogether, there has been a noticeable slow-down in buy-out activity across all market segments, particularly in large, going-private transactions.

With the collapse of the credit markets, many commentators and M&A practitioners predicted that deal terms in private equity buyouts, particularly in going-private transactions, would undoubtedly change. Yet, while there is little doubt that financing terms have changed, including the disappearance of “covenant-lite” loans and other debtor-friendly loan features, there has been surprisingly little change in deal terms. In fact, a review of going-private transactions announced this year indicates that financial buyers continue to be willing to live with certain seller-favorable terms that have arisen in going-private acquisition agreements in recent years.

Financing Conditions
In years past, “financing outs” or conditions to the buyer’s obligation to close an acquisition based on the availability of sufficient debt financing, were an expected component of the definitive agreement executed by private equity sponsors in connection with leveraged buyouts. These financing outs are intended to insulate the private equity sponsors from the risk that the debt financing necessary to consummate an acquisition would not be available on the expected terms. In the buyout boom of recent years, however, target company boards of directors were successful in negotiating for the elimination of these conditions, as they sought to provide more certainty to their shareholders as to the likelihood of a transaction actually closing. And with the previous availability of easy credit, private equity sponsors apparently viewed the absence of financing outs as carrying little risk. In today’s credit market, however, the lack of a financing condition can have serious consequences.

Yet despite the many failed deals resulting from failures to obtain debt financing, financing conditions have not made a comeback and have only appeared in one going-private deal so far this year. Perhaps the reverse termination fee (as discussed below) is a recognition on the part of target companies and private equity buyers that, despite the lack of a financing condition, financing is always at risk. The reverse termination fee simply attempts to quantify that risk.

Reverse Termination Fees/Sponsor Guarantees
Reverse termination fees, fees paid by a buyer in the event it terminates an acquisition agreement, initially arose as a quid-pro-quo between public target companies and private equity sponsors. Historically, the typical going-private structure involved the use of a newly formed shell company as the acquisition vehicle and a merger agreement that included a financing out and did not provide for any recourse directly against the private equity sponsor if the shell company failed to perform under the merger agreement. In the buyout boom, public target boards of directors began to demand that the private equity sponsor stand behind these thinly capitalized shell companies by providing a guarantee so that the public target company had a meaningful remedy in the event of a breach. Private equity sponsors usually agreed to this construct but insisted upon capping their liability and eliminating the ability of the target company to seek specific performance of the merger agreement. The cap was typically a reverse termination fee that mirrored the break-up fee paid by the target to the buyer in the event that it terminated the merger agreement in favor of a superior competing offer.

It is quite clear that the reverse termination fee structure remains intact, with all ten deals having such a provision, and all but two including a sponsor guarantee (in some instances, the guarantee was not just limited to the reverse termination fee). This is likely due to the fact that, appropriately drafted, reverse termination fees can effectively limit and quantify a private equity sponsor’s liability, particularly when coupled with an explicit provision as to their being the target’s sole and exclusive remedy in the event of a breach by the sponsor.

Specific Performance
The remedy of specific performance is an extraordinary equitable remedy that compels a party to execute a contract according to the precise terms agreed upon or to execute it substantially so that, under the circumstances, justice will be done between the parties. In the M&A context, specific performance grants the target the right to force the acquirer to complete the transaction.

Prior to the credit crunch, private equity deals generally followed one of two models regarding specific performance in the event the private equity sponsor refused to complete the transaction:

(i) the only remedy of the seller was to collect the reverse termination fee and specific performance of the agreement was expressly prohibited or (ii) the seller had the right to force the acquiring entity to specifically perform its agreement. In the latter case, since the acquiring entity was a shell company, the specific performance right is more likely to be used to require the buyer to obtain regulatory approvals and enforce the debt and equity commitment letters. An example of how this might play out is the Clear Channel case where private equity firms Thomas H. Lee Partners and Bain Capital sued a group of banks (Citigroup, Morgan Stanley, Credit Suisse, Royal Bank of Scotland, Deutsche Bank and Wachovia) seeking “specific performance” of a commitment letter detailing plans to fund their $20 billion buyout of Clear Channel Communications. Interestingly, though, the agreement between Clear Channel and the private equity buyers barred specific performance against the buyers; THL and Bain nonetheless brought suit against the commercial banks. The parties have since settled their dispute (see article on page 6), but only after months of legal wrangling.

Private equity sponsors have continued to push back on this point, with a clear preference for barring specific performance. Of the ten going-private deals announced so far this year, all have had reverse termination fees and specifically or effectively barred specific performance of the agreement. Consistent with prior practice, all of the deals pair a reverse termination fee with a general prohibition on specific performance of the buyer’s obligations.

Instead of the typical “no shop” provision that has long been standard issue in merger deals — to keep sellers from soliciting higher offers after reaching an agreement to be sold — in the non-auction context target company boards of directors began negotiating deals with private equity buyers that allowed them to actively seek higher offers after reaching agreement. Pursuant to this “go-shop” provision, the buyer effectively acts as a stalking horse, with its price setting a floor for other potential buyers and providing a sense of certainty to shareholders.

While go-shop provisions arose in an effort by target company boards of directors to satisfy their Revlon duties in the absence of a pre-deal auction, the reality is that go-shops, to date, have seldom resulted in third-party bids. That’s not to say that go-shops are simply a façade; rather, properly executed, they can serve to validate the deal price as a legitimate market-clearing price for the target, thereby supporting a deliberate and effective process that should satisfy a target board’s fiduciary duties. Of the ten deals so far this year, six of the targets were effectively shopped prior to signing a definitive agreement. Of the remaining four deals, all contained a go-shop. Accordingly, expect go-shops to remain in going-private deals where there is no pre-deal auction.

So it seems that, on average, going-private deal terms have yet to move from where they stood prior to the collapse of the credit markets. With seller-favorable provisions remaining in these transactions, it may be due to the continued effort on the part of private equity firms to maintain their reputations, as their livelihood depends on their ability to maintain a healthy pipeline of deals. But perhaps the reason has just as much to do with the fact that target company boards of directors have learned much from the many failed deals arising out of the credit crunch, and have held firm on these provisions so as to afford greater protections to their shareholders.

While it is difficult to draw firm conclusions from only ten deals, we look forward to more data points to compare as the year progresses. There likely will not be any large going-privates for the balance of the year. Many are forecasting that the middle market will remain strong, however, given the lower dependence on debt for middle market deals (typical leverage for middle market deals is in the 3x-5x EBITDA range, compared to 8x-10x EBITDA range for larger transactions).

Additionally, and perhaps even more important, middle market private equity groups have an estimated $200 to $400 billion in uninvested capital that they need to deploy. In other words, stay tuned.

1 The author would like to thank Robert A. Rosenbaum for his assistance with the preparation of this article.

This article originally appeared in the June 2008 issue of Dorsey's Private Equity Focus.