Private equity buyers sometimes worry that their financing, particularly its impact on timing and conditionality, puts them at a competitive disadvantage vis-à-vis strategic buyers. While strategic buyers must also at times rely on debt financing, historically they have been willing to bear the financing risk by accepting uncapped monetary damages and unlimited specific performance remedies for breaches caused by a financing failure. But times have changed, and provisions relating to allocation of financing risk have become some of the most hotly contested deal terms in both strategic and private equity transactions alike.

We published an article in the Spring of 2009 highlighting a then emerging trend in which strategic buyers had begun borrowing private equity technology in the form of reverse termination fees, or RTFs, to limit their exposure in the event of a financing failure (and sometimes in other circumstances as well).¹ In light of the recovery of the capital markets in the more than three years since that article was written, we decided to take a fairly methodical look back at how the market for financed strategic transactions has evolved since then. We surveyed publicly available, leveraged strategic deals involving U.S. targets that were announced between January 2009 and June 2012, had a transaction value of at least $300 million and provided for payment of an RTF (28 transactions met these criteria). The chart highlights some of the key financing-related terms in these agreements.

Back in 2009, some observers had predicted that the use of RTFs by strategics to reduce their financing risk was simply a short term product of the extreme paralysis in the financing markets during that period and would disappear once the financing markets rebounded. However, the results of our study have confirmed our own experience over the past few years—that the convergence was not an isolated development. Rather, the emerging trend we highlighted back in 2009 did in fact represent the beginning of a movement towards a greater use by strategic buyers of private equity technology. The consequence for private equity firms is that they are now, in many cases, on more equal footing with strategic buyers when competing for assets.

Background

In the three-year period leading up to the financial meltdown in 2008, financial sponsors and strategic buyers utilized different structures to allocate the financing risk inherent in leveraged transactions:

• In strategic acquisitions, the buyer would effectively bear all of the financing risk, with the acquisition agreement (1) containing no financing condition, (2) providing the seller with unrestricted rights to specifically enforce the buyer’s obligation to close (even if the contemplated debt financing was not available at the time of the required closing) and (3) providing the seller with the ability to sue for uncapped monetary damages in the event that the buyer failed to close when required.
• In the typical financial sponsor transaction, the acquisition agreement would include an RTF structure with the following key characteristics: (1) a requirement that the debt financing be available prior to the seller being able to force the buyer to close (or, in many cases, no ability for the seller to specifically enforce buyer’s obligation whatsoever (known as the “pure option” formulation)) and (2) a fixed RTF (often in the range of 3% to 4% of the purchase price) payable in the event of the buyer’s failure to close when required or other significant breach, which payment would generally serve as the seller’s sole monetary recourse against the buyer.²

Unlike the strategic model, the private equity formulation provided (and continues to provide in today’s market) the buyer with the comfort of knowing up front what its maximum monetary exposure would be if the anticipated financing were not available at closing. Private equity buyers have also been able to limit the specific performance remedy to situations where the debt is available, so that a buyer does not have to worry that it will be forced to close with all equity in the event of a financing failure. The combination of these two features results in a sharing of the financing risk with the seller.

The chart below shows the number and approximate percentage of all publicly available, leveraged transactions involving U.S. targets and strategic buyers with a transaction value of at least $300 million during the period from 2009 to June 30, 2012 that contained RTF structures (according to the Practical Law Company’s surveys).

The general downward trend in the percentage of deals including RTF structures from roughly half in 2009 to between one quarter and one third today indicates that the strategic deal market is not moving towards a widespread and complete adoption of the private equity RTF model. However, the number of strategic deals that have continued to utilize RTF structures is not insignificant, illustrating that such a structure is a viable option for strategic buyers that are unwilling to bear all of the financing risk. We think this trend benefits private equity buyers to some extent, both by beginning to level the playing field in auctions and by further conditioning sellers to more of a risk sharing model.

It is worth noting that almost one-third of the transactions we surveyed involved a portfolio company buyer in which a financial sponsor committed to provide additional equity financing in connection with the add-on acquisition. It is, of course, not surprising that companies controlled by financial sponsors, who are providing equity, would have more success negotiating for the inclusion of an RTF structure given the hybrid nature of portfolio company acquisitions and the sponsors’ familiarity with the RTF model.

The other point worth making is that it seems, at least anecdotally, that RTF structures are more likely to be found in transactions where there is meaningful financing risk and where the buyer has a good argument for why the seller should bear some of the risk. For example, you are more apt to see this structure in a deal where there is significant leverage or where the target company represents a meaningful component of the overall credit underlying the financing. In these circumstances, a seller may be willing to share more of the risk since the financial performance and prospects of the company it is selling has a larger impact on the availability of the financing. Conversely, if a large, investment grade public company is acquiring a relatively small target, there is less financing risk to be shared (and less justification for sharing it) because the buyer may have numerous potential sources of financing, including issuing debt or equity securities at the parent company level or drawing down on an existing facility. The availability of financing in that case depends more on the creditworthiness and overall performance of the buyer, not the target.

Strategic Deal RTF Terms

Amount of RTF

The average size of the RTFs in our study was approximately 5% of the equity value of the target, which is a bit lower than the average private equity RTF during the same period, likely reflecting the stronger alternative remedies available to the seller in most leveraged strategic deals (e.g., monetary damages for willful breach, often uncapped) and the relatively lower financing risk in most strategic acquisitions. Three of the transactions included a two-tier RTF structure, with one fee payable in the event of a true financing failure through no fault of the buyer and a higher fee payable in the event of a willful breach by the buyer.

The 28 acquisition agreements we reviewed fall into three categories in terms of monetary recourse:

• Only six agreements (including two of the three two-tier RTF deals) provided that the RTF was the sole and exclusive monetary remedy (i.e., the seller had no ability to recover any monetary damages other than the RTF even for willful breach);
• Eighteen agreements provided that the RTF was the sole and exclusive remedy, except in limited circumstances where the RTF is not payable and the seller can then sue for damages for “willful breach” (capped at the amount of the RTF in four of the agreements, but uncapped in the other fourteen); and
• The remaining four agreements allowed the seller to choose whether to accept payment of the RTF or sue for willful breach with uncapped damages. In comparison to the typical private equity formulation, the RTF provisions in most of these agreements do not provide the strategic buyer with the same level of comfort with respect to monetary exposure that financial sponsors are accustomed to receiving in their acquisition agreements. Although we are aware of a few private equity deals in which damages beyond the RTF are permitted for willful breach, the vast majority cap exposure at the amount of the RTF.³

Only 5 of the 28 acquisition agreements permitted the seller full and unconditional specific performance remedies to force the buyer to close in the event of a financing failure. The vast majority of agreements (22 of 28) first required satisfaction of certain conditions that have become customary in private equity deals (e.g., availability of the debt financing and confirmation from the seller that it stands ready to close. One agreement allowed specific performance of certain specified buyer obligations (e.g., the use of reasonable efforts to obtain the financing), but interestingly did not permit the seller to force the buyer to actually close the transaction.

Of the 28 acquisition agreements, 13 explicitly required the buyer to go as far as suing its lenders as part of its obligation to use reasonable efforts to obtain the financing, while four agreements explicitly provided that the buyer would not be forced to sue its lenders. The remaining 11 agreements did not expressly address the issue one way or the other.

Financial sponsors competing with strategic buyers in an auction should be aware that the large majority of them are still willing to accept the entire financing risk and thus will be providing greater deal certainty to the seller. However, the current market provides support for the use of an RTF structure in a strategic acquisition if the buyer has significant negotiating leverage or if otherwise warranted in light of the deal dynamics. Additionally, the strength of the debt markets and other factors relating to the certainty of the financing could affect the appropriateness of an RTF structure in a particular transaction.

It will be interesting to see where the market settles out over the next few years, both in the strategic and private equity arenas. Will the majority of strategic buyers continue to bear most, if not all, of the financing risk in leveraged transactions? Will there be a significant increase or decrease in the number of strategic transactions that borrow the private equity RTF framework? Will there be further convergence of terms? Our view is that terms relating to the allocation of financing risk—in both the private equity and strategic markets—are unlikely to remain static and will instead continue to evolve through active and focused negotiation.

Footnotes:

1. See the Spring 2009 edition of the Debevoise & Plimpton Private Equity Report, "Something Old, New, Borrowed, and Blue: Have Strategics Borrowed Conditionality from the Private Equity World?"

2. The average size of RTFs as a percentage of purchase price has increased since 2009, with current private equity RTFs generally ranging between 5% and 7% of purchase price.

3. The average size of the lower-tier fee was approximately 3% of the equity value, while the average size of the upper-tier fee was approximately 5.2% of the equity value.