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Qualifying as an Excluded Party in a Go-Shop: Can You Wake Up Late But Still Say You Were On Time?

Kohli, Sachin

(August 2007, Private Equity Alert)



By Sacha Jamal and Sachin Kohli

In the December 2006 edition of the Private Equity Alert, we profiled the recent trend towards including go-shop provisions in going-private transactions. More importantly, we noted that not all go-shop provisions are created equal and that sponsors should seek to understand their potential traps. One such trap surfaced in the litigation surrounding Aeroflex Incorporated’s recent attempt to go-private. The Aeroflex situation involves one private equity consortium utilizing a go-shop provision to “jump” another private equity consortium’s deal. The central issue in the Aeroflex litigation is whether the parties to the original deal are entitled to a full break-up fee or a reduced break-up fee.

Background of Aeroflex

On March 2, 2007, Aeroflex announced that it agreed to be acquired by affiliates of General Atlantic and Francisco Partners for $13.50 per share, or approximately $1 billion. As part of the transaction, General Atlantic and Francisco Partners agreed to a go-shop as a post-signing market check. Under the go-shop provision, Aeroflex was allowed to actively seek out alternative acquisition proposals up until and including April 18, 2007, which is referred to as the “Solicitation End Date.” After the Solicitation End Date, Aeroflex was required to cease any discussions or negotiations with any parties that were not “Excluded Parties” (discussed below) and became bound by a no-shop provision with a typical “fiduciary out.” In addition, after the Solicitation End Date, the break-up fee increased from $22.5 million to $37.5 million unless the bidder was an Excluded Party.” An “Excluded Party” is defined as any party that has made a bona fide written acquisition proposal prior to the Solicitation End Date with respect to which the Aeroflex board determines constitutes or would reasonably be expected to lead to a superior proposal that was reasonably capable of being consummated.

On the day before the Solicitation End Date, Veritas Capital submitted a non-binding proposal to the Aeroflex board to undertake a leveraged recapitalization of Aeroflex, in which the public stockholders of Aeroflex would (i) receive a $14.00 special cash dividend and (ii) retain an equity stub of approximately 21.2%. The Aeroflex board determined that Veritas was an “Excluded Party” for purposes of the go-shop provision, which General Atlantic and Francisco Partners disputed because, among other things, the proposal was not, in their opinion, sufficiently definitive and the proposal was conditioned on additional diligence and lacked committed equity financing (although it did have committed debt financing).

Nearly a month after the Solicitation End Date, on May 18, 2007, Veritas, along with affiliates of Golden Gate Capital and Goldman Sachs, submitted a new offer to cash out all of the stockholders for $14.50 per share. On May 25, 2007, Aeroflex terminated the General Atlantic/Francisco Partners merger agreement and entered into a new merger agreement with entities controlled by Veritas. Also on that same day, Aeroflex paid the reduced $22.5 million break-up fee to General Atlantic and Francisco Partners based on the argument that (i) the new proposal was a Veritas proposal (even though affiliates of Golden Gate Capital and Goldman Sachs provided guarantees for, and are expected to contribute, $200 million of the $372 million of the equity capital to the acquisition entity at closing) and that (ii) Veritas is an Excluded Party. However, General Atlantic and Francisco Partners claim that they are entitled to the higher $37.5 million break-up fee based on the argument that (i) Veritas should never have been considered an Excluded Party because the original Veritas proposal would not reasonably be expected to lead to a superior proposal; (ii) Veritas withdrew and replaced its original proposal by making a new proposal with a different structure, so even if Veritas were to be considered an Excluded Party under the original Veritas proposal, this withdrawal should have revoked its Excluded Party status; and (iii) Golden Gate Capital and Goldman Sachs were not a party to the original Veritas proposal and, therefore, are not Excluded Parties.

Advice for the Future

A sponsor signing up an initial deal (which we call the “initial sponsor,” as opposed to the sponsor jumping the deal, which we call the “interloper sponsor”) can learn the following lessons from Aeroflex:
  • Hard Stop - To help bring more certainty for the initial sponsor in a go-shop provision, the initial sponsor may want to consider using a “hard stop” for the go-shop period. Essentially, this eliminates the Excluded Party definition because a new deal qualifies for the reduced break-up fee if it is signed by a certain date - without exception. This result is rare, and, in our 2006 survey of Sponsor-Backed Going Private Transactions, we noted that only 8% of go-shop transactions surveyed had a “hard stop.” Also, a selling company may ask for a longer go-shop period in exchange, but if the additional days are kept to a minimum, this may be a worthwhile trade for the initial sponsor.
  • Secondary Hard Stop - One complaint from the initial sponsor in the Aeroflex case is that the interloper sponsor made its offer and then there was silence for almost a month. The initial sponsors in Aeroflex are using this fact to argue that the interloper sponsor ceased to be an Excluded Party. One alternative for an initial sponsor that is unable to obtain a hard stop for the go-shop period is to have a hard stop on how many days after the end of the go-shop period an interloper sponsor can be considered an “Excluded Party” without the merger agreement being terminated. Of course, this approach could possibly backfire if an interloper sponsor applies pressure on the selling company to terminate the initial sponsor’s merger agreement to qualify for the reduced break-up fee.
  • Percentage Test - Another approach is to specify a percentage of the equity that must come from the Excluded Party in the final interloping group to qualify for the lower break-up fee.

For example, in the Avaya transaction with TPG and Silver Lake Partners, the merger agreement provides that at least 75% of the equity in a revised proposal must come from the original “Excluded Party” for a reduced break-up fee. A selling company will argue for a lower percentage, and the initial sponsor will argue for a higher percentage, so depending on the final percentage, it is unclear who will come out ahead. However, this approach has the advantage of providing greater certainty.
  • Require Identification by Name - In the Aeroflex case, Veritas submitted its bid on behalf of its affiliates and co-investors and did so one day before the Solicitation End Date. An initial sponsor should insist that the definition of Excluded Parties should only count those co-investors that have been specifically identified.
  • Post-Signing Equity Syndication - An initial sponsor should limit the ability of an interloper sponsor from syndicating equity post-signing to get around limitations in the Excluded Party definition (see the last bullet point below). The complexity with this point is that the break-up fee is paid at the time the merger agreement is terminated, and the question is what sort of forward-looking test should be used - for example, should co-investors that are contemplated to come in post-signing be considered or just parties that have signed equity commitment letters?

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The interloper sponsor has less flexibility because by definition, a merger agreement has already been signed with the initial sponsor. Nevertheless, the following points are worth considering:
  • Process is Important - The interloper sponsor should carefully review the merger agreement and make sure to comply with all technical requirements of the go-shop. If the go-shop has “loopholes,” the interloper sponsor should preserve all rights possible (for example, by making the bid on behalf of other unnamed co-investors) because the final deal may end up being different than the interloper sponsor originally contemplated and the flexibility may come in handy.
  • Equity Syndication - In the Aeroflex deal, Veritas owned and controlled the two entities signing the merger agreement. Although this structure improves the argument that this is a deal from Veritas (the party that made a bid before the deadline), Golden Gate and Goldman Sachs provided limited guarantees to Aeroflex for their respective equity commitments. To strengthen its argument, Veritas could have committed to Aeroflex for the entire amount of the equity and then received back-to-back equity commitment letters from Golden Gate and Goldman Sachs. This approach would have improved Veritas’ argument for paying the lower termination fee but, of course, Veritas would have had to weigh the risk of its co-investors not funding their respective equity commitments and leaving Veritas exposed on its commitment. Additionally, Aeroflex may not have accepted that approach and Veritas’ fund formation documents may have limited it from pursuing this strategy.

Conclusion

The use of go-shop provisions as a post-signing market check will most likely continue in connection with going-private transactions. Initial sponsors and interloper sponsors should be cautious of the subtle nuances of these provisions and recognize that not all go-shops are created equal. Depending on the specifics of the go-shop provision, as is demonstrated in Aeroflex, an interloper sponsor can emerge after the “end” of the go-shop period but still argue that the lower go-shop break-up fee applies.
   
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