June 01, 2005
Two recent high-profile leveraged buy-out (LBO) transactions appear to reflect a major departure from the traditional approach of private equity sponsors being insulated against exposure to liability arising out of LBO acquisition agreements.
Traditionally, private equity sponsors have been successful in insulating their funds from liability in the event a proposed LBO is not completed. In a typical acquisition agreement involving a private equity buyer, the actual purchaser signatory is a newly formed “shell” company owned by the sponsoring private equity fund. The only assets of this purchaser entity are the debt commitments received from the lenders and, in some cases, an equity commitment received from the sponsoring private equity fund. In addition, LBO acquisition agreements almost always include a debt “funding condition,” relieving the buyer of its obligation to close the transaction if the debt financing sources do not actually provide the funds contemplated by the debt commitments. Despite these insulating factors, target companies and their advisors generally have taken comfort from the knowledge that major private equity funds must be diligent to protect their images as reliable buyers that consistently close transactions when the closing conditions are satisfied. As a result, well-known private equity funds historically have been quite successful in resisting requests by target companies to be granted any contractual rights to proceed directly against the sponsoring funds.
The departure from the traditional approach in the recent Sungard and Neiman Marcus transactions is true both with respect to the weakening or elimination of the buyer’s traditional debt “funding condition” (combined with the addition of a “reverse termination fee” payable by the buyer in certain circumstances), and also with respect to an apparent erosion of the traditional unwillingness of the sponsoring private equity funds themselves to accept liability.
Based solely upon publicly available information filed with the SEC and as described in detail below, the Sungard acquisition agreement included provisions, such as a reverse termination fee from the buyer, that shifted real (but limited) economic risk to the buyer and its sponsoring private equity funds in the event that the acquisition did not close due to the failure to obtain funding under debt commitments or due to any breach by the buyer of the acquisition agreement.
Extremely Limited Funding Condition
The Sungard acquisition agreement eliminated the concept of a debt “funding condition” to the buyer’s obligation to the close the transaction, except in two very limited circumstances. Specifically, the agreement preserved the funding condition only where the failure to obtain the debt proceeds resulted from either a “Market MAC” or a “Lender MAC,” both of which terms were defined very narrowly. For a “Market MAC” to occur, it was not sufficient that there be merely an extremely adverse change in the financing markets. Rather an occurrence generally would have to be so severe as to cause a general suspension of trading or limitation of prices on the New York Stock Exchange for at least three consecutive trading days. Likewise, “Lender MAC” was defined narrowly and generally applied only if the buyer’s lenders were prohibited from providing funds due to legal prohibitions, lender insolvency proceedings or similar matters.
Absent the occurrence of either of these limited exceptions, the buyer would be in breach of the acquisition agreement if the lenders failed to fund in a case where other closing conditions were satisfied. Because the buyer’s general “material adverse change” closing condition also was quite narrow, the Sungard buyer would be obligated to close the transaction even if debt financing proceeds were not obtained and even if significant adverse events affected the target company prior to the closing.
Reverse Termination Fee
The Sungard acquisition agreement provided that a fee of $300 million (approximately 2.65% of the purchase price and approximately 8.57% of the aggregate equity commitments) would be payable by the buyer to the target company in the event the closing did not occur due to the failure to receive debt financing proceeds (when other closing conditions were satisfied, including there not having occurred a “Market MAC” or “Lender MAC” as described above), or if the closing did not occur due to another breach of the acquisition agreement by the buyer.
Liquidated Damages - No Further Liability
In a case where the buyer was obligated to pay the $300 million reverse termination fee, the Sungard agreement made clear that such fee was the limit of the buyer’s exposure. There was no right for the target company to obtain any additional damages or any other remedies beyond the fee. Although the $300 million fee would be automatically payable by the buyer in the applicable events without any obligation of the target company to demonstrate that it actually incurred damages equal to the amount of the fee, the treatment of the fee as liquidated damages would allow the buyer and its sponsoring private equity funds, in a case where significant adverse developments had occurred with respect to the target’s business, the ability to elect to walk away from the transaction in order to “cut their losses” and be certain of no additional exposures.
Private Equity Sponsors Responsible for Amounts Owed by Buyer
While the buyer signatory to the Sungard acquisition agreement was a separate shell entity, each of the buyer’s sponsoring private equity funds guaranteed to the target company the payment of their respective pro rata portions of the $300 million reverse termination fee. This clearly put the private equity funds in the position of being directly liable to the target company for the payment of the reverse termination fee. This amount represented less than 10% of the funds’ aggregate equity commitments.
Neiman Marcus Transaction
Based solely upon the publicly available information on file with the SEC, the Neiman Marcus acquisition agreement (like the Sungard agreement) included provisions, such as a reverse termination fee from the buyer, that shifted economic risk to the buyer in the event the acquisition did not close due to the failure to obtain funding under debt commitments or due to any breach by the buyer of the acquisition agreement. Unlike the Sungard agreement, however, the Neiman Marcus agreement provided that the buyer could be exposed to liability in excess of the reverse termination fee in several situations.
No Funding Condition
Whereas the Sungard acquisition agreement narrowed the buyer’s traditional debt funding condition so that it only applied in extremely limited circumstances, the Neiman Marcus acquisition agreement went a step further and altogether eliminated the funding condition. As a result, the buyer would be in breach of the agreement in any case where the debt financing proceeds were not actually received and the other closing conditions were satisfied. As was the case in Sungard, the buyer’s general “material adverse change” closing condition was quite narrow. As a result, the buyer would be obligated to close the transaction even if debt financing proceeds were not obtained and even if significant adverse events affected the target company prior to the closing.
Reverse Termination Fee
The Neiman Marcus acquisition agreement provided that a reverse termination fee of $140.3 million (approximately 2.75% of the purchase price and approximately 9.05% of the aggregate equity commitments) would be payable by the buyer to the target company in the event the closing did not occur due to the failure to receive debt financing proceeds (when other closing conditions were satisfied) or due to another breach of the acquisition agreement by the buyer.
Liquidated Damages Only in Certain Circumstances - Buyer Had Potentially Greater Liability in Other Circumstances
The Neiman Marcus acquisition agreement provided that, in some circumstances, the $140.3 million reverse termination fee constituted complete and liquidated damages and therefore was the limit of the buyer’s liability. However, unlike the Sungard agreement, the Neiman Marcus agreement included two important exceptions to this liability limitation:
First, the buyer could be liable for additional target company damages up to $500 million in the aggregate (an amount equal to approximately 9.8% of the purchase price and approximately 32.3% of the applicable equity commitments) if the failure of the closing to occur did not result solely from the failure to obtain funding of debt proceeds but from some other breach by the buyer. Unlike in the Sungard transaction, so long as the lenders were willing to fund their debt commitments, this meant that the buyer would not be able to simply “cut its losses,” decide not to close and limit its liability to the amount of the reverse termination fee in a case where significant adverse developments had occurred with respect to the target’s business.
Second, the $140.3 million fee did not constitute liquidated damages, and the buyer could be liable for target company damages up to $500 million in the aggregate, in a case where sufficient funding of the debt commitments was not obtained due to the failure to meet leverage ratio targets or other tests in the debt commitments. Because the leverage ratio targets were based on the performance of the target company prior to the closing, this potentially put the buyer at risk for damages in excess of the $140.3 million reverse break-up fee in certain cases involving adverse changes in the target company’s business.
Liability of Private Equity Sponsors
The proxy statement filed by Neiman Marcus with the SEC in connection with the proposed acquisition indicates that the equity commitments from the private equity sponsors would be available not only to fund the purchase price in the event the closing occurred, but also “to satisfy any liabilities or obligations” of the buyer in the event of a breach of the acquisition agreement by the buyer. Accordingly, although the equity commitment letters have not been publicly filed, it is reasonable to assume that they provide some mechanism to allow the enforcement by the target company of this commitment to fund damages owed by the buyer.
What do Sungard and Neiman Marcus Mean for the Future?
The future impact of the approaches taken in the Sungard and Neiman Marcus transactions is not yet clear. Time will tell if these transactions will have the effect of redefining the provisions that are considered “market” with respect to the potential liability of sponsoring private equity funds. Sungard and Neiman Marcus were very large transactions (purchase prices of approximately $11.3 billion and $5.1 billion, respectively) involving consortiums of multiple private equity funds and for which there was significant competition in the auctions. Even if there are attempts to use these transactions as precedent for other very large competitive transactions, private equity funds hopefully will continue to be successful in resisting the precedent in other transactions. Most sellers appear to continue to acknowledge that reputable funds will not put their reputations at risk by failing to close deals once all closing conditions have been satisfied, and as a result most sellers do not require direct sponsor liability.
To the extent that private equity buyers are required to modify the traditional approach in order to effectively compete for future large deals, a few points should be kept in mind:
First, if a “funding condition” is to be eliminated or severely restricted in an acquisition agreement, it will be important to negotiate with lenders to provide very little, if any, flexibility for lenders to refuse to fund in a case where the buyer is contractually obligated to close. It also is important to separately address the conditions to the funding of the equity commitment.
Second, while imposing sponsor liability, an approach like the one used in the Sungard transaction in essence gives the sponsors the right to walk away from the deal upon payment of the breakup fee (an amount that may be only a fraction of the total equity commitment). This is clearly preferable to any approach that exposes the private equity sponsor to direct contractual liability for a greater portion of, or all of, the equity commitment.
Finally, although fund documents typically would not prohibit a fund from accepting contractual liability to a target company in the event an acquisition does not close, fund partners are not likely to be pleased if they are forced to fund capital commitments in such a case. Accordingly, despite the fact that sellers will undoubtedly point to the Sungard and Neiman Marcus transactions as potential precedent, the discomfort of being required to send capital calls for an LBO transaction that didn’t close should continue to be a powerful incentive for private equity sponsors to resist efforts to allow these transactions to become precedent.
1. In rare cases, some private equity sponsors have provided letters of credit as support for a buyer’s obligations under a purchase agreement.
2. Rather than having the private equity sponsor “guarantee” all or a portion of the buyer entities obligations under the acquisition agreement, another means of imposing direct liability on sponsoring private equity funds is to require the private equity sponsor to execute an equity commitment letter in favor of the buying entity that contains third party beneficiary or reliance rights in favor of the target company. This approach is designed to allow the target company to sue the private equity sponsors directly to recover amounts committed to be funded to the buyer entity if the conditions to closing of the acquisition agreement have been met and the buyer does not close. Like the “guarantee” approach, this approach also has long been resisted by private equity sponsors. Because the variations in approaches to the terms of these letters are legion, experienced counsel is necessary to address the exact terms of the letter if this concept is to be entertained.
3. Private equity sponsors have been subjected to litigation arising out of busted LBO transactions notwithstanding the fact that the funds neither guaranteed the obligations of the buyer entities nor granted third party beneficiary or reliance rights to the sellers with respect to their equity commitment letters. The theories of liability are frequently based on claims of fraud or alter ego. In a freely bargained agreement entered into solely by the buyer entity (particularly one carefully drafted to include a “non-recourse” provision) these claims should rarely be successful. To the extent one of these claims was successful, however, the exposure of the private equity firm would potentially be greater than it would have been in the case of a “guaranteed” reverse break-up fee that was a small percentage of the equity commitment.