August 26, 2007
Home Depot and the Private Equity "Problem"
The Wall Street Journal is reporting that Home Depot has agreed to cut the sale of its wholesale supply unit to $8.5 billion, eighteen percent less than the $10.325 billion agreed to a few months earlier. The sale to affiliates of Bain Capital Partners, The Carlyle Group and Clayton, Dubilier & Rice will likely close this week on this basis. The deal is important because it is the first time in this market crisis that private equity firms have relied upon their reverse termination fee "option" to substantially drive down the price of an acquisition. It is also shows how stretched the banks are these days and the lengths that they are going to keep private equity debt off their books.
Like may other private equity agreements, the sale agreement for HD Supply specifically limited the private equity consortium's damages in case it decided not to close the transaction for any reason whatsoever, and specifically excluded the option of specific performance. Here, the agreement limited the consortium's damages of no more than $309,750,000. As I have written before, many private equity deals contain this provision; and in this volatile market and the current credit-squeeze the option like nature of these provisions cannot be ignored. This was the case here as, according to the Journal, the banks who agreed to finance this transaction, including JP Morgan Chase, actually offered at one point to pay this fee on behalf of the private equity consortium if they agreed to walk. This is bad, folks.
That the banks would go these lengths shows how desperate they are to avoid the situation First Boston found itself back in '80s when it got stuck in the "burning bed", unable to redeem hundreds of millions it had lent for the leveraged buyout of Ohio Mattress Company, maker of Sealy mattresses. First Boston only escaped bankruptcy by being acquired by Credit Suisse. In the case of HD Supply, the banks apparently asserted that they were no longer required to comply with their commitment letters to finance the acquisition because of the prior agreed change in the purchase price and the revised market conditions it reflected. The position seems a bit tenuous, but I don't have all the facts, and the letters aren't publicly available. Ultimately, though, it appears the need of all the parties to save reputation in the markets as well as Home Depot's need to finance its share buy-back, pushed them to a deal; according to the Journal, Home Depot is providing guarantees on part of the six billion dollars in bank financing provided in connection with the leveraged buyout deal as well as taking up to 12.5% of the equity, while the private equity firms are putting in more equity.
Of greater significance is the fact that the parties would go to these lengths to renegotiate a deal, and make the threats they have around the reverse termination fee. This doesn't bode well for the many other private equity deals in the market today that have this similar reverse termination fees (e.g., SLM, TXU, Manor Care, etc.). As we move into Fall and the banks begin to sweat their liability exposure, expect more re negotiations and a high chance that the economics of one of these many deals will become so bad that either the private equity firms or their financing banks will blink, taking the reputation hit, walking away from the deal and paying this fee. Food for thought as you chew your hot dog over this upcoming Labor Day weekend.
Final Point. The banks and private equity consortium will spin this as a MAC case, but a review of the definition of MAC on pp. 5-6 of the merger agreement finds a weak case for that (the MAC contains the standard carve-out for changes in the industry generally and markets except for disproportionate impact; it appears to be a tough case to establish here). I believe the banks and buying consortium will claim the MAC in order to publicly cover for the raw negotiating position they have taken by using the reverse termination fee and threatening to walk.
NB. Home Depot's counsel on this transaction was again Wachtell. Interesting, given the criticism Marty Lipton received in advising Nardelli on his infamous "take no questions" shareholder meeting.
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