August 16, 2007
Private Equity's Option to Buy
In times of market stress, agreements that at the time seemed reasonable can cause dilemma for the parties. Perhaps the most interesting of these right now is the one associated with the liability limiting provisions that private equity actors have sometimes negotiated in their acquisition agreements. These provisions limit the liability of the private equity companies to a set amount no matter whether they intentionally breach the deal or not. The amount is typically at three-four percent of deal value. And, these provisions exclude the possibility of specific performance to require the private equity firm to consummate the transaction. So, the net effect is to give the private equity adviser a walk-away right with a cap on their liability at a fixed dollar amount. A number of troubled deals have this provision, including Manor Care, SLM, TXU (see the provisions here, here and here). Lone Star did not have this provision in its agreement; the result is that its liability exposure is substantially higher (see my post on this here).
These clauses essentially give the private equity fund an "option" on the acquired company. They can rationally assess at the time of closing whether it is worth it to close in numerical dollar terms. This makes for a very interesting calculus, particularly in these times. Private equity firms who have negotiated these clauses must be making some hard, number-crunching decisions. No one likes to pay the size of these possible payments ($1 billion in the case of TXU, $900 million in the case of SLM), tarnish their reputation as a bad player or admit to your investors that you made a bad decision, but sometimes cutting your losses is the better part of valor. Or at least it is a good negotiating chip.
Nonetheless, I'm not sure that sellers have fully appreciated the impact of these clauses. I suspect the conversation goes something like this: "Buyer: We're a private equity firm and our investors require that we cap our losses. You have a three percent break fee, shouldn't that be the same for us? Seller: Well, that makes sense". OK, it probably doesn't go exactly like that, but the point is that the three percent here may not be the right price. Would a correctly priced option cost that little? (interestingly, if you have some reasonable certainty as to a closing date this would be a European option so you could actually try and use Black-Scholes). Does this amount properly compensate the company and its shareholders for a blown deal? And should the private equity firms even have this option; this is not something that would seem rational with an industry buyer? Seller's counsel would do well to highlight these issues to their clients, particularly the optionality embedded in these liability limiting clauses.
NB. It is not quite a private equity deal but the Tribune deal has similar provisions which limit the liability of Sam Zell to $25 million (see Sec. 8.20 of the Zell purchase agreement). Not bad on an $8 billion transaction.
Addendum: a reader has pointed me to a clause in the Avaya merger agreement which more thoughtfully addresses this issue. In Section 7.3(f) the parties specifically cap monetary damages in case of breach but provide for specific performance. This effectively ends the optionality contained in the other agreements discussed above. Here is the relevant language:
Notwithstanding the foregoing, it is explicitly agreed that the Company shall be entitled to seek specific performance of Parent’s obligation to cause the Equity Financing to be funded to fund the Merger in the event that (i) all conditions in Sections 6.1 and 6.2 have been satisfied (or, with respect to certificates to be delivered at the Closing, are capable of being satisfied upon the Closing) at the time when the Closing would have occurred but for the failure of the Equity Financing to be funded, (ii) the financing provided for by the Debt Commitment Letters (or, if alternative financing is being used in accordance with Section 5.5, pursuant to the commitments with respect thereto) has been funded or will be funded at the Closing if the Equity Financing is funded at the Closing, and (iii) the Company has irrevocably confirmed that if specific performance is granted and the Equity Financing and Debt Financing are funded, then the Closing pursuant to Article II will occur. For the avoidance of doubt, (1) under no circumstances will the Company be entitled to monetary damages in excess of the amount of the Parent Termination Fee and (2) while the Company may pursue both a grant of specific performance of the type provided by the preceding sentence and the payment of the Parent Termination Fee under Section 7.1(b), under no circumstances shall the Company be permitted or entitled to receive both a grant of specific performance of the type contemplated by the preceding sentence and any money damages, including all or any portion of the Parent Termination Fee.
Practitioners take note.
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