Something old, new, borrowed and blue

During the seemingly distant wave of M&A activity from 2005 through the first half of 2007, deal terms evolved with the birth in private equity transactions of the reverse termination fee, or RTF. Reverse termination fees limit a buyer's exposure in the event it fails to close a deal under certain circumstances. Notably, this structure is now creeping into strategic acquisitions, with interesting implications for private equity buyers.

Reverse termination fees in the private equity context were initially conceived a few years ago as an alternative to a financing condition. With frothy credit markets and heightened competition for assets, private equity buyers (especially in large cap deals) began in 2005 or so to give up their long-cherished financing outs in order to compete on more equal footing with strategic buyers. Private equity firms, however, were not willing to expose themselves to unlimited monetary damages or a specific performance claim that could theoretically force them to close on transactions even if their lenders had balked. Sponsors thus negotiated for a limitation on their liability, usually in the form of a predetermined fee (ranging from 3% to 4% of deal value and often the size of breakup fees in going-private transactions), which would serve as the target's sole recourse in the event that the buyer failed to close due to an inability to obtain its financing. In many deals, this limitation on liability extended to any failure by the buyer to close, regardless of whether related to a financing issue or not, and with different approaches depending on whether the buyer had otherwise breached the acquisition agreement.

Target boards often accepted this structure, notwithstanding that it wasn't actually equivalent in terms of deal certainty as the formulation being offered by strategic buyers (i.e., no financing out and no limitations on monetary damages or injunctive relief). The fee was viewed as being painful enough that a private equity firm would be unlikely to pay it simply to abandon a deal. And while there have been some well-documented, unintended consequences of this structure, ranging from buyers renegotiating transactions between signing and closing to buyers completely abandoning deals as in the Cerberus Capital Management LP-United Rentals Inc. transaction, such terms have largely survived the market disruption (albeit with modifications in some cases).

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In contrast to the private equity formulation, strategic deals historically did not include any financing contingencies or limitations on liability, either because third-party acquisition financing was often not required (buyer stock, revolver capacity or cash on hand was used instead) or because strategic buyers, who usually have a stronger credit profile than a LBO borrower, were simply willing to bear the more limited financing risk. However, the use of stock as acquisition currency has declined significantly in the past year or so, primarily as a result of the significant downturn in the equity markets, and cash deals have become much more prevalent, even in very large transactions. This trend has forced strategic buyers in many cases to turn to third-party acquisition financing to fund their deals, and in the process they have discovered that even investment-grade companies are unfortunately not immune to the credit crisis. In light of the difficulty in securing financing, strategic buyers have in many cases turned to the RTF structure as a means of sharing the risk with the target company. (Ironically, many deal observers wondered back in 2005, when RTFs emerged, whether strategic and private equity terms were converging with the elimination of the financing condition in large private equity transactions.)

Mars Inc.'s acquisition of Wm. Wrigley Jr. Co., announced in April 2008, is perhaps the purest example of the emergence of RTFs in strategic transactions. In that transaction, Mars successfully negotiated for an RTF of $1 billion -- about 4.35% of the total transaction value -- and payment of the reverse termination fee was Wrigley's sole remedy if Mars failed to close for any reason (i.e., Wrigley was not entitled to seek specific performance or monetary damages beyond the amount of the RTF). Mars therefore obtained what has been referred to as a "pure option," much like the prevailing private equity structure. While $1 billion is not an insubstantial sum, the size of the fee is, as a percentage of deal value, well within the range of RTFs seen in LBOs and would, of course, provide scant comfort to Wrigley if it were to be left at the altar in a situation where the company's value had declined by an amount substantially in excess of 4.35%.

Other strategic buyers have also successfully capped their exposure for failure to close as a result of a financing failure, though not all deals have been as buyer-friendly as Mars-Wrigley. Pfizer Inc., for instance, in its $68 billion acquisition of Wyeth signed in January, is subject to an RTF of $4.5 billion (approximately 6.6% of total deal value), but it is not Wyeth's sole remedy in the event the failure to close is unrelated to the financing. So, unlike Mars-Wrigley, in such event Pfizer's monetary liability is not limited in any way, and Wyeth is also entitled to seek specific performance.

A similar deal structure was utilized in Merck & Co.'s acquisition of Schering-Plough Corp., which was announced in March. That transaction featured a $2.5 billion RTF (approximately 6.1% of transaction value) payable by Merck should its financing fall through, and is Schering-Plough's sole remedy in such circumstance. Like Pfizer though, Merck was not able to limit its liability for a breach unrelated to the financing, nor was it able to avoid granting Schering-Plough a right to specific performance in such case.

One recent megadeal that departs from the trend is Roche Holding AG's $46.8 billion purchase of the shares of Genentech Inc. that it did not already own, which was announced just a few days after the Schering-Plough transaction. The acquisition, ultimately structured as a negotiated tender offer, did not include any financing contingencies or limitations on liability. But there was a good reason for Roche's confidence -- the company had already raised $39 billion by the time the deal was announced, which greatly reduced its financing risk. Roche was basically in the position of a large, credit-worthy strategic buyer back in the days of readily available capital, and thus was apparently willing to forego a cap on its exposure for failure to close.

The Mars, Pfizer and Merck experiences are just a few recent examples of the convergence of private equity and strategic deal terms. International Paper Co. obtained similar financing-related protections in its acquisition of Weyerhaeuser Co. back in March of 2008. And variations on the structure were also utilized in JDA Software Group Inc.-i2 Technologies Inc., Kinetic Concepts Inc.-LifeCell Corp., Excel Maritime Carriers Ltd.-Quintana Maritime Ltd., Macrovision Solutions-Gemstar-TV Guide International Inc., Ashland Inc.-Hercules Inc. and Brocade Communications Systems Inc.-Foundry Networks Inc.

The conventional wisdom is that except in times of exuberant credit markets, strategic buyers have a number of advantages over financial buyers in competing for assets. Key among them is the willingness to enter into acquisition agreements with far less conditionality than private equity firms are prepared to bear. But with strategics' stock prices at or near historic lows and with very little liquidity in the credit markets, they have been forced to move toward a private equity model with respect to terms relating to deal certainty, an important consideration for target boards. This convergence could level the playing field somewhat for financial sponsors, at least for so long as it lasts. Of course, when the debt and equity markets return to some semblance of normalcy, it is quite possible that strategics will be willing once again to forego these limitations on their exposure. But this does create an opportunity for private equity buyers, at least in the short term. Unfortunately for them, this comes at a time when LBO financing is extremely difficult to obtain. But if firms are willing to put more equity into transactions, they would not only be taking advantage of depressed asset values, but could also benefit from this newfound parity with respect to deal conditionality.

It is worth noting as an aside that private equity buyers have certain other inherent advantages over their strategic counterparts in the auction context. For example, a potential sale necessarily involves the provision by the target of a large amount of sensitive information, which is particularly unsettling where the merger discussions are with a major competitor. Because there are necessary links between the parties that have led the buyer to believe that the acquisition would be attractive in the first place, including synergistic product lines, or similar customer pools, there is a greater risk that a failed transaction with a strategic buyer would have more problematic commercial consequences. Although potential buyers are typically bound by confidentiality agreements, they are often not enough to assuage the target's fear of entering into talks with a competitor, and rightly so. In addition, strategic acquirers may face more stringent antitrust review under the Obama administration than was the case during the Bush administration.

So the convergence in deal terms with respect to conditionality may offer some welcome relief to private equity buyers plagued by less-than-active leveraged financing markets. They can agree to terms on conditionality similar to those being proposed by some strategics, but with the added benefit that a busted deal with a private equity firm is far less damaging to a business than one with a competitor. While this may not be enough to increase private equity deal activity without a far more vibrant financing market, it is a modest silver lining for financial sponsors -- and illustrates how the deal world constantly evolves. n

Kevin A. Rinker is a partner and Shelby E. Parnes is an associate in the New York office of Debevoise & Plimpton LLP. A version of this article originally appeared in the spring issue of the Debevoise & Plimpton Private Equity Report.

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