Desperately seeking certainty

The past year has been brutal for private equity. Since debt markets cratered a year ago, numerous large buyouts, including SLM Corp., United Rentals Inc. and, most recently, Huntsman Corp., have collapsed. The 523 buyouts worth $65 billion since Aug. 1 pale in comparison to 2005, 2006 and the first half of 2007. Shares of industry bellwether Blackstone Group LP have fallen by half since its initial public offering at the peak of the boom last June.

But a longer-term view is more encouraging.

U.S. private equity activity since Aug. 1 would top that of any year between 1990 and 2003 and came within hailing distance of 2004's 531 deals worth $106.5 billion, according to research firm Dealogic.

The largest deal signed since Aug. 1 -- Bristol-Myers Squibb Co.'s $4.1 billion agreement to sell its ConvaTec wound-therapeutics unit to PE firms Nordic Capital and Avista Capital Partners -- pales next to the largest buyouts of 2005 and 2007, but it's in the same range as Blackstone's $4.7 billion purchase of TRW Automotive Holdings Corp. in 2003, at the time the largest leveraged buyout since RJR Nabisco in 1988.

The run of collapsed deals has led some observers to predict that sellers would demand greater contractual certainty from PE shops in merger agreements, but so far that hasn't happened. Instead, sellers have gained some of the certainty they seek from more secure debt and equity financing arrangements while PE buyers have become more vigilant in rooting out dangerous ambiguities in contracts.

"There's certainly more talk about certainty," says R. Newcomb Stillwell, an M&A partner at Ropes & Gray LLP in Boston. "But in almost all cases, there hasn't been any change at the end of the day in what's considered an acceptable structure in M&A papers, whether [material adverse effect] clauses or the amount of money sellers expect to put up. The deals are just a lot smaller. "

Thomas Repke, Jeffrey Rothschild and Andrew Shanbrom of McDermott Will & Emery LLP and Kevin Schmidt of Debevoise & Plimpton LLP concluded similarly in two surveys of recent LBOs. Most of last year's large LBOs allowed prospective acquirers to walk upon payment of a reverse termination or breakup fee of about 3% of the deal's value and barred targets from seeking specific performance of the merger agreement. Last August, Bain Capital LLC, Carlyle Group and Clayton, Dubilier & Rice Inc. used the right to extract a 17% price cut in their buyout of HD Supply, from $10.3 billion to $8.5 billion. Other buyout shops then walked from deals on the same basis, including JC Flowers & Co. LLC, which jilted SLM.

That structure gave the buyer an option on the target for the period between signing and closing: If the buyer still wanted the target on the latter date, it could execute the agreement; if not, the buyer could walk after paying a termination fee. Starting with the 2005 sale of Neiman Marcus Group Inc., LBO merger agreements often included a "two-tier" breakup fee, in which a buyer would pay a lower percentage in the event it couldn't obtain financing and a higher one if it decided to walk from the deal in the absence of a contractual right to do so, such as a so-called material adverse effect at the target.

The McDermott and Debevoise lawyers found that those provisions remain standard. "All of the going-private deals signed since last October have explicitly provided that the seller will have no right to force the closing," Schmidt wrote. "At least one deal did allow the seller the right to seek specific performance of the financing covenant, but for most, the only remedy if a buyer refuses to chase its lenders would be a claim for damages."

Paul Shim, an M&A partner at Cleary Gottlieb Steen & Hamilton LLP, agrees: "The merger agreements in the deals that have been done since the bubble burst have largely followed the reverse break fee, no-financing condition, no-specific-performance paradigm."

The ConvaTec LBO was an exception to this buyer-favorable structure. The seller, Bristol-Myers Squibb, won the right to force buyout shops Avista and Nordic Capital to close on their $2.1 billion equity commitment and to sue the lending banks if they tried to back out of the deal. Bristol-Myers was able to get such terms because it ran a robust auction in which both strategics and buyout shops bid; the company emphasized deal certainty as a necessary element of a winning bid, a stance that followed the path trod by Michaels Stores Inc. in 2006 and Avaya Inc. last year.

Perhaps the greatest change in buyout merger agreements in 2008 has been a focus on contractual clarity, a direct response to Delaware Chancellor William B. Chandler III's ruling in the URI case. There, Cerberus Capital Management LP claimed it had the right to walk from its $6.6 billion agreement to buy the equipment rental company upon payment of a $100 million reverse breakup fee. URI argued that the merger agreement provided for specific performance, which it sought as a remedy. Chandler found the document unclear on that point but ruled for Cerberus because he gave more credence to its version of the merger negotiations than URI's.

The judge found for Cerberus on the "forthright negotiator principle," under which, he wrote, "the subjective understanding of one party to a contract may bind the other party when the other party knows or has reason to know of that understanding." The ruling highlighted the risks of contractual ambiguity that lawyers often accept as a way to paper over differences that might otherwise impede a deal clients want to sign. After the URI decision, private equity shops are pushing for language that clearly states the target has no right to specific performance -- a position many LBO merger agreements took even before URI.

"There is absolute clarity on the specific performance issue," says Debevoise's Schmidt. "To the extent there was any ambiguity in how these provisions were written in some deals, that has been removed."

But if merger agreements haven't given targets greater certainty, other aspects of recent LBOs have. First, the deals are smaller and easier to finance. Second, over the past year, PE shops have avoided deals in highly regulated industries where government approvals can take several months or even a year or more to obtain, part of a general trend toward executing transactions more quickly. If a standard LBO merger agreement is in part an option that the target gives to the PE firm, one way to reduce the value of that option is to reduce its length -- the time between signing and closing.

"In the old days, you had 60 to 90 days between signing and closing," says Robert Profusek, a partner at Jones Day in New York. "That's the push today, to have that length. The nine- to 15-month drop-dead periods that became common starting in 2006 are totally off the table." In contrast, the BCE Inc. buyout still hasn't closed a year after it was signed; the Clear Channel Communications Inc. buyout has taken even longer.

Buyout financing has also led to greater certainty. Sponsors are now putting up to about 50% of a deal's value in equity, according to Hydee Feldstein, a partner at Sullivan & Cromwell LLP in Los Angeles. The higher the percentage of equity a sponsor puts into a deal, the better the investment must perform for the sponsor to get its expected return on equity -- and, conversely, the more confident the sponsor must be to sign up the deal in the first place.

"Because sellers are asking PE buyers to take on greater financial risk than in the past if the financing falls through, we're seeing buyers seek much more definitiveness from their lenders at the commitment stage," says Ron Cami, a partner at Cravath, Swaine & Moore LLP in New York. (Cravath represented Bristol-Myers on ConvaTec, though Cami did not work on the deal.) For example, he says, "I saw one buyer negotiate all the covenants at the commitment stage and another even negotiated the entire credit agreement up front in an effort to eliminate the documentation condition that caused problems when the debt markets went south." Since banks realize they may not be able to syndicate the debt incurred in an LBO, they're evaluating debt as creditors rather than brokers and thus demanding more performance requirements in the financing papers, such as Ebitda requirements.

So despite the upheaval, despite collapsed and renegotiated deals, despite leverage ratios of 1-to-1, the market found a model for executing deals that seems to work. "Rather than saying, 'The market's changed,' maybe the period of 2006-7 was the change, and we're going back to basics," Profusek says.