The record-setting pace of private equity transactions continued unabated during 2005. Published estimates indicate that more than 1,500 private equity transactions took place globally in 2005, representing deal value of more than $300 billion, with more than one-third of that number representing transactions in the US. These US transactions have included a large number of public-to-private transactions, which are often larger in value on average than their private company counterparts, with terms that reflect the realities of the intense competition inherent in dealing with public company targets in the US. These deals were often the result of hotly contested auctions in which leveraged buyout (LBO) buyers needed to compete in price with strategic buyers - whose ability to use deal synergies often makes it easier for them to pay a premium price. These mega private deals were marked in two respects during 2005: significant changes to traditional deal terms, relating particularly to the debt and the equity financing for the transaction, and the continuing use of large consortia or clubs of private equity funds to consummate these transactions.

Important provisions of acquisition agreements have changed in private equity deals during 2005 and continuing into 2006. Private equity sponsors, particularly in public-to-private deals, are generally accepting more risk - more risk in being obligated to close the transaction in less than perfect circumstances (exhibited by these buyers' acceptance of additional exceptions to the definition of what constitutes a material adverse change (MAC) to the target's business or the absence of a financing condition to the requirement to close) and more risk in connection with the target not achieving the results the buyer had planned (exhibited by fewer representations and warranties in the acquisition agreement and lower caps on seller indemnification, coupled with provisions that establish indemnification as a buyer's exclusive remedy for warranty breach).

These changes to the financing provisions are departures from decades-long practices in this area: changes affecting the existence or terms of the financing condition and other financing-related provisions in the acquisition agreement, the identity of the PE firms' signatory to the transaction documents, as well as the aspects of the deal for which such entities will be on the hook and the dollar extent of such recourse and, lastly, the existence of monetary penalty provisions relating to the failure of these transactions to close, which include reverse break-up fees payable to a target if a deal does not close due to the failure of the financing to close – all were present in the 2005 mega-deals.

Bidding consortia are not new to private equity transactions. But given the size of these deals in 2005, these consortia grew both in number of participants and in the overall level of each member's equity participation. In addition, the identity and nature of the participants changed to include in a single consortium more than one LBO firm accustomed to playing the lead role in transactions. Often, reflecting a new trend to analyze - and, perhaps, finance - targets differently, these consortia included one or more participants with a special expertise or interest - such as the Vornado Realty Trust's participation in the Toys "R" Us transaction. Commentators have noted how these complexities affect the operation of a consortium - both pre- and post-closing - but sellers and their advisers need to be mindful of the effect these changes have had and will continue to have on bidding process design and risks associated with consummation of a transaction.

It remains to be seen whether these trends will continue or whether they will cross over to private company deals and middle-market deals. However, the change in these terms, even if not destined to be copied in deals in these markets, is an indication of dealmakers' increased familiarity with the terms of financed transactions and might be a harbinger of continued examination and modification of those terms to suit the specifics of any given target's situation and the circumstances of that auction. The keyword in all of this might well be flexibility: there is no one way in which deals - even the large public deals - will be done. But there is certainly a good deal more attention being paid to the precise terms of the financing for these transactions, with an emphasis on tailoring them to suit the needs of a specific auction setting. LBO funds' willingness to do this might be a function of the need for such firms to be competitive with strategic players in the M&A marketplace or that global deals outside of the US have forced funds to become accustomed to doing transactions without financing conditions; that experience coupled with the ability to share risk with a greater number of participants in larger bidding consortia could be leading these firms to accept a higher level of risk. It might also be the natural outgrowth of second and third generation LBOs in which PE funds are often selling portfolio companies to other PE funds, resulting in sophisticated financial investors being on both sides of these transactions. Whatever the cause, it is a significant development and bears watching.

Debt financing provisions in acquisition agreements

Historically, a typical LBO acquisition agreement would contain a closing condition related to obtaining the debt financing for the transaction, coupled with representations in which the buyer would describe the commitment letters it had obtained to finance the transaction (and, typically, attach those letters) and covenants obligating the buyer to use a certain level of effort - reasonable best efforts, or commercially reasonable efforts - to obtain financing. In addition, the covenants often included provisions requiring the buyer to obtain alternate financing if for any reason the committed financing fell through and, importantly, defined that alternate financing - generally as financing on economic terms no less favourable to the buyer in the buyer's judgment than that originally planned. The commitment letters received by the buyer generally would also be subject to a number of conditions, possibly broader and more numerous than those contained in the acquisition agreement.

This whole package of provisions, of course, depended upon the existence of a financing condition: an acquisition agreement for an LBO without a financing condition would be almost identical to that of a strategic buyer - with the possible exception of the absence of an affirmative representation as to the availability of funds. There would be no need for an LBO buyer to make representations about, or give covenants with respect to, financing for the transaction if obtaining it were totally its own risk.

With the increased use of auction settings in recent times, we have seen heightened review of the terms of a buyer's commitment papers, resulting in increased convergence between the conditions to an acquisition agreement and the conditions to the bank financing, both in the commitment papers and the loan documents signed at the time of the acquisition agreement. Over time, several conditions that might have been included in commitment papers, such as conditions relating to the lender's continued diligence, have been increasingly eliminated. Moveover, even when conditions remain in the commitment papers, such as the no material adverse change condition discussed below, the provision in the financing papers is often conformed to that in the acquisition agreement, as compared to the previous practice, when it would generally have been drafted much more broadly.

That trend again exhibits the level of involvement by sellers and their advisers in the review of financing documents. The convergence of terms and the need to compete might have encouraged bidders to go to the extreme and eliminate financing conditions: a number of multibillion-dollar deals were done in 2005 without a financing condition, including The Neiman-Marcus Group ($5.1 billion); Wyndham International ($1.44 billion); Insight Communications ($2.1 billion); SBS Broadcasting ($1.86 billion); and Shopko Stores ($1.15 billion).

Even when a financing condition was included in the acquisition agreement, a close review of the terms of the condition can show the buyer accepting a high level of deal risk. The year's $11.3 billion mega-deal, Sungard Data Systems, included a sharply proscribed financing condition, limiting the financing condition to a lender MAC (insolvency of or a lending restriction on a lending institution providing at least 25% of the debt financing) or market MAC (banking moratorium, suspension in market trading or war or other events materially disrupting the markets), but, significantly, no event or occurrence that had anything to do with Sungard or its business. It is likely that in most circumstances in which a buyer has been unable to obtain financing, the cause was not a bank failure or a market or syndication issue - it has been due to some failure at the target company, often revealed during additional due diligence in the time between signing and closing or shown in deteriorating or less-than-projected financial reports for a previously unreported period. The ready availability of financing in 2005 has led deal professionals to think more and more of PE acquisitions as market trades, but the fact remains that the financial condition and results of operation of the target matter, at least as a support for the acquisition price upon which the financing is based. So the determination to proceed without a financing condition, or with an extremely limited one, is indeed risky, particularly if the financing commitment papers have conditions that are broader than or additional to those in the acquisition agreement.

The existence of a no material adverse change condition in the acquisition agreement will ameliorate a buyer's risk but certainly not eliminate it. Recent Delaware case law has generally shown the difficulties buyers face in proving that a material adverse change had occurred in the target's business. In IBP, the Delaware Chancery Court (applying New York law) held that a drop in the target's earnings reported in the period from signing to closing was not enough to prove that a material adverse change had occurred, because such a change needed to be sustained in duration, having a provable material effect on the long-term earnings potential of the target - not helpful for a buyer that bases its purchase price on a hefty multiple of current or anticipated earnings. The issue of the circumstances under which the occurrence of a significant liability could be a MAC was also addressed in Frontier, in which the Delaware Chancery Court held that litigation filed between signing and closing could not form the basis for the failure of a buyer's material adverse change condition unless the related damages were sufficiently foreseeable and large, essentially requiring the plaintiff to show the damages that would be suffered due to such litigation and not just the apparent significance of the litigation or the expected costs of defending it.

Material adverse change cases are by nature highly fact-specific and there will be circumstances in which a buyer will be able to prove a MAC had occurred at the target company. Nonetheless, the case law in this area - IBP, Frontier and others - shows the difficulties inherent in doing so. Suffice to say that well-advised buyers should be concerned about and carefully consider the risks of proceeding without a financing condition - taking this risk might not spread much past the mega deals. However, this increased emphasis on, and understanding of, financing terms might encourage targets to tinker elsewhere. Well-informed and well-advised sellers will continue to place an increased level of pressure on the precise terms of a buyer's committed financing, making sure it is as tight as possible with few conditions. Commitment papers typically already include market flex terms - pricing and other terms that a lender may adopt to syndicate the financing and as to which the borrower-buyer is obligated. Perhaps in the right circumstances sellers might even put pressure on buyers to be obligated to seek alternative financing on terms not quite as favourable as those in the commitment papers.

This risk-taking trend was also reflected in other aspects of LBO acquisition agreements, including particularly in private company transactions. Agreements that for years were marked by extensive representations and warranties with fulsome indemnification are now including slightly less extensive representations coupled with caps on indemnification, sometimes to a fraction of the purchase price. Clearly, this is a response to competitive pressure. But again, buyers beware - Delaware case law generally upholds bargained-for contractual disclaimers of reliance by a buyer on any information other than the representations and warranties in an acquisition agreement, and a recent Delaware case, ABRY Partners, has shown that a cap on indemnification in an acquisition agreement will be upheld unless fraud or intentional misrepresentation can be proven.

Equity financing

For decades acquisition agreements have been signed on the buy-side by special purpose entities set up by the PE fund buyer for the sole purpose of that transaction; sellers have long worried about the ability to obtain redress from these vehicles and not being in privity of contract with the PE fund itself. The equity necessary to fund the deal was generally committed by the PE fund to the entity, subject to the satisfaction of the remainder of the conditions in the acquisition agreement, particularly the funding of the debt necessary to complete the transaction, and the seller might have been designated as a third-party beneficiary to that letter, giving it the right to sue the PE fund directly for the failure of its equity commitment. Many buyers felt that this still left a gap: PE fund liability for pre-closing breaches of the acquisition agreement, particularly covenants such as the covenant to use commercially reasonable (or other) efforts to obtain the required financing. For years PE funds have argued that their reputational risk associated with failing to fulfill these obligations was so large that sellers need not worry about any failures, and that might well have been correct. Nonetheless, as a legal matter there was a disconnect: the seller was only able (on the documents, at least) to sue the shell entity for failures related to this covenant, and expenses and other pre-closing obligations covenants that might be present in some deals.

2005 saw a sea change in this area - although the form of support varied, increasingly PE fund buyers agreed to be liable for material breaches of these covenants. Several of the year's deals saw some direct obligation on fund buyers for the failure of the financing or some other breach as a part of the documented transaction: Sungard Data Systems, The Neiman-Marcus Group, Insight Communications and Tommy Hilfiger, for example. Many transactions incorporated a contractual feature that went beyond the LBO fund buyer merely standing behind breaches of the agreement: a reverse termination fee, that is, a fee to be paid by the buyer to the target if the financing failed to close, which was included in transactions both with and without financing conditions.

The reasons for including such a provision in any given acquisition agreement run the gamut, but it is certainly true that such provisions could serve to bridge the gap between financial buyers and strategic buyers in competitive auctions, in which a target/seller might be attempting to justify its choice of an LBO fund buyer with the attendant financing risk. This might be particularly true in public-to-private transactions, because public companies have an increased level of concern about failed deals and the damage a public failure will cause the target. That concern could lead a public company board of directors to believe that such a penalty provision is justified.

The amount of an LBO fund buyer's direct liability for the shell entity, including reverse termination fees, varies widely even over the mega deals. Reverse termination fees, if present, can be large but rarely as large as termination fee payments (topping fees) in public deals, which typically range from 2.5% to 3% of the purchase price. The amount of liability backed by PE fund buyers varied widely deal to deal in 2005: interestingly, in the Neiman-Marcus transaction the reverse termination fee payable if the financing failed to close was $140.3 million while the parent entities' liability for other kinds of breaches was capped at $500 million. In a number of situations a bidding consortium's liability for breach was less than the equity commitment. While the trend of PE funds having some measure of direct liability for the obligations of the special purpose entities that they create for a specific transaction could be viewed as aiding sellers, the certainty of fixing a maximum amount of liability as liquidated damages in these transactions - and the freedom that brings from worrying about liability based on other legal theories such as piercing the corporate veil - could be even more valuable to a PE fund buyer, particularly if the level of damages is lower than its equity commitment.

Issues associated with consortium deals

As deals get larger, more and more large bidding consortia are being employed to win bids and consummate deals. Certain issues have traditionally been associated with these bidding groups: In particular, there is a risk that large groups could fall into disarray, possibly causing disruption to the bidding process, in spite of a consortium's goal to speak with one voice and present a unified front to a seller. A consortium also needs to work out numerous post-closing matters, including board membership, governance matters, veto rights over key decisions, and the timing and form of the exit from the investment.

However, in 2005, it became clear that the existence of these consortia is having an increasingly important effect on the design of the bidding process itself. Targets and their financial advisers have been addressing the implications of having several of the available and likely bidders clubbing to make a bid, since such actions could limit the overall number of interested parties in any given target company and, without careful planning, could affect a seller's ability to obtain the maximum purchase price for the target. In addition, with so many parties in a deal, there is reason to worry about protecting the target's confidential information from widespread dissemination as well as the confidentiality of the bidding process itself, particularly in the case of public company targets.

To maintain a robust process, financial advisers have been attempting to use the deal's confidentiality agreement to prohibit these kinds of activities and generally enforce the rules of the auction. Confidentiality agreements typically will include provisions prohibiting bidders from discussing the possible transaction with other prospective bidders or joining with other bidders to make a bid. These provisions can lead to debate both in drafting and interpretation due to the difficulties associated with defining the scope of prohibited activities, especially because a seller will want to allow bidders to work with financing sources (which can be a diverse group, depending on the target) to produce a fully financed bid package. The situation is further complicated insofar as overall transaction size might require equity commitments larger than individual funds typically can provide. And teaming up could help a potential bidder stay in an auction if adding a certain member to the group will provide it with needed industry expertise or if sharing risk is a factor. Sellers also need to attempt to ensure that sufficient financing sources are available to keep the number of bidders high; publicized accounts of the auction for Albertson's indicated that financial advisers were attempting to work through issues associated with the possibility of a number of prospective bidders entering into exclusive arrangements with financing sources.

Attempts to protect the process in these ways can be expected to continue, although it is unclear whether confidentiality agreements can be expected to effectively provide this protection, given the difficulties in predicting the steps that might occur and the uncertainties associated with proving the level of damages that might have been incurred with respect to alleged breaches of such provisions.

2005 has received a lot of attention as a record year for private equity, but it was also a year of significant changes in the traditional terms on which private equity transactions have been consummated. Those terms and other practices can be expected to continue to evolve as more experienced and knowledgeable private equity players take their seats on both sides of the bargaining table.

Eileen T Nugent is co-head of the private equity group at Skadden Arps Slate Meagher & Flom

Author biography

Eileen T Nugent Skadden Arps Slate Meagher & Flom Eileen T Nugent is a mergers and acquisitions partner who has worked on a wide variety of acquisitions and dispositions of companies, subsidiaries and divisions, both public and private, hostile and negotiated, in the US and around the world. A number of these transactions have been leveraged buyouts (LBO) and she is co-head of the firm's private equity group. Nugent has represented a full range of transactional parties, including buyers, sellers, controlling stakeholders, boards of directors and special committees, LBO organizers and management teams, as well as investment bankers and various financing sources. She has worked on numerous recapitalizations and other reverse LBO transactions, such as initial public offerings, and is one of the firm's leading practitioners in the field of M&A and restructuring of financially distressed companies. The breadth of her experience has resulted in her being increasingly regarded as a senior legal, business and strategic advisor to her clients, particularly in the areas of corporate governance and conflict-of-interest situations, including dealing with significant stockholders. Selected recent public company transactions include her representation of Warner-Lambert Company in its planned $85 billion merger-of-equals with American Home Products and its ultimate acquisition by Pfizer; AMC Entertainment in its $2 billion sale to JP Morgan and Apollo Partners; Marathon Fund in its proposed acquisition of Shopko Stores; Donna Karan in the sale of Karan's company and Donna Karan International to LVMH; Saks Fifth Avenue in its sale to Proffitt's; Kelso & Company in its acquisition of Endo Pharmaceuticals Holdings from EI du Pont de Nemours and Endo in its subsequent merger with Algos Pharmaceutical Corporation; and Martin Marietta Corporation's proposed acquisition of Grumman Corporation.