Macs: New ways to kill a deal

Author: | Published: 1 Jul 2008
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It's rare for a private equity buyer and its target to team up and litigate on the same side. But in the US, radio company Clear Channel and its private equity acquirers Bain Capital and Thomas H Lee (THL) did just that. The New York suit centred on the financing banks reneging on lending terms. As the company's stock had been trading below the offer price due to the turmoil in the credit markets, the private equity firms and Clear Channel accused the banks of shying away from providing funding now that market conditions have deteriorated. After agreeing to provide credit that would mature in six to eight years, the banks now insist on a three-year maturity.

The case came to represent the state of play in large M&A deals.

A new phrase is emanating from Wall Street, across the Atlantic to Canary Wharf and reaching even as far as Hong Kong: lender's remorse. Banks are regretting the terms of financing they agreed on last year, and some are trying to back out.

And for deals negotiated now, there is a shift in the conditionality that banks are prepared to accept in their commitments to fund acquisition financing. This pushback is shifting the risk of financing back to the buyers, who in turn feel compelled to transfer some of the risk back to the seller.

In short, if banks insist on making borrowing more risky, those doing the borrowing will pass whatever risk they can onto the sellers. This, coupled with the volatility of the markets, has hastened the rise of the material adverse change (Mac) clause. But the clause will not simply become more important in the coming months. With the threat of litigation, the clauses will start to look different too.

Get-out clause

The Mac clause functions as a condition to the buyer's obligation to close on a transaction – it's a get-out clause. It applies from the date of the seller's most recent financial statements to the closing of the deal. With the fading of financing outs (in private equity-led deals) the clauses are often the only way for a buyer to terminate a deal without paying the hefty reverse breakup fee.

Until last summer, buyers generally had no desire to kill deals. And with the availability of cheap financing and a glut of suitors, Macs were mere boilerplate. Now things have changed. With financing terms far harsher than a year ago (as Bain and THL will testify), the Mac is expected to take on increased prominence. But with companies underperforming and a wave of litigation expected, these clauses are now being negotiated with one eye on how they'll look in courts.

The benefits of Macs are clear and buyers have little to lose in asking for it. For instance, most deals are structured to limit the buyer's downside to the reverse breakup fee (the charge leveled at an acquirer that backs out of a deal). If the buyer claims a Mac has occurred but the court disagrees, it will be treated just the same as a terminated deal without a Mac, and have to pay the reverse breakup fee. This breakup fee may be smaller than a multi-billion dollar acquisition, but firms are aware of the damage to their reputation if they walk away from a deal with supposedly acceptable terms. Macs cost no more than a reverse breakup fee, but are priceless in terms of salvaging reputation. So on the buyer side, there is no harm in asking for one.

However, asking for a Mac and agreeing on one are entirely different propositions.

The devil's in the drafting

This is because Mac clauses have no definition. What, for instance, constitutes material? This ambiguity means that buyers' and sellers' counsel face fierce negotiations over the wording of a clause, especially in grim financing conditions.

Sellers have always wanted narrow, specific terms with carve-outs (terms that limit what constitutes a Mac). Their main priority now is to seek carve-outs that reflect market conditions. "The seller will argue that its results may deteriorate, but that so will its peers'," says Barbara Mok, partner at Jones Day in Hong Kong.

This is where the major battles are being fought. Do a target's poor results, when similar to those of its industry peers, warrant a buyer terminating a deal? Tihir Sarkar, a partner at Cleary Gottlieb in London thinks not, and predicts sellers will be granted these carve-outs as a matter of routine from now on. "This kind of volatility in the world markets will be an area where sellers will want to limit termination risk by narrowing Mac-out clauses," say Sarkar. "It's just not going to be acceptable to the seller to be subject to those kinds of uncertainties." he says.

It's understandable then, that sellers are focusing on aligning their performances with those of their peers. Genesco's Delaware victory of Finish Line (see box-out) set a precedent for sellers successfully claiming these industry-focused carve-outs.

It's not so simple for buyers and their counsel. Historically, buyers fought for a broad Mac, because the vaguer the definition, the more scope there is for claiming one. A broadly drafted Mac is more of a mission statement to play on ambiguity further down the line. "It gives the buyer some wiggle room," says Lee Suet Fern, director of Stamford Law in Singapore. No seller wants its financial records examined under the cold light of a court. And once a deal is announced neither party, especially the seller, wants it killed, for the sake of its reputation.

Nevertheless, the definition of a Mac hasn't changed since the market crashed last summer. A study by Kenneth Wolff and Cason Moore of Skadden Arps Slate Meagher & Flom compared the terms of Mac clauses in recent public deals to those before the crash. It looked at the 3Com/Bain & Huawei, Radiation Therapy/Vestar and Goodman Global/Hellman & Friedman deals (all made from October 2007 onwards) alongside five transactions announced in July 2007. The definition of a Mac was broadly the same.

A Mac, according to these deals, is "facts, circumstances, events or changes that are, or are reasonably expected to become, materially adverse to the business, financial condition or results of operations of the company and its subsidiaries, taken as a whole".

Buyers: be specific

But things are likely to change soon. If a case is remotely likely to end up in court, case law shows that the clause will be read against the party that tries to cite it. This means buyers should also be willing to narrowly define what constitutes a Mac. The terms may be demanding of the target, but they should at least be specific.

A buyer requesting a clearly defined Mac seems disingenuous, but it is not. "Importantly, a court will always try to anticipate what was in the buyer's mind when the clause was negotiated." says Robert Ashworth, head of Freshfields' corporate practice in Asia.

So demands on the performance of the target can be high, but they need to be transparent to hold up in court. Common court laws don't favour the seller by default necessarily, but if a party is trying to invoke an exclusion provision, the burden of proof will fall upon that party. A woolly Mac will reflect badly on both parties but is likely to damage the buyer's claim more.

These theories, until now largely hypothetical, will be put into practice as litigation over failed deals increases. Only a handful of disputes have so far reached the Delaware Chancery Court in the US, and fewer still have come to court in Asia. But this will change now that the credit squeeze has set in. Europe is also likely to see more cases.

Macs in Asia

That Mac clauses are burgeoning in Asia is surprising, given that it's the only region where potential targets have remained largely unscathed by the financial crisis. A study carried out by Lee Suet Fern, director at Stamford Law in Singapore, examined the frequency of Macs in takeovers of publicly listed companies in Singapore, Malaysia, Hong Kong and Australia (see box-outs). The survey found that although Mac clauses aren't common in Singaporean, Malaysian and Hong Kong M&A they are on the rise, especially in Hong Kong – where three out of five public M&A deals included such a clause in 2007.

"I didn't see any on term sheets in Hong Kong deals three years ago but we've been recommending them to private equity buyers for most of 2007 onwards," says Ashworth.

Chinese sellers are also getting used to the concept of Macs, and understandably so. "If you're investing large amounts of money into a relatively young Chinese company, you'll want a Mac," says Ashworth. On the face of it, this seems counter-intuitive, considering the number of private equity buyers and the scarcity of good targets in China. But when it comes to actual deal making the Chinese may be willing to concede a Mac in exchange for similar sell-side protection, such as a break-fee.

Asian companies may be one step removed from the turmoil of the west, but the rise of the Mac in the region underscores a general trend: Macs now matter.

Narrow is the new wide

In seminars and forums everywhere, Macs are being discussed with the same ferociousness as they are negotiated. Counsel know that the clauses are more important now than ever.

But to talk of the pendulum swinging back to buyers (as many are) misses the point. Anaemic markets don't justify a vague, catch-all Mac being stamped on the seller.

They do, however, make a failed bid and exercising of a Mac more likely. And because courts have traditionally put the burden of proof on buyers, their counsel will need to keep Macs specific. The expected wave of litigation will see more failed M&A deals going to court. Cerberus/United Rentals (see box out) and Clear Channel's saga are prime examples. Here, vagueness would have suited only the seller, by showing up the acquirer and its counsel as cynical during the drafting.

Mac clauses will almost certainly change. No one argues that that is not the case. But, most importantly, buyers' counsel will now have one eye on the courts when they negotiate. The days of woolly, catch-all drafting are over; a new tighter, narrow clause will emerge.

Tom Young Asia editor with additional reporting from Lynann Butkiewicz and Nicholas Pettifer

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