Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion

by Steven M. Davidoff

  In the 1990s, targets began to contractually bind private equity firms to acquisitions by demanding and receiving equity commitment letters from the private equity firms.These letters obligated the firms to supply the shell with the necessary equity to complete the transaction. Previously, the target had relied on the good will of the private equity firm to provide the equity component. The gap in financing these transactions was filled by this change, ensuring that the shell subsidiary had access to both debt and equity to complete the transaction. During this time period, debt commitment letters commonly included terms for bridge financing. Bridge financing is interim financing between the completion of the transaction and the placement of any high-yield, permanent financing. Adding this facility provided greater comfort to the target that the transaction would be completed if the issuance of any of the permanent high-yield debt was delayed.51

  SunGard and the Transformation of Private Equity

  Then came SunGard. SunGard was the largest private equity deal since KKR’s acquisition of RJR/Nabisco, more than a decade and a half before. It was also a club deal involving multiple private equity buyers, and it was something novel for private equity, a technology deal.52 SunGard was an IT services and software company. In short, SunGard was a unique and historical private equity deal. Because of this, SunGard’s lawyers at Shearman & Sterling LLP were worried about the financing risk. To address this issue, Shearman & Sterling negotiated the removal of the financing condition. The result was a tighter deal, ostensibly more favorable to the target. The equity portion of the transaction was agreed through an equity commitment letter executed by the seven private equity firms. The debt portion of the transaction was agreed through a commitment letter that included a bridge financing facility.

  In exchange for agreeing to the removal of the financing condition, SunGard provided the private equity buyers the ability to terminate the agreement and walk on the deal if they paid a reverse termination fee of $300 million. If the shell was unable to complete the buy-out for financing or simply refused to do so—that is, the deal was terminated—the consortium would pay a fee of $300 million to SunGard as compensation. 53 The fee was called a reverse termination fee because it was patterned on the termination fees that targets typically agreed to pay buyers if they subsequently accepted a higher offer from another bidder. Since the shell was still that, an empty corporation without funds, the private equity buyers issued a guarantee for this payment.54 (See Figure 2.2.)

  This type of structure had previously been utilized in real estate deals. However, the SunGard “structure” was the first significantly sized private equity transaction to employ such architecture. It quickly took hold in private equity transactions for two reasons. First, private equity firms preferred the structure because it eliminated an argument of veil piercing.Veil piercing allowed a target to pierce the limited liability of corporate acquisition shells and obtain a judgment against the fund itself. In exchange for agreeing to the reverse termination fees, the private equity firms provided a no-recourse guarantee, under which the targets waived any veil-piercing claim. Thus, the private equity firm capped its aggregate liability at the reverse termination fee. Second, targets preferred the structure because it ensured a measure of compensation if the financing on the transaction failed. The SunGard reverse termination fee structure thus represented an improvement on the old structure.

  Figure 2.2 Structure of SunGard Data Systems, Inc Buy-out

  SOURCE: SunGard Data Sys. Inc., Definitive Proxy Statement (Schedule 14A) (June 27, 2005)

  Figure 2.3 sets forth my own calculations as to the percentage of private equity deals utilizing a reverse termination fee structure from 2004 through 2008.The figure shows a rapid shift in practice as the use of financing conditions dropped in inverse proportion to utilization of the reverse termination fee structure.

  Figure 2.3 Adoption of Reverse Termination Fee by Private Equity Firms (% of Total Acquisitions 2004-2008/Value Greater $100M)

  SOURCE: Factset MergerMetrics

  The structure sometimes varied in important ways. For example, in the 2005 buy-out of Neiman Marcus Inc., the private equity buyers agreed to a two-tiered termination fee. A lower fee would be paid if the deal collapsed on account of a failure of financing, a higher one if the buyer simply decided to walk on the transaction without reason. A third variation of this arrangement arose in other buyouts where the target could supposedly force the private equity shell to enforce—in legal terms, specifically perform—the debt and equity commitment letters to complete the transaction, but if the shell was unable to do so and the financing failed, only the reverse termination fee was payable.

  In its first two variations, this arrangement provided a flat-out option to the private equity firm to exit a transaction simply by paying the reverse termination fee. This was a high level of explicit optionality for private equity buyers. The reverse termination fee typically amounted to approximately 3 percent of the deal fee. Accordingly, before completing an acquisition, private equity firms could simply gauge whether the deal was worth completing or if it would be more economical to walk on the deal and pay the reverse termination fee. Lawyers at the time appeared well aware of this potential but often advised their clients that a private equity firm’s need to preserve its reputation for making good on its deals would prevent this economic calculus.

  Moreover, despite outliers, the fee largely stayed at 3 percent and was not varied for individual transaction or regulatory risk. Parties kept to this number because of the symmetry of the reverse termination fee with the regular termination fee. But this symmetry was false. The termination fee was regulated by Delaware law and was designed to compensate a buyer in case of a winning competing bid while the reverse termination fee was designed to compensate the target for a failed deal and deter a buyer from walking. The reverse termination fee structure was an improvement on the old structure since it provided compensation to the target if financing could not be arranged. However, in hindsight, the reverse termination fee was set too low, and the failure to appropriately set it would come to haunt targets during the financial crisis.

  Private Equity in the Sixth Wave

  Private equity was also learning from its prior missteps. The RJR-KKR transaction had taught the industry the dangers of singlehandedly attempting to bag the elephant. Private equity firms began to increasingly work together on sizable transactions, sharing transaction expenses and risk. The SunGard transaction was the first significant one of these, but many more were to follow. Of the top 10 private equity deals from 2004 through 2007, six involved more than one private equity firm.55 Gone were the days when Teddy Forstmann and Henry Kravis were mortal enemies, never to speak, let alone work together. Now private equity firms often collaborated, avoiding competition for transactions and another RJR-type bidding war. Again, the SunGard transaction was significant for being one of the first of these deals. Targets complained that this resulted in bid rigging and lower premiums paid to their shareholders, and the Department of Justice investigated private equity for anticompetitive behavior, but the practice continued unabated.56

  Private Equity and Its Critics

  As private equity again rose in prominence, it once again stirred public controversy. Private equity was criticized for cutting jobs, closing offices and factories, and underspending on capital investment in order to service their acquired companies’ high debt.This was a criticism that harked back to the 1980s. One prominent study found that companies acquired by a private equity firm on average suffered a 7 percent decline in employees after a buy-out, though the fall was partly offset by new jobs generated at new facilities due to the “creative destruction” process private equity engendered.57 The verdict on capital expenditures, though needing further research, generally found that private equity acquisitions resulted in increased capital spending.58 Furthermore, other studies found that private equity acquisitions spurred innovation in the patenting process, though it remains to be seen whethe
r private equity merely spurred patenting or actually fostered creativity.59

  The new poster boy for private equity, Stephen Schwarzman, CEO of Blackstone, did not help its image. Labeled “Wall Street’s Man of the Moment,” he put a very public face on private equity when the writer Kurt Andersen described him in New York magazine as “a perfect poster boy for this age of greed, shark like, perpetually grinning, a tiny Gordon Gekko without the hair product.”60 A Wall Street Journal profile chronicled Schwarzman as regularly eating crab costing $400 a claw, obsessively haranguing his house staff, and generally behaving like a spoiled child. His $3 million 60th birthday party cemented his reputation as the not-so-nice public face of private equity.61 Henry Kravis reportedly fumed at Schwarzman’s bad publicity, but many termed his fury jealousy over Blackstone’s usurpation of KKR as the largest of the buy-out firms in competition with the Carlyle Group. No matter, this publicity did not help the public perceptions of private equity as a greedy cast bent only on acquiring and rendering corporations. To counter growing negative perceptions, private equity even went so far as to create a new industry group, the Private Equity Council, to put a more human face on the business and coordinate lobbying among the firms with Congress and other governmental organizations.62

  Private Equity’s Bubble?

  Then, there was talk of a bubble. By the beginning of 2007, private equity was paying ever higher prices and borrowing ever increasing amounts as the credit market continued to percolate. Not only were banks allowing greater leverage at low prices to private equity acquisitions but also they began to significantly liberalize the terms they demanded. The Neiman Marcus transaction, which followed shortly after SunGard, was notable for completely eliminating the market-out in debt commitment letters, a change to the structure that would persist in all of its variations. Private equity firms began to negotiate covenant “lite” high-yield debt, which provided their companies significantly more latitude to act and avoid a default. Financing also began to include payment in kind, or PIK, toggles as a standard feature—PIK toggles allowed a private equity acquisition to repay debt in kind with more debt rather than cash if the company’s cash flows became insufficient to service the existing debt. These toggles and the lack of debt covenants would substantially benefit private equity in the workouts of the financial crisis. In 2008, private equity firms with respect to Clear Channel Communications Inc., Harrahs Entertainment Inc., Realogy Corp., and other troubled portfolio companies repeatedly exercised these toggles.63

  Market watchers increasingly pointed to this conduct and vocally proclaimed both a credit and private equity bubble that would eventually burst. The $4.75 billion that Blackstone and its owners, including Schwarzman, reaped selling part of their interest in Blackstone in its June 2007 initial public offering was also cited as a sign of impending doom. Schwarzman himself received $684 million from the sale. He was not only capitalizing on the market but also needed to do something to allow buy-in for his more junior partners who could not afford to repurchase his stake upon his retirement. Still, if the smart money was selling, and selling at such lofty prices, it didn’t bode well.64

  The public gobbled up the Blackstone initial public offering, and others such as KKR attempted to follow. Here, the public was fulfilling its own desire to reap private equity riches. These alternative asset adviser IPOs were poor substitutes.The advisers still needed to pay and incentivize management, and their cash flows were much more volatile than the funds themselves and increasingly dependent on management fees. Nonetheless, the SEC continued to ban the public listing of private equity funds while permitting the listing of these advisers. The AFL-CIO accurately protested this dichotomy in a letter to the SEC, apparently preferring to keep both from the public markets. 65 They were ignored.

  There were other problems on the horizon. As these private equity firms increased in size, they increasingly resembled the defunct conglomerates of the 1970s. KKR and Blackstone were now two of the largest private corporations in the world. KKR and Blackstone, in particular, began to expand into new areas by providing bank financing to other corporations, operating hedge funds, and providing investment banking services. Large private equity firms began to be called financial supermarkets because of their size and scope. Given their size, diverging business interests, and the growing number of private equity firms competing for business, it appeared uncertain whether private equity could reap the same profits as in previous years.

  Figure 2.4 Private Equity Global Announced Takeovers (Percent of Total

  Global Announced Takeovers) 1980-2008

  SOURCE:Thomson Reuters (includes all leveraged buyouts)

  Nonetheless, into 2007 the private equity juggernaut continued (see Figure 2.4). In that year alone, private equity would raise more than $276 billion in new commitments, an amount that would sustain more than $1 trillion in new acquisitions .66 As of March 2007, KKR alone had more than $53 billion in assets under management, and Blackstone had $78.7 billion.67 All were prowling for acquisitions. In the first six months of 2007, private equity announced fully 50.6 percent of all U.S. acquisitions and more than $313.8 billion worth of U.S. public acquisitions, including buyouts of AllTel Corp., Bausch & Lomb Inc., ServiceMaster Co., and First Data Corp.68 The media labeled private equity’s managers the new titans (see Figure 2.5).

  Meanwhile, private equity spearheaded the financial revolution. The firms increasingly put more sophisticated capital structures on their targets, including intricately layered senior, subordinated, unsecured, and preferred financing. The portfolio companies began to frequently dividend out cash from their acquisitions midstream, recapitalizing the companies and capturing value in real time. The result was to pry as much value as possible from the company through finance, slice the risk involved in the acquisition as discretely as possible, and allow for the minimum amount of equity to be placed on the acquired company. In doing so, private equity utilized the modern tools of financial engineering and the growing securitization market to price and sell these securities. Their techniques spilled over and began to be utilized in the more general takeover market. But their extreme resort to financial alchemy also engendered cries that their profits were simply the result of this magic rather than hard work.

  Figure 2.5 Private Equity Global Announced Takeovers (Value and Number) 1980-2008

  SOURCE:Thomson Reuters (Includes all leveraged buyouts)

  Academics postulated that private equity’s financing activities would spell the end of public markets as companies increasingly were acquired by private equity firms. The overregulation of Sarbanes-Oxley was particularly cited as a cause for the private equity boom. Companies were going private to avoid this regulation. Others cited the revolution in finance, which permitted more stable management of capital flows and allowed a company to avoid equity and the public markets as the cheapest cost bearer for risk.69 Those who took this hypothesis and forecast the end of public markets were engaging in deliberate hyperbole. Private equity needed the public markets to exit their investments. Moreover, many private equity firms registered the debt of their newly acquired firms with the SEC, subjecting them to substantially the same regulatory requirements as when they were public.70 The regulatory story thus also seemed overstated. Nonetheless, the talk spoke to private equity’s lofty prominence.

  Defying the criticism, private equity was again flying. The firms entered the summer of 2007 as the rulers of the capital markets egged on by the deal machine and the billions of fees private equity deals created. But many had forgotten a lesson from the 1980s; credit and private equity, like the economy, is cyclical. The up side of the cycle would not last. The seeds of private equity’s downfall would lie in the SunGard transaction and private equity’s life-need for debt financing. In 2007, private equity had paid the banks $15.6 billion in fees, and the banks jumped to do the firms’ bidding.71 In the midst of this, private equity had forgotten who was pet and who was master. It was the banks, and they would bite back sava
gely in the coming financial crisis.

  Chapter 3

  Accredited Home Lenders and the Attack of the MAC

  The first hint of trouble came abruptly on February 27, 2007. On that day, the Dow Jones Industrial Average precipitously dropped 546 points, closing the day down by 3.29 percent, a fall mimicked in the other major indexes.The drop came unexpectedly and after a year of unusually low volatility in the stock markets.The source of the drop was hard to pinpoint; reports speculated that it was due to worry over a decline in the bubbling Chinese stock market, a possibly weakening U.S. economy, or remarks earlier that day by former chairman of the Federal Reserve Alan Greenspan.1 Whatever the cause, at first it appeared to be a short-term blip.The markets would quickly bounce back, and investors would continue blithely along.

  The drop would turn out to be a missed sign. A maelstrom was coming. Soon the implosion of the housing market and accompanying subprime mortgage crisis would initiate a parade of catastrophic events, including a steep decline in the stock market, credit and financial crises, a near market meltdown, and a sharp economic downturn. These events would buffet the capital markets and expose the faults and parameters of acquisition agreements and deals generally. In later stages of the crisis, deals would be stretched and stressed at every seam, as buyers struggled to escape contractual commitments and targets sought to hold buyers to their word. But in the beginning of this period, these disputes would focus on a clause embedded in acquisition agreements to address just such unexpected events: the material adverse change clause, or MAC. The financial crises’ first echoes would produce a series of MAC claims, disputes that would markedly affect the course of later illfated takeover deals in 2008.