Third, and related to the second point, the economic incentives of private equity firms push them to complete the acquisition. In other words, private equity firms initially enter into the transaction because of a desire to acquire the company.The transactional costs incurred to enter first into this agreement also pressure private equity firms to complete their transactions.
Fourth, private equity lawyers relied on prior precedent. In this regard, SunGard provided a precedent for the structure, one that private equity attorneys rapidly adopted. A deviation from what became the market norm at the time would likely be seen as off-market and therefore unlikely to be proposed by attorneys or accepted.
These four reasons provide an explanation for why a different, more certain structure has historically been utilized for strategic transactions, acquisitions made by a functioning company rather than a private equity firm. Strategic transactions lack the optional nature of private equity acquisitions. In strategic transactions, the structural norm is to eschew financing conditions and reverse termination fee structures. Instead, target companies obligate the buyer to specifically perform the acquisition in case of a breach of the acquisition agreement. Unlike the private equity context, this agreement is secured by the assets of the buyer.
The traditional reason offered for this dichotomy in structure is a financing rationale. In a strategic transaction, a buyer has assets to secure its obligations and is not dependent on the vagaries of the financing market to complete its transaction. But many strategic buyers employ substantial leverage to effect acquisitions while private equity funds do have assets—the contractual agreements of their investors to fund the buyout. A stronger explanation is that a strategic buyer is not in the business that private equity firms are—acquiring companies. If a strategic buyer reneges on its acquisition agreement, the reputational loss is likely to be less because it is not consistently in the acquisition market, and stronger contractual protections are justified.
All of these forces combined to make the private equity structure, though optional, acceptable. Similarly, when lawyers were negotiating the rest of the structure, it was papered over as the best bargain that could be achieved. The deal would obviously go through because of the forces pushing it to close. The flaws in this structure or even any mistakes made would thus not matter due to these other forces. This is the best possible explanation for the other errors in structure, such as the drafting mistakes litigated in the United Rentals/Cerberus dispute. Unfortunately, the harsh winds of the credit crisis changed this assumption. Table 4.1 lists the significant terminated private equity deals during 2007-2008. It is a sobering list.
Table 4.1 Failed and Renegotired Private Equiry Transactions 2007-2008
SOURCE: Steven M.Davidoff “The Failure of Private Equiry” 82 Southen California Law Review 101, at Ex. A (2009).
These failures are only one part of a much bigger failure. The collapse of private equity occurred in the postcredit bubble hangover. The deals reached in those headier times were made in an atmosphere that did not expect the collapse that occurred. In hindsight, the companies who did agree to these exits and whose deals did not implode proved to have made a very good decision, however questionable it may have been at the time. The burden of those deals mostly fell on the private equity firms and more significantly their lenders. The private equity firms could pay so much because the lenders made loans at insufficient interest rates and with too much leverage. Thus, the principal failure of the private equity industry in the period leading up to August 2007 was the failure of financial institutions to properly price their loans and financial instruments. This allowed private equity firms to acquire a vast portfolio of companies at low interest rates, with too flexible credit terms, and with minimum money invested.This particular failure is part of a broader credit crisis that has had astounding economic implications for our world economy as many of these portfolio companies struggle under the weight of this debt.
In the end, this was simply a product of misplaced incentives. The banks were no longer in the It’s a Wonderful Life mode, where they saw their lenders in person, assessed their credit, and were penalized when a creditor defaulted on its loan. Rather, in the sixth wave, lending became a matter of securitization and the ability of banks to securitize and sell leveraged buy-out and other debt.
The banks’ focus in their risk management and lending committees was whether the debt could be securitized and sold to third parties. Whether it was paid back or not, once sold, it became someone else’s problem, a factor that the banks simply did not take into sufficient account. And that is what got us into the mess the economy is in.
The failure of these private equity deals showed the strength of banks and their dominant role in the private equity process. In each of these collapsed transactions, it was the banks rather than private equity that had the most to lose.When they could no longer act from behind the scenes after the easy deals had cleared in the fall of 2007, the banks emerged with a vengeance to escape transactions that no longer made economic sense. In doing so, the banks showed that in the private equity relationship, they were the ones that called the shots.
This left targets to suffer at the hands of the reverse termination fee and lawyer practices in agreements (such as agreeing to reverse termination fees) that appeared inexplicable. In retrospect, they were a product of lawyers’ overreliance on extralegal forces to close transactions. In other words, lawyers relied on private equity’s reputation and need to close transactions to paper over fundamental errors and mistakes in agreements, as well as an optional closing structure. In particular, lawyers failed to vary the reverse termination fee dependent upon the closing risk of a particular transaction, instead preferring to leave at 3 percent no matter the deal’s characteristics. But when the economic incentives were no longer there, the banks and private equity firms no longer felt bound by these extralegal constraints and instead struggled mightily to find or invent any reason to escape from their legal obligations.
In a sense, this failure was a failure of lawyers and targets of prescience. Who could have predicted such a maelstrom? The failure also exposed the errors of lawyers in the process, errors that were normally hidden and should not have been made. It also uncovered the failure of lawyers to vary deal terms depending upon deal risk, failures that likely should have been compensated for regardless. Ultimately, in the post-August 2007 litigation, private equity firms always appeared to be able to find some clear or less than clear contractual or legal basis to attempt to terminate their agreements. The failure of private equity shows the importance of extralegal forces in gluing together transactions. In complex transactions, there will always be limits to what attorneys can do. At some point, further additions or revisions to the contract are constrained by the limits of imagination or are otherwise hampered by time constraints. This may mean that there is some hook that a buyer can always find to attempt to terminate a transaction.
In other words, when a dispute arises, lawyers are always reasonably certain in the complex contract context that they can find some flaw to litigate. This type of behavior was clearly on display in the private equity failures of the past year. The consequence is that in the private equity context and likely complex acquisition contracts generally, reputation and trust are an important and inescapable component of a contract. In future deals, parties would do well to remember this. Nonetheless, they should also remember that a tight, well-drafted agreement can provide benefits. One need only compare the settlements of Penn National, which had a tight albeit partially optional agreement, with United Rentals, which ultimately had a more optional pure reverse termination fee structure. Both were spurned by their would-be private equity buyers, but the former received more than a billion dollars, and the latter only $100 million.
The Future of Private Equity
The serial collapse of private equity deals and the market conflagration left private equity firms reeling. The market for private equity deals disappeared
. In 2008, globally only $109.9 billion worth of private equity acquisitions took place, down from $512 billion in the prior year .50 This was only 3.8 percent of total takeover volume, a level not seen since 2001. It was even worse in the first quarter of 2009—globally, only $7.9 billion worth of private equity acquisitions were announced in the entire quarter.51 Putting this in perspective, worldwide activity for the quarter was less than a fifth of the TXU acquisition alone.
The lack of dealmaking activity gave private equity needed time to devote attention to its 2004 through 2007 crops of increasingly distressed acquisitions. The number of troubled portfolio companies seemed to expand on a daily basis and included such luminaries as Chrysler, Clear Channel, Freescale Semiconductor, Inc., GMAC LLC, Harrahs, Linens ‘n Things, and Realogy. The burden of these failed acquisitions would no doubt weigh on private equity returns for their new millennium funds.
Private equity firms pushed the limits of their latitude under their previously negotiated debt in attempting to salvage these companies and their investments. Unfortunately, though, for already burnt debt holders, private equity firms often structured these workouts at the expense of debt leveraging off the relatively slim terms banks had agreed to during the credit bubble. The result was litigation in the case of Realogy’s and Freescale’s debt restructurings and a continuing deterioration in private equity’s reputation.52 In the next round of acquisitions, banks and the purchasers of securitized private equity debt will no doubt respond by demanding significantly tighter terms. The private equity firms probably knew this was coming anyway and felt that playing hardball with debt holders during these workouts would not change the inevitable.
Private equity firms began to downsize. Blackstone laid off 7 percent of its workforce in December 2008.53 Investors also began to become wary of their investments and future commitments. The Harvard University endowment, for example, put out to bid a third of its private equity portfolio valued at $1.5 billion.54 It received no acceptable bids. And Stephen Schwarzman, the king of private equity and now a significantly poorer man, disappeared. One reporter relayed this exchange when he inquired at Blackstone’s offices in December 2008 for an interview of Schwarzman:
“Mr. Schwarzman’s office,” said the receptionist, “is no longer taking calls.”
“Ever?”
“Not for the foreseeable future, I’ve been told.”55
Private equity was not out forever. Unlike hedge funds, private equity had long-term commitments with its investors. As of January 2009, one estimate put at $472 billion the amount private equity firms globally still had in uncommitted funds that it could draw down.56 This number was likely to be an overestimation, as private equity investors, already suffering from losses, will probably struggle to avoid fully honoring these commitments. Still, this provided the firms who were not fully committed with some level of funds to make distressed investments during the storm and to ride it out. The ones who were fully committed were less fortunate, faced with a never-ending sea of workouts and an inability to raise future funds. Private equity also had a 30-year track record of excess returns to continue to raise money on. In future fund-raisings, it would no doubt claim the financial crisis as an unexpected aberration to be discounted. Moreover, the collapse of the investment banking model left firms like Blackstone and KKR in a better position to offer boutique investment banking services in competition with middle-market investment banks, a topic I explore further in Chapter 12.
Private equity was largely returned to its position of the early 1990s, albeit with a significantly smaller war chest and a number of headaches to deal with. The days of the $40 billion dollar mega private equity deal have probably passed. Meanwhile, private equity firms unwilling to continue to subject themselves to the harsh scrutiny of the public markets are likely to unwind the publicly traded structures they had created in headier times. But for dealmaking to return in force, private equity will need to repair its deteriorated relationship with financing banks and targets.
In the wake of private equity’s collapse, there was also a marked shift in deal structure. First, lawyers, not surprisingly, went back to basics. They attempted to clean up forms and draft more clearly and simply in response to the apparent drafting errors that had come to light. There was a focus on reading and rereading contract drafts to catch errors, and all parties put in significant efforts to negotiate tighter contracts. Lawyers simply became more important to the deal process.
Many also expected targets to negotiate more certain deals.This has not happened thus far. Instead, the private equity structure has shifted in the opposite direction toward a model more favorable to private equity. Approximately 80 percent of U.S. private equity transactions announced in 2008 utilized a pure reverse termination fee structure.57 This is a telling response. The nature of this shift again marks a recognition that the drivers to closing in a private equity transaction substantially exist outside the contract language. It also represents a collapse of the bargain between private equity firms and target companies, which permitted more rigorous forms of the reverse termination fee structure to exist.
It also reflects the nature of credit in these troubled times. Credit is hard to obtain and, until drawn, is in danger of being pulled by the banks. Private equity firms were simply unwilling to do deals with credit risk and, in any event, were often unable to obtain credit. Attorneys were unable to find some way to bridge the gap. Instead, in the new distressed takeover market, targets self-selected. It is no surprise that the few 2008 private equity deals were in industries less affected by the market disruption.Targets justified using the reverse termination fee structure because of their stable cash-generative business models, which would make them less resistant to any adverse impact by the economic crisis. This would ensure that their business remained stable and the private equity acquisition would complete.
Private equity attorneys have not come up with a better way to structure transactions than through use of the reverse termination fee.The result is that many sellers will not do business with private equity because they cannot offer completion certainty. For now, this is a function of the credit market, but as a recovery takes hold, the question is what will private equity agreements look like? In the short term, there may be higher reverse termination fees to adjust for the closing risk. The private equity reverse termination fee in the pre-August 2007 vintage transactions was in hindsight set too low and too mechanically at the 3 percent norm.58
Targets will attempt to ensure closing certainty by making the penalty for walking significantly higher. This may lead to bifurcated reverse termination fees: a higher fee for a buyer’s breach of the agreement or a financing failure, and a lower one in other circumstances.We may also see the return of nonrefundable deposits or escrow arrangements to ensure that a target obtains some recompense for a failed deal.
In addition, private equity may attempt to make deals more certain by trying to negotiate complete credit agreements with banks beforehand. Finally, MAC clauses may perversely become even broader, as sellers grapple with the problems of a MAC clause and its interaction with a reverse termination fee. Here, targets would be attempting to make MAC claims harder in order to prevent private equity from using these clauses for reputational cover against invocation of a reverse termination fee. Of course, the true solution to the MAC issue is to simply eliminate the MAC clause in private equity deals, but this is likely to be too extreme a step for lawyers.
None of these solutions bridges the gap and provides more certainty to targets while providing private equity firms latitude to walk in case of a financing failure. This gap could be bridged by demanding bigger equity infusions from private equity firms or in smaller deals actually obtaining full equity commitments from private equity funds for the entire purchase price. It could also be met by targets and buyers demanding that financing be committed at signing. In the meantime, private equity will continue to suffer as it is unable to complete deals on account of the lack of certai
nty. This drag will become remarkably clear when market conditions return to normal and sellers are able to negotiate from a stronger position.Who, after all, and if given the choice, would do a deal with Apollo after its conduct in Huntsman? Not me.
But solutions to this certainty gap are likely only to definitively appear once the takeover and credit markets fully heal. For the time being, private equity has been able to leverage its bargaining position in a distressed market to obtain pure reverse termination provisions when it can find financing to do a deal. This lack of certainty, however, and private equity’s inescapable dependence on its dominant force, financing banks, have also significantly hampered the private equity industry. Meanwhile, banks themselves were suffering as they fell behind in their race to write off bad debt brought on by the credit bubble. But the banks’ fervent attempts to raise capital in the winter of 2008 showed another possible way for private equity: alternative capital sources such as sovereign wealth funds.
Chapter 5
Dubai Ports, Merrill Lynch, and the Sovereign Wealth Fund Problem
Sovereign wealth funds burst onto the world scene in the fall of 2007.Their emergence was not so coincidentally timed with the first stirrings of the credit crisis. In the fall of 2007 into the winter of 2008, U.S. financial institutions eagerly solicited capital from these funds and paid millions to lobbyists to grease the regulatory wheels for this investment.1 The money initially flowed. In 2008, global sovereign wealth fund investment in financial institutions was $32.7 billion. This capital was a lifeline for financial institutions struggling under the weight of real estate and leveraged buy-out debt. It was not just financial institutions. That same year, sovereign wealth funds globally invested $47.2 billion.This was a decrease from 2007, when $77.7 billion was invested, but still a 434 percent increase over the $10.9 billion invested in 2004.2 (See Figure 5.1.)
Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion Page 13
