Post-Closing Indemnity Negotiating and Structuring Closing - - PowerPoint PPT Presentation

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Private Equity M&A Key Deal Terms: Reverse Break Fees, Seller Remedies, Post-Closing Indemnity

Negotiating and Structuring Closing Conditions, Termination Rights and Post-Closing Indemnification in a Changing Market

Today’s faculty features:

WEDNESDAY, JULY 29, 2015

John J. McDonald, Partner, Troutman Sanders, New York Michael Weinsier , Partner, Troutman Sanders, New York

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PRIVATE EQUITY M&A KEY DEAL TERMS: FIDUCIARY OUTS, REVERSE BREAK FEES, SELLER REMEDIES, GO-SHOP DEALS AND POST-CLOSING INDEMNITY

Michael Weinsier

Partner Troutman Sanders LLP michael.weinsier@troutmansanders.com

John McDonald

Partner Troutman Sanders LLP john.mcdonald@troutmansanders.com

CURRENT TRENDS IN PRIVATE EQUITY M&A DEALS

Pluses for M&A Deals

• M&A deal volume continues to increase. Announced deals through March

2015 were $746B, up 9% from $685B in the same period in 2014.

• Improving consumer confidence and steady, albeit slow, economic growth.
• Continued favorable credit markets, although regulatory limitations on

leverage ratios has pushed down the amount of bank debt available for deals.

• Strategic investors hold large cash reserves, which they are using to make

acquisitions, given relatively limited prospects for organic growth.

• Private equity firms have significant "dry powder" and are coming up against

the ends of their funds' investment periods.

• Shareholder activism has encouraged companies to focus on core operations

and “unlock value” by making strategic spin-offs and corporate divestures.

• Historically high EBITDA multiples have motivated private equity firms to sell

their portfolio companies now.

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Negatives for M&A Deals

• BASEL III (Europe) and US bank regulatory (OCC, FRB, FDIC) restrictions on

leverage ratios have reduced the availability of bank debt financing for M&A transactions, particularly from “systematically important” banks. 6x EBITDA has become the effective limit on leveraged loans from banks. Non-bank lenders (e.g., hedge funds, BDCs) have only partially filled the void.

• Historically high valuations, combined with the new leverage restrictions,

have resulted in lower private equity participation in M&A.

• Continued uncertainty in Europe, particularly as a result of fear of

“contagion” from the Greek debt crisis.

• The Obama administration’s September 2014 executive action significantly

reduced “inversion” transactions, which had been a significant contributor to M&A transaction volume.

• Interest rates are expected to start rising toward the end of the year.

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CURRENT TRENDS IN PRIVATE EQUITY M&A DEALS

CURRENT TRENDS IN PRIVATE EQUITY M&A DEALS

M&A Deal Statistics

• Q1 2015 deal volume up 15.2% versus Q1 2014 and up 57.7% versus Q1 2013.1/
• Strategic buyers, rather than private equity buyers, represent an increasingly

large percentage of overall M&A transaction value, constituting 85% of

• verall M&A value ($418B) of deals in Q1 2015.2/
• The average purchase price multiple for Q1 2015 was 7.9x EBITDA, down

from 8.3x in Q1 2014.2/ Average YTD 2015 purchase price multiple is 7.3x EBITDA, down from 10.0x EBITDA for 2014.3/

• The average leveraged loan has declined to 6.3x EBITDA this year from 6.6x

in 2014. 4/ In Q3 and Q4 2014, ~60% of buyout loans exceeded 6x EBITDA. In Q1 2015, it was down to 21%.5/

1/ Bloomberg Global M&A Market Review Q1 2015 2/ Pitchbook M&A Report Q2 2015 3/ Pitchbook US PE Breakdown 3Q 2015 4/ Thompson Reuters 5/ S&P Capital IQ LCD 8

CURRENT TRENDS IN PRIVATE EQUITY M&A DEALS

Private Equity Trends

• 2,955 US-based PE investments closed in 2014, representing $522.6B in value,

versus 2,947 and $501.5B in 2013.*

• Because of high stock market prices, PE-led “going private” transactions of

large-cap public companies have declined substantially. Instead, takeovers

• f such companies are almost all by other public companies.
• “Secondary buyouts”, in which a PE sponsor sells a portfolio company to

another PE firm, are on the rise.

• PE firms are increasingly employing a “buy-and-build” strategy using “bolt
• n” acquisitions by existing portfolio companies, which enables them to take

advantage of economic synergies with targets, similar to strategic buyers. AlSuch transactions constituted 60% of PE control investments in 2014, versus 40% in 2013.*

• Because large-cap public companies are expensive to buy and have limited

room for improvement, large PE firms have migrated into the middle market.

* Pitchbook/Merrill Datasite 2015 Annual US PE Breakdown

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BEST PRACTICES FOR NEGOTIATING DEAL TERMS— BUYER AND SELLER PERSPECTIVE

“Fiduciary Outs”

• "No-Shop" Provisions - To induce the Buyer to enter into the purchase

agreement and commit itself to buy the Target company, the Target company and its stockholders will agree to not sell the Target company to another buyer during the time period between signing and closing.

• "Fiduciary Outs” – In acquisitions of publicly-traded companies there is

usually a “fiduciary out” exception from the no-shop provision, particularly where the Target company hasn't conducted a full "market check":

• if Target company receives an unsolicited offer to buy the company at a price

that is so superior to the existing deal that it would constitute a breach of the Target company board members’ fiduciary obligations to its stockholders…

• then, Target company can terminate the existing transaction or change its

Board’s recommendation to stockholders to advise against the pending transaction (which will have the same practical effect) and instead sell the Target company to the other buyer.

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BEST PRACTICES FOR NEGOTIATING DEAL TERMS— BUYER AND SELLER PERSPECTIVE

Fiduciary Outs (cont.)

• Although privately-held company boards also have fiduciary duties to

stockholders, fiduciary outs are not commonly seen in acquisitions of privately-held companies.

• If “Superior Proposal,” Target company has to notify the original buyer and

give it the opportunity to improve its offer so that it is superior to the new

• ffer (a “topping” bid).
• Although the Target company’s board will take into account all aspects of the

new offer in deciding whether it is superior to the existing offer, price is the predominant consideration (Revlon duties).

• Original buyer receives termination fee (usually 2.5-3.5% of transaction

consideration) and reimbursement of its transaction-related expenses (usually capped at a specified amount).

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BEST PRACTICES FOR NEGOTIATING DEAL TERMS— BUYER AND SELLER PERSPECTIVE

Reverse Break Fees

• Typically Buyer is obligated to close the acquisition as long as Target company

has satisfied its closing conditions. However, some deals allow Buyer to pay a “reverse” termination fee to Target company (essentially a liquidated damages payment) and terminate the transaction.

• Has become the norm since the 2008 financial crisis, particularly in deals in

which Buyer is a private equity fund, since fund sponsors want to protect themselves from a lawsuit and potentially substantial liability if the necessary debt financing cannot be obtained.

• Sometimes Buyer can terminate only if a specified event happens. Less

frequently, there is “pure optionality,” in which Buyer can exercise the termination right for any reason.

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BEST PRACTICES FOR NEGOTIATING DEAL TERMS— BUYER AND SELLER PERSPECTIVE

Reverse Break Fees (cont.)

• Most common event enabling Buyer to invoke the reverse break fee

termination right is when it can’t obtain the necessary debt financing to be able to consummate the deal.

• Other events include inability to obtain regulatory approvals (most commonly

antitrust) or key contractual consents.

• Parties should specify in the purchase agreement that the “specific

performance” provision (under which Target company can force Buyer to close) does not apply if Buyer exercises its right to terminate the transaction and pay the reverse break fee.

• Reverse break fees are usually larger than conventional break-up fees (4-5%,

as opposed to 2.5-3.5%).

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BEST PRACTICES FOR NEGOTIATING DEAL TERMS— BUYER AND SELLER PERSPECTIVE

Financing Failure – Remedies for Sellers

• Seizure of the debt markets following the 2008 financial crisis resulted in

numerous M&A transactions in which Buyer couldn’t obtain the necessary debt financing to be able to consummate the transaction.

• Resulting litigation was instructive in helping parties plan what will happen if

there is a “financing failure.”

• Some M&A transactions, most commonly those with a private equity fund

(rather than strategic) buyer, include a “financing contingency” in which Buyer is not obligated to close if it cannot obtain necessary debt financing to be able to consummate the acquisition.

• Financing contingency deals usually require Buyer to use “commercially

reasonable efforts” or “best efforts” to obtain the debt financing.

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BEST PRACTICES FOR NEGOTIATING DEAL TERMS— BUYER AND SELLER PERSPECTIVE

Financing Failure – Remedies for Sellers (cont.)

• Buyer usually required to obtain “commitment letters” from lenders with

debt financing and take all necessary actions to satisfy the conditions under the commitment letter and obtain the debt financing.

• In deals in which there is no financing contingency, but Buyer will need to
• btain debt financing to be able to consummate the transaction, it runs the

risk of being sued by Target company if it is unable to close because it cannot

• btain the necessary debt financing.
• In this situation, Buyer will often propose a “reverse break fee” structure

(discussed above) to put a cap on its potential liability if the debt financing cannot be obtained.

• Liability could otherwise be a very large amount since Target company will

likely argue that the broken deal resulted in it being viewed as “damaged goods” in the marketplace.

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BEST PRACTICES FOR NEGOTIATING DEAL TERMS— BUYER AND SELLER PERSPECTIVE

Go-Shop Deals

• Target company boards often conduct "auctions" to protect themselves from

fiduciary duties breach claims arising out of accepting a purportedly "inadequate price" for the company.

• Investment bank invites potential bidders to conduct due diligence and

submit offers and the board then selects the best offer.

• Assumption is that price determined through open auction process is "highest

and best price" that could be obtained.

• However, auctions are time consuming (typically, at least 3-6 months),

expensive (the investment banker fees can be substantial) and, through the due diligence process, sensitive Target company information can be supplied to competitors that, although subject to a non-disclosure agreement, may still be used to the Target company’s disadvantage.

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BEST PRACTICES FOR NEGOTIATING DEAL TERMS— BUYER AND SELLER PERSPECTIVE

Go-Shop Deals (cont.)

• Sometimes, Target company will receive a “preclusive” offer that is so much

higher than the existing trading price that it would be unlikely to be exceeded in a competitive auction process.

• Buyers making preclusive offers typically do so to avoid protracted auction

processes and require Target company to act quickly in accepting the offer.

• As a result, “go-shop” deal structure was created. Contrary to the normal

“no-shop” structure, in which Target company and its stockholders are precluded from soliciting other offers and doing a deal with another buyer

• nce the purchase agreement is signed, Target company is specifically

authorized to seek out alternative offers during a specified time period after the purchase agreement is signed.

• Go-shop period usually ends once Target company stockholders vote on deal.

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BEST PRACTICES FOR NEGOTIATING DEAL TERMS— BUYER AND SELLER PERSPECTIVE

Go-Shop Deals (cont.)

• Existing buyer has “topping rights” with respect to other offers obtained and

gets a break-up fee from Target company if the purchase agreement with the

• riginal buyer is terminated to do a deal with another buyer.
• Break-up fee is typically less than a conventional fiduciary out termination

right (1.25%-1.75%, as opposed to 2.5-3.5%).

• Go-shop deals are somewhat controversial, as skeptics believe that fewer

buyers will be willing to break up an existing deal, as compared to participating in a competitive auction, so the go-shop process won’t really act as an effective market check on the pricing of the original deal and ensure that the stockholders receive maximum value.

• A widely reported 2014 study supports these criticisms. See:

http://dealbook.nytimes.com/2014/05/23/go-shop-go-fish/.

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POST-CLOSING INDEMNIFICATION

Generally

• Indemnification payments effectively reduce the purchase price paid by

Buyer to Target company stockholders.

• As a result, post-closing indemnification provisions are usually among the

most heavily negotiated deal terms in M&A transactions in which a privately- held company is being acquired. Not in Public Company Acquisitions

• M&A transactions in which a public company is being acquired typically do

not include post-closing indemnification because, by way of Target company’s SEC filings, all material information about Target company has been disclosed to Buyer (under threat of securities fraud liability).

• Also presents a logistical issue with post-closing indemnification in an

acquisition of a public company because public companies often have large and diffuse stockholder bases.

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POST-CLOSING INDEMNIFICATION

Scope of Indemnification

• Usually covers losses resulting from breaches of reps & warranties and

covenants in the purchase agreement.

• Often also a “tax indemnity” provision requiring Target company stockholders

to compensate Buyer for all pre-closing Target company tax liabilities.

• In asset purchase (rather than stock purchase or merger) transactions, Target

company usually indemnifies Buyer for any losses from “Excluded Liabilities.”

• “Excluded Liabilities” - typically defined as all liabilities associated with the

pre-closing operation of the Target company other than accounts payable and

• ther current liabilities included in the closing balance sheet.
• Asset purchase structure often used for Target companies with significant

historic liabilities that Buyer is unwilling to assume, or where only an

• perating division or business line (as opposed to a subsidiary) is being sold.

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POST-CLOSING INDEMNIFICATION

Duration of Indemnification

• Indemnification obligations of Target company stockholders for reps &

warranties usually extend for 1-2 years post-closing.

• Exceptions are reps & warranties concerning tax, employee benefits and

environmental matters (which usually extend until expiration of the underlying statute of limitations).

• Also excepted are reps & warranties concerning “fundamental matters” like

due organization, authority to enter into the purchase agreement, capitalization and clear title to Target company assets or shares (which usually have no time limit). Who is “On the Hook”?

• In stock purchase and merger transactions, Target company stockholders are

responsible for providing indemnification to Buyer.

• In asset purchase deals, Target company entity provides indemnification,

sometimes with stockholder guarantee.

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POST-CLOSING INDEMNIFICATION

Who is “On the Hook”? (cont.)

• Each Target company stockholder is usually responsible for its pro rata

portion of indemnification amounts….

• … and solely responsible for indemnification concerning its individual actions

(e.g., reps concerning ownership of its shares and breach of its non- compete/non-solicit covenants).

• “Rep and warranty” insurance is becoming an increasingly popular way to

satisfy Target company stockholders’ indemnification obligations. Indemnification Deductibles and Thresholds

• Sometimes indemnification obligations of Target company stockholders are

subject to “deductible” (i.e., Buyer is forced to absorb the first “X dollars” in otherwise indemnifiable losses) (Seller-favorable).

• Alternative is “threshold” (i.e., Buyer must wait to make an indemnification

claim until it has indemnifiable losses at least equal to the threshold amount, but then receives full compensation for all losses “back to the first dollar”).

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POST-CLOSING INDEMNIFICATION

Indemnification Deductibles and Thresholds (cont.)

• Sometimes, there is a “mini-basket” or de minimus claims threshold (Seller

favorable) in which the Buyer cannot make a claim involving less than a specified amount of losses (although related claims are aggregated). Indemnification Caps

• Target company stockholders’ total possible indemnification liability is

usually typically subject to a “cap,” sometimes as low as 10-20% of the purchase price amount or as high as the full purchase price amount. Private equity sellers customarily require low caps.

• Sometimes, a separate (larger) cap amount applied to taxes, environmental

matters or known contingent liabilities.

• A Target company stockholder’s indemnification obligation is sometimes

capped at the amount of transaction proceeds that it receives in connection with the deal.

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POST-CLOSING INDEMNIFICATION

Indemnification Caps (cont.)

• Where indemnification escrow fund is Buyer’s “sole remedy” for

indemnification (increasingly becoming the norm, particularly in sales of PE/VC-backed companies), it effectively acts as an indemnity cap. Carve-Outs from Deductibles/Thresholds and Caps

• Breaches of “fundamental” reps & warranties, covenant breaches, fraud and

willful misconduct by Target company are usually carved-out from the deductible/threshold and (sometimes) cap. Sometimes a full purchase price cap, rather than the (lower) general cap, applies to these types of claims.

• Typically mini-basket or de minimus claims don’t count toward the

deductible/threshold and cap.

• In asset purchase transactions, “Excluded Liabilities” are typically carved-out

from the deductible/threshold and cap.

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POST-CLOSING INDEMNIFICATION

Escrows and Other Indemnity Obligation Satisfaction Methods

• Part of the purchase consideration (usually 10-20%) is placed into an escrow

account with third party bank for 1-2 years after closing (often for the same time period as the survival of the “non-fundamental” reps and warranties).

• Sometimes, the escrow “steps down” in amount over time.
• If the escrow funds are not Buyer’s “sole remedy” for Target stockholders’

indemnification obligations, usually Buyer is required to exhaust the escrow funds first, before proceeding against Target stockholders.

• If purchase consideration includes non-cash consideration (e.g., Buyer stock,

“Seller notes” or earnout payments), need to specify order of forfeiture to satisfy Buyer indemnification claims (e.g., first Buyer stock, then Seller notes, then earnout).

• If Buyer stock is part of transaction consideration, need to specify its value

for claim satisfaction purposes (e.g., fixed at closing or “floating” fair market value at time of claim).

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POST-CLOSING INDEMNIFICATION

Rep and Warranty Insurance

• Provides a source of recovery to the insured if the Target company

stockholders’ representations and warranties (R&W) in the purchase agreement are (unintentionally) inaccurate.

• Has gone from being virtually non-existent to very common within the last

five years, particularly in M&A transactions involving private equity sponsors.

• Benefit is that Target company stockholders can reduce the transaction

consideration placed into escrow (1-5% of total transaction consideration, rather than 10-20%) and the indemnification exposure of the Target company stockholders, while Buyer still has recourse for a larger amount.

• While coverage adds expense to the transaction, can expedite the process of

negotiating the purchase agreement, particularly the materiality thresholds in the reps and warranties, the escrow amount and the indemnification deductible/threshold and cap.

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POST-CLOSING INDEMNIFICATION

Rep and Warranty Insurance (cont.)

• In competitive auction transactions, the lower escrow amount and reduced

post-closing liability of the Target company stockholders resulting from use of R&W insurance can provide a Buyer’s bid with a significant advantage over

• ther bidders not utilizing R&W insurance.
• R&W insurance can provide the Buyer with broader or longer duration

protection against breaches of the Target’s reps and warranties than it would

• therwise be able to negotiate with the Target.
• Policies can be either “buyer-side” or “seller-side.” Buyer-side is more

popular because claims are not precluded if a member of the Target company deal team had knowledge of the issue.

• Coverage starts once the “retention” has been satisfied – typically deductible

+ amount placed into escrow. Insurers want Target company stockholders to have “skin in the game,” but coverage can be obtained with no recourse against the Target stockholders (although at a higher price).

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