New York Private Equity Lawyer & Attorney : Geoffrey Parnass : Corporate & Business Law

The ratio of total debt to EBITDA in mid-market private equity transactions is now as high as it was in 1997 – 4.7 times for companies with less than $50 million in EBITDA and 5.4 times for companies with more than $50 million of EBITDA (Source: Standard and Poors). The ratio of EBITDA less CapEx to Cash Interest in highly leveraged loans is also falling – in the 4^th quarter of 2006 the ratio fell to 2.2 times (Source: Standard and Poors).

At the same time, the covenants being written for leveraged loans are becoming more “lite”: several years ago, loan covenants were written at a 15% discount to model; now they are being written at a 25% discount.

“Covenant-lite” transactions come in many forms. In their most direct form, the covenants that require the borrower to “maintain” certain financial ratios are eliminated altogether, and the lenders are left to rely only on covenants that restrict a company from “incurring” or actively engaging in certain action. For example, a covenant that requires a company to maintain a ratio of debt to EBITDA can be breached if the financial condition of the company deteriorates, as the covenant is measured periodically, usually quarterly. But a covenant that only restricts a company from incurring new debt cannot be violated simply by a deteriorating financial condition, the company has to take affirmative action to breach it. 

Less direct forms of “covenant-lite” include carve-outs in traditional maintenance covenants that forgive in advance a certain measure of deviation from the standard. It is sometime more palatable to embed these carve-outs in a traditional loan covenant than discard the covenant altogether.

In addition to covenant-lite structures, private-equity sponsored deals have started to include a greater number of “equity cure” provisions. These enable a borrower to cure a covenant deficiency by adding more equity into a deal to count as EBITDA, thereby curing the breach. The additional equity does not have to be used to pay down debt and can be used for different purposes such as capital expenditures. In effect, the private equity sponsor is pre-negotiating an equity infusion without having to get lender approval.

This trend is of course a function of the amazing amounts of liquidity available in the credit markets to fund acquisitions.  The impact of these covenant-lite transactions will be to retard the speed with which lenders will be able to take control over troubled deals.  That may not be such a bad thing.  Lenders are not equipped to own a business and typically sell too quickly when forced to take over a company.  The next downturn may provide less opportunity for distressed debt investors than previous business investment cycles, as fewer private equity sponsors may be handing over the keys to their lenders.  

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In a recent case from Delaware’s chancery court, the clear language in a merger agreement, controlling dispute resolution matters, was enforced by the court even where the method specified wasn’t the best way to resolve the dispute. The case underscores the importance of thinking carefully about the implications of arbitration clauses, and especially how two or more arbitration schemes relate to each other. 

Matria Healthcare entered into an agreement to acquire CorSolutions Medical for $445 million. Both companies were engaged in the disease management business. Nearly 5% of the purchase price ($20.3 million) was set aside in an escrow account to satisfy claims that the closing net working capital of CorSolutions fell short of a minimum target. The escrow account was also available to satisfy claims under the indemnification provisions, including breaches of representations and warranties.

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Fortress Investment Group LLC, one of the first private equity funds to go public, manages private equity funds with more than $17.5 billion in committed capital. The stock was priced at $18.50 on February 8, 2007 but quickly began trading at $31 per share on the first trading day. It has since tracked a steady decline and currently trades at $25 and change.

One of the private equity funds that Fortress manages provides debt and equity funding to other sponsors of private equity transactions. This fund finances small to mid-market transactions, deals with $5 million and more of EBITDA. Fortress provides “one stop financing” for these deals, lending all of the debt needed to finance the transaction and even part of the equity when necessary and attractive. The company likes to see a capital structure consisting of at least 40% of equity before it will finance the other 60%.

At a recent private equity conference, a representative of Fortress admitted that it was getting to be a struggle to find quality deals in the mid-market arena. One-stop financing has become the norm, and the field is seeing a good deal of competition on the lending side from hedge funds, mezzanine lenders and others. Sponsors are looking for and getting friendlier covenant and deal terms in order to maintain control of the company if a downturn in the economy should occur. The absence of good quality deals gives sponsors the ability to drive down interest rates and covenant protections.  At the same time, the amount of debt financing provided to sponsors is at peak multiples.

The pressure to continue putting funds to work is sure to lead to poor credit decisions by lenders.  Whether the gurus at Fortress will also fall to these temptations remains to be seen.

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Credit continues to be readily available for buyouts of all sizes at attractive terms.  One notable features of leveraged acquisition financing in the past few years has been the growth of “second lien” debt financing in place of traditional “high yield” debt financing.

As the name suggests, the providers of second-lien financing get a security interest in the underlying collateral, but it is ranked second to the senior debt. Specifically, the second-lien lender agrees to subordinate its security interest to the rights of the senior lender. Over time, as the senor term debt is repaid, the second-lien financing achieves a higher position in the capital structure, as it remains senior to trade and other unsecured debt. Under the Bankruptcy Code, holders of second-lien debt will have priority over unsecured creditors, the right to adequate protection, the right to post-petition interest, and the right to object to sales of collateral unless they are paid in full from the proceeds of sale.

The growth and popularity of second-lien financing has nearly eclipsed traditional high yield financing, especially in large transactions. But even in the mid-tier arena, second-lien financing is making rapid inroads on traditional high yield financing. The difference in pricing between second-lien and high yield financing can be 200 to 300 basis points. Whether the second-lien position is adequate compensation for this reduced interest will be discovered when the next round of defaults and workouts hits the private equity markets.  

In many ways, second lien financing is a product of the collateralized loan obligation market. CLOs are pools of capital that invest in collateralized loan obligations. The vast amount of cash that has poured into CLOs in recent years has increased the availability of financing structured as second-lien debt.

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The purpose of having the financial and affirmative and negative covenants in senior loan agreement becomes clear in the Defaults section of the agreement. It’s here that they get their teeth. 

The first events of default are non-payment of principal or interest. There is generally no grace period for principal payments. Interest payments are usually given a short grace period of five days. After that, nonpayment results in immediate default of the entire loan.

Another category of defaults occur if any representation made by borrower proves to have been incorrect in any material respect at the time it was made. This is a static test, looking only at the representation on the date it was made and asking if it was true or false in all material respects on that date. The limitation to material issues is intended to rule out minor inaccuracies as a cause of loan defaults.  What constitutes materiality is not usually defined in much detail.

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Affirmative covenants are those things the borrower must affirmatively do during the term of the loan agreement. Most of these requirements are things the borrower would do in any case without being instructed by a lender, such as pay its taxes, comply with laws, and meet its financial obligations. Other covenants are matters that work to conserve the borrower’s cash flow, focus borrower on a specific line of business and generally keep its nose to the grindstone.

Negative covenants are the things the senior lender says that a borrower may not do. Most of these are things the borrower wouldn’t do anyway. The rest are designed to keep the borrower focused on running its business in the ordinary course and repaying the senior lender’s debt.

Here is a list of certain affirmative and negative covenants that are often negotiated in the credit agreement of a private equity transaction:

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Financial covenants are specific financial benchmarks that the borrower must satisfy during the term of the loan. The covenants generally change over the course of the loan, reflecting improvements in growth and financial condition that are expected to occur. The following are typical financial covenants in senior loans made in connection with private equity transactions:

• Leverage Ratio. Compares the borrower’s total debt from all sources to its EBITDA (earnings before interest, taxes, depreciation and amortization).
• Interest Coverage Ratio.  Compares the borrower’s EBITDA to its cash interest payment obligations.
• Fixed Charge Coverage Ratio. Compares the borrower’s EBITDA minus capital expenditures to its fixed obligations for interest, principal on debt, cash dividends of preferred stock and income tax liabilities.
• Capital Expenditures. The amount the borrower can spend on capital expenditures.

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The closing conditions in a senior loan agreement spell out what hoops the borrower must jump through before it is able to draw down the loan proceeds. The first condition is that borrower must sign all the contracts diligently prepared by the bank’s lawyers to document and secure the transaction. In addition to the main credit agreement, the bank’s lawyers prepare the following documents:

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Senior credit facilities in private equity deals generally include one of more term loans and a revolving credit facility. The term loan is a fixed amount that is loaned for a defined term. The loan is usually repaid in fixed installments of principal and interest so that the loan balance decreases with each payment.  

The revolving credit facility is a commitment to loan funds from time to time based on the borrower’s inventory and accounts receivable. The facility will have an upper limit of availability, but the actual amount that can be borrowed will vary from month to month based on the amount of inventory and receivables. Each month the borrower has to pay interest on the outstanding balance and, if the loan balance exceeds the borrowing base, and amount of principal equal to the excess. When the facility matures, usually in a year, the entire amount becomes due and payable. If conditions are good, the facility is generally renewed. 

A portion of the credit facility may be dedicated to providing letters of credit, if the borrower uses these instruments in its business. Senior credit facilities can be prepaid, thought there are often penalties associated with prepayments that occur other than at stated intervals. The facilities must be prepaid with the proceeds of assets sales, public offerings and other extraordinary transactions.

Interest rates may be computed on the basis of bank prime rates or LIBOR, with certain rights to switch back and forth between the two forms of loans as financial conditions may determine. Senior lenders also charge a number of fees on the initial borrowings and on the specific commitments that are made to provide ongoing financing.

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A lawsuit places the outcome of a dispute in the hands of a third party. That party may be a judge, jury, or an arbitrator in binding arbitration. Regardless, it transfers ultimate power to make a final decision over a dispute from the parties directly involved to a person who has no stake in the outcome of the dispute. The outcome of litigation under these circumstances is unpredictable, to say the least. 

Litigation also places final control over the dispute in the hands of someone much less familiar with the problem at hand than the parties themselves. Many civil courts handle everything from tort claims to family law matters to business disputes. While judges may be knowledgeable in a specific area of law, they will have no prior experience in the facts of a particular case. The judge may also have little or no experience in business, and lawyers often have to educate a judge in complex legal and factual circumstances that may be foreign to the judge.

Litigation is not an efficient method of problem solving. The rules of civil procedure governing pre-trial matters and the rules of evidence at trial are complex and arcane. Courts move from one dispute to another rapidly and it is difficult for even conscientious jurists to stay familiar with the parties and their disputes between appearances. Companies that have attempted to operate through a court procedure, such as a receivership or a bankruptcy, know that this is a very cumbersome and inefficient way of making complex business decisions.

Litigation of course is also very expensive. There is no natural limit on the cost of litigation. The $50,000 legal dispute can be as complex legally and factually as the $5,000,000 business dispute. Once commenced, litigation acquires a life of its own.  It is not a simple matter to cancel a lawsuit after it has acquired a certain momentum. Once this critical mass is reached, lawsuits tend to move in a glacial manner toward an unpredictable resolution. Especially in high stakes matters, it is likely that the parties lose control of the cost of the solution.

Finally, litigation typically destroys whatever relationship existed between the plaintiff and defendant. It may also require a considerable effort to collect or enforce a judgment, which increases the intensity of the hostility. Successful businesses operate in an atmosphere of good will and trust. Those companies that are known to handle problems in a fair manner may do better over time than those who are litigious and hostile.

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All companies look to forge strong relationships with their distributors. These affiliations are particularly important in industries where distributors add value through education, showrooms, installation or other service elements.

The first question in any distributor affiliation is how much control the supplier should exercise over the relationship. This question often turns on whether the manufacturer produces a commodity product or a proprietary one and the relative size of the parties. Distributors usually will not accept efforts to control the distribution of a product that can be obtained from a number of sources. However, a manufacturer that produces a proprietary product that is in demand has the ability, if it wishes, to exercise important controls over its distribution network.

Some manufacturers build a distribution control system into their marketing plan by setting up franchise systems or exclusive distributorships from the start. Whatever the name, these systems share a common goal from the point of view of the manufacturer: to shape the way its products are distributed in the marketplace.

The past 20 years have seen a marked increase in the control exercised by manufacturers over their products. Antitrust law and policy have adopted the view that consumers benefit when a manufacturer exercises control over its network of distributors in certain ways. Of course, it remains illegal to control pricing policies. That said, there are a wide variety of measures that manufacturers can adopt to shape the way their products get to market.

Perhaps the simplest measure is to grant a customer the exclusive right to sell products in a territory. This is often necessary to entice a well-capitalized distributor to take on a new product line. Other permitted controls include customer restrictions, advertising and trademark policies, stocking requirements for inventory or samples, and full line or exclusive requirements.

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Sherman Act

The Section 1 of the Sherman Act states that every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce is illegal. There must be an agreement or conspiracy among two or more people and the restraint of trade must be “unreasonable”. Examples of agreements that result in an unreasonable restraint of trade include price fixing; allocations of customers or territories; group boycotts; and certain tying arrangements.

The requirement of an “agreement” in Section 1 means that the law does not apply to actions taken by a company unilaterally. However, the courts over the years have been liberal in the interpretation of the agreement or conspiracy requirement. An agreement or conspiracy has been inferred from circumstances such as:

• Meetings attended by competitors followed by collective action (without evidence of discussions).

• An aura of secrecy surrounding meetings among competitors.

• Actions taken by competitors that appear to go against normal self-interest.

• Simultaneous adoption of identical practices by competitors.

The law assumes, cynically perhaps but with some justification, that when competitors get together, they will try to eliminate or reduce any competition that exists between them.

That said, there is no agreement under antitrust law if a company simply announces a policy and independently carries it out. It is also legal for a company to receive complaints and act on them. Further, a corporation cannot combine with itself or one of its subsidiaries. The line between unilateral action and collective action can get blurred in the real world.

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The indemnification provisions of a purchase agreement function like an insurance policy. Each party (buyer and seller) stands behind its warranties and agrees to make the other party whole if there is a loss that is attributable to or covered by the misstatement or broken promise. 

In some cases, the indemnification may take the form of protection against the claim of a third party. For example, if the seller warrants that the business may be conducted without infringing the intellectual property of any third party, and that proves not to be true, then the seller must hold the buyer harmless against the claim made by the third party. In other cases, the indemnified matter may be a direct loss suffered because the quality of the assets transferred is not as represented. For example, if the seller’s receivables are warranted to be collectible in full, and there is a shortfall in collection, the buyer can recover the shortfall from the seller.

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Buyer will often make specific promises regarding hiring and retaining employees of the business. If so, the purchase agreement will identify the buyer’s obligations in this regard and identify the benefit plans, severance obligations, and accrued bonus and vacation rights of the transferred employees. For example, the buyer may agree to grant service credit to employees for purposes of vesting in benefits, even though these credits may not be required by law.

The contract will describe the circumstances under which the agreement can be terminated.  Both parties will be able to terminate if the other party breaches the agreement and fails to cure the breach after being given the opportunity to do so. Also, the contract can be terminated if the closing does not occur by a defined date. This may occur, for example, if a third party or governmental approval is needed but can’t be obtained, or if financing can’t be obtained within a defined time period. This outside termination date is usually negotiated in the term sheet.

As the parties generally conduct the transaction across the borders of several states, the laws of one state will be chosen to govern the contract. Also, the courts of a specified jurisdiction will be chosen to hear disputes arising under the contract. In lieu of court adjudications, the parties may elect to implement an alternative form of dispute resolution, such as mediation and arbitration.

The contract will often have a number of things attached to it, such as schedules of information, forms of notes or equity instruments delivered as part of the purchase price and allocations of the purchase price. These items are specifically incorporated in the contract and are often part of the items delivered by the parties at the closing.

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In private equity transactions, the most important thing that needs to happen before a closing occurs is the buyer needs to raise the financing needed to pay the seller the cash portion of the purchase price. Sometimes this is stated as an express condition, meaning that if financing cannot be obtained, the private equity firm will not be in breach of the agreement. If it is not an express condition, then the private equity firm will be in breach of contract if the financing cannot be raised. But because the private equity firm generally forms a special purpose entity for the sole purpose of completing the acquisition, there isn’t a company against which seller can assert a claim. For this reason, even where financing is not stated as an express condition, as a practical matter there is a financing condition in most private equity transactions.

Smart sellers sometimes require that a buyer provide firm financing commitments from equity and debt sources before a binding purchase agreement is signed. Alternately, sellers may demand that the buyer place cash in escrow that becomes forfeit in case financing is not raised by a stipulated date.

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The first covenant given by seller is the promise that it will operate its business only in the “ordinary course” and “consistent with past practice” between signing the purchase agreement and closing. The covenant goes on at length about specific things that seller will and will not do during this period without the permission of buyer. The purpose of these sections is to make sure that no significant or unusual transactions are undertaken without buyer’s knowledge and consent.

Seller agrees to give the private equity firm and its representatives access to its books, records, facilities and employees between signing the purchase agreement and closing. This is often necessary to bring in lenders for the transaction and let them complete their due diligence and investigation of seller and its business. 

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Representations and warranties serve two functions. They are part of the due diligence process where the private equity buyer looks at all material information about the target’s business; representations and warranties reflect the results of this investigation. They are also the insurance policy that the seller gives the private equity buyer about the truth and accuracy of the business information. The “representations” are assertions that the information furnished is correct and the “warranties” are legal obligations to stand behind the statements financially.

The subject matters of the representations and warranties cover all major facets of a business. Although the representations are worded in absolute terms, in practice the seller creates a schedule of exceptions and attaches them to the purchase agreement. These exceptions contain information about the company’s business and assets that deviate from the standard representations. Accordingly, these exceptions are important to the private equity buyer and their disclosure often provokes further negotiations.

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The sale of a company in a private equity deal typically begins with a term sheet spelling out the major terms of the transaction and setting out a timetable for due diligence, document preparation and closing. The parties then negotiate a definitive purchase agreement containing representations and warranties, covenants controlling actions before and after the closing and indemnification provisions. The time between contract signing and the closing is devoted to obtaining consents of third parties, waiting for clearance under the Hart-Scott-Rodino Act, securing financing to pay the purchase price or concluding other tasks that are required to be completed before closing.           

One of the key issues in any private equity transaction is who will manage the company after it is sold. Sometimes the answer is quite simple, as where the prior owners intend to retire. Other times the answer is more complex, as where the prior owners are required to remain involved in the company to ensure a smooth transition or to secure an earn-out.

Most of the time, the current senior managers of the target company are very important to sustain a core business, such as relationships with customers, product development or brand name. In that case, the private equity buyer may insist that these people sin independent employment contracts. They in turn acquire substantial influence over the transaction and may even have an impact on the sale price.

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Although office and manufacturing leases are generally recorded on the books as a liability, they are in fact critical business assets. Substantial investments are made in preparing an office or manufacturing center for occupancy. Also, a company generates good will associated with its location.

When leasing office or manufacturing space, an initial matter to consider is the difference between rentable and usable square footage. Prices are usually quoted on an annual square foot basis, so it is important to know whether the quote is based on actual useable space. Tenants should verify the square footage number provided by the landlord before signing the lease.

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No one cares about the law of sales and collections until something goes wrong.   When disputes arise, the parties dust off the “boilerplate” provisions printed on the back of their purchase orders and invoices. Often these provisions are in conflict with one another or do not cover the issue that actually exists. In these circumstances, where the contract involves the sale of goods, the parties must look to the provisions of the Uniform Commercial Code for answers. This Code, adopted in every State, provides a uniform body of rules for sales of goods. For sales of services, the common law of contracts applies. 

The success of the Uniform Commercial Code in regulating the sale of goods has crossed over into general contract law, and many provisions of the Code have influenced the development of general contract law.

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A trade secret is any information that derives its value by virtue of remaining secret and is in fact the subject of efforts to maintain its secrecy. A trade secret is a secret piece of information that provides a competitive advantage over those who do not know the information. A trade secret can be virtually anything: a formula, pattern, program, method, technique, process, sources of supply, customer lists, business and marketing plan, or new product under development. Once the secret is disclosed, it ceases to be a trade secret.

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Copyright law protects "works of authorship."  This means that there must be an author—a human being—and work created by the author. Works are typically thought of as pieces of literature, music, drama, choreography, photography, graphic arts, sculpture, motion pictures, videos, architecture, and computer software, although virtually any other work that is fixed in a tangible medium can be protected by copyright law.

To receive copyright protection, a work must be "original" and must be "fixed" in a tangible medium of expression. The originality requirement is easy to satisfy. A work is original for copyright purposes if it owes its origin to the author and was not itself copied. A work can incorporate preexisting material and still be original. When this happens, the copyright on the new work covers only the original material contributed by the author.

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Trademarks are an important tool for companies that develop and maintain brand names. Well-known brand names are used to forge direct ties with consumers or a diverse distribution system. Brands reduce the marketing costs of companies as end users rely on the reputation for quality embodied in the brand.

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A patent is often compared to an agreement between an inventor and the United States government. The government gives the inventor the exclusive right to practice the invention for a period of time, generally 20 years. In return, the inventor discloses all the details of the invention to the public through the patent application process. The inventor gets to exploit the invention for 20 years without competition. After that, the invention can be freely used by the public. 

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A private placement is a process, not a source of funding. A private placement simply means that the stock is sold in the private market, and cannot be resold in any public stock markets. As a practical matter, no private placement can occur without a placement agent, underwriter or direct source of capital, such as a venture capitalist. Although a private placement is not itself a source of capital, the phrase has become a shorthand way of referring to capital that is provided by private investors, rather than the public stock market.

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Companies that have burned through what cash friends and family have been willing to provide, and still can’t get a bank loan, turn to strangers for money. These strangers go by many names, one being “venture capitalists”. 

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A company with stable growth, revenues and cash flow and assets to serve as collateral can usually get bank financing. This is the least expensive form of capital. Banks charge interest rates keyed to various indexes. Interest costs have been low recently, and look to remain that way for the foreseeable future.

Bank financing documents can appear lengthy and complex, although the lending relationship is quite simple. After providing the funding, the lender is primarily concerned with receiving scheduled payments of interest and principal. The many protective clauses in the loan agreement are designed to maximize the lender’s chances of getting repaid in the event of a default and giving it an early warning if financial problems start to develop before an actual payment default occurs.

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LBO deals are typically done through limited liability companies, while venture capital deals are typically done through corporations. The difference is governed by tax considerations and the expected exit strategy.

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The limited liability company, or LLC, is by far the legal entity most favored by private equity. LLCs enjoy the distinct tax advantage of passing through tax attributes, such as income, loss and gain, to owners. At the same time LLCs are infinitely flexible, offering the ability to create a private world of terms and conditions governing the relations of the members. Only the limits of human imagination restrict the scope of provisions that the LLC agreement can contain. Limited partnerships, which LLCs have largely replaced, have the same flexibility, but they also have a number of annoying structural and capital requirements in order to pass tax scrutiny. 

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