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

The DVD releases of future Disney films featuring Marvel superheroes undoubtedly will contain bonus items for the cinephile. If a single viewing of a movie doesn’t sate your appetite, you’ll probably be able to watch it again accompanied by the director’s audio commentary. The Walt Disney Company’s S-4 registration statement regarding its proposed merger with Marvel Entertainment, Inc. contains a director’s commentary of a different stripe. The SEC filing includes a six-page section titled the “Background to the Merger” that describes the terms of Disney’s first proposal to Marvel, subsequent negotiations among their legal counsel, and explanations for why Marvel eventually agreed to the deal. We’ll break down this behind-the-scenes look at the talks. Keeping in mind that Disney and Marvel are both Delaware corporations, it’s difficult not to read this section – with its emphasis on the transaction’s deal protection terms – as a preemptive apologia of the Marvel directors’ actions in light of their Revlon duties to maximize shareholder value in the sale.

Disney-Marvel Negotiations: The Director’s Cut

Negotiations between Disney and Marvel focused on two transaction documents: the merger agreement and a voting agreement with Marvel’s CEO Isaac Perlmutter, who owns about 37% of Marvel’s shares through various affiliates. On August 11, Disney’s lawyers emailed their initial drafts of the merger agreement and voting agreement to Marvel’s legal counsel. According to the S-4, Marvel objected to several deal protection mechanisms contained in Disney’s proposal:

• a “force the vote” provision requiring Marvel to put the Disney deal before Marvel’s shareholders, even if Marvel’s board of directors received a superior bid for Marvel by a third party;
• a break-up fee equal to 4% of the transaction value if Marvel ended the deal;
• a  soft lock-up provision that would proscribe Marvel’s board from dropping its recommendation of Disney’s offer unless a third party made a superior offer to Marvel; and
• a demand that Mr. Perlmutter agree (i) to vote his Marvel common shares in favor of the Disney transaction and (ii) to veto any other transaction with another prospective buyer for a period of 18 months after the termination of the merger agreement.  

After two weeks of intense negotiations, a number of substantive terms remained outstanding. Disney continued to insist on a “force the vote” provision in the merger agreement and refused to concede on any of the deal protection measures contained in its first draft of the Perlmutter voting agreement. On August 27, Marvel’s special transaction committee informed the company’s financial and legal advisers that it would not recommend a transaction to Marvel’s board that included a “force the vote” provision or an 18-month tail on Mr. Perlmutter’s voting agreement because they considered these terms to be improper restrictions on the Marvel board’s ability to consider or enter into transactions with other potential buyers prior to the consummation of the Disney deal.   

During the ensuing days, Marvel told Disney that it would be willing to agree to a break-up fee equal to 2.9% of the transaction value in return for concessions by Disney on the other requested deal protection measures. 

In response to Marvel’s counteroffer, Disney agreed:

• to remove the “force the vote” provision;
• to let Marvel terminate the merger agreement in favor of a superior proposal if the board decided that “failing to do so might reasonably be expected to be a breach of its fiduciary duties;”
• to reduce the break-up fee from 4% to 3.5% of the transaction value;
• to allow Marvel’s board to change its recommendation of the Disney transaction to Marvel’s shareholders if it concluded that it had a fiduciary duty to do so; and
• to eliminate the 18-month tale on Mr. Perlmutter’s voting agreement (so that a termination of the merger agreement would constitute a termination of the voting agreement as well). 

Marvel’s Board of Directors Meeting

Marvel’s board of directors convened a meeting on August 30 to consider Disney’s revised proposal with its financial and legal advisers. During the course of the meeting, Marvel’s outside legal counsel advised the board on the agreements’ deal protection measures and the board’s fiduciary duties under Delaware’s general corporation law in the event that it received a possible superior proposal from a third party after the signing of the Disney merger agreement. Marvel’s lawyers also analyzed the procedure for considering alternative bids for the company under the merger agreement, the situations in which the board could terminate the merger, and the conditions under which the break-up fee would be payable to Disney. In the end, Marvel’s attorneys concluded that Disney’s deal protection measures “provided the Marvel board of directors with sufficient flexibility to entertain bona fide alternative proposals, were consistent with the Marvel board of directors’ fiduciary duties and were not coercive to Marvel stockholders.”

The following day Disney and Marvel signed the merger agreement and Mr. Perlmutter and Marvel entered into the voting agreement with Disney.

Critic’s Corner

Of course, the “Background to the Merger” section only summarizes discussions between Disney and Marvel. The disclosure contained in Disney’s S-4 stresses the companies’ haggling over the deal protection terms, but negotiations over the purchase price and the proportion of cash and stock that made up the purchase price were probably not mere subplots to the main action. Nevertheless, the narration of Disney’s and Marvel’s back-and-forth over the deal protection terms at times resembles Kabuki theater more than the Hollywood blockbusters the marriage of the two companies is likely to spawn. While it’s well known that a board’s fiduciary duties under Delaware law to maximize the sale price of a company does not impose any “legally prescribed steps that directors must follow to satisfy their Revlon duties,” Delaware courts have done a fairly decent job of coloring in the outlines of directors’ obligations to shareholders in the sale of a company since the 1986 landmark ruling. The story told by Disney’s S-4 raises questions about what purpose the inclusion of terms likely proscribed by Revlon in the first draft of a merger agreement serves. For example, how useful are such terms as bargaining chips when making an initial offer to a potential seller’s board of directors? When a buyer agrees to eliminate these types of deal protection measures in subsequent negotiations, has it really conceded anything of value? 

The Sequel

Nowadays, it seems that almost every profitable movie has a sequel in the works before it has even finished its run in the cinemas. We see no good reason why this blog post shouldn’t follow suit:

Much of the discussion in the S-4 regarding merger negotiations between Disney and Marvel addresses what actions the Marvel board would be permitted to take if it were to receive a “superior proposal” from a third party. But without an explanation of what constitutes a superior proposal under the merger agreement, any discussion of the proposed merger signifies very little. When we revisit the Disney-Marvel merger in a later post, we’ll take a closer look at the merger agreement’s definition of a Superior Proposal.

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As we previously noted, the ILPA (International Limited Partners Association) recently published a wide-ranging set of “best practices” that it hopes will shape the practices of the private equity sponsor community. In this piece, we’d like to focus on ILPA’s recommended changes to the fiduciary duty provisions of investment partnership agreements. First, we’ll summarize ILPA’s wish list in the area of fiduciary duties. Then, we’ll examine the investor documents of a well-known sponsor (KKR) to see how far apart current practice is from ILPA's wish list.

First, a little background. A fiduciary duty is a relationship of confidence or trust between two parties. A fiduciary must be loyal to the person to whom he owes the duty. He must not put his personal interests before that duty, and must not profit from his position as a fiduciary, unless the principal consents. Under common law rules, the general partner of an investment partnership owes a fiduciary duty to the limited partners. 

In Delaware, where most investment partnerships are formed, the fiduciary duty include an obligation to act in good faith and with due care and loyalty. The duty of care requires a general partner to act for the partnership in the same manner as a prudent person would act on his own behalf.  The duty of loyalty prohibits a general partner from taking any action or engaging in any transaction that is not in the best interests of the partnership where a conflict of interest is present. However, Delaware law also says say that these duties can be “restricted or eliminated” in the partnership agreement. Most sponsors take advantage of the opportunity to both restrict and eliminate fiduciary duties.

ILPA hopes to push back against the erosion of fiduciary duties and “reinforce” the fiduciary duties of the sponsor community. Specifically, it wants to delete:

• Provisions that reduce fiduciary duties “to the fullest extent allowed by law”.
• Provisions that allow general partner to use its sole discretion and weigh its own self-interest against the interest of the fund.
• Provisions where limited partners waive broad categories of conflicts or affiliated transactions.
• Provisions that allow general partner and its affiliates to be exculpated or indemnified for conduct constituting a material breach of the partnership agreement, breach of fiduciary duties, or other “for cause” events.

So, how far back do LPs have to push on fiduciary duties? To answer that, we looked at the prospectus filed by KKR & Co. LP last year when it tried to go public. The prospectus summarizes the lengths to which KKR has gone to restrict or eliminate any fiduciary duty to investors. In short, KKR has fully eliminated the core fiduciary obligation to put the interests of investors ahead of its own interests, and to act solely in the best interests of investors where a conflict is present. In making any discretionary decision, the KKR general partner is allowed to take into account whatever factors it wishes, including its own interests, and does not have any duty or obligation to consider any factors affecting investors.

Moreover, the KKR general partner cannot be liable to investors for any act unless there has been a final and non-appealable judgment by a court determining that it has acted in bad faith or engaged in fraud or willful misconduct. That's a pretty high hurdle.

As the prospectus itself informs us, in language only a lawyer could love: “These modifications are detrimental to our unitholders because they restrict the remedies available to our unitholders for actions that without those limitations might constitute breaches of duty, including a fiduciary duty, and they permit our Managing Partner to take into account the interests of third parties in addition to our interests when resolving conflicts of interest.”

It looks like ILPA and its members have a ways to go.

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Waterfall Structure

• The LP’s capital contribution plus preferred return should be paid first, before any distributions are made to the GP’s carried interest
• Establish GP carry escrow accounts with reserves of 30% or more to cover potential claw back liabilities
• Carry on recapitalizations should be paid only when the full amount of LP capital is returned on the recapitalized investment

Calculation of Carried Interest

• Carried interest should be calculated on net profits, not gross profits
• Carry should not be paid on current income
• Carried interest should be calculated only on an after-tax basis

Claw back

•  Claw back liabilities should be determined and reported periodically
•  Claw back liabilities should be paid within 2 years and should be gross of taxes paid
•  Effective joint and several claw backs should be implemented to make sure that full claw back liabilities are met

Management Fee Structure

• Management fees should be based on reasonable operating expenses and reasonable salaries, so that fees are not excessive.
• Management fees should reduce upon formation of follow-on fund and at the end of the investment period
• The management fee should be used to pay all normal operating costs of the GP, including interactions with the LPs. The LPs should have the power to review the partnership expenses annually
• Placement agent fees should be paid by the GP
• All transaction, monitoring, directory, advisory and exit fees should accrue 100% to the benefit of the fund.     

The Principles also include detailed suggested changes to the fiduciary duty requirements of the GP. For example, provisions of fund documents that disclaim or reduce fiduciary duties should be eliminated.  We will discuss these recommendations in more detail in a later post.

The Association is currently gathering formal endorsement of the Principles from its members and promises to publish a list of the endorsing institutions on its website.

How will the Principles be received by the sponsor community? That awaits to be seen. Institutional investors would love to establish a set of best practices across the sponsor community in order to make their investments in the asset class more uniform, and more favorable. They would like to reign in the variations in how sponsors define and enforce rules governing distributions, claw backs, and fees.  The sponsors will certainly resist any uniform treatment, and look for advantages at the margins, whether in the area of distributions or discretion in the application of fees.  Assuming a large number of institutional investors formally endorse the Principles, it may become difficult, if not impossible, for the GP community to ignore the recommendations.  The LP community has taken to heart the motto: United We Stand, Divided We Fall.         

Related Post:  Increased Capital Calls and Diminished Distributions for Private Equity LPs

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On May 27^th, Schering-Plough and Merck provided an “update” on the status of their dispute with Johnson & Johnson over the valuable Remicade distribution agreement between J&J’s Centocor subsidiary and Schering-Plough.  We previously wrote about this dispute, which centers on whether J&J has the right to terminate the distribution agreement under a “change of control” provision, and thereby capture sole rights over the international distribution of Remicade.  The press release confirmed that J&J instituted arbitration proceedings under the distribution agreement, which could go on for 9 to 12 months.  The deal will go ahead despite the outcome of the arbitration, as the possible termination of the distribution agreement was excluded from the “material adverse effect” condition in the merger agreement.

 As others have noted, the complex reverse merger structure adopted by Schering-Plough and Merck seems specifically designed to escape one of the two competing definitions of “change of control” in the distribution agreement.  Despite the merger parties’ insistence that J&J’s case “is contradicted by the clear language of the Remicade distribution agreement”, the outcome was uncertain enough to warrant a prominent risk factor in the Form S-4 registration statement filed by Schering-Plough. That disclosure includes the not-so-subtle suggestion that a settlement is likely: 

“[D]ue to the uncertainty surrounding the outcome of any threatened or actual proceeding, the parties may choose to settle a dispute under mutually agreeable terms.  Any agreement reached with Centocor to resolve a dispute under the distribution agreement may result in the terms of the distribution agreement being modified in a manner that may reduce the benefits of the distribution agreement to the combined company.”

Given the amount at stake ($2.1 billion annual revenue), the strangely ambiguous language of the distribution agreement, and the conciliatory nature of arbitration, it seems that a negotiated settlement is the most likely outcome.

Related Posts: Merck-Schering’s Reverse Merger: Change of Control Provisions in Material Contracts

                         Can Merck-Schering’s Deal Structure Avert a Change of Control?

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In our third and final post today on noteworthy deal protection provisions in the KKR-Sum Total merger agreement, we review Sum Total’s remedies for a breach or termination of the agreement by KKR. (Our first post covered the agreement’s “go shop” and “no shop” provisions and KKR’s break-up fee; our second post discussed the absence of a “financing out” for KKR.)

No Reverse Break-Up Fee

Sum Total is not entitled to a reverse break-up fee if KKR breaches or terminates the agreement under any circumstances.     

Specific Performance

The merger agreement pointedly provides that specific performance constitutes Sun Total’s “sole and exclusive remedy” for breaches of the merger agreement by the KKR merger vehicle or of the guarantee by Accel-KKR Fund III, L.P. Sum Total’s only recourse, in other words, is to get a court order compelling KKR to complete the merger. Sum Total has even agreed that if a court declines to enforce the specific performance remedy and awards monetary damages instead, the company may only collect its court ordered award if KKR is no longer willing to go ahead with the merger. 

The remedies section of the merger agreement appears to have been drafted in the shadow of the Delaware Chancery Court’s ruling in United Rentals v. Ram Holdings. In that case, the target company United Rentals moved for summary judgment on its claim that it was entitled to specific performance from a Cerberus-led private equity fund consortium under the terms of their merger agreement. The court, however, found that the priority of the two remedies provided to United Rentals under the merger agreement -  a reverse break-up fee and a right to specific performance - was ambiguous. Determining that neither United Rentals nor Cerberus was able to demonstrate that its proposed interpretation of the merger agreement was the only one that would be reasonable as a matter of law, the court resorted to extrinsic evidence by applying the forthright negotiator principle to divine the parties’ intent at the time of contract. The remedies section of the KKR-Sum Total merger agreement appears to be closely drafted to memorialize the parties’ intent that Sum Total’s only remedy is specific performance and that KKR’s right to specific performance does not preclude it from seeking its break-up fees.     

NB: The merger agreement also gives Sum Total the right to force the shell holding company serving as KKR's merger vehicle to compel Accel-KKR Fund III, L.P. to finance the purchase price of the merger.

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Following our post earlier today in which we reviewed KKR's break-up fees and the "go shop" and "no shop" provisions in the KKR-Sum Total merger agreement, we now examine the absence of a “financing out” in the agreement.

No Financing Out

In private equity buyouts, the acquisition vehicle tends to be a shell holding company with no assets. At the closing of highly leveraged cash-for-stock mergers, the holding company is funded by an equity investment from the funds participating in the merger and by senior and mezzanine, or “bridge,” loans from a syndicate of banks. Upon receipt, the holding company immediately transfers these funds to the target company for distribution to the target’s shareholders to complete the merger.   (The movement of these funds as they’re wired from entity to entity is mapped out in painstaking detail beforehand by the accounting firms in a chart dubbed the “funds flow.”) 

Although private equity firms usually have obtained signed letters from the banks committing their funds to the transaction before they enter into a merger agreement, firms always face the danger that, at some point between signing the merger agreement and closing, their lenders renege on their financing commitments or increase the costs of borrowing. To protect themselves against the possible loss of debt financing on acceptable terms, private equity funds in years past have negotiated a “financing out” in merger agreements by setting the continued availability of financing from their bank syndicates as a condition to closing the deal. 

The merger agreement does not have a “financing out” for KKR because the firm is financing the Sum Total merger solely with an equity investment from Accel-KKR Fund III, L.P., a fund dedicated to investing in mid-market technology companies. With no fear of a third-party’s failure to make good on its loan promises, KKR faces very little risk that it will not be able to come up with the cash to complete the transaction. 

Guarantee from KKR Fund

In fact, it is Sum Total who bears some risk that the KKR fund may fail to contribute cash to the shell holding company serving as KKR’s merger vehicle. The merger agreement gives Sum Total additional comfort by having the right to force the merger vehicle to compel the KKR fund to finance the purchase price. Sum Total also has a direct guarantee from Accel-KKR Fund III, L.P. for the holding company’s (and its subsidiary’s) obligations under the merger agreement. In effect, Sum Total’s contractual right to force the KKR fund to finance the transaction serves as an alternative, extra-judicial means of enforcing its right to specific performance under the agreement.

Sum Total’s right to specific performance will be the subject of our third and final post on the deal protection terms in the KKR-Sum Total merger agreement.

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A signed merger agreement with Accel-KKR in hand, Sum Total’s board has a month to go to the market to find a better deal. On Friday, Sum Total Systems, Inc. announced that Accel-KKR had offered its shareholders $3.80 per share in a definitive merger agreement filed with the SEC. For this deal at least, the private equity fund has foregone the LBO model, financing the entire $124 million price tag with an equity investment from a KKR fund focused on mid-market technology companies. By the time the markets closed on Friday, Sum Total stood at $3.83 a share, a 22% jump from the previous day’s closing price of $3.13. Trading volume for Sum Total’s shares skyrocketed to 5,759,368 on the day, compared to an average daily trading volume of 330,000 shares. 

Investors seem eager to become beneficiaries of an anticipated bidding war. While Sum Total’s board of directors has recommended the KKR merger, the company’s shareholders have yet to vote on the deal. According to the website Mergers Unleashed, a JPM Securities’ analyst report affirmed its $5 per share target value for Sum Total’s stock after Accel-KKR announced the merger deal. KKR has laid its cash and deal terms on the table, now it’s time to see whether anyone else will sit down and ante up.  

Over the course of the day, we’ll take a look at some of the noteworthy deal protection measures in the KKR-Sum Total merger agreement: 

“Go Shop” Period and "No Shop" Provisions

The Sum Total board of directors has a one-month “go shop” period (ending just after midnight on May 24) to solicit competing offers for the company’s shares. From May 24 until the company’s shareholders approve the merger, Sum Total’s board may not engage in any discussions with other parties regarding the sale of the company. This “no shop” provision has a customary fiduciary exception that allows the company’s board to entertain unsolicited written acquisition proposals so that Sum Total’s directors can fulfill their Revlon duties under Delaware corporate law to bargain for the highest price obtainable for the company’s shareholders. Though the Revlon court observed that “no shop” provisions are a legal deal protection measure under Delaware law, the court held that an absolute “no shop” prohibition on a company’s board of directors “when a board’s duty becomes that of an auctioneer for selling the company to the highest bidder” is impermissible.     

Even if it receives a better offer, Sum Total can’t terminate the agreement without first going back to KKR. If the board considers approving a merger agreement with another buyer, Sum Total must give KKR detailed information about the proposal, negotiate a potential counteroffer with KKR, and permit KKR to present a revised merger agreement to the board of directors for their consideration. KKR has found some relief, it seems, from the Revlon restrictions placed on their ability to lock-up the deal by negotiating a right of first refusal if a competing bidder proposes a higher price.    

Break-Up Fee

If the merger agreement is terminated because the Sum Total stockholders don’t approve the deal, the company breaches certain of its covenants (including the no shop restrictions), or the board changes its recommendation without entering into a merger agreement with another buyer, Sum Total must pay KKR a $4.95 million break-up fee. If the company terminates the agreement because the board has authorized the company to execute a merger agreement with another buyer offering the company’s shareholders a better deal, then KKR’s break-up fee is reduced to $3.1 million.  

Update:  Other aspects of the deal protection measures in the KKR-Sum Total merger agreement are discussed in:

No "Financing Out" Required: KKR's Equity Financing of the Sum Total Merger

Sum-Total's Remedies Under the KKR Merger Agreement

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The private equity sponsors behind the Clear Chanel acquisition – Bain Capital and Thomas H. Lee Partners -- are looking at the possibility of paying a $500 million reverse termination fee to Clear Channel if they are forced to walk away for lack of bank financing. Maybe the sponsors can recover some of this from the lenders who promised to provide the financing – time will tell. The banks committed to provide about $16 billion of new debt, which they may struggle to sell given turmoil in the leveraged loan market.   And even if they do manage to sell it, they might face a mark-to-market hit of about $2.5 billion. Lawsuits recently begun in New York and Texas may clarify whether the banks are responsible for causing the deal to break.

The sponsors will have a hard time arguing that a material adverse change in Clear Channel’s fortunes has occurred, given that the company reported a 52 percent rise in fourth-quarter earnings. Assuming that some or all of the break-up fee has to be paid by the sponsors, who really has to foot that bill – the limited partners in the funds or Bain and THC?

An LBO partnership agreement typically provides that deal expenses, including “broken deal” costs, are paid by the investment partnership, namely, the limited partners. However, these costs are typically offset against the management fee paid by the fund to the sponsors. That provision makes the sponsor ultimately responsible for broken deal costs, but caps the exposure at the amount of the management fee. 

The impact of this situation can be seen in Blackstone’s recent 10K filing. There, in the MD&A section, Blackstone described certain shortfalls in management fee income that occurred during 2007. Prominent among the causes for this shortfall was a reverse termination fee that was paid when Blackstone terminated the acquisition of a subsidiary of PPH Corporation. Here is the relevant portion of Blackstone’s MD&A section:

"An increase in fund management fees of $47.2 million, as a result of $4.68 billion of additional capital raised for BCP V during the year ended December 31, 2007, was entirely offset by increased management fee reductions of $47.4 million. The increase in management fee reductions was due to increases of $38.2 million of broken deal expenses, which included a $24.2 million reverse termination fee incurred in connection with the termination of BCP V’s planned acquisition of a subsidiary of PHH Corporation, and $9.2 million of placement fees paid for additional capital raised by BCP V."

No wonder Bain and THL are suing the banks left and right.

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The most recent issue of the Debevoise & Plimpton Private Equity Report notes that, at the current time, there are more than 50 private equity transactions in North America with an aggregate transaction value of more than $60 billion waiting to get done. Each of these deals was signed up prior to the current credit crunch.  It remains to be seen how or whether these transactions will get done, and it so on what terms. Separately, it remains open how the current macro economic conditions will impact private equity deals going forward.

The issue also contains an interesting discussion of the Forthright Negotiator doctrine, which this blog has discussed before.  Ambiguity can often be found, or manufactured, during the course of litigation.  The United Rentals case stands for the proposition that what is communicated in negotiating sessions, sidebars and email exchanges, whether involving lawyers, bankers or clients, can carry great weight in shaping a court’s understanding of a disputed contract.  Look for more emails reiterating the parties' intentions, even in the face of contract language that is clear.

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A recent spate of private equity cases has turned on the question whether the buyer has the right to walk away from a deal and pay a fixed price, known as the reverse termination fee.  Rather than be spurned, the target clutches at the specific performance clause in the merger agreement, and tries to push the deal through.  This year, so far, of the seven announced private equity deals for public companies, all have had reverse termination fees.  Moreover, each of the seven deals explicitly barred specific performance of the agreement.

As a result, private equity sponsors have the option to walk away from the deal for a fixed cancellation price.  In this environment, where guaranteed financing terms just aren't available, probably no other structure is possible for a leveraged deal.

 The recently announced deal to buy Getty Images, the pictures and video distributor, for $2.4 billion including debt, marks this trend.  The private equity firm, Heller & Friedman, rejected specific performance language and even added "no recourse" language directly in the merger agreement.  No recourse language typically states that the seller cannot directly sue the private equity firm for damages or specific performance. In Getty Images the merger agreement language states:

 
“[Getty Images] acknowledges and agrees that it has no right of recovery against, and no personal liability shall attach to, in each case with respect to [The Reverse Termination Fee Liability Limitation], any of the [Hellmann & Friedmann] Parties (other than [Acquisition] Parent to the extent provided in this Agreement and the Guarantor to the extent provided in the Limited Guarantee), through [Acquisition] Parent or otherwise, whether by or through attempted piercing of the corporate, limited partnership or limited liability company veil, by or through a claim by or on behalf of [Acquisition] Parent against the [Private Equity Fund] Guarantor or any other [Hellmann & Friedmann] Party, by the enforcement of any assessment or by any legal or equitable proceeding.”

It seems that parties have become disenchanted with the idea of specific performance as a remedy.  The courts have been reluctant to decree a merger, perhaps due to the significance of the remedy.  After all, how does one order the merger of two parties when one of them has changed its mind?  A merger requires willing parties on both sides to make things work.  Money, careers and even communities hang in the balance. The remedy itself seems unrealistic in the context of business combinations.

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The recent decision of the Delaware Court of Chancery in the case brought by United Rental against the acquisition vehicles formed by Cerberus Capital imposes an affirmative duty to be forthright, or not devious, in the process of contract negotiations. The ruling seems to undo decades, if not centuries, of negotiating wisdom and practice. 

The United Rental court was unable to dispose of the case on summary judgment, as the contract interpretations offered by both sides were plausible. Because no decision as a matter of law could be reached, the court had to delve into the real intention of the parties on the issue whether they intended to provide a specific performance remedy.

To do this, the court heard testimony from 7 witnesses over a 2 day period. United Rental had the burden of proof to show that the parties intended to allow the remedy of specific performance, rather than the $100 million termination payment offered by Cerberus.

After all this testimony, the court remained unable to determine the shared objective intent of the parties. It therefore proceeded to adopt the breathtaking “forthright negotiator” principle:

“in cases where an examination of the extrinsic evidence does not lead to an obvious, objectively reasonable conclusion, the Court may apply the forthright negotiator principle.  Under this principle, the Court considers the evidence of what one party subjectively “believed the obligation to be, coupled with evidence that the other party knew or should have known of such belief.” In other words, the forthright negotiator principle provides that, in cases where the extrinsic evidence does not lead to a single, commonly held understanding of a contract’s meaning, a court may consider the subjective understanding of one party that has been objectively manifested and is known or should be known by the other party.”

Calling the negotiations “deeply flawed”, because both sides “failed to clearly and consistently communicate their client’s positions”, the Court found that United Rental’s attorney “categorically failed to communicate that United Rental believed it preserved a right to specific performance”. The Cerberus attorney, on the other hand, did clearly communicate his understanding that the agreement precluded specific performance. Because the United Rental lawyer did not continue to repeat his view that the agreement provide for specific performance, and relied instead on the fact that the agreement contained inconsistent provisions, he failed to satisfy the “forthright negotiator” principle.

It may come as a shock to corporate attorneys that deviousness has been barred from contract negotiations. Yet that is law of Delaware:  “United Rental knew or should have known what Cerberus’s understanding of the Merger Agreement was, and if it disagreed with that understanding, it had an affirmative duty to clarify its position in the face of an ambiguous contract with glaringly conflicting provisions."

A duty indeed!

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As this website predicted on November 24th, the Delaware Court of Chancery on December 21, 2007 found that the sole and exclusive remedy of United Rental was the $100 million break up fee specifically provided for in the Merger Agreement with entities controlled by Cerberus Capital.

The exchange of drafts and the meetings between the parties indicated that the breakup fee was intended to preclude any other remedies, including specific performance..  United Rental’s case was based on the fact that the contract continued to have language providing for equitable remedies like specific performance, even though other sections said that this remedy was superseded by the breakup fee. In deposition, the Cerberus attorney conceded that it would have been “clearer” to delete the specific performance section altogether.

Given the relatively clear cap on exposure in the Merger Agreement, one would expect that the opinion of the Delaware court would stick closely to the express contract language and the law of summary judgment. In fact, most of the opinion does that. But the court ultimately relied on an interesting though obscure principle of contract interpretation called the “forthright negotiator principle.”

According to the court, under the forthright negotiator principle, “the subjective understanding of one party to a contract may bind the other party when the other party knows or has reason to know of that understanding. Because the evidence in this case shows that defendants [Cerberus] understood this Agreement to preclude the remedy of specific performance and that plaintiff [United Rental] knew or should have known of this understanding, I conclude that plaintiff has failed to meet its burden and find in favor of defendants.”

“The forthright negotiator principle provides that, in cases where the extrinsic evidence does not lead to a single, commonly held understanding of a contract’s meaning, a court may consider the subjective understanding of one party that has been objectively manifested and is known or should be known by the other party.”

The only support for this principle cited by the court was a section of the Restatement of Contracts. 

The very interesting history of these contract negotiations indicates that the parties never explicitly resolved the issue of whether the $100 million breakup fee was the sole and exclusive remedy. The court found that because the parties never clearly drafted any agreement on the termination fee, it would award judgment to the side that most clearly and consistently articulated its subjective understanding of the agreement to the other side. In this, the court found that the Cerberus attorney was more consistent in his statements that the termination fee was intended to preclude specific performance. The attorney for United Rental, the court found, implicitly agreed with the Cerberus position during oral contract negotiations.

The case came down to this fact: “Though URI, through [its lead attorney], had many opportunities throughout the negotiation process to clearly vocalize its understanding of its rights for specific performance under the Merger Agreement, URI consistently failed to communicate this to Cerberus representatives.”

The very interesting implications of this decision for the manner in which merger negotiations are conducted will be the subject of future postings here.

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Does Cerberus have the unilateral right to walk away from its deal with United Rental and limit its exposure to a break up fee of $100 million?  Or does United Rentals have the right to specifically enforce the merger agreement?  That's the issue at the heart of lawsuits currently pending in Delaware and New York arising out of this failed acquisition. 

Cerberus had this to say about United Rental's Delaware action for specific performance in a press release issued November 19th:

"We believe that United Rentals has been less than forthright in its legal filings and its communications concerning those filings.  The fact is that RAM negotiated for and obtained the right to withdraw from the Merger Agreement of July 22, 2007 and instead make a one-time payment in the aggregate amount of US $100 million.  This ability to walk away from the transaction with this limited exposure was specifically bargained for, is clearly and unambiguously stated in the Merger Agreement and related documentation, and is not in any way conditional on the occurrence of a material adverse change, the termination of the Merger Agreement by United Rentals or any other event."

Also, according to Bloomberg, Cerberus started its own lawsuit in New York Supreme Court seeking a declaration that its maximum exposure to United Rentals is $100 million. In the suit, Cerberus says United Rentals has no remedy other than the right to pursue the $100 million brake up fee, which serves as a cap for any or all losses or damages relating to or arising out of the merger agreement.

Let's see where that clear and unambiguous statement appears in the merger agreement.  Section 8.2(c) of the agreement says:

"In the event that this Agreement is terminated by [United Rentals] pursuant to Section 8.1(d)(i) or Section 8.1(d)(ii), then [Cerberus] shall pay $100,000,000 to [United Rentals] as promptly as reasonably practicable (and, in any event, within two business days following such termination), payable by wire transfer of same day funds."

OK then.  Section 8.1(d)(i) says that United Rental can terminate the agreement upon certain breaches by Cerberus of the merger agreement, and Section 8.1(d)(ii) says that United Rental can terminate the agreement if the merger isn't completed by a certain date.  Neither of these things has happened, and United Rentals isn't seeking the fee. 

Later on, in Section 8.2(e), there is a clause limiting liability for termination events to $100 million.  It says that United Rental's right to terminate the merger agreement under Sections 8.1(d)(i) or (ii) and receive the $100 million fee under Section 8.2(c) is the "sole and exclusive remedy" of United Rentals against Cerberus for "any and all loss or damage suffered as a result thereof" and Cerberus shall not have "any further liability or obligation of any kind or nature relating to or arising out of this Agreement or the transactions contemplated by this Agreement as a result of such termination."  This fee is "the sole and exclusive remedy for recovery" in the event of "the termination of this Agreement by [United Rentals] in compliance with the provisions of Section 8.1(d)(i) or (ii)."  

So far, it looks as though United Rentals has the winning position, as this language pretty clearly says that the $100 million payment is the sole remedy only in the situation where United Rentals has terminated the merger agreement due to a misrepresentation or failed deadline.  Up until now, there isn't any absolute cap on liability if Cerberus breaches the agreement and walks away.

But keep reading.  At the very end of Section 8.2(e), comes the provision that finally supports Cerberus:

"In no event, whether or not this Agreement has been terminated pursuant to any provision hereof, shall [Cerberus], either individually or in the aggregate, be subject to any liability in excess of [$100 million] for any or all losses or damages relating to or arising out of this Agreement or the transactions contemplated by this Agreement, including breaches by [Cerberus] of any representations, warranties, covenants or agreements contained in this Agreement, and in no event shall [United Rentals] seek equitable relief or seek to recover any money damages in excess of such amount from [Cerberus].

That's pretty clear.  Although there is plenty of language in the agreement that appears to support United Rentals' position, this one sentence appearing at the end of Section 8.2(e) seems to cap Cerberus' exposure at $100 million.   The stock market seems to agree as well.

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United Rentals Inc. recently sued the shell companies formed by Cerberus Capital Management to acquire the company after Cerberus informed it that it was not prepared to proceed with the $7 billion deal. Cerberus wants to cancel the deal because of trouble with financing. United Rentals is doing fine, having just reported a great quarter. The lawsuit raises an interesting issue on the interplay between the specific performance remedy and a liquidated damages provision providing for a $100 million payment in the event the merger agreement is canceled.

Cerberus and United Rental agreed to the deal in July 2007. The merger agreement has detailed provisions regarding financing. For example, it provides that if the Cerberus entities are not able to obtain financing from syndicated sources, it will draw down on a $4 billion of bridge financing commitments given by a group of lenders including Banc of America, Credit Suisse, Morgan Stanley and Lehman Brothers. As everyone knows, the syndication market for these deals has dried up, so people are looking at the bridge financing package.

Cerberus went along through the fall and the United Rental shareholder vote as though everything were fine. Several days ago, apparently reacting to pressure from the bridge lenders, it notified United Rental that it was not prepared to impair its relationship with the bridge lenders by forcing them to fund, even though the merger agreement required them to do so. Instead, it notified United Rental that it “elected not to consummate the transaction” and would pay a break-up fee of $100 million.

Cerberus or its advisers also leaked news of the potential breakup to the press and the stock dropped fast, erasing more than $1.2 billion of market cap.

The lawsuit is a study in the remedy of specific enforcement. United Rental wants to force the Cerberus entities to go through with the deal, and wants the Delaware Chancery Court to order Cerberus to draw down the bridge financing. Cerberus on the other hand acts as though it holds an option to buy the company which can be canceled by paying the $100 million break up fee. 

The break up fee section says the fee is due only if the merger agreement is terminated. Cerberus doesn’t seem to have the right to terminate the agreement. Cerberus is counting on the fact that specific performance is not a favorite judicial remedy, especially where the parties have contemplated a specific financial damages remedy, like a break up fee. But this agreement has all the makings of a good specific performance action. 

Right now, the market doesn’t think the chances of United Rentals are so good, as the stock price is substantially below the merger price.

 

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Deep within Blackstone's recent 10Q, in the MD&A section, the company discusses the negative impact that the "considerable turbulence" in the housing and sub-prime mortgage markets has had on other fixed income markets. 

"Deteriorating conditions in fixed income markets prevented lenders from syndicating senior loans and high yield debt."

Translation:  when the music stopped the the banks got stuck holding our last deals.

"[T]he backlog resulting from pending private equity-led transactions reached record levels."

Translation:  the banks can't get rid of the paper.

"This backlog resulted in lenders becoming less willing to fund new, large-sized acquisitions and as a consequence, the volume of new private equity acquisitions declined significantly in the quarter."

Translation:  until the pipeline gets opened we can't get the big dogs closed.

"Recently announced private equity-led acquisitions have mostly been smaller in size, with less leverage and less favorable terms for the debt provided, including more onerous loan covenants."

Translation:  looks like it's back to Plan A.

"The duration of current conditions in the credit markets is unknown."

No translation needed.

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Knowing how to get out of a deal is often as important as knowing how to get in.  When a company blows up, it's easy to find a representation that went awry.  But when things turn sour because of legislation or macro economic issues, you've got to look at the MAC clause.

The MAC, or material adverse change, clause sets the conditions under which a deal may be terminated without penalty. MAC exceptions, which are often appended to such clauses, outline specific circumstances under which the MAC doesn't apply, meaning the deal must proceed even if there is a material change.

During the deal frenzy of the past several years, sellers have had the upper hand in negotiating deal terms, a trend that has extended to the MAC clause. To win deals, buyers have agreed to loose MAC clauses with lots of exceptions, or in some cases have foregone MACs altogether.

The litigation currently pending in Delaware between SLM (Sallie Mae) and J.C. Flowers & Co. will, if it goes that far, shape the understanding of MAC clauses for the next few years.  J.C. Flowers and its partners have sought to walk away from the deal, in part on the basis that new Federal legislation will decrease the earning of the company.  SLM has of course insisted that the deal must go through, and issued a press release saying that "core earnings" at the company will be negatively impacted by only 1.8 to 2.1 percent annually over the next 5 years.  The issue is whether the MAC clause is triggered by the adverse impact of the new Federal legislation.  The clause reads as follows:

"Material Adverse Effect" means a material adverse effect on the financial condition, business, or results of operations of the Company and its Subsidiaries, taken as a whole, except to the extent any such effect results from: ... (b) changes in Applicable Law provided that, for purposes of this definition, "changes in Applicable Law" shall not include any changes in Applicable Law relating specifically to the education finance industry that are in the aggregate more adverse to the Company and its Subsidiaries, taken as a whole, than the legislative and budget proposals described under the heading "Recent Developments" in the Company 10-K, in each case in the form proposed publicly as of the date of the Company 10-K) or interpretations thereof by any Governmental Authority..."

As the highlighted language shows, SLM and JC Flowers were acutely aware of the potential impact of the new Federal legislation on the earnings of Sallie Mae.  This was not a thunderbolt from out of the blue.

SLM's position is that the "core earnings" of the company will only be reduced by 1.8 to 2.1 percent  MORE than what was already presented in the 10-K.  This sets the bar well under the 10% figure which most lawyers and judges would agree is "material".  As the M&A Law Prof Blog points out, the Delaware courts set a high bar for proving a MAC.  Under these cases the party asserting a MAC has the burden of proving that the adverse change will have long-term effects and must be materially significant.

Of course the issue may be settled before any trial.  Justine Strine has been pressing the sides to settle.  A renegotiated price is the likely outcome, as SLM will not likely want to remain in the public eye after this battle.

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In the investment world, there is no shortage of firms where everyone drinks the koolaid, believing the firm is a truly unique organization with values and a culture shared by no one else. Most times, the koolaid drinking is done in private, at partners’ meetings or golf retreats where the steady gaze of outsiders does not interfere with the collective daydream. It is therefore jarring to see the drinking done in public, especially in so formal a setting as a prospectus for an initial public offering.

The Summary section of the IPO prospectus of Blackstone Group contains the following announcement:

We Intend to be a Different Kind of Public Company

While we believe that becoming a publicly traded company will provide us with many benefits, it is our intention to preserve the elements of our culture that have contributed to our success as a privately-owned firm. In particular, as described below, we intend to continue to manage our business with a long-term perspective, to focus at all times on seeking to optimize returns to the limited partner investors in our investment funds and to retain our partnership management structure and culture of employee ownership of our business. 

Because our businesses can vary in significant and unpredictable ways from quarter to quarter and year to year, we do not plan to provide guidance regarding our expected quarterly and annual operating results to investors or analysts after we become a public company.

The logic here appears to be that one fosters a long-term perspective on business by refusing to provide guidance to investors about quarterly and annual operating results. But then, it is not really evident how these things are connected.  Is it really true that by not disclosing its quarterly and annual profit expectations, which Blackstone surely prepares internally, the firm will better manage its business for the long term?

It seems one thing to believe in the long-term perspective, after having drunk deeply from the bowl.  It is another thing to prominently feature the belief in an IPO prospectus.  But then, it was only a statement of intent. 

And what of the belief itself? Do private equity firms really manage their investments with a “long-term perspective”? Happily, Christina Padgett of Moody's Investor Service has recently written on this subject. In a recent report, Ms. Padgett wrote:

While Moody's would agree that leverage is likely to impose discipline and provide higher equity returns, the current environment does not suggest that private-equity firms are investing over a longer-term horizon than do public companies, despite not being driven by the pressure to publicly report quarterly earnings"

The report goes on to note that Celanese US Holdings, a chemical business owned by Blackstone Group, borrowed money within a year of the acquisition to pay a dividend to the private-equity firm, removing more than 95% of the cash equity originally invested in the deal. 

Blackstone's investors at least can breath a sign of relief, knowing that the firm has a sharp eye for the short term as well as the long. 

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The recent tax proposal submitted by the two top lawmakers on the Senate Finance Committee "closes a loophole" in the treatment of publicly traded partnerships. 

Years ago, 1987 to be exact, Congress passed legislation treating publicly traded partnerships as corporations.  It excluded however partnerships that derived at least 90% of their income from interest, dividends, and gains from the disposition of a capital asset.  Blackstone and other private equity firms that are flocking to go public have relied on this exemption since most of their income qualifies for the exclusion.  The exemption is huge -- corporations pay up to 35% of their income to Uncle Sam.

The new bill provides that the exception from corporate treatment for a publicly traded partnership, 90 percent or more of whose gross income is qualifying income, does not apply in the case of a partnership that derives income from investment adviser services or related asset management services.  Such a partnership is treated as a corporation for Federal tax purposes and is subject to the corporate income tax.

This strikes at the heart of the private equity firm, which receives fees and carried interests from investment adviser services.  As such, the legislation is pointed directly at firms such as Blackstone that hoped to be publicly traded partnerships without paying a corporate tax.

Reflecting, however, the strong connections that Blackstone must have in Washington, the new bill contains a 5-year exception for any private equity firm that is already public or that has an IPO registration statement already on file with the SEC.  As my tax colleague Stephen Foley notes, Blackstone may have successfully lobbied for the ability to be one of the few private equity firms that can ever go public.

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Going-private transactions sponsored by private equity firms are facing increased resistance from public shareholders.  The resistance takes many forms, all designed to improve the price.  Like any seller these days, the opportunities to leverage competing bids typically bear fruit. 

A sponsor that faces stiff public stockholder resistance, and that wants to keep pricing within reason, has a few strategic alternatives:

Stub Equity

“Stub equity” has been included as a feature in several recent transactions, including Harman, Clear Channel and Aeroflex in the United States. Stub equity gives public stockholders the option to choose either cash or stock in the company post-leveraged buyout. Stub equity is intended to deflect concerns that the going concern value of the target is worth more than the sponsor takeout price by offering the public stockholders the ability to choose, at least in part, to roll its investment going forward (possibly on a tax deferred basis). The amount of stock that may be issued to public stockholders is typically capped by the sponsors. Generally, caps have been in the 20% to 30% range of the company’s equity post-leveraged buyout, although in at least one transaction, Countryside, the cap was set at 55%. Stub equity has a number of disadvantages to sponsors, such as the requirement to register with the Securities and Exchange Commission the shares to be issued to the public stockholders and the requirement that the target remain a public company and file Securities and Exchange Commission reports for some period of time after the closing. This structure also has certain drawbacks for public stock-holders, particularly retail investors, as the sponsors may not be required to maintain a NYSE or NASDAQ listing for the stub equity so there may be very limited liquidity. 

Contingent Value Rights

Similar to earn-out rights in a private company transaction, contingent value rights provide a mechanism to bridge a perceived value gap, and thereby help mitigate public stockholder opposition. Contingent value rights give public stockholders additional value if future hurdles are met and, as an example, can be tied to future financial targets or the sales price in the event of a divestiture of a division or key assets. However, unlike stub equity, contingent value rights customarily give public stock-holders limited upside potential and don’t carry any downside risk. A variation of contingent value rights was recently part of a stockholder derivative settlement in the Sabre Holdings going private transaction. The sponsors agreed to pay the public stockholders a percentage of any profits above a certain benchmark price if the sponsors flipped the company or divested certain crown jewel assets within a six month period following closing. This type of supplemental payment for public stockholders may become more common in merger agreements.

Time will tell how the great push back by public stockholders affects the going private trend.

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It's hard to ignore the growth of covenant-lite lending in private equity deals, when even famous investment gurus like  Anthony Bolton remark on it, and at his farewell dinner no less.  Here is what Mr. Bolton had to say on the topic:

“I think the phrase is ‘covenant-lite’, but in many cases it appears to mean no covenant at all,” Mr Bolton said. He added: “Covenant-lite borrowing ... will come back at some stage to haunt the banks,” he said.

Quotes about covenant-lite lending are usually paired with a dire prediction, such as the premonition of another financial bubble.  But will covenant-lite lending really come back to haunt the banks?   

In a typical covenant-lite deal, the lenders give up what are called "maintenance" covenants.  As the name suggests, these are requirements that the borrower maintain certain financial standards at regular intervals.  For example, a borrower might be required to certify that at the end of each quarter, it has maintained a certain ratio of EBITDA to total debt.  These covenants are designed to be an early warning system that the borrower's earnings are deteriorating, and it might become unable to meet debt service requirements at some time in the future.  With these maintenance covenants gone, the lenders rely solely on what are called "incurrence" covenants.  These require that a borrower meet defined financial standards not on a regular basis, but only when there is a specific event, such as an acquisition.  For example, if the borrower wants to make an acquisition, it must certify that it will meet a specific EDITDA coverage test after the acquisition is taken into account.   

Finally, in covenant-lite deals, the other covenants are less restrictive, for example allowing for more extensive dividend payments or larger capital expenditures.

How bad are covenant-lite loans?  Despite the publicity these deals receive, they appear to be limited to large private equity deals involving companies with earnings cycles that are relatively well known or at least fairly predictable.  With companies like these, perhaps the function of maintenance covenants -- to provide an early warning system -- isn't necessary.  What good is a warning when the funds have already been loaned?  Perhaps maintenance covenants aren't really needed, and their elimination is simply a matter of efficiency.

Perhaps the traditional way of lending, where a borrower is required to certify periodically that it remains healthy enough to maintain its debt, is out of date.  Then again, if it is merely out of fashion, we may see it come round again.  Time will tell.

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The recently announced LBO of Harman International Industries by KKR and Goldman Sachs Capital Partners offers the great unwashed public the chance to own a piece of the post-acquisition company alongside the sponsors.  We have until the record date of the meeting called to approve the merger in which to buy the current shares of Harman and elect to exchange them for a piece of the "stub" post-closing equity.  The terms of the exchange will put us on the same terms as KKR and Goldman, that is, each dollar we roll over into the stub will travel the same road to riches as the dollar invested by our new partners.  Who's your daddy now?

Taking the stub is not mandatory.  We can also take cash.

If there is widespread interest in holding a slug of the leveraged equity, up to 27% of the company could remain in public hands.  With the steady stream of SEC filings the company will be required to make, we'll be able to follow the progress of our investment.

You can count on one hand the number of recent deals in which stub equity has been offered to the public.  Does the Harman deal presage a new wave of investing, reflecting the stronger negotiating power of sellers?  Or is this a one-time thing. 

I guess that will depend on how well the stub does.  If it does as well as the historic performance of these PE sponsors, then the boards of directors of future sellers may even come under pressure to provide stockholders the opportunity to hold a piece of the stub.  From the PE sponsor side, offering a piece of stub equity may deflate the pressure to overpay.

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The most recent issue of the excellent Deal Lawyers newsletter has a piece by Geoffrey Levin at Kirkland about club deals. 

It discusses the clubbing phenomenon from the standpoint of large public company sellers, noting that clubbing can be a great tool to coax out the best offer from a field of bidders and satisfy Revlon fiduciary duties.  Clubbing has been written about extensively as a way for private equity firms to make bids they otherwise might be loathe to consider.  Levin points out that sellers have to watch out that clubbing doesn't dry up the pool of bidders.  He goes through a number of useful provisions to insert in the seller's confidentiality agreement to strike the right balance between fostering club land and not getting crushed in the process.

Club deals get a lot of press, though they are far more prevalent at the top end of the private equity market than elsewhere.  Most deal makers naturally would prefer not to share the fruits of a successful bid with other firms.  Also, clubbing gets its popularity from the fact that target companies currently outstrip the ability of existing firms to swallow deals whole.  As fund sizes get larger, that may not be such a problem in the future.  Finally, a lot of syndication of risk in large deals can go on behind the scenes, as firms sell off chucks of equity exposure in private transactions.

One thing that may come of clubbing in the not so distant future is the merger of large private equity firms.  By working together through the purchase, management and sale of deals, PE firms will get to know one another and see the benefits of even closer affiliations.  If you think about the large PE firms as the premier capital aggregators of the 21st Century, you might conclude that they will become the Goldmans of the future.

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Several recent deals illustrate the extent to which financial covenants have all but disappeared from senior loan agreements in private equity transactions. The following transactions were chosen at random.

• In the October 2005 acquisition of Neiman Marcus by Texas Pacific Group and Warburg Pincus, the $2 billion senior loan facility provided by Credit Suisse and Deutsche Bank Securities had no financial covenants. The agreement did have the usual negative covenants, but even these were significantly weakened. For example, the restriction on incurring other indebtedness had 23 exceptions.

• In the November 2005 acquisition of the Vitamin Shoppe by Bear Stearns Merchant Banking, the senior revolving loan facility provided by Wachovia Bank had one financial covenant. It said that if the availability on the revolver was nearly tapped out (less than 10% remaining) then during the four preceding quarters the Fixed Charge Coverage Ratio had to be at least 1.1 to 1.0, or barely enough to cover the charges.

• Finally, in the January 2006 acquisition of AMC Entertainment by J.P. Morgan Partners and Apollo Management from Bain Capital Partners, the $850 million senior credit facility provided by Citicorp had one financial covenant. This covenant provided that as long as the revolver remained outstanding, the company had to maintain a ratio of Senior Debt to EBITDA, on a pro forma basis (!), of at least 3.25 to 1.0.

These random selections from the credit agreements of large and mid-market deals illustrates the extent to which lenders have turned over the risk of defaults to the ultimate purchasers of the debt, namely, the CLO pools.

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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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