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

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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