This post is based on a memo by David Fox and Daniel E. Wolf of Kirkland & Ellis LLP.
In the aftermath of the economic crisis that began in mid-2007, much ink has been spilled on the lessons learned by buyers and sellers regarding the pitfalls of deal certainty and the development of new paradigms for both financial and strategic buyers. Many assert that in the post-crash M&A market there has been substantial crosspollination between the traditional deal structures used by those two categories of buyers in the pre-2007 period, with financial buyers being forced to accept deal terms that were once only demanded of strategic buyers and with strategic buyers demanding some of the looser deal commitment terms that previously benefited only financial buyers.
We argue that any attempt to identify a simplified new paradigm or market for basic deal certainty terms is an overly simplistic view of the deal market in these early days of recovery — rather, we believe that the perceived departures from traditional deal structures are largely a reflection of a complex equation of a dozen or so contractual variables that interact with overall deal dynamics, including company-specific and secular market conditions, to produce a deal-specific outcome in the relevant post-crash transactions.
Before outlining this proposition in greater detail, it is useful to briefly trace the history of divergence between deal terms in cash deals for strategic buyers and financial, or private equity, buyers.
Before 2005
Historically, there was a wide divergence between deal models for strategic and financial categories of buyers. Strategic buyers, with the backing of their balance sheets, were expected to commit fully to the completion of an announced cash acquisition backed by a provision providing for a specific performance remedy of the buyer’s obligation to close. Sellers were comfortable relying on the potential to obtain such an order of specific performance to force a closing combined with an assumption that alternatively they would be able to collect lost premium in a damages action against a reneging buyer (noting that the validity of this assumption, at least under New York law, proved somewhat tenuous with the 2005 decision in the Northeast Utilities case).
By contrast, financial buyers were able to proceed with much looser legal commitment to the completion of a cash buyout. Financial sponsors, whose business model depended on borrowing a significant portion of the purchase price in order to leverage their equity investment, often benefited from the inclusion of a “financing condition” in their purchase agreements, meaning they were able, as a theoretical contractual matter, to walk-away from closing, usually without consequence, in the event debt financing was not available. At the time of signing, the financial buyer often delivered a negotiated debt term sheet and/or a “highly confident” letter from debt
financing sources, with such documents providing little if any legal assurance that the debt in fact would be funded. A shell entity created by the financial buyer was the only party to the contract with the seller, meaning that, absent veil-piercing, any specific performance remedy would be largely ineffective.
Sellers accepted the financial buyer’s argument that, as a repeat acquiror, the reputational damage associated with it walking away from any deal were so great that the optionality inherent in the deal terms was a negligible risk. With the very low incidence of failed deals, mostly a function of rational deal terms and levels of leverage and available liquidity in the debt markets, the effectiveness of reputational concerns as a constraint on financial buyers was never really tested.