“Topped again” is a frustrated refrain often heard from PE firms these days when attractive targets in this competitive market slip into the hands of rival bidders. With many firms sharing similar IRR expectations, the economic difference between a winning and losing bid among sponsors can be quite small, so every dollar of additional purchase price could prove decisive.
Strategic buyers present a different profile in competitive auctions. Sellers may perceive that strategics present some disadvantages as potential buyers—potential antitrust issues, confidentiality and poaching concerns—but their ability to realize synergies often justifies superior financial offers. Taking advantage of synergies need not be unique to strategic acquirors, however. Just as strategic buyers have been lifting techniques from the private equity playbook to utilize in their deals (see “Imitation is the Sincerest Form of Flattery: Continued Use of Private Equity Technology in Acquisitions by Strategic Buyers” in the Summer/Fall 2012 issue of the Debevoise & Plimpton Private Equity Report), some sponsors are seeking to grow existing portfolio companies through bolt-on acquisitions in order to replicate some of the dynamics enabling strategic buyers to pay higher prices in deals.
Buying a complementary business through an existing portfolio company can present a sponsor with additional deal considerations that do not exist in most private equity transactions. The most fundamental of these, of course, is that in addition to courting management of the target, the sponsor must ensure that the existing portfolio company’s management team is fully supportive of the deal. This article discusses some of the other considerations in deals of this type, including some that may present additional execution risk and suggests some ways to mitigate those risks.
In add-on deals, a sponsor should work closely with its portfolio company in performing self-diligence to confirm the validity of any synergies or other financial benefits built into its pricing model.
Financing Agreements. One of the first areas for serious diligence should be the portfolio company buyer’s existing debt agreements. If the sponsor intends to finance the acquisition under the portfolio company’s existing debt agreements, the threshold issue, of course, will be whether sufficient borrowing capacity exists to permit the acquisition (discussed in greater detail below). But the sponsor and the portfolio company’s management also need to ascertain whether the post-closing combined entity can comply with the existing covenants applicable to the portfolio company and still operate the combined business as anticipated. If the answer to these questions is not clearly affirmative, and if refinancing or amendments to the debt agreements at the portfolio company level is not attractive, the sponsor may want to acquire the new business, at least initially, in a separate silo, and then share personnel and functions through a services agreement with the existing portfolio company. Of course, the economics of this services arrangement would need to pass muster under the affiliated party transaction covenants in the separate debt agreements of each company. Another approach, which may be necessary, especially if the portfolio company’s debt agreements have only a few years before maturity, is negotiating an “amend and extend” transaction.
Management Arrangements. Another key area of focus should be the portfolio company buyer’s arrangements with management. Do those agreements provide flexibility to adjust titles, roles and responsibilities in order to integrate key members of the target’s management as officers and as directors as desired? Or, will such changes give rise to a right on behalf of one or more of the portfolio company’s managers to terminate his or her employment with “good reason?” Also, if the sponsor has put in place a traditional incentive arrangement at the portfolio company, with units vesting over time as well as based upon exit hurdles, will the plan need to be recalibrated to incorporate the new members of the management team as well as the scale of the combined business? The sponsor will need to be particularly sensitive to any covenants requested by the seller to maintain the target’s existing benefit arrangements for a period of time following the closing as it may not be feasible to operate two different regimes within the newly combined company.
Contractual Concerns. Other areas that should be reviewed with particular care include long-term leases for sites that may be rendered redundant, exclusivity arrangements with sales agents and representatives and material supply and IT services agreements that the combined company may seek to renegotiate in light of the increased post-closing purchasing volume. Preclusive provisions in any one of these agreements are unlikely to be a deal killer, but a number of thorny obligations, in the aggregate, could negatively impact value. Any of these agreements could also present consent issues that would need to be disclosed in the “no conflicts” representation that the portfolio company buyer will likely be asked to provide in the purchase agreement.
Diligence undertaken on the target in transactions of this kind needs to cover all of the same areas as any other buy-out transaction, but also needs to focus on limitations on the ability of the combined business to realize anticipated synergies and other cost savings. These can arise by virtue of any non-competition or exclusivity arrangements that purport to be binding upon affiliates as well as collective bargaining agreements at facilities that may be combined or closed following the closing.
Deal Conditionality—Allocating Antitrust Risk
Of course, to the extent a sponsor chooses to act like a strategic buyer by pursuing an acquisition through an existing portfolio company, it will face some of the risks confronted by strategic buyers, especially the antitrust risks associated with combining businesses in the same horizontal or vertical space. Acquisitions of significant size must be reported to the U.S. antitrust enforcement agencies (and possibly other countries’ antitrust regulators) prior to consummation, thereby potentially delaying a closing if a U.S. enforcement agency seeks additional information about the acquisition’s competitive implications by issuing a (highly burdensome) “second request,” and even potentially imperiling the deal if the agency brings suit to have the transaction enjoined. In many instances, non-U.S. antitrust regulatory authorities can also delay the closing and request additional information about the transactions and the business’ markets.
Private equity deal makers may not be accustomed to doing transactions in which there is a substantive antitrust issue and may need to be closely advised about the process. Prior to entering into a transaction with meaningful antitrust issues, the parties generally assess the risk of government action and, in negotiating the purchase agreement, allocate the risk, including by negotiating the following two key issues:
Undertakings by the Buyer to Facilitate the Transaction’s Approval. Generally, the buyer undertakes to take steps to seek and achieve the antitrust enforcement agencies’ approval of the transaction. These efforts are often described in various transactions as “Best Efforts,” “Reasonable Best Efforts,” “Commercially Reasonable Best Efforts” and the like. There is no definitive court precedent detailing what each of these efforts standards may require, although some contracts include “hell or high water best efforts clauses” that are generally thought by practitioners to mean what they say.
An alternative attractive to buyers, albeit also imprecise, is to provide that in no event will the buyer be required to take any steps that would have a material negative effect on its business. Another, more precise alternative, is for the parties to stipulate with some or detailed specificity what the buyer is required to divest if necessary to accomplish the transaction. This undertaking can take various forms, such as the obligation to divest manufacturing plants responsible for a particular percentage of sales, particular named plants or particular subsidiaries. (The parties might also agree that divestitures above a certain level will result in a purchase price adjustment.)
Although this approach has the quality of greater precision, the purchase agreement must be submitted to the antitrust agencies with the notification filing. Accordingly, a contractual clause requiring the buyer to take substantial measures to satisfy government regulators, including divesting substantial assets if necessary, may signal to the enforcement agencies that the parties likely concluded that the transaction raises troublesome competitive issues and how far the buyer is willing to go to facilitate the transaction.
Antitrust Termination Fees. Like the reverse termination fee payable by a buyer to a seller (RTFs) in the event a transaction fails to close due to a failure of financing, buyers, particularly in deals with genuine substantive antitrust risk, are increasingly agreeing to pay the seller a fee if the deal falls apart for failing to clear antitrust review. Some antitrust-related RTFs are modest. Two high-profile deals from 2011, however, had sizable RTFs: AT&T—T-Mobile (cash, assets and spectrum totaling approximately US $6 billion) and Google—Motorola (US $2.5 billion). This represents approximately 15% and 20% of the total values of the deals in question, respectively.
Whatever their size, RTFs compensate the seller for losses suffered by its business during the disruptive sale period and, perhaps most importantly, they provide an incentive for the buyer to secure regulatory approval. Indeed, in a deal with a sufficiently large RTF, it is fair for the buyer to question whether an affirmative covenant is even necessary.
Deal Conditionality—Financing Risk
Whether the acquisition will be financed under the portfolio company’s existing debt facility or through a new debt financing, a sponsor will confront financing issues that would not arise if the buyer were a Newco. Under an existing facility, the portfolio company will need to confirm it will be able to meet incurrence tests and leverage ratios, which are typically (but not always) measured as of closing. Therefore, the initial portfolio company borrower will have performance risk during the period between signing and closing for itself as well as the business to be acquired. Similarly, if a new facility is contemplated, the debt commitment papers will likely include requirements for solvency certificates and offering or syndication documents with respect to the entire business. Each of these elements will involve significant administrative work and could present increased execution risk.
The sponsor will also need to keep in mind that if asset divestitures are required to obtain antitrust approval, ratio compliance will need to take into account the divestitures and the divestitures (which may need to be undertaken as quickly as possible) will need to comply with asset sale limitations in the existing debt agreements.
Because an operating portfolio company will generally be the contracting party in these transactions, the private equity sponsor could reasonably take the position that the portfolio company’s commitment should be sufficient and the sponsor should not be obligated to provide seller with any guaranty of the portfolio company’s obligations under the purchase agreement. This may or may not be a winning position depending on the facts and circumstances. If the deal is dependent upon new equity financing, an equity commitment letter will likely be requested. Moreover, if new debt financing is contemplated and the sponsor and/or the portfolio company buyer is seeking the benefit of an RTF, seller may argue that sponsor should provide a limited guaranty of that fee given that the transaction is being structured with deal technology more often used in the private equity world. (For a possible rejoinder to this position, again see “Imitation Is the Sincerest Form of Flattery: Continued Use of Private Equity Technology in Acquisitions by Strategic Buyers” in the Summer/Fall 2012 issue of the Debevoise & Plimpton Private Equity Report.) Of course, the sponsor could decide that it (and its portfolio company) would be willing to forgo an RTF limitation on liability even where one might otherwise be appropriate in exchange for the sponsor not being required to guarantee a termination fee.
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The opportunity to be a “strategic thinker” in a bidding process is understandably appealing for sponsors. But, sponsors focusing on add-on acquisitions need to adjust their typical acquisition mindset to take into account the additional complications that, if anticipated and addressed, could well result in a winning bid and a smoothly integrated business combination.