Doing deals

The financial press has been awash in recent months with the long running saga associated with the $20bn buyout of US media company Clear Channel Communications, which had for many become a symbol of the increasing fragility of private equity transactions in the prevailing volatile economic climate. The deal, initially signed at the height of the buyout boom in November 2006, hit trouble when the financing banks threatened to pull the plug over fears that they would be forced to make large scale write-downs against the $17bn of leveraged loans they had agreed to provide. The dispute was eventually settled in May, when the banks, which had been sued by the private equity sponsors Bain Capital and THL Capital, agreed to a heavily re-negotiated deal on the eve of the trial that saw the purchase price dropped in return for higher interest rates on the loans.

Clear Channel is not unique; a host of deals that were signed in the US pre-crunch have run into problems as both banks and financial sponsors have become cautious in the face of falling valuations. Many transactions have therefore been similarly re-structured or collapsed altogether in recent months, raising questions regarding the way private equity deals are legally structured and the certainty of their completion once signed. This is particularly prevalent in the UK market, which typically develops in line with US trends, as these deals may provide an indicator of the way legal structures are likely to evolve in the short to medium term as the economic gloom continues to deepen.

Clause for concern?

One of the major contractual provisions that banks and sponsors have been attempting to utilise when trying to escape from a given transaction is the Material Adverse Change (MAC) clause, which is a regular feature in US deal structures. The clause is designed to give the bidding parties the ability to walk away from a deal if the fundamentals of the target company have changed to such an extent that it is effectively no longer the same business proposition as when the transaction was originally signed.

It is, though, worthy of note that at the height of the buyout boom, when sellers were in the dominant negotiating position, these clauses were often scaled back and in most cases they did not cover any change in the business' financial position, even in situations where a forecast profit had become a significant loss. "The difficulty is in the wording and determining what constitutes a 'material' change, which has limited the clause's use as it is merely a matter of conjecture as to whether a certain event satisfies the test," explains Martin Bishop, partner at Pinsent Masons. However, now that the market has turned and the power dynamic has shifted back towards buyers, the scope of these clauses may increase once again.

Interestingly, in recent years these clauses have not just been scaled back but have been virtually absent from private equity transactions in the UK due to the intense competition for assets. The question is, now that the market has turned, will they make a return? Ian Bagshaw, Partner at Linklaters, suggests that this is unlikely: "Where there are particular vulnerabilities - such as in bank rights issues - they may be used, but this has always been an area where they are common. Private equity firms will probably hold back though as deal certainty has become a major selling point at the moment". However, Tom Leman, partner at Pinsent Masons, suggests that in the case of certain deals, particularly public-to-private transactions, there will be substantial pressure to increase the scope of MAC clauses: "Whilst many believe that the current valuations of UK public stocks may lead to an increase in public-to-private bids, the banks funding the transactions will be acutely aware that they cannot rely on MAC clauses. As the majority of such deals have a longer offer period than private transactions, will banks be prepared to expose themselves to the current market volatility during that period when they cannot rely on a get out clause?"

Furthermore, from the perspective of the banks providing the leverage for buyout transactions, which have obviously felt the impact of the current downturn most keenly, the MAC clause is not the only legal provision at their disposal, with greater emphasis now also being placed on the market flex clause that typically forms part of the funding agreement. This clause, similar to a MAC, is designed to protect the financing institution against market shifts, particularly in terms of its ability to syndicate the debt package: "The bank effectively retains the ability to change the terms and conditions of the loan, even if the deal has already fully completed, in order to get the loans syndicated," explains Bishop. He goes on to suggest that it is these flex clauses, rather than the MACs, that may take on a greater importance in the coming months: "Pre-August, like MACs, market flex terms were being consistently wound back in favour of the borrower, but the terms are now much more lender friendly and we are seeing a return to the sort of provisions we saw five or more years ago".

Walking away

The relative weakness in recent years of the MAC and market flex clauses in deals gives rise to the question of how banks and sponsors have been able to wriggle free from transactions. The answer seems to lie in the way the deal is structured, specifically the fact that the transaction agreement is signed with a newco set up by the private equity fund and not the fund itself. In the US, to offset this legal imbalance the fund will typically sign a limited guarantee with the target business, with this agreement requiring it to pay a fee (typically around 3%) if they walk away from the deal.

In the UK such break-up agreements have not historically been common in private equity transactions, though rather than being seen as facilitating potential buyers wishing to get out of completing a deal, many observers actually see this as helpful to deal certainty. "It is very hard to walk away from a deal in the UK, or in Europe generally, as break-up agreements are not common and the only get out is a nuclear one: simply refusing to complete. Transactions are therefore relatively water tight because of the serious reputational issues associated with this," explains Bagshaw.

Once again though, Leman claims transactions involving public companies present a different proposition due to their inherent complications and the longer time frame over which they are conducted, and they therefore often do involve a break-up fee that is negotiated with the takeover panel. With increasing emphasis being placed on legal conditions that may place power once again with buyers and competitive tension reduced, he further suggests that this may now begin to cross over into the private sector: "In the current market transactions are taking longer to complete and prices are difficult to sustain during the due diligence period. Sellers may therefore test bidders' commitment to purchase the target at an agreed price by asking for fee underwrites or break fees at the outset, something that was of less of a concern in the seller friendly market place last year."

Doing deals

It seems, then, that the litigation issues in which many private equity deals have become mired in the US have been almost entirely absent in the UK. Interestingly, and counter-intuitively, this actually seems to be because of a lack of the very legal structures which have been outwardly designed to protect vendors from sponsors walking out on deals. "Things are rather different here in comparison to the US, where the regulatory conditions tend to be more stringent and hence deals can take rather longer to complete. The reputational factor also helps, as deals here are generally smaller and so if a bank or sponsor does walk away it looks very bad," explains Stuart Fleet, Partner at Kaye Scholer.

However, the cautious sentiment prevailing in the market is rapidly growing and the scope of legal conditions currently seems to be expanding. Though this is not likely to have a significant direct affect on deal certainty, particularly as provisions such as the flex clause are typically utilised after the deal has completed, these issues will arguably place added emphasis on asset selection and therefore may negatively impact on an already slowing market. "Deals are still being done, especially in the mid-market, but they are going very slowly at the moment as the expectations of the various parties are currently quite far apart," concludes Bishop.

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• Topics
• Regulation
• UK / Ireland
• Media