As a result of the credit crisis brought about by the summer 2007 collapse of the subprime mortgage market, the number of announced leveraged buyout (LBO) transactions has diminished substantially. A total of 455 private equity buyouts of U.S. targets were announced between April 1, 2007, and September 30, 2007, with a total deal value of approximately $347.5 billion, including 229 deals with undisclosed values. By contrast, a total of only 329 deals were announced between October 1, 2007, and March 31, 2008, with a total deal value of approximately $59 billion, including 172 deals with undisclosed deal values. (These statistics are based on searches of the Mergermarket.com “Deals” database conducted on April 18, 2008.)
The purpose of this article is to assess what, if any, impact the current credit market conditions are having on mid-market LBO deal terms affecting sellers’ remedies for material breaches by the buyer, as well as deal terms affecting the ability of buyers to walk away from deals without becoming liable to the seller for the purchase price. This article reviews the following six transactions announced since January 1, 2008, which are reflective of current mid-market conditions:
- The TriZetto Group, Inc.’s agreement to be acquired by Apax Partners, dated April 11, 2008 (the TriZetto agreement)
- H & R Block Inc.’s agreement to sell the mortgage loan servicing business of its Option One Mortgage Corporation subsidiary to W.L. Ross & Co. LLC, dated March 17, 2008 (the Option One agreement)
- Getty Images, Inc.’s agreement to be acquired by Hellman & Friedman LLC, dated February 25, 2008 (the Getty Images agreement)
- CHC Helicopter Corporation’s agreement to be acquired by First Reserve Corporation, dated February 22, 2008 (the CHC Helicopter agreement)
Performance Food Group Company’s agreement to be acquired by The Blackstone Group and Wellspring Capital Management, dated January 18, 2008 (the Performance Food Group agreement)
- Bright Horizons Family Solutions, Inc.’s agreement to be acquired by Bain Capital, dated January 14, 2008 (the Bright Horizons agreement)
These deals were selected based on the following criteria: each deal (i) is currently “active,” (ii) has a deal value of more than $1 billion and (iii) was announced after January 1, 2008. This article focuses on deals valued at more than $1 billion, because such deals are more likely to include a debt financing component, and thus are more likely to be affected by changes in the credit markets.
Reverse Termination Fees
Certain merger agreements provide that the private equity sponsor’s acquisition company or merger sub (collectively, the buyer) must pay a pre-determined “reverse termination fee,” or “reverse break-up fee,” to the seller if the agreement is terminated under certain circumstances specified in the agreement. Typically, the reverse termination fee is triggered if, after the conditions to the obligations of the buyer have been satisfied, the buyer fails to consummate the deal as required by the agreement, or the agreement is terminated as a result of some other material breach on the part of the buyer. All of the agreements reviewed provide for a reverse termination fee.
It is an interesting question whether the continued inclusion of reverse termination fee provisions in the typical post-credit-crisis acquisition agreement should be viewed from the perspective of either private equity sponsors or sellers as a positive or negative feature of the post-credit-crisis LBO market. When a deal is governed by an agreement that in all other respects is “buyer friendly,” sponsors would prefer to have the option to walk away from the deal without paying any fees to the seller.
On the other hand, when coupled with carefully crafted provisions limiting the availability of other remedies to the seller, such as exclusive remedy provisions and provisions waiving the seller’s right to specifically enforce the agreement, the reverse termination fee can be viewed as a means of limiting the sponsor’s ultimate exposure to liability or as liquidated damages. The cost of paying the reverse termination fee may seem reasonable when compared to the prospect of being forced to consummate a deal that has become, from the sponsor’s perspective, undesirable.
Exclusive Remedy Provisions and Specific Performance Provisions
The interplay between exclusive remedy provisions and specific performance provisions has garnered a great deal of attention in recent months. This is in response to the widely publicized lawsuit filed by United Rentals, Inc. (URI), against Cerberus Capital Management (Cerberus) on November 29, 2007, seeking specific performance of the merger agreement that URI entered into with an acquisition sub of Cerberus on July 22, 2007, and the ensuing opinion in United Rentals v. Ram Holdings, Inc., 937 A.2d 810 (Del. Ch. 2007), issued by the Delaware Court of Chancery on December 21, 2007.
With the exception of the Option One agreement, all of the agreements reviewed provide that the reverse termination fee is the seller’s exclusive remedy under the agreement for a breach by the buyer. Moreover, the TriZetto, Performance Food Group, Getty Images and CHC Helicopter agreements each contain provisions explicitly stating that the seller is not entitled to an injunction to prevent breaches of the agreement by the buyer or to enforce specifically the terms and provisions of the agreement. The absence of provisions permitting the seller to seek specific performance of the agreement represents a shift away from the seller-friendly specific performance provisions that were included in agreements for certain other private equity deals that were signed prior to the onset of the credit crisis, such as the agreement of Penn National Gaming, Inc., to be acquired by Fortress Investment Group LLC and Centrebridge Partners LP, signed on June 15, 2007.
A “financing out” refers to a merger agreement provision that permits the buyer to terminate the acquisition agreement without substantial consequences to the buyer or private equity sponsor if the financing arranged by the sponsor becomes unavailable prior to closing. Notwithstanding that the current reduction in deal flow is in large part a result of the scarcity of financing, the “financing out” makes an appearance in only one of the agreements reviewed in this article (the Option One agreement). Moreover, four out of the other five agreements include provisions explicitly stating that the buyer’s ability to obtain financing is not a condition to closing (the TriZetto agreement being the exception).
Moreover, excluding the Option One agreement, none of the agreements reviewed provide for any change in the obligations of the buyer/sponsor in the event that the financing becomes unavailable, such as a reduction of the amount of the reverse termination fee.
Some LBOs include “limited guarantees” under which the sponsor guarantees some or all of the obligations of the buyer, including, in certain cases, the reverse termination fee and/or financing commitments. Five of the six deals reviewed in this article include a limited guarantee, under which the private equity sponsor guarantees certain obligations of the acquisition sub under the purchase agreement.
Under the terms of the CHC Helicopter limited guarantee, First Reserve Corporation guarantees the entire amount of the reverse termination fee. By contrast, under the limited guarantee that pertains to the Performance Food Group agreement, The Blackstone Group guarantees only part of the two-tier reverse termination fee. The terms of the limited guarantees pertaining to the TriZetto, Getty Images and Bright Horizons agreements have not been publicly disclosed.
With thanks to Stephen Older and Joel Grosberg for their contribution to this article.
The mergers and acquisitions (M&A) market in China has grown steadily since 2000. In 2000, there were 225 completed M&A deals with a total disclosed value of approximately U.S.$42.8 billion. In 2006, approximately 800 M&A deals were completed with a total disclosed value of approximately U.S.$95 billion. By the end of October 2007, there were 528 completed deals for the year with a total disclosed value of approximately U.S.$64 billion.
Three legislative movements partly drove this market boom. First, in 2006, China’s Ministry of Commerce (MOC) issued new regulations on M&A transactions in China, the Regulations on the Merger and Acquisition of Domestic Companies by Foreign Investors (the Regulations), which clarified previously vague regulations regarding M&A activity. Second, effective December 1, 2007, the revised Catalogue Guiding Foreign Investment in Industry (the Catalogue) was issued, which opened a number of new areas of the Chinese economy to direct foreign investment. Third, effective January 31, 2006, the Measures for Strategic Investment by Foreign Investors upon Listed Companies (the Measures) were implemented, which for the first time allowed foreign investors to invest in Chinese public companies.
Acquirers looking to Chinese companies for potential targets should have a general understanding of the governing corporate regulations in China and conduct careful due diligence to avoid some of the common pitfalls that may be experienced in M&A transactions.
Understanding Corporate Regulations in China
Before an acquirer commits to acquire a Chinese target company, the acquirer should have a very clear understanding of the regulations that govern any proposed acquisition of the target company. The most important applicable regulations governing M&A activity are: (1) the Regulations, which govern all foreign-related M&A transactions in China; (2) the Catalogue, which divides China’s economy for foreign investment purposes into four categories (encouraged, prohibited, restricted and permitted); and (3) the Measures, which open the door for foreign investors to invest in Chinese public companies in the A-Share market, which was formerly available only to domestic investors (in contrast to the B-Share market, which was originally available only for foreigners, but was opened to domestic investors in 2001).
The Regulations, which went into effect on September 8, 2006, for the first time allowed non-Chinese companies to acquire Chinese domestic companies using a stock swap. Prior to the Regulations, foreign acquirers were only allowed to purchase Chinese companies with cash or tangible or intangible assets. However, the Regulations limit the entities that are qualified to use a stock swap only to listed or public companies in jurisdictions with sound regulatory systems, and offshore special purpose vehicles directly or indirectly controlled by Chinese companies or Chinese nationals. As a result, few stock swaps have been approved since the Regulations went into effect.
The Regulations permit two types of M&A transactions: (i) equity acquisitions where foreign investors buy existing or newly issued shares of a Chinese company and (ii) asset acquisitions where non-Chinese investors buy the assets of a Chinese company. The Regulations also set out the rights and obligations of non-Chinese investors, including approval authority, capital requirements and share distribution between non-Chinese and domestic Chinese investors.
The investment vehicles most frequently used by non-Chinese investors to acquire assets or equity of a Chinese company include: wholly foreign-owned enterprises (WFOE), equity joint ventures with a Chinese partner (EJV), contractual joint ventures with a Chinese partner (CJV) and joint stock companies (JSC). WFOEs, EJVs, CJVs and JSCs are frequently referred to as “foreign invested enterprises” (FIEs). A WFOE organized as a limited liability company is the preferred legal entity for non-Chinese investors since it does not require the participation of a Chinese partner. There may be legal minimum or maximum capital contribution requirements for a non-Chinese investor to establish an FIE, depending on the specific industry in which the FIE intends to engage or its intended business scope. Generally, capital may be contributed in cash or tangible or intangible assets, but intangible assets (including intellectual property and technology) may not exceed 70 percent of the fair market value of the contributed capital.
A JSC is the only FIE that qualifies for public listing in China, which may be important to acquirers, as the Chinese domestic stock markets have started to gain prominence. Any other form of FIE must be converted into a JSC before it can be listed on a Chinese stock exchange. The minimum required registered capital of a local JSC is RMB5 million. However, the registered capital threshold for a foreign-invested JSC is RMB30 million, and the foreign investor(s) must hold no less than 25 percent of the total registered capital. Also, in order to be listed on a Chinese stock exchange, a JSC must have share capital of at least RMB30 million.
Governmental approval is required for a number of transactions involving FIEs, including formation, transfer of shares, M&A transactions, increase or decrease of capital, and dissolution. The Regulations also require MOC approval for any foreign acquisition that would result in the transfer of a controlling interest in a domestic company relating to key industries with an actual or potential effect on “national economic security.” While “national economic security” is not defined in the Regulations, which may lead to broad and possibly divergent interpretations, acquirers may gauge the level of MOC review by looking to the Catalogue.
Investments in the “encouraged” industries are subject to fewer approval formalities. “Encouraged” industries make up the vast majority of the Catalogue and include projects related to new agricultural technology, new energy sources and use of renewable resources, projects that develop manpower and resources of central and western China, projects using new technology and projects that fulfill international market demand and increase exports. Some projects in the “encouraged” category may be eligible for preferential treatment, particularly if they are located in certain geographical locations.
The “restricted” industry projects are subject to government examination and approval, but such approval cannot be assured. “Restricted” projects include projects that may have an adverse effect on the environment and energy conservation, projects relating to exploring for or extracting rare or precious mineral resources, and projects involving technology already used in China and where existing capacity already meets market demand.
“Prohibited” projects include projects that endanger state security or harm public interest, pollute the environment or endanger health, occupy large tracts of farmland or endanger the security or efficient use of military resources, use manufacturing techniques or technologies unique to China, or are otherwise prohibited under state laws and administrative regulations.
“Permitted” projects refer to projects where foreign investors are allowed to invest with no encouragement or discouragement from the Chinese government. Unlike the other categories, the Catalogue does not list the “permitted” projects or areas. “Permitted” projects could be viewed as a catch‑all, since any project not covered by the “encouraged,” “restricted” or “prohibited” categories could be inferred to be “permitted.” Foreign investors may enter into any such project just like domestic investors.
In accordance with the Measures, approval from both the MOC and the China Securities Regulatory Commission are necessary for foreign investors to invest in and exit from Chinese public companies. A foreign investor that wishes to assign or transfer its holdings in a Chinese public company must apply for approval of such assignment or transfer by the local Chinese foreign exchange authority.
Foreign investors in Chinese companies must also follow certain other rules, including the following:
- A purchase of public shares must be made by transfer agreement or subscription agreement.
- An investment may be made in installments; however, the proportion of the shares obtained after the first installment must be no less than 10 percent of the issued shares.
- If the shares owned by foreign investors are less than 10 percent of the total number of shares outstanding, such public company shall not be entitled to foreign investment status.
- The public shares held cannot be transferred for a period of three years after acquisition.
- The foreign investor’s or its parent’s total overseas paid-in capital must be no less than U.S.$100 million, or the total overseas paid-in capital under its or its parent’s management must be no less than U.S.$500 million.
Conducting Due Diligence
Acquirers need to keep in mind that some Chinese target companies are either still state owned or were recently privatized, which has implications for the attitude of management and employees as well as management style. For example, many Chinese companies and employees are not used to review or compensation based on performance or milestone targets. Accurate record keeping is also often lacking, and basic financial information may not be available or be of customary quality, either as a result of different standards and record keeping practices or accidental oversight. For example, some acquirers have encountered Chinese companies with two sets of financial record books, an internal book and an external book that is used to under-report profits, which implicates custom duties, income tax, VAT, business tax and local taxes.
Acquirers should also keep in mind that all land in China is state owned. Acquirers can only purchase land use rights for a limited period of time. For industrial use, the maximum period is 50 years with the option to renew. The price for the land use rights were set by regulation in 2006 in which land was classified in 15 levels in accordance with location. In order to attract foreign and domestic investment, certain locations’ land prices can be set at a fairly low level, and local governments may also provide additional financial incentives. Acquirers need to consider land status, land price payments and any possible side deals with local governments, all of which may affect the purchase price.
In all potential M&A deals, detailed diligence is required to uncover hidden liabilities (including possibly delinquent taxes, regulatory violations and penalties) and to confirm that the target company has clear title to its assets. Problems with either of these may affect the structure of the acquisition and price.
As China’s M&A market and activity continue to grow and attract a greater number of non-Chinese investors, those entering the Chinese market should be aware of the newly revised and implemented rules and regulations, and be sensitive to the cultural and diligence issues that may be unique to Chinese target companies and related M&A transactions.
Despite significant criticism from German economy and industry leaders, the German Federal Government currently plans to enlarge the possibilities of controlling and prohibiting foreign investments in German companies in order to protect “public security and order.” The present legal situation in Germany allows restrictions of transactions, especially in the arms industry and the field of encryption technology. A foreign investor that wishes to acquire more than 25 percent of the shares in an arms or encryption manufacturer is obliged to notify the German Federal Ministry of Economics and Technology (FME) of the intended investment. The FME may interdict the proposed transaction within one month.
Pursuant to the recent German Federal Government’s proposal to amend the German Foreign Trade and Payments Act (Außenwirtschaftsgesetz) as well as the related directive (Verordnung zur Durchführung des Außenwirtschaftsgesetzes), the FME may examine any investment leading to a shareholding of at least 25 percent in a German company by a foreigner or a foreign company, or by a company with a foreign shareholding of at least 25 percent. Contrary to the origin of the discussion, the FME’s right to examine or prohibit such transactions shall not be limited to investments by public funds, but extend to all foreign investors and all sectors. After having examined the proposed investment, the FME may authorize it, authorize it under conditions or even prohibit it, provided that that “public security and order” require such measures. The period of time in which the FME may commence its examinations shall be limited to three months from signing or the publication of the resolution concerning the offer, or the acquisition of control.
Under the proposed amendment, however, the foreign investor shall no longer be obliged to notify the FME of the intended investment. The draft act does not yet establish criteria for when “public security and order” shall be deemed to be in danger of being breached. Also, by equally extending to foreign investors resident in the European Union, the draft act raises concerns regarding compliance with European law and is currently being reviewed by the European Commission.
As a result, future share purchase or swap agreements concerning a shareholding being possibly precarious with respect to the (amended) German Foreign Trade and Payments Act may be concluded on the condition subsequent of an interdiction by the FME. Thus, such agreements may become retroactively invalid upon interdiction by the FME. This provision shall motivate foreign investors to notify the FME of their intended investments—even if they are not obliged to do so—in order to abbreviate the time of legal insecurity from three months to only one month. If an investment is prohibited by the FME, the transaction will need to be reprocessed. If this is not possible, as in the case of a stock market transaction, the shares shall be sold by force. Because of the legal insecurity, it will be advisable to ask the FME at an early stage of the transaction, at least before signing, to provide a document of compliance of the intended transaction with the provisions of the (amended) German Foreign Trade and Payments Act.
Competing tender offers are parallel offers by independent bidders to the same target company. Although competing tender offers are common in other regions, they are rarely seen in Germany. The failed takeover of stock-listed Techem AG in 2006 was the first bidder competition under the German Securities acquisition and Takeover Act, or Wertpapiererwerbs- und Übernahmegesetzes (WpÜG).
The high transaction volumes at a takeover of a publicly listed corporation might prevent potential bidders from entering a bidding competition. However, such reluctance might be diminished by the increased funds raised by private equity firms and their increasing activity in the sector of stock-listed companies. In the past year, the press has reported several attempts by private equity investors to take over Continental AG. As a result, competing offers might be seen more frequently.
Advantages and Disadvantages of Competing Tender Offers
Usually, competing tender offers result in higher offer prices for the shareholders. The quoted takeover of Techem led to a final offer price of €55 per share, compared to an initial price of €44 per share. However, bidding competition also has several disadvantages, particularly for the target company. For example, the takeover process consumes a substantial portion of existing management resources. Under the WpÜG, the management and supervisory board of the target company must issue a thorough statement on the offer. This statement must include an opinion on the fairness of the offered price and must be renewed after each increase in the offer price.
Another disadvantage is that contractual partners and banks will await the result of the takeover and the completion of a new shareholder structure before making substantial investments in the target company or granting credit. As a result, the management will endeavor to end the pending phase of a takeover process as soon as possible. Competing offers increase this pending phase, since the WpÜG does not contain any provision regarding the maximum term of a takeover process in case of competing offers.
WpÜG Provisions Regarding Competing Tender Offers
The only WpÜG provision for competing tender offers states that the target company shall not be impaired in its business operations. However, each amendment to a tender offer (e.g., an increase in the offer price) results in an extended offer period for the relevant tender offer and also for the competing offer, to balance out the offers. In theory, tender offers could be extended ad infinitum, which is, of course, not acceptable for the target company. Therefore, some scholars in Germany argue that a bidder should be able to increase the offer price only once. The British Takeover Code resolves such dilemma by the so-called “guillotine”—the Takeover Panel may impose a final time limit for announcing revisions to competing offers.
Under German law, it may be possible for the German Federal Financial Supervisory Authority, or Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin), to intervene in the case of extensive competing offers. In general, the BaFin may prohibit a tender offer that causes damage to the target company. In such cases, the BaFin has broad discretionary power. It may even be possible for the BaFin to recommend and enforce an auction process such as that set forth in the British Takeover Code.
Such an auction process might be more appropriate than a total prohibition of further increases in the offer prices. A balance between the interests of the bidder, the target company and the shareholders is possible, and the target company is freed from the restrictions of a current takeover process. In addition, the shareholders receive a higher price for their shares than they would under a prohibition of further increases in the offer price, and they also receive an appropriate term to decide on the acceptance of the offer. However, such an order by BaFin remains without legal basis in Germany so far.
Competing tender offers cause problems for the target company, and these problems are insufficiently governed by the WpÜG. Because of the incomplete provisions regarding competing takeover offers, it would be advisable for the BaFin to issue certain guidelines. Alternatively, the legislator could enact an auction process similar to the British example. As a result of the increasing activity of private equity investors in the public sector, such a provision could become relevant very soon.