We anticipate two competing forces in the lower-to-middle market in 2008: (1) the credit markets crisis, litigation over busted private equity buyouts and general economic concerns may result in more buyer friendly deal terms, while (2) an increase in the number of potential buyers such as special purpose acquisition corporations (SPACs), foreign buyers and hedge funds, coupled with the resilient private equity overhang, should cause deal terms to become more seller-friendly.
While we're on the lookout for tighter closing conditions and narrower material adverse change or "MAC" clauses, that has not yet transpired, primarily given the continued availability of credit for smaller transactions and the buyer-friendly dynamics mentioned above.
Buyer-friendly terms, like financing outs and other closing conditions, may ultimately command a premium price rather than disappearing from deal terms. But private equity funds may reasonably anticipate that certain trends in larger buyout terms may trickle down to smaller deals. Of course, we don't have a crystal ball, and we can only make an informed prediction regarding possible deal term trends. However, a few things are certain.
The litigation surrounding high-profile transactions should produce the first judicial interpretations of such concepts as MACs and "reasonable best efforts," as well as the enforceability of termination fees and specific enforcement clauses. Also, most economic downturns (whether the product of a recession or fear of one) and valuation adjustments are accompanied by revived interest in seller paper and earn-outs to bridge valuation gaps.
The two competing forces will make deal term creativity and flexibility critical. To follow are some potential changes in transaction protocols and definitive agreement terms with (or around) which private equity funds may need to negotiate.
Longer No-Shops, Reverse Due Diligence
Everyone expects increased due diligence by private equity funds, so auction processes and no-shop provisions will often be longer. To avoid a more lengthy transaction process that creates uncertainty and may depress sales price, smart sellers will plan ahead and engage their accountants and lawyers to conduct "reverse due diligence." They will also amend management and third-party assignment or control provisions, in an effort to head off buyer surprises and delays.
Rise in Frequency of Go-Shops
Go-shop rights exchanged for exclusivity (a target's right to test the buyer's offer with other potential buyers) may become more common. One could argue that they benefit sellers and buyers. While the seller is afforded the opportunity to receive a higher price, both the buyer and seller can save time as compared with an auction.
In addition, buyers may be persuaded that avoiding an action is more important than exclusivity, since studies show that the first buyer is significantly more likely to win the target with a go-shop than when participating in an auction, especially in management buyouts.
Seller Paper, Equity "Roll- Overs," Employment Arrangements, Earn-Outs
Should the unavailability of credit move to the middle market, buyers may increasingly ask sellers to accept promissory notes for part of the purchase price - especially to bridge valuation gaps or to overcome due diligence concerns (by using note setoffs as an escrow alternative).
Sellers may also be convinced to leave more equity in the deal to reduce the buyer's need for debt or equity financing. Sellers may have to agree to take part of their payment for their equity as compensation under an employment agreement, frequently with time and performance-based vesting provisions. This allows the target to pay the money over time and take a deduction for tax purposes.
Of course, the ultimate tool for bridging sellerbuyer valuation gaps is the "earn-out," where a portion of the purchase price is calculated based on post-closing company performance. Transactions involving seller financing and equity rollovers are more document intensive, but may increasingly become the only way to get some deals done.
Earn-outs are among the most detailed provisions to negotiate and draft, because they must address relevant performance standards, add-on acquisitions, overhead allocations and other issues. While the frequency of earn-outs has fallen in recent years, they may make a noticeable comeback.
Material Adverse Change, Material Adverse Effect Clauses
Many attorneys agree that published cases (e.g., Harman, SLM) addressing what constitutes a "material adverse" change or effect suggest that the analysis is relatively seller favorability.
Those cases explain that the change must be something the buyer was not or could not have been aware of, and that the determination should be made from the perspective of a long-term buyer. Therefore, buyers are drafting non-exclusive, specific lists of things that would constitute a MAC. Courts should respect the lists since they reflect the intent of the parties.
It is unclear how events not listed will be treated, and whether a private equity buyer's perspective (as opposed to a long-term strategic buyer) might be factored in.
Financing Contingencies, Termination Fees, Sponsor Guarantees
Sellers should be expected to be more cautious about "financing outs." However, in contrast to larger public deals, we have not seen "reverse" termination fees or buyer penalties for failure to obtain financing in middle market or smaller transactions. The same goes for sponsor guarantees.
Purchase Price Adjustments & Escrows
Buyers will likely be more interested in closing estimates of working capital and other price adjustments, as well as in providing a separate escrow to cover adjustments rather than allow the indemnification escrow to be used for this purpose. Buyers may also increasingly tie post-closing adjustments to financial metrics or milestones other than just working capital (e.g., net worth, debt or earnings).
Survival periods for seller representations and warranties have steadily declined from 12 months to one audit cycle after closing. The market standard may move back to 24 months or more, at least for certain types of liabilities, including those related to intellectual property.
Losses eligible for indemnification may increasingly include those relating to "diminution in value" as opposed to actual damages or third-party claims. Buyer conservatism may also result in smaller indemnification baskets, increased indemnification caps and escrows, and fewer carve outs from each. It is unclear how much, if anything, buyers will have to pay as a premium to get these changes.
Competing pro-buyer and pro-seller forces make it difficult to predict the transaction dynamics and terms for smaller and middlemarket deals. Competition among buyers will definitely increase, allowing sellers to exercise more leverage regarding deal terms. Valuation multiples may decline or "normalize." In any event, arguments about what terms are "market" may become less effective as a negotiating strategy.
In the end, making transaction terms more creative will be essential to winning and closing deals.
Steve Keeler (email@example.com) and Bob McElroy (firstname.lastname@example.org) are Partners resident in, respectively, the Charlottesville and Richmond, Virginia offices of McGuireWoods LLP. Mr. Keeler practices in the firm's Private Equity Group and Mr. McElroy is a chair of the firm's Business Tax Group.