Private Equity Law Review

Conflicts of Interest in LBOs -- a Case Study

Geoffrey Parnass — Tue, 22 Feb 2011 11:04:01 -0500

Vice Chancellor J. Travis Laster, a member of the Delaware Chancery Court, handed down a recent decision highlighting the substantial conflicts of interest that bedevil the investment banking industry in leveraged buyout transactions, and how one board of directors mishandled these conflicts. Steven Davidoff in his NY Times DealBook blog gives a fine account of the matter.

The case concerns the buyout of Del Monte by PE firms Kohlberg Kravis Roberts, Centerview Partners and Vestar Capital Partners, for $5.3 billion including debt.

Barclays Capital was hired by Del Monte to run a sale process for the company. Barclays made sure that its long time client, KKR, would be the winner of the bid, subject to a “go shop” provision. In return, Barclays received a commitment from KKR that it would represent KKR and the other buyers in placing the debt financing for the deal. Vice Chancellor Laster excoriates the Del Monte board for letting this conflict of interest play out under its nose. He painstakingly laid out the time table and steps taken by Barclays to put together a deal that served the interests of KKR and Barclays.

From the court’s opinion:

“Barclays secretly and selfishly manipulated the sale process to engineer a transaction that would permit Barclays to obtain lucrative buy-side financing fees. On multiple occasions, Barclays protected its own interests by withholding information from the Board that could have led Del Monte to retain a different bank, pursue a different alternative, or deny Barclays a buy-side role. Barclays did not disclose the behind-the-scenes efforts of its Del Monte coverage officer to put Del Monte into play. Barclays did not disclose its explicit goal, harbored from the outset, of providing buy-side financing to the acquirer. Barclays did not disclose that in September 2010, without Del Monte’s authorization or approval, Barclays steered Vestar into a club bid with KKR, the potential bidder with whom Barclays had the strongest relationship, in violation of confidentiality agreements that prohibited Vestar and KKR from discussing a joint bid without written permission from Del Monte.”

After months of behind the scenes steps, Barclays finally informed Del Monte’s board that Barclays also planed to be a major participant in the distribution of debt securities for the buying group. It was a tricky moment because the board was relying on Barclays’ opinion saying that the KKR bid is fair from a financial standpoint. How could that opinion be trusted when the giver of the opinion had lined up a lucrative engagement to distribute debt securities for the buyers? In fact, the fees Barclays would earn on the debt distribution were higher than the fees it would earn from representing Del Monte in the sale. The solution was pretty simple. Barclays had the board hire a second firm -- Perella Weinberg -- to give a second investment banking fairness opinion. The fee for that opinion - $3 million – was paid by Del Monte with the approval of its board.

Adding to the intrigue, in an earlier round of bidding, Vestar Capital Partners, a PE firm with loads of experience in the canned food business, made the highest offer. In the second round, Barclays paired Vestar with KKR, in violation of the “no teaming” provisions of earlier agreements the firms had entered into with Del Monte, and had them submit a joint bid. Problem was, Barclays didn’t let the Del Monte board know it had taken this step, leading the board to believe that Vestar had dropped out. Vice Chancellor Laster found that this shady business alone “materially reduced the prospect of price competition for Del Monte”.

Here is a copy of the opinion.

One reason for the board’s inertia may have to do with the fact that the CEO of Del Monte presented the board with little option but to sell the company. Despite being pressed by the board for a succession plan to deal with his planned retirement in 2012, the CEO dallied, and in the end recommended a sale of the company. Personally, he stood to gain $24 million if Del Monte were sold before his retirement in 2012.

The initial proxy materials filed by Del Monte omitted to describe the true story behind Barclays’ activities. In response to this litigation, an extensive proxy supplement was mailed to shareholders describing all the goings on. The mailing of those materials eliminated one of the two remedies sought in the litigation. The other remedy -- to delay the meeting and give Del Monte time to solicit other offers – was granted by the court.

Of course, due to the ironclad protections under Delaware law absolving board members from financial liability where they have acted “reasonably”, this injunctive relief was the only remedy against directors available to the plaintiffs. From the court’s opinion:

“Unless further discovery reveals different facts, the one-two punch of exculpation under Section 102(b)(7) and full protection under Section 141(e) makes the chances of a judgment for money damages vanishingly small.”

Implied Covenants in Earn-Outs -- Lady Duff-Gordon Rides Again

Geoffrey Parnass — Thu, 24 Jun 2010 10:09:26 -0500

Where earn-out compensation represents a significant portion of the seller’s consideration in a purchase transaction, the buyer is required to use reasonable efforts to achieve the purposes of the earn-out. That is the law in Massachusetts, as per a recent Federal appeals court decision, and any other State where Justice Cardozo’s memorable opinion in Wood v. Lucy, Lady Duff-Gordon is still quoted.

PerkinElmer, a publicly traded lab equipment company, acquired the business and assets of Sonoran Scanner, a private company engaged in the computer-to-plate (CTP) printing business. Sonoran’s main product was a $500,000 machine that offered a high-speed digital alternative to the costly and time-consuming analog process required by conventional plate technology printing. Like many good ideas, this one ran low on funding. The founder had invested $3.5 million of his own funds, but the company had no sales. Out of cash, the founder sought a purchaser to undertake the continued development and marketing of the CTP technology.

PerkinElmer paid $3.5 million at closing (most of which went to creditors) and agreed to certain earn-out payments if sales targets were met over a 5 year period. PerkinElmer would pay $750,000 if at least three CTP machines were sold in the first year following closing, $1.5 million (less any previously paid earn-out amounts) if at least ten machines were sold by the end of the second year, and additional amounts if certain gross margin targets on sales of CTP machines were met. The additional earn-out payment (over and above the $1.5 million) during the five year payout period was a maximum of $2 million.

Sadly, the CTP business, as operated by PerkinElmer, was a failure. Only one CTP unit was sold and there were no earn-out payments. The founder blamed the failure on PerkinElmer. Unfortunately, the purchase agreement contained no express covenants regarding how the business was to be run during the earn-out period.

The Court of Appeals held that the acquisition agreement contained an implied contractual term requiring that PerkinElmer use reasonable efforts to develop and promote the CTP technology, citing the famous 1917 case from the pen of then Judge Cardozo known as Wood v. Lucy, Lady Duff Gordon. In this case, Otis F. Wood, a New York advertising agent, signed on Lucy, Lady Duff-Gordon, otherwise known as "Lucile" (her couture label), to market garments and other products bearing her endorsement for a period of one year. The contract was exclusive, and gave Duff-Gordon half of all revenues that Wood was able to generate. Wood's only duties under the contract were to account for monies received and secure patents as necessary - there was nothing requiring him to exert any efforts (although if he did nothing, there would be no revenues to share). Around the same time, Duff-Gordon came up with an idea to market a line of clothing "for the masses," and she broke the exclusivity provision by endorsing products sold by Sears Roebuck. Wood sued, and Duff-Gordon defended on the grounds that no valid contract existed with Wood since he had not made an express promise to do anything. The issue for Judge Cardozo was whether to find that Wood had made an implied promise to exert efforts to achieve revenues, thereby making the contract enforceable. Cardozo held that Wood did make such an implied promise:

We are not to suppose that one party was to be placed at the mercy of the other. . . . [The] promise to pay the defendant one-half of the profits and revenues resulting from the exclusive agency and to render accounts monthly was a promise to use reasonable efforts to bring profits and revenues into existence.

Although the context was different (the Cardozo case was an exclusive representation agreement), the First Circuit in Sonoran Scanner held that PerkinElmer had made a similar implied promise to use reasonable efforts to achieve the earn-out, even though the contract had no such language. The court was swayed by the fact that the potential earn-out compensation was “substantial” (potentially $3.5 million) in relation to the up-front payments made by PerkinElmer (also $3.5 million). Also relevant was the fact that most of the $3.5 million closing payment was paid to creditors and did not benefit the founder. Finally, there was no language in the agreement negating an obligation by PerkinElmer to use reasonable efforts or conferring absolute discretion on it as to the operation of the business.

Drafting tip: if you are representing the buyer, and don’t want to get hit with an implied obligation to use reasonable efforts to achieve an earn-out, be sure to put in a clause giving your client full discretion as to the operation of the business during the earn-out period.

Going Private: Rule 13e-3 and Private Equity Buyouts - Part 2

Geoffrey Parnass — Tue, 27 Oct 2009 19:22:30 -0500

In acquisitions of public companies, private equity sponsors often seek to retain members of the target’s management to run the day-to-day operations of the portfolio company after closing. Almost invariably, the sponsors will offer management shares in the surviving company in order to align the managers’ interests in improving the company’s profitability with those of the private equity fund. Sponsors may offer managers an equity interest in the surviving company in proportion to their existing equity interests in the target company (known as “roll over” equity). Alternatively, they may allow managers to invest their own funds to purchase equity in the surviving company alongside the private equity fund (a deal structure known as a “buy-in management buyout” or “bimbo”). When management is offered equity in the acquiring company without having to take out loan notes to finance their buy-in, their shares are known as “sweet equity.” Such equity interests may be offered either in addition to or in lieu of equity options that vest over time or upon meeting certain financial milestones (referred to as “promote equity”).

When private equity sponsors issue equity interests in the surviving company to a public target’s current management, the managers may be considered “affiliates” of the target company who are “engaged” in a transaction subject to the Securities Exchange Act’s Rule 13e-3 “going private” filing requirements. Although the Staff of the Division of Corporation Finance of the Securities Exchange Commission as a policy does not provide guidance on whether or not a particular party should be deemed an “affiliate” for purposes of this rule, Compliance and Disclosure Interpretations (C&DIs) released by the Staff on January 26, 2009 together with the Staff’s interpretive releases provide practitioners guidance on what types of deal structures may require Schedule 13E-3 filings. For an overview of Rule 13e-3’s definitions of a “going private” transaction and “affiliate,” please see Part 1 of this post.

Management as “Affiliates” in Private Equity Buyouts

The SEC has maintained that the determination of a person’s status as an affiliate is a factual question that only may be determined by considering all the relevant circumstances of a given transaction. Nevertheless, the Staff’s C&DIs provide some insight into the factors considered by the Staff to be determinative of a person’s affiliate status. Judging whether or not officers or directors of a publicly traded target company are affiliates of the company under Rule 13e-3 generally turns on whether or not they have the power to direct or cause the direction of the management and policies of the target company. According to the Staff’s interpretive releases and C&DIs, the continuity of management or directors of the target before and after the transaction in question likely indicates that the deal requires compliance with Rule 13e-3.

In the interpretive release adopting Rule 13e-3 (Release No. 34-16075), the Staff suggested that even if an unaffiliated private equity sponsor engages in arm’s-length negotiations regarding the acquisition of a target, yet intends to keep the target’s management in place after the purchase is completed, the parties engaged in the transaction may be required to file Schedule 13E-3. Among the factors the Staff takes into consideration are:

an increase in consideration received by management;
any alterations in management’s executive agreements that are favorable to management;
equity participation of management in the acquiring or surviving entity; and
the representation of management on the board of directors of the acquiring or surviving entity.

The Staff has consistently held that members of senior management of a public corporation that is “going private” are affiliates of the company. In deals where a transaction is accomplished by way of a merger, the Staff has concluded that senior managers are required to file Schedule 13E-3, even though:

management’s involvement in the target’s negotiations with the buyer was limited to the terms of each manager’s future employment with or equity participation in the acquiring or surviving company; and
the target’s board of directors appointed a special committee of outside directors to negotiate all other terms of the transaction except management’s role in the acquiring or surviving entity.

Measures taken by a public company’s board of directors to protect shareholders from the possibility that its officers or directors may collude with a buyer do not alone obviate the need for a Schedule 13E-3 filing. Factors considered by the Staff include: whether management would hold a material amount of the surviving company’s outstanding equity securities, occupy seats on the company’s board of directors in addition to having senior management positions, or would otherwise be in a position to “control” the surviving company.

Although the Staff has not defined what constitutes a “material” equity interest in a company, historically it has determined that a 10% ownership interest is sufficient to cross the materiality threshold. Nevertheless, this 10% figure should not be taken as a bright-line rule, as even a smaller equity interest in a public target may trigger Rule 13e-3 if other evidence of “control” is present.

Private Equity Funds as “Affiliates” of the Target and its Management

In one of the January 2009 CD&Is, the Staff specifically addressed the situation where a financial buyer, previously unaffiliated with the target, intended to enter into separate agreements with members of the target’s senior management resulting in management’s ownership of 20% of the surviving entity after the deal closed. Although the managers neither negotiated the merger agreement with the private equity sponsors nor executed any documents regarding their future equity participation, the Staff held that “where there exists a general understanding that a target’s senior management will receive equity in a surviving equity, whether derived from unexecuted documents or otherwise, Rule 13e-3 may apply.” The Staff reasoned that because senior management understood they would be equity holders in the surviving entity, the financial buyer in effect straddled both sides of the transaction (i.e. as both acquirer and target). Owing to the substantial equity participation in the transaction by senior management, each of whom would remain in a position to influence the policies of the target, the financial buyer could be in “control” of the target before the deal closed.

As the previous CD&I demonstrates, where management of the target company is effectively “on both sides” of the transaction, the private equity funds (and any acquisition vehicles formed for the deal) may also be deemed to be affiliates of the target company engaged in the transaction and thus be required to file Schedule 13E-3. In Release No. 34-16075, the Staff stated that “affiliates of the seller often become affiliates of the purchaser through means other than equity ownership, and thereby are in control of the seller’s business both before and after the transaction. In such cases the sale, in substance and effect, is being made to an affiliate of the issuer.”

A recent example of this scenario may be found in the July acquisition of Bankrate, Inc. by funds advised by Apax Partners in which the Apax funds, the holding companies set up by Apax to complete the deal, members of senior management, and Bankrate jointly filed a Schedule 13E-3.

House Hearing on Private Equity and Venture Capital Regulation - Part 2: Leveraged Buyouts

Geoffrey Parnass — Fri, 23 Oct 2009 13:39:13 -0500

In debates over public policy, the first battle often involves a contest over narrative. If others adopt your story, you can gain an early advantage by having lawmakers solve the problems you define for them. In this month’s hearings on “Enhancing Oversight of Private Pools of Capital” before the House Financial Services Committee, Douglas Lowenstein, President of the Private Equity Council (PEC), told a familiar tale: Twin brothers, both productive and contributive to the common good, unjustly subjected to different standards. Why should Abel’s gifts be accepted, while Cain’s gifts are rejected? Mr. Lowenstein did not invoke our shared concept of justice, but instead turned to the pragmatist’s supreme value: practicability. In his criticism of Congressman Paul Kanjorski’s (D-PA) draft amendments to the Investment Advisers Act of 1940 (IAA), Mr. Lowenstein claimed the bill’s venture capital exemption may “prove impossible to implement” because private equity and venture capital funds “have virtually the same business model, skill set, and compensation structure.” But how accurate is this statement?

Private Equity vs. Venture Capital

In his own testimony before the Committee, Terry McGuire of the National Association of Venture Capitalists drew a distinction between venture capital’s investments in young enterprises and private equity’s buyouts of mature companies:

Importantly, the capital supplied to a venture capital fund consists entirely of equity commitments provided as cash from investors in installments on an as-needed basis. Venture capital funds do not use debt to make investments in excess of the partner’s capital commitments or “lever up” the fund in a manner that would expose the fund to losses in excess of the committed capital or that would result in losses to counter parties requiring a rescue infusion from the government.

Venture capital’s “straightforward equity investment,” Mr. McGuire concluded, meant that venture capital “risk is contained and measured,” thereby distinguishing it from the systemic risk Rep. Kanjorski’s draft legislation seeks to monitor.

When describing private equity investments, however, Mr. Lowenstein spoke only of “adding managerial expertise, making capital and R&D expenditures, expanding into new markets and developing new products, and making strategic acquisitions to create the scale required to compete and become market leaders.” Nowhere did he discuss the centrality of restructuring the balance sheet, or leverage recapitalization, to PEC members’ strategy for increasing the rate of return on their investments. On the contrary, most of Mr. Lowenstein’s discussion of private equity practices focused on the limited partnerships at the fund level rather than delving into an explanation of how such funds finance their portfolio company acquisitions. When he touched upon borrowings by portfolio companies, he did so only to note that such loans constituted “a small portion of the overall credit market.”

In spite of the striking similarity between the PEC’s remarks on October 7 with those delivered to the same Committee on July 17, the PEC tellingly dropped any reference to the 3:1 to 4:1 Debt/Equity ratio carried by private equity fund investments. Back in July, the PEC cited the ratio to compare it to the 32:1 Debt/Equity ratio of failed investment bank Lehman Brothers, a favorable foil, to be sure. Even then, the PEC stressed that Lehman’s parent company carried the debt, thus exposing “the entire bank to collateral calls.” Limited partners in private equity funds, on the other hand, have no such exposure because their organizational documents preclude follow-on equity infusions into existing investments.

By concentrating on the risks to LPs of any single portfolio company capsizing, the PEC may have lost the forest for the trees. After all, the Obama administration, the Federal Reserve, and Congress have made it clear that the impetus behind regulatory reform is “to monitor and identify emerging risks to financial stability across the entire financial system.” In this context, any assessment of private equity funds must take into account all stakeholders in their portfolio company investments, including banks and bondholders.

Leveraged Recapitalization (or Restructuring the Balance Sheet)

To begin with, “private equity” is somewhat of a misnomer; a more apt name would be “private levered equity,” a term that would at least acknowledge the critical role of leveraged buyouts (LBOs) in private equity’s investment strategy. Until the credit markets dried up over the last 12 months, equity investments by LBO funds have always been supplemented by a healthy dose of debt financing. Historically, private equity buyouts have been largely funded by acquisition debt, usually comprising senior term and revolving loan facilities paired with a post-acquisition high-yield bond offering, which was occasionally backstopped by mezzanine financing. (In addition to high interest rates, mezzanine loans usually require warrants attached, allowing lenders to roll over into a shareholder’s position upon the occurrence of certain adverse events.)

What’s the advantage of using relatively small amounts of equity in an investment? Part of the answer may be found in the implications of what is known in modern portfolio theory as the Modigliani-Miller theorem. Nobel Laureates Franco Modigliani and Merton Miller showed that – at least in “perfect capital markets” – the composition of a firm’s securities does not change the total value of a firm’s assets. That is, a firm may divide its cash flows into dividends to shareholders and interest payments to creditors without decreasing the value of its underlying business operations. Without getting into the way in which real-world market imperfections affect the implementation of the Modigliani-Miller theorem, we’ll summarize its influence on the structure of LBOs.

The expected rate of return on an investment increases in proportion to a company’s Debt/Equity ratio. (The basic principle is the same as mortgaging the purchase of a house.) In practice, the portion of a portfolio company’s cash flows available for dividend payments to the LBO fund actually is decreased for several reasons. An increased Debt/Equity ratio results in a commensurate increase in the risk that a company will go bankrupt because it fails to make timely interest payments on its debt obligations. For deeply subordinated high-yield debt, for example, some of this risk is borne by bondholders, who accordingly demand higher interest rates, thus siphoning off some of the company’s cash flows that would otherwise go to shareholders. But the cost of servicing debt in turn is reduced by an important provision of the U.S. corporate tax code: interest payments by a company on its debt are tax-deductible (whereas dividend payments are not). So every dollar paid to the company’s senior lenders and bondholders in fact only costs the company a fraction of that amount; the benefits of this tax shield ultimately accrue to the LBO fund that owns the company. (It should be noted that the Wall Street Journal reported this week that a presidential tax-policy panel headed by Paul Volcker is currently examining whether to eliminate the “tax code’s bias toward raising money from tax-deductible debt issues rather than from stock sales.”)

Leveraged Buyouts & the 2006-2007 Credit Bubble

In arguing against the need to disclose information to the SEC, Mr. Lowenstein insisted that “third parties that privately negotiate with PE funds,” including creditors, “are all highly-sophisticated market participants with the leverage to bargain with the fund at the time that the counterparty or creditor relationship is first established.” Yet, the experience of the past four years has demonstrated that even sophisticated lenders are subject to market forces and may sacrifice their negotiating leverage in order to capture fees in a highly competitive environment. As Professors Colin Blaydon and Fred Wainwright of Dartmouth’s Tuck School of Business described the situation in a 2006 article, “The Balance Between Debt and Added Value,” before the credit bubble burst:

Banks and other lenders are aggressively competing with each other for deals to generate fees and interest income in the midst of a relatively low interest rate environment. The result has been a steady expansion of the amount of debt available for leveraged acquisitions and a relaxation of lenders’ terms and conditions. This expansion of debt availability has permitted investors to quickly recapitalize their acquired companies and make large dividend payments to themselves and other equity owners.

In previous posts, we’ve covered the advent of so-called “covenant lite” senior loan agreements (which eliminated or reduced maintenance covenants requiring companies to meet certain financial ratios) and “payment-in-kind,” or PIK notes, to bondholders (which permit a company to issue additional notes to bondholders in lieu of cash interest payments). Declining interest rates over the course of 2006 and 2007 coupled with banks’ eagerness to generate underwriting fees from bond issues enabled private equity funds to generate immediate returns for their investors through financial engineering.

According to a New York Times story on the bankruptcy filing of the Simmons Bedding Company, the company’s private equity owners Thomas H. Lee Partners paid itself and its limited partners a $375 million dividend with the proceeds of post-acquisition debt issuances, allowing it to recover all of its initial equity investment. This sort of recapitalization through additional borrowing serves two purposes: it puts cash directly in the hands of an LBO fund’s LPs and GP and it decreases the fund’s exposure to the portfolio company’s risk profile. Even though portfolio companies generally were able to lock in their debt obligations at low interest rates, these highly leveraged companies were vulnerable to a general economic turndown. Ironically, many of the institutional investors who as limited partners in private equity funds benefited from leverage recapitalization also suffered as portfolio company bondholders when they were only able to recover cents on the dollar, if anything at all.

Private Equity Firms & the Banks

Although senior term and revolver loans for acquisitions are initially funded by a consortium of lead banks, the banks seek to syndicate interests in the loans to other counterparties in an attempt to decrease their risk exposure to any single portfolio company’s financial performance. Similarly, banks underwriting post-acquisition high-yield offerings privately place the bonds with a large number of institutional investors, many of whom later sell interests in these notes to other qualified institutional buyers in the secondary market. A single LBO investment, in other words, has many stakeholders other than the private equity fund itself.

What happens when the market for LBO senior loan syndication or private placements of high-yield bonds suddenly dries up? Usually, the banks are left holding the debt. Foretelling things to come, Bloomberg reported in July 2007 that “banks have had to dig into their own pockets to finance parts of at least five leveraged buyouts over the past month because of the worst bear market in high-yield debt in more than two years.”

In late 2006, when private equity funds eyed larger prey, both on their own and in concert with others in “club deals,” banks began to offer buyout firms “equity bridge loans” for the first time since the late 1980s. When banks issued equity bridge loans, they intended them to serve as temporary advances of credit to a private equity fund to facilitate the acquisition of a company. After the deal closed, the banks would then seek to find buyers for the equity stake they had taken in the portfolio company. Although such loans carried a high degree of risk, the competition among banks during the years 2006 and 2007 for the high fees they earned from LBOs provided them with sufficient incentive. After all, according to Dealogic, private equity firms generated 22% of investment banking fees during the period from mid-2006 through mid-2007. In August 2007, BusinessWeek reported that banks were “on the hook for billions of dollars,” although none of the banks would reveal their exposure.

Leveraged Buyouts & Systemic Risk Regulation

As far back as May 2007, Federal Reserve Chairman Ben Bernanke warned that the LBO model resulted in banks’ sharing a significant amount of risk in private equity investments:

There are some significant risks associated with the financing of private equity including bridge loans. ... We are looking at that….. I urge banks to closely evaluate the risk that they’re taking not only in the context of a highly liquid, benign financial environment, but in one that might conceivably be less liquid and benign.

As Chairman Bernanke recognized over two years ago, the institutional investors constituting private equity funds’ limited partners are not the only stakeholders in LBOs.

None of this should be misconstrued as a call to arms for the regulation of all private equity funds. But unless Congress takes into account the nature of private equity’s leveraged buyouts – especially ones conducted by billion-dollar mega funds like those managed by the PEC’s members – regulatory reform will most likely fail.

In closing, it’s worth reading the Wall Street Journal’s coverage of Terry McGuire’s interview with founder and chairman of global private equity firm Advent International, Peter Brooke:

The people that over-leveraged their companies, the people that did these dividend recapitalizations and the things of that nature, have done no one any good…We have to face the fact that there is going to be some form of restrictive legislation on private equity managers…The bad guys deserve it, the good guys don’t deserve it, but I’ll tell you, they’re all tarred with the same brush.

House Hearing on Private Equity and Venture Capital Regulation- Part 1: The Private Equity Council

Geoffrey Parnass — Wed, 21 Oct 2009 17:10:33 -0500

Everybody likes a fight. So it came as no surprise that the media dredged up some hackneyed headlines to describe the House Financial Services Committee’s hearings on regulating hedge funds, venture capital, and private equity earlier this month. Whether they dodged bullets at a “Showdown at the VC Corral” or witnessed bloodlust as “PE lobbyists throw VCs under the bus,” journalists let us know that – surprise! – the private equity community trashed the venture capital exemption in Congressman Paul Kanjorski’s (D-PA) draft bill on amendments to the Investment Advisers Act of 1940 (IAA). Even so, it was somewhat disappointing that nobody offered any details about the testimony of Douglas Lowenstein of the Private Equity Council (PEC). True, details don’t always make for compelling news copy, but the PEC’s testimony seems to warrant a second look. Part 1 of this post first asks the questions: “On behalf of whom does the PEC speak?” and “What weight should Congress give to their opinions?” We then review some of the PEC’s specific complaints about Rep. Kanjorski’s draft bill. In Part 2, we’ll analyze the PEC’s arguments for eliminating the bill’s venture capital exemption, especially its facile equation of private equity acquisitions with venture capital financing.

How Representative is the Private Equity Council?

What is the Private Equity Council? It’s a D.C.-based trade group formed in February 2007 to lobby public policy makers on behalf of some of the largest private equity firms in the U.S., including Blackstone, KKR, Carlyle, Bain, Apollo, Apax, and Madison Dearborn, each of which has over $10 billion in assets under management. By its own admission, the PEC represents only a dozen large private equity firms, even though it estimates that there are over 2,000 private equity firms based in the U.S. By comparison, the National Venture Capital Association (NVCA) has over 450 members, more than half of the approximately 740 U.S. venture capital companies, representing more than 90% of the venture capital industry’s assets under management. The PEC’s presence at the Committee’s hearing on “Enhancing Oversight of Private Pools of Capital” probably speaks more to its members’ influence on Wall Street and K Street than it does to its suitability as an advocate for the private equity industry as a whole.

To be sure, the PEC’s members will be among those most affected by any regulation of alternative investment vehicles and consequently deserve to have their voices heard by Congressional lawmakers. They are also most likely to be scrutinized by any governmental body charged with the duties of a “systemic risk regulator.” At the same time, the Committee should not take the opinions of Mr. Lowenstein on Rep. Kanjorski’s bill as representative of the some 1,900 other private equity firms, who apparently don’t merit a seat at the bargaining table. It should be borne in mind that some of the PEC’s members either already are, or soon will be, subject to SEC registration and reporting requirements. The Blackstone Group LP (BX) currently trades on the New York Stock Exchange (NYSE), while KKR’s recently completed reverse merger with its Euronext Amsterdam-listed affiliate KKR Private Equity Investors positions it for a planned NYSE listing in the spring of 2010. Meanwhile, the PEC’s other members tend to target acquisitions of relatively mature companies, many of whose securities are publicly traded. In the process of taking such companies private, private equity funds must comply with various SEC requirements, including the Securities Exchange Act’s Rule 13e-3 “going private” disclosures for affiliates of equity issuers, the Williams Act’s regulations governing tender offers, Regulation 13D filings on beneficial ownership, and Section 16’s insider trading rules.

In his prepared testimony, Mr. Lowenstein tacitly acknowledged that many of the investment and fundraising activities of the PEC’s members already fall within the purview of governmental authorities. He seemed resigned that more stringent regulation was inevitable when he gave his lukewarm endorsement: “we are generally supportive of requiring registration of advisers to private pools of capital.” As expected, Mr. Lowenstein’s criticisms of specific provisions in the Kanjorski bill relate the objections of the PEC’s members. It would be foolish to ignore the obvious fact that small- to midsized private equity firms have no trade association that the Committee could have summoned to the Hill. Aside from these firms’ limited resources, the “lone wolf” investment style of private equity firms discourages the formation of a nationwide trade association. After all, the PEC itself was formed only after its members began to club together in mega deals for large corporations. But it would be even more foolish for Congress to disregard how the Kanjorski bills regulatory reforms will impact the vast majority of private equity firms.

Big Private Equity’s Need for a Competitive Advantage

A close reading of Mr. Lowenstein’s October 6 testimony before the Committee indicates that the PEC’s members are most concerned with the prospect that the draft legislation’s “broad disclosures to third parties” would put its constituents at a “serious competitive disadvantage.” By contrast, the testimony of Terry McGuire of the NVCA focused on how the onerous regulatory burdens of the IAA would interfere with venture capital firms’ ability to “start and grow new companies.” Mr. McGuire pointed out that even relatively large venture capital firms – such as his own Polaris Venture Partners – run on skeleton crews ill-equipped to shoulder heavy administrative burdens. Compliance with the requirements imposed on IAA registered advisers would not only hamper the investment activities of big VC firms, but venture capital firms of all types and sizes.

Mr. Lowenstein took particular issue with Section 204(b)(7) of the discussion draft, which would grant the SEC broad rulemaking authority to require IAA registrants to provide reports, records, and other information to “investors, prospective investors, counterparties, and creditors” of private funds. For private equity firms to comply with these requirements, Mr. Lowenstein contended, “is potentially destructive of normal commercial relationships and could expose proprietary information and trade secrets to those with whom we compete.” The PEC’s members appear to fear a scenario in which they are compelled by the SEC to disclose certain information to one of their senior lenders, such as JPMorgan or Goldman Sachs, which could then pass on such information to the banks’ respective private equity affiliates, like JPMorgan Partners or Goldman Sachs Private Equity Group. Averring that keeping such information confidential is crucial to retaining a private equity fund’s competitive advantage, Mr. Lowenstein exhorted the Committee to eliminate the provision from any final legislation. Such concerns more likely represent those of the PEC’s membership than of the typical private equity fund, which is unlikely to be able to convince banking behemoths like JPMorgan or Goldman Sachs to provide debt financing on a $50-$150 million leveraged buyout of a midmarket company.

Moreover, for reasons we’ll explore in more detail in Part 2, Mr. Lowenstein’s argument that creditors and investors that negotiate with private equity funds “are all highly-sophisticated market participants with the leverage to bargain with the fund at the time that the . . . relationship is first established” rings hollow. Does anyone who witnessed the lending frenzy of 2006 – 2007 honestly believe that banks in such a competitive landscape would “simply refuse to lend to the fund if the lender is not satisfied that it has received sufficient upfront information about that fund and its investments?”

Assets under Management Threshold

It’s true that elsewhere in his testimony Mr. Lowenstein championed the concept of “calibrated reporting requirements for different types of funds,” an argument that on its face promotes the interests of smaller private equity funds. A good argument could – and should – be made that the IAA’s $30 million threshold is too low for advisers to private funds, many of whose deals, whether structured as leveraged buyouts or pure equity buyouts, could not arguably pose a systemic risk to the financial system. But even here, where Mr. Lowenstein appears to stand up for most private equity firms, he subsequently undermines this position by demanding that “the language [of the bill] base calibration not just on the type and size of the fund, but on their potential to cause systemic risk.” The problem with this argument is that nowhere does Mr. Lowenstein propose another way for Congress to devise a metric for determining systemic risk.

Once again, this proposition only serves the interests of the PEC’s members. As Part 2 will show, Mr. Lowenstein’s insistence that the size and type of fund bears no relation to whether or not its investment activities pose a systemic risk relies on his attempt to equate venture capital financing with private equity LBOs. According to the PEC, the two are merely different species of the same genus. But the history of large LBOs over the past three years tells another story. Remember, as recently as this past April French banks seriously considered quarantining their LBO debt in a “bad bank” lest their liabilities metastasize.

House Financial Services Committee Proposes Hedge Fund & Private Equity Regulation

Geoffrey Parnass — Mon, 05 Oct 2009 14:02:18 -0500

At the end of last week, the House Financial Services Committee focused on regulatory reform measures designed to mitigate systemic risk to the financial system and to regulate hedge funds and private equity. Federal Reserve Chairman Ben Bernanke offered his advice on what steps Congress should take to reform U.S. financial regulation. Congressman Paul Kanjorski introduced draft legislation that would require all private equity and hedge funds that manage assets in excess of $30 million to register with the Securities Exchange Commission, but would exempt venture capital funds from SEC registration. This week, the Committee expects to be just as busy. Tomorrow, October 6, the Financial Services Committee plans to hear testimony from representatives of the venture capital, hedge fund, and private equity industries. In today’s post, we’ll summarize Mr. Bernanke’s recommendations for managing systemic risk, dissect Rep. Kanjorski’s draft bill, and provide you a brief preview of tomorrow’s hearing.

Bernanke’s Testimony on the Oversight of Systemic Risk

The Chairman of the Federal Reserve, Ben Bernanke, journeyed to Capitol Hill last Thursday to offer the House Financial Services Committee his perspective on proposed financial regulatory reforms. Like Treasury Secretary Timothy Geithner, who appeared before the same Committee back in March, Mr. Bernanke emphasized the current regime’s deficiencies in managing systemic risks to U.S. financial markets. Single agencies may be well suited to oversee a single firm or financial sector, Mr. Bernanke pointed out, but have neither the resources nor the expertise to oversee divers types of market players, let alone to anticipate the ways in which their dealings with one another may threaten the financial system as a whole.

As a remedy to this regulatory malady, Mr. Bernanke highlighted two areas for reform. First, he advised Congress to establish an “oversight council” empowered “to monitor and identify emerging risks to financial stability across the entire financial system, to identify regulatory gaps, and to coordinate the agencies’ response to potential systemic risks.” As conceived by Mr. Bernanke, the oversight council would comprise representatives from governmental agencies tasked with supervising the financial sector. In order to fulfill its mandate, the oversight council would need to have access to a wide range of information from various agencies regarding the institutions and markets they supervise as well as the authority to collect information on its own.

Second, Mr. Bernanke recommended the “reorientation of individual agency mandates to include . . . the responsibility to try to identify and respond to the risks” posed by the firms and markets within each agency’s purview. While Mr. Bernanke acknowledged that each agency individually could take on this challenge, he suggested that they would be aided or advised by the oversight council as well. Although individual agencies could adapt their responses to systemic threats arising in the areas over which they have authority, Mr. Bernanke considered it probable that many systemic risks would cross traditional regulatory boundaries. In such situations, the oversight council would be best positioned to intervene.

Mr. Bernanke’s proposed “oversight council” fleshed out the bare bones of Mr. Geithner’s “systemic risk regulator.” The Board of the Federal Reserve, it appears, lined up behind President Obama’s prescriptions for regulatory reform. It therefore was not surprising when Congressman Paul Kanjorski (D-PA), Chairman of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises released draft legislation mirroring a model bill issued by the Obama administration in July.

Private Fund Investment Advisers Registration Act of 2009

Late in the day on October 1, Rep. Kanjorski circulated a “discussion draft” of the Private Fund Investment Advisers Registration Act of 2009, which would eliminate the Investment Advisers Act of 1940's “private fund adviser” exemption. Under the draft bill, all hedge funds and private equity funds with assets under management in excess of $30 million would be required to register with the SEC. The text of the bill introduces a definition of the term “private fund” into the Advisers Act. In its proposed formulation, a private fund would mean an investment fund that would qualify as an investment company under the Investment Company Act of 1940 were it not for the exceptions provided by §3(c)(1) or §3(c)(7) of the Company Act and that either (i) is organized under the laws of the United States or (ii) has 10% or more of its outstanding securities by value owned by United States persons. Under the Company Act, Section 3(c)(1) excludes funds beneficially owned by 100 persons or less and Section 3(c)(7) excludes funds whose securities are owned by certain “qualified purchasers” from the definition of an investment fund.

The proposed bill would also eliminate the “private fund adviser” exemption under §203(b) of the Advisers Act, which presently is available to any adviser that has fewer than 15 clients and does not generally hold itself out to the public as an investment adviser. As we explained in an earlier post, the SEC historically has interpreted the term “client” in §203(b)(3) to refer to the limited partnerships advised by hedge fund managers and private equity firms rather than to the investors constituting their limited partners. Rep. Kanjorski’s draft legislation vests the SEC with broad rulemaking authority, including the power to change the definition of the term “client” under the Advisers Act. This provision pointedly overturns the 2006 ruling by the D.C. Circuit Court of Appeals in Phillip Goldstein v. SEC that vacated the SEC’s “Hedge Fund Rule,” which allowed the agency to “look through” a limited partnership’s legal structure to count each limited partner as a client.

The Private Fund Investment Advisers Registration Act would require all SEC-registered hedge fund managers and private equity firms to maintain records or file reports disclosing:

the amount of assets under management;
the use of leverage (including off-balance sheet leverage);
counterparty credit risk exposures;
trading and investment positions;
trading practices; and
such other information as the SEC (in consultation with the Federal Reserve) determines necessary or appropriate for the assessment of systemic risk.

The draft bill also empowers the SEC to share information about hedge funds and private equity firms with either the Federal Reserve or any other government agency tasked with monitoring systemic risk to the financial system.

Rep. Kanjorski’s proposed legislation exempts advisers to venture capital funds from registering with the SEC. In its current draft, the bill vests the power to identify and define the term “venture capital fund” with the Commission. This exemption has been heralded by many as a victory for the venture capital community, which has contended that its investments do not pose any viable threat to the financial system. Prior to the release of Rep. Kanjorski’s draft legislation, Barney Frank (D-MA), Chairman of the House Financial Services Committee, explained: “We are supportive of the role of venture capital, we are working in consultation with venture capital, and I don’t think there will be anything in there for venture-capital firms.”

Aside from the discussion draft’s close tracking of the Treasury Department’s own proposal for the regulation of hedge funds and private equity, the House Financial Services Committee’s alignment with the Obama Administration on this issue is perhaps best exemplified by Rep. Kanjorski’s adoption of one of Mr. Geithner’s favorite metaphors for hedge funds and private equity firms. In his press release accompanying the distribution of the bill, Rep. Kanjorski observed: “[W]e need to ensure that everyone who swims in our capital markets has an annual pool pass.”

Capital Markets Regulatory Reform Hearing

Last Wednesday, representatives of the hedge fund industry’s main lobbying group, the Managed Funds Association, met with Mr. Geithner, Mr. Bernanke, and Mary L. Schapiro, chairwoman of the SEC, to voice their opinions on President Obama’s plans for overhauling the financial regulatory system. We expect to hear more from representatives of the hedge fund and private equity community at tomorrow’s Financial Services Committee’s hearing on “Capital Markets Regulatory Reform.” The following individuals are scheduled to testify before the full committee:

The Honorable Richard H. Baker, President, Managed Funds Association
Mr. Douglas Lowenstein, President, Private Equity Council
Mr. James S. Chanos, Chairman, Coalition of Private Investment Companies
Mr. Terry McGuire, Co-Founder and General Partner, Polaris Venture Partners, and Chairman, National Venture Capital Association

You can watch a live webcast of the hearing on the House Financial Services Committee’s website.

Hedge Fund and Private Equity Regulation Series

For other posts in our series on U.S. regulatory proposals for private equity and hedge funds, see:

Regulation of Private Funds: Senator Reed and the Congressional Hearings

Senator Jack Reed's (D-RI) bill, the Private Fund Transparency Act of 2009 (S.1276), was referred to the Senate Committee on Banking, Housing, and Urban Affairs on June 16, 2009.

Geithner Calls for a Lifeguard to Monitor “Private Pools of Capital”

Going Private: Rule 13e-3 and the Acquisition of Public Companies - Part 1

Geoffrey Parnass — Wed, 30 Sep 2009 09:52:15 -0500

When a private equity fund buys substantially all of a public company’s outstanding shares in a cash offering, the acquisition may be described colloquially as “taking the company private.” From the perspective of the Securities Exchange Commission, however, the term “going private” applies specifically to situations where either the issuer of an equity security or one of its affiliates purchases the shares. When this occurs, Rule 13e-3 under the Securities Exchange Act of 1934 requires the issuer and any of its affiliates participating in the transaction to file detailed disclosures on Schedule 13E-3. At first blush, it would appear that the buyout of a public company by an unaffiliated private equity firm wouldn’t implicate Rule 13e-3. Nevertheless, as we’ll explain in Part 2 of this post, the structure of leveraged buyouts by private equity firms often triggers the additional disclosure obligations mandated by the Rule.

More often than not, private equity buyers seek to retain a public company’s executive officers to manage the company’s business operations after the transaction has closed. Private equity firms typically offer these managers so-called “sweet equity,” or shares in the new holding company that will own the public company’s business operations post-closing, as an enticement for them to remain. Owing to the way in which Rule 13e-3 defines the term “affiliate,” the issuance of equity interests to these executives frequently requires both them and the private equity fund to comply with Rule 13e-3. In today’s post, we’ll review the general requirements of Rule 13e-3. In Part 2, we’ll examine how the Rule applies to private equity buyouts where a public company’s existing managers stay on to run the business after closing.

“Going Private” Transactions

The SEC adopted Rule 13e-3 over concerns that a “going private” transaction conducted by an issuer or its affiliates may be designed to favor its own interests rather than those of unaffiliated shareholders. When a public company launches a tender offer to purchase substantially all of its own outstanding equity securities, it plays a unique role. Unlike third-party buyers who must conduct arm’s-length negotiations over the terms and conditions of an acquisition, an issuer may abuse its insider position to dictate terms – including the proposed purchase price – unilaterally.

Going private transactions tendered by an issuer or its affiliates present complex agency problems. Directors and managers of a company charged with representing the interests of a company’s shareholders may instead promote the interests of the entity acquiring the securities. The directors, for example, could choose to launch the tender offer during a period of depressed market prices, resulting in a loss to unaffiliated selling shareholders. In addition, directors and officers of the company could use coercive practices in order to secure shareholder votes approving the transaction. To protect shareholders from manipulative tactics, the SEC requires issuers and its affiliates to provide investors with extensive information about the transaction.

In order for a transaction to be considered “going private,” Rule 13e-3 demands that it meet three criteria. Specifically, it must:

be a transaction or series of transactions resulting in the purchase of a security by the issuer or one of its affiliates, that
has either a reasonable likelihood or the purpose of producing, either directly or indirectly,
the effect of causing a class of equity securities of an issuer subject to Section 12(g) or Section 15(d) of the Exchange Act (a) to be held by fewer than 300 persons or (b) to be delisted or no longer authorized to be quoted on an inter-dealer quotation system of a registered national securities association (such as NASDAQ).

Rule 13e-3’s Definition of “Affiliate” and “Control”

In the context of buyouts of public companies by private equity funds, the determination of whether or not Rule 13e-3 applies turns on whether an affiliate of the issuer (that is, the public company that is the target of the acquisition) is considered to be a buyer of the target’s equity securities. Rule 13e-3 defines an affiliate of an issuer as “a person that directly or indirectly through one or more intermediaries controls, is controlled by, or is under common control of such issuer.” Although Rule 13e-3 does not specify what constitutes “control,” Rule 12b-2 of the Exchange Act, which applies generally to rules under the Exchange Act, defines “control” as “the possession, direct or indirect, or power to direct or cause the direction of the management and policies of a person, whether through ownership of voting securities, by contract or otherwise.”

This broad definition of control creates an unsettling degree of uncertainty as to who or what may be considered an “affiliate” of an issuer in a transaction involving the acquisition of a public company’s shares. In some situations, the SEC may decide that a person indeed exercises such control where he has the power to influence a company’s management and policies, even if the person holds a low percentage of the company’s voting securities.

Schedule 13E-3

Rule 13e-3’s filing and disclosure requirements apply to both the issuer and any of its affiliates engaged in the “going private” transaction. According to the SEC, the rule is designed to ensure that all holders of the class of securities subject to the transaction receive information regarding the issuer and each of its affiliates engaged in the transaction. To that end, Schedule 13E-3 requires a discussion of the purposes of the transaction, any alternatives that the company considered, and whether the transaction is fair to all shareholders. The Schedule also must inform investors whether and why any of its directors disagreed with the transaction or abstained from voting on the deal. Moreover, Schedule 13E-3 must indicate whether a majority of directors who are not company employees approved the transaction.

In Part 2 of this post, we’ll analyze the application of Rule 13e-3 in buyouts by private equity funds in which managers of the public company are offered “sweet equity” in the new holding company.

The Disney-Marvel Merger Negotiations: From the Opening Scene to the Closing Credits

Geoffrey Parnass — Sat, 26 Sep 2009 22:12:47 -0500

The DVD releases of future Disney films featuring Marvel superheroes undoubtedly will contain bonus items for the cinephile. If a single viewing of a movie doesn’t sate your appetite, you’ll probably be able to watch it again accompanied by the director’s audio commentary. The Walt Disney Company’s S-4 registration statement regarding its proposed merger with Marvel Entertainment, Inc. contains a director’s commentary of a different stripe. The SEC filing includes a six-page section titled the “Background to the Merger” that describes the terms of Disney’s first proposal to Marvel, subsequent negotiations among their legal counsel, and explanations for why Marvel eventually agreed to the deal. We’ll break down this behind-the-scenes look at the talks. Keeping in mind that Disney and Marvel are both Delaware corporations, it’s difficult not to read this section – with its emphasis on the transaction’s deal protection terms – as a preemptive apologia of the Marvel directors’ actions in light of their Revlon duties to maximize shareholder value in the sale.

Disney-Marvel Negotiations: The Director’s Cut

Negotiations between Disney and Marvel focused on two transaction documents: the merger agreement and a voting agreement with Marvel’s CEO Isaac Perlmutter, who owns about 37% of Marvel’s shares through various affiliates. On August 11, Disney’s lawyers emailed their initial drafts of the merger agreement and voting agreement to Marvel’s legal counsel. According to the S-4, Marvel objected to several deal protection mechanisms contained in Disney’s proposal:

a “force the vote” provision requiring Marvel to put the Disney deal before Marvel’s shareholders, even if Marvel’s board of directors received a superior bid for Marvel by a third party;
a break-up fee equal to 4% of the transaction value if Marvel ended the deal;
a soft lock-up provision that would proscribe Marvel’s board from dropping its recommendation of Disney’s offer unless a third party made a superior offer to Marvel; and
a demand that Mr. Perlmutter agree (i) to vote his Marvel common shares in favor of the Disney transaction and (ii) to veto any other transaction with another prospective buyer for a period of 18 months after the termination of the merger agreement.

After two weeks of intense negotiations, a number of substantive terms remained outstanding. Disney continued to insist on a “force the vote” provision in the merger agreement and refused to concede on any of the deal protection measures contained in its first draft of the Perlmutter voting agreement. On August 27, Marvel’s special transaction committee informed the company’s financial and legal advisers that it would not recommend a transaction to Marvel’s board that included a “force the vote” provision or an 18-month tail on Mr. Perlmutter’s voting agreement because they considered these terms to be improper restrictions on the Marvel board’s ability to consider or enter into transactions with other potential buyers prior to the consummation of the Disney deal.

During the ensuing days, Marvel told Disney that it would be willing to agree to a break-up fee equal to 2.9% of the transaction value in return for concessions by Disney on the other requested deal protection measures.

In response to Marvel’s counteroffer, Disney agreed:

to remove the “force the vote” provision;
to let Marvel terminate the merger agreement in favor of a superior proposal if the board decided that “failing to do so might reasonably be expected to be a breach of its fiduciary duties;”
to reduce the break-up fee from 4% to 3.5% of the transaction value;
to allow Marvel’s board to change its recommendation of the Disney transaction to Marvel’s shareholders if it concluded that it had a fiduciary duty to do so; and
to eliminate the 18-month tale on Mr. Perlmutter’s voting agreement (so that a termination of the merger agreement would constitute a termination of the voting agreement as well).

Marvel’s Board of Directors Meeting

Marvel’s board of directors convened a meeting on August 30 to consider Disney’s revised proposal with its financial and legal advisers. During the course of the meeting, Marvel’s outside legal counsel advised the board on the agreements’ deal protection measures and the board’s fiduciary duties under Delaware’s general corporation law in the event that it received a possible superior proposal from a third party after the signing of the Disney merger agreement. Marvel’s lawyers also analyzed the procedure for considering alternative bids for the company under the merger agreement, the situations in which the board could terminate the merger, and the conditions under which the break-up fee would be payable to Disney. In the end, Marvel’s attorneys concluded that Disney’s deal protection measures “provided the Marvel board of directors with sufficient flexibility to entertain bona fide alternative proposals, were consistent with the Marvel board of directors’ fiduciary duties and were not coercive to Marvel stockholders.”

The following day Disney and Marvel signed the merger agreement and Mr. Perlmutter and Marvel entered into the voting agreement with Disney.

Critic’s Corner

Of course, the “Background to the Merger” section only summarizes discussions between Disney and Marvel. The disclosure contained in Disney’s S-4 stresses the companies’ haggling over the deal protection terms, but negotiations over the purchase price and the proportion of cash and stock that made up the purchase price were probably not mere subplots to the main action. Nevertheless, the narration of Disney’s and Marvel’s back-and-forth over the deal protection terms at times resembles Kabuki theater more than the Hollywood blockbusters the marriage of the two companies is likely to spawn. While it’s well known that a board’s fiduciary duties under Delaware law to maximize the sale price of a company does not impose any “legally prescribed steps that directors must follow to satisfy their Revlon duties,” Delaware courts have done a fairly decent job of coloring in the outlines of directors’ obligations to shareholders in the sale of a company since the 1986 landmark ruling. The story told by Disney’s S-4 raises questions about what purpose the inclusion of terms likely proscribed by Revlon in the first draft of a merger agreement serves. For example, how useful are such terms as bargaining chips when making an initial offer to a potential seller’s board of directors? When a buyer agrees to eliminate these types of deal protection measures in subsequent negotiations, has it really conceded anything of value?

The Sequel

Nowadays, it seems that almost every profitable movie has a sequel in the works before it has even finished its run in the cinemas. We see no good reason why this blog post shouldn’t follow suit:

Much of the discussion in the S-4 regarding merger negotiations between Disney and Marvel addresses what actions the Marvel board would be permitted to take if it were to receive a “superior proposal” from a third party. But without an explanation of what constitutes a superior proposal under the merger agreement, any discussion of the proposed merger signifies very little. When we revisit the Disney-Marvel merger in a later post, we’ll take a closer look at the merger agreement’s definition of a Superior Proposal.

LPs Push to Reinforce Fiduciary Duty of Sponsors

Geoffrey Parnass — Fri, 18 Sep 2009 14:15:04 -0500

As we previously noted, the ILPA (International Limited Partners Association) recently published a wide-ranging set of “best practices” that it hopes will shape the practices of the private equity sponsor community. In this piece, we’d like to focus on ILPA’s recommended changes to the fiduciary duty provisions of investment partnership agreements. First, we’ll summarize ILPA’s wish list in the area of fiduciary duties. Then, we’ll examine the investor documents of a well-known sponsor (KKR) to see how far apart current practice is from ILPA's wish list.

First, a little background. A fiduciary duty is a relationship of confidence or trust between two parties. A fiduciary must be loyal to the person to whom he owes the duty. He must not put his personal interests before that duty, and must not profit from his position as a fiduciary, unless the principal consents. Under common law rules, the general partner of an investment partnership owes a fiduciary duty to the limited partners.

In Delaware, where most investment partnerships are formed, the fiduciary duty include an obligation to act in good faith and with due care and loyalty. The duty of care requires a general partner to act for the partnership in the same manner as a prudent person would act on his own behalf. The duty of loyalty prohibits a general partner from taking any action or engaging in any transaction that is not in the best interests of the partnership where a conflict of interest is present. However, Delaware law also says say that these duties can be “restricted or eliminated” in the partnership agreement. Most sponsors take advantage of the opportunity to both restrict and eliminate fiduciary duties.

ILPA hopes to push back against the erosion of fiduciary duties and “reinforce” the fiduciary duties of the sponsor community. Specifically, it wants to delete:

Provisions that reduce fiduciary duties “to the fullest extent allowed by law”.
Provisions that allow general partner to use its sole discretion and weigh its own self-interest against the interest of the fund.
Provisions where limited partners waive broad categories of conflicts or affiliated transactions.
Provisions that allow general partner and its affiliates to be exculpated or indemnified for conduct constituting a material breach of the partnership agreement, breach of fiduciary duties, or other “for cause” events.

So, how far back do LPs have to push on fiduciary duties? To answer that, we looked at the prospectus filed by KKR & Co. LP last year when it tried to go public. The prospectus summarizes the lengths to which KKR has gone to restrict or eliminate any fiduciary duty to investors. In short, KKR has fully eliminated the core fiduciary obligation to put the interests of investors ahead of its own interests, and to act solely in the best interests of investors where a conflict is present. In making any discretionary decision, the KKR general partner is allowed to take into account whatever factors it wishes, including its own interests, and does not have any duty or obligation to consider any factors affecting investors.

Moreover, the KKR general partner cannot be liable to investors for any act unless there has been a final and non-appealable judgment by a court determining that it has acted in bad faith or engaged in fraud or willful misconduct. That's a pretty high hurdle.

As the prospectus itself informs us, in language only a lawyer could love: “These modifications are detrimental to our unitholders because they restrict the remedies available to our unitholders for actions that without those limitations might constitute breaches of duty, including a fiduciary duty, and they permit our Managing Partner to take into account the interests of third parties in addition to our interests when resolving conflicts of interest.”

It looks like ILPA and its members have a ways to go.

Drafting Advancement and Indemnification Provisions in Limited Partnership Agreements

Geoffrey Parnass — Wed, 16 Sep 2009 23:13:58 -0500

A July ruling by the Court of Chancery holds important lessons for how Delaware courts interpret advancement and indemnification provisions in limited partnership agreements. In J. Michael Stepp v. Heartland Industrial Partners, L.P., two former officers and directors of the defunct Collins & Aikman Corporation sought advancement of legal fees and indemnification from the company’s majority investor, Heartland Industrial Partners, L.P. After C&A disclosed historical accounting irregularities, J. Michael Stepp and David A. Stockman incurred hefty expenses resulting from civil and criminal proceedings brought against them in connection with their roles at the portfolio company. Heartland rebuffed the directors’ request, insisting that (i) the general partner of the private equity fund had the discretion to refuse their advancement application and (ii) the directors failed to satisfy the requirements of the partnership agreement’s indemnification clause. The Court of Chancery disagreed and chastised Heartland for relying on ambiguous contractual language to shirk its obligations.

Contractual Ambiguity Resolved Against General Partner

In his opinion, Vice Chancellor Strine drew on general principles of Delaware contract law. Confronted with a partnership agreement marred by slipshod drafting, Strine emphasized the public policy considerations behind Delaware courts’ approach to interpreting the foundational documents of business entities.

Delaware courts resolve ambiguities in governing instruments in order to provide uniform, predictable interpretations of the documents that officers, investors, and other constituencies who provide benefits to the entity rely on in making their decisions about whether to participate in the entity’s activities. This principle of interpretation protects the participants’ reasonable expectations, which in turn benefits the entity by encouraging participants to provide their capital, be it human or financial, at a lower cost than they would if they faced greater uncertainty.

Directors, officers, and employees of limited partnerships, Strine observed, generally do not take part in the negotiation of the partnership’s organizational documents. Consequently, when deciding whether to work for a limited partnership, they must rely on the plain meaning of the terms of the partnership agreement in order to understand their rights and obligations. To protect the reasonable expectations of people who join a partnership after its formation, Strine reasoned, Delaware courts construe ambiguous terms against the drafter of the governing instrument.

Advancement of Legal Fees & Expenses

The court granted the directors’ motion for summary judgment that they had a mandatory right to the advancement of legal fees and expenses under the limited partnership agreement. After finding themselves defendants in half a dozen civil actions, Stepp and Stockman first applied for advancement of legal fees and expenses to C&A’s and Heartland’s insurance carriers. Once they exhausted the insurance policies, the directors turned to Heartland itself. Heartland’s general partner refused to authorize their petition.

The relevant section of the partnership agreement read: “[e]xpenses reasonably incurred by an Indemnitee shall be advanced by the Partnership,” but “[n]o advances shall be made by the Partnership. . . without the prior written approval of the General Partner.” Heartland claimed that the prior written approval requirement granted the general partner sole discretion to decide whether to accept or deny an application for advancement. The court rebuked Heartland for its strained interpretation of the written approval requirement because it eviscerated the mandatory advancement language. Strine instead construed the requirement as performing the ministerial function of ensuring the directors’ request for an advancement of expenses was reasonable. According to the court, the general partner did not have the power to withhold its written approval merely to block the directors’ contractual rights to mandatory advancement.

Indemnification of Legal Fees & Expenses

Stepp and Stockman sought indemnification for expenses related to their defense against criminal charges, all of which were dismissed without prejudice by a federal court. The partnership agreement contained expansive indemnification rights by promising the directors restitution for “any and all claims. . .of any nature whatsoever.” But the partnership agreement subjected this broad indemnity to certain qualifications. In its motion to dismiss, Heartland maintained that the partnership agreement required the directors to demonstrate good faith, lawfulness, and the absence of any willful or knowing misconduct.

The partnership agreement was silent with respect to the rights of indemnitees who were successful in proceedings brought against them. As a result, the court held that the terms of the agreement did not clearly require an indemnitee to prove good faith, lawfulness, or lack of willful misconduct where, as occurred in the case of Stepp and Stockman, the indemnitee emerged victorious in the underlying proceeding. In support of its construction, the court cited recent Delaware case law mandating an award of indemnification after the dismissal of a case without prejudice.

Indemnification decisions, the court explained, should be made on a case-by-case basis. Otherwise, directors who are defendants in lawsuits would have to wait until all proceedings against them have been dropped or resolved. To apply Heartland’s interpretation of the agreement would contravene Delaware’s “strong public policy interest in promoting indemnification. . . to encourage capable people to serve as directors.” Given the agreement’s mandatory indemnification provision and the directors’ successful defense against the criminal charges brought against them, the court observed that Heartland bore the burden of proof that Stepp and Stockman did not satisfy the indemnification requirements. The court accordingly rejected Heartland’s motion to dismiss the directors’ claims for reimbursement.

Freedom of Contract & Delaware’s Limited Partnership Act

Vice Chancellor Strine noted that Section 17-108 of Delaware’s Limited Partnership Act affords limited partnerships greater freedom to draft their own indemnification plans than is available to corporations under Section 145 of Delaware’s General Corporation Law. In the case of Heartland, the court remarked that “drafters of the Partnership Agreement used their contractual freedom to craft an approach to indemnification that employs language drawn from § 145, but in a selective way that creates some room for confusion.”

When drafting indemnification provisions in limited partnership agreements, general partners should focus on clarity and not rely on boilerplate or statutory language adapted from other sources of law. Freedom of contract does not come without substantial responsibilities. Bespoke partnership agreements need to be tailored to the specific circumstances of the contracting parties and any potential third-party beneficiaries. Populating a limited partnership agreement with a farrago of provisos and exceptions does not give a general partner the right to break its explicit contractual promises.

Private Equity LPs Seek to Impose "Best Practices" on Sponsor Community

Geoffrey Parnass — Sun, 13 Sep 2009 17:03:10 -0500

The Institutional Limited Partners Association, a trade association that represents 220 institutional investors in private equity funds, recently published a set of Private Equity Principles, designed to guide future dealings between its members and the private equity sponsor community. The Association’s members include public and corporate pension funds, endowments, foundations, family offices and insurance companies with more than $1 trillion in private equity funds under management. The publication of the Principles is the first time that a group of influential limited partners has collectively published a set of core requirements for private equity fund documents.

The Principles were developed by the Association and its members to “correctly align” the interests of private equity sponsors and institutional investors in private equity funds. The concepts reflect “suggested best practices” that should shape the private equity industry in the future. Among the best practices endorsed by the group, it is significant to note that no change in the basic 80/20 profit split is recommended. The Principles say this split has “typically worked well to align interests”.

What comes up for scrutiny and criticism are provisions relating to carried interests, claw back liabilities and management fees. In particular, the Principles urge tougher provisions on carried interest escrow reserves (a 30% escrow), a 2-year repayment of claw back liabilities, tougher provisions on the size and application of management fees, and the payment of all transaction and monitoring fees to the fund rather than the GP or other sponsor affiliates.

Here is a summary of the key provisions:

Waterfall Structure

The LP’s capital contribution plus preferred return should be paid first, before any distributions are made to the GP’s carried interest
Establish GP carry escrow accounts with reserves of 30% or more to cover potential claw back liabilities
Carry on recapitalizations should be paid only when the full amount of LP capital is returned on the recapitalized investment

Calculation of Carried Interest

Carried interest should be calculated on net profits, not gross profits
Carry should not be paid on current income
Carried interest should be calculated only on an after-tax basis

Claw back

Claw back liabilities should be determined and reported periodically
Claw back liabilities should be paid within 2 years and should be gross of taxes paid
Effective joint and several claw backs should be implemented to make sure that full claw back liabilities are met

Management Fee Structure

Management fees should be based on reasonable operating expenses and reasonable salaries, so that fees are not excessive.
Management fees should reduce upon formation of follow-on fund and at the end of the investment period
The management fee should be used to pay all normal operating costs of the GP, including interactions with the LPs. The LPs should have the power to review the partnership expenses annually
Placement agent fees should be paid by the GP
All transaction, monitoring, directory, advisory and exit fees should accrue 100% to the benefit of the fund.

The Principles also include detailed suggested changes to the fiduciary duty requirements of the GP. For example, provisions of fund documents that disclaim or reduce fiduciary duties should be eliminated. We will discuss these recommendations in more detail in a later post.

The Association is currently gathering formal endorsement of the Principles from its members and promises to publish a list of the endorsing institutions on its website.

How will the Principles be received by the sponsor community? That awaits to be seen. Institutional investors would love to establish a set of best practices across the sponsor community in order to make their investments in the asset class more uniform, and more favorable. They would like to reign in the variations in how sponsors define and enforce rules governing distributions, claw backs, and fees. The sponsors will certainly resist any uniform treatment, and look for advantages at the margins, whether in the area of distributions or discretion in the application of fees. Assuming a large number of institutional investors formally endorse the Principles, it may become difficult, if not impossible, for the GP community to ignore the recommendations. The LP community has taken to heart the motto: United We Stand, Divided We Fall.

Elan Loses to Biogen in Court for Assigning Tysabri Obligations to Johnson & Johnson

Geoffrey Parnass — Fri, 11 Sep 2009 15:32:04 -0500

Attorneys for Biogen Idec Inc. and Elan Corporation finally faced off in a Manhattan federal court earlier this month. The two companies had adopted increasingly antagonistic postures towards one another as elements of Elan’s cooperation and financing agreements with a Johnson & Johnson subsidiary became public. Shane Cooke, Elan’s CFO, told the Wall Street Journal in July that its arrangements with J&J contemplated the possibility of the two companies working together to buy Biogen’s Tysabri stake if Biogen is acquired by a third party. Biogen protested that Elan’s proposed deal ran afoul of the companies’ collaboration agreement for the multiple sclerosis drug Tysabri. A defiant Elan filed a complaint in federal court requesting a declaratory judgment that it had not violated the collaboration agreement and a permanent injunction prohibiting Biogen from terminating their partnership. After five hours of oral argument, U.S. District Court Judge Deborah Batts ruled that the Elan-J&J partnership infringed the Tysabri agreement.

As we explained last month, the Tysabri collaboration agreement provides that if either Biogen or Elan is acquired by a third party, then the non-acquired party has the option to purchase its stake in Tysabri. The agreement also contains a customary provision prohibiting the assignment of any rights or obligations to an unaffiliated third party without the other party’s written consent. At the hearing, Biogen’s attorneys cited a confidential clause in one of the Elan-J&J agreements giving Johnson & Johnson the option to finance an Elan change of control purchase of Biogen’s share in Tysabri. The clause requires Elan to take instructions from Johnson & Johnson if it ever enters into negotiations to purchase Biogen’s stake. By granting this option to J&J, Biogen argued, Elan effectively transferred its rights under the agreement to Johnson & Johnson. As Biogen’s attorney Michael Gruenglas put it, Elan "is no longer in the driver's seat, Johnson & Johnson is driving the car."

Although Judge Batts concluded that “it would seem there has been a breach of the Biogen-Elan collaboration agreement,” she saw the legal issues differently. Contrary to Biogen’s characterization of the Elan-J&J pact, Judge Batts declared that Elan had not assigned any of its rights to Johnson & Johnson. Instead, Batts explained: "It appears to the court that Elan has designated an obligation it has to Johnson & Johnson by taking direction from Johnson & Johnson on the purchase price negotiations.”

Judge Batts appears to have based the rationale for her decision on redacted portions of the Tysabri agreement’s “change of control” provision. The version of the collaboration agreement filed with the SEC details Biogen’s and Tysabri’s acquisition rights upon a change of control in the other party. But the publicly available version of the contract omits important clauses relating to the conduct of negotiations once the non-acquired party exercises its acquisition rights. This version of the contract reads: “[i]n the event the Non-Acquired Party exercises its election [sic] to purchase the interest of the Acquired Party under this Agreement, the Parties shall…”, but then expunges the next 36 lines of the change of control provision. Significantly, the excised portions address how the companies are to proceed in the event that the non-acquired party decides to acquire the other party’s Tysabri stake. From Judge Batt’s justification for her ruling, it appears that these omitted clauses specify how pricing and other negotiations should be conducted.

By putting the power of the purse strings in J&J’s hands, Judge Batts determined that Elan had effectively delegated its negotiating power to Johnson & Johnson. Under the Tysabri agreement, Elan has a right to exercise its change of control purchase option, but it also has a corresponding obligation to negotiate with Biogen on such matters as the valuation of Biogen’s stake in the drug. According to Judge Batts, when Elan agreed to let J&J dictate the terms of those negotiations, it violated the “no assignment” provision of the collaboration agreement by transferring this obligation to Johnson & Johnson.

As part of her ruling, Judge Batts remarked that Biogen was within its rights under the Tysabri agreement to give Elan a chance to rectify its breach and noted that Elan had 23 days left in the agreement’s 60-day cure period. The Wall Street Journal reports that Johnson & Johnson and Elan have been discussing ways to amend their cooperation agreement so as to avoid violating the Elan-Biogen Tysabri partnership. Proposals by Johnson & Johnson include reducing their investment in Elan by as much as $100 million.

Revised FDIC Policy Clears Way for Experienced PE Firms

Geoffrey Parnass — Wed, 02 Sep 2009 23:16:18 -0500

We recently discussed the FDIC's adoption of a final policy statement governing private equity investments in failed banks. As we and other commentators have noted, the final policy continues to put private equity investors at a disadvantage when compared to strategic investors such as existing regulated bank institutions. Most importantly, the policy imposes a substantially higher capital requirement for private equity firms (10% of Tier 1 capital vs. 5%) which must be maintained for at least 3 years.

The final policy statement reflects the FDIC's earnest desire not to turn over bank deposits -- that amazing funding source guaranteed by the full faith and credit of the United States -- to unschooled and possibly unscrupulous owners. That mistake was made during the last banking crisis, and one thing that people in large bureaucracies learn well is not to repeat the mistakes of the recent past. Accordingly, the FDIC must do what it can to ensure that the private capital which comes to the rescue of failed banks is provided this time by firms and management teams that respect the sanctity of bank deposits, and the FDIC's guarantee.

The policy statement is just that -- a statement of policy. In many important areas, there are no detailed regulations, defined terms, or clear rules to guide deal making. Sooner or later, any private equity firm looking at purchasing a troubled bank must contact the FDIC to get its opinion on the meaning of key provisions of the policy. One may justly conclude that this is exactly what the FDIC wants to have happen. By compelling firms to get critical interpretive clearance on key deal terms, the FDIC has the ability to screen firms and their management teams and sift the wheat from the chaff, so to speak.

The final policy statement is an important road map for well-regarded and experienced private equity firms to invest in troubled banks. Other players, without deep experience and respected management teams to run the banks, may as well sit out this round. Of course, things can change. The crisis may escalate and the need for fresh capital may become acute. Also, given the large number of troubled banks on the horizon, there may be opportunities to purchase the assets of institutions that must be liquidated because they fail to find buyers deemed worthy by the FDIC.

FDIC Adopts Strict Rules for Private Equity Investment in Failed Banks

Geoffrey Parnass — Wed, 26 Aug 2009 22:57:20 -0500

The FDIC made some compromises, but will continue to hold private investors in failed banks to a higher standard than strategic buyers. The FDIC’s board approved a final policy on private equity investment in troubled financial institutions by a 4-1 vote; Director John Bowman stood alone in opposition to the measure. Even so, the FDIC expressed a commitment to review the policy in six months. The chair of the FDIC Board, Sheila Bair, said that the 61 private comment letters “gave us a lot to think about.” In today’s post, we’ll summarize public comments and the final rules for the policy’s capitalization, source of strength, and cross guarantee requirements.

Capitalization. The majority of comments opposed the FDIC’s proposed rule that private equity investors maintain a 15% Tier 1 leverage ratio in failed banks. Some pointed out – as we did over a month ago – that the suggested ratio was three times that currently imposed on healthy banks. The heightened capitalization requirements, many argued, would place private equity investors at a competitive disadvantage to strategic buyers. Others predicted that private equity firms would be less likely to invest in failed banks and more likely to offer less competitive bids to the FDIC.

Final Rule. Banks owned by private equity investors are required to maintain a 10% Tier 1 leverage ratio for the first three years. The FDIC reserves the right, however, to impose a higher leverage ratio on a particular investor if it determines that the situation warrants special treatment. After three years, private equity-owned banks must remain “well capitalized” (or maintain certain financial ratios specified in FDIC regulations). The FDIC justified the increased capital requirements as a necessary protection against the “higher risk profile” of private investments in troubled financial institutions.

Source of Strength. The controversial source of strength requirement would have required private equity funds to infuse ailing banks with additional capital. Comment letters overwhelmingly objected to this rule, claiming it could create unlimited liability for private investors. Even more to the point, a number of commentators observed that the rule would bar private equity firms from investing in failed banks altogether. By the terms of their organizational documents, private equity funds are prohibited from providing capital support to or making subsequent investments in their portfolio companies.

Final Rule. It’s gone. The FDIC deleted the source of strength provision, noting that it would not be possible for private equity firms “as a practical matter.” (It’s not clear why the FDIC did not take practical matters into account when drafting its initial proposal.)

Cross Guarantee. Commentators complained that the cross-guarantee requirement would place the other investments of private equity investors at risk. They emphasized that different funds – even those managed by the same private equity firm – have different investors and accordingly should be treated separately. Several commentators claimed the rule would impede a private equity manager from investing in two different banks through two different funds with two distinct groups of investors. As we wrote earlier, the rule would also inhibit club deals in failed banks.

Final Rule. The FDIC raised the threshold for the cross guarantee rule to apply. Under the revised rule, if investors own 80% or more of two or more banks, the stock of the banks commonly owned by those investors must be pledged to the FDIC. If one of the banks fails, the FDIC may exercise its pledge to the extent necessary to recoup any losses it incurs.

It looks like the FDIC will have a lot of inventory on hand in the coming months. Every week we witness more and more bank failures. The forecast doesn’t bode well either. According to the Financial Times, Dick Bove of Rochdale Securities predicts that another 150-200 banks will likely fail in the next several months. So far, the FDIC has not been able to get rid of all of the failed banks already on its books. The New York Times reported that of the 77 banks that have failed this year, the FDIC has found buyers for only 69 of them.

We suspect the FDIC hasn’t gone far enough to make investments in failed banks attractive to private equity firms. If banks continue to fail, the FDIC will most likely have no choice but to open the market to as many potential buyers as possible. In six months’ time, it wouldn’t be surprising if we see the FDIC Board revisiting these issues once again.

Flawed FDIC Guidelines May Block Funding for Failed Banks

Private Equity May Invest in Law Firms

Geoffrey Parnass — Fri, 21 Aug 2009 21:57:48 -0500

When shopping for law firms, private equity firms may head straight to Tesco. Tesco, one of Britain’s grocery retail giants, has become synonymous with one-stop shopping. Known for its bargains, the ubiquity of its stores, and its relentless advertising campaigns, Tesco seems to have little in common with private equity or law firms. Now, thanks to the British tabloids’ obsession with catchy headlines, “Tesco Law” stands for a set of new regulations that will allow law firms to issue shares to non-lawyer investors, merge with companies, and list shares on the London Stock Exchange. Though these new rules don’t become effective until 2011, Bloomberg reports that several private equity firms have already scouted the market by holding quiet talks with law firms.

Reform of the Legal Profession

The Legal Services Act of 2007 sets the stage for the legal profession in England and Wales to become arguably the most liberal in the world. According to the Ministry of Justice, the government designed the reforms to “encourage more effective competition and [to allow firms] to provide a range of legal services to consumers, increasing access to justice.” The government began rolling out the reforms this past March. By forming “legal disciplinary practices” under the Legal Services Act, law firms can be owned by different types of lawyers and can sell up to a 25% stake to non-lawyers. The only requirement is that the firm continue to limit its business to providing legal services. In the next stage, expected to be implemented in 2011, firms will be allowed to reorganize as alternative business structures, providing them even greater flexibility in raising capital. Once reorganized, law firms will be able to offer shares in their firms to non-lawyers, merge their firms with companies that offer other services, and list their shares on the London Stock Exchange.

So far, according to The Law Society’s Gazette, the legal disciplinary practice option has not attracted many keen investors. But private equity firms don’t seem to have cold feet merely because others have been afraid to dip their toes in the water. Bloomberg reports that small and mid-sized private equity funds may be willing to invest millions of pounds in law firms. Fleming Family & Partners Ltd., Phoenix Equity Partners Ltd. and Lyceum Capital Partners LLP are all said to be considering investments. In interviews with Bloomberg, representatives from private equity firms indicated that they are also evaluating investments in other legal service providers.

Non-lawyer Investors and the Future of the Legal Profession

From initial news reports, it appears that the Legal Services Act will have the greatest influence on mid-sized firms. Law firms that historically have been limited by liquidity constraints will be able to raise capital through equity offerings. With more money on hand to expand their services, entrepreneurial mid-sized firms may acquire greater market shares. As of now, the UK’s prestigious “Magic Circle” firms scoffed at the idea of allowing non-lawyers into the fold, but they may have to reassess their stance once a radically new legal regime has altered the competitive landscape.

It’s tempting to see the changes in England and Wales in the light of whispers about possible changes to the legal profession in India. Currently, foreign lawyers cannot practice in India and foreign law firms cannot open offices there either. Undeterred by resistance, British law firms have been pressing the Indian government for changes to India’s protectionist policies. If India were to loosen restrictions on the practice of law by foreigners, we could witness a Copernican turn in the management of law firms. Companies already outsource routine legal tasks, such as prior art searches in patent applications, to captive or third-party legal process outsourcing companies. Non-lawyer investors in British law firms would be less likely to heed traditional conceptions about the legal profession. It may take a non-lawyer to recognize and take advantage of the cost benefits achievable through vertical integration in the legal industry by consolidating traditional law firms with other legal services providers, including outsourcing companies.

What about the chances of a successful law firm IPO? Unfortunately, the May 2007 initial public offering of Australian class action law firm Slater & Gordon is the only case study we have of a law firm’s stock listing. Slater & Gordon’s stock has declined by around 33% from its high price in September 2007. Yet, Deloitte & Touche notes that Slater & Gordon’s stock price has tracked the overall market and concludes the correlation suggests that the market values law firms just as any other business.

Negotiating Liability with Your Due Diligence Advisers: M&A Engagement Letters

Geoffrey Parnass — Mon, 17 Aug 2009 22:27:51 -0500

Before you let your team of due diligence advisers loose in the data room, it’s crucial to reach an agreement about each adviser’s role and responsibilities. Accountants, banks, and other M&A advisers recognize their success depends on their ability to deliver reliable, incisive analysis of a target’s business operations and future prospects. On the other hand, advisers also have an interest in limiting their liability for the advice they give to their clients. When negotiating engagement letters for M&A due diligence services, private equity firms and other buyers should pay careful attention to provisions that restrict their right to seek compensation for losses brought on by bad advice. In today’s post, we review several customary ways in which advisers try to decrease their risk exposure in engagements for M&A due diligence.

Scope of the Engagement

An M&A adviser will often try to limit its liability by narrowly defining its area of expertise. To some extent this makes sense. Understandably, accountants don’t want to be held liable for having given legal advice, even if their financial review may have legal consequences, such as a modification to the deal’s structure. But private equity firms should ensure that the scope of the adviser’s engagement is not so narrowly construed that it effectively eliminates the firm’s recourse against the adviser. In M&A transactions, this issue is usually resolved by limiting the scope of the adviser’s liability to the contents of a final due diligence report. Anchoring the adviser’s liability to a specific, written deliverable eliminates ambiguity about which statements the private equity firm may rely upon.

In practice, an adviser issues preliminary drafts of its reports to the firm and other advisers at periodic intervals throughout the due diligence process. The private equity firm, after all, wants to know immediately about any previously unknown risks or “deal killers.” An effective due diligence program helps the firm understand a potential target’s strengths and weaknesses and identify issues that need to be addressed in negotiations with the seller. Periodic due diligence updates enable private equity firms to keep abreast of what its advisers have learned about the target in real time. Without receiving some comfort in the engagement letter that they will only be liable for their final deliverables, M&A advisers may not be as willing to provide potential buyers with provisional reports.

Limitations on Liability

Engagement letters contain a number of provisions that specify the circumstances under which advisers may be taken to court and restrict the amount for which they may be sued. In New York, a court will not infer that an adviser’s liability has been limited unless clearly and unambiguously expressed in the engagement letter. Except for certain exclusions held to be against public policy, however, New York courts will uphold liability limitations in contracts between sophisticated commercial parties.

There are several mechanisms an M&A adviser may use to limit its liability:

Causation Requirement. Advisers often seek to restrict their liability to losses that are “finally judicially determined to have resulted primarily from” a misstatement or omission. The purpose of this clause is to fix the adviser’s liability to losses directly attributable to errors in its final report. Unfortunately, the phrase “resulted primarily” has no settled sense and raises the specter of Jarndyce and Jarndyce in future litigation. A better drafting choice for a potential buyer is to make the adviser liable for all losses “directly arising from or related to” the firm’s reliance on the adviser’s final due diligence report.

Restriction on Damages. Engagement letters generally exclude liability for any “indirect or consequential damages.” Consequential damages are losses that do not arise directly or immediately from a contractual breach, but indirectly result from the breach. They can include such claims as loss of revenue and may be recovered if a court concludes that the indirect losses were foreseeable. This provision is often heavily negotiated. Private equity firms argue it’s foreseeable that they may suffer indirect damages as a result of misstatements or omissions in an adviser’s report. Advisers in turn contend that the ultimate investment decision lies with the firm and their risk in the engagement should be commensurate with their fees. In the end, these discussions become relatively less important compared with negotiations over the adviser’s liability cap.

Cap on Liability. One of the most important provisions in an engagement letter deals with the amount for which an adviser may be held liable. Advisers will typically seek to put a ceiling on their exposure by capping their liability at a fixed amount, at the amount of fees they receive under the engagement, or at some multiple of their fees. The amount of an adviser’s liability cap ultimately turns on a number of deal-specific factors, including the deal’s size and complexity, the importance of an adviser’s findings in the negotiation of essential deal terms, such as price, and the adviser’s transaction fee.

Definition of Misconduct. The adviser will generally include a provision stating that it will only be liable for losses resulting from its “gross negligence or willful misconduct.” In New York, courts have described gross negligence as acts or omissions that exhibit a reckless indifference to the rights of others or “smack of intentional wrongdoing.” Though not precisely defined by the courts, gross negligence can be thought of as unintentional acts so careless that they ignore the rights of others or appear as though they were intentionally designed to do so. Willful misconduct occurs when a person commits an intentional act with knowledge that the act is likely to result in injury or damage or otherwise exhibits a reckless disregard for its consequences. Advisers’ acceptance of liability for gross negligence and willful misconduct comports with New York common law. New York courts have refused to enforce contractual provisions precluding liability for willful misconduct or grossly negligent acts, finding them to be against public policy.

Growing the Company through Strategic Acquisitions

Earnouts in Today's M&A Market: Bridging the Valuation Gap or Exploiting the Negotiation Gap?

Geoffrey Parnass — Thu, 13 Aug 2009 19:45:58 -0500

Are earnouts in today’s M&A market still primarily serving to bridge the valuation gap between buyers and sellers? Or do we need a different explanation for the prevalence of earnouts in recent, large M&A deals? Buyers and sellers are negotiating in what is arguably the most uncertain economic climate of the past decade. Whereas in the past, the caricature of a cautious, risk averse buyer bargaining with an optimistic seller may have served as a useful – if crude – illustration of the buyer-seller valuation gap, it’s unlikely there are many Panglossian sellers out in today’s market. What is more, the idea that the valuation gap arises from a buyer’s superior knowledge about market and industry conditions doesn’t seem as plausible when applied to large deals between sophisticated players.

Earnouts have been a common term in acquisition agreements for high-growth businesses and small companies. By making part of the purchase price contingent on a target’s ability to meet future earnings targets or reach designated milestones, a buyer can reduce its exposure to the risk that the target doesn’t fulfill the seller’s rosy predictions. At the same time, a buyer can promise to reward the seller if the target’s post-sale performance equals the seller's projections of its pre-sale prospects. An earnout, the theory goes, enables wary buyers and eager sellers to bridge the gap between their respective valuations of the target’s future profitability.

What accounts for this disparity in valuations? Professor Brian Quinn quotes the abstract of a recent paper by Roberto Ragozzino and Jeffrey Reuer concluding that the use of earnouts “increases with information asymmetries surrounding mergers and acquisitions.” In their article, the authors argue that earnouts appear more often in acquisitions where the target is a new company or for other reasons doesn’t have access to the buyer’s superior market and industry knowledge. For acquisitions of small, private companies by buyout firms and strategic buyers like public corporations, Ragozzino’s and Reuer’s empirical findings make sense. But for this M&A season’s rash of earnouts, especially those appearing in large transactions, we may need to abandon our reliance on the explanatory power of a presumed valuation gap.

The cost of capital for buyout firms and other acquirers has risen considerably. On top of that, buyers are operating with an informational deficit. Even if they feel they may have a strong grasp of a target’s industry and confidence in its business model, the outlook for the general economy over the next 12 to 18 months is foggy at best. More important, unlike the M&A boom period of a few years ago, buyers do not have to push past as many elbows to bring a potential seller to the bargaining table. Buyers, that is, appear to have a negotiating advantage in today’s market. Earnouts help buyers negotiating with poor information under current economic conditions in two ways. First, it allows them to limit their financial exposure to new investments in the event the economy doesn’t revive in the short- to mid-term. Second, it allows them to defer a significant portion of the purchase price to a time when the cost of capital should be cheaper.

It’s true that earnouts in private equity deals have always served as a risk management tool. Yet, in the past earnouts generally served to protect buyers from a target’s failure to compete successfully in its industry, not from a continued or worsening recession. Now, however, private equity firms and other buyers are not merely hedging against business and industry-specific variables. They’re signing up for a broader insurance policy against future market conditions. The prevalence of earnouts in today’s market cannot be entirely attributable to a valuation gap; it would be wise to take a close look at the negotiation gap as well.

Related Posts:

Valuation of a Private Company

Growing the Company through Strategic Acquisitions

Pharma Contractual Dispute: Biogen and Elan to See Each Other in Court

Geoffrey Parnass — Mon, 10 Aug 2009 22:45:18 -0500

A billion dollar drug. A change of control. A collaboration agreement. And Johnson & Johnson. Sound familiar? No, we’re not talking about the Schering-Plough and J&J dispute over whether the Merck-Schering merger violates the Remicade distribution agreement. This time, Johnson & Johnson may have gone into the breach, rather than having alleged it. The case involves Massachusetts-based Biogen Idec, the Irish drug company Elan Pharma, the multiple sclerosis drug Tsyabri, and around a billion dollars in annual revenue. The question is whether Johnson & Johnson’s purchase of a minority interest in Elan violates Biogen’s and Elan’s agreement to jointly develop and market Tsyabri.

In July, a Johnson & Johnson subsidiary entered into a set of financing and cooperation agreements with Elan worth around $1.5 billion. The agreements (which are not publicly available) would give J&J a 14.8% stake in Elan along with the option to finance Elan’s purchase of Biogen’s 50% interest in the multiple sclerosis drug Tsyabri. Under the terms of a development and marketing collaboration agreement signed by Biogen and Elan in 2000, if one of the parties to the agreement is acquired by a third-party, then the other party has the option to purchase the acquired party’s rights to Tsyabri. So why has Elan offered Johnson & Johnson this option to finance a purchase that may not ever happen?

Elan, it seems, has been keeping a watchful eye on Biogen’s shareholders. Back in June, Carl Icahn – who has a 5.6% stake in Biogen – succeeded in getting two of his four nominees on Biogen’s board of directors. Icahn’s victory came after a fierce proxy battle waged over the course of six months. Although Icahn’s broader platform, which included moving the company’s state of incorporation to North Dakota, did not receive support from the board, there are no signs that the activist shareholder plans on relenting any time soon. On the contrary, Icahn has indicated that he intends to promote a sale of the company. By cozying up to Johnson & Johnson, Elan can ensure it has quick access to capital should Biogen suffer a change of control.

Biogen was clearly troubled by the prospect of a big pharma player getting too close to its Tsyabri partner. If Biogen were to lose its rights to Tsyabri under the collaboration agreement’s change of control provision, the company’s value would sink. In what can only be a signal that communication channels between Biogen and Elan have broken down, Biogen sent off a July 28 letter to Elan alleging that the Elan-J&J partnership would materially breach the collaboration agreement. Specifically, Biogen claims that Johnson & Johnson’s option to finance a change of control purchase by Elan violates the collaboration agreement’s prohibition that neither party may assign or delegate any of its rights or obligations under the agreement without the written consent of the other party. Under the agreement, a material breach would initiate a 60-day cure period, at the end of which Biogen could terminate the collaboration agreement and take over Elan’s rights to Tsyabri.

On August 6, Elan responded by filing a complaint in a Manhattan federal court seeking a preliminary injunction staying the 60-day period and a ruling that Elan’s and Johnson & Johnson’s arrangement does not breach the Tsyabri collaboration agreement. A federal judge in Manhattan has set a hearing for August 31.

Without being able to review the Elan-Johnson & Johnson agreements, it’s difficult to assess whether or not their terms violate the Tsyabri collaboration agreement. From Elan’s own description of the agreements, however, we can presume with reasonable confidence that the issue will boil down to whether Johnson & Johnson’s option to finance an Elan change of control purchase of Biogen’s Tsyabri stake is equivalent to an assignment or delegation of Elan’s rights under the collaboration agreement. After reviewing the Tsyabri collaboration agreement, it doesn’t seem that the Elan-J&J deal violates the no assignment provision.

Of course, we’ll be able to hear the opinion of a federal judge on the matter shortly.

Update: Elan Loses to Biogen in Court for Assigning Tysabri Obligations to Johnson & Johnson

Can Merck-Schering's Deal Structure Avert a Change of Control?

Reviewing a Confidentiality Agreement: What a Potential Buyer Wants

Geoffrey Parnass — Thu, 06 Aug 2009 21:38:15 -0500

Yet another draft confidentiality agreement sitting in your Inbox? Private equity firms, investors, and businesses looking for growth opportunities always seem to be signing a new non-disclosure agreement with another potential business seller. Many times, a seller’s first draft of the agreement will be aggressively one-sided. What sorts of issues does a potential buyer care about in a confidentiality agreement? In today’s post, we’ll highlight some of the terms buyers typically negotiate when marking up a confidentiality agreement received from a potential seller. While some of the discussion focuses on the special situation of private equity firms, much of it applies to any confidentiality agreement related to the purchase or sale of a company. (If you’d prefer to follow the discussion below with a first draft of a non-disclosure agreement in front of you, click here.)

Definition of “Confidential Information.” The definition of “confidential information” generally comprises all oral and written information furnished to the buyer as well as any derivative products, such as the buyer’s analyses of the seller’s underlying financial statements. There are, however, several customary exceptions to the definition of confidential information that may be absent from a seller’s first draft. A buyer will generally seek to have the following types of information deemed non-confidential: information that (1) comes into the public domain (other than due to a breach by the buyer), (2) the buyer can demonstrate was already in its possession prior to the seller’s disclosure, (3) is given to the buyer by a third-party that is not itself bound by a duty to keep the seller’s information secret, or (4) is developed by the buyer independently, without any use of the information supplied by the seller.

Return of Confidential Information. Most sellers require a potential buyer to return all confidential information if negotiations end without a deal. Buyers in turn often ask that they at least be given the option to destroy the information and usually agree to a seller’s request that the destruction be certified in writing by the buyer. In a time when data rooms are often online and vendor due diligence reports are distributed by email, the physical return of confidential information may be impracticable.

Permitted Disclosures. If the buyer is going to share confidential information with its financial, accounting, legal, or other advisers, the buyer will identify them in the agreement’s definition of permitted recipients. Of course, distributing confidential information to people not directly under the buyer’s control creates additional risks, but the buyer’s exposure can be diminished by taking some additional precautions.

Limit Liability for Third-Party Breaches. If the buyer’s advisers have been included among the permitted recipients, then the buyer usually takes measures to limit its liability for any non-permissible disclosures by its advisers. For example, a buyer may insert language stating that the buyer will not be held liable for the disclosure of confidential information by any adviser that signs a non-disclosure agreement directly with the seller. The buyer may try to persuade the seller that the advisers are best positioned to police their respective employees’ use of the confidential information. Moreover, if advisers are contractually bound to the seller to keep the information private, they may have a greater incentive to abide by the agreement’s terms. Alternatively, a buyer may sign “back-to-back” confidentiality agreements with each of its advisers. These back-to-back agreements substantially reflect the terms and conditions of the buyer’s underlying confidentiality agreement with the seller. In the event that the buyer is sued by the seller because of a disclosure by one of the buyer’s advisers, the buyer will have a contractual cause of action against the breaching adviser.

Establishing Breach and Liability for Damages. A confidentiality agreement typically makes the buyer liable for any claims or losses resulting from the buyer’s disclosure of confidential information. It is therefore in the interest of the buyer to limit the types of losses for which it can be held liable. A buyer usually negotiates to eliminate all consequential damages (that is, damages suffered by the seller but only indirectly caused by the buyer’s breach), such as lost profits, from its liability. Another concern of the buyer is how the parties will determine whether a breach causing damage to the seller has occurred. To protect its right to appeal a lower court’s ruling, a buyer may want to include a stipulation that a breach by the buyer must be “established by a final, non-appealable order issued by a court of competent jurisdiction.” This provision can save the buyer from the unlikely – but infuriating – situation in which it has already been forced to pay damages to the seller, even though an appellate court later rules in its favor.

Sunset Clause. It may come as a surprise, but many first drafts of confidentiality agreements don’t include a sunset clause specifying when the buyer’s obligations under the agreement end. Given that if the deal doesn’t go through all written and electronic information will be destroyed, a reasonable term ranges from 1 to 3 years.

Non-Solicitation of Employees. When certain key employees are essential to a seller’s business, the confidentiality agreement may include clauses prohibiting the buyer from soliciting or employing the seller’s employees. Buyers generally tailor their comments on this section to fit their specific needs. If the buyer is a company trying to grow its business by acquiring a competitor, for example, considerable care is taken to ensure the non-solicitation and non-employment provisions don’t unduly interfere with the buyer’s efforts to recruit top talent. If, on the other hand, the buyer is a private equity firm investigating a new business, then the firm generally seeks more limited exceptions. Customarily, the non-employment provision does not apply to any job offer that results from a general advertisement (such as in a newspaper or on the Internet) or occurs after a person has left the seller’s employ (without encouragement from the buyer) and a specified period of time has elapsed.

No Additional Obligations. In order to emphasize the limited nature of the buyer’s and seller’s respective obligations under the confidentiality agreement, a potential buyer often inserts a clause emphasizing that until the buyer and seller have executed a definitive agreement regarding the acquisition, the buyer doesn’t have any obligation to the seller regarding the transaction.

Novation to Acquisition Vehicle. When the potential buyer is a private equity fund, more often than not an advisory entity associated with the fund, rather than the fund itself, signs the confidentiality agreement with the seller. If the deal closes successfully, it’s in the interest of the advisory entity to be released from its obligations under the confidentiality agreement. For this reason, private equity firms try to include a novation clause under which the advisory arm will be released, and the fund’s acquisition vehicle will assume, all of the buyer’s obligations under the confidentiality agreement upon the transaction’s closing.

Increased Capital Calls and Diminished Distributions for Private Equity LPs

Geoffrey Parnass — Mon, 03 Aug 2009 21:17:56 -0500

Returns for private equity investors suffered their worst decline on record in 2008, according to a study issued by London-based research firm Preqin. Limited partners ended up paying more money into buyout funds than they took out. The Financial Times reported that general partners made $148 billion in capital calls from limited partners, but only distributed $63 billion in returns. Concerned about their ability to meet future capital calls in the face of diminished expectations for distributions, institutional investors appear wary of increasing their exposure to private equity.

Hampered by the decline in markets, private equity general partners continue to scramble to find profitable exits. A recent Dealogic analysis reviewed by The New York Times reveals that exits from portfolio company investments by private equity funds generated only $20.8 billion in the first half of 2009, down from $115 billion in the first half of 2008. General partners have also achieved little success in finding attractive acquisition targets. Even when private equity firms have identified valuable buyout opportunities, tight credit markets have hindered them from financing the deals. CNNMoney.com writes that only three loans were given to leveraged buyout funds in the first half of 2009. Lenders’ reluctance to finance leveraged buyouts have forced private equity GPs to adjust their deal structures, relying more heavily on equity investments (and corresponding capital calls from their LPs). Apax Partners LLP, for example, recently bought the personal financial information provider Bankrate, Inc. for around $571 million in cash.

An increase in capital calls, decrease in distributions, and the scarcity of debt financing for deals have made it difficult for firms to raise financing for new funds. The Dow Jones Private Equity Analyst found that during the first half of 2009 general partners only raised 50% of the capital that they raised during the first half of last year. For those investors that have decided to commit to new funds, however, at least one study suggests that limited partners increasingly have been able to negotiate more investor-friendly terms in the funds’ limited partnership agreements. Last year’s large discrepancy between the amount of capital calls and distributions seems to have emboldened institutional investors to seek greater contractual rights and better financial terms from general partners.

Evidence from a research report issued by Preqin in July suggests that limited partners have successfully negotiated more favorable terms in fund partnership documents in at least some cases. Preqin discovered that there has been a reduction in the average management fee demanded by general partners to 1.8% (compared to an average of 2% which had held steady for the past several years). Limited partners have also been able to win some concessions on restrictive covenants. Preqin indicates that there has been an increased prevalence of both “key-man” and “no-fault divorce” clauses in limited partnership agreements.

A key-many provision allows limited partners to suspend their obligations to make further capital contributions for new investments if certain key personnel at the general partner leave the fund or otherwise neglect to spend sufficient time and effort managing the fund’s investments. (When Steven Rattner left the Quadrangle Group in February to head Obama’s auto industry task force, his departure triggered a key-man clause in a fund’s limited partnership agreement.) No-fault divorce clauses permit a specified majority (often 75%) of a fund’s limited partners to vote to suspend their obligations to make capital calls, remove the general partner, or even terminate the partnership, if they determine that the general partner is no longer acting in the interests of the fund.

Although there is a growing secondary market for private equity fund interests, private equity as an asset class remains more or less illiquid. Limited partnership agreements typically bind investors to a 10-year commitment, often with an option to extend their commitment for up to 3 years until all portfolio investments have been exited. Moreover, investments in private equity funds take between two to seven years to generate returns for their limited partners. While it’s likely that institutional investors are leveraging what they see as an increase in negotiating power to extract concessions from general partners, it’s also possible that investors are reassessing the risks that buyout funds pose for them as an asset class. After a year of continual capital calls from general partners, institutional investors may have a renewed appreciation for contractual mechanisms that permit them to halt capital calls – and thus stanch the bleeding – during tough economic times.