Friday Letter Why PE managers like MACS

Private equity managers can strategically execute “Material Adverse Change” clauses to renegotiate deals in their favour –though doing so brings significant reputational risk.  

The management team at US hotel chain Innkeepers knows far too well that a business deal agreed is not a deal completed.

Last week we reported New York-based private equity firm Cerberus Capital Management and Chatham Lodging Trust terminated a $1.1 billion agreement to acquire stakes in scores of hotels owned by Innkeepers USA Trust. The two buyers cited a material adverse effect (MAE) clause in the acquisition agreement as justification for the move.

Many press reports (including our own) rightfully drew parallels between the news and the still recent credit collapse. Between a tumultuous 2007 to 2009 period a number of large buyout deals were abandoned using MAE or material adverse change (MAC) clauses – some of the more notable included dropped plans to acquire Harman International Industries, HD Supply and Sallie Mae, among others.

Today as markets fluctuate in response to fears of a double-dip recession more investment managers may exercise MAC provisions as a way out of an agreement struck under more stable economic conditions. The private equity industry knows this best.

Unlike trade buyers, buyout firms can generally negotiate a walkaway right from a deal at a cost usually no more than three percent of the deal price– commonly known as a “reverse termination fee.” In contrast, a trade buyer is usually on the hook for the full acquisition price. If the trade buyer attempts to terminate a deal because of the target's MAC and the target takes the matter to court, the liability risks are significant.

Even better for GPs is the use of MAC clauses as a negotiating tool. In a worst case scenario the GP pays the reverse termination fee and moves on to the next deal. In the best case scenario a target lowers its acquisition price in the hopes of preserving the deal and its relationship with the private equity bidder.

The latter scenario is more likely as sellers often undergo significant changes in anticipation of a buyout, making their stakes in the successful execution of an acquisition higher. And neither party is necessarily eager to fight its case in court where case law on the use of MAC clauses remains uncertain (however the burden will be high on the party exercising the MAC), points out Douglas Getter of Dechert.

A cynic may then have answers as to why Cerberus expressed an interest in still purchasing Innkeepers hotels just days after pulling out of its initial bid. Innkeepers said it was pursuing its legal options, arguing during its restructuring process it has maintained normal business operations despite recent volatility in the global markets.

However it would be wrong for GPs to read much into the Cerberus deal when it comes to their own MAC options. Unusually Innkeepers did not negotiate any carve-outs in its agreed MAE clause. Most sellers insist on exemptions to the use of a MAE or MAC to provide certainty in the clause’s applicability. These often include an exception for an overall decline in the economy outside of the seller’s control.

More broadly using a MAC provision too often is a reputational risk for firms. Sellers may think twice about doing business with a GP known for pulling the trigger on a MAC provision at the first sign of market trouble.

Should market volatility continue, it is safe to expect MAC provisions will become more fiercely negotiated between GPs and targets. Consistently using a MAC clause as a negotiating tool is not an easy way to kick off negotiation discussions in your next deal.