Recent lawsuits have caused banks to demand stricter closing conditions for private equity deals, and so firms need to rethink the promises they make to acquisition targets to avoid being stuck closing a deal even if the financing falls apart.
Increasingly, specific closing conditions could also increase a private equity sponsor's legal liability if a deal fails to close because lenders decide not to provide debt.
Credit Suisse's and Deutsche Bank's $1.7 billion settlement with chemical manufacturer Huntsman is just the latest court case to exacerbate banks' hesitancy to finance private equity buyouts. In that case, the banks tried to pull out of funding Huntsman's merger with Apollo-backed Hexion because they said the combined companies would be insolvent. A judge disagreed.
According to Dechert partner Mark Thierfelder, the settlement will likely continue the trend over the last 18 months of lenders looking for “increasingly specific outs to their financing commitments”.
If a bank wants out of a deal, it will want to be able to point to specific, unambiguous conditions that haven't been met, to give acquisition targets little grounds for legal action. For example, a debt financing agreement in 2007 might have included a minimum closing leverage ratio. But now, such a covenant might not be seen as secure enough, because the sponsor could theoretically raise its equity investment to influence the ratio if the target's EBITDA declines. Instead, a bank might simply stipulate a minimum EBITDA level.
As debt financing agreements are subjected to more closing conditions and therefore become less absolute, private equity sponsors will want to rethink their own agreements with acquisition targets, so they aren't left with no financing and an obligation to complete a deal.
“Pressure will increase in the contract negotiation between the sponsor and the target,” Thierfelder says. “The question will continue to be whether, and to what extent, the target or the sponsor bears the risk of whatever conditionality exists in the financing commitments.”
The Huntsman lawsuit should make private equity firms take notice because suits against underwriters can have ripple effects on the private equity sponsors as well: banks typically want private equity sponsors to indemnify them against losses they suffer arising out of the transaction, except when the bank itself was grossly negligent, acted in bad faith, or had willful misconduct. This means in many cases, a suit against the banks financing a private equity deal could implicate the private equity firm as well.
The past 18 months have shown just how litigious acquisition targets can be – private equity firms will need to draft contracts with the utmost care in the future to stay out of court.