The TXU energy deal looks destined to become the biggest buyout ever. But the deal already may have set a record for the largest reverse break-up fee ever agreed to—an eye-popping $1 billion.
In just the last two years, reverse break-up fees have become a common feature of going-privates and other large LBO transactions, a sign of the growing power of sellers. Buyout firms agree to have their funds pay these fees if forced to walk away from an agreed-to transaction for pre-set reasons. By far the most common reason is for failure to line up debt financing. That’s the case with the TXU reverse break-up fee. A less common reason is for failing to secure regulatory approval for a deal.
Just about all sponsored going-privates above $5 billion in transaction value from Oct. 1 2005 through year-end 2006 featured a reverse break-up fee provision, according to a recent survey by law firm Weil, Gotshal & Manges. The same survey found the provision present in three quarters (74 percent) of sponsored going-privates valued at $1 billion to $5 billion, and 63 percent of such transactions valued at $500 million to $1 billion. By custom, the reverse break-up fee tends to be the same size as the deal’s break-up fee (a fee paid by the seller to a rejected suitor under certain conditions). Break-up fees usually run between 2 percent to 3 percent of a target company’s equity value.
Needless to say, that ends up being a big number given the tidy sums that buyout firms are agreeing to pay for companies. Late last year, Apollo Management and Texas Pacific Group signed on to a two-tiered reverse break-up fee when they agreed to pay $15.1 billion for the equity of Harrah’s Entertainment, according to a source. They would pay $500 million to Harrah’s for walking away over failing to secure financing, and $250 million for failing to get approval of the deal by regulatory boards.
So where did reverse break-up fees come from, exactly? The year 2005, which saw the take-privates of Sunguard Data Systems Inc. and Nieman Marcus Group Inc., turned out to be a watershed. Before that, buyout firms typically negotiated financial contingencies into their take-private agreements. Under these provisions, buyers walked away scot-free if they weren’t able to arrange debt financing.
Financing contingencies remain a common feature in the leveraged buyouts of small and mid-sized private companies. But directors of publicly traded companies wince at the prospect of having a potentially disruptive sale process announced only to see it fall apart. And by 2005, their bargaining power was strong enough to compel many suitors to dispense with the financing contingencies. Doing so exposed potential buyers to huge liabilities, since in the event of a broken deal the seller could sue over breach of contract and claim damages. As a result, buyers negotiated the reverse break-up fees into their agreements as a way to cap their liabilities.
And who is on the hook for the reverse transaction fees? The limited partnerships managed by the buyout firms, which essentially means limited partners.
Now all that said, it’s hard to imagine a scenario in which buyout firms would willingly walk away from a large take-private. A reputation for doing so would be the kiss of death. But last week’s stock market volatility sent a chilling reminder to the buyout market that lenders haven’t always been there for them—especially when equity markets are in flux. No one has ever had to pay a reverse break-up fee, said one attorney. But, he added, “it will be interesting to see LP reaction if and when it does happen.”
For more on reverse break-up fees, contact Paul Kingsley, partner at Davis Polk & Wardwell, at 212-450-4277.
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