Merger Agreements

It all starts with that merger agreement. In this post I discuss the provisions of the agreement that occupy 80% of the space and are irrelevant 95% of the time: Those sections which address when a party has a right not to close.

In the overwhelming majority of deals and in the absence of a global financial crisis, the parties are enthusiastic about closing and these provisions are not relevant. But lawyers are paid to think about things that can go wrong.

To understand how lawyers can take what seems like a simple concept of a purchase of a company and turn it into a monstrous document, you need to understand a bit about how the sausage is made. Merger agreements are not drafted by a lawyer sitting down and dictating to a secretary. They are always based on a precedent transaction or melding several precedent transactions—and the opposing lawyer expands it with even more precedents which favor his side.

If you want to understand the dynamic involved, pull out your mortgage or your will, which you probably have not read carefully either. Their wordiness has three things in common with merger agreements: First, the basic language and structure are based on what similar documents looked like over a century ago. Second, every time a problem arises (for wills, think a secret illegitimate child and, for mortgages, think the fauxclosure scandal) lawyers want to address these contingencies with additional provisions. Third, over time there are more laws and regulations, adding still more provisions in response.

There are other elements that apply to mergers but probably not to your documents. First, when two parties negotiate a provision, the wording almost always gets longer, not shorter. Compromise tends to increase complexity. Second, when you are dealing with billions of dollars, no contingency or risk is too small to merit a section. And finally, word processing has replaced typewriters and carbon paper allowing unlimited rewrites and expansions, which lawyers love. As a result, drafting acquisition agreements is truly a growth industry, even if it is not true that lawyers are paid by the word.

Turning to the substance, there are four “Articles” in every merger agreement that define the rights of a party to avoid closing:

Conditions. The conditions article tends to be quite short– just two or three pages— and relatively straightforward. For example, regulatory requirements need to be satisfied. The representations and warranties (or “reps” as they are shorthanded and which I discuss below) need to be true in all material respects both at signing and closing. And most importantly, there cannot have been a “material adverse change” in the business.

The “MAC” clauses are heavily negotiated. Buyers are concerned by recent court cases making it relatively difficult to invoke these clauses. Sellers try to carve out certain events from the MAC clauses—for example the circumstances under which general industry or economic developments would not give the buyer a right to walk.

Unlike most of the wording of the provisions discussed in this post, this provision always involves input from the most senior lawyers, bankers and client executives. Finally, there can be conditions specific to a deal: for example, a private equity buyer planning to use significant borrowed funds may insist on a financing condition. Obviously a buyer resists this and I will discuss some of the implications of such a condition in my subsequent post.

Representations and Warranties. When you buy a private company, it can be a bit like buying a toaster. You get a series of reps which, if they turn out wrong (like a toaster not working), you can use to get your money back. In public deals, though, it is not realistic to offer the buyer a refund for breaches of the reps. Yet the parties still give reps. Their only function is to trigger the condition discussed above and blow up the deal.

Nevertheless, enormous amounts of time can go into negotiating the reps. For example, extended discussions can be had around whether a particular rep should be qualified by materiality—so that if it is just a little not true, it is not a breach. And similarly lengthy discussions can occur over whether a representation is given to a company’s “knowledge.” Ironically, these qualifications make little or no difference. Remember that the reps only have to be true “in all material respects” to require the other party to close regardless of individual qualifications. And “knowledge” is one of my favorites of the meaningless discussions: since the reps function as conditions and the reps need to true at closing, a buyer can give the seller knowledge by whispering in his ear at closing. So why do lawyers fight over these words in the reps? No one likes to give a flat statement and be wrong—even if it has no contractual consequences—so lawyers spend a lot of time helping their clients hedge the language.

Covenants. A merger agreement generally contains extensive covenants restricting how the business of the target is operated between signing and closing. To some extent this is the mirror image of the reps and warranties—reps and warranties discuss what has happened and covenants discuss what will happen. A breach of a covenant could produce a lawsuit, but once again the primary remedy for a material breach is usually a right to walk away.

Termination. The agreement can be terminated for a number of reasons: breach by the other party, failure to obtain required shareholder or regulatory approval, and if the conditions cannot be satisfied by a specified “drop dead” date. This article contains the right to terminate the deal if a better offer comes along—the so-called “fiduciary out”.

In most cases, would a buyer walk away from a major merger if the seller refuses to give a separate representation that there are no zoning issues at any of seller’s numerous properties or that all insurance is in place when there is no reason to believe these are critical subjects? Generally no. (After all, buyers always get reps on the accuracy of the public filings and the presentation of financial statements.) Some buyers have more leverage than others and get more of what they want. In many cases, though, the resolution of numerous minor disputes, laid out in thousands of words, is largely an arbitrary process. If anything, each side wants to feel it received a “fair” number of points against its negotiating partner. This, of course, encourages each side’s lawyers to raise lots of points.

Social Issues in M&A

It’s not only deal price that buyers and sellers tussle over. They also negotiate over who will be in charge at the new company, and other “social issues” such as the location of corporate headquarters, treatment of employee stock options, the makeup of the board of directors, maintenance of employee benefit plans after the closing and post-closing indemnities and insurance for target officers and directors.

Indeed, if you were cynical, you might think that sometimes the difference between a “merger of equals”—where neither side’s shareholders receives a premium—and an acquisition in which target shareholders receive a substantial premium, may turn on which individuals will be running the combined companies.  Merger of equal negotiations are more complex than this, but it certainly is a factor.

These social issues are sometimes spelled out in the agreement and in other cases there are more informal arrangements—which should be, and usually are, disclosed in the proxy statement.

There can be, of course, an inherent conflict on some of these issues. Frequently, independent board committees are formed specifically to resolve social issues. Social issues generally don’t involve large financial commitments relative to the size of the transaction. But if you put yourself in the place of the executive officers of a target company—even if they have generous golden parachutes—you can see why the social issues are critical in many deals

Reverse Termination Fees

What happens if a buyer can’t complete a transaction even though nothing has gone wrong at the company to be acquired? And how will management of the target company be treated following the deal?

Reverse Termination Fees. The name says it all: This is the opposite of the typical “breakup fee,” which is paid by a target company to the initial buyer if the target takes another offer.

In a reverse termination fee, it is the prospective buyers who fork over money when an acquisition doesn’t close, if it’s not the target company’s fault. This is a topic that did not come up in merger agreement negotiations until a few years ago, when private equity players started to become prominent buyers.

When a company like Pfizer agrees to buy King Pharmaceuticals for $3.6 billion in cash, there is no need for a reverse termination fee. Even if plans to borrow some money for the deal, Pfizer can easily afford the purchase price, there is no financing condition and the conditions to Pfizer’s obligations to close can be specified in the merger agreement along the lines of my prior post.  If Pfizer refuses to close the deal and the companies’ contract requires it to do so, King Pharmaceutical can run to the courts to force Pfizer to finish what it started.

In short, Pfizer’s entire balance sheet is behind the deal and there is no question that King Pharmaceutical could obtain a remedy if it needed one.

But when a private equity firm buys a public company, like KKR’s recent deal for Del Monte Foods or TPG and Leonard Green’s agreement to acquire J. Crew , it is a bit more complicated. That is because in every private equity acquisition, there is a “deal behind the deal”. The actual buyer is almost always a “shell”—or a company formed just for the purpose of the transaction.  (In the J. Crew deal, for example, the shell company is called “Chinos Acquisition Corp.”)

There is nothing dishonest or unusual about this: the PE sponsor will commit its equity to the deal, but that will not be enough to pay the entire purchase price; much of the money must be borrowed. For confidentiality reasons, and to avoid spending a ton of money on transaction costs for deals that go nowhere, most of the “deal behind the deal” is done after the public announcement of an acquisition.

PE firms don’t generally put their entire balance sheets behind a single acquisition. Frequently their agreements with PE investors don’t permit them to take that risk.

Surprises do happen. And even if there is is no formal financing condition, it is not so easy for the target to run to court to force a deal to close. If the bank financing is not completed and the purchaser is a shell, the PE sponsor might be perfectly willing to put up the equity, but this will not be enough to complete the transaction.

Initially, because of their similarity in structure to breakup fees, the reverse fees were frequently the same amount. But if a PE buyer is left at the altar, it generally pockets the breakup fee and moves on to the next deal with a profit. Targets fare much worse if a corporate marriage falls through. Employees expecting a takeover have moved on or are looking for new jobs.  And when a deal is announced, a target company’s shareholder base tilts literally overnight towards arbitrageurs, who tend to put tremendous pressure on a jilted target to accept a new deal.

What seems to have become standard now is a reverse termination fee that substantially larger than the breakup fee. In the KKR/Del Monte deal, for example, the reverse termination fee is two to four times the breakup fee—or 7% of the total purchase price.  In TPG/J. Crew the reverse termination fee is four to seven times the breakup fee—or again about 7% of the purchase price.

Seven percent of the purchase price may still not make a jilted target whole, but it certainly is a tidy sum of cash to nurse its wounds.

Anil Kumar’s cheap betrayal of McKinsey’s soul

On the front of the McKinsey & Co website is a link to a McKinsey Quarterly article titled Motivating People: Getting Beyond Money.

It is a good topic, for the biggest question about the involvement of Anil Kumar, a McKinsey director, in an insider trading ring allegedly headed by Raj Rajaratnam of the Galleon hedge fund, is why he put his own reputation – and that of the firm – at risk for $2.6m.

Mr Kumar has agreed to forfeit this money, which is said to have been paid to him in return for providing inside information on companies he gleaned through his work at McKinsey, and apologised in a New York court for the “shame and embarassment” he caused his colleagues.

It is a shocking incident for McKinsey, like other blue chip advisory firms such as Goldman Sachs, depends on being trusted with its corporate clients with confidential information.

So far, McKinsey appears to have escaped lightly enough from the affair, although that would change if any other cases of its directors leaking information came to light.

But why on earth did one of McKinsey’s most senior employees break the rules so egregiously simply for material gain? Are McKinsey partners not paid enough as it is?

Perhaps not, is the answer. The annual distribution per partner at McKinsey has fallen from its peak as a result of the financial crisis and, although we do not know the figure since McKinsey is a private firm, is much less than the annual bonus of a senior investment banker.

The case of Mr Kumar shows that at least one McKinsey partner could be bribed for a fraction of what Wall Street’s elite earns.

What would Marvin Bower, the partner who built the modern McKinsey – and who passed on his stock to his partners at book value on his retirement rather than put it into debt – have thought?

Bower, dubbed “the soul of McKinsey”, would not have been impressed, it is safe to say. Rajat Gupta, a former McKinsey managing director, says of Bower:

“Convinced that behaviour and conduct are every bit as important as skills and expertise, Marvin sought to build the firm into an enduring, values-based institution.”

Among the five principles laid out on its website is:

“Keep our client information confidential. We don’t reveal sensitive information. We don’t promote our own good work. We focus on making our clients successful.”


No wonder Mr Kumar was so emotional in a New York court about what he did.

Ten reasons to work in private equity :)

Here is a list of 10 tongue-in-cheek reasons given by David Rubenstein, a co-founder of the Carlyle Group, for why private equity is still a great career.

Mr Rubenstein included his list in a recent presentation on the industry. The public controversy surrounding private equity has clearly not made him lose his sense of humour.

His reasons are:

1. There is no educational requirement – anyone can get into the business, no barrier to entry.

2. You don’t have to keep time sheets or fill out insurance reimbursement forms.

3. Lack of clear skills or a high IQ is not a handicap – it may be a plus.

4. You get to hire lawyers and economists, the people who were smarter than you in college.

5. Your ability to make charitable contributions will get you invited to much higher class parties (and get your children into higher class colleges).

6. Someone pays you 20 per cent (if not 25 per cent or more) of the profits on their money.

7. You will have every reason not to forget to negotiate a pre-nuptual agreement.

8. Private equity and hedge fund professionals live to 90 – no reported heart attacks.

9. There is no random steroid testing.

10. You can afford better grade assisted living arrangements.

New Social Investment Model

When entrepreneurs start a social venture, they are immediately in conflict: A social venture develops social connectedness, intellectual resources and skills, creative expression, personal health, a safer and cleaner environment.

But most equity investors measure their own success by financial returns, thus the social enterprise must also meet financial expectations. When setting course, social entrepreneurs may be immediately caught between a rock and a hard place.

Microfinance has emerged as a solution by providing debt, which changes the expectation of risk, thus of returns.  Microfinance manages risk through its small scale and other methods. Yet social enterprises, particularly in developed countries, often require an investment scale that microfinance can't address.

But a hybrid is possible.

An example of such hybridizing is what Marc Dangeard is building with the Entrepreneur Commons, which is explained on his blog as follows:

"A not-for-profit social network of entrepreneurs providing financing for early stage companies through debt guaranteed by a mutual guarantee fund. The financial risk is mitigated by the mutual guarantee fund. The risk on the 'management' side is mitigated by the social network: loans are by invitation only, so you will have to be approved by your peers to get in. ..."

Interestingly enough this hybrid model may also help angels and other investors improve their return on capital: Marc relays that a study of over 1,300 VC and PE firms worldwide shows that the returns they bring on average is 3% below the S&P 500 (after fees; 3% above, before fees). So market rates are actually competitive returns, and investors receive steady revenue stream of debt repayments for the lifetime of Entrepreneur Commons, instead of the feast-or-famine of funding rounds and exits.

So this model is an insightful way to solve the problems of
•    providing seed capital for social ventures that facilitates non-financial asset building
•    providing financially competitive market returns for investors
•    providing liquidity for investors. 

Do we really need more money??

Ask any entrepreneur, social or otherwise, and the answer is always an emphatic “yes”. 

We are all keen to get our hands on more capital, convinced this will solve all our problems.

We seek it everywhere and demand governments to “do more” for the sector. When Barack Obama recently requested $50 million for a Social Innovation Fund, I queried the amount, suggesting it was trivial. After all, in Britain the government has invested hundreds of millions of pounds into social enterprise and is currently considering at least another £300 million to support a Social Investment Wholesale Bank.

But the question arises—is all this government money a good thing? I challenge the notion and point out that the social business sector, especially in the UK, was in danger of being flooded by too much government funding.  Does this not crowd out private investment? Are the criteria for decision-making apolitical, or are they heavily influenced by partisan calculations or “cronyism”? In such times of burgeoning fiscal debt and individual hardship, is such government largesse appropriate?

There is a more fundamental question. Are we focusing too much attention on the supply of investment to the sector? Funds for investment can be organised quickly—overnight if you're Bill Gates. But to build a successful social venture can take at least 5 to 10 years. By focusing excessively on the investment side, are we not missing an opportunity to invest more into building great businesses?  Won’t this imbalance harm the earliest investors, who will realise poor financial returns as too much capital will be chasing too few good deals? Won’t the longer-term future of Impact Investment suffer as a consequence?

I understand the importance of bringing more capital into the sector. But we must ask ourselves what is the best use of incremental funding at this time—more investment or building more great social ventures? The companies need professional non-executives, sound financial control, well-conceived marketing and sales strategies, etc