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.