The majority of private equity transactions are structured with a deferred closing, i.e. the parties will sign the relevant transaction documents on a specific date then consummate (“close”) the transaction by paying the purchase price and transferring the asset at some later date.1 The reason for this is simple: a private equity transaction will require the parties to obtain—without limitation—third party financing, various regulatory approvals, third party consents, and corporate governance approvals.
As such, the transaction documents will include two critical sets of contractual terms: closing conditions (also known as “conditions precedent”), and pre-closing covenants. This post will focus on the former, with the latter to be discussed in a subsequent post. The pre-closing covenants limit what the seller(s)—and to a lesser extent, the purchaser(s)—can do before the closing, while the conditions precedent provides the party to whom such condition is owed the right to refuse to close the transaction, notwithstanding the fact that it has signed the transaction agreements.
I will start by defining a condition precedent under Anglo-American contract law. A condition precedent is an event, the occurrence of which must take place before a party to the contract is required to perform its obligations under the contract. In an acquisition agreement, conditions precedent will be owed—at minimum—by the purchaser(s) to the seller(s), and by the seller(s) to the purchaser(s). In more complex acquisitions, other parties may also have conditions precedent that must be satisfied before the acquisition will close.
A simple example of a condition precedent that might be found in a private equity acquisition agreement is:
All Encumbrances relating to any credit facility agreement granted by Stark Industries, Inc., including without limitation, charges over certain fixed assets, shall have been irrevocably discharged, and the necessary regulatory filings in connection with such discharge shall have been completed.
In simpler language, this condition precedent requires the seller(s) to ensure that at the time of the closing the security interests granted to Stark Industries, Inc. have been cancelled, thus ensuring that the purchaser(s) have the assets free and clear of any third party claims. If the seller(s) have not managed to do so at the time for closing, the purchaser(s) will have the right—at its discretion—to refuse to proceed with the transaction.
Common Conditions Precedent
While conditions precedent are as a rule “bespoke”, there are some common conditions precedent that are almost inevitably included in the acquisition agreement:
- The parties have obtained the necessary regulatory approvals for the transaction, including anti-trust2 approvals
- The parties have delivered to each other the requisite board and stockholder consents authorizing the transaction
- The parties have obtained the necessary third party consents (e.g. customers and lenders) for the transaction
- The parties have delivered the requisite legal opinions in connection with the transaction
- The parties have delivered all ancillary documentation necessary to effect the transaction
- The purchaser(s) have delivered evidence that the purchase price (stock or cash) has been paid
- The seller(s) have delivered evidence of the release of any security interests or liens over the assets of the target
In principle, the conditions precedent to closing are designed to limit the risk that the purchaser(s) will be required to consummate the transaction without being able to obtain the full benefit of the transaction. For example, if the parties cannot obtain anti-trust approval, the purchaser(s) would not be able to acquire the target, and the purpose of the transaction would fail. Similarly, if a key customer has a change of control clause in its contracts with the target, the purchaser(s) will require the seller(s) and the target to obtain consent for the acquisition prior to consummating the transaction, lest that key customer choose to terminate the contract after the transaction.
While most sophisticated seller(s) and purchaser(s) will not quibble much over the inclusion of these conditions precedent, the devil, as in most aspects of acquisition agreement negotiations, is in the details. Expect substantial time and energy to be spent on getting to an agreement on such things as what regulatory approvals are conditions precedent, which third party consents must be obtained as a condition to the closing, and what ancillary documentation must be delivered.
Bring Down of Representation and Warranties
One condition precedent to closing that is typically found in most U.S. acquisition agreements is the “bring down” condition, which provides that the closing of the transaction is conditional on the representations and warranties given at the time the acquisition agreement was signed being true at the time of the closing.
The logic of this can be illustrated with a simple thought experiment. Let us assume that among the representations and warranties made by the seller(s) at the date the acquisition agreement is signed is a representation that a very valuable piece of equipment is in good condition in all material respects. At the date the agreement was signed, this was true. However, the day after the agreement was signed, a fire broke out and the equipment was irreparably damaged. However, because the representation was true at the date the agreement was signed, the fact that the representation is no longer true at closing does not give the purchaser(s) the right to refuse to close the transaction.
The solution to this problem is a “bring down” provision that states that the representations and warranties must be true at the date of the closing. In this case, the representation about the equipment is not true at closing, and thus the purchaser(s) may choose to refuse to close the transaction.
In general, there are three forms principal forms of bring down conditions in an acquisition agreement:
- An unqualified bring down: The representations and warranties are true and correct in all respects as of the closing date.
- A qualified bring down: The representations and warranties are true and correct in all material respects as of the closing date.
- A material adverse effect qualified bring down: The representations and warranties are true and correct in all respects, except to the extent that the failure of such representations and warranties to be true and correct would not reasonably be expected to cause a material adverse effect on the target.
One example of a bring down condition is set out below:
Subject to Section 7.1(b), each of the Sellers’ representations and warranties in this Agreement will have been accurate in all material respects as of the date of this Agreement and will be accurate in all material respects as of the Closing Date as if then made;
Each of the Sellers’ representations and warranties in Section 4.3(a) and 4.4, 4.5, 4.13, and 4.31, and each of the representations and warranties in this Agreement that contains an express materiality qualification, will have been accurate in all respects as of the date of this Agreement and will be accurate in all respects as of the Closing Date as if then made.
The sample bring down uses both qualified and unqualified bring down conditions for different categories of representations and warranties. This reflects the fact that some representations and warranties will be of such importance that any inaccuracy, no matter how small, should entitle the party to whom such representation or warranty was made to walk away from the transaction; while other representations and warranties need only be accurate in all material respects and are thus not nearly as important to the party to whom the representation or warranty was made. In my experience, this bifurcated approach to the representations and warranties is common in most bring down conditions, and in most representations and warranties, for that matter.
That being said, the bring down condition is often heavily negotiated, given that it allocates risks among the seller(s) and purchaser(s), and can permit a party to refuse to consummate the transaction. The end product is often a sign of where the respective parties stand in terms of bargaining power and the importance that the parties attach to various representations and warranties. For example, the seller(s) may attempt to limit the purchaser(s)’ ability to use this condition to situations where, in aggregate, the inaccuracies in the representations and warranties result in a material change in the value of the target.3 The purchaser(s), by contrast, will attempt to require the seller(s) to repeat the representations and warranties continuously from signing to closing, to enable the purchaser(s) to avail itself of the right to walk away from the transaction if there is a breach in between the signing and the closing.4
Material Adverse Change
The material adverse change condition allows a party—usually the purchaser(s)—to walk away from the transaction if there are material adverse changes affecting the target. Virtually all acquisition agreements will contain some form of material adverse change condition, although the precise terms of the material adverse change condition will be the product of extensive negotiations between the seller(s) and the purchaser(s).
A common definition of a “Material Adverse Change” is:
“Material Adverse Change” means, with respect to the Company and the Subsidiaries, taken as a whole, any change, event, or effect that, individually or in the aggregate, (a) has had, or is reasonably likely to have, a material adverse effect on the business, assets, financial condition, liabilities or results of operations of the Company and the Subsidiaries taken as a whole, or (b) materially impairs or delays the ability of the Company and the Subsidiaries to consummate the transactions contemplated by this Agreement; provided, however, that none of the following changes, events or effects shall be taken into account in determining whether there has been a “Material Adverse Change”: any change, event, or effect to the extent arising from or relating to (i) the United States or the global economy or financial, banking or securities markets in general (including any disruption thereof and any decline in the price of any security or any market index), (ii) natural disasters, acts of terrorism, sabotage, military action or war (whether or not declared) or the escalation thereof, (iii) the industry in which the Company operates generally, (iv) changes in applicable law, (v) the taking of any action expressly required to be taken pursuant to the terms and covenants set forth in this Agreement or taken at the written direction of the Purchaser, (vi) any failure to meet any internal or published projections or forecasts relating to the Company or its anticipated or projected results of operations for any period ending on or after the date of this Agreement (provided, that the underlying causes of any such failure may be considered in determining whether there is a Material Adverse Change), or (vii) any announcement or public knowledge regarding this Agreement.
The definition above fits into a common pattern of first defining what a material adverse change is (clauses (a) and (b)), and then enumerating specific exceptions to that definition (sub-clauses (i) to (vii)). One can write literally entire articles on just this one topic, which I will not be doing today. I will, in the interest of being at least somewhat thorough, make a few observations.
First, notice the phrase “taken as a whole”. This is a seller-friendly term as it implies that the material adverse change would have to be over the company and its subsidiaries. However, one can (and would, if one is the seller(s)) certainly argue that the buyer is acquiring the company and its subsidiaries, and that a material adverse change for one subsidiary might not qualify as a material adverse change for the entire group of companies being acquired.
Second, the seller(s) has excluded changes arising from a decline in the global or U.S. economy or financial markets, general changes in the industry in which the target operates, natural disasters, terrorism, acts of war. All of these exclusions have the effect of focusing the clause on only changes that are “endogenous” to the target rather than on changes that are “exogenous” to the target. On the whole, this is a fairly seller-friendly material adverse change clause.
Third, note that the purchaser(s) have not included any language to carve-out “disproportionate impact”, i.e. if any of sub-clauses (i) to (vii) had a disproportionate impact on the target compared to other participants in the same industry and/or markets. This is a purchaser-friendly term that purchaser(s)’ counsel should insist on, in order to permit the purchaser to rely on the material adverse change provision in some circumstances. This purchaser-friendly term has become increasingly common as purchaser(s) take steps to protect their interests.
Fourth, the Delaware case law on material adverse changes suggests that the Delaware courts would seldom find that a material adverse change clause has been triggered.5 One possible response to the reluctance of the courts to find that a material adverse change clause has been triggered is to tailor specific, objective criteria for the triggering of the clause. For example, setting an EBITDA target as a closing condition, such that if the target fails to meet that EBITDA target, the purchaser(s) can walk away from the transaction.6
For a brief look at some statistical data collected on material adverse change conditions, we can turn to the excellent survey by Nixon Peabody in 2015, which covered 355 transactions:
One aspect that I find interesting is the fact that so few transactions, even now, specify that a material adverse change will occur upon losses exceeding a certain threshold (or failure to meet other objective criteria). It strikes me as an area where counsel and investment professionals ought to work together to set such triggers, in order to protect the purchaser(s) in the event of changes in the conditions of the target.
From the 1990s to the 2008 financial crisis, one might find financial conditions in leveraged buyouts, which permitted the purchaser(s) to walk away from a transaction if the purchaser(s) were unable to secure debt financing for the transaction. During this period, seller(s) frequently agreed to such terms on the basis of a reasonable belief that the purchaser(s) would take all necessary steps to secure financing rather than suffer the reputational damage of failing to close a transaction.
Since the financial crisis, most acquisition agreements will not include any financing condition. Instead, the parties will negotiate for a reverse break-up fee that will be paid by the purchaser(s) to the seller(s) if the purchaser(s) are unable to secure financing and decide to walk away from the transaction. The reverse break-up fee will often be between 5 – 10% of the deal size, a number sufficiently high to incentivize the purchaser(s) to make reasonable efforts to secure the debt financing necessary to close the transaction. To secure the payment of the reverse break-up fee, seller(s) will often require the private equity sponsor to provide a guarantee for the reverse break-up fee, since the actual purchasing entity will often be a newly incorporated company with no assets.
Matching Closing Conditions in Credit Facility Agreements
It bears repeating, since it is one of the most important aspects of structuring a private equity transaction, that it is absolutely essential for the closing conditions in the acquisition agreement and the credit facility agreements to match. This ensures that the purchaser(s) is not put in the awkward position of having its debt financing fail to close, while being compelled to close (or pay the reverse break-up fee) under the terms of its acquisition agreement.