Having discussed purchase price adjustments, representations and warranties, indemnities, and closing conditions, I now turn to the last of the main sections of an acquisition agreement, the covenants.
Whenever an acquisition is signed on one date and closed on another date, there will be a need for covenants to protect the purchaser(s) from certain acts that the seller(s) could do during the period from signing to closing, and vice versa.1
As a general rule, the covenants given by the seller(s) to the purchaser(s) will be more onerous than the covenants given by the purchaser(s) to the seller(s), since the seller(s) will retain control of the target company until the transaction closes.
A proper understanding of the covenants in an acquisition agreement requires a definition of a “covenant”, as understood in Anglo-American law. At its most fundamental level, a covenant is a solemn promise to do, or to refrain from doing, something. A covenant can be a positive covenant (a promise to do something),2 or a negative covenant (a promise to not do something).
An example of a positive covenant drawn from an acquisition agreement I worked on, providing that the target and the seller(s) would provide reasonable access to the premises and the records of the target and its subsidiaries:
The Company shall, and the Sellers and the Company shall cause the Subsidaries to, give reasonable access to the Purchaser and its accountants, counsel, financial advisors and other representatives, and to prospective lenders, placement agents and other Debt Financing Sources and each of their respective representatives, during normal business hours, upon reasonable advance written notice, throughout the period prior to the Closing, to the Company’s and the Subsidiaries’ respective properties and facilities, Contracts and records of the Company and the Subsidiaries as such Person may reasonably request.
An example of a negative covenant drawn from an acquisition agreement I worked on, providing that the target and the seller(s) will not enter into a transaction to sell the target to any third party:
The Company and the Sellers shall not, and shall not permit any of their respective officers, directors, employees, affiliates or representatives (including, without limitation, any of their respective investment bankers, attorneys, accountants, or other advisors) to, directly or indirectly, (i) solicit, initiate, support or encourage or take any other action to facilitate, any inquiries with respect to a potential or actual Alternative Transaction or the making of any proposal or offer that constitutes, or is reasonably likely to lead to, any Alternative Transaction; (ii) enter into, maintain or continue discussions or negotiate with any person or entity in furtherance of such inquiries or any Alternative Transaction; (iii) agree or allow the Company to agree or endorse or support any Alternative Transaction; or (iv) cause or allow the Company or any of its officers, directors, employees, affiliates or representatives to do any of the foregoing.
As an aside, covenants are practically ubiquitous in most financial contracts, particularly in leveraged loan agreements and bond indentures, which have extensive covenants that are designed to act as a “straitjacket” that reduces the risk that the borrower will take actions detrimental to the interest of the lenders. During 2009, immediately after the global financial crisis of 2008, I spent far too much time becoming fairly intimately aware of the details of these leveraged loan covenants, as Partners Group had private equity funds and mezzanine and senior debt funds.
Covenants in a private equity acquisition agreement range from almost boilerplate covenants inserted by attorneys as a matter of course, to bespoke covenants tailored for the transaction. I would note, however, that even boilerplate covenants can be negotiated, and the results of those negotiations can have real impact on the positions of the purchaser(s) and seller(s). I would never leave this entirely to counsel to address; there are too many things that could go wrong.
We can divide covenants in an acquisition agreement into two broad categories:
- Pre-closing covenants: Pre-closing covenants apply between the date the acquisition agreement is signed and the date the transaction closes. These covenants aim to preserve the value of the business the purchaser(s) are acquiring, ensure that the parties to the agreement make reasonable efforts to consummate the transaction, and prevent the seller(s) from shopping the target around after the acquisition agreement is signed.
- Post-closing covenants: Post-closing covenants apply after the transaction closes. These covenants aim to ensure that the purchaser(s) cooperate with the seller(s) to keep certain tax and business records (in case of tax or other regulatory audits), ensure that the purchaser(s) maintain directors & officers insurance for the outgoing directors and officers of the target company, prevent the seller(s) from competing with the target, prevent the seller(s) from soliciting employees of the target, and ensuring that the purchaser(s) or seller(s) do not use trademarks or trade names that were transferred to the purchaser(s) or retained by the seller(s).
Access to Information
The seller(s), the target company, and its subsidiaries will covenant to provide the purchaser(s) with access to the offices and premises of the target company and its subsidiaries, as well as access to the books and records of the target company and its subsidiaries.
While this is a boilerplate pre-closing covenant, the details of what is covered by the covenant to provide access to information will be negotiated in some detail. The purchaser(s) will want to ensure that it has all the necessary access to the offices and premises of the target company and its subsidiaries (if applicable) to conduct due diligence of the physical property, plant and equipment of the target and its subsidiaries. Moreover, the purchaser(s) will also want access to the books and records of the target company and its subsidiaries to conduct due diligence on the business they are acquiring. The purchaser(s) will not want to be overly restricted in their ability to conduct due diligence, and will resist limits on timing for their visits to the offices and premises and the subject matter they can inspect in the books and records of the company and its subsidiaries. The purchaser(s) will also resist having to give very advance notice of an intent to visit or inspect, to limit the ability of the target company to sweep issues under the rug.
The purchaser(s) will also need to ensure that their counsel, accountants, financial advisers, and potential sources of debt capital are also able to access information and visit the offices and premises of the company for the purpose of conducting due diligence.
For the seller(s) and the target company’s management, their objective will be to minimize the disruption to the business of the target. To do so, they will frequently limit visits to normal business hours, and require that the purchaser(s) take steps to avoid disrupting the normal business operations of the target and its subsidiaries. The seller(s) and the target company’s management will also seek to limit the persons that will have access to the offices, premises, books and records of the target and its subsidiaries, in order to manage the risk of confidential information relating to the target and its subsidiaries being disclosed to unauthorized parties.
One further issue that seller(s) and the target company’s management may take into account is the need to limit the number of people within the target company and its subsidiaries that know of the proposed transaction. As such, it may wish to require the purchaser(s) to direct all requests for access to a designated list of individuals with knowledge of the proposed transaction. For example:
[A]ll requests for such access will be directed to such Person or Persons at [FINANCIAL ADVISOR] as the Company may designate from time to time.
This allows the seller(s) and the target company’s management to control the flow of information to employees and third parties such as suppliers or customers, and will often be an issue of great importance to them during this period.
Conduct of Business
In my opinion, this is the most important pre-closing covenant in most private equity acquisition agreements. It normally consists of what I call a “general affirmative covenant” to operate the business normally, and a more detailed list of negative covenants that explicitly prohibit the seller(s), the target company and its subsidiaries from doing certain things without the consent of the purchaser(s).
The purchaser(s) will want the seller(s) and the target company’s management to operate the target company’s business normally, and preserve the business relationships, key employees, assets of the target company and its subsidiaries. This is covered by the general affirmative covenant to operate the business normally.
Furthermore, to prevent the seller(s) and target company management from siphoning away value from the company during the period between signing and closing, the purchaser(s) will seek to constrain them by imposing certain negative covenants. The list is transaction-specific, but could include (among others):
- Issuing any new equity interest in the target company or its subsidiaries, or repurchasing any equity interests in the target company or its subsidiaries
- Transferring any equity interest in the target company or its subsidiaries to any person other than the purchaser(s) or their designated acquisition vehicle
- Paying any dividends or repaying any shareholder loans
- Incurring any new indebtedness3
- Granting any security interest on the properties or assets of the target company or its subsidiaries
- Entering into any merger, acquisition, or consolidation with any other corporate entity other than in connection with the transaction
- Entering into any joint venture, strategic partnership, or other relationship with a third party other than in connection with the transaction
- Acquiring any assets or selling any assets of the target company or any subsidiary other than in the ordinary course of business
- Amending any of the constitutional documents of the target company or any subsidiary other than in accordance with the terms of the acquisition agreement
- Increasing the salary or compensation of any current or former director, officer, employee, or consultant of the company or any subsidiary, or pay any bonuses to any of the foregoing individuals
- Making any material changes to the business of the target company or any subsidiary
- Incurring capital expenditures above a specified threshold
- Entering into, amending, or terminating any material contract (as defined in the acquisition agreement)
As one can imagine, the conduct of business pre-closing covenant will be heavily negotiated between the purchaser(s), the seller(s), and the target company’s management. The purchaser(s) will seek to impose strict limits on the ability of the seller(s) to extract value from the target company between signing and closing, most commonly by repurchasing shares, paying a dividend, or repaying any outstanding shareholder loans. The purchaser(s) will also seek to prevent the seller(s) and the target company’s management from taking actions that materially change the assets and business of the target company, for example selling assets or operating businesses, incurring debt, making capital expenditures, or altering any material contracts or business relationships. Finally, the purchaser(s) will also wish to ensure that the target company’s management does not take the opportunity to extract value from the target by declaring any extraordinary bonuses, pay increases, and other cash or non-cash compensation.
For the seller(s) and the target company’s management, the goal will be to ensure that they can run the business of the target company with the least disruptions.
Regulatory Filings and Required Consents
These pre-closing covenants from purchaser(s) and seller(s) requires purchaser(s) and seller(s) respectively to take necessary steps to make required regulatory filings and obtain required governmental, shareholder, and third party consents to the transaction.
This can be of particular importance where a transaction has potential merger control (anti-trust) rammifications, is subject to foreign direct investment restrictions, or involves a highly regulated industry.
Assistance with Debt Financing
One of the most important pre-closing covenants that the purchaser(s) will require is a covenant from the seller(s) and the target company’s management to assist with the purchaser(s)’ efforts to secure debt financing for the transaction.4
During the period from the date of this Agreement to the earlier of the Closing and the termination of this Agreement in accordance with its terms, Seller and the Company shall use their reasonable best efforts to provide Purchaser with all cooperation, and shall use their respective reasonable best efforts to cause their respective Affiliates and Representatives to cooperate with Purchaser in connection with Purchaser’s arrangement of Debt Financing; provided, that nothing herein shall require such cooperation to the extent it would unreasonably interfere with the business or operations of the Company or any of its Subsidiaries.
The reality is that the purchaser(s) will need the cooperation of the target company’s management to facilitate the debt financing arrangements,5 for example by assisting with the preparation of offering memoranda for the debt financing, participating in road shows organized by the arranging banks to market the loans to prospective institutional investors and other banks, providing financial information required under the terms of the debt financing agreements, facilitating the taking of security over the assets of the target company as required by the lenders, and assisting the arranging banks to complete required know-your-customer and anti-money laundering checks.
I have sometimes seen drafts of the acquisition agreement prepared by seller(s)’ counsel that do not include this pre-closing covenant. Given that competent purchaser(s)’ counsel in any leveraged buyout transaction will always add this covenant if it isn’t already present,6 I find this little exclusion a waste of the parties’ time and energy.
Reasonable Best Efforts by Purchaser(s) to Consummate
The seller(s) will include a pre-closing covenant requiring the purchaser(s) to use reasonable best efforts to consummate the transaction. This will often be heavily negotiated by purchaser(s) to avoid inadvertently creating a binding obligation to complete the transaction and negating any rights to terminate the transaction that might be present in other parts of the acquisition agreement.
The purchaser(s) will often seek to amend this pre-closing covenant to provide flexibility to its obligation to consummate, in particular, with respect to securing debt financing or alternatives if the proposed debt financing fails to materialize.
The exclusivity provision is a crucial pre-closing covenant that constrains the seller(s) from negotiating with multiple parties for a sale of the target company.7 It takes over from the exclusivity that would have been negotiated in the letter of intent or term sheet, and covers the period from the signing of the acquisition agreement to the closing. For the most part, counsel should be able to handle this without much input from the investment professionals. If the seller(s) have any unusual structures or affiliates that might be able to negotiate a sale of the target, it would be a good idea to discuss this with counsel so that the exclusivity can be drafted to include them, but otherwise, leave this in the hands of competent counsel.
Non-solicit and non-compete
Non-solicit and non-compete covenants are post-closing covenants that constrain the ability of the seller(s) to solicit the employees of the target company and its subsidiaries or compete with the target company and its subsidiaries.
In most transactions, the purchaser(s) will be acquiring the target on the basis of assurances from the seller(s) that they will not simply set up a new company to compete with the target. To provide a contractual remedy against the seller(s) if they begin competing against the target after the transaction, the parties will enter into a non-compete covenant, specifying that for a specific period, the seller(s) will not—directly or indirectly—compete with the target.
If the seller(s) are private equity sponsor(s), this non-solicit and non-compete may need to explicitly include the private equity sponsor(s), since the seller(s) will often be a special purpose vehicle incorporated specifically for the transaction and will cease to operate after the sale of the target.
It may also need to be drafted carefully to avoid restricting the ability of the selling private equity sponsor to make future acquisitions in the same or related industry.
Directors and Officers Insurance
One crucial post-closing covenant that the seller(s) will seek is a covenant from the purchaser(s) to purchase and maintain directors & officers liability insurance covering the outgoing directors and officers for a period of time. This “tail” insurance coverage is of particular importance to the outgoing directors who will want to ensure that they are insured for any acts or omissions during the time they were directors of the company, at least until the expiration of the statute of limitations for corporate litigation.
Beyond the common covenants mentioned above, every acquisition agreement will have specific pre-closing and post-closing covenants tailored to fit the circumstances of the transaction.
Some examples of bespoke pre-closing and post-closing covenants that I have seen include:
- Requiring the target company’s management to consult regularly with the purchaser(s) in relation to a proposed bolt-on acquisition that was already in progress at the time the parties signed the acquisition agreement
- Requiring the target company’s management to take steps to bring the company’s China subsidiaries into compliance with local labor laws, including making good any shortfalls in social security, unemployment and other required contributions8
- Requiring the seller(s), the target company, and the purchaser(s) to cooperate to complete a required corporate restructuring in connection with the transaction
- Requiring the target company to terminate certain related party transactions prior to closing, for example, management service agreements with a selling private equity sponsor, or transactions with corporate entities owned or controlled by the target company’s management, founders, or their affiliates
With this post, I’ve concluded my survey of the key provisions in a private equity acquisition agreement. This survey just scratches the surface of an acquisition agreement—there are a lot of nuances that cannot be conveyed without writing what would be the equivalent of a small textbook.
While I may, if there is interest, discuss certain specialized acquisition agreement topics in the future, and will likely comment on new developments if they prove interesting, I believe this series stands on its own. It will at least assist the average private equity investment professional to better understand one of the key transaction documents in a private equity transaction.
Other Posts in the SPA Series
- Stock Purchase Agreement Series — Overview
- Stock Purchase Agreement Series — Purchase Price
- Stock Purchase Agreement Series — Representations and Warranties
- Stock Purchase Agreement Series — Indemnities
- Stock Purchase Agreement Series — Closing Conditions
- Stock Purchase Agreement Series — Covenants
- As a general rule, there will often be more covenants from the seller(s) to the purchaser(s) since there are a lot more things that determined seller(s) can do to extract value from the target company at the expense of the purchaser(s). ↑
- These are also referred to as affirmative covenants. ↑
- The parties will often negotiate this to exclude indebtedness incurred in the ordinary course of business, acquisition indebtedness incurred in connection with the transaction, or indebtedness in excess of a specified amount. I’ve seen all of the above in varying combinations in the private equity transactions I’ve worked on. ↑
- It goes without saying that this pre-closing covenant is applicable only to leveraged buyouts; growth capital transactions will not as a general rule incorporate leverage financing. ↑
- For most leveraged loans used in leveraged buyouts, the arranging banks will not hold all the leveraged loans on their balance sheets, but will instead place the majority of the leveraged loans with other banks and other institutional investors. Most leveraged loans will include flex provisions allowing the bank to alter the terms—including tenor and interest rates—to enable the leveraged loans to be sold. As such, the roadshows, offering memoranda, and other marketing documents can have a significant impact on the pricing of the leverage loans, and potentially on the ability of the acquirer to make the acquisition. ↑
- In my experience, competent counsel is worth paying for. In each of the leverage buyouts I did with Partners Group in the Asia-Pacific, the quality of the counsel made a great difference, in terms of negotiating terms and controlling the process. ↑
- Also referred to as a “no-shop” provision. ↑
- This can be a major issue in China, where some foreign-owned enterprises have not been entirely compliant with Chinese employment law requirements for an extended period of time due to lax enforcement. ↑