In 2006, M&A deal activity hit record levels. Global M&A volume for last year was $4.06 trillion, up 21% over the prior record of $3.3 trillion established in 2000, according to market researcher Dealogic. Last year's worldwide M&A volume was 36% higher than the $2.99 trillion recorded in 2005. In the United States, M&A deals reached a combined total value of $1.6 trillion, close to the $1.7 trillion record for values of U.S. transactions set in 2000. Much of the action has involved acquisitions by private equity groups. Private equity accounted for half of the top 10 transactions and a quarter of the overall values in 2006, according to Thomson Financial. Several of the largest private equity takeovers in history in the United States were announced in 2006, led by the $21.3 billion leveraged buyout of hospital operator HCA by a consortium of private investment funds including Bain Capital Partners, Kohlberg Kravis Roberts & Co. and Merrill Lynch Global Private Equity.
Private Equity Buyers Are Creating A Seller's Market
There are several reasons for the recent boom in private equity M&A activity. First, today's market is overflowing with private equity capital looking for investments. Many private equity funds took advantage of the strong market in 2005 and cashed out their investment portfolios, distributing loads of cash to their investors, many of which were pension funds. These pension funds used the profits realized in 2005 and reinvested them last year in private equity investments, which are expected to continue generating rates of return well above what is available in the public markets. Furthermore, extraordinarily low spreads in the debt markets and the aggressive expansion of hedge funds into debt financing offer plenty of cheap financing. Also, the compliance costs and potential liabilities associated with Sarbanes-Oxley have driven many investors and managements from the public markets. Finally, private equity firms with six or seven year horizons that were created in the heyday of private equity investment in 1999 and 2000 are about to expire, leading their managers to dispose of numerous assets, which are increasingly being purchased by other private equity firms (in so called "secondary transactions"). All of these factors have led to a dramatic increase in the amount of capital in the private equity market and a substantial increase in the percentage of total M&A volume involving private equity buyers and sellers, which has swung the pendulum in the seller's favor in today's M&A market, where hungry buyers are on a buying spree.
Private equity players are participating in larger and larger transactions, where traditionally private equity players had stayed mainly in the middle market. Seven of the ten largest buyouts of all time took place last year. In recent years, private equity players have been pooling their money to pay for large targets in so-called "club deals." Furthermore, some financial buyers are beginning to amalgamate such large portfolios of assets that they can take advantage of synergies that were once only available to strategic highly-capitalized buyers, in effect themselves becoming strategic buyers. These trends have resulted in the entry of private equity funds into larger transactions, which means that sellers throughout the entire spectrum of transaction values are increasing their leverage over buyers.
With so much excess cash on hand, private equity funds are competing in a race to deploy their funds. There is an oversupply of money chasing a limited number of quality targets, causing private equity buyers who want to compete to offer sellers top prices and very seller-friendly deal terms. In order to extract the best price and terms, sellers are running their sales through an auction process, giving sellers leverage through the ability to play buyers off of one another, control over the timing of events and the diligence process, and exposure to financial buyers (including private equity firms) who might not otherwise have been targeted for the transaction. With multiple bidders to choose from, sellers can negotiate from a position of strength, greatly influencing the price, terms and structure of the deal.
Sellers Are Using Their Leverage To Negotiate Favorable Contract Terms
While the seller's top priority in the auction is maximizing transaction value, sellers are placing increasing importance on the bidder's proposed contract terms. Sellers are offering particularly seller-friendly purchase agreements and carefully comparing the bidders' markups in evaluating the overall bid packages in order to differentiate among the bidders. In order to beat out the competition, private equity firms are submitting bids with very aggressive terms, including high purchase prices and purchase agreement markups with limited changes. This competitive market has resulted in a shift in deal risk to the buyer. Transaction terms in private M&A deals (particularly in larger transactions) are beginning to mirror those found in public deals, with representations and warranties that do not survive the closing or that survive for a relatively short time period, limited or no post-closing recourse against the seller, and few closing conditions. Other pro-seller deal terms emerging in the current environment include:
No Financing Contingency - Most leveraged buyouts in the United States traditionally have provided that one of the conditions to a buyer's obligation to consummate the transaction is that the buyer has obtained the requisite financing, as those transactions by definition involve significant leverage and sponsors do not maintain significant cash on hand from operations. However, recent private equity M&A transactions have been consummated with no financing contingency, including the following major transactions: the $21.3 billion leveraged buyout of hospital operator HCA by a consortium of private equity funds including Bain Capital Partners, Kohlberg Kravis Roberts & Co. and Merrill Lynch Global Private Equity; the $8.3 billion acquisition of ARAMARK by Joseph Neubauer and investment funds managed by GS Capital Partners, CCMP Capital Advisors and J.P. Morgan Partners, Thomas H. Lee Partners and Warburg Pincus LLC; and Apollo Management, L.P.'s $9 billion acquisition of Realogy Corporation.
Reverse Break-Up Fees - Although break-up fees, imposing penalties on the seller in the event that the transaction is not consummated, are common in takeover deals involving two public companies, private equity buyers have traditionally resisted them. Recently, sellers have been demanding "reverse break-up fees," to shift deal-completion risk to private equity buyers. For instance, under the terms of the $27 billion buyout of Clear Channel Communications, Inc., announced in November 2006, the private equity group buyer consortium, led by Bain Capital Partners, LLC and Thomas H. Lee Partners, L.P., will be required to pay a break-up fee in the amount of $500 million to Clear Channel if they cannot obtain financing.
Assumption of Industry Risk in MAC Conditions - It is becoming more common for private equity buyers to assume the risk of downturns in the seller's industry as an exception to the "material adverse change" closing condition. Private equity buyers have historically objected to assuming industry risk on the basis that they do not become industry participants until they close the acquisition. However, in almost 80% of private equity deals announced in 2005 and early 2006, the buyer assumed industry risk in material adverse change closing conditions.
Hell or High Water Clauses - Financial bidders have an advantage over strategic bidders who are also significant competitors to the target's business because transactions between competitors require cumbersome anti-trust review, which can derail the entire transaction. In order to create a level playing field with financial buyers and make their bids more attractive to sellers, who are strongly averse to any impediments to the closing of their transactions, strategic buyers are agreeing to remedy any potential competition law problems by offering divestitures or other remedies up to some pre-agreed level (so-called "hell or high water clauses").
Limited Indemnification - Sellers taking advantage of their market power and desiring to make a clean exit are insisting on limited indemnification provisions to minimize the magnitude of their exposure and the length of time during which the buyer can bring an indemnification claim. Indemnification basket amounts are increasing and liability caps are decreasing. Buyers are agreeing to shorter survival periods: where once buyers could expect survival periods of up to three years, many recent transactions have had survival periods of just one year or less. "Anti-sandbagging" clauses, which provide that the buyer will not be entitled to be indemnified for an inaccurate seller representation if the buyer knew of that inaccuracy before the closing, also are becoming more common. Sellers are limiting their indemnification obligations by excluding consequential, indirect and punitive damages and requiring that the buyer mitigate damages. Escrow support for the seller's indemnity obligations is becoming less prevalent and escrow amounts are becoming a much smaller percentage of the purchase price. Some buyers are purchasing representation and warranty insurance to avoid the escrow support requirement altogether and to make their offers more attractive to sellers.
Market researchers project that access to capital will remain strong for both strategic and financial buyers in 2007, making auctions run by investment banks even more competitive, delivering strong valuation multiples and favorable legal terms for sellers. Private equity funds are also expected to continue to expand from investing in traditional industrial companies into other industries. The flow of capital to the private equity markets has been and will continue to be a powerful driving force behind the seller's market. As greater competition and pricing pressure continue to mount, buyers who intend to remain competitive in the seller's market will have to increase their purchase prices, limit their closing conditions and accept limited post-closing recourse.
William R. Parish, Jr. is a Partner in the Houston office of King & Spalding, where his practice is focused on mergers and acquisitions and dispositions (including auction and negotiated sales), private equity, joint ventures, energy matters, and international infrastructure and project development transactions. He can be reached at (713) 276-7413. Jonathan S. Ayre is an Associate at the firm's Houston office, where he is engaged in the international practice area. He can be reached at (713) 276-7312.