Why are so many private equity deals blowing up?
—Alan Engle, Great Neck, New York
The short answer is that the world has changed (read: the US subprime mortgage mess has erupted). A lot of companies that were once hell-bent on acquiring hot new properties suddenly want out of deals that are starting to look too cold for comfort.
It’s sort of like those hours after the Titanic ran afoul of the iceberg. The realists in the crowd didn’t exactly stroll to the lifeboats. They bolted.
That’s what you are seeing now—and not just from private equity firms. Many companies, emboldened by the strong economy and its abundance of low-cost credit, have spent the last few years buying up every acquisition target with a pulse. Along the way, deal makers did not exactly ignore risk; they just thought they would be able to handle any form of ‘mishegoss’, or craziness, later.
Well, it is “later” now, and deal makers are starting to bail.
It’s amazing that some can. Or at least, they can try—thanks to MAC, the Material Adverse Change clause embedded in virtually every merger-and-acquisition contract. Indeed, in our view, what’s happening with MAC right now provides an important, if wince-inducing, management lesson about when a CEO should delegate the “details” concerning significant risk—which is basically never.
Wince-inducing, because it is astonishingly easy to do otherwise.
Imagine yourself at the centre of a deal being forged. Your team started the process by making the target company’s team a “generous” offer of, say, $23 a share. “Ridiculous!” was their retort. “We’re not going to our board with anything less than $27.”
Then, for the next slew of days, if not weeks, you wrangle, begrudging each other $.50 at a time. Finally, after negotiating every last provision of the financials, the end comes into sight with a price of $25.50—right in the middle, with a little sweetener thrown in for the target.
And, no surprise, it is 8pm on a Friday night. So you and the other CEO shake hands, in equal parts exhausted and exultant, and turn to the lawyers. “Paper this up,” you both say, “and have it ready before the market opens on Monday.” At which point, the lawyers go into hyper-drive.
One of their jobs is to come up with a list of all the things that could go wrong between the announcement of the deal and its close, such as a major strike against the target company, or one of its big customers going belly up. Such an accounting of every possible “adverse change” is the more straightforward part of the contract process, and usually gets done without too much sound and fury.
The hard part—the part that usually gets short shrift—is the clause in the contract that defines exactly what would make any adverse change “material”, that is, significant enough to merit killing the deal.
Materiality is hard to nail down for several reasons, but the main one is simply that the laws governing it are not particularly crisp. That makes it very difficult under any circumstances, let alone high-pressure ones, to put a fine point on the meaning of the term.
Is it a 20% hit to earnings? Or a 15% decrease in revenues? Who knows? And so, the lawyers usually end up leaving the language vague enough for both sides to say, “Well, OK. Good enough.”
Fast forward, then, to an adverse change, like the subprime crisis we are in right now, and you understand why so many companies are engaged in legal slugfests over what their MAC clauses technically allow.
Sallie Mae, Inc., the US’ largest student loan provider, and the private equity firm JC Flowers & Co., Llc. could be in court for years, for instance, as could Cerberus Capital Management, L.P., the international private investment firm, and United Rentals, the world’s largest equipment rental company. What a waste of time, energy and money for everyone involved.
In time, of course, credit will loosen and the economy will recover, and when that happens, the details of any given MAC clause will matter a lot less. But, even then, there will always be contracts with room for manoeuvring and mischief around their terms—if only because there will always be deal makers who would rather hedge their bets than face the reality that, sometimes, MAC happens.
If the current subprime mess teaches us anything, however, it is that principals should stay with their deals through to the bitter end, sorting out every last detail surrounding risk. It’s grunt work, we realize, gritty, boring and plain not fun. But when the stakes are high, you have no choice. Don’t delegate the pain away.
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