Munich-based partner Jörg Kirchner and NY-based partner Eli Hunt discuss four key ways that private equty transactions in European and the US tend to differ. Kirchner, a Global Co-chair of Latham & Watkins’ Corporate Department, noted, “In the US and European markets, the terms of a transaction are always subject to negotiations and to the leverage of the seller or the buyer. But we have noticed certain differences in the markets.”
Hunt added, “That's right. Although every deal is different and we're talking in generalities, we have seen some distinguishing trends in the markets.”
1. Vendor Due Diligence (VDD) Report
Kirchner: In Europe, you do encounter vendor due diligence reports during transactions. These reports are prepared or commissioned by the seller. They provide an overview of certain matters relating to the target, typically covering past financial results, commercial relationships, environmental status and — less often — the legal structure and terms of the target’s legal contracts and ongoing legal risks. The report’s purpose is to enable the bidders in a transaction to familiarize themselves with the target as quickly as possible. VDD reports are not supposed to replace the buyer’s due diligence; instead they are meant to facilitate it. They are particularly useful when you have complex targets and structures, and in the context of leveraged transactions they provide the financing sources a helpful picture for facilitating the lender-diligence.
As far as the legal aspects of the reports are concerned, they are more often written as fact books. The firm’s lawyers summarize the relevant terms of the contracts, legal relationships (such as joint ventures and licenses) and litigation fact patterns, rather than offering legal conclusions. The potential buyers need to rely on their own counsel for evaluating these facts to form legal advice and conclusions.
Hunt: It is very rare in the US for the seller or the seller’s counsel to provide a legal diligence report on the target company. In the US, diligence is done almost exclusively — at least in the form of a report — by the buyer and its advisors. The target or its financial advisors will often prepare an information memorandum giving an overview of the business; and counsel will often conduct some sell-side diligence as a practical matter, but this is generally not provided in the form of a report to bidders. For instance, the seller may have its counsel help in preparing disclosure schedules, but these are limited statements in response to specific reps and warranties, as opposed to a full-blown report.
2. Material Adverse Effect (MAE) Clause as a Closing Condition
Kirchner: Buyers and potential lenders seek protection to ensure that when the transaction closes, the target hasn’t lost substantial value between the date on which the buyer based its purchase price versus the actual closing date when the buyer assumes ownership of the asset. In the US, part of the package for limiting this risk is a material adverse effect closing condition both in the purchase agreement and in the financing documents as a condition for funding any acquisition debt at closing.
However in most markets in Europe, banks offer “certain funds” to finance leveraged acquisitions of companies and therefore do not insist on this material adverse effect closing condition. Similarly and as a result the condition has become increasingly rare in purchase agreements. Europe also has comparatively little case law or precedent around the interpretation of these clauses. So there is a stronger tendency in Europe that the Purchaser takes the risk of the decrease of value of the target company after signing. However when material adverse effect closing conditions are used they tend to be more specific than the clauses in the US.
Hunt: In the US, an MAE closing condition is very customary. In a financed deal, it’s going to be in the bank commitment letter as a condition of financing and ultimately the loan documentation. Buyers will need a similar MAE condition in the acquisition agreement, but will customarily seek the condition even in deals that aren't financed. While the exact interpretation of an MAE is based on state-by-state caselaw in the US, it is generally considered a very high hurdle — it’s not a minor blip; it is typically thought of as something that has substantially changed in the business in an adverse and enduring way.
3. Liquidated Damages Reverse Termination Fee
Hunt: Reverse break-up fees are often used in US deals, particularly if those deals involve third party financing. In financed deals, this is motivated in part because you don’t have a funds certain regime like in Europe, and the buyer is relying on a third party for the money it needs to close. These reverse termination fees are often liquidated damages, so they serve to compensate the seller, and also as a cap on damages for the buyer. However, there are many variations on when a reverse break-up will be paid and whether it is the sole remedy. You may essentially have a two-tiered approach: where if the financing is not there, there is a reverse termination fee payable; and if the financing is there, then there is an additional remedy, which might include a higher fee, the right to seek additional damages or equitable relief.
In that context, you will often see reverse break-fees coupled with specific performance — the ability of a seller to specifically enforce the buyer’s obligations to seek the financing, and close the transaction if the financing is actually there. This is a fairly common approach, although it all gets negotiated.
Kirchner: In Europe, in transactions that are not financed — a reverse break-up fee is often requested — but is relatively rare. It’s normally used when the buyer brings an antitrust risk to the table — a risk that the transaction will not be approved by merger control authorities (maybe because the buyer already has a dominant market position). So in that event, if the seller does the transaction at all, it wants to be sure that the buyer carefully assesses the antitrust risks and then incurs a potential financial loss if it can’t close, to make sure that there is a high degree of deal certainty in the end.
Hunt: That’s consistent with the US as well when there are regulatory concerns; you’ll sometimes see a reverse break fee to bridge that gap. It can compensate the seller if the deal doesn't get done for regulatory reasons and essentially cap the buyer's liability for regulatory undertakings.
Kirchner: In transactions that are financed, the buyer normally does not have the right to walk away with payment of a break fee. The banks in Europe typically draw upon certain funds so the likelihood they can walk away is very low. And if they walk away, the buyer is on the hook — it is obliged to pay losses incurred by the seller.
This results in two issues: the first is how do you do define and prove the losses? And secondly, does the buyer have enough liquidity to pay these losses? This issue comes up when you deal with private equity buyers, which have formed a holding company that has no liquidity. The private equity owners of the holding company are then obliged to fund the amount of damages into the buyer, so the buyer can pay the damages.
Hunt: That’s also consistent with the US, with the caveat that the amount the private equity buyer is obligated to fund to support the damages would typically be capped at an applicable reverse break fee or damages cap. But if you have a deal with specific performance, the private equity buyer may also be on the hook to fund the full equity commitment in order to cause a closing (as distinct from the payment of damages).
Kirchner: In Europe, the amount of damages is customarily capped at the amount of the equity the private equity fund would have funded to the buyer if a closing had occurred, which should help align the incentives of the buyer and seller to get the deal done. However, the difficulty in Europe is that the seller would have to prove what the amount of the losses are. Whereas in the US, with a true reverse break-fee, the private equity fund is exposed only to the damages the seller and buyer agreed upon.
4. Disclosure of Data Room
Kirchner: In Europe, the seller compiles a data room for the buyer for its diligence. Then the seller will give representations and warranties in the purchase agreement. The representations and warranties in that purchase agreement are subject to two significant caveats. First the seller may specifically disclose exceptions to the representation and warranties through specific contractual delinations. Alternatively, the seller may disclose the entire data room, which basically means that the contents of the data room serves as a contractual exception to all of the representations and warranties. If there are facts that result in a breach of the representations and warranties — and those facts are included in the data room — they are deemed to be disclosed with the result being that the representation or warranty is not breached. These facts in the data room need to have been fairly disclosed (i.e., you shouldn’t list a major litigation case in a data room in the category of a material contract because that’s not where you would look for them), but it is still a very general disclosure that has become more or less market standard. And I think in the United States, this is pretty unusual.
Hunt: Correct. In the US, this is fairly uncommon and you get a lot of resistance to this from buyers. US buyers generally want specific disclosures tailored to the representations and warranties in the form of disclosure schedules. These schedules can be expansive (and may ultimately more or less list everything from a data room), but they are generally expected to be fairly self-contained, without reference to an additional outside data room.
