Private Equity M&A During a Pandemic
A good deal of M&A activity in Connecticut has traditionally been in the private equity space. While many remain worried about health, safety and financial well-being during this ongoing pandemic, it is nonetheless interesting to speculate as to how COVID-19, and the economic downturn it is causing, may change some terms commonly found in private equity acquisition agreements. Private equity M&A lawyers have seen a prolonged sellers’ market that has lasted at least a decade. During this period, certain terms in private equity purchase agreements have diverged from the terms found in other types of M&A. While there remain certain factors that support the continuation of the pro-seller market – most importantly, the historically high amount of uninvested capital (“dry powder”) held by private equity funds and the fact that interest rates are at historical lows and capital needs to be deployed somehow – many in the private equity world envision the pendulum swinging and buyers gaining leverage against sellers in negotiations.
If private equity buyers begin to assert more leverage on sellers as to the terms and conditions of the purchase agreement, where would one expect terms to change? Indemnification terms that relate to net pricing are likely to be affected – buyers pushing harder on the length of survival periods for representations and warranties and the size of baskets or deductibles, on the one hand, and liability caps, on the other. The more interesting developments, however, might involve revisiting issues that have run away from buyers over the last few years. Specifically, trends to watch for may involve the following three issues: (i) representation and warranty insurance, (ii) fraud waivers, and (iii) absence of pro-sandbagging clauses.
1. Representation and Warranty (“R&W”) Insurance. If we exit our prolonged sellers’ market, it would not be surprising to see fewer deals utilize R&W insurance, or at least have the seller retain more exposure on matters not covered by the policy or amounts which exceed the policy limits.
The single most important trend in M&A practice over the last several years has been the explosion in the use of R&W insurance. When it entered the mainstream private equity practice, R&W insurance laid most of the risk of a breach by seller of its representations on the insurance company, although the seller would still usually retain liability with respect to (i) a small amount (usually between 0.25% and 1% of the purchase price) of the aggregate damages from a breach of a representation before the R&W insurance would start paying benefits, (ii) damages above the maximum benefits payable under the R&W policy, and (iii) damages from certain so-called “fundamental representations.” With the rapid expansion of insurance companies rushing into this marketplace and looking to aggressively gain market share, the market evolved to a point where, in many cases, insurers were issuing policies where sellers could walk away with no contractual liability for breaches of representations, as would occur in the typical sale of a public company. This material change in practice did not come without risks to a buyer. These risks include: (i) the “moral hazard” that sell-side disclosures might be less extensive and of lower quality if sellers do not have a financial stake in the veracity of their representations; (ii) having no recourse against either seller or an insurer for a breach if the buyer had knowledge of the breach at the time of the closing (a bigger issue in deals where the closing is deferred from the time of the signing); and (iii) even where buyer has insurance coverage from a breach, having to defend (and thus deal with the cost and delay) of a possible attempt by the insurer to prove that the buyer’s listed deal team members had actual knowledge of the breach at the time of the closing and thus voided the coverage.
2. Fraud Waivers. Assuming that we have reached the end of the pro-sellers’ market, another trend to watch for would be fewer private equity buyers allowing anti-reliance clauses. Delaware law (which is usually the governing law of private equity M&A) has always stood for the proposition that fraud cannot be waived (see FdG Logistics v. A&R Logistics Holdings). Yet during the prolonged sellers’ market, Delaware courts have barred fraud claims for statements outside the purchase agreement (e.g. financial projections, an offering memorandum or management meetings) where, by clear language in the purchase agreement (and the exact language is important – see TrueBlue v. Leeds Equity Partners IV), a buyer has represented that it has not relied upon any statements of seller other than those contained within the four corners of the purchase agreement (see Prairie Capital III v. Double E Holding). It will be interesting to see if private equity buyers join buyers in other types of M&A in taking stronger stands against these anti-reliance provisions.
In Connecticut, law on this point appears to follow Delaware law in finding that fraud outside of the four corners of the agreement may be waived only where the contract clearly states that the buyer is not relying on information outside of the four corners of the agreement (see Vertrue v. Meshkin).
3. Absence of Pro-Sandbagging Clauses. The end of the pro-sellers’ market might cause buyers and their counsel to be more assertive in demanding pro-sandbagging clauses.
In M&A parlance, “sandbagging” refers to a buyer bringing a claim against a seller for a breach of a representation that the buyer knew was false at the closing. One survey of public company acquisitions of private companies shows that 39% of contracts in the study had express clauses that allowed sandbagging, 53% were silent as to whether sandbagging was allowed and 8% expressly prohibited it (see Am. Bar Ass’n Mergers & Acqs. Mkt. Subcomm., 2019 Private Target M&A Deal Points Study).
Until recently, most experts interpreted Delaware law as allowing sandbagging in the absence of a clause either prohibiting or permitting it, which meant that the overwhelming number of M&A deals either expressly or by law permitted sandbagging (see Cobalt Operating v. James Crystal Enterprises). Recently, however, in the Delaware Supreme Court’s Eagle Force decision, all five justices noted in dicta that, as a matter of Delaware law, it is an open question whether sandbagging is allowable in the absence of a contractual clause either permitting or prohibiting the practice (see Eagle Force Holdings v. Campbell).
The Eagle Force decision, alone, might have caused a change in the practice, pushing more contracts to expressly permit sandbagging. But, during the sellers’ market buyers generally made the choice not to risk changing their normal terms and risking becoming less competitive in auctions. This drafting decision could be revisited if buyers have more leverage.
As a Connecticut law matter, one court (a federal District Court in Massachusetts) has applied Connecticut law to the issue of sandbagging, finding that sandbagging was permissible under Connecticut law in a case where the acquisition agreement did contain a pro-sandbagging clause (see Pegasus Mgmt. Co. v. Lyssa). It is unclear whether a Connecticut state court would follow the decision of a federal judge from the First Circuit, or whether the same decision would have been reached in the absence of a clause either prohibiting or permitting sandbagging.
Assuming that the sellers’ market in private equity deals has ended, will buyers and their counsel abandon habits formed over the period when sellers had most of the leverage? Will buyers change their views on these contractual provisions? Time will tell.