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“$163 million?!!!? Hey, Terminate ME!” (Break-up fees in the middle market)

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Hillshire Brands agreed last month to acquire Pinnacle Foods for $4.3 billion in a deal intended to broaden Hillshire’s product offerings beyond Ball Park hot dogs, Jimmy Dean sausages, and other protein products by adding Pinnacle’s roster of iconic grocery brands including Birds Eye, Mrs. Paul’s, Log Cabin, Duncan Hines, Vlasic and more.  The market quickly signaled disapproval of Hillshire’s product diversification strategy as a bidding war broke out between Tyson Foods and Pilgrim’s Pride for ownership of Hillshire.  Tyson’s winning bid was contingent on Hillshire canceling its deal to acquire Pinnacle, and Hillshire announced yesterday that its Board of Directors determined to withdraw its recommendation in favor of the Pinnacle acquisition.

As a result, Pinnacle Foods may receive a termination fee in the amount of $163 million.

“$163 million?!!!?  Hey, terminate ME!!!!!”

Or so one of our middle-market business-owning clients said when he heard that news.  This client is particularly attuned to the topic, as the sale of his business was derailed when the expected acquirer backed out of the transaction just a few days before closing.   Although we quickly engaged with another buyer and ultimately completed the sale at an advantageous valuation, the seller was understandably vexed that the original buyer could walk away from the deal without compensating the seller for the professional service fees and transaction costs the seller incurred up to that point.  How could that be?

A brief history

Termination fees first became common in public company M&A, where securities laws obligate the Board of Directors of a targeted company to maximize transaction value for the target’s stockholders.   If a subsequent bid surfaced at a higher valuation and a Board broke off the original agreement , the inclusion of a termination fee ensured, first, that the competing bid was materially higher (exceeding the sum of the original deal price plus the cost of the break-up fee) before the target would break off the deal; and second, that the jilted acquirer would be reimbursed by the break-up fee for all or part of its expenses.

But sellers are sometimes left at the altar, too.  The fee payable to Pinnacle from its broken deal with Hillshire is a reverse termination fee (“RTF”), a concept which originated a decade ago to protect sellers in private equity deals.   As originally structured, RTFs were payable to the seller if the PE firm could not obtain the requisite debt financing to close a leveraged buyout, and the RTF was the seller’s exclusive remedy.  During the recession PE firms quickly realized that RTFs were a low-cost way to walk away from deals for any reason at a capped and certain cost, and many private equity deals were cancelled as a result.  Most sellers place a high value on certainty of closing the deal, so the abuse of reverse termination fees in recent years has led to tighter legal drafting that allows a private equity acquirer to pay a break-up fee and exit a deal only if financing is unavailable despite the buyer’s efforts to obtain it.

Reverse termination fees crossed over from private equity deals to large public company deals beginning with the Mars-Wrigley acquisition in 2008, to protect target companies both from deal financing risk and from antitrust regulatory approval risk.  For example, Sysco’s pending acquisition agreement with US Foods provides for an 8.5% break-up fee payable to US Foods if antitrust approval is not obtained.

Break-up fees in the middle market

So then, what of our client’s vexation?  If termination fees and reverse termination fees are so prevalent in billion dollar private equity deals and in public company deals, why not in middle market private company acquisitions too?

The simple answer is that break-up fees are not “market” in private company transactions.  We informally surveyed a number of M&A lawyers who confirmed that break-up fees are not commonly agreed upon in middle-market transactions.  Letters of intent with private company sellers typically grant exclusivity to the selected buyer, so acquirers don’t need protection against subsequent higher bids.  And while private sellers would like the protection of break-up fees, prospective acquirers do not have the same visibility in the early stages of negotiations into the financial statements and strategies of private companies as they find in the quarterly filings of publicly-traded companies.  Acquirers will say they are investing significant time, effort and money into their due diligence reviews of the private company, and will insist that this investment should be proof of the acquirer’s good faith and sincere intention to close the deal.

In the absence of a break-up fee to protect against the many costs of a cancelled business sale, owners of privately-held companies are best protected by working with a team of experienced advisors including an M&A attorney and an investment banker to oversee a sale process that thoroughly vets prospective acquirers’ financing, strategic motivations and reputations.  If you (or one of your clients) are contemplating a sale, please contact us for a confidential conversation.