10 March 2008
One of the well-documented features of private equity's 'golden era' was the evolution of ever more borrower-friendly acquisition finance documentation. Private equity sponsors have been very successful at reallocating the balance of risk between bank and borrower during the past five years.
One example of this was the migration of certain funds conditionality from UK public-to-private transactions to private deals - to the extent that the certain funds concept is now the market standard in private deals throughout Europe. In other words, banks have agreed to the absence of financing conditions outside the control of private equity sponsors (unless those conditions are also a condition of the acquisition).
The great benefit of the certain funds concept is that it has allowed private equity sponsors to present a vendor with an offer to purchase a target without a financing condition. In doing so, it has significantly improved sponsors' bargaining power with vendors relative to trade buyers.
The practice has therefore developed whereby purchasers typically enter into a sale and purchase agreement with a vendor that does not contain a financing condition on the strength of a commitment letter and term sheet. The letter details the commitment of the underwriting bank(s) to provide acquisition and working capital facilities to the purchaser on a certain funds-basis and according to the terms described in the attached term sheet. In addition, acquisition finance lawyers acting on the sponsor-side have taken control of the preparation of the commitment papers, resulting in there being far more detail contained in a typical set of papers than was the case five years ago.
One of the consequences of the credit crunch has been a renewed focus on documentation. The conventional wisdom for some time has been that a bank would not risk serious damage to its reputation by dropping out of a deal; indeed, to date, the deals which have collapsed have done so when the private equity firm rather than the bank has withdrawn.
However, the scale of the losses being suffered by financial institutions worldwide is leading banks in the US and European markets to give serious consideration to walking away from deals where they have committed to provide facilities. The consequence of that shift is that banks and borrowers (and their advisers) are refocusing on each party's strict legal rights under acquisition finance documentation.
The obvious question - in the context of a certain funds commitment letter and detailed term sheet running up to 100 pages in length - is: are the underwriting banks obliged to provide the facilities they have 'committed' to provide?The answer turns on the precise wording of the commitment and the particular facts of the transaction. However, it has become relatively standard in the European market for commitment letters to contain some wording to the effect that "the parties will negotiate in good faith and use all reasonable endeavours to agree the finance documents" and that "the finance documents will contain the terms set out in the term sheet and, in relation to matters not dealt with in the term sheet, in accordance with sponsor precedent".
The traditional position, as confirmed by the House of Lords in Walford v Miles, is that agreements to negotiate and agreements to agree are not enforceable because they lack sufficient certainty to have binding force. The obligation to negotiate with a view to agreeing documentation (or similar constructions of that phrase) is also considered to conflict with the inherent negotiation process, which may lead one party to delay or withdraw from the negotiation if that party believes it is in its best interests to do so. That is a position all banking lawyers will be familiar with, and is the position typically recited when the enforceability of commitment papers is raised. In Walford, every term of the agreement needed to be agreed before there could be a workable contract between the parties.
Contrast that position with the detailed term sheets typically attached to bank commitment letters in mid-market and big-ticket European leveraged buyouts, which set out in great detail the structure, terms and pricing of the facilities being offered. To the extent that the long form finance documents need to address matters not dealt with in the term sheet, there is a wealth of sponsor precedent and market documentation - such as the standard form documentation prepared by the Loan Market Association (LMA) - that can be used to determine administrative and mechanical provisions, as well as providing the methodology to calculate basket sizes and financial covenant ratios.
The conclusion, therefore, is that a correctly worded commitment letter and sufficiently detailed term sheet can constitute a binding and enforceable contract that allows a court to determine the provisions of the long form finance documents, notwithstanding that any statement in the commitment papers to the effect that the parties will use reasonable endeavours to agree may be unenforceable.
It is satisfying for an acquisition finance lawyer who acts for sponsors that commitment papers (in the majority, prepared by counsel to the borrower) have withstood a high degree of scrutiny in the past six months.
Notwithstanding that fact, acquisition finance lawyers acting for private equity sponsors will continue to endeavour to refine the documentation with a view to providing greater certainty and detail at the commitment paper stage of the process. This will involve:
• Greater specificity in commitment letters around what constitutes 'sponsor precedent' - including references to specific historic transactions.
• Increased use of LMA standard documentation as the final arbiter for administrative and mechanical provisions.
• Increased focus on determining basket sizes, thresholds and materiality levels that typically apply to representations, undertakings and events of default.
• Increased focus on determined financial covenant levels, or greater detail around the methodology for determining covenant levels once the base case has been prepared.
• Greater specificity of intercreditor terms, especially where the capital structure includes classes of debt other than senior and mezzanine.
Philip Crump is a partner at Kirkland & Ellis International