Break fees and reverse break fees, long the virtually exclusive province of public M&A are edging their way into the private sector lexicon.
Why? Because break fees are deal protection measures that create more certainty about parties’ commitment to a transaction and reduce the risk of anyone wasting time and resources.
Commitment, for its part, tends to vary with risk, itself a function of volatility and uncertainty, which are among the common descriptors of Canada’s current economy, especially in the energy sector.
“Over the last few years, I’ve seen a lot more private deals that should close but don’t because of differences on valuation or problems with financing,” says Bryan Haynes of Bennett Jones LLP in Calgary. “The collapse of energy prices has only exacerbated the situation.”
Haynes points to a particularly excruciating example.
“In one recent deal where there was no break fee or deposit, the vendor simply waited out the standstill and walked away from the deal, leaving the purchaser with close to $1 million in sunk costs,” he says. “Most likely, a better offer came along. But I can tell you that our client, who is a sophisticated buyer, made it clear in the post-transaction debriefing that it will be seeking break fees to protect itself in the future.”
To be sure, there is some protection built into private M&A transactions by way of letters of intent providing exclusivity, standstills and no shop provisions.
“But these protections do not provide a method to recover lost expenses,” Haynes says.
To alleviate that, then, break fees are making their way into private M&A negotiations.
“Break fees, which I have now seen in a few recent deals, are intended to compensate vendors for time and resources spent if the vendor walks away from the deal with no legitimate basis to do so arising from the due diligence,” Haynes explains. “The reduced visibility of a private transaction means break fees are less targeted at potential competing bids and more to either party cooling on the deal in a volatile and depressed market.”
But whether or not break fees in private M&A can be called a “trend” is not clear.
“There isn’t enough deal flow these days to establish a firm trend, although the topic does come up a lot more than it did in the past,” says KayLynn Litton of Norton Rose Fulbright Canada LLP. “One of the problems is that distressed targets don’t have the resources to pay break fees, even more so when two distressed parties are seeking a combination to relieve their situation.”
While much of the talk centers around the energy sector, there’s evidence that break fees in private M&A are also seeping into other sectors such as agriculture and high tech.
“The emergence of break fees or break fee discussions in the oil and gas industry is consistent with what I’ve been seeing in other sectors in my practice,” says Troy Ungerman, Litton’s Toronto-based partner.
Break fees may also be sneaking in the back door by the deposit route.
“Historically, deposits have been used to fetter out buyers who weren’t capable of closing or weren’t earnest buyers,” Haynes says. “They were meant to get prospective buyers to show the cash and were not really aimed at walk away situations.”
That’s changing. Generally, deposits were intended to be credited against the purchase price.
“Sometimes the vendor could negotiate forfeit conditions, but the protection afforded was so limited as to be almost symbolic,” Haynes says. “Nowadays there’s been a bit of a transformation in the terminology, so what used to be called deposits can be referred to as break fees.”
Parties’ need to protect themselves is also emerging in material adverse change clause negotiations.
“MAC clauses are usually limited to things that would impact a target or its assets in a way that is disproportionate to the sector as a whole,” Litton says. “They have historically excluded things that affected the industry or the industry regionally, as well as macroeconomic factors. But now there’s more pressure to bring in complicated clauses that are broader in their scope.”
Regardless of the specifics, then, what seems clear is that deal protection measures are on the rise in private M&A.
“We anticipate seeing more of them, especially break fees, to give comfort to parties,” Haynes says.