Exclusivity from the Seller's Perspective
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Private equity buyers traditionally attach a lot of importance to proprietary deals or to getting exclusivity in potential transactions. Private equity sellers, however, do not always think that what is good for the goose is good for the gander. As private equity owners think about exiting their investments in negotiated transactions, they will often need to address the difficult and complicated decision of whether to grant exclusivity at some point in the process. That decision will have implications in terms of deal dynamics, but may also have legal consequences. In this article, we explore some of the issues that private equity sellers should consider in handling an exclusivity request, using three different exit scenarios: (1) the sale of a portfolio company to a strategic buyer; (2) an auction process for a portfolio company; and (3) the sale of a public company in which a private equity firm holds a significant equity interest.
A portfolio company has been approached by a strategic buyer offering a dazzling purchase price and a request for an exclusivity period to conduct due diligence and negotiate a binding purchase agreement.
Assuming the time is right for a sale, the private equity firm must consider whether there are one or more buyers that might pay a higher price and present the same or a better deal with respect to speed, certainty and risk allocation. This analysis involves considering other potential strategic buyers, as well as a sale to another private equity firm. If it seems unlikely that a better deal could be had, or the exercise of finding this out would be unduly time-consuming and distracting for the portfolio company management team, then the exclusivity request should be seriously considered.
First, exclusivity avoids the strain that an auction process can create for a management team, not just in terms of answering questions and providing information, but also uncertainty regarding potential new owners. Second, limiting the negotiations to a single buyer reduces the chances of a leak. The public scrutiny that comes with "being on the block" can lead to inquiries from employees, customers, suppliers and business partners about the company's plans that may prove distracting, even harmful, to the company's operations and business. Moreover, running an effective auction may require sharing competitively sensitive information with multiple parties, which could likewise be harmful to the company's business and, potentially, have a deleterious effect on the initial bidder's view of the company's value. Finally, exclusivity provides the benefit of establishing a moral commitment by the buyer to the process and establishes a concrete time frame for signing a deal, since the potential buyer will be incentivized to reach a binding agreement before the exclusivity period ends.
If, after considering all these variables, the private equity firm is inclined to grant exclusivity, it may want to consider whether the benefit to the buyer of a proprietary transaction should come with a price tag--such as an increase in the buyer's offer price--although any agreement on value at this stage is, obviously, not binding.
The private equity firm has conducted an auction for a portfolio company. The highest bidder submits a bid letter which "requires" the target company to provide exclusivity as a condition to its offer.
In this scenario, the seller obviously concluded that the pros of an auction process outweigh the cons. As a result, the primary focus of the exclusivity analysis should be the impact on the seller's negotiating leverage and its ability to maximize value. Agreeing to exclusivity would mean effectively freezing out the other bidders. While giving the high bidder exclusivity should incentivize that bidder to work quickly toward signing, the seller needs to be wary of the high bidder feeling so empowered that it begins to negotiate the outstanding deal points more aggressively. (One way to mitigate this problem is to attempt to negotiate the key terms of the transaction, in addition to price, before agreeing to exclusivity.)
On the other hand, while refusing to provide exclusivity may keep the high bidder on its best behavior, it will also mean foregoing the benefit of a deadline that the exclusivity period provides. In fact, the high bidder may feel that time is on its side and try to extend the negotiations with the knowledge that, at some point, the seller will be reluctant to turn to the second-place bidder--either because the seller will have invested so much time with the high bidder that it will want to avoid having to start over with someone else, or because it knows that the second bidder will likely have enhanced leverage, knowing that the seller was unsuccessful with the high bidder (assuming, in each case, that the seller has not been simultaneously negotiating with both parties).
In practice, the seller's banker delivers a message to the high bidder that written exclusivity will not be provided but, if the high bidder rebids at a certain level, that bidder will become the front-runner and will have de facto exclusivity until a specified date. During that period, the banker will try to maintain a connection with the other bidders so that there are fallback options for the seller.
As both scenarios #1 and #2 demonstrate, the response to an exclusivity request during the sale of a privately-held portfolio company is driven by deal dynamics, not legal considerations. That is because, in the context of a sale of a privately-held portfolio company, the legal exposure associated with granting exclusivity is usually not significant due to the portfolio company's small number of minority stockholders, if any. The analysis becomes more complicated as we move to the public company arena.
The private equity firm has a significant stake in a public company. A buyer has emerged with an offer at a substantial premium over the current trading price and a request that the target company work exclusively with it toward the signing of a definitive deal.
As with scenario #1, the private equity firm, or, more precisely, the portfolio company board, must consider whether the timing is right and the extent to which the offer is appealing when compared to the company's trading price, financial performance, prospects and long-term strategic plans. In addition, and unlike in the private company context, legal issues play a significant role in the analysis regarding exclusivity. This is because the fiduciary duties of directors of public companies, while not different from those of directors of private companies, raise heightened risks if breached, due to the near inevitability of the shareholder litigation that accompanies public company transactions. In short, if the board decides that the company will be sold, the directors' fiduciary duty is to seek the best price reasonably available.
There are, of course, a number of reasons why a board of a public company might prefer to proceed without a pre-signing market check and negotiate exclusively with one buyer. Not unlike the considerations discussed in the private company context, one of the biggest concerns is the distraction to the business of a public process and the strain on the management team of a protracted process with multiple potential buyers. These concerns are arguably heightened in the public company context where leaks and rumors get more air time and can have greater consequences, such as an impact on the trading price against which the deal price will be measured. Proceeding quickly and without the public spotlight decreases potential disruption and distraction with employees, customers, suppliers and other business partners.
While these are all good reasons for granting exclusivity, they cannot be viewed in a vacuum. Granting exclusivity, even for compelling reasons, comes with legal risks for the target's board as a result of the potential for fiduciary duty claims by stockholders, or in reality, the plaintiffs' lawyers that represent them. This does not mean that a public company board cannot grant exclusivity--as Chancellor Laster of the Delaware Chancery Court said in the recent Del Monte case, granting exclusivity is a tactical decision that courts "will rarely have cause to second guess" (assuming that the board is independent and active and assisted by non-conflicted advisors). It does, though, mean that the company's board should consider carefully the advantages and disadvantages of granting exclusivity, and should build a record of its evaluation. It also means that, until the company's stockholders have voted on the transaction, the board must be able to consider competing proposals.
This is why public company merger agreements contain "fiduciary out" provisions permitting the target's board to recommend that stockholders vote against a proposed merger if a better deal comes along. That is the case regardless of whether a pre-signing market check has been conducted. However, granting exclusivity is relevant to how easy the board has to make it for competing bidders to enter the process after a deal is signed. A target that chooses to negotiate exclusively with one buyer prior to signing may seek to mitigate its legal exposure by pressing for relatively loose post-signing deal protections. For example, it can (1) insist on a "go-shop" provision allowing active solicitation of competing offers for some period after signing, (2) attempt to set the break fee at the low end of the range and provide for an even lower fee during the go-shop period and/or (3) limit the buyer's matching rights in the context of a competing offer.
The decision to grant exclusivity is a complicated one. We have attempted to cover a number of the considerations in a few different scenarios, but ultimately, the determination will require a careful analysis of the particular facts at hand and a good deal of judgment on the part of the seller. The good news is that private equity sellers and their advisors will have likely been through this drill many times, including on the buy-side, and are, therefore, well-positioned to make a judgment call under a variety of different circumstances.
Margaret Andrews Davenport is a partner, and Michael A. Diz is an associate, in the New York office of Debevoise and Plimpton LLP. Contact: firstname.lastname@example.org.
A version of this article originally appeared in the Winter issue of the Debevoise and Plimpton Private Equity Report.