Breakup Fees and Reverse Termination Fees in M&A

Breakup fees

A breakup fee refers to a payment a seller owes a buyer should a deal fall through due to reasons explicitly specified in the merger agreement. For example, when Microsoft acquired LinkedIn in June 13, 2016, Microsoft negotiated a $725 million breakup fee should any of the following happen:

1. LinkedIn Board of Directors changes its mind
2. More than 50% of company’s shareholders don’t approve the deal
3. LinkedIn goes with a competing bidder (called an “interloper”)

Breakup fees protect buyers from very real risks

There’s good reason for buyers to insist on a breakup fees: The target board is legally obligated to try to get the best possible value for their shareholders. That means that if a better offer comes along after a deal is announced (but not yet completed), the board might be inclined, due to its fiduciary obligation to target shareholders, to reverse its recommendation and support the new higher bid.

The breakup fee seeks to neutralize this and protect the buyer for the time, resources and cost already poured into the process.

This is particularly acute in public M&A deals where the merger announcement and terms are made public, enabling competing bidders to emerge. That’s why breakup fees are common in public deals, but not common in middle market deals.

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Reverse termination fees

While buyers protect themselves via breakup (termination) fees, sellers often protect themselves with reverse termination fees (RTFs). As the name suggests, RTFs allow the seller to collect a fee should the buyer walk away from a deal.

Risks faced by the seller are different from the risks faced by the buyer. For example, sellers generally don’t have to worry about other bidders coming along to spoil a deal. Instead, sellers are usually most concerned with:

1. Acquirer not being able to secure financing for the deal
2. Deal not getting antitrust or regulatory approval
3. Not getting buyer shareholder approval (when required)
4. Not completing the deal by a certain date (“drop dead date”)

For example, when Verizon Communications acquired Vodafone’s interest in Verizon Wireless in 2014, Verizon Communications agreed to pay a $10 billion RTF should it be unable to secure financing for the purchase.

However, in the Microsoft/LinkedIn deal we referenced earlier, LinkedIn did not negotiate an RTF. That’s likely because financing (Microsoft has $105.6 billion in cash on hand) and antitrust trust concerns were minimal.

Reverse termination fees are most prevalent with financial buyers

Concerns about securing financing tend to be most common with financial buyers (private equity), which explains why RTFs are prevalent in non-strategic deals (i.e. the buyer is private equity).

A Houlihan Lokey survey looking at 126 public targets found that an RTF was included in only 41% of deals with a strategic buyer but included in 83% of deals with a financial buyer. In addition, the fees as a percentage of the target enterprise value are also higher for financial buyers: 6.5% as compared to 3.7% for strategic buyers.

The reason for the higher fees is that during the financial crisis, RTFs were set too low (1-3% of deal value), so private equity buyers found it was worth paying the fine to walk away from companies in meltdown.

RTF + specific performance

In addition to the RTF, and perhaps more importantly, sellers have demanded (and largely received) the inclusion of a provision called “conditional specific performance.” Specific performance contractually empowers the seller to force the buyer to do what the agreement requires, hence making it much harder for private equity buyers to get out of a deal.

“allows a seller to “specifically enforce (1) the buyer’s obligation to use its efforts to obtain the debt financing (in some cases, including by suing its lenders if necessary) and (2) in the event that the debt financing could be obtained using appropriate efforts, to force the buyer to close. Over the past several years, that approach has become the dominant market practice to address financing conditionality in private equity-led leveraged acquisitions.

Source: Debevosie & Plimption, Private Equity Report, Vol 16, Number 3

Both RTF and the conditional specific performance provisions are now the prevalent way that sellers protect themselves – especially with financial buyers.