United States: Wielding A Club

This article originally appeared in the June 29, 2006, issue of The New York Law Journal.

Private equity firms increasingly have been joining in consortia to make large corporate acquisitions. Recent headline-grabbing deals include the $11.3 billion buyout of SunGard Data Systems and the $15 billion acquisition of The Hertz Corp. In early June, Brookfield Properties and The Blackstone Group agreed to team up to buy real estate investment trust Trizec Properties and Trizec Canada, for about $8.9 billion. Oil-and-gas pipeline company Kinder Morgan Inc. announced in late May a $21.8 billion buyout offer that would reportedly rank as the largest management-led buyout to date. Goldman Sachs Capital Partners, American International Group Inc. and the Carlyle Group are among the investors in the proposed transaction.

According to the periodical Buyouts, of the 845 private equity deals completed last year valued at about $200 billion, 125 were club deals, meaning that private equity shops were teaming up nearly 15 percent of the time. This year, through mid-June, there have been more than 500 private equity deals at a value of $157.4 billion, according to Dealogic.

Generally, a club deal may be defined as any acquisition by two or more investors, typically private equity firms, or "sponsors." Until recently, such consortia were relatively less common in acquisition deals, and the task for counsel was confined to representing a single private equity firm. As club deals proliferate, they are raising difficult issues among members of these consortia and as a result, posing new challenges to their legal counsel. Club deals require engaging in complex control-sharing arrangements among members that typically are accustomed to maintaining full decision-making authority.

Private equity firms reap an array of benefits by joining in consortia. Clubs allow them to pool their finances with other investors to buy large companies that would have been too costly for an individual firm to buy. Club deals often involve targets with multi-billion dollar pricetags.

The vast amount of money available in recent years to private equity firms from pension funds and other institutional investors has helped buyout firms form ever larger investment funds, and by joining in clubs, they have further expanded the range of potential acquisition targets. Joining clubs also enables investors to partner with sponsors or strategic investors with relevant industry experience.

Clubs spread the cost of multi-billion-dollar acquisitions among the consortium members as well as the risk of such a large investment. Spreading risk is necessary because private equity firms are generally required by their partnership agreements to diversify their funds and often have a cap (typically about 10 percent) on the amount that each fund can place in a single investment. Joining in consortia allows each sponsor to remain within those limits while taking an equity stake in a target it might not otherwise be able to invest in.

For lawyers representing one or more sponsors in a club deal, it is vital to structure the transaction so that the original goals of the client are protected, despite unexpected bumps in the road over the life of the investment. Because of the number of parties involved, club deals are potentially rife with conflicts. These include potential conflicts among private equity firms with different time frames and objectives, as well as with strategic investors seeking a business relationship with the target.

Contractual terms ideally should be detailed and anticipate potential conflicts. Contractual terms aside, club deals work best when all the investors share the same basic expectations for the deal and its eventual outcome. However, the participation of several firms will undoubtedly require cooperation and compromise for a successful deal.

Consortia can be formed from before the submission of a bid until after the deal has been awarded. For example, in the buyout of SunGard Data Systems the lead sponsor, Silver Lake Partners, reportedly did not form the consortium until after reaching a general agreement on terms with SunGard.

When club members initially come together, they need to enter confidentiality agreements with the target and each other, which permits the club members to engage in due diligence and hopefully permit them to share their analyses with the other club members. They also typically enter into a bidding agreement, by which they consent to maintain exclusivity, create procedures for making the bid, choose advisors to represent the group and share expenses. The bidding agreement or an interim agreement will also address which members of the group may decide to amend or terminate the acquisition agreement or waive closing conditions and which member takes the lead role in negotiating management and financing agreements, and allocation of termination and management fees. Each firm will also provide an equity commitment letter to the acquisition entity, with the target or seller and the other sponsors as third-party beneficiaries. The amount of exposure in the event of a default is typically limited and heavily negotiated.

Usually, each firm in a club will retain its own outside counsel. However, one private equity firm will often take the position as lead negotiator for the consortium. The lead firm's counsel will then represent the club, and each member's counsel will represent their client for specific issues that relate to their client, such as agreements among the members and tax structuring.

Challenges for Counsel

Club deals pose an array of challenging issues for counsel. A central issue is allocation of control in a consortium. For the most part, those firms that have the greatest equity investment in the deal will have the most influence in voting and will take the lead on bid negotiations and setting the deal structure and financing terms. A stockholders' agreement governs the relationships among the club members and the target's management in relation to the club's investment in the target.

In the stockholders' agreement, the array of basic control questions and management issues facing counsel includes: Is a simple majority or a super majority required for voting decisions or is the approval of certain groups of sponsors or all sponsors required for certain voting decisions? Which sponsors will be entitled to board seats on the target board and which to only observer rights? Which sponsors are required for a quorum for a stockholder, board or committee meeting? When and to whom can a member transfer part or all of its interest? At what levels do sponsors lose voting rights if they sell some of their ownership interest? Does the lead firm in the club receive all of the management fees paid by the portfolio company or do the firms split the fees among the club's members? These issues, and many related ones, must be worked out early for a successful club arrangement.

The decision to exit the investment raises another group of key issues to be decided among the parties. Ideally, there should be consensus among the firms about the time frame and method for exiting the investment (e.g., an IPO vs. sale to a third party) and expected financial return. A typical provision is the creation of "drag along" rights, which allow one or more consortium members to force others to sell their interest when the members possessing the drag-along right decide to sell their own interest. In addition, "tag along" rights ensure that a minority interest holder firm can participate in an exit if the majority interest holder or group of interest holders sells. Great care must be exercised when drafting these highly negotiated provisions.

The presence of strategic partners in consortia, while not common, does occur - for example, in the recent acquisition of more than 1,100 Albertson's Inc. stores by a consortium that included chain store operator Supervalu Inc., drugstore chain CVS Corp., and investment firm Cerberus Capital Management. A strategic partner can bring valuable industry expertise to the club, but further complicates certain issues, such as exits, because of the different time frames and objectives the strategic investors may have.

More Clubs to Come

So far, there have not been headline-making club deal failures, and since mega club deals are relatively new, it remains to be seen what will happen if any of the multi-billion dollar deals hit bumps in the road.

This year, enormous pools of cash are again being raised by private equity firms, and by joining in consortia, they will be putting some of the world's largest corporations in their sights. For counsel, the challenge of resolving the many legal issues that arise in connection with these deals appears likely to become increasingly common.

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