US private equity firms have the cash and confidence to fuel increased M&A activity. PE firms have more than $500bn dollars of “dry powder”, or committed equity, that if not put to work will be returned uninvested. The dry powder now available to PE firms is well known. This pool of equity capital has been available during the last two years while little M&A activity took place. But now the US leveraged loan market has reopened for business and healthy cash inflows by investors into US debt funds (both leveraged loan funds and high yield funds) have fueled demand for new debt issuances.

At present, US banks are discussing raising up to $10bn of new debt for potential transactions, thereby permitting PE firms to examine targets of up to $16bn.

Six months ago, the maximum debt that could be raised for a new transaction was $4bn. A year ago: $0. The availability of equity and debt, however, does not insure M&A activity. PE firms must be willing to invest. The first half of 2010 saw a return of confidence at US PE firms. Why such a reversal from 2009’s gloom? There are two principal reasons:

1. In 2009, these firms spent an enormous amount of time and energy on their existing portfolio. This internal focus paid off; most private equity portfolio companies are financially stable and, in many instances, beating 2010 forecasts. Strong results foster growing optimism.

2. Over the last 20 years, the best PE investments were made during the 12 months following a recession trough, a fact of which PE firms are well aware. Now is the right time in the economic cycle to invest. With this cash and confidence, PE firms are closely examining US public companies for potential going private targets.
Going Private Transactions

As a PE firm examines a potential target, the firm and the target’s board must address a transaction risk that was highlighted in 2008 as “busted” going private transactions accumulated — the risk of financing failure. This risk is easy to understand. In the US, when a PE firm and a target agree to a going private transaction, it is not guaranteed that the necessary financing will be available later on to close the transaction. For example, when a US PE firm announces that it is acquiring a $10bn US public company, with $7bn of debt and $3bn of equity, it is not guaranteed that the $7bn of debt will be funded by the banks at the closing. The banks “commitment” to the transaction is not the functional equivalent of a letter of credit. In the UK, the financial regulatory regime requires such commitments to be equivalent to letters of credit (“certain funds” is the term most often used to describe these commitments).

The US has no similar requirement. While nothing prevents US banks from making “certain funds” commitments, to date US financial institutions have elected not to write “certain funds” paper. The difference between “certain funds” and committed financing was highlighted in 2008 and 2009 when it was difficult for PE sponsors to close on committed financing in many US going private transactions. In some of these difficult deals, the funding, for one reason or another, fell through—an adverse development which played out in the public spotlight. Now, a target’s board and a PE sponsor must address the risk for financing failure and develop a template for handling the risk. Without such a paradigm, it is difficult for a going private transaction to move beyond a “potential” deal. One solution is for US financial institutions to make certain funds commitments. Perhaps some day this will happen, but it hasn’t happened yet.

An Emerging Model
Instead of waiting for certain funds to appear in the US, market participants recently created a new transaction paradigm. This model has four elements (assuming a going private transaction of a $10 billion target, which is funded with $7 billion of debt from the bank and $3bn of equity from the PE firm):

1. The new paradigm separates the financing failure risk into two categories: 1) failure to fund because the target’s performance has deteriorated, and 2) failure to fund because of other reasons. The paradigm places the risk of its non-performance squarely on the target. The PE firm is not obligated to complete the transaction if the target’s performance has dropped below a specified level, e.g., below a minimum level of EBITDA.

2. The paradigm removes the PE firm’s “option” to walk away from the deal. It creates a letter of credit certainty of funding of the PE firm’s equity if the bank is willing to fund the debt. Therefore, if at closing the target’s performance exceeds the minimum performance threshold and the bank is ready to fund the $7bn of debt, then the PE firm’s $3bn equity commitment becomes “certain funds” and the closing occurs.

3. If, however, the bank is unwilling to fund the $7bn of debt even though the target’s performance exceeds the threshold, then the paradigm places the “market” risk on the PE firm and requires the firm to pay to the target a penalty, or a financing failure fee.

4. The amount of the financing failure fee is established at a level that reassures the target’s board that the PE firm will use its reasonable best efforts to obtain the $7bn of debt, but the fee is not so large as to deter the PE firm from making an offer to the target. The fee is between 1.5x and 2.5x the amount of the target’s customary “breakup fee” (which is approximately 3 percent of the transaction’s value), e.g., for a $10bn target, the PE firm’s financing failure fee would be between $450m and $750m (and the target breakup fee would be $300m).

This new paradigm has been adopted in several US going private transactions, including Madison Dearborn Partners’ acquisition of BWAY. Target boards and their advisors have become comfortable with the model’s ability to address the financial failure risk.

The equity and debt available to PE firms, their growing investment confidence, and addressing the risk of financing failure will fuel a vibrant PE M&A market in the US for the remainder of 2010.

Kirk A Radke is a partner at Kirkland & Ellis LLP