At a recent regional private equity event, an advisor remarked to me that he had been involved in over 20 due diligence exercises in recent years, none of which had resulted in a completed transaction.
Deal-doing within the region presents its own challenges. The private equity community has commented on the mismatch of valuations, an underdeveloped legal infrastructure and lack of acquisition finance as reasons why deals break down. Bearing in mind the significant proportion of deals that fail to complete within the region, investors should look for ways to protect their position by means of inserting break fees in their term sheets.
Break fees allow any party in a transaction a certain amount of cost protection in the event of deal failure. They therefore provide a degree of comfort in devoting the necessary resources to pursue a transaction.
Typically, a break fee will oblige a party to bear some or all of the professional and other advisory costs incurred in the negotiation and due diligence stages of a deal, if it is not completed. A buyer or investor may require protection to cover the costs it is expending in due diligence and advisors' fees. A seller, on the other hand, may ask for a break fee to compensate it for the fact that while it is committed to exclusivity with one party, it loses the opportunity to deal with another.
If the deal does not complete, the seller will have incurred its own costs which it needs to be able to recover. While the break fee (whether one-way or two-way) is therefore an attractive protection, there are various pitfalls that may render a break fee either ineffective or unenforceable.
Trigger event
It should be very clear in what circumstances the break fee is payable, however negotiating and drafting this so that the break fee is effective can be complicated. For example, the failure by a seller to accept a binding offer within a set range following due diligence may commonly trigger a break fee. However, a seller may not wish to commit itself to such a provision in case the terms of such a binding offer are within the specified range, but not of an acceptable risk profile.
Alternatively, if one party wishes to withdraw from negotiations for whatever reason, or negotiates with a third party during a binding exclusivity period, then this may trigger a break fee. However, such a provision can be frustrated if that party simply decides to run down the exclusivity period or attempts to use frustrating action to exhaust the period, and then withdraws post the expiry of the exclusivity period.
Of course one might draft a provision that provides for this eventuality, but proving a party had ceased to negotiate in good faith or was simply frustrating the exclusivity period is likely to be difficult to prove and consequently the break fee will be difficult to recover.
Understanding break fee coverage
It is not unusual for advisors, particularly in private equity deals, to act on a contingency basis. Therefore any break fee should be drafted to include fees incurred on such a basis. It is common for the party being asked to bear the break fee to respond that this is exactly the point of advisors acting on a contingency basis, and it should therefore not be placed in a worse position than the party, which had the benefit of the contingency arrangement in the first place.
This is perhaps the most controversial issue when negotiating break fees. It would be tempting to negotiate a break fee that is expressed to be at an extremely high level, in order to act as a powerful disincentive to a counterparty from withdrawing from the transaction.
However, most common law jurisdictions will not uphold such clauses as they will be deemed to be penalty clauses. Typically such jurisdictions have a test that such provisions must be a genuine pre-estimate of loss to the injured party, rather than an arbitrarily inflated figure.
In our view, the local law would operate in a similar way and a judge or arbitrator would exercise their discretion to make the amount payable proportionate to the loss sustained. In addition, the exercise of such discretion under local law is likely to be less sympathetic to the party seeking to enforce the break fee. It may be safest to seek a costs indemnity from the other side if possible, however, this is dependent upon the governing jurisdiction chosen and legal advice should be sought on the correct formulation of the proposed break fee.
Enforceability
Terms sheets are often not legally binding save for certain provisions. The break fee should be one of the provisions that is expressed to be legally binding. However, of itself, this is unlikely to be enough.
The parties should give careful consideration to the law that governs such term sheet. Bearing in mind the provisions of the local law discussed above, English or DIFC law should provide a degree of certainty in the ability to rely upon a break fee.
In addition, consideration should be given to the court or arbitral regime in which any breach would have to be pursued to assess if the break fee can be enforced in reality. Within Dubai, the increasing prevalence of the DIFC-LCIA arbitral regime, and the extended jurisdiction of the DIFC Courts provides an attractive forum for enforcement. However, there is no rule of thumb, and any such provision should be agreed having taken legal advice.
From the above therefore, we see that the concept of the break fee is a very useful one particularly in the context of deal-doing within the Middle East. However, in order for it to be effective it should be very carefully considered and drafted with the appropriate legal advice.
Sandeep Dhama is a senior associate at SJ Berwin's Middle East office, a position he has held since 2012. He specializes in M&A, joint ventures and private equity, with expertise in capital markets and restructuring.
© Zawya 2013
