Behind All Those Undone Deals

Nervous dealmakers are trying to use loosely written escape clauses to bail out

Why are so many private equity deals blowing up? — Alan Engle, Great Neck, N.Y.

The short answer to your question is that the world has changed. (Read: The subprime mortgage mess has erupted.) And a lot of companies that were once hell-bent on acquiring hot new properties suddenly want out of deals that are starting to look like disasters waiting to happen. It's sort of like those hours after the Titanic met the iceberg. The realists in the crowd didn't stroll to the lifeboats. They bolted.

That's what you're seeing now, and not just from private equity firms. Many companies, emboldened by the strong economy and low-cost credit, have spent the last few years buying up every acquisition target with a pulse. These dealmakers didn't exactly ignore risk; they just thought they'd be able to handle any form of mishegas later.

Well, it's "later" now, and dealmakers are starting to bail. And the amazing thing is, some can. Or at least, they can try—thanks to MAC, the Material Adverse Change clause embedded in every M&A contract. Indeed, in our view, what's happening with MAC right now provides an important, if wince-inducing, management lesson about when a CEO should delegate the "details" concerning significant risk—which is basically never.

Wince-inducing because it's dangerously easy to pass off the task of nailing down MAC to the legal eagles. Imagine yourself at the center of a deal being forged. Your team started out the process by making the target company's team a "generous" offer of, say, $23 a share. "Ridiculous!" was their retort. "We're not going to our board with anything less than $27." Then, over days, even weeks, you wrangle, begrudging each other 50 cents at a time. Finally, after negotiating every aspect of the financials, the end comes into sight with a price, slightly sweetened for the target, of $25.50. And, no surprise, it's 8p.m. on a Friday night. So you and the other CEO shake hands, exhausted and exultant, and turn to the lawyers. "Paper this up," you both say, "and have it ready before the market opens on Monday."

At which point, the lawyers go into hyperdrive. One of their jobs is to list all the things that could go wrong before the deal closes, like a major strike against the target company or one of its big customers going belly up. Such an accounting of every possible "adverse change" is the more straightforward part of the contract process, and usually gets done without too much sound and fury. The hard part—which often gets short shrift—is the clause that defines exactly what would make any adverse change material, that is, significant enough to merit killing the deal.

Materiality is hard to nail down for several reasons, but the main one is that the laws governing it are not particularly crisp, making it very difficult to put a fine point on the meaning of the term. Is it a 20% hit to earnings? Or a 15% decrease in revenues? Who knows? And so, the lawyers usually end up leaving the language vague enough for both sides to say, "Well, O.K. Good enough."

Fast forward, then, to an adverse change—like the subprime crisis—and you understand why so many companies are engaged in legal slugfests over what their MAC clauses technically allow. Sallie Mae and the private equity firm J.C. Flowers could be in court for years, for instance, as could Cerberus and United Rentals. What a waste of time, energy, and money for everyone involved.

In time, credit will loosen and the economy will recover. And when that happens, the details of any given MAC clause will matter a lot less. But even then, there will always be contracts with room for maneuvering and mischief, because there will always be dealmakers who would rather hedge their bets than face the reality that, sometimes, MAC happens. If the subprime mess teaches us anything, it is that principals should stay with their deals through the bitter end, sorting out every last detail surrounding risk. It's grunt work: gritty, boring, and plain not fun. But when the stakes are high, you have no choice. Don't delegate the pain away.

Before it's here, it's on the Bloomberg Terminal.