The speed of economic change in the energy sector has created legitimate concerns about volatility in the marketplace. This has caused both vendors and purchasers to be more cautious in deal making. One way to help the situation is to give more certainty that each party is committed to the deal despite any heightened deal risk. Break Fees can be used as an effective deal protection measure that gives parties certainty and protection against wasted time and resources.
Break fees are routinely used in public M&A deals. They incentivize targets to work with purchasers and provide a monetary fee to the purchaser if the target elects to walk away. Recent deal point surveys put the number of public M&A transactions using break fees at 95 percent and higher. In private M&A on the other hand, break fees are very uncommon, only appearing, we estimate, in between two and three percent of transactions. We feel this number may go up based on the shifting economic circumstances brought on by the collapse in oil prices.
There are two basic forms of break fees: the standard "target pays" break fee and the reverse "purchaser pays" break fee.
Standard Break Fee
The standard approach involves a fee that the target pays to a prospective purchaser if it breaks off the deal prior to closing (routinely in order to stop targets from accepting an offer from another suitor). They are negotiated in advance and the fee usually attempts to provide a measure of the damages the prospective purchaser incurs if the target backs out. These sunk expenditures could include internal and external due diligence costs including legal, accounting and banking fees.
Reverse Break Fee
There have also been a number of deals in which reverse break fees have appeared, which reflects a concern by the target that a given purchaser may prove unwilling or unable to complete the deal. Recent deal point studies have shown that nearly 40 percent of public M&A transactions use reverse break fees.
The reverse break fee (sometimes called a reciprocal break fee when used alongside a standard break fee) covers risk to the target that a deal may not close. Initially reverse break fees matched standard break fees in size, but have risen with the greater recognition in the marketplace that if a transaction fails, the target potentially suffers greater consequences than the purchaser. For a target, there are reputational issues, employee morale, and similar legal and due diligence costs as outlaid by the purchaser.
Further, a broken deal can result from more than a purchaser losing interest. Even if it wants to complete the transaction, there are financing and regulatory hurdles that can scupper the transaction. Fortunately for targets, reverse break fees can step in to compensate.
Public & Private M&A
While break fees are and will continue to be ubiquitous in public M&A deals, they are rare in private M&A transactions. And while they may not be 'market' in private deals, we anticipate seeing more use of all deal protection measures, and break fees in particular, to give comfort to parties in the energy marketplace.
While there is protection built into private M&A documentation with letters of intent providing exclusivity, standstills and no shop provisions, they do not provide a method to recover lost expenses. Reduced visibility means private M&A break fees are less targeted at a subsequent bid for the target, and more related to either party cooling on the deal in this volatile and depressed market.