The on-again-off-again acquisition of Twitter by Elon Musk has provided due diligence lessons to be learned for middle-market dealmakers as transaction planners closely followed Musk’s attempts to back out of what originally was a $44 billion acquisition deal struck in April.
Musk’s legal attempts to nix the deal that ultimately closed on Oct. 27th, 2022 could be traced to a concept of due diligence introduced in the Securities Act of 1933, says Chris Gyves, partner with Womble Bond Dickinson. The act outlines the basis for a “due diligence defense” against civil liability for a buyer who wants to back out of an M&A deal. If the buyer can show that they performed a reasonable investigation and had reasonable grounds to believe that there were no material omissions before agreeing to the deal, then the buyer has grounds to back out if something important is revealed later that didn’t show up in the due diligence, Gyves says.
“You’re talking about an investigation where you’re digging in on the buy-side to evaluate the target’s business, to develop a comprehensive understanding of the risks and the opportunities and dangers associated with doing a deal,” Gyves says. “You’re answering questions like: Do I want to buy this? If so, at what price? On what terms? And how do I minimize any issues in getting to and through closing.”
In the case of the Twitter-Musk deal, Musk admits in his court filings that he did little due diligence, Gyves says.
“One of the interesting things about the Musk-Twitter deal–you can see this in Musk’s answer in the litigation–is that he takes the position: ‘Well, due diligence here was going to be costly and inefficient, so I’m going to focus on the contractual representations being accurate,’” Gyves says. “He short-cut his diligence efforts.”
If Musk had performed a full due diligence process, he might have had a better case to back out of the deal. And while it is important that the buyer can rely on the representations and warranties in an M&A agreement, in the Twitter-Musk agreement there were no representations about one of Musk’s key issues: The extent of “bot” accounts on Twitter, or automated accounts controlled by software.
“I think his level of due diligence, as indicated so far, is maybe not typical, certainly not typical of middle-market transactions,” Gyves says. “Based on what we’re seeing here, I would say that in middle-market deals, we tend to see more robust due diligence processes in place.”
For middle-market transaction planners, the watercooler talk about the Twitter-Musk deal is mostly about the tension between Musk’s claim that he should be allowed to walk away from the deal because of a material adverse effect and Twitter’s claim that Musk should be forced to close the deal based on specific performance provisions in the contract, Gyves adds.
“That tension exists in any deal with these terms, regardless of size. Sellers don’t like to agree to a deal that they then lose; buyers want to buy something they thought they were buying,” he says.
What’s interesting about the Twitter-Musk litigation is that both buyers and sellers typically find it difficult to win in court, Gyves says. It’s not common to see a court let a buyer get out of a deal based on a material adverse effect clause, nor is it common to see a buyer forced to consummate a deal based on a specific performance clause.
A side note on Twitter-Musk: The Delaware judge presiding in the case, Kathaleen McCormick, did rule in a dispute last year to force a buyer to go through with a purchase. The buyer, KCake Acquisition, an affiliate of Kohlberg & Co., was forced to close its deal to acquire DecoPac from Snow Phipps, a New York-based PE firm that has since changed its name to TruArc Partners.
“In the ongoing pursuit of deal certainty, I think transaction planners are going to be watching to see how the court ultimately examines these clauses as applied to the facts. And that may give us some indication of things we need to do in the future in other deals,” Gyves says.
There are lessons to be learned for the middle market about the deal process and merger terms. “However this deal ultimately is sorted will guide the dance the buyers and sellers do, and in future deals, it will guide how their advisors approach the process of negotiating the definitive agreement and drafting of some of the terms in the agreement,” Gyves says.
So far, the Twitter-Musk dispute has offered a reminder for M&A buyers of the importance of “good hygiene,” he says: Dig in on the attributes of the business that are important or that could create risk, get representations on those issues from the seller and carefully craft your “walk-away” rights.
For sellers, the reminders are: Make sure you negotiate a very protective specific performance clause and a breakup fee, and make sure your interim operating covenant spells out required steps between signing and closing.
Twitter-Musk isn’t the only cautionary tale that middle-market dealmakers discuss. For direct lenders, part of the appeal of the middle market is the tighter deal documentation that can head off some of the risks that arise with higher-tier deals, says Pankaj Gupta, a president at direct lender WhiteHorse Capital.
Two recent such examples of lending deals gone bad with large-cap private equity-backed companies are the J. Crew and Serta Simmons Bedding cases, Gupta says.
According to the Yale Law Journal, J. Crew exploited a “trap door” in a complex credit agreement to remove $250 million in intellectual property collateral from the business—and out of its lenders’ reach—to refinance other debt. J. Crew filed for Chapter 11 bankruptcy in 2020.
In the Serta Simmons Bedding case, the mattress company issued a debt-for-debt exchange that “primed” some senior lenders—giving new lenders payment priority over them without their consent– and a New York court ruled in Serta’s favor in 2020. WhiteHorse has a core focus on preventing priming, Gupta says.
“We and the markets are cognizant of the games that lawyers come up with and we make sure that we can protect against those types of outcomes,” he says. “We are constantly having discussions as an organization about the trends in the marketplace, things to watch out for and protections that we absolutely need.” M&A
