Should You Be Using Reverse Termination Fees?

Although reverse termination fees (“RTFs”) have been a relatively rare feature in the middle market, recent research suggests that the use of the penalty is becoming more common in deals between $100 million – $500 million.

Unlike a traditional termination fee, “In a reverse termination fee, it is the prospective buyers who fork over money when an acquisition doesn’t close, if it’s not the target company’s fault,” explained Ronald Barusch in a WSJ article. In 2012, the average middle-market RTF for a public company buyout was 5.2% of target equity value.

Whether sellers are becoming more demanding, or rigorous due diligence is causing more deals to fall through, many negotiations now end with an RTF in the contract. “This is a topic that did not come up in merger agreement negotiations until a few years ago, when private equity players started to become prominent buyers,” continued Barusch.

Below is a collection of some of the most relevant and recent literature discussing when, how much, and how to negotiate RTFs:

1. When Acquirers Get Cold Feet: What is The Value of the Reverse Termination Fee?
   This August 2013 paper offers a theoretical calculation to help a buyer determine the ideal reverse termination fee for a deal of any size. Employing the formula can help defend the rationale for a determined RTF during negotiations. The paper also explains why an RTF gives the seller greater bargaining power. Here is an alternative (paid) paper discussing the use of Black-Scholes pricing formula for RTF pricing.

2. Transforming the Allocation of Deal Risk Through Reverse Termination Fees
   This comprehensive paper by Afra Afsharipour — one of the leading academicians on RTFs — walks through the evolution, implications, and potential drawbacks of using an RTF during the negotiation process. Afsharipour predicts that “[RTFs] will be a mainstay of acquisition agreements to come regardless of economic conditions.”

3. PE Buyer/Public Target M&A Deal Study: Large and Middle Markets
   Analyzing private equity acquisitions of U.S. public companies in the middle and large-cap markets, Schulte, Roth & Zabel collected some relevant data around frequency and rates of RTFs. The study found that “From 2010 to 2012, the number of middle market deals where the buyer was obligated to pay a RTF under certain circumstances increased from 50% in 2010 to 60% in 2011 and 89% in 2012.” Houlihan Lokey offered a similar study earlier this year, as well.

4. Broken Promises: The Role of Reputation in Private Equity Contracting and Strategic Default
   According to this 2012 paper, most private equity firms choose RTFs between 4% – 8%. However, most deals are completed thanks to reputational concern, not fear of paying an RTF. The paper concludes “that both reputation and explicit contracting can play important and interrelated roles in private equity and complex business relationships generally.”