Oxbow: A Study In The Cost Of Misalignments In Good Deals

This article originally appeared in Law360. Reprinted with permission. Any opinions in this article are not those of Winston & Strawn or its clients; the opinions in this article are the authors' opinions only.

By nature, equity interests in private companies are illiquid. One of the key issues for investors, and in particular, private equity sponsors, to consider in any investment is the path to liquidity. The specific issues that arise in negotiations will depend on whether the investment is for a controlling or noncontrolling stake. The recent Oxbow Carbon LLC Unitholder Litigation in Delaware between William Koch and certain minority investors in Oxbow Carbon LLC provides an opportunity to conduct a case-study of how things can go badly wrong on a minority investor’s road to liquidity.

The dispute revolved around the attempt by the minority investors to exercise put and forced-sale provisions contained in Oxbow’s operating agreement. See our prior article. This article, and those that follow, focus on the practical lessons to be learned from this case. Here we focus on how the economic terms of the transaction were potentially misaligned with the parties’ motivations for transacting. Further, the deal terms may not have appropriately set the parties’ expectations on what was a fair outcome. Although these issues can be difficult to spot in the heat of the moment (and without the benefit of hindsight), it is worthwhile to study how deal terms may have contributed to an otherwise successful deal spiraling into litigation.

Background: Put and Forced-Sale Provisions
Buyers pay premiums in control deals. Accordingly, minority investors prefer to exit investments alongside a change-in-control, which allows them to participate in the “control premium.” Tag-along, put and forced-sale provisions are all designed to achieve this objective. Tag-along provisions are passive rights that allow minority investors to “tag-along” on a sale by the controlling investor.

Put and forced-sale provisions, on the other hand, are active rights that allow an investor to force a liquidity event. When they exist in a deal, put rights usually become exercisable between three and seven years after the original investment. This provides the company and its controlling investor (if there is one) runway before the rights can be exercised, but also provides the minority investor assurance it can monetize its investment (and harvest a control premium) within its fund life.[1]

Exercise of a put triggers a valuation process. Though valuation processes may differ dramatically between deals, the objective is to arrive at a reasonable approximation of the company’s equity value in a sale transaction. However, these valuations are occasionally subject to floors and caps. Once the put price is determined, the company typically must accept or reject it. Proceeds to fund the put price come from one of three sources: (1) cash on the balance sheet (including from divestitures in anticipation of the put), (2) debt financing or (3) a new equity investment.

If the company rejects the put—or cannot fund it—other rights in favor of the minority investor may “spring” to life. Common examples of such springing rights include increased governance and board rights, ticking preferred features and forced-sale provisions.

The Misalignment
In 2006, Oxbow was contemplating two acquisitions. Koch solicited minority investments from private equity funds in connection with those acquisitions. Oxbow did not need the investment to fund either operating expenses or the contemplated acquisitions because, “Oxbow was a mature, profitable, and well-capitalized company.” Koch sought the investment because he “wanted to be conservative and have more equity on our balance sheet,” and to take on “a minority financial partner interested in the growth opportunities the Company would provide.”[2]

This investment closed in 2007 with two participating investors: Crestview Partners LP and Load Line Capital LLC (collectively, the “minority members”). The minority members acquired approximately 33 percent of Oxbow’s equity and were entitled to 3 of 9 board seats. They appear to have been selected as investors due, in part, to pre-existing relationships with Koch.

However, these relationships would become strained over time as a result of investment terms that were in tension with Koch’s desire for a conservative balance sheet. Oxbow is a business that operates in an industry prone to exuberant booms and busts. Problematically, the investment terms contemplated both (1) a mandatory quarterly distribution of net cash flow (which didn’t allow Oxbow to store cash in boom times to cushion against the busts), and (2) a seven-year put, back-stopped by a forced sale, in favor of the minority members.[3]

There is ample evidence that, despite a long boom cycle, Oxbow’s balance sheet had deteriorated by the time of the put exercise. In an October 2014 downgrade of Oxbow’s indebtedness, Moody’s highlighted the mandatory cash-sweep as a contributor to Oxbow’s plight. As a result of the cash-sweep and a challenging business cycle, 2016 debt/EBITDA ratios had trended to 5.6x.

Thus, layering the put on top of the cash-sweep created a combustible situation. Oxbow claims to have unsuccessfully explored many ways to satisfy the put, but:

• It had little to no room to draw on its revolver without breaching financial covenants.
• Even if it could accumulate cash, its credit agreement restricted using cash on the put.
• Finally, its credit agreement limited the ability to offer equity with preferred features.

This left very few financing options. One typical option would have been a partial control sale (i.e., greater than 50 percent, but less than 100 percent). But, as everyone knew, this kind of transaction was a nonstarter for Koch. Koch’s well-known battles with his brothers for corporate control of the family business instilled in him a fear of losing control of Oxbow.

At Koch’s request, the minority members delayed exercise of the put multiple times. Crestview also extended their fund life to accommodate a delayed exit. When they ultimately tried to force a sale of Oxbow, they were exercising a “negotiated for” right. They were not acting unreasonably.

However, the interplay of the cash-sweep and the put / forced sale provisions established dynamics that limited Koch’s options and made it reasonable for him, viewing the world through his own eyes, to compare the minority members to the corporate raiders of the 1980’s.

“For nearly seven years … the Company made substantial cash distributions,” Koch reminisced before going on to state that the minority members would, “routinely make toasts to Oxbow as their most successful investment … That’s why it’s particularly frustrating to me that just a few years later, they now want the additional benefit of an Exit Sale …”

The minority members had received at least 1.86x MOIC by the time of put exercise.[4] It was already a good deal; the only question was whether it would be great. Koch believed he delivered on his promises and the minority members responded by trying to take Oxbow from him. His choices were: (1) lose control of Oxbow during a trough in the economic cycle, or (2) engage in scorched-earth litigation. He chose litigation.

Crafting Solutions Based on Deal Motivations
The litigation materials include allusions to trouble with Koch’s personal finances and creditworthiness. It’s entirely possible the cash-sweep was just as appealing to him as it was to the minority members and, only in hindsight, did the full ramifications of the cash-sweep become apparent.

But, deal-making is a sandbox for creativity. Eliminating the cash-sweep entirely is just one approach; there are many different ways the tension between the cash-sweep and the put could have been solved.

Potential Solution No. 1: Deleveraging the Balance Sheet
The most realistic way to satisfy the put was deleveraging the balance sheet over time. Deleveraging could result from growth or prepayments on debt. Everyone prefers deleveraging through growth, but using cash from operations to manage debt balances is an important downside tool, particularly in a cyclical business.

If mandatory cash-sweeps were important, there might have been room to minimize balance sheet impact. Cash-sweep provisions tend to be complex mechanisms and Oxbow’s verified complaint indicates this deal was no exception.[5] While it appears there was some wiggle-room for discretionary capital expenditures, Oxbow could only prepay debt with supermajority approvals. However, because of the forced-sale provisions, the minority members’ interests may not have been aligned with Koch’s. This blocking right potentially allowed them to act opportunistically to frustrate repayment of the put and, thus, trigger their forced-sale rights.[6]

Certainly, an investor focused on interim distributions might want to maintain controls around prepayments. But, there might have been a middle-path to explore. For instance, one possible construct would have allowed Koch discretion to make prepayments based on certain pre-agreed financial metrics modeled off of the debt documents (e.g., leverage ratios).

This would have allowed cash-sweeps to coexist with enough balance sheet flexibility to debt finance the put purchase. Of course, the minority members might have reasonably countered that Koch should simply set aside some of his distribution receipts to fund the put purchase.

Potential Solution No. 2: Using MOIC and IRR Thresholds to Govern Put and Forced-Sale Rights
Some investment performance metrics utilized by private equity funds, such as multiple on invested capital (MOIC), are agnostic as to the timing of returns. The appeal of MOIC is its simplicity. It’s just returns from investment, expressed as a multiple of invested capital.

In the context of the private equity industry, with relatively standardized fund lives, MOIC can be an easy way for limited partners to evaluate fund performance at a glance. One of the problems with MOIC is it doesn’t time-weight investment returns (i.e., it doesn’t differentiate between $50 harvested tomorrow or 100 years from now). Of course, timing matters to private equity funds and their limited partners.

Other important fund performance metrics fill the gap. For example, the internal rate of return, or IRR—which is the discount rate that makes the net present value of cash flows equal zero—is heavily impacted by the timing of returns. IRR greatly prefers a $50 return tomorrow to a $50 return 100 years from now.

For this reason, the promise of interim distributions (which, according to the litigation filings, was unique in the Crestview portfolio), likely made an investment in Oxbow particularly attractive. Mandatory cash-sweeps dramatically increases IRR. Encumbering interim distributions with potential solution No. 1 would have negatively affected projected IRR. In other words, Koch may have traded cash-sweeps in return for the minority members taking a lesser stake in Oxbow. If that was the case, and the quarterly cash-sweeps were a fundamental part of the deal economics, the pressure created by the combination of the cash-sweep and put could have been addressed differently. Rather than encumbering cash-sweeps, back-end liquidity rights could have been subject to limitations (which would have a less dramatic impact on IRR).

Although the litigation focused on the minority members’ ability to force a sale if all members received 1.5x MOIC, Koch also had the ability to drag-along the minority members into a sale transaction if, when combined with prior distributions, it would result in 2.5x MOIC. This indicates a 2.5x MOIC was considered a big win for the minority members. This is an important data point in light of the minority members’ 1.86x MOIC (at a minimum) prior to put exercise.

After the put exercise, Oxbow solicited interest for financing from replacement minority investments. Oxbow did not receive any offers that exceeded $120 per unit for a minority stake. It considered this a low valuation, even applying a minority discount that was suppressed by, among other things, leaks into the market of the put exercise.

Even with the suppressed valuation of $120 per unit, a transfer of interests by the minority members would have resulted in at least 3.06x MOIC (and the front-loading of these returns through interim distributions means that MOIC understates the value Koch delivered). Since the minority members were willing to be dragged into a deal with a 2.5x MOIC, this suggests that—based upon the original expectations of the parties of what constituted a “win”—it may not have been appropriate for the minority members to be entitled to use the put / forced-sale provisions in this upside scenario to trade the control position Koch so deeply valued for incremental returns derived from a control premium.

Parties do sometimes negotiate for floors and caps on put/forced-sale rights. The facts of this case suggest that, rather than focusing on a 1.5x MOIC floor for a forced sale, Koch may have been better off focusing on a cap on the put and forced-sale provisions. The principled argument is that, while it is appropriate for the minority members to force a control sale in situations where minimum return criteria weren’t satisfied, a balancing of interests favors Koch maintaining control of his own destiny in an upside scenario.

If a cap had been introduced, this concept likely would have defined, and therefore set expectations on, a fair outcome. Clear contractual guidelines on fair outcomes could have preserved the investors’ relationships and prevented them from resorting to costly litigation.

Deals move quickly, with multiple different work-streams feeding into the process. Deals also tend to have forward momentum, where past decisions are not revisited. It can be difficult to step back, look at the picture holistically, and understand how all the interlocked pieces may facilitate a productive relationship or drive the parties toward litigation.

The public forum of the judicial system allows practitioners to learn lessons about how other transactions unravel. By digging into the factual record of this case—and the economic deal terms that may have made litigation more likely—we came away with three lessons to apply to our own practice: (1) understand the reason each of the parties are motivated to do the deal and under what circumstances they would no longer be willing to transact, (2) understand proposed deal terms—and the future they will create—holistically, and (3) craft material terms that appropriately set expectations on fair outcomes and create the greatest likelihood of producing “win-win” scenarios for the parties.

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[1] Private equity funds are subject to term limits. A common formulation is “10 plus 2.” This means a 10-year life, with the right to extend an additional 2 years. To ensure the fund harvests its investments during its term, a fund is typically only permitted to make investments within its first 4-6 years. Accordingly, a 7-year put approximates the maximum investment horizon for a fund at the end of its investment period.

[2] Koch may be overstating Oxbow’s ability to support these acquisitions without equity financing. Following these 2007 acquisitions (and the incurrence of debt to fund them), reported debt/EBITDA ratios of Oxbow spiked to almost 6x (though this ratio dropped to under 2x in 2010).

[3] Note that Oxbow’s LLC Agreement was filed with the court under seal and, as a result, was not available to the authors. References to provisions in the LLC Agreement are based on excerpts and summaries included in the pleadings and opinions.

[4] Based on the following: (1) by 2011, the minority members had already received at least 1.5x MOIC from cash-sweeps, (2) in order to satisfy the 1.5x MOIC for the Small Holders (discussed in prior article), an exit sale needed to pay them $414 per unit, and (3) based on the $300 per unit valuation attributable to the units when issued to the Small Holders, an additional $36 per unit appears to have been distributed following the issuance of these units in 2012.

[5] The complaint states that, “The Company is required to first apply its cash to pay operating expenses, capital expenditures, third party indebtedness, royalty obligations, lease commitments, reserve amounts required by lenders, all budgeted cash expenditures actually incurred, reasonable working capital reserves, and any other cash capital expenditures approved by the Directors.”

[6] The litigation filings hint that the minority members did not waive the cash-sweep, but the behavior under this provision isn’t entirely clear. The filings suggest that as a control sale became more likely, the minority members advocated for reallocating portions of the budget toward debt prepayments (which would have increased equity holders’ share of enterprise value). These positions were portrayed as objectionable to Koch because it shifted money away from growth toward near-term value maximization in a control sale. There are also suggestions in the record that the minority members viewed certain expenses as inappropriate extravagances for Koch’s benefit. An alternative explanation of the divide between the parties is that the minority members were acting appropriately and seeking to cut fat during a business cycle that did not support luxuries of the past.