Kevin Miller of Alston & Bird provides this analysis: Although the primary focus of the press coverage regarding the recent In re El Paso S’holder Litig. case in the Delaware Court of Chancery has been on alleged management and financial advisor conflicts, there is a lot of discussion in the hearing transcript regarding valuation issues:
1. Chancellor Strine specifically references the debate as to whether terminal value multiples should be based on a comparable companies analysis (which may implicitly include a minority discount) or a comparable transactions analysis.
2. Plaintiffs allege that the terminal multiples used by El Paso’s financial advisors implied a perpetuity growth rate of 0.7% for a a company that allegedly has significant growth prospects – arguing that its absurd for the financial advisors to have used financial analyses implying that El Paso will grow at less than half the rate of inflation.
3. Chancellor Strine appears critical of using a terminal value multiple based on a comparable companies analysis that is below the mean/median multiple for the comparable companies – effectively taking a haircut off of a multiple that already reflects a minority discount.
See the following quotes from the attached transcript:
On Selection of Terminal Value Multiples
THE COURT: I understand. I assume you’ll think it’s too low. There are ways to do exit multiples because there is, for example, a philosophical debate you could have about if you use a current trading multiple of comparable companies, does that arguably embed a minority discount if you use this as an exit multiple.
On the other hand, if you think the growth rate of companies over time tends to normalize to the market perhaps using the current trading multiples, adjust for that. And, whereas, if you use comparable transactions, which are sales of whole companies, then you’d be overstating the future exit multiple.
You know, so there is that philosophical debate that men and women of valuation science and the academy never solved these problems.
And they don’t really think about them much, but judges like us who have to do appraisals do.
What did they, in fact, use? Did they use a current sample of so-called comparable companies? Did they use comparable transactions? [...]
MR. DiPRIMA: I think it’s trading data. And they did look at a median for the current period and used a slightly lower multiple for the terminal period. And that’s calculated in the book, Morgan Stanley’s —
THE COURT: So they used a lower period for the — they used a minority, a current minority trading multiple, and then they reduced it to use it as an exit multiple for an entire company?
MR. DiPRIMA: The multiple they used is I believe slightly below the median.
THE COURT: Of the current minority trading multiples?
MR. DiPRIMA: Correct. And I think part of the idea of that is that when you’re out to 2016, you’re in a slower growth period.
THE COURT: Well, if that’s the idea of it, and that may be part of why I talked about before decelerating the multiple by using a current minority trading multiple, but what you’re saying is they decelerated it even more. They took the minority —
On The Implied Perpetuity Growth Rate
THE COURT: I think what Mr. Clarke said, fundamentally, about KMI is if you look at the objective economic information in this record about KMI versus El Paso in the pipeline area, a big reason why KMI was buying El Paso was because of the attractiveness of its pipeline business; that if, really, what you’re assuming is that the future prospects of that pipeline business as recently as 2015 will translate into a perpetuity growth number of about a third of the historical inflation rate, then Kinder Morgan would not be doing this deal. The whole premise of the deal is stupid. That El Paso is dead. And yeah, I mean, this would be a great deal $10 per share less or something like this.
I mean, to get to a perpetuity growth rate of .7 takes some doing because what you have, obviously, is you’re going to have growth. You look at periods. And there might be a period between 2015 to 2025 where El Paso is still growing higher than the market.
Then you’re talking normalizing. Usually, you have to normalize through when they grow at the rate of the overall economy, then to where they kind of keep and they’re sort of the same share. This assumes that they’re relatively rapidly becoming less valuable as a proportion of the economy; in fact, not keeping up with inflation; in fact, not even keeping up with half of inflation; and it’s just a really odd thing.
On the Use of Medians
THE COURT: I’m talking about whether they used the median — look, I’m not saying the bankers did it here, but it is often the case that bankers will come up with eight comparable companies. That will generate a median. And use something that turns out to be the multiple of one of the companies, and they don’t use the median of their selected companies.
On Equity Risk Premium
THE COURT: Having had a case, frankly, where a very large bank changed the historical — the way it made a deal look more fair was to have its view of the historical equity risk premium change by nearly 2 percent within a period of two months. Which is a remarkable intellectual achievement, given that the historical risk premium is calculated — there is a debate about whether it goes back to the Ibbotson data or whether it goes back to the 19th century.
And then when I asked them whether they had done it at their committee, this is something they had decided for all representations, no. They were on the buy side. I said, Would you ever use this on the sell side? And the guy actually was real candid, and said something like, Heavens no. You know, and —
Here is another excerpt from Shareholder Representative Services’ new 3rd Edition of “Tales from the M&A Trenches“:
The dispute resolution terms in merger agreements are technical and cause many non-lawyers to glaze over when reading them. Details about who controls the defense of third party claims, jurisdiction, arbitration procedures and other similar terms are not fun to read but can be very important if problems do arise later. One particular issue worthy of special attention is which party controls the defense of third party claims. There are good arguments on each side for wanting this control. On the buyer’s side, the third-party claim is usually a claim against the combined company, and the buyer will want to control its exposure to such proceedings. On the seller’s side, if the claim relates to an indemnifiable matter, any payment of fees or settlement amounts is likely to come from the escrow, so the selling stockholders are most likely the ones ultimately paying the bill.
If the party that controls the defense is not the party responsible for any related payments, there can be a moral hazard problem. It is certainly possible that the party with control of such matter will behave differently if it is not their own money at stake. For instance, if the buyer controls the litigation but the payments are to come from the escrow, the buyer might be tempted to hire more expensive counsel than they otherwise would and might be motivated to agree to settlement terms early to avoid spending more time on the matter. Similarly, if the shareholders control the defense of a claim that will be subject to the indemnification basket or that might otherwise not be paid from the escrow, they might behave differently.
If the party that controls the defense is not the party responsible for any related payments, there can be a moral hazard problem.
If you’re in the mood for a freebie, I recommend taking Koncision up on its offer to received a copy of its confidentiality agreement template for free. I’ll spare you my droning on about how great it is…
Tune in tomorrow for the webcast – “The Dynamics of Disclosure Claims” – to hear Kevin Miller of Alston & Bird, Blake Rohrbacher of Richards Layton and Steven Haas of Hunton & Williams discuss how the dynamics of disclosure claims – including the procedural posture and risk/reward analysis of a potential appeal by defendants – are causing outside counsel to transaction participants to recommend increasingly detailed disclosure of such information in merger proxies and notices of appraisal rights. Please print off these course materials in advance.
Yes, we are holding webcasts on consecutive days – today’s program is “Transaction Insurance as a M&A Strategic Tool“…
Tune in tomorrow for the webcast – “Transaction Insurance as a M&A Strategic Tool” – to hear Keith Flaum of Dewey & LeBoeuf, Mark Thierfelder of Dechert and Craig Schiappo of Marsh’s Private Equity and M&A Services Group discuss how the use of insurance in deals is gaining popularity as a tool to bridge the gap on one of the most fundamental deal issues in any M&A transaction: the potential post-closing erosion of value. Please print off these course materials in advance.
I rarely blog about Professor Steven Davidoff’s writings for the NY Times’ DealBook (aka the “Deal Professor”) because I presume anyone who bothers to read this blog must also read his excellent missives. His latest blog is about that rare event, a real-life material adverse change. He writes about how Diamond Foods’ recent revelations of fraud probably constitute a MAC for Procter & Gamble’s deal to buy the company…
John Clifford of McMillan sends us this news: Increases to a merger notification threshold under Canada’s Competition Act and the investment review threshold under the Investment Canada Act recently were announced. The Competition Act generally requires advance notification of certain merger transactions involving operating businesses in Canada where “size-of-parties” and “size-of-target” financial tests are both exceeded:
- The “size-of-parties” test requires that the parties to a transaction, together with their affiliates, have assets in Canada, or annual gross revenues from sales in, from or into Canada exceeding C$400 million.
- Currently, the “size-of-target” test generally requires that the assets to be acquired or the value of assets in Canada owned by the corporation the shares of which are being acquired exceeds C$73 million, or the annual gross revenue from sales in or from Canada generated by those Canadian assets exceeds C$73 million.
2009 amendments to the Competition Act provided for an indexing of the size-of-target test to reflect annual changes to Canada’s gross domestic product. The Competition Bureau announced earlier today (February 7, 2012) that the size-of-target threshold will be increased to C$77 million. The 2012 threshold will come into effect following publication in the Canada Gazette, which the Bureau anticipates will occur on February 11, 2012. The “size-of-parties” test remains unchanged.
The Investment Canada Act requires that any non-Canadian that acquires control of a Canadian business (whether or not that business is controlled by Canadians prior to the acquisition) must file either a notification or an application for review. For the purposes of the Act, a non-Canadian includes any entity that is not controlled or beneficially owned by Canadians. Generally, direct investments (i.e., the acquisition of the shares or assets of a Canadian corporation) by WTO Investors are subject to pre-closing review and approval if the Canadian business:
- Has assets valued in excess of an annual threshold, which for 2011 was set at C$312 million; or is
- Cultural in nature and has assets in excess of C$5 million.
The Investment Review Division announced that the review threshold for the direct acquisition of non-cultural businesses by WTO Investors likely would increase to C$330 million in 2012, retroactively effective back to January 1, 2012. It is expected that the Minister of Industry will confirm that adjustment in the very near future.
As noted in this Weil alert, Bill Baer has been nominated as the new head of the DOJ’s Antitrust Division.
Here are the results from Weil Gotshal’s 5th annual survey of sponsor-backed going private transactions that looks at the material transaction terms and trends in going private transactions in the United States, Europe and Asia-Pacific.