The Covid-19 pandemic has seen previously sky-high M&A valuations plummet, at least for now. As a result, buyers looking to press on and do deals in this environment need to find creative ways to bridge gaps between the value at which deals can get done & what sellers believe their businesses are worth under normal conditions. This Dechert memo discusses strategies that buyers can employ in order to accomplish that objective.
Perhaps the memo’s most interesting suggestion is to look to Asia for insights as to how dealmakers there have approached valuation issues in the current environment. Asian financial markets have dealt with the effect of COVID-19 longer than U.S. or European markets, and have also had experience dealing with SARS and similar market disruptions. As a result, it may be helpful to consider recent valuation trends in those markets. These include:
– The use by sponsors of downside protections typically incorporated in venture capital transactions, given the similarities between the current environment of valuation uncertainty and the valuation uncertainties inherent in venture capital investments. These measures include negotiating for most favored nation clauses, down-round protections and enhanced liquidity and dividend preferences.
– Investors increasingly structuring their investment as a hybrid debt/equity instrument to ensure there is down-side protection, with the prospect of equity upside in the future.
– Investors providing convertible bridge loans with an agreed-upon conversion discount triggered by a subsequent equity investment, which provides initial capital to the target business and also provides the investor with more time to conduct diligence and determine the appropriate equity valuation.
The memo also addresses the possible use of earnouts, noting that while they are often complex and frequently end up in litigation, the can be a useful tool in an economic downturn. In addition, it discusses the possible use of toe-hold and other minority investments, which – if properly structured – can allow a company to obtain needed capital without a full exit at a depressed valuation, and also provide a path to control for the investor.
European regulators are becoming increasingly concerned about attempts by non-EU buyers to obtain control over suppliers of essential products – and healthcare products in particular. This Cleary Gottlieb memo says that the European Commission is urging member states to use existing foreign direct investment rules & introduce robust screening mechanisms where they don’t currently exist, in order to protect “critical health infrastructure, supply of critical inputs, and other critical sectors.” This excerpt summarizes the EC’s message:
The EC’s communication notes that the COVID-19 pandemic could give rise to “an increased risk of attempts to acquire healthcare capacities (for example for the productions of medical or protective equipment) or related industries such as research establishments (for instance developing vaccines) via foreign direct investment.” It further states that “vigilance is required to ensure that any such FDI does not have a harmful impact on the EU’s capacity to cover the health needs of its citizens.”
Because “acquisitions of healthcare-related assets would have an impact on the European Union as a whole,” the communication urges Member States that do not have screening mechanisms, and have not yet implemented the FDI Screening Regulation, “to set up a full-fledged screening system and in the meantime to use all other available options to address cases where the acquisition or control of a particular business, infrastructure or technology would create a risk to security or public order in the EU, including a risk to critical health infrastructures and supply of critical inputs.”
The memo also provides some details on the EU’s new FDI Screening Regulation, which will go into effect in October 2020. The EC’s communication to member states particular emphasis to the possibility of post-closing enforcement actions under a mechanism introduced by the FDI Screening Regulation.
In an effort to maintain my sanity by providing some non-pandemic content, I stumbled across the Chancery Court’s recent decision in Walsh & Devlin v. White House Post Productions, LLC, (Del. Ch.; 3/20), which involved claims arising out of an LLC’s attempt to back out of a contractual buyout process that it had started.
The LLC agreement’s buyout provision was one that is pretty common in a variety of settings involving companies with management investors alongside PE firms or other sponsors. It gave the LLC the right to buy out management investors upon termination of employment, and established a “triple appraisal” pricing process. The LLC notified the plaintiffs that it intended to exercise that right, and duly produced the first appraisal. When the plaintiffs sought information in order to obtain a second appraisal, the LLC informed them that it had changed its mind and was no longer interested in buying their membership interests.
The plaintiffs went ahead and sought an second appraisal anyway, and when that appraisal produced a valuation that was 10% higher than the one produced buy the LLC, they sought to have a third appraisal completed. At this point, the LLC went silent. The plaintiffs responded by filing a lawsuit that essentially asked the Chancery Court to order the LLC to finish what it started.
The defendants moved to dismiss the breach of contract claim against the LLC. They argued that delivery of the buyout notice was simply an offer, which the LLC had the right to rescind at any time prior to acceptance. The plaintiffs countered that the exercise of the buyout right created a binding “call option.” After reviewing in detail the terms of the buyout clause, the Vice Chancellor held that the plaintiffs stated a claim:
The Buyout Provision is a call option. It contains both elements of an option contract: an offer to enter into an underlying agreement for the sale of property and a promise to keep that offer open. The underlying agreement is the Company’s “right to purchase” a member’s units “[i]n the event [that] [m]ember ceases to be employed by the Company.” The collateral agreement is Plaintiffs’ promise to keep that offer open: “such [m]ember shall be obligated to sell” his units to the Company. In sum, when executing the LLC Agreement, the parties agreed that all of pre-negotiated buyout terms would bind the parties in the event the Company exercised its option. This is, in all practical effect, the way a call option operates.
Because she concluded that the buyout provision was a call option, VC McCormick said that the Company could not withdraw from the price-fixing process after exercising that option – and she found that it was reasonably conceivable that the notice initiating the buyout process “constituted an exercise of the Company’s power of acceptance” under the buyout provision.
This kind of language is probably in thousands of buy-sell agreements, and I bet the drafters never thought for a minute that adding the language “. . .and the seller shall be obligated to sell” did anything more than add suspenders to the contractual belt. My guess is that language may get a closer look in the future.
By the way, I originally was going to title this blog “Delaware Chancery Says ‘No Backsies'” – but I concluded that was undignified, even applying the increasingly lax standards of a man who has spent the last two weeks in sweatpants staring vacantly into a seemingly endless stream of Zoom meetings.
Unfortunately, there’s likely to be an avalanche of debt restructurings over the coming months, and this Ropes & Gray memo says that some of them may trigger CFIUS review. Although loans are generally exempt from the CFIUS review process, adding a slice of equity or convertible debt to a foreign lender’s interest as part of a restructuring may alter the analysis:
In general, lending transactions are not within the scope of CFIUS’s jurisdiction, provided that they do not grant the foreign person economic or governance rights more characteristic of an equity investment. If a financing or lending transaction, for example, grants a foreign party (1) an interest in profits of a U.S. business; (2) the right to appoint members of the board of directors of the U.S. business; or (3) other comparable financial or governance rights characteristic of an equity investment, CFIUS could have jurisdiction over the transaction. Where a non-U.S. lender acquires a convertible debt instrument that will confer equity-like rights upon conversion, the CFIUS jurisdictional analysis becomes fact-specific.
Convertible instruments raise potential concerns because under the CFIUS regs, they are regarded as “contingent equity interests” and have the potential to trigger CFIUS jurisdiction either at the time of their acquisition or upon their conversion, depending on the circumstances.
The memo also notes that CFIUS jurisdiction can also be triggered by a default under a loan agreement, if there is a significant possibility that a foreign lender may acquire control of a U.S. business or qualifying access or rights over a technology, infrastructure or data (TID) U.S. business.
This March-April Issue of the Deal Lawyers print newsletter was just posted – & also sent to the printer – and includes articles on:
– Pre-Closing Covenants: Operating in the Ordinary Course of Business
– CFIUS 2020: Five Things to Know about Filings and CFIUS Risk
– FTC Targets M&A Agreements in Continued Campaign Against Noncompete and No-Poach Clauses
– Delaware Supreme Court Examines Director Liability for Acquisitions
– FTC and DOJ Announce New Draft Vertical Merger Guidelines
Remember that – as a “thank you” to those that subscribe to both DealLawyers.com & our Deal Lawyers print newsletter – we are making all issues of the Deal Lawyers print newsletter available online. There is a big blue tab called “Back Issues” near the top of DealLawyers.com – 2nd from the end of the row of tabs. This tab leads to all of our issues, including the most recent one.
And a bonus is that even if only one person in your firm is a subscriber to the Deal Lawyers print newsletter, anyone who has access to DealLawyers.com will be able to gain access to the Deal Lawyers print newsletter. For example, if your firm has a firmwide license to DealLawyers.com – and only one person subscribes to the print newsletter – everybody in your firm will be able to access the online issues of the print newsletter. That is real value. Here are FAQs about the Deal Lawyers print newsletter including how to access the issues online.
That was fast. A couple of weeks ago, I blogged about the FTC’s implementation of temporary e-filing procedures and its decision to deny HSR early termination requests while the new procedures were in place. On Friday, the FTC issued new guidance indicating that early termination requests were back on the table. However, as this excerpt from the guidance indicates, it’s still far from business as usual:
Parties and their counsel should not call the PNO or the litigation shops to advocate for early termination of the waiting period applicable to a notified transaction. We understand that all parties who request it would like early termination of the waiting period, but current conditions require us to prioritize processing filings that raise competitive concerns.
Premerger staff is at capacity, and both Agencies’ litigation teams are already working hard to evaluate the extent to which individual transactions might present competitive concerns. Forcing our staff to spend additional time engaging with parties or their counsel will slow our review, not expedite it, and will increase the stress on the premerger program.
In case they have to hit people over the head, the FTC’s guidance goes on to make it clear that during the Covid-19 crisis, early termination will be granted in fewer cases, and more slowly, than under normal circumstances.
This Sidley memo says that one of the consequences of the coronavirus outbreak may be a decline in proxy contests during the current season. As this excerpt points out, the reason is that given current market volatility, activists may be unwilling to commit to the kind of long-term hold that a successful proxy fight would necessitate:
It is important to understand that if an activist launches a proxy contest to replace directors, an activist must be prepared to remain in the stock for the foreseeable future – at least until the annual shareholder meeting and, if successful in obtaining board seats, at least 6-12 months beyond that. While there are no legal restrictions to the contrary, as a practical matter, an activist cannot initiate a proxy contest and sell or reduce its position shortly afterward.
An activist who does this stands to lose credibility with long-term institutional investors and becomes more susceptible to being portrayed as a “short term” investor in future activism campaigns. It is even more difficult for an activist to exit a stock if an employee of the activist fund, rather than candidates that are at least nominally independent, takes a board seat. Material nonpublic information received by the activist employee in the board room is imputed to the activist fund, thereby restricting the fund’s ability to trade in the stock.
The memo cautions that once the crisis passes, companies should expect activists to return to proxy contests with a vengeance. It notes that 130 proxy contests were launched in 2009, after the financial crisis, and many companies that can hide during a bull market have their vulnerabilities laid bare during a downturn.
Speaking of vulnerabilities, Sidley recently published a follow-up memo discussing the advisability of implementing a poison pill. This excerpt provides a reminder about how Delaware courts will evaluate such a decision:
In the current environment, boards of public companies should, at a minimum, make sure they have an up-to-date poison pill on the shelf and consider whether to adopt one. At least in Delaware, the standard of review of the board’s decision to adopt depends on the company’s particular circumstances at the time of adoption. In Delaware, if a poison pill is adopted on a “clear day” (i.e., where the company is not facing a hostile takeover bid or other specific threat), the business judgment rule applies (Moran), whereas adoption of a poison pill as a defensive measure in response to a specific threat is subject to enhanced scrutiny (Unocal).
Notably, even if a poison pill is adopted on a clear day, the decision whether to redeem the poison pill in the face of a hostile bid remains subject to enhanced scrutiny. In these extraordinary times, a board may, in the exercise of its reasonable business judgment, conclude that it is in the best interests of the company and its shareholders to adopt a poison pill even in the absence of a specific threat.
We’re starting to see some information on how Covid-19 has affected the deal market, along with some speculation about what it may mean for M&A going forward. Here’s an excerpt from this Greenberg Traurig memo on the current state of the market for public deals:
It’s not surprising that, to date, M&A activity for Q1 2020 is down substantially from the corresponding period of 2019. While activity was already somewhat slower due to uncertainty about future fiscal, tax, trade, regulatory, environmental and other policies at issue in the U.S. federal elections in November, the COVID-19 pandemic has had a pronounced negative impact on deal making and poses significant threats to near and medium-term corporate earnings performance and the global economy.
Industries such as travel, tourism, hospitality, sporting events, motion picture exhibition, live entertainment, consumer retail, home construction, auto manufacturing and financial services are being hit hard by the sharp reduction in demand as well as state and local government directives to cease operations at least for the near-term. Several industries will have to continue to contend with significant disruptions in their supply chains.
Not surprisingly, the memo goes on to say that until the crisis passes, U.S. & global M&A will likely remain soft. The memo also provides some interesting commentary about deal structures – including this excerpt addressing whether the precipitous fall in market values will impact stock for stock “mergers of equals”:
Except in cases of unusual, historical issuer-specific stock price volatility (where collars, price protection mechanisms and possibly walkaway rights might be requested, but are seldom agreed to), concerns about diminution of the issuer’s stock price between signing and closing are mitigated because, assuming the rationale for a synergistic business combination is sound and accepted by investors and analysts, macroeconomic impacts should affect the stock price of each merger constituent approximately equally and their stock prices should trade in tandem between signing and closing.
As a result, the memo concludes that the decline in stock values due to Covid-19 shouldn’t influence the business decision of strategic dealmakers about whether to proceed with true business combinations or MOEs. Of course, the memo says it’s likely to be a different story in situations involving a sale of control, where sellers are likely to have a strong preference for cash in a “volatile and bearish” stock market.
Earlier this week, I blogged about the possible resurgence of poison pills in response to the unprecedented market volatility resulting from the Covid-19 pandemic. This Cooley blog provides recommendations about other actions companies should take to shore up their defenses against activist challenges in the new environment. This excerpt discusses the need to refresh the company’s strategic plan:
The future of virtually all issuers will be materially affected by the pandemic. As with enterprise risk assessment, now is the time for companies and boards to review their strategic plan as affected by these developments, assess opportunities and challenges facing the company and review the company’s expected financial performance, capital requirements and balance sheet. Management should also be prepared to regularly review with the board current responsive updates to its operating plan and discuss the strategic, technological, market or other contingencies that are addressed and anticipated.
Not only may these efforts enable your company to weather the storm in a healthier position, it will be important to consider how corporate strategy promotes the long-term success of the company and interests of stakeholders to effectively respond to activism or opportunistic takeover proposals should they arise.
Other areas addressed by the blog include board engagement, enterprise risk assessment, shareholder communication and takeover preparedness.
I blogged last week about the FTC’s decision to not grant early termination of the HSR waiting period while its Covid-19 driven temporary e-filing rules are in effect. In the unlikely event that you’re in a rush to close a pending deal, this Winston & Strawn memo says that the DOJ’s Antitrust Division has more bad news for you:
Following the Federal Trade Commission’s (FTC) recent announcement regarding temporary changes to its Hart-Scott-Rodino (HSR) processes, the DOJ Antitrust Division (“Division”) announced that it also has adopted temporary changes to its HSR processes, which will apply during the COVID-19 emergency.
For “mergers currently pending or that may be proposed,” the Division announced that it is “requesting from merging parties an additional 30 days to timing agreements to complete its review of transactions after the parties have complied with document requests.” This follows a similar announcement from the FTC in which it indicated that it would seek modifications to timing agreements with merging parties on a “matter-by-matter” basis.
The memo says that this request will “almost certainly” result in longer review times for companies that have received a Second Request, since it will tack on an additional 30 days to the 60-90 period typically called for in the timing agreements that parties receiving a second request merging parties routinely enter into with the DOJ.