DealLawyers.com Blog

From the RiskMetrics’ “Risk & Governance Weekly” (note RiskMetrics will host a M&A trends webcast next Wednesday):

This year has been a tale of two M&A markets. Before the credit crunch of August, U.S. investors demonstrated a greater willingness this year to oppose going-private transactions and other deals. During the first half of 2007, companies announced a record $2.5 trillion in transactions, including $616 billion in purchases by private equity firms, according to Bloomberg News. The availability of inexpensive and abundant credit allowed private equity firms to pursue bigger targets, including First Data, Equity Office Properties Trust, and TXU–the largest-ever U.S. leveraged buyout.

Facing pressure from hedge funds, boards at Acxiom, Applebee’s, and other companies agreed to put their firms up for sale. After watching more boards approve private equity sales, investors became more skeptical of the fairness of initial offers and more willing to hold out for a better price.

Traditionally, target company shareholders have rarely turned down transactions. This year, however, investors rejected buyouts at Cornell Cos., Eddie Bauer, Lear, and Cablevision. The vote at Eddie Bauer in February was particularly noteworthy because no dissident investor had filed a Schedule 13D to publicly oppose the $9.25-per-share deal. In January, Cornell shareholders turned down an $18.25-per-share offer from Veritas Capital. The votes at Cornell and Eddie Bauer were among the first signs this year of an investor backlash against private equity buyouts.

In late October, ClearBridge, Gamco Investors, and other Cablevision investors rejected a $10.6 billion buyout by the firm’s founding Dolan family, which owns a 20 percent stake and has tried unsuccessfully twice before to take the cable television firm private. While the tighter credit markets have reduced the likelihood of other offers, the Cablevision shareholders argued that the Dolan family’s $36.26 per share bid undervalued the company.

In several cases this year, companies repeatedly delayed transaction votes while they tried to build sufficient support from shareholders. One prominent example is Clear Channel Communications, where the investor vote on a buyout by Thomas H. Lee Partners and Bain Capital Partners was delayed four times amid opposition from Fidelity Management and Highfields Capital Management. The buyout firms eventually raised their bid from $37.60 to $39.20 per share and won 98 percent support.

Other examples of delayed transaction votes include OSI Partners and Genesis Healthcare. In June, Inter-Tel postponed a vote on its sale to Mitel Networks amid fears that investors would reject the deal. Inter-Tel shareholders approved the sale in August after the company posted disappointing second-quarter results.

In the Clear Channel transaction, the private equity acquirers sought to win over skeptical investors by offering the opportunity to obtain up to a 30 percent “stub equity” stake, so they could share in the future profits of the privatized company. Similarly, the acquirers of Harman International Industries offered a 27 percent stake to Harman’s investors. Investors became more interested in stub equity transactions after watching private equity firms take companies private and then reap substantial profits a few years later through a public offering. While these stub equity stakes generally have limited liquidity and governance rights, the Clear Channel investors have negotiated certain governance rights, including the right to elect two of the new company’s 12 board seats.

In the Clear Channel, Lear, and Topps transactions, companies were ordered by Delaware judges to delay votes after shareholders filed lawsuits alleging that directors had breached their fiduciary duties. In the Lear case, a judge ordered the company to provide more information to investors on negotiations over the CEO’s severance package. In the Topps case, the court delayed the vote on a buyout by Madison Dearborn Partners and Tornante after concluding that the board failed to act in good faith to consider a competing offer from rival UpperDeck. The Topps ruling also is notable because the court decided to keep jurisdiction over the case, even though investors sued earlier in New York state court. The case illustrates that Delaware judges want to maintain their important role in overseeing transaction disputes between companies and investors.

Several companies bypassed a shareholder vote by agreeing to a friendly tender offer. One example was Laureate Education, which agreed to a $62-per-share offer from a private equity consortium in June after shareholders–including T. Rowe Price and Select Equity Group–objected to a $60.50-per-share bid. Friendly tender offers had been all but extinct until 2006 when the Securities and Exchange Commission amended its “best price” rule to exclude employment agreement payments to insiders. Tender offers can be more advantageous to acquirers because the transactions can close more quickly and there are no record dates to contend with. Also in June, the private equity purchasers of Biomet replaced a $44-per-share buyout with a $46-per-share tender offer.

Among the most contentious deals of the year was CVS’s acquisition of Caremark Rx, a Tennessee-based pharmacy benefits manager. Facing opposition from CtW Investment Group and other Caremark investors and a hostile bid from Express Scripts, CVS eventually increased its offer by $7.50 per share. Caremark investors, who received an additional $3.3 billion in value, approved the deal in March after a Delaware judge delayed the vote twice and ordered the company to provide more disclosure on investment bank fees and investors’ appraisal rights.

Another development this year was the greater activism by large mutual fund companies, which historically have taken a passive role. For instance, OppenheimerFunds helped lead a successful investor revolt in March at video game maker Take-Two Interactive, where the company’s former CEO had pleaded guilty to stock option backdating. Fidelity opposed the Clear Channel buyout, while T. Rowe Price made 13D filings to challenge Laureate Education’s buyout and Diversa’s going-private transaction.

After the Credit Crunch
The M&A climate has changed significantly after problems in the subprime mortgage market led to a wider corporate credit crisis in August. As credit tightened, banks tried to get out of their financing obligations by urging private equity firms to walk away from transactions. Shareholders at target companies almost overnight became less aggressive in agitating for better terms, realizing that in most cases the terms negotiated by their board earlier this year would not be bettered, at least in the near term. One notable example of this change was the mid-August decision by hedge fund Pershing Square to drop its opposition to a $5.3 billion buyout of Ceridian, a human resources firm.

Since August, some buyers have tried to back out of deals by either paying a reverse break fee (e.g., at Acxiom) or more commonly, by citing the “MAC” clause in the transaction contract, a clause that allows buyers to walk if there has been a “material adverse change” to the target’s business after the contract’s execution. The prospective acquirers of Harman International, Sallie Mae, and Genesco all have invoked these clauses to try to get out of those transactions.

With the relatively novel but now ubiquitous reverse break fee acting as a cheap option that caps a buyer’s ultimate liability, the mere threat of MAC litigation may force sellers to agree to reduced terms, regardless of the strength of the sellers’ legal arguments. The dearth of legal precedent in the Delaware courts on MAC clauses only compounds the dilemma for sellers.

In one case, a failed deal resulted in an extraordinary boardroom fight. On Oct. 31, Cerberus Capital withdrew from a management-led $6.1 billion buyout of Affiliated Computer Services, citing the poor credit market. The next day, ACS Chairman Darwin Deason, who was part of the buyout group, called for the ouster of five independent directors. Deason said the directors may have violated their fiduciary duties by failing to approve the deal before the credit crisis. The board members had sought to shop the company to other bidders and had urged Deason and Cerberus to drop an exclusivity provision. The directors agreed to resign, but they denounced Deason’s “bullying and thuggery.” The directors accused Deason of trying “to subvert the [sale] process in order to prevent superior alternatives to your proposal from being consummated.”

Notable Proxy Fights
As of mid-October, RiskMetrics Group had issued recommendations on 33 proxy contests that went to a vote, about the same number at this time last year. One notable difference this year has been the dramatic increase in the size of companies targeted by dissident campaigns. Three of these targets this year (Home Depot, Sprint Nextel and Motorola) have market caps above $40 billion. As the size of the targets increase, activist hedge funds have been forced to obtain the support of “mainstream” non-activist investors. Activists targeting $40 billion companies cannot simply form “wolf packs” of other hedge funds and expect to win a shareholder vote.

So far this year, it appears that activist hedge funds have been able to convince mainstream investors to support many of their activist campaigns. For example, Relational Investors was able to pressure Home Depot ($65 billion-plus market cap) into selling its supply business and forcing out high profile and controversial CEO Bob Nardelli in January. In October, Relational also successfully pushed Sprint ($50 billion-plus market cap) to force out CEO Gary Forsee.

In May, corporate raider-turned-activist Carl Icahn managed to capture 46 percent of the vote at Motorola ($40 billion-plus market cap), despite the fact that Icahn remains a polarizing figure in the investor community. Breeden Capital, led by former SEC chairman Richard Breeden, was able to capture an extraordinary 85 percent support at H&R Block ($7 billion market cap) in September.

The ability of activists to win support from mainstream investors has caused target companies to become increasingly willing to seek out settlements. As of early July, 32 potential proxy fights had settled, according to RiskMetrics Group data. Among the settlements were those reached at Comverse Technology, Southern Union, Pogo Producing, and Brinks. Most of the time, the accords are really target company capitulations that allow the board and management to save face. If one considers most settlements to be activist “wins,” then activists have easily won a majority of their engagements.

An open question for 2008 is what effect the credit crunch will have on the behavior of activist investors. Two of the most common demands by activist funds are to “sell the company” or to undertake a leveraged recapitalization. To the extent that there are fewer potential buyers, and target companies cannot tap into easy credit to complete recapitalizations, there may be fewer activist campaigns next year.