Katten’s recent “2023 Middle Market Private Equity Report” provides plenty of insights into how PE firms view the challenges and opportunities middle-market deals will face this year. Here’s an excerpt from the intro:
Middle-market private equity (PE) firms have mixed expectations for the U.S. mergers and acquisitions (M&A) market in 2023, citing high inflation and concern that interest rates will keep climbing—but dealmakers are maintaining cautious optimism in key sectors. Though many investors expect to make additional acquisitions, some are bracing for a challenging regulatory environment, while others are prioritizing alternative deal types to mitigate impacts from macroeconomic volatility.
That split outlook is reflected in this report, which is based on a survey of 100 U.S. middle-market PE dealmakers engaged in a diverse array of industries, including financial services, education, health care, insurance, manufacturing and industrial, media and entertainment, real estate and technology. Nearly three-quarters of investors expect deal activity in 2023 to either remain at the same level as last year or increase (40 percent and 33 percent, respectively), while over a quarter (26 percent) expect a slowdown.
The amount of dry powder that PE firms have on hand could be driving this disconnect—especially as an overheated economy, domestic policymaking and geopolitical tensions come to a boil. With debt markets tightening and financing harder to procure, liquidity has become crucial to snapping up deals. Though some dealmakers have struggled, others have taken advantage of lower valuations to expand on investments in technology and finance.
With the darkening clouds of a potential recession on the horizon—and a clearer picture of what a post-COVID-19 economy will look like—it should come as no surprise that while the majority of market players don’t anticipate a deal slowdown in 2023, they are not overwhelmingly bullish either.
The report also addresses dealmakers’ assessment of M&A opportunities in various industry sectors and notes how deal practices, such as due diligence and financing structures, are evolving to address current market conditions.
Last month, in SMART Local Unions and Councils Pension Fund v. BridgeBio Pharma, (Del. Ch.; 12/22) the Chancery Court dismissed breach of fiduciary duty allegations against a controlling stockholder and certain directors of the target in connection with a take-private transaction, despite the target’s receipt of higher competing offers from an unaffiliated third party. Instead, Vice Chancellor Fioravanti held that the transaction satisfied the MFW standard and dismissed the plaintiffs’ complaint.
The case arose out of a 2021 merger in which BridgeBio Pharma, which owned 63% of the stock of Eidos Therapeutics, acquired the remaining 37% of Eidos’s common stock in a merger. Under the terms of the merger agreement, Eidos stockholders had the right to elect to receive either 1.85 shares of BridgeBio common stock or $73.26 in cash for each share of their Eidos common stock. The definitive merger agreement was entered into in October 2020 was the result of a process which saw Eidos’s special committee successfully negotiate significant increases in the consideration to be paid by BridgeBio.
Subsequently, GlaxoSmithKline made a proposal to acquire Eidos for $120 per share in cash. The Eidos board concluded that this could lead to a “superior proposal,” and exercised its right under the agreement to negotiate with Glaxo. However, BridgeBio had previously indicated that it was not interested in selling its stake in the company and reiterated this in response to this proposal. Ultimately, Glaxo withdrew from the process and the take-private transaction with BridgeBio was approved by 80% of the minority stockholders.
Prior to entering into the transaction, BridgeBio made an aborted attempt to acquire Eidos in August 2019, and renewed that effort in August 2020. Each of BridgeBio’s acquisition proposals was conditioned upon approval of a deal by a majority of the minority stockholders, and Eidos formed a special committee to evaluate the 2020 proposal. The plaintiffs did not challenge the deal’s compliance with these MFW conditions. Instead, they contended that MFW should not apply where the target has received a clearly superior proposal from an unaffiliated third party. Vice Chancellor Fioravanti rejected those arguments, and this excerpt from Dechert’s memo on the decision summarizes his reasoning:
The Court rejected plaintiff’s threshold argument that the Merger was not subject to MFW protection because GSK made an offer for the minority shares that was substantially higher than the consideration offered by BridgeBio and BridgeBio rejected it. The Court reasoned that, under Delaware law, a controlling stockholder is not required to accept a third-party sale or to give up its control, and MFW itself approved a transaction where the controller was explicit that it would not sell its shares to a third party.
The Vice Chancellor also rejected the plaintiff’s arguments that the special committee wasn’t properly empowered and that the vote of the minority stockholders was coerced. He also rejected challenges to several proxy disclosures. Interestingly, one of these was the common practice of not identifying a competing bidder by name in the proxy statement.
In BridgeBio’s Form S-4, Glaxo was identified as “Company C.” The Vice Chancellor noted that Company C was described as being a “large international pharmaceuticals company” and that the special committee concluded that its proposals were superior to BridgeBio’s, and concluded that this was sufficient for stockholders to conclude that Glaxo’s offers were bona fide.
What’s going to drive M&A activity in 2023? Willis Towers Watson thinks the answer lies in four macroeconomic trends – the quest for digital transformation, rising interest rates & economic instability, opportunities created by supply chain disruption, and the “mainstreaming” of ESG in M&A. This excerpt from WTW’s recent report on these trends addresses supply chain opportunities:
Supply chain chaos became acute in 2020 as many industries were hamstrung by a need for more access to parts and products from other regions, namely China. The disruption caused to manufacturing and technology has been a game-changer. The need to get products closer, faster and cheaper to market makes potential sellers “in country” far more attractive.
These disruptions to supply chains are likely to be long-term issues continuing well into 2023, and companies will look to M&A transactions to boost their operational resilience. To maintain efficient, cost-effective operations and to equip themselves for disruptions due to unexpected external forces, businesses will focus on reinventing their supply chain networks with onshoring and sourcing suppliers closer to production facilities.
The report offers an upbeat conclusion – while M&A flourishes in confident markets, there are also opportunities during downturns. As the markets adjust to continuing instability, potentially higher interest rates and inflation, M&A will remain a priority on the boardroom agenda and dealmakers with technology needs and a sound deal justification will find plenty of opportunity.
Earlier this week, the FTC announced the new thresholds for HSR filings. This excerpt from Fenwick’s memo on the new thresholds has the details:
Size of Transaction Threshold. Under the new thresholds, the parties to a merger, consolidation, or acquisition of voting securities or substantial assets will, in most cases, need to file pre-acquisition notifications with the FTC and the DOJ and observe the HSR Act’s waiting periods before closing if the transaction will result in either of the following:
– The acquiring person will hold more than $111.4 million worth of voting securities and assets of the acquired person and the parties meet the “size of person” requirements below; or
– Regardless of the parties’ sizes, the acquiring person will hold more than $445.5 million worth of voting securities and assets of the acquired person (size of person test is not applicable).
Size of Person Threshold. Meeting any one of the following three subtests satisfies the size of person test:
– A person with $222.7 million or more of total assets (on its most recent regularly prepared balance sheet) or annual net sales (from its most recently completed fiscal year) proposes to acquire voting securities or assets of a person engaged in manufacturing (note that software is not considered manufacturing) with $22.3 million or more of annual net sales or total assets; or
– A person with $222.7 million or more of total assets or annual net sales proposes to acquire voting securities or assets of a person not engaged in manufacturing with $22.3 million or more of total assets (net sales test does not apply); or
– A person with $22.3 million or more of total assets or annual net sales proposes to acquire voting securities or assets of a person with $222.7 million or more of annual net sales or total assets.
The new thresholds and filing fees will take effect on February 24, 2023 (30 days after publication in the Federal Register).
Just about a year ago, the FTC & DOJ announced that they were considering ways to modernize the federal merger guidelines “to better detect and prevent illegal, anticompetitive deals in today’s modern markets. This McDermott memo says that we should expect to see the new guidelines issued soon:
On January 18, 2022, The FTC and the DOJ launched a joint public inquiry soliciting input on ways to modernize the federal merger guidelines. The federal enforcement agencies voiced concerns over increased market concentration across many industries. The issues of interest involve reevaluating the agencies’ positions on the types of transactions that should be viewed as presumptively anticompetitive, market definition, so-called “nascent” competition, buyer-side monopsony power (with an acute focus on labor markets) and digital (i.e., “tech”) markets. The new merger guidelines, expected to be released in Q1 of 2023, will likely be a major overhaul of the prior guidelines and empower the agencies to bring enforcement actions in line with theories applied in recent investigations and merger challenges.
So, the FTC & DOJ plan to bake new enforcement theories that have largely received a cold shoulder from the federal courts into their revamped merger guidelines? Well, in the immortal words of Pepper Brooks, “it’s a bold strategy Cotton, let’s see if it pays off for them.”
A motion for attorneys’ fees may seem like an odd place to address the provisions of Section 242 of the DGCL that require separate class votes to approve certain matters submitted to stockholders of a Delaware corporation, but Vice Chancellor Zurn’s opinion in Garfield v. Boxed, Inc., (Del. Ch.; 12/22), did just that.
The case arose out of a de-SPAC transaction. The SPAC had Class A & Class B common stockholders and proposed amendments to the certificate of incorporation in connection with the de-SPAC that would have increased the authorized number of Class A shares & changed the stockholder vote required to authorize further change the number of shares. The SPAC planned to have all common stockholders vote on the de-SPAC merger and the charter amendments, as a single class. The plaintiff objected, claiming that a class vote was required under Section 242(b) of the DGCL, and the SPAC changed the structure of the transaction to provide for a class vote.
The plaintiff subsequently moved for an award of legal fees, arguing that by ensuring the transaction was approved in the manner required under the DGCL, his actions conferred a significant benefit upon the SPAC. The SPAC opposed that motion, arguing that the separate class vote wasn’t required under Section 242(b) because the Class A and Class B shares were simply different series of the same class of stock.
Section 242(b) provides that “The holders of the outstanding shares of a class shall be entitled to vote as a class upon a proposed amendment, whether or not entitled to vote thereon by the certificate of incorporation, if the amendment would increase or decrease the aggregate number of authorized shares of such class, increase or decrease the par value of the shares of such class, or alter or change the powers, preferences, or special rights of the shares of such class so as to affect them adversely.”
Vice Chanellor Zurn rejected the SPAC’s contention that the shares were merely different series of the same class, and held that a separate class vote was required. As this excerpt from Shearman’s blog on the decision explains, the Vice Chancellor’s decision focused squarely on the language of the SPAC’s certificate of incorporation:
Explaining that Delaware courts “apply the general rules of contract interpretation to disputes over the meaning of charter provisions,” the Court held that the Class A and Class B shares were two classes of common stock rather than merely two series of the same class. The Court highlighted that the charter used the word “class”—and not the word “series”—to describe these shares. The Court also noted that DGCL Section 102(a)(4) prescribes that “[i]f the corporation will have authority to issue more than one class of shares, then the certificate must set forth the number of shares of all classes and of each class and whether the shares are par or no-par.”
The Court found that the charter’s listing of the number of authorized shares for each of the Class A and Class B common stock, along with their par value, appeared “designed to authorize … statutorily compliant ‘classes’.” The Court added that, by contrast, the charter expressly provided authority to the board to issue “one or more series of Preferred Stock.” Therefore, the Court concluded, “[r]ead as a whole and together with the DGCL,” the charter “granted the [SPAC] authority to issue … only classes of common stock—not series.”
Accordingly, Vice Chancellor Zurn concluded that the plaintiff conferred a meaningful benefit on the SPAC by ensuring that the transaction was validly approved, and awarded the plaintiff $850,000 in attorneys’ fees.
Last year was a pretty dismal one for IPOs, and I haven’t seen many predictions saying that 2023 will be a banner year for going public either. That being said, the IPO window can open and close quickly, and this Weil memo explains that PE-backed companies need to be prepared to take advantage of IPO opportunities when they arise:
In 2022, many portfolio companies delayed their IPOs and will look to either go public or be acquired in 2023 or 2024 as markets improve. While many sponsors will exit their investment through a sale to a strategic buyer or another PE firm, there may be periods in the next year or two in which it is more advantageous to complete an IPO rather than an M&A deal. These market “windows” do not stay open forever, so it is critical for portfolio company management to be ready in the event an IPO is the desired path.
In addition, many portfolio companies pursue a “dual track” process and consider both an IPO and a strategic sale at the same time to create price tension on the overall exit transaction. To maximize the pricing leverage from this process, the portfolio company needs to be ready to consummate an IPO if it is determined that the IPO route will generate the most value.
The memo goes on to review the key matters that portfolio companies can address now in order to keep the IPO option open and move quickly to market if the window opens.
I blogged last week about the FTC’s proposed rules banning most non-compete agreements & the limited exception that it provides for non-competes entered into in connection with the sale of a business. This Hunton Andrews Kurth memo takes a broader look at the implications for M&A if the FTC adopts the rules in their current form, and summarizes some potential alternatives to standard non-compete arrangements that dealmakers may want to consider. For example, this excerpt discusses how deferred purchase price arrangements might help achieve the buyer’s objectives:
M&A purchasers and sponsors looking to retain the seller equityholders of a target may consider deferring a portion of the total purchase price as a means of retaining key selling equityholders. Deferred payment mechanisms can be structured in a number of ways, including by using seller financed promissory notes, earnouts or other contingent purchase price structures such as conditioning the payment of deferred purchase price upon achievement of certain financial metrics or employment through a certain date.
Although an earnout or deferred purchase price structure may accomplish the purchaser’s retention and competition objectives, sophisticated sellers could be reluctant to defer too much purchase price in a high-interest rate environment and will be aware of the leverage created by the Proposed Rule, if implemented, and may be reluctant to agree to such provisions, particularly if the provisions are tied to the individual’s continued employment post-closing where significant consideration is earned at closing.
In addition to describing various non-compete alternatives, the memo echoes one of the concerns that I raised – the possibility that the expansive language used in the rule could result in the FTC interpreting it broadly enough to cause certain payments that are contingent on continued employment to be de facto non-compete provisions.
According to an analysis by Bloomberg Law’s Emily Rouleau, “mega deals” didn’t escape the overall downturn in M&A activity last year:
After reaching an annual deal count of 46 in boom-year 2021—which was one of the highest annual counts of mega deals on record, according to Bloomberg data—a total of 34 M&A mega deals, valued at $10 billion or greater, were announced in 2022. Of 2022’s 34 mega deals, 27 were controlling-stake transactions, four were spinoffs, two were transactions for a minority or additional stake, and one was a joint venture deal. Last year’s controlling-stake mega deal count was also the lowest count since 2017 and below the 10-year average count of 32 transactions for that subset of deals.
The news wasn’t all bad for M&A’s behemoths – while annual mega deal volume dropped by nearly $100 billion from $840 billion in 2021 to $749 billion in 2022, the average size of the mega deals that did get done was $22 billion, which is higher than the average in 2020 ($19 billion) and 2021 ($18 billion).
Private equity funds like to tout their investments as being resilient during economic downturns. This Institutional Investor article highlights a recent study that supports that hypothesis. The study found that PE-backed companies outperformed their non-sponsored peers during the 2020 downturn resulting from the COVID-19 pandemic:
PE-backed companies significantly outperformed their unsponsored peers during the economic downturn unleashed by Covid-19 in 2020, according to the latest research from Paul Lavery from the Adam Smith Business School at the University of Glasgow and Nick Wilson from the Credit Management Research Centre at Leeds University Business School. Firms owned by private equity had higher growth in sales, assets, head count, and other key performance metrics in 2020 and 2021.
Sales at PE-owned companies increased 6 percent more than at other private companies, while total assets rose 10 percent more, according to the research.
The study’s authors point out that theirs isn’t the first study to support the idea that PE-backed businesses are more resilient during hard times than other businesses. Several studies found similar results in the wake of the 2008 global financial crisis.