– A Small World After All: R&W Insurance in Cross-Border M&A
– Maximizing Value & Minimizing Risks in Carve-Outs: Seller’s Pre-Sale Preparation
– Director’s Abstention on Merger Vote Deemed Material to Shareholders
– LLCs: The Limits of the Implied Covenant of Good Faith
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Last Friday, a New York judge issued a preliminary injunction prohibiting Xerox from taking further steps to complete its pending deal with Fujifilm. The judge’s 25-page opinion is worth reading – it recounts one of the more remarkable factual backgrounds for an M&A case that I’ve ever seen.
There’s so much going on in this case that I don’t know where to start. So, I’ll just rely on this excerpt from a recent “FT Alphaville” blog summarizing the court’s ruling:
In an extraordinary ruling late Friday, New York state judge Barry Ostrager enjoined Xerox from pursuing a shareholder vote on the deal, a relatively rare move that demonstrated how tainted he found the deal process (based on evidence from discovery and a hearing last week). Longtime Xerox shareholder Darwin Deason, along with a class of other shareholders, alleged that the Xerox CEO Jeff Jacobson engineered a dishonest transaction in order to save his job. They also claim the circumstances of the transaction saved Fuji, his alleged co-conspirator, from the need to deal with Xerox’s largest shareholder, Carl Icahn. (Deason was also allowed by the judge to pursue a proxy fight at Xerox.)
Ostrager said the circumstances of the transaction precluded the court from deferring to independent directors’ judgement. This is because the deal — which was ultimately approved by the board — transferred control of Xerox to Fujifilm without any payment to shareholders, named Jacobson as CEO of the combined entity, and gave Jacobson/Xerox say over the makeup of the combined entity’s board.
Xerox & Fuji both have said they disagree with the ruling & plan to appeal. Xerox is a New York corporation – and this recent column from Alison Frankel asks if Delaware would’ve issued an injunction under these circumstances. Despite the alleged sketchiness of the process, this excerpt says there’s some reason for doubt:
In 2014’s C&J Energy Services v. City of Miami Employees’ Retirement Trust, the Delaware Supreme Court reversed an injunction against C&J’s merger with Nabors Industries. The state justices essentially said that when independent boards exercise their business judgment to approve strategic mergers – and give shareholders a right to vote on the deals – Chancery Court should not stand in the way, particularly if there’s no competing bid for the company.
It will be interesting to see how this case – and this deal – play out. But holy cow, what an opening act!
The EU’s new General Data Protection Regulation imposes substantial obligations on companies to protect the personal data and privacy of EU citizens for transactions occurring within EU member states. The GDPR goes into effect in this month – and U.S. companies with substantial European operations have been gearing up for compliance.
This Davis Polk memo says that given the broad extraterritorial application of the GDPR, U.S. dealmakers need to do the same. The memo says that the implications of the GDPR need to be taken into consideration from diligence through structuring to post-closing integration. This excerpt discusses issues that should be addressed in the purchase agreement:
Prudent purchasers and investors will factor GDPR compliance into their purchase agreement structuring and risk allocation mechanisms. If the transaction is structured as an asset purchase, particular care will be needed to determine whether the transfer of the target’s databases itself may violate the GDPR (e.g., by exceeding the scope of the applicable consent or by transferring data outside of the E.U. to a jurisdiction that has not been deemed adequate by the European Commission).
Covenants may be appropriate to ensure continued compliance (or development of a compliance program) or notification of any new breaches between signing and closing the transaction. Risk allocation provisions should also be thoughtfully negotiated to ensure appropriate excluded liability, representation and indemnity coverage. Representations regarding compliance with law are insufficient to fully address data privacy risks and should be expanded to cover data-privacy related contract provisions, industry standards and practices, and existence and handling of data breaches.
In many instances, private equity sponsors may pursue a potential IPO by a portfolio company while at the same time exploring that company’s possible sale. This PwC blog discusses the considerations that sponsors should keep in mind when pursuing this dual-track exit strategy.
The blog points out firms may choose to be proactive or reactive in their approach to a dual-track strategy— either openly pursuing willing buyers while moving closer to an IPO, or only considering purchase offers they receive. This excerpt discusses the factors that might cause a sponsor to adopt a more proactive approach:
– Market volatility – When market volatility is high, PE firms may want to adopt a proactive strategy, actively pursuing potential buyers in an attempt to reach an exit price within a more predictable range. It should be noted that high market volatility inherently also provides additional uncertainty around the completion of a successful IPO and/or sale.
– Holding period – In an IPO, the PE firm must retain a significant stake in the company, which would prolong the holding period for an investment. With that in mind, if the end of the planned holding period is approaching or has passed, or an exit must be assured to meet fund return targets, a trade sale can be used as a backup option to potentially expedite the exit process and receive the full proceeds from a sale.
– Control over exit value – If a PE firm wants more control over the exit value, an IPO filing will help to establish a price floor, and the additional competitive pressure of a viable IPO process can drive bidders to submit higher offers. Research confirms the wisdom of this strategy: A study published in the Journal of Business Venturing examined 679 exits from 1995-2004 and found that PE firms following an active dual-track exit strategy earned a 22-26% higher premium over those which pursued a single-track exit approach.
In contrast, a more reactive approach may be appropriate if resources are limited or the firm doesn’t want to fully divest its investment.
This Fried Frank memo reviews recent Delaware appraisal decisions and identifies situations in which Delaware courts are likely to make awards that are lower than the deal price – as well as those in which it isn’t. The memo points out that in recent decisions, the statutory mandate to exclude value arising from the merger itself has strongly influenced the approach to valuation. However, this excerpt points out that the statutory mandate notwithstanding, there are still circumstances in which a Delaware court is likely to make an appraisal award that exceeds the deal price:
Given the new emphasis by practitioners and the Court of Chancery on the statutory mandate to exclude value arising from the merger itself, we expect that, absent legislative change with respect to the mandate or clarification by the Supreme Court, below-the-deal-price results will continue to be seen in arm’s-length merger cases—whether the court (a) views the sale process as having been robust (and thus relies on the deal price-less-synergies) (or even if the court relies on the unaffected market price) or (b) views the sale process as not having been robust (and thus relies on a DCF analysis).
We note, however, that the a below-the-deal-price result in the case of (b) is potentially “incongruous” (as Vice Chancellor Glasscock characterized the result in AOL)—because, intuitively, an appraisal result should be higher than a deal price that resulted from a deficient sale process. For this reason, when the court relies on a DCF analysis due to the sale process for an arm’s-length merger having been less than fully robust (not seriously flawed), we expect that the result typically will be reasonably close to the deal price (as it was in AOL). However, we expect that, when the court views the sale process as having been seriously flawed, the appraisal result may well be above (even significantly above) the deal price.
Because DCF analysis can produce a very wide range of results depending on the inputs selected, the memo points out that it should result in a premium to the deal price if the amount by which the price undervalues the company exceeds the value of merger synergies excluded in the DCF analysis. For that same reason, the memo says that appraisal results in non-arm’s-length merger cases generally will continue to be above the deal price.
This O’Melveny memo addresses the 9th Circuit’s recent decision in Varjabedian v. Emulex – in which the Court held that liability under Section 14(e) of the Exchange Act may be based upon negligence. Section 14(e) is the Williams Act’s general anti-fraud provision, and prohibits misstatements or omissions in connection with tender offers. As this excerpt notes, the 9th Circuit’s decision creates a split among the circuits on this issue:
The Ninth Circuit acknowledged that five other circuits (the Second, Third, Fifth, Sixth, and Eleventh) had held that § 14(e) requires that plaintiffs plead scienter, but was “persuaded that the rationale underpinning those decisions” should not actually apply to the first clause of §14(e). According to the Ninth Circuit, those other circuits ignored or misread Supreme Court precedent in relying on the “similarities between Rule 10b-5 and § 14(e)” to import Rule 10b-5’s scienter requirement to § 14(e) claims.
That is because the Supreme Court in Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 (1976), made clear that adding “scienter [a]s an element of Rule 10b-5(b) had nothing to do with the text of Rule 10b-5.” To the contrary, the Court in Hochfelder “acknowledged that the wording of Rule 10b-5(b) could reasonably be read as imposing a scienter or a negligence standard.” Id. (emphasis in original).
It nonetheless found that “Rule 10b-5 requires a showing of scienter because it is a regulation promulgated under Section 10(b) of the Exchange Act, which allows the SEC to regulate only ‘manipulative or deceptive device[s],’” which necessarily entails scienter. Id. at 13 (emphasis in original). In other words, Rule 10b-5 requires a showing of scienter because of the authorizing statute, not based on the Rule’s language. According to the Ninth Circuit, “[t]his rationale regarding Rule 10b-5 does not apply to Section 14(e), which is a statute, not an SEC rule.”
The memo points out that the circuit split created by the decision increases the likelihood that the Supreme Court will take up the issue of whether scienter is required under Section 14(e). Meanwhile, the decision is likely to provide incentives for plaintiffs in nationwide class actions to file their cases in the 9th Circuit.
Over the past several years, some activists have pursued a strategy of buying a potential acquirer’s stock after the announcement of a deal and initiating public campaigns designed to influence the deal’s terms – or even block it outright. This recent study takes a look at the strategy, how it affects the firms that are targeted, and the returns it generates for activists.
The study says that it’s buyers with a poor record of return on invested capital who are likely to find their deals targeted by activists. The type of transactions likely to attract acquirer arbitrage are stock deals in which the target has takeover defenses in place, and which have attracted competing bidders. These characteristics are associated with a heightened risk of overpaying, inefficiency, and lower returns for acquirers.
How successful is the acquirer arbitrage strategy? The study says the results are pretty impressive:
In 36% of all targeted deals, activist arbitrageurs manage to block the deals; in comparison, the matched sample without activist intervention has a 91% completion rate. In an additional 17% of the cases, activists are successful in pushing to make the terms more favorable to the acquirers, including lowering the bids. On average, activist arbitrageurs earn a risk-adjusted return that is 6.0 percentage points higher than the matched sample in the post-deal announcement time period. Presumably, the superior returns also accrue to the long-term shareholders of the acquirers. In fact, the market reacts positively to the disclosure of activist involvement: the average abnormal return measured over the 20-day window around the disclosure date amounts to 5.7%.
This Akerman memo reports on the environment for private equity funds under $1 billion in size. The memo addresses deal flow, exit flow & fundraising for funds below $1 billion and those below $500 million in size. Here’s an excerpt on deal flow for sub-$500 million funds:
Deal activity was down slightly in 2017 in this sector of the market (funds less than $500M), as were purchase price multiples. However, compared to historical norms, both remain elevated. Last year’s deceleration in multiples was a sign of discipline and cautious optimism among investors, who are facing headwinds of increased PE competition, high valuations and the increased activity of fundless sponsors. In all, about $20.2 billion was invested in 2017 via 662 transactions.
Overall value was up slightly from 2016 ($17.9 billion), reflecting higher than normal price tags and the amount of new capital in the market, which totaled $16.9 billion last year. The PE market has enjoyed a historically long business cycle and historically low interest rates. The market is cautious at the moment.
Investors have found it harder to find good companies selling at good multiples, and additional work is being done to find potential value. To mitigate today’s multiples, sub-$500 million funds have taken to add-ons in large numbers as a way to achieve multiple expansion. The 363 add-ons done in 2017 represented 55% of total deal activity, and the $5.9 billion spent on add-ons last year was a record.
Valuations in this segment of the market remain high by historical standards. For deals under $100 million, the median EBITDA multiple was 6.8x in 2017. The report also says that because interest rates remain low, PE returns will not be too sensitive to increases this year – assuming that the Fed doesn’t move into panic mode.
This AlixPartners report says that the relationship between portfolio company CEOs & their private equity owners is often pretty rocky – and that it too often leads to disruptive & costly departures. Here’s an excerpt:
For too many PE owners, misalignment is triggering unplanned turnover among their portfolio company CEOs. Indeed, for this year’s survey respondents, CEO turnover was unplanned for 34% of investments. And everyone’s paying the price. Such turnover can disrupt entire companies, causing confusion and sparking fear among managers and employees about what the change in leadership will mean for them. Result? Productivity and morale plummet.
Equally worrisome, as much as 46% of the PE firms participating in our survey said that unplanned CEO turnover was eroding the internal rate of return (IRR) on their investments. And a whopping 83% said that such turnover was lengthening their investment hold times
What’s the problem? The report says there’s often a lot that CEOs & PE funds don’t see eye-to-eye on. PE funds say that CEOs need to better appreciate their investment timeline & need for urgency, their desire for the CEO to focus on value creation, and the need for transparency. CEOs say that PE funds need to understand the drivers of the business & the CEO’s motivations, to exhibit more patience and listen to the CEO, and to be realistic about the speed of execution of the business plan.
Given the prevalence of CEO departures, the report recommends that PE funds factor the costs associated with that possibility into their investment theses. It also recommends that greater attention be paid to assessing CEOs during due diligence, and that funds consider allowing neutral third parties play a central role in the assessment process.
Listening to Alexa laugh at me while I pound away on my keyboard doesn’t make me real excited about the prospect of this – but this recent Norton Rose Fulbright blog says that the future of M&A due diligence belongs to artificial intelligence. Here’s an excerpt:
Enter artificial intelligence (AI) platforms. AI enables law firms to review a large number of contracts for standard considerations in a systematic manner, including change-of control, assignability, and term, while minimizing errors or oversights in the function that the AI program is coded to perform. An AI program for due diligence collects the pertinent documents at their source, filters agreements from non-agreements, and then identifies, analyzes, and classifies the content of the contracts.
This permits the program to organize and structure the documents in the Virtual Data Room, as well as identify and even complete, to the extent permitted and possible, the missing fields. Due to advances in machine learning, a given AI program run in successive iterations can learn and retain knowledge of key contract clauses and previously encountered due diligence issues.
Since AI processes the contracts that are relevant to the transaction, a lawyer’s review of the data output provided by AI is much more time- and cost-efficient than manually performing the review from the outset. This allows lawyers to focus their time on more sophisticated tasks, such as analysis of the data output and providing recommendations to the client. As we reported last year, Kira’s Diligence Engine, a machine learning contract search platform, claims that AI platforms can save lawyers 20-90% of time expended on contract review without sacrificing accuracy.
Maybe the best evidence of AI’s potential as a tool for lawyers is the number of providers who are already in the game – and shut up, Alexa!