In the current deal environment, private equity sponsors are increasingly looking for alternative ways of generating liquidity for their investments. A partial exit, in which the sponsor liquidates part of its investment in a portfolio company while retaining an ongoing interest in the business, is one increasingly popular alternative. This recent Foley blog addresses the potential benefits and challenges associated with partial exits. This excerpt provides an overview of some of the reasons why a sponsor might consider a partial exit:
There are several reasons why a firm might choose to do a partial exit instead of waiting for the exit event, including pressures from investors to generate liquidity. Firms have been holding onto their portfolio companies for extended periods since the end of the “zero interest rate” environment, which can lead to pressure from their investors. Bain & Company’s Private Equity Mid-Year Report states, “While exits also appear to have arrested their freefall, activity has landed at a very low level. And as limited partners (LPs) wait for distributions to pick up, most funds are still struggling to raise fresh capital.” A partial exit provides immediate liquidity that can be utilized to either invest in new opportunities or return capital to investors, helping manage the fund’s lifecycle.
There can also be a highly strategic component to a partial exit depending on who purchases an interest in the asset. A strategic investor can often bring in new expertise, resources, or access to new markets that can aid in the company’s growth. Suppose the investor brings complementary strengths to the partnership. In that case, it can also guide the company’s direction, positioning the company for the kind of growth that can lead to an exit at a much higher valuation down the road.
Finally, a partial exit provides a valuable mark to the portfolio’s valuation for the general partners and their marketing to new and existing LPs for the next fund.
Challenges associated with a partial exit include the need to ensure an alignment of interests between the sponsor and the incoming investor so that there is a clear strategic vision for the portfolio company, as well as the complexities associated with establishing an acceptable balance of control and decision-making authority between the sponsor and the new investor.
Last month, CFIUS issued its 2023 Annual Report to Congress. The report highlights key indicators of CFIUS’s activities and process, including the complexity and volume of its cases. The report says that there were 233 written notices of transactions filed with CFIUS in 2023 that it determined to be covered transactions, and that a subsequent investigation was conducted with respect to 128 of those 233 notices. The parties ultimately withdrew the notice and abandoned the transaction in 14 of these instances, either for commercial reasons or after being unable to identify mitigation measures acceptable to CFIUS and the parties involved.
There are a whole bunch of numbers in this report, and I could go on like this for quite a while, but that would be really tedious. Instead, I’m just going to point you in the direction of Davis Polk’s memo on the report and offer up an excerpt from that memo identifying some of the report’s key takeaways:
– Complex filings are not getting any easier (or shorter). As discussed above, the time to resolve investigations continues to increase, despite growth in CFIUS resources and staffing. In our experience, the increase in the number of questions from and information requested by the Committee during an investigation continues to drive longer timelines.
– Mitigation measures continue to expand. While the share of notices that resulted in the imposition of some form of mitigation measures remained the same as in 2022 (roughly 18%), it is significantly higher than in 2020 (12%) and 2021 (11%). Moreover, CFIUS’s indicative list of mitigation measures continues to expand, tracking changes to typical NSAs. Expansion has focused largely on data security and increased information and reporting requirements.
– Expect non-compliance with mitigation measures to be more heavily scrutinized and penalized. As discussed in our recent client update, CFIUS has increasingly focused on enforcement, and the Treasury Department issued a notice of proposed rulemaking earlier this year to amend its compliance and enforcement provisions to sharpen its enforcement authorities. Consistent with this trend, in 2023, CFIUS assessed or imposed four civil monetary penalties for noncompliance with material provisions of mitigation agreements, double the total number of previous penalties in the entire history of CFIUS, and issued its first formal finding of a violation of the mandatory filing requirements.7 The report notes that CFIUS member agencies increased investment in monitoring and enforcement resources in 2023.
– Shifting trends in non-notified transactions. CFIUS has made clear that investigating non-notified transactions is a priority of the Committee. As forecasted in the Committee’s 2022 report, though, the total number of non-notified inquiries has continued to decline, from 135 in 2021 and 84 in 2022 to 60 in 2023, as the Committee uses its increased investigative resources to work through a backlog of historical transactions.8 That said, the percentage of non-notified inquiries resulting in a formal request for a filing is trending upwards from ~6% in 2021 and ~13% in 2022 to ~22% in 2023, and we expect that CFIUS will continue to closely monitor for transactions of interest.
In Fortis Advisors v. Medtronic Minimed, (Del. Ch.; 7/24), the Delaware Chancery Court dismissed claims by a sellers’ representative that the buyer wrongfully deprived the target’s former stockholders of a $100 million contingent milestone payment. The Court rejected the plaintiff’s claims based on the earnout provision’s unusually buyer-friendly language concerning the buyer’s obligations with respect to the achievement of the milestone.
The merger agreement contained language stating that the parties intent was that “development, marketing, commercial exploitation and sale of the Milestone Products” could be exercised by the buyer in accordance with its business judgment and in its “sole and absolute discretion.” It went on to say that the parties acknowledged that the buyer’s ability to exercise its discretion “may have an impact on the payment of the Milestone Consideration.”
While the agreement also provided that the buyer could not “take any action intended for the primary purpose of frustrating the payment of Milestone Consideration,” it also said that the buyer would not “have any liability whatsoever to any [former target stockholder] for any claim, loss or damage of any nature that arises out of or relates in any way to any decisions or actions affecting whether or not or the extent to which the Milestone Consideration becomes payable.”
The plaintiff alleged that the buyer’s decision to defer hiring new salespeople, commencing a marketing program and refusing to pursue regulatory clearance and sales of a particular product were actions intended to frustrate payment of the Milestone Consideration. However, the Court concluded that “[d]eferring action and refusing action are functional opposites of “tak[ing]” action.” If the buyer had covenanted to use reasonable efforts to achieve the milestone, the Court said that those omissions might carry more weight, but not with the buyer-friendly language contained in the agreement.
The Court observed that the unusual language in the contract put the plaintiff in the position of having to satisfy a pleading burden that it just could not meet:
The Court first notes the unusually heavy burden that Fortis contractually imposed on itself. This is not a case where Medtronic covenanted to use “best efforts,” “commercially reasonable efforts,” or even “good faith efforts” to achieve the First Milestone. To the contrary, in an arm’s-length transaction, Medtronic secured for itself sole discretion to take actions that Medtronic knew would frustrate the First Milestone, so long as the action had some other primary purpose. Fortis freely assented to that arrangement. The Court is not aware of any Delaware precedent applying such a buyer-friendly contingent payment scheme, and the parties cite to none.
Thus, while Fortis is correct that Delaware law imposes a “‘minimal’ and ‘plaintiff-friendly’ standard” at the pleading stage, Fortis must contend with a voluntarily undertaken contractual standard that is far from plaintiff-friendly. To meet that standard, Fortis cannot simply raise an inference that Medtronic acted in a way that had the purpose or effect of defeating the First Milestone, Fortis must plead facts that raise an inference that Medtronic acted with the primary purpose of defeating the First Milestone. Fortis fails to raise the latter inference.
While the Court dismissed the plaintiff’s claims relating to the earnout, it allowed the plaintiff to move forward with claims that the buyer wrongfully withheld amounts held in an escrow account based on the buyer’s alleged untimely assertion of indemnity claims.
This recent Greenberg Traurig memo addresses the implications of the 2024 DGCL amendments that drafters of merger agreements, resolutions, and other corporate documents should keep in mind. This excerpt addresses implications of the provisions of new Section 147 of the DGCL permitting the board to approve a merger agreement in final or “substantially final” form on drafting board resolutions:
New Section 147 provides that, whenever the board of directors is required by the DGCL to approve an agreement, instrument, or document, the agreement, instrument, or document may be “in final form or in substantially final form.” Although “substantially final” is undefined in the DGCL, commentary suggests that it will be limited to inconsequential and immaterial changes. Board resolutions providing such approvals may now be drafted accordingly to permit some flexibility, though counsel should exercise caution when determining whether a board has approved a “substantially final” form of the applicable document. A more conservative approach would track preexisting best practices of board approval in final form.
The memo also addresses the implications of language in Section 147 permitting the board to ratify the final version of a merger agreement as of the date that it previously approved the agreement. It recommends that if the board previously authorized a version of the agreement that wasn’t completely finalized, it may be prudent for the board to adopt pre-closing resolutions ratifying the agreement retroactive to the date of the board’s earlier action approving the agreement.
Over the past few years, nothing’s been hotter than AI. In fact, I haven’t seen anything generate as much buzz among lawyers since the height of the dotcom craze, when some members of my old law firm’s management began to dress like Steve Jobs & wander the halls talking about how we needed to “get the Internet space.” Since we were based in Cleveland, about 95% of our clients at the time were traditional rust belt businesses & the 1% or so that were dotcoms didn’t have any money, but that still didn’t stop us from having fun while the craze lasted.
Anyway, this brief Vinson & Elkins memo provides some helpful insights into the risks associated with buying or investing in tech businesses focusing on AI and some guidance on how to manage them. This excerpt addresses the IP-related risks that buyers and investors need to scope out:
Transactions involving AI pose intellectual property (“IP”) and ownership risk in three significant areas: the AI models, the data used to train them, and the output. Prior to acquiring a business that uses an AI model, decision-makers should conduct diligence to assess how the model was created, by whom and the resources used. AI models can be developed using internal company resources, but many also use open source software code or commercial third-party software in the development of the model. The model may be created or modified by employees, contractors or other third parties.
The AI model is then trained, sometimes with large and varied datasets. AI providers may obtain the training data from internal resources, but many also obtain training data from customers, vendors, employees, websites (through crawling and scraping), books, photographs, maps, or otherwise from third parties. A model may then be fine-tuned for a specific application. Any use of training data, code or other information from others creates a risk that the others may have an IP ownership stake in the model.
Buyers should also carefully review customer agreements and licenses where third-party rights are obtained for use in training AI models. If an AI model is used to generate output, that output will also be subject to IP rights. The owners of the model and training data may have a claim to IP rights in the output, as may anyone prompting or running the AI model. Generative AI models may also generate content that infringes IP rights of third parties who had nothing to do with the AI model, its training or running the model.
The memo says that it’s essential not to assume that the AI model, training data or output is owned by the target or that it’s free to use. The law in this area is unsettled, and the memo urges buyers who want to minimize risk to confirm that the target either owns or has valid licenses covering any uses of the model, training data and output.
I don’t usually delay blogging about Chancery Court decisions, but I did last week after working my way through Vice Chancellor Laster’s opinion in Seavitt v. N-Able, (Del. Ch.; 7/24). The case is the latest in the series of post-Moelis cases challenging governance provisions in stockholders’ agreements working their way through the Chancery Court.
Since the case was decided under pre-market practice amendments law, you probably won’t be surprised to learn that the challenged provisions didn’t fare well. That being said, parts of the decision are pretty interesting – such as the discussion of the extent to which a charter provision may be dependent on “facts ascertainable outside of the document” and what constitutes “facts” in this context. I think I may blog about that aspect of the decision later this week.
So, my delay in blogging wasn’t because I didn’t find the opinion interesting. Instead, my problem is the same one that it appears VC Laster had with the case – aside from the impact on the parties involved, most of it seemed like a waste of time. That’s because when the Delaware General Assembly adopted this year’s amendments, it provided that Section 122(18)’s Moelis fix wouldn’t apply to pending cases. As the Vice Chancellor put it, that created a “donut hole”:
It seems likely that the proponents of the Market Practice Amendments did not want to appear to be affecting pending lawsuits and therefore created the donut hole. Speaking for myself, I would have preferred the Market Practice Amendments without the donut hole. Once a decision has been made to change the law retroactively, there is no reason to force the courts to apply the superseded law to a smattering of cases. That is a waste of judicial resources. It also risks creating confusion because there will be more extant decisions addressing issues where the Market Practice Amendments could lead to a different result.
But maybe I jumped the gun on concluding that there’s not much to be gleaned from the opinion for post-market practice amendment cases. On Friday, I found a thread over on X in which Ann Lipton pointed out that in addressing the enforceability of the various governance provisions challenged in this case, Vice Chancellor Laster may have provided some hints on how he’d come out on these issues under the new regime established by Section 122(18).
The Chancery Court recently dismissed breach of fiduciary duty claims arising out of a $400 million reduction in the purchase price to be paid to target stockholders as a result of post-signing equity awards to insiders that allegedly violated the terms of the merger agreement. In In re Anaplan, Inc. Stockholders Litigation, (Del. Ch.; 6/24), Vice Chancellor Cook held that because the transaction was approved by a fully informed and uncoerced vote of the target’s stockholders, it was subject to business judgement review under Corwin.
The key takeaway from this decision may just be that if you want to make a quick exit from a lawsuit based on Corwin cleansing, your best bet is to lay the whole situation out in your proxy disclosure without sugar coating it. This excerpt from Vice Chancellor Cook’s opinion suggests that’s exactly what the target did here:
Immediately up front in the Supplemental Proxy, the Board set forth its position, which was readily understandable to any stockholder reading it—that the Board believed the Company and its directors and officers had acted in good faith and in compliance with the Original Merger Agreement, but that a bona fide dispute had arisen with Thoma Bravo on that issue.
Stockholders would further understand that, rather than continue to dispute the issue and risk losing the deal, the Board made the business judgment that it was in the best interests of Anaplan and its stockholders to agree to a price reduction in return for securing the still premium transaction and enhanced closing certainty. This explanation was followed by an additional eight pages laying out in substantial detail the Board’s position, Thoma Bravo’s position, the dispute between the counterparties, and the negotiations over an amended merger agreement over a roughly two-week period.
In order to satisfy Corwin, it’s not enough that the stockholder vote is fully informed – it must also be uncoerced. The plaintiffs argued that the circumstances of the transaction involved “situational coercion,” because the status quo was so unpalatable that stockholders had no alternative but to vote for the deal at the reduced price. Specifically, they argued that if the stockholders didn’t approve the deal, the stock price would plummet. Vice Chancellor Cook rejected that argument as well:
To be sure, a stockholder would prefer more money for her shares to less, all things being equal. This would seem to hold true in all transactions involving rational economic actors. But it does not follow that a merger, or the vote thereon, is situationally coercive under our law simply because the merger offers a premium relative to the expected trading price for shares if stockholders do not approve the deal.
Anaplan stockholders had a choice to accept the revised merger or to vote it down and thereby retain their shares in the standalone company. Plaintiff does not allege the Company, or its shares, would be worthless or even materially impaired in terms of their intrinsic value. Anaplan stockholders had the opportunity to retain an interest in a multibillion-dollar company with significant revenue. The difference between good, better, and best here is not grounds for situational coercion.
The Vice Chancellor also rejected arguments that the transaction was “structurally coercive,” holding that those arguments boiled down to “a beef with Corwin itself.” He concluded that the plaintiffs were essentially arguing that the stockholders’ overwhelming vote to approve the deal shouldn’t be accorded any weight because it was bound up in their desire to receive a premium. VC Cook concluded that this ain’t the way it works:
Plaintiff’s argument seems to suggest that corporations, and our courts, have been missing structural coercion inherent in merger votes for nearly a decade. Corwin, however, establishes a framework in which our law respects equity owners’ fully informed decision to cash out their shares for a premium via a merger and accords that decision cleansing effect rather than labeling it coercion. That is a very deliberate feature, not a bug, of the system.
According to a recent Institutional Investor article, private equity funds are sitting on a mountain of dry powder – or at least some of them are. The article says that PE & VC funds have added nearly $50 billion to their cash reserves since December 2023. That’s double the amount they added during the previous 12-month period and brings the amount of dry powder to more than $2.6 trillion. But this excerpt says that the wealth hasn’t been shared equally – and that the big boys have raked in a disproportionate amount of the spoils:
Record dry powder is not a proxy for the health of the private equity and VC industries. A short list of the largest managers accounts for a disproportionate share of the cash. The 25 firms with the largest war chests collectively have $556.19 billion of uncommitted capital, more than 21 percent of all dry powder globally, according to S&P Global Market Intelligence. Topping the list of managers are KKR (which has had a celebratory five-years stretch) and Apollo Global Management, which each have more than $40 billion in dry powder. Ten others have at least $20 billion and the rest have at least $12 billion.
Overall, the rise in the amount of funds available for investment is a sign of renewed optimism about the deal market, but the article notes that fund managers aren’t out of the woods yet – capital is still a lot more expensive than it was a few years ago and the divide between buyers and sellers on valuation is still pretty wide.
Many D&O policies include “bump-up” exclusions that can come into play when a buyer increases the price to be paid in an acquisition in response to litigation challenging the deal. Earlier this year, Meredith blogged about a federal court’s decision holding that a “bump-up” exclusion in a D&O insurance policy resulted in the loss of coverage for the target company’s directors.
A recent Cooley blog reviews case law from various jurisdictions addressing the applicability of the bump-up exclusion. It concludes that determining whether the exclusion applies to a particular settlement depends on the wording of the exclusion, the structure of the underlying deal, and the law of the jurisdiction governing the policy. This excerpt addressing the Delaware Superior Court’s decision in litigation between Viacom and its insurer illustrates the importance of both policy terms and deal structure in determining whether the exclusion applies:
In 2023, in Viacom Inc. v. U.S. Specialty Insurance Company, the Delaware Superior Court again applied Delaware law and held that the bump-up exclusion did not apply to the settlement of a post-close lawsuit because the underlying deal did not qualify as an “acquisition” under the terms of the exclusion. The bump-up exclusion at issue stated that covered “Loss” did not include:
any amount representing the amount by which the price of or consideration paid or proposed to be paid for the acquisition or completion of the acquisition of all or substantially all of the ownership interest in, or assets of, an entity, including [Viacom], was inadequate or effectively increased.
The court noted that the underlying transaction was an all-stock merger between Viacom and CBS, at the close of which CBS owned all of Viacom’s assets, and Viacom shares were automatically converted into CBS common stock, with former Viacom shareholders owning approximately 39% of CBS outstanding common stock.
After examining the bump-up exclusion, the court determined that it was ambiguous. While the merger qualified as an acquisition of Viacom by CBS under the ordinary dictionary definition of “acquisition,” other provisions in the D&O policy distinguished between a “merger” and an “acquisition” and treated them as distinct types of transactions. Because the exclusion was ambiguous – and Delaware law required ambiguity to be resolved in favor of the insured – the court held that the bump-up provision did not apply to the settlement of the post-close litigation commenced by former Viacom shareholders.
The blog warns that in light of this developing case law, carriers are expected to include broad bump-up exclusion provisions that will limit coverage in a wide range of M&A transactions, and recommends that M&A practitioners carefully review their clients’ D&O policies to appropriately counsel them on the likelihood that a claim will not be covered.
This recent Sheppard Mullin blog addresses a topic that’s becoming increasingly important in M&A transactions – how to draft reps & warranties that cover AI issues for deals that don’t involve AI-related businesses. The blog points out that even non-AI companies frequently incorporate a lot of AI tools into their business, and that the AI-related issues that need to be addressed in the diligence and drafting process include infringement, confidentiality, IP ownership and protection, regulatory compliance, and other risks such as indemnity obligations or managing the use of AI by contractors.
That sure sounds like a lot, but the blog says the good news is that in many cases, drafting appropriate AI-related reps in these deals may simply involve some tweaks to the IP reps:
In some cases, existing IP representations and warranties can be expanded to address the definition of AI technology either as its own defined term or to be incorporated into other IP related definitions like “software” or “technology”, as needed. AI technology may include generative AI tools such as ChatGPT or tools which include AI like MSWord which has Co-Pilot integrated and the definitions should take the specific uses by the target into account. These types of tools use machine learning algorithms and large volumes of training data to develop models that can generate outputs in the form of high quality text, images and other content based upon user inputs.
If these tools are used by the target, it may also be necessary to include a concept of “Training Data” to flush out AI risks in the target business. Training Data is usually described as data, fine tuning and RAGS consent used to train, pretrain, validate, or otherwise evaluate, improve, modify or supplement a software algorithm or model. In general, the actual scope of the definitions will vary depending on the results of the target company diligence. For example, diligence may also reveal whether the target has an established policy for its employees on the use of AI in its business. Reviewing these policies can also influence these definitions as well as if the target uses contractors who create work product using AI.
The blog goes on to observe that buyers need to confirm rights to the use and ownership of the output of AI tools, and that reps covering infringement of and rights to Training Data, ownership of AI technology tools, ownership & protectability of outputs from those tools, licenses to inputs from AI technology and separate copyright & patent reps should be considered.