I blogged last month about some of the reasons spin-offs might be an attractive alternative for public companies during periods of market turbulence. This Sullivan & Cromwell memo says that the advantages of a spin-off aren’t limited to US companies, and that their European counterparts have also embraced them. This excerpt provides some statistics:
Spin-offs are widely used as a method of disposing of business assets in a tax efficient manner. In a spin-off, the parent’s shareholders receive pro rata shares in the spun-out entity (“SpinCo”). In some cases of so-called partial spin-offs, which are common in France and Germany, a portion of the shares in the spun-out entity remains with the parent company (“Parent”).
While not a new phenomenon, spin-offs have become an increasingly popular tool in recent years, occurring in record-high numbers in 2021. This trend has continued in 2022. Despite the decline in global M&A activity, 78% of respondents to Aurelius’ eighth annual corporate carve-out survey said that they expect the volume of corporates divesting non-core European and UK businesses in 2023 to increase year over year and 84% of respondents believe that a need to refocus on core operations will be a key driver of divestment activity.
There were 127 spin-offs announced worldwide in 2022; and it is likely that this “spin-mania” – compared to the declining level of M&A activity – will continue in 2023.
The memo addresses some of the reasons that European companies find spin-offs to be an attractive alternative – which are similar to those that make these deals attractive to US companies. It also discusses the factors that make these particularly challenging transactions on either side of the pond.
I was searching for blog topics recently and came across this interesting piece from Institutional Investor about how private equity executives are confiding in their “coaches” over the troubles that they’re facing in the current environment:
Falling private-market valuations and a tougher fundraising environment are starting to weigh on private-equity executives — but those aren’t the only concerns driving more CEOs to seek guidance from outside coaches. Personal coaches to private-equity executives report that their clients are increasingly worried about their impact on their employees, business, and even the world.
“When everything is up and to the right, everyone feels optimistic and gets along. As clouds roll in, these high achievers tighten up and tend to become defensive and argumentative,” executive coach Justin Doyle said.
And a storm is brewing — and in some cases has already arrived, Doyle said. His 20 private-equity clients are using sessions with him to vent their frustrations and worries, freeing up mental space so they can focus on solutions and be more productive at work.
These are definitely tough times for anybody in the deal business, but – and I know I’m a terrible person for admitting this – when I read this article, I could only picture Tony Soprano working through the personal impact of the problems in his, um, “waste management consulting” business with his psychiatrist, Dr. Melfi.
Yesterday, the FTC overturned a prior administrative law judge’s ruling and ordered Illumina to unwind its 2021 acquisition of multi-cancer early detection (MCED) test maker GRAIL. Commissioner Christine Wilson, who resigned from her position effective at the end of March, concurred in her Democratic colleagues’ decision to order the divestiture. This excerpt from the FTC’s announcement of the decision summarizes the basis for its ruling:
The Commission found that the acquisition would diminish innovation in the U.S. market for MCED tests while increasing prices and decreasing choice and quality of tests. This is extremely concerning given the importance of swiftly developing effective and affordable tools to detect cancer early.
The Opinion raises other concerns about the acquisition that support the Commission’s divesture order:
– Illumina is currently, and for the reasonably near future, will remain the only viable supplier of a critical input: NSG platforms necessary for MCED tests. Entry barriers prevent rival platforms from competing with Illumina’s high throughput, high accuracy, and favorable cost profile.
– Illumina can easily foreclose GRAIL’s competitors by raising their costs or withholding or degrading access to supply, service, or new technologies—inputs on which MCED test developers rely.
– Illumina has an enormous financial incentive to ensure that GRAIL wins the innovation race in the U.S. MCED market. Illumina stands to earn substantially more profit on the sale of GRAIL tests than it does by supporting rival test developers. And Illumina’s ample mechanisms for effecting foreclosure give it multiple ways to act on that incentive.
Illumina and GRAIL attempted to address antitrust concerns by implementing what they called “Open Offer” supply agreements. Illumina claimed that these agreements provided customers with protections on service, supply, pricing, intellectual property, and confidentiality, and included several provisions that provided them provide parity with GRAIL.
The FTC rejected this approach, concluding that the supply agreements were an ineffective remedy that tackles harm on an ad hoc basis. Reflecting the agency’s strong distaste for behavioral remedies, the opinion concluded that such measures “simply cannot substitute for the incentives of a competitive marketplace.”
Illumina plans to appeal the FTC’s decision, but for now, it’s faced with an order to “unscramble the eggs.” The company’s initial decision to close the deal without obtaining sign-off from antitrust regulators in the US & Europe was controversial, and Illumina is also currently facing a proxy contest led by Carl Icahn seeking board seats & calling for the deal to be unwound.
Woodruff Sawyer recently published a guide for insurance due diligence on M&A transactions. The publication highlights the importance of insurance and risk management due diligence for private equity transactions, and notes that poor execution of due diligence and implementation of insurance and employee benefit programs may expose buyers to increased risks that could diminish short-term EBITDA and the long-term value of the target’s business.
This excerpt discusses some important findings about issues with target coverage that Woodruff Sawyer observed last year in due diligence investigations for middle-market and growth equity transactions:
No comprehensive, strategic approach to insurance and risk management. While a foundation of coverage has been established, no long-term insurance strategy for EBITDA protection has been developed or implemented. The insurance advisor should recommend ways to both professionalize the
program and raise the level of sophistication of the insurance program post-close to maximize EBITDA protection over the lifecycle of the investment.
Key coverages are missing. For many target acquisitions, the deal represents the first time the company has accepted institutional investors or considered a buy-out from a private equity sponsor. This situation means new board members and potentially a new approach to insurance. What may have been treated as low priority pre-close (due to cost, for example) may be treated differently with a new private equity owner or growth equity investment because the buyer or investor will always seek to protect their investment.
Limits are inadequate. Like the previous point, a company pre-close will choose a limit for a variety of reasons. We have found the company typically has not performed any benchmarking analysis around limit adequacy. As an institutional investor becomes involved, there should be greater thought around limit adequacy to protect the short and long-term EBITDA of the company.
Examples of key coverages that are frequently missing include D&O, commercial crime, cyber liability or product recall liability, while examples of coverages that frequently have inadequate limits include cyber liability, business income and extra expense, contingent business income, and products liability.
In this Private Equity – 2023 Outlook, Wachtell reviews the key themes that drove deal activity in 2022 and expectations for 2023. On the financing side, the article describes some creative transaction structures that sponsors have been employing amid tumultuous credit markets. Here’s an excerpt:
– Buy now, borrow later. Some sponsors followed a “buy now, borrow later” path—up to and including all-equity deals, such as KKR’s buyout of April Group—writing large equity checks and planning to increase leverage when markets improve.
– You can take it with you… Also en vogue were deal structures that allow a target’s existing debt to stay in place post-transaction—for instance BDT Capital’s purchase of Weber. This approach, while “debt-efficient,” can limit buyout opportunities to more modest transactions, such as capping the new investment below 50%, and otherwise moderating consent and board rights to avoid tripping change-of-control provisions. Such was the case, for instance, in Kohlberg’s “secondary” transaction to buy a 50% stake of USIC from Partners Group.
– Seller notes. In certain situations, e.g., where the seller is a large strategic shedding noncore assets, buyers looked to “seller notes” and other forms of seller-provided financing to close the funding gap. For instance, Searchlight Capital Partners’ and Rêv Worldwide’s acquisition of Netspend from Global Payments was funded, in part, by Global Payments-provided financing.
The article also addresses recent trends in liability management transactions and the rise of direct lending.
Small deals can be expensive. In today’s cost cutting environment, it’s increasingly important to accurately estimate transaction costs, and this EY article highlights that many buyers aren’t budgeting enough and may be ignoring key factors when estimating integration costs. EY analyzed M&A transaction costs of 229 deals between 2010 and 2022 and determined that transaction costs are often driven more by the degree of change required than the size of the transaction.
The article highlights the following key considerations when estimating transaction costs:
– The size of the targeted synergy and amount of change needed
– Severance and employee-related costs, which can account for more than 66% of integration costs in some deals—while they mean cost savings in the future, the cost of acquiring talent needs to be considered as well
– While transaction costs may range from 1% to 4% of deal value, deals over $10 billion often have lower average costs as a percentage of value
– Integration costs can vary significantly by sector
As a fantasy and sci-fi nerd, this recent MoFo alert reminded me of a riddle from “The Hobbit”:
This thing all things devours:
Birds, beasts, trees, flowers;
Gnaws iron, bites steel;
Grinds hard stones to meal;
Slays king, ruins town,
And beats high mountain down.
The answer, of course, is time. And deals—stock-for-stock deals, especially—are yet another of its potential victims. As the alert notes, speed is the antidote to this deal risk, but rushing through diligence and negotiations presents its own risk. M&A practitioners must find the right balance. To that end, the alert presents a number of practical suggestions for signing on an accelerated basis, while running a thoughtful process. Here is an excerpt with a few of the suggestions:
– Do everything you possibly can before you engage with the other side. For a buyer, it should do all the analysis and due diligence it can before it approaches the target. As the target is publicly listed, it is required to file extensive amounts of information under securities laws. All of this information should be reviewed and understood by the buyer and its advisors. By completing a significant amount of the due diligence work before engaging, a buyer decreases the amount that needs to be done post-engagement and its now significant knowledge of the target will allow it to conduct more focused due diligence after engagement. This allows for a much quicker due diligence process while the parties negotiate the deal, without undermining the effectiveness of the buyer’s due diligence.
– If the circumstance presents itself, the buyer and target should consider first engaging shortly after quarterly earnings reports are released. This provides the parties with the benefit of the most recent information and a three-month period to reach a signing before the next earnings release.
– Consider avoiding a “testing the waters” or “small, slow concessions” approach to negotiations. These approaches will likely increase the timeline and run an increased risk of a leak.
Boards may face pressure from shareholders to publicly announce that they are considering strategic alternatives, including a sale of the company, but announcement comes with significant risks, some less obvious than others. This HLS blog post by Patrick Ryan of Edelman Smithfield, citing research from Jenny Zha Giedt at the George Washington University School of Business, acknowledges the potential benefits—a more robust process and possibly higher premiums—but notes that the significant consequences excerpted below, beyond share price impact and negative attention, often lead financial advisors to recommend against announcement:
– A public process consumes substantial time from directors and management, distracting them from overseeing and running the business.
– The company may face challenges retaining and recruiting employees.
– Relatedly, productivity can suffer as employees worry about things like job security and whether they’ll have to relocate in the event of a sale.
– Other stakeholders including customers, especially those with long-term contracts, often have concerns about how a sales process could affect them.
– Competitors may capitalize on the perceived instability following the announcement, costing you market share.
Whether a board chooses to disclose at the start of the process, or eventually makes a public statement once news has leaked or in the face of activist pressure, the blog presents some practical advice for a well-planned communication strategy to preserve shareholder value (see the post for details on each recommendation):
1. Identify likely stakeholder concerns pre-announcement and prepare a detailed and prioritized outreach plan to address them to the extent possible.
2. Acknowledge and place bounds on uncertainty.
3. Ensure consistency of messages when tailoring communications for various stakeholders.
4. Communicate with employees frequently and empower people managers.
Over on TheCorporateCounsel.net, John recently blogged about the SEC’s latest non-GAAP enforcement action. While we usually cover non-GAAP compliance matters on that blog, Regulation G enforcement actions are infrequent enough to be notable, and this enforcement action involved M&A related adjustments. Specifically, the SEC took issue with certain expenses that were improperly excluded from non-GAAP numbers as transaction, separation and integration-related (TSI) costs.
It’s been a couple years since we’ve had a non-GAAP enforcement action. Last week, the SEC reminded us that they’re still watching for problems. The Commission announced charges against a company for allegedly misleading disclosures about its non-GAAP financial performance in multiple reporting periods from 2018 until early 2020.
One of the things that got the company in trouble was allegedly failing to adopt disclosure controls & procedures specific to non-GAAP measures. The SEC says that led to misclassifications of excluded expenses and misleading disclosures of what exactly had been excluded. Here’s more detail from the 11-page order (also see this Cooley blog):
DXC also had insufficient processes to ensure that its business practices for classifying costs as TSI were consistent with the plain meaning of the company’s own description of those costs in its periodic reports filed with the Commission and in its earnings releases. The absence of a non-GAAP policy and specific disclosure controls and procedures caused employees within the business units and in the Financial Planning & Analysis area (“FP&A”) to make subjective determinations about whether expenses were related to an actual or contemplated transaction, regardless of whether the costs were actually consistent with the description of the adjustment included in the company’s public disclosures. As a result, DXC negligently misclassified certain internal labor costs, data center relocation costs that were unrelated to the merger, and other expenses as TSI costs.
Without admitting or denying the findings in the order, the company consented to a cease-and-desist order, to pay an $8 million penalty, and to undertake to develop and implement appropriate non-GAAP policies and disclosure controls and procedures. The SEC considered the company’s cooperation and remedial actions in accepting the settlement offer.
I blogged a few weeks ago that “disclosure controls” enforcement actions are trending. We all need to pay attention to the link between disclosure controls & disclosure content – including for voluntary disclosures – because the SEC certainly is doing that. As Lawrence noted last week on PracticalESG.com, the SEC’s interest in whether companies are accurately explaining what makes up the information they’re providing could also translate to scrutiny of ESG disclosure controls in the future.
A recent Stanford report on shareholder activism highlights some of the ways in shareholder activism and companies’ responses to it continue to evolve. In recent years, companies have frequently been admonished to “think like an activist” and identify & address potential weaknesses before activists leverage them into a successful campaign. This excerpt from the report says that’s proven to have been good advice:
As a result, more companies are looking at themselves through the lens of an activist and proactively taking actions that an activist would advocate (thereby weakening the argument for an activism campaign). Given that activists derive their power from gaining shareholder support, this means companies too are more likely to think in terms of maintaining shareholder support. Companies conduct preparedness exercises and advanced planning to discuss how they would respond, even before an activist engagement takes place. Preparedness also means that boards are much more conversant and comfortable with activism.
These practices took a dramatic step forward following the high-profile campaign between Nelson Peltz and Dupont, in which mega-cap companies realized they are not too big to become a target. Preparedness exercises have since proliferated to many large, medium and, in some cases, small-sized firms.
One result of this preparation is that companies have increased their success when campaigns come to a vote. According to statistics from FTI Consulting, whereas the activism slate historically has prevailed 50 percent of the time in a proxy contest, in recent years that success rate declined below 30 percent. Only around 30 directors are replaced each year in contested elections in the United States.
The report notes that how the universal proxy rules will affect these statistics remains to be seen, but says that boards will study early campaigns in order to learn how to improve their responses to activists in the new environment.