by tom hopKiNS aNd JaSoN NorthCutt
Additionally, strategics often include non-financial factors in their transaction analysis, such as synergies, defensive advantages and other competitive factors.
Non-financial aspects of an acquisition agreement such as time to close, allocation of risks and lack of closing contingencies can also play a significant role in
determining the winning bid for a company.
Because strategic buyers often have a strong grasp of the fundamentals of the target’s industry (and possibly of the target itself), they are often better positioned to assess the scope and magnitude of potential risks posed by the target’s business. Private equity firms, however, often have to educate themselves about the target’s industry and specific business, which is a time consuming process. Further, since a private equity firm is compensated only if its returns are in excess of a hurdle rate, sponsors often take a more hard-line view of the target’s potential risks, which results in transaction agreements that allocate greater economic risks to the sellers.
Most private equity firms do not have the human capital required to operate their portfolio companies day-to-day. Private equity buyers often require management stockholders to ‘roll over’ a significant portion of their equity rather than cashing out 100 percent of their holdings. They will also likely insist that most or all of the key management sign long-term employment contracts as a condition to closing. Even though the selling stockholders will continue to hold a stake in the target going forward, the private equity firm will control the company and the sellers will find themselves as minority stockholders.
For a selling stockholder that is looking to ‘cash out’ and move on to the next
venture or retire, these requirements can be unattractive. Strategic buyers, however, have operational executives and systems in place to run the business and are less sensitive to keeping management in place.
Third, amendments to Rule 144 and Rule 145 by the US Securities and Exchange Commission (SEC) that became effective on 15 February 2008 will also likely benefit strategic buyers. Strategic buyers often issue their securities to sellers as part of the merger consideration. Sellers, understandably, prefer liquidity and want the ability to resell these securities as soon as possible. The changes to these rules reduce or remove restrictions on secondary sales, which should allow strategic buyers to use their stock as transaction currency to increase the valuations of the targets.
Below are summaries of some of the
primary changes to Rule 144 and 145 which are most likely to benefit strategic buyers.
Rule 144 provides a safe harbour for
resales of restricted and control securities.
Restricted securities include securities issued in a transaction not involving a public offering, such as where a strategic buyer issues unregistered shares to the stockholders of a target in a private
placement. Control securities are securities of an issuer held by an affiliate of the
issuer. To qualify for a Rule 144 resale of restricted securities, several conditions must be satisfied. These conditions limit the ability of holders of restricted securities to resell the securities, and therefore reduce their value to the
holders. The Rule 144 amendments most significantly affect secondary sales of restricted securities by non-affiliates and make it easier and faster for sellers to get liquidity for their company. As amended, Rule 144 (i) shortens the holding period
for restricted securities of reporting companies to six months from one year;
(ii) allows non-affiliates of reporting companies to freely resell restricted securities after the six month holding period if the issuer satisfies the public information condition; and (iii) allows non-affiliates of reporting or non-reporting companies to freely resell restricted
securities without complying with any Rule 144 conditions after a one year holding period, rather than two years. Affiliates of reporting companies will still need to comply with the Rule 144 limitations and requirements when selling equity securities of the issuer under Rule 144.
The holding period for affiliates of non-reporting companies remains one year, and will still need to comply with the Rule 144 limitations and requirements when selling equity securities of the issuer under Rule 144.
Simultaneously with the amendment to Rule 144, the SEC also substantially eliminated the ‘presumptive underwriter doctrine’ in Rule 145. Under prior law, an affiliate of a target who received securities in a registered transaction was deemed to be an underwriter. Even though the securities were not restricted securities (because they were sold in a registered transaction), to negate this underwriter status, the resale had to comply with Rule 145 (which mirrored the Rule 144 requirements, without the holding period and Form 144 requirements). Now, except in limited circumstances, affiliates of a target who receive shares registered on Form 4 will be able to freely resell them immediately, unless the holder is also an affiliate of the issuer (in which case the rules
governing control securities will continue to apply).
In addition to strategic buyers regaining competitiveness over private equity
sponsors, the ongoing credit crunch is likely to reduce the overall number of bidders;
therefore, we expect sellers to have less leverage generally against buyers in the negotiation process. We expect fewer auctions, resulting in lower valuations.
Where auctions are commenced, we expect an increase in preemptive bids with ‘go-shops’ – a limited ability of the target to search the market post-signing for other potential buyers. As a result, target boards of directors will have to be increasingly mindful of their fiduciary duties relating to business combinations. Agreement terms will likely become more buyer-friendly, such as more conditions to closing for buyers and lower indemnity baskets and higher indemnity caps and escrows.
In conclusion, we think the continuing credit crunch and the associated deal execution risks involved in selling to private equity sponsors will result in increased competitiveness by strategic buyers. Also, the recent relaxing of rules regarding secondary sales should increase the value to sellers of receiving a buyer’s securities, especially if the buyer is a reporting
company. Less activity from private equity sponsors is likely to lower the valuations and otherwise lead to more buyer-friendly terms in deal agreements.
Tom Hopkins is a partner and Jason Northcutt is an associate at Sheppard, Mullin, Richter & Hampton LLP.
There are numerous trends currently affecting the cross-border M&A market.
Investors from emerging economies are increasingly interested in developed economies. Activity by private equity funds is growing in emerging economies. National investment strategies are growing. New hot sectors are emerging, particularly financial services and infrastructure. Valuations are rising as a result of emerging market investments.
Acquirers looking to complete M&A transactions in emerging markets face many challenges. Fiscal and legal regimes are often unpredictable. There is a need to identify key tax issues. Buyers must choose the appropriate method of market entry. Cultural differences can be a major hindrance. Finance facilities are limited.
There are differing approaches to business valuations and accounting policies. Political risks must be assessed.
Key trends
International investment flows are
changing. Whereas in the past the direction of flow was almost universally from the developed to the developing markets, this is no longer the case. Last year, for example, saw the Anglo-Dutch steelmaker Corus acquired for £6.2bn by Tata Steel of India, which outbid a Brazilian rival.
While this changing environment creates opportunities for businesses in developed markets seeking new investment finance,
there are associated threats. Companies seeking to complete M&A deals in their home markets face fresh competition from investors in the developing world. As competition grows, so do the prices that must be paid.
Notable among the new investors from the developing markets are sovereign wealth funds, which are likely to have a considerable impact on future investment flows. In 2007, the value of such funds grew by around $1.3 trillion, while new issues of government gilts worldwide totalled just
$600bn. Seeking a home for their surplus cash, sovereign wealth funds have begun turning to new, higher risk investments – including listed companies and private equity. This trend seems set to continue.
For example, as long as energy prices remain high, sovereign wealth funds from oil-producing states will continue to grow in size. If sovereign wealth fund investments quadruple over the next 10 years, as has been suggested, their influence on cross-border M&A will increase further.
While investors from emerging markets are creating competition for deals in more developed economies, western private equity funds are similarly increasing competition in developing markets. PE funds already account for a large proportion of corporate acquisitions in established markets, and this phenomenon looks likely to be repeated elsewhere as PE houses seek new high growth opportunities.