REIT and Real Estate M&A and Restructurings

Adam Emmerich is a partner in the corporate department at Wachtell, Lipton, Rosen & Katz focusing primarily on mergers and acquisitions and securities law matters. This post is based on a Wachtell Lipton firm memorandum by Mr. Emmerich and Robin Panovka.

Despite a sluggish year-end, overall deal activity in 2011 was strong, continuing the recovery from the post-crisis slump. In addition to strong overall volume (roughly $70 billion of deals), 2011 was impressive for its range of deals, from large-scale public-to-public mergers in the consolidating industrial and healthcare sectors, to major private-to-public acquisitions as private (often over-levered) assets and companies continued to undergo major ownership changes across many sectors, including distressed hotel and retail portfolios that were over-levered in the last cycle. There was even some leveraged opportunistic buying, at enterprise values much reduced from the peak, with credit windows opening for brief periods on a spot basis depending on the deal and buyer involved.

While the uncertainty caused by the European crisis and other economic conditions has created a wait-and-see attitude in many boardrooms, our sense is that things are warming up and that the conditions that generated impressive deal volume in the first half of 2011 will again drive a healthy volume of deals in 2012. Many boards and CEOs who hit “pause” in the last few months have their fingers hovering over the “play” button, ready for action when the time is right on the lineup of deals that have been percolating for some time. The balance sheets of most of the larger REITs remain strong, dry powder is still plentiful, and opportunities continue to arise, especially given the low supply of new development product, strong investor appetite, and the distressed pools possibly coming on line as the first big wave of pre-financial crisis 2007 debt matures in 2012.

We list below some themes and issues we are keeping an eye on as 2012 begins:

Structuring for Volatility; Stock Deals. The major acquisitions by REITs in 2011 utilized stock rather than cash as the acquisition currency, eliminating financing risk and helping to address the equity-raising risks posed by volatile stock prices. We expect to see continued use of significant stock components in 2012 deals, but cash cannot by any means be counted out. While the traditional bank commitment market continues to be flighty and fickle for highly leveraged transactions, the situation for stable, high-grade buyers is markedly better, and sensible transactions can attract substantial lender support. As in 2011, deal structures that can preserve a significant amount of cheap existing debt will be favored, and parties will focus keenly on the lender and other third party consents that may be required (keeping in mind that stock transactions often utilize forward triangular structures that incrementally increase the consent burden in order to address tax concerns). We also expect buyers and sellers to continue to explore collars, caps, and similar mechanisms where stock is used as currency, as a compromise allowing buyers to sidestep bank financing where desirable while providing sellers some protection against unexpected levels of market volatility.

Debt as Control Currency. The path for gaining control by buying strategic debt positions continues to show promise. Fulcrum debt positions in several of the loan pools that mature in 2012 are already in the hands of opportunistic players, who are positioned to lead recapitalizations if and when refinancing options fail to materialize. It is estimated that at least half of the $50 billion plus of CMBS mortgages coming due in 2012 will not be refinanceable given the still constrained (though growing) refinancing market and the excessive debt-to-equity ratios on the maturing 2007 vintage loans. By whatever means, control of many of these portfolios is likely to trade in the next 12 to 24 months, including to established, well-capitalized REITs that can use their balance sheets and equity raising powers to accomplish cash deals.

Winning Deals. The surplus of bidders in some of the competitive deals we saw in 2011 puts a premium on both strategy and tactics. Deal makers in a crowded room need to understand and use a variety of tools, including knowing how and when to preempt an auction, go hostile, agree to serve as the “stalking horse”, utilize debt and mezzanine positions, extract trapped value through spin-offs or restructurings, or just hang around the hoop.

Bankruptcy Auctions and Restructurings. One of the lessons from the 2011 bankruptcy auctions, perhaps obvious to repeat bankruptcy bidders, is that the sale process is heavily influenced by the overriding goals of bankruptcy and the overseeing bankruptcy judge. No matter how strong a legal or factual argument may be, it stands a good chance of imploding if it is perceived as running counter to the interest of maximizing the value of the estate. Several recent bankruptcy cases have demonstrated that court-supervised auctions, with hearings to approve the selection of a stalking horse prior to the auction and to confirm the auction results thereafter, give disappointed bidders significant opportunities to upset the apple cart. But once approved and consummated, bankruptcy sales continue to provide buyers the comfort of finality, including important protections from sellers’ creditors, that might not be present in distressed sales outside of bankruptcy.

Dealing with Unitholders. Recent arbitration proceedings have yielded useful guidance on how to address UPREIT unitholder tax protection agreements in various deal formats, including private equity transactions that take UPREITs private and end the unitholder liquidity resulting from the previously publicly-traded REIT stock. One of the key lessons has been that unitholder objections can sometimes be addressed by structuring the acquisition transaction so that the unitholders are provided the option of taking either exactly the same taxable consideration as shareholders (cash or common stock) or a tax-deferred, market-based, preferred equity security with an equivalent market value. While such a preferred instrument typically is not convertible into publicly traded stock, it often pays cash dividends at a market rate and has a finite life after which the unitholder receives cash. The ultimate cash payment is of course taxable, but the life of the instrument is typically the same as the term of the pre-existing tax protections, thus providing unitholders the tax-deferral benefit of their original bargain.

Tender Offers in Cash Deals. In cash deals, employing tender offers to speed an acquisition will continue to be favored to address banks’ financing commitment duration concerns, hit financing markets when they are open, and improve certainty for sellers. Recent years have seen “top-up” options – which permit an acquiror of a majority of the shares to reach 90% or other relevant squeeze-out threshold (when authorized shares are available) – gain increasing acceptance as an elegant solution to lenders’ preference for shorter commitments and sellers’ increased distrust of both lenders and the capital markets. Hybrid, dual-track deals, involving both a tender offer and a simultaneous voted proxy process have also become more common. Such options should gain acceptance in cash deals in the real estate area in 2012.

No-shops, Go-shops, Deal Protection and Other Fiduciary Matters. Delaware and other courts continue to reject the “one size fits all” sale process as a fiduciary requirement, even while the scrutiny to which boardroom deal decisions are subjected has remained thoroughgoing and intense, with several notable knuckle rappings for controlling shareholders, target boards and bankers in 2011. Careful, sensible decisions will be respected by the courts, but they must be based on an appropriate record and well documented. Deal protection measures and fiduciary out provisions must equally be specifically tailored for the particular circumstance of each company and transaction. If REIT M&A blossoms in 2012, target boards will need to be mindful that structuring and implementing appropriate transaction processes and protective arrangement requires a sophisticated and nuanced understanding of the landscape of a particular transaction – keeping in mind that no two transactions are alike – and of the legal landscape more generally. Maryland continues to be perceived as a somewhat friendlier jurisdiction for deal-related litigation, but the lessons of recent experience in Delaware shouldn’t be overlooked by REITs and other publicly traded companies, wherever incorporated. In addition, deal-related litigation is often now routinely brought not only in the jurisdiction (or jurisdictions) of the parties’ incorporation, but also elsewhere as well, including the location of headquarters or other forums of convenience, with the burden on deal parties and their counsel to sort out the resulting tangle.

CMBS Complexities in Restructurings. CMBS structures are fertile ground for complex intercreditor disputes involving, at times, master servicers, special servicers and beneficial holders of CMBS certificates. In a recent important decision in In re Innkeepers USA Trust, et al., the bankruptcy court for the Southern District of New York held that holders of CMBS certificates lacked standing to object to a bid procedures motion filed by the debtors. Significantly, the court held that certificate holders were merely investors in a creditor (the CMBS trust) and thus lacked direct interests in obligations against the debtors. The court further ruled that the certificate holder in Innkeepers was contractually bound by the “no action” clause of the servicing agreement which prohibited certificate holders from instituting any suit, action or proceeding under the servicing agreement unless various conditions were met. In light of the Innkeepers decision, acquirers of debt of CMBS or REMIC structures involving often-complex and multi-tiered debt arrangements must consider the standing issues they will confront in the chapter 11 proceeding and the sometimes disparate interests of the special servicers with respect to the exercise of rights and remedies regarding the collateral.

Availability of Financing. The inconsistent availability of real estate financing had a major impact on restructurings in 2011. In just one example, the popular Atlantis resort in the Bahamas was unable to refinance its CMBS debt and announced that it is turning over the keys to its lenders, while the neighboring Baha Mar attracted sufficient funding only from a government sponsor, the Export-Import Bank of China, which is providing the $2.6 billion commitment required to complete a settlement with existing lenders and commence a substantial construction project. We expect that 2012 will see similar inconsistency, with some real estate projects emerging as the financing winners and others being forced to relinquish ownership to the debtholders.

Unsolicited Advances. Select smaller and medium-sized REITs continue to receive lowintensity unsolicited advances from larger players, hedge funds and activists. Volatility has sapped some of the energy from would-be hostile acquirors, but REITs should keep in mind that they are not takeover-proof (PSA’s acquisition of SHU punctured that myth some time ago) and should prepare accordingly.

Executive Compensation. Executive compensation will continue to be a hot issue and will require careful focus in REIT boardrooms. Even companies that passed last year’s say-onpay vote with flying colors should prepare for the upcoming season with a fresh perspective, as the second season of say-on-pay will present new challenges. Some investors may have applied more relaxed standards to companies last year in recognition of the fact that mandatory say–onpay was new. In addition, shareholders and proxy advisory firms may focus on a company’s response to the first mandatory say-on-pay vote, which was not an issue last year. Indeed, in both its recently released white paper on Evaluating Pay for Performance Alignment and its U.S. Corporate Governance Policy 2012 Updates, Institutional Shareholder Services (ISS) has made clear that round two will vary in a number of fundamental ways from round one, including significant changes in its critical “pay for performance” test. In addition, ISS will now evaluate on a caseby- case basis its recommendation regarding say-on-pay proposals and compensation committee member elections where a company’s say-on-pay proposal in the previous year received the support of less than 70% of the votes cast. This may make companies treat a say-on-pay vote with majority, but less than 70%, support as effectively a lost vote, making careful planning more important than ever. Boards should ensure that compensation programs are updated to attract, retain and properly incentivize talented executives, while taking into account increased market sensitivities to pay and practices that are strongly encouraged by the markets and institutional investors. For a further discussion of ISS’ pay-for-performance policy, see our memos of November 18, 2011, “ISS Updates Voting Policies for the 2012 Proxy Season,” and December 20, 2011, “ISS Issues White Paper on Say On Pay ‘Pay for Performance’ Test.” For a discussion of the actions a company may consider taking to help with its say on pay vote, see our memo of November 9, 2011, “How to Win the Say on Pay Vote.”

Boardroom Dynamics. Although REITs, and public companies more generally, have increasingly adopted the corporate governance reforms that the corporate governance community has sought for years (including say–on-pay, majority voting and annually elected boards), we do not expect activist shareholders to dial back their campaign to direct the structure and decisionmaking of boards of directors in 2012. One of greatest challenges facing boards is navigating these demands, as well as various new legal mandates, while maintaining a singular focus on the long-term strategy and success of the company. In the M&A context, this pressure can prove acute, as boards weighing whether a transaction will prove value-creating to shareholders in the long-run may expect to face the wrath of certain institutional and activist shareholders focused on short-term gains rather than on the growth of the enterprise over time. More on the challenges faced by boards of public companies can be found in our recent memos, Some Thoughts for Boards of Directors in 2012, The Spotlight on Boards and Key Issues for Directors 2012.

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