Strategic M&A, Spin-Offs, Hostile Transactions and Private Equity

Strategic M&A Continues to Drive Overall Deal Activity

The dollar value of announced M&A transactions involving U.S. targets rose by approximately 12 percent during 2011 compared with 2010, according to Dealogic data. However, the total number of announced transactions remained relatively flat, with activity levels at their highest in the first quarter of 2011 and slowing during the rest of the year amid increasing economic uncertainty and market volatility.

Strategic M&A was the primary driver of overall activity last year, with an increase in larger, billion-dollar-plus transactions compared to 2010. Strategic buyers — in particular, well-established investment grade companies that have substantial amounts of cash on their balance sheets, improving outlooks on future business performance and access to financing on favorable terms — looked to M&A as a way to generate growth faster than could be achieved organically in the current economic environment. Industry sectors that were particularly active in 2011 M&A transactions included pharmaceuticals/health care, energy/oil & gas, telecommunications/ technology, real estate, chemicals and financial services. Given the liquidity available to strategic buyers, we expect cash to continue to be the preferred form of consideration in acquisitions, although equity and mixed consideration will continue to be used in transformative combinations (including mergers of equals), transactions where the buyer faces leverage constraints and those in which the seller is unwilling to give up the opportunity to participate in the potential future upside of the combined company.

However, in light of ongoing uncertainty in the economic environment, both buyers and sellers have exhibited caution in approaching M&A transactions. Boards and CEOs of potential buyers continue to be wary of potential adverse investor reaction to major acquisitions during a time of uncertainty. Moreover, some sellers have been reluctant to sell in the current environment and consider it more desirable to do so only after economic conditions have stabilized and market valuations have improved.

Spin-Offs as a Value-Enhancing Divestiture Alternative

In recent years, companies considering the divestiture of a business increasingly have looked to spin-offs as an attractive alternative to a traditional business unit or divisional sale in light of the deal execution challenges presented in the current environment. Recently announced examples include Abbott Laboratories’ spin-off of its research-based pharmaceuticals business, Fortune Brands’ spin-off of its home and security business, Kraft Foods’ spin-off of its North American grocery unit, McGraw-Hill’s spin-off of its education business, Sara Lee’s spin-off of its international coffee and tea business, and the split of each of Tyco International and ITT into three companies, substantially completing the disassembling of two of the remaining major conglomerates. Particularly among larger companies, spin-off transactions are viewed as a means to unlock value for shareholders on a tax-free basis by separating divergent businesses, providing each separated business with greater focus on its own growth prospects and strategies, and better aligning management’s interests with the applicable business. Additionally, spin-offs may position the separated businesses as more attractive acquisition candidates, thereby creating additional potential benefits for shareholders. Further, subject to applicable tax limitations, it is possible to realize cash proceeds in connection with a spin-off — by conducting an initial public offering of a portion of the spun-off company prior to its full separation, placing debt on the spun-off company’s capital structure prior to its separation or engaging in other monetization strategies. In light of the various benefits, spin-offs generally have been well received by investors looking to improve near-term returns. Indeed, a number of hedge fund activists recently have called for certain public companies to consider spin-off transactions to enhance value.

Some companies considering divestiture of a business have opted for a dual-track approach of pursuing a sale of the business to be separated while simultaneously preparing for a potential spin-off or IPO of that business. A dual-track process can ensure that the seller will have a path to separate the business if a sale is not successful and may provide the seller with negotiating leverage if a sale process only attracts limited interest among potential bidders.

Companies contemplating a spin-off should be aware that the documentation and implementation process can be complex, requiring significant advance preparation. Key issues to be addressed in a spin-off context include, among others:

Defining the scope of the businesses, assets and liabilities (including any “shared” assets and liabilities) to be separated, while ensuring that the company to be spun off will be able to operate as a viable, independent company post-separation;

• Determining any commercial, indemnification and other arrangements expected to continue between the separated businesses post-spin;
• Determining the appropriate capital structure for the spun-off company;
• Determining the governance (including board composition) and structural takeover protections of the spun-off company; and
• Addressing employee- and management-related issues for the spun-off company.

Significant tax work, including planning for the internal reorganization steps necessary to separate the spun-off company and obtaining private letter rulings from the Internal Revenue Service, also typically is required to ensure that the spin-off and any related monetization strategies are properly effected on a tax-free basis.

Increase in Hostile Transactions/Multiparty Bidding Wars

Hostile or unsolicited transactions have increased significantly over the past two years and are likely to be prominent in 2012. These transactions have included all-cash offers as well as stock or mixed-consideration offers. Strategic buyers with significant cash reserves and available financing have continued to make unsolicited bids and pursue hostile tactics in order to seize upon growth opportunities not otherwise available and push for a sale even when the target is not otherwise a willing seller. Given recent market volatility, the trading prices of many public companies are still well below their 52-week highs, and target trading multiples and valuations remain attractive to potential buyers. Target companies with significant cash balances and weakened structural takeover defenses could find themselves particularly vulnerable to an unsolicited approach in the current environment as potential strategic buyers gain more confidence. Even financial buyers, which have not traditionally been known to make hostile bids for companies, have entered the fray (e.g., Oaktree Capital Management’s unsolicited bid for JAKKS Pacific). In addition, a number of target companies have faced increasing shareholder activism relating to extraordinary transactions or corporate governance “wedge issues” (e.g., say-on-pay, votes on golden parachutes and proxy fights for board representation) or even bids made by an activist to acquire a company with the intent of putting the company “in play” (e.g., Carl Icahn’s activities at Clorox, Commercial Metals Co. and Mentor Graphics), which could add to target company vulnerability.

As we have commented previously, [1] companies contemplating a hostile or unsolicited strategy should be aware of the inherent challenges to completing such a hostile transaction and an increase in the rate of successful defenses made against such offers in recent years. In addition, the Delaware Court of Chancery’s Airgas decision confirms the latitude a target board has in opposing an unsolicted offer. As a result, the success rate of hostile offers has been mixed, with most not succeeding and the target company either managing to stay independent (e.g., ConAgra Foods’ withdrawn offer for Ralcorp Holdings) or ending up being acquired by another party (e.g., Cephalon’s acquisition by Teva Pharmaceuticals after receiving an unsolicited bid from Valeant Pharmaceuticals).

The practice of third parties bidding to acquire companies that already have announced transactions also has been prominent (e.g., the bids from Validus Holdings and Berkshire Hathaway for Transatlantic Holdings following its announced deal with Allied World Assurance, the successive bids by Hertz and Avis-Budget Group for Dollar Thrifty, and the bid by Nasdaq OMX and IntercontinentalExchange to acquire the New York Stock Exchange following its earlier agreement to merge with Deutsche Börse). As deals are announced at valuations that are, from a buyer’s perspective, relatively attractive in the current market, we anticipate a continuation of the practice of “deal jumping.”

Private Equity Firms Remain Active Amid Difficult Markets

Private equity investment activity in the U.S. declined slightly in 2011 compared to 2010 and, while an improvement over 2009, has remained well below the levels seen prior to the financial crisis. While some market observers had predicted higher levels of private equity buyout activity based on the significant amounts of “dry powder,” or callable capital reserves, of the private equity funds, continued economic uncertainty and volatile market conditions for the leveraged loans and high-yield bonds that typically finance private equity buyout transactions have made deals more difficult to get done on attractive terms. Factors that also may be contributing to this restrained level of activity include, among others, bank requirements that greater percentages of deal consideration include equity financing provided by the private equity funds and increased competition in bidding for attractive targets. As a result, the deals that have been completed are generally smaller acquisitions with less leverage than those prior to the financial crisis. In addition, we have seen an increase in “add-on” acquisitions by private equity firms involving businesses that are complementary to existing portfolio companies. We believe that private equity firms will continue to put their capital to work in new investments in 2012, but likely will be subject to the same factors currently impacting these investments.

In addition, private equity firms continue to review alternatives for their existing portfolio companies — including restructurings, recapitalizations and divestitures — in an environment where public market exit alternatives have been more difficult to implement successfully, and portfolio companies with high levels of leverage and slowly recovering financial performance may not be positioned optimally for a public exit or sale. Complicating matters for private equity firms is the fact that many continue to face end-of-fund-life issues, which have arisen with greater frequency as the private equity industry matures and more funds are reaching their contractually mandated duration. Funds with these end-of-life issues often have the difficult task of convincing buyers to eliminate or curtail future obligations of the private equity sellers, including indemnification and post-closing covenants, in order to allow the funds to liquidate and make final distributions to their investors. We expect these issues to continue in 2012.

Continued Focus on Key Deal Terms

Buyers and sellers in strategic and private equity transactions continue to focus on provisions affecting deal certainty, with a particular emphasis on provisions relating to the buyer’s financing of the transaction and the seller’s recourse in the event that financing is not available. In strategic transactions, while there have been some exceptions, the majority of deals continue to employ the traditional model of specific performance and full recourse against the buyer if it fails to close when closing conditions are satisfied. Sellers also have focused on the material adverse effect condition and definition to have greater assurance that the buyer cannot avoid its obligations to close on that basis, given the uncertainty in the current environment.

In private equity acquisitions, we have seen several variations of reverse termination fee constructs in agreements, with the trend toward the stricter of the variations. During the prior cycle, private equity buyers had benefited from the “pure option” model, which would permit them to pay a reverse termination fee (typically 3-4 percent) as the sole remedy if they failed to close for any reason. A number of recent transactions have employed a more stringent model that applies the reverse termination fee remedy structure only if the buyer’s debt financing is unavailable notwithstanding the buyer’s efforts; otherwise, the seller would have the ability to require the buyer to draw upon its financing and close the transaction. In other transactions, we have seen bifurcated reverse termination fees, where a higher fee is payable if the buyer’s financing is available but the buyer does not close. Sellers also have been focused on narrowing “marketing period” provisions that would give the buyer the right to delay closing for a specified period of time after being provided information about the target for use in its financing materials.

The recently increased level of antitrust enforcement activities by the government has resulted in buyers and sellers spending more time negotiating regulatory provisions in acquisition agreements in order to achieve the appropriate balance of risk sharing between the parties. While sellers have an interest in ensuring deal certainty, buyers have an interest in ensuring that regulatory divestiture obligations do not have a material impact on the expected benefits of the transaction. Increasingly, parties are paying greater attention to defining specific efforts required to obtain the necessary regulatory approvals, including the extent to which the buyer will have an explicit obligation to divest or hold separate assets (and what, if any, limitations are put on such obligations), litigate against the government or make other commitments to obtain the required approvals. Defining these efforts can be particularly challenging when vertical antitrust issues are involved. The remedies available to the seller if such efforts are not successful also has been a highly negotiated issue. While there have been some recently announced deals with substantial reverse termination fees for failure to obtain regulatory approvals (e.g., AT&T’s agreement to pay Deutsche Telekom a fee of $3 billion in cash and provide wireless spectrum with a book value of $1 billion, as well as certain roaming rights — which recently was terminated and the fee paid — and Google’s agreement to pay Motorola Mobility $2.5 billion), these continue to be the exception, and some recent agreements have had either no fee or a more modest fee.

Deal protection also remains a key issue in negotiations, as buyers seek greater certainty that their deal will close once announced. Fiduciary out provisions, including “intervening event” provisions that enable a target to change its recommendation of the deal in certain circumstances outside of a superior proposal context, and the breakup fees payable in such circumstances, remain topics of negotiation. In addition, we continue to see requests by some public company targets that have not conducted a presigning auction or market check for go-shop provisions which permit the target actively to solicit other bids for a specified period of time following signing (typically 30-45 days) and provide for a lower breakup fee if a higher offer is made during the go-shop period. Go-shop provisions are far more typical in agreements involving private equity buyers but have surfaced in some discussions involving strategic buyers. Strategic buyers frequently have rejected such requests, as they are unwilling to permit target management to shop their deal to third parties and proactively share sensitive, confidential information with third parties (including competitors) that may or may not surface with a higher bid for the target. Targets that are able to obtain a go-shop provision may feel compelled to go through a full sale process or risk being criticized if they do not do so. As a compromise, some strategic buyers have agreed to a hybrid provision in which the breakup fee for an unsolicited superior proposal would be reduced during a specified period of time after signing, but the target would not be permitted to proactively solicit competing bids.

Endnotes

[1] See Skadden Insights, “Mid-Year Outlook: Continued Corporate Focus on Strategic Growth Drives M&A Market” (June 21, 2011), available at http://www.skadden.com/Index.cfm?contentID=51&itemID=2453.
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