U.S. UPDATE – Mergers and Acquisitions – 2012
- As we enter 2012 and as the U.S. economy continues to stabilize, there appears to be a growing sense of optimism about further recovery in the M&A market. Greater perseverance and transactional creativity and sophistication will continue in 2012 as parties seek to manage and allocate risks in a structured manner in an environment of continued uncertainty. At the same time, high levels of shareholder activism along with the ever-increasing prospect of litigation and judicial review of transaction processes underscore the crucial importance of the basics – above all, that the board of directors be actively involved in M&A planning generally as well as in overseeing any specific transaction process.
- Though current conditions make it difficult to gauge the size and nature of the M&A market in 2012, a number of factors suggest the possibility of increased deal activity in the coming year. The continuing, post-recession/post-financial-crisis emphasis on deleveraging and strengthening of corporate balance sheets makes cost-saving M&A synergies particularly valuable, especially as many companies have already exhausted their own cost-cutting opportunities. Global market pressures, economic volatility and industry-specific factors across a wide array of industries put pressure on corporations to increase scale, diversify their asset base and/or spread R&D costs across larger platforms.
- Heightened economic, tax and regulatory uncertainties have caused players in the M&A market to approach transactions with greater care and caution. The implications of the European financial crisis for the U.S. economy and financing markets remain unclear. Stock market volatility, uncertainty about changes to the U.S. corporate tax rate, increasingly aggressive U.S. antitrust enforcement, and the looming U.S. presidential election also contribute to a lack of forecasting visibility, which in turn significantly impacts the willingness of CEOs and boards of directors to engage in M&A activity. Facing these uncertainties and risks, but also anticipating greater incentives or greater industry-imperatives to merge and acquire, M&A participants are approaching transactions with greater determination and creativity, and M&A transaction structures have trended toward greater complexity and sophistication.
As we enter 2012 and as the U.S. economy continues to stabilize, there appears to be a growing sense of optimism about further recovery in the M&A market. During the first half of 2011, the M&A market continued a resurgence that began in the latter part of 2010, with higher aggregate deal value than had been seen since before the financial crisis. Though worldwide M&A activity declined in the second half of 2011, reflecting uncertainties regarding the volatile global financial climate, it has continued at a relatively strong pace, and a number of significant transactions have recently been announced, including Kinder Morgan’s $38 billion acquisition of El Paso, United Technologies’ $18 billion acquisition of Goodrich, and Gilead’s $11 billion acquisition of Pharmasset.
Though current conditions make it difficult to gauge the size and nature of the M&A market in 2012, a number of factors suggest the possibility of increased deal activity in the coming year. The continuing, post-recession/post-financial-crisis emphasis on deleveraging and strengthening of corporate balance sheets makes cost-saving M&A synergies particularly valuable, especially as many companies have already exhausted their own cost-cutting opportunities. Global market pressures, economic volatility and industry-specific factors across a wide array of industries put pressure on corporations to increase scale, diversify their asset base and/or spread R&D costs across larger platforms. These trends were particularly apparent – and can be expected to continue – in the technology, health care and energy sectors, with transactions such as Google’s announced $12.5 billion acquisition of Motorola Mobility, Express Scripts’ announced $29.1 billion acquisition of Medco Health Solutions, and BHP’s completed $12.1 billion acquisition of Petrohawk. In addition, although debt markets have been volatile, financing has been and continues to be available for strategic acquirors with strong credit and for well-established private equity firms. LBO activity was high in 2011 compared to 2008-2010, with transactions such as the $6.1 billion acquisition of Kinetic Concepts by a group led by Apax Partners, the $3 billion acquisition of Emdeon Inc. by Blackstone, and the $2.8 billion acquisition of BJ’s Wholesale Club by Leonard Green & Partners and CVC Capital Partners.
Heightened economic, tax and regulatory uncertainties have, however, caused players in the M&A market to approach transactions with greater care and caution. The implications of the European financial crisis for the U.S. economy and financing markets remain unclear. Stock market volatility, uncertainty about changes to the U.S. corporate tax rate, increasingly aggressive U.S. antitrust enforcement, and the looming U.S. presidential election also contribute to a lack of forecasting visibility, which in turn significantly impacts the willingness of CEOs and boards of directors to engage in M&A activity. Facing these uncertainties and risks, but also anticipating greater incentives or greater industry-imperatives to merge and acquire, M&A participants are approaching transactions with greater determination and creativity, and M&A transaction structures have trended toward greater complexity and sophistication. Most deals today are taking longer to incubate and execute than in the 2004-2007 period. But some deals that would have died on the drawing board during 2008-2010 are now getting done, due largely to the greater perseverance and problem-solving attitude of transaction participants.
Looking ahead to 2012, we believe that these trends towards greater perseverance and transactional creativity and sophistication will continue as parties seek to manage and allocate risks in a structured manner in an environment of continued uncertainty. At the same time, high levels of shareholder activism along with the ever-increasing prospect of litigation and judicial review of transaction processes underscore the crucial importance of the basics – above all, that the board of directors be actively involved in M&A planning generally as well as in overseeing any specific transaction process.
Below, we review a few trends from 2011 that we expect to continue in 2012.
Bridging Valuation Gaps
The financial crisis and resulting uncertainty in the U.S. and global economies has made it difficult for companies to predict future performance (their own, or their target’s) or to forecast synergies and other transaction benefits with the same level of confidence seen in the past. As a result, acquirors and targets have developed transaction structures that are aimed at bridging gaps in their respective assessments of valuation and risk. For example, following Kinder Morgan’s decrease in its offer price for El Paso, the parties negotiated the addition of warrants to the consideration mix, giving El Paso shareholders the right to buy additional Kinder Morgan stock within five years at a specified price. In a comparable context, in an effort to address more specific valuation risks relating to future performance, Sanofi-Aventis included the largest offering to date of contingent value rights in its consideration mix for Genzyme, entitling Genzyme shareholders to receive additional cash payments if specified milestones related to certain drugs are achieved over time. Likewise, in the acquisition of Clinical Data by Forest Laboratories, Forest agreed to pay shareholders of Clinical Data $30 per share in cash plus contingent consideration of up to $6 per share upon achievement of certain commercial milestones related to a particular drug.
Contingent value rights and similar deferred consideration structures not only bridge valuation gaps, but can also increase deal certainty by addressing risks that would otherwise be managed through closing conditions. In addition, their use reduces purchase price risk for acquirors and can lower up-front financing requirements while at the same time offering sellers the opportunity to achieve their price expectations. While the deals cited above are recent high profile examples of partially deferred and conditional consideration, such an approach can be used in deals of any size and with private or public parties.
In light of a heightening emphasis in the United States on antitrust enforcement, greater attention is required to the antitrust-related provisions of merger agreements, including the so-called “efforts” clauses, cooperation obligations and reverse termination fees. Reverse termination fees – originally found almost exclusively in transactions with financial buyers – have become significantly more common in strategic transactions as a means of allocating antitrust risk. An antitrust-related reverse termination fee is generally payable by an acquiror to a seller if a transaction is terminated as a result of a failure to obtain antitrust clearance, either because the relevant governmental authority declined to clear the transaction or because the acquiror refused to commit to divestitures or conduct restrictions beyond a pre-agreed limit. In many cases, use of a reverse break-up fee may appeal to both parties: to the seller because the fee provides partial compensation in the event of antitrust failure and creates a strong incentive for the buyer to obtain clearance; and to the buyer because the fee establishes a clear limit to the buyer’s risk, assuming compliance with its contractual efforts covenants. In our experience, efforts covenants generally do not impact the government’s substantive antitrust assessment of proposed mergers – i.e., the agencies don’t demand more simply because the contract has a higher efforts standard. While courts have expressed concern that large termination fees payable by a seller to an acquiror may prevent a competitive bidding process, reverse termination fees do not create the same concerns and therefore may be significantly larger as a percentage of deal value than standard termination fees.
Examples of antitrust- or regulatory-related reverse termination fees include the Google – Motorola Mobility transaction ($2.5 billion fee – approximately 21% of the equity value of the transaction) and the Texas Instruments – National Semiconductor transaction ($350 million fee – approximately 5.7% of the equity value of the transaction). The reverse termination concept may also include more than just a fee. In AT&T’s recently terminated deal to acquire T-Mobile from Deutsche Telekom, AT&T paid to Deutsche Telekom a termination fee consisting of $3 billion in cash (7.7% of the equity value of the transaction) and spectrum rights with a book value of $1 billion and was moreover required to enter into a roaming agreement with Deutsche Telekom, with the aggregate market value of the break-up package a publicly estimated $6 billion (15.4% of the equity value of the transaction).
The perception of stiffened antitrust enforcement has also encouraged greater use of specifically crafted “limit of regulatory pain” provisions as opposed to reliance upon the traditional “material adverse affect” concept. In the AT&T – T-Mobile transaction, for example, the acquiror was not required to take any actions (such as agreeing to divestitures or conduct restrictions) that would have an adverse effect greater than a specified dollar amount, and the merger agreement included complex provisions for calculating the value of any such adverse effects.
In addition to the size of the fee, there are a number of other important issues to consider in developing a reverse termination structure and fee that is tailored to a particular transaction, including the nature and extent of efforts that must be used by the parties to obtain antitrust clearance before the agreement may be terminated and the fee paid, and whether control of the approval-seeking process will be joint, or led by the buyer. As with contingent value rights, parties can and should be flexible and creative in developing an approach suited to the particular circumstances and risks at hand.
Changing Litigation Landscape
The M&A plaintiffs’ bar has become increasingly aggressive over the past decade – with lawsuits filed against 85% of deals in 2010 compared to 12% in 1999 – and the response of the Delaware courts to this trend and in specific cases, particularly over the past 12 months, is affecting M&A practice, process and planning.
Three 2011 Delaware Chancery Court developments, in particular, should affect M&A in 2012.
- Greater board-level oversight of financial advisor role and of sale process tactics. In the Del Monte Foods case, the court stopped the vote of Del Monte’s shareholders in a sale to a consortium led by KKR based on concern that members of the buying group had been permitted to team-up without advance knowledge of the Del Monte board, and that Del Monte’s financial advisor, which was also providing stapled financing to the acquirors, was conflicted. The case provided several important reminders: that the terms of confidentiality agreements, including tactical terms such as anti-teaming provisions, must be fully thought-through and entirely respected; that there must be board-level consideration of the role and mandate of the company’s financial advisors, especially (but not exclusively) in situations where stapled financing may be offered; that bankers should receive and follow clear instructions from target boards; and that bankers should ensure that any conflicts of interest are disclosed in advance, with specificity, to the target board of directors. It is important to note that Delaware courts have long recognized that stapled financing offered by sell-side advisors can be permissible as long as there is good reason, close oversight by the board, and benefit to the company. Del Monte does not change this.
- Greater Care in Controlling-Shareholder Transactions. The Southern Peru Copper Corp. case – where the court ruled that a transaction between a company and its controlling shareholder was not entirely fair and awarded $1.26 billion in damages –constitutes a timely reminder on the importance of careful special committee processes. Following Southern Peru, the mandate and focus of each special committee will need to be considered with greater care, as will the valuation methodologies and assumptions to be used, especially in circumstances where customary valuation methodologies may not be fully appropriate or applicable.
- More Intensive, Aggressive Shareholder Litigation Due to Fewer Settlements Based Solely on Revised Public Disclosure. Historically, companies have often been able to settle deal-related shareholder lawsuits by revising the deal-related proxy disclosures and paying plaintiffs’ attorneys’ fees. In comments and rulings over the past 15 months, the Delaware Chancery Court has indicated that these forms of settlements are not favored. While in some cases this hardened attitude may deter the plaintiffs from suing in the first place, in other cases it has had and will have the effect of leading the plaintiffs’ bar to engage in more aggressive behavior, making it harder to close deals and requiring greater sophistication in the drafting of merger agreement closing conditions and allocation of closing risks.
On the positive side, the decision in Air Products & Chemicals Inc. v. Airgas Inc. serves as a welcome reminder that – despite the increase in deal-related shareholder lawsuits – well-functioning, well-informed and well-advised boards are empowered to think and act like businesspeople, to make-judgments and take considered risks without fear of legal liability. The conduct of the Airgas board in the face of an unsolicited takeover bid, the Delaware Chancery Court wrote, “serves as a quintessential example” of these fundamental principles: if directors act “in good faith and in accordance with their fiduciary duties,” the Delaware courts will continue to respect a board’s “reasonably exercised managerial discretion.”
Shareholder Activism and Hostile Takeover Activity
In the first half of 2011, favorable market conditions and recent changes in corporate governance produced a substantial increase in hostile takeover activity and shareholder activism, especially in the form of activist shareholders themselves putting companies in play by making stalking horse bids. There were a number of particularly large unsolicited bids made by activist shareholders in 2011, including Carl Icahn’s $10.7 billion bid for Clorox and $1.9 billion bid for Mentor Graphics, and Trian Fund Management’s $7.6 billion proposed acquisition of Family Dollar. While these bids do not necessarily result in a sale of the company, they do put pressure on the board of directors. This blueprint may well be copied by other activists in 2012. All companies, regardless of size, should have up-to-date plans for dealing with activists and hostile acquirors, including annual strategic, board-level reviews focused on understanding the company’s business and legal defenses and vulnerabilities and anticipating the nature of the arguments the activists or raiders might make.
The continued legitimacy of takeover defenses was acknowledged in February 2011, when the Delaware Court of Chancery rejected the broadest challenge to the poison pill in many years and reaffirmed the primacy of the board of directors to determine matters of corporate control. The decision in Air Products & Chemicals Inc. v. Airgas Inc. upheld the validity of the poison pill to protect a company against a hostile approach and rejected the idea that a poison pill should have an expiration date. So long as directors act in good faith, on an informed basis and not in their personal interest, their business judgment decisions will be upheld in Delaware, and they may feel confident in acting to protect companies from opportunistic, hostile bids. Being pro-active in M&A planning and in a company’s own strategic initiatives will also typically help support a strategy of continued independence.
Committee on Foreign Investment in the United States
Following the financial crisis, M&A activity rebounded in Asia more quickly than in other regions, and Asian participants are expected to become increasingly active in cross-border M&A. In January 2011, the China National Offshore Oil Corporation (CNOOC) agreed to buy into several shale oil and gas leases in the United States owned by Chesapeake Energy for $570 million and to fund an additional $697 million to cover two-thirds of Chesapeake’s drilling and completion expenses. This deal followed a similar CNOOC – Chesapeake agreement in October 2010 under which CNOOC purchased one-third of a shale oil and gas project from Chesapeake for $1 billion. Similarly, in 2010, Temasek, a Singapore state-owned company, invested $500 million in Chesapeake Energy. In addition, in April 2011, China Huaneng Group, a large Chinese state-owned electricity producer, completed its acquisition of a 50% interest in Intergen for $1.2 billion, and in June 2011, Aditya Birla Group, an Indian company, completed its $875 million acquisition of Columbian Chemicals Company. Even though foreign investment in the U.S. remains generally well received, parties have abandoned transactions in the face of CFIUS opposition – including Huawei’s proposed minority investment in 3Com in 2008 and Tangshan Caofeidian Investment Corporation’s proposed acquisition of 60% of Emcore’s fiber optics business in 2010. Prospective non-U.S. acquirors of U.S. businesses should undertake a comprehensive analysis of U.S. political and regulatory implications well in advance of any acquisition proposal or program, particularly if the target company operates in a sensitive industry or if the acquiror is sponsored or financed by a foreign government (see our memo “Cross-Border M&A – Checklist for Successful Acquisitions in the U.S.”, January 3, 2012).
Spinoffs and Divestitures
Spinoff activity increased substantially in 2011, reaching an aggregate of $230 billion in transaction value (six times the level in 2010) and 8% of global deal activity. In an uncertain environment where business-unit dispositions may be difficult to execute or result in unacceptable tax leakage, spinoffs offer companies an internally-driven transaction alternative that can unlock value and/or separate higher-multiple from lower-multiple businesses. Significant spin-off and similar break-up transaction activity in 2011 was seen in a broad range of industry sectors, with high-profile examples including Tyco International’s three-way split off of its ADT North America residential security business and its flow control businesses, ConocoPhillips’ plan to spin off its refining and marketing business, Kraft’s split off of its North American grocery business, McGraw-Hill’s split into two public companies, ITT’s split into three public companies, Abbott Laboratories’ plan to spin off its branded drug business and become two separate companies, Expedia’s completed spinoff of TripAdvisor and Covidien’s announced spinoff of its pharmaceutical business.
Under appropriate circumstances, the so-called “reverse Morris Trust” structure can be used by large companies to spin off a business unit and merge it with another company or business in a tax-efficient manner. This structure requires that the merger partner be smaller than the spun-off business. For example, in the recently-announced Acco Brands – MeadWestvaco transaction, MeadWestvaco will spin off its consumer and office products business and the new entity will then merge into a unit of Acco Brands so that MeadWestvaco shareholders will ultimately hold 50.5 percent of the combined entity. Favorable tax treatment of these transactions, as well as any other M&A activity occurring close in time to a spinoff, is available under the tax laws only under limited conditions, and sophisticated planning and analysis is required. Companies should also carefully consider the impact of the announcement of an intended spinoff. Such announcements can result in the spinning company, the spun-off company, or both, becoming the subject of acquisition interest from other companies or private equity firms.
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Whether the promise of the new year brings a significant round of new merger activity or simply a continued steady pace of deal activity, mergers and acquisitions remain a fixture of the corporate landscape. Successful execution of M&A in this environment requires the creativity to address uncertainty and transaction-specific risks but also the discipline and foresight to adhere scrupulously to enduring principles of active board involvement and procedural integrity.