M&A returns but with new complications
When the financial crisis hit, mergers and acquisitions were plunged into a deep freeze and deals simply ceased. Now, nearly two years after the global markets unraveled, lending is beginning to thaw. Banks are granting loans to sound creditors, and deals that wouldn’t have had a prayer a year ago are gaining the debt financing necessary to move forward. Potential buyers are gaining the confidence to step back into the market.
Indeed, this August has seen a number of big deals proposed and the month could yet break records for August M&A activity, according to Thomson Reuters. By the middle of the month, deal volume stood at $197.6 bn, following proposals from, among others, Intel ($7.7 bn), BHP Billiton ($40 bn) and UK insurer RSA ($7.8 bn).
For the deals that are getting done, however, some hurdles have emerged that never previously existed, and the process for making deals has permanently changed.
‘I’m seeing M&A activity pick up for businesses that have a record of profits and strong, reliable cash flow,’ says Patrick Daugherty, a capital markets partner at Foley & Lardner in Chicago. ‘Good deals can be financed fairly liberally, but not with the same liberality that immediately preceded the meltdown.’
Steven Davidoff, a law professor at the University of Connecticut, agrees, noting that some large hurdles exist. ‘There are still factors out there that are drags on the M&A market,’ he explains. ‘We live in a volatile economy, and people are focused on the bottom line rather than game-changing M&A.’
Almost everyone believes the new M&A landscape is different from the old one. Hostile deals are becoming more commonplace, as are international deals. A case in point is BHP Billiton’s $40 bn bid for Potash Corporation of Saskatchewan.
The recent Kraft/Cadbury merger also illustrates both trends. Creighton Condon, a senior M&A partner in the London office of Shearman & Sterling who worked on the Kraft/Cadbury deal on behalf of Cadbury, points out that UK firms are ‘very hard to defend’ in a hostile takeover. Specifically, shareholder rights plans and similar defensive maneuvers are not permitted in the UK.
Condon reports that as an increasing number of short-term shareholders bought into Cadbury, Kraft boosted its stake in the company, too. Thus, he says, ‘it became increasingly hard to defend Cadbury in the hearts and minds of shareholders because shareholders were looking for a short-term profit.’
Davidoff says hostile transactions have dominated the news in an otherwise ‘thin market’. As examples, he cites Air Products and Chemicals’ attempt to buy Airgas and the ongoing war between Hertz Global and Avis Budget to acquire Dollar Thrifty.
‘Companies should have been doing due diligence in the heyday of M&A activity, but people were basically shouting Ready, fire, aim,’ contends Scott Moeller, professor at the Cass Business School in London. Fortunately, that situation has changed for the better; Moeller has noticed that ‘deals are getting done for strategic reasons more than financial ones,’ and boards are discussing what they’ll do one and even two years after a deal has been signed.
Moeller suggests that the poster child for the current M&A market might be UK company Prudential’s thwarted attempt to acquire the Asian life insurance arm of AIG, a deal that recently unraveled. Explaining why, Moeller says: ‘There’s a lot more shareholder activism and a need on the part of both the buyer and the seller to do the due diligence. That deal probably should have been pulled because the due diligence hadn’t been done.’
Condon observes a similar trend, noting that ‘people are cautious about moving forward on deals where there are any significant diligence hiccups.’ This is true of the recent bid by RSA for the general insurance business of rival Aviva. Both RSA and Aviva shareholders are said to be cautious about the deal, as there are questions over whether RSA got its sums right in its bid proposal.
Potential deals are also faltering because of disagreements over price. According to Aileen Meehan, an M&A partner at Dewey & LeBoeuf in New York, ‘there’s a lot of cash available for transactions, but buyers are still concerned about over-paying and that sellers’ expectations are unrealistic. When the parties are able to agree on price, sellers are very concerned about certainty of closing so we are seeing more negotiation by sellers aimed at minimizing conditions to closing.’
Meehan adds that when a financial services company is being acquired, her firm has seen sellers oblige buyers to assume the risks associated with implementation of the recent financial reform legislation.
Benjamin Grossman, an M&A lawyer at Jones Day in New York, points out that the increased scrutiny on deals is making it harder for buyers and sellers to reach a meeting of minds on price. ‘It’s natural,’ he says. ‘Buyers are looking for a bargain, thinking, We were just at the precipice. Sellers believe, Things are better now. I’m not selling at a fire sale.’
Reverse break-up fees
Because of heightened attention to due diligence and a general atmosphere of skittishness, companies are looking to provisions that can make walking away from a deal a little less harrowing. Today’s buyers want the latitude to exit a transaction if financing fails without having to pay too steep a penalty.
A break-up fee – or a pre-negotiated sum to be paid if the target reneges – has been a mainstay of M&A contracts for quite some time. Ever since the financial crisis, however, some deals have also included ‘reverse break-up fees’. The reverse break-up fee is a sum that the acquirer must pay the target if the acquirer’s financing fails or even if the buyer simply has second thoughts and wants to walk away from the deal.
In the past, reverse break-up fees were a feature of private equity deals. Post-crash, these fees have grown more common in strategic transactions as well. The size of the fee has also grown: in the past, reverse break-up fees were usually 3 percent of the value of the deal, the same as the break-up fee a seller would pay for terminating an agreement. Since the financial crisis exploded, however, reverse break-up fees have climbed to anywhere from 6 percent to 10 percent, says Davidoff.
In some instances, significantly higher reverse break-up fees can be seen. Cerberus Capital Management signed an agreement in April to acquire DynCorp International; the agreement requires Cerberus to pay as much as 20 percent of the deal’s value if it walks away, according to regulatory filings.
‘Ever since the bust, there’s not a lot of faith in lawyers negotiating a contract so tight that no buyer can walk away,’ explains Grossman. ‘When it comes to reverse break-up fees, sellers just want to make sure that if buyers do walk away, it’s sufficiently painful from an economic perspective.’
Governance measures raise the bar
The rise of shareholder activism is putting additional burdens on directors considering an M&A deal. ‘The activist shareholder community is willing to challenge deals that it believes under-value the company,’ says Davidoff. ‘Activists also challenge if they feel the company was not shopped enough or if they believe management is participating in a buyout group that is perceived to have undue advantage.’
Jonathan Newton, who heads the corporate securities group for the Houston office of Baker & McKenzie, points out that certain governance measures, such as say on pay, are also making M&A deals trickier to complete. Under new regulations, before a merger there must be a non-binding advisory (say-on-pay) vote on golden parachutes. ‘The shareholders of company B may be more than happy to be acquired by company A,’ says Newton. ‘But when they see certain executives are getting humongous payments, that might cause some people to vote against the deal.’
Companies that recently held a say-on-pay vote on golden parachutes do not have to hold another advisory vote in the event of a merger, however. This exception might prove important. Newton notes that executives mulling whether to hold say-on-pay votes every one, two or three years might ask themselves how heavily they plan to be involved in deal making.
‘Most companies would just do the say-on-pay vote every three years,’ Newton explains. ‘But if you are a highly acquisitive company, you might say, Let’s do the vote every year so when there’s a merger there’s nothing to add to the merger vote on pay.’
For companies considering M&A in the post-crash environment, the experts agree that attending to the details is paramount. Even for companies reluctant to reengage in deal making, it pays to understand the new realities. ‘There’s a lot of talk about the backlog of deals and what will happen once everyone’s back from holiday,’ concludes Moeller. ‘You’ll probably be seeing more M&A activity in the fall.’