Where
are we, exactly? Someplace we've never been before. The private equity
firms are taking a break from stirring things up. The bankers are
scrambling to fix the valves on the structured finance machinery that
pumped all that money into leveraged buyouts. That leaves a business
landscape marked by uncertainties but also brimming with opportunities
for strategic buyers.
That, more or less, was the consensus market outlook expressed by
some of the world's leading strategic acquirers when they gathered in
New York early last month for a conference organized by Corporate
Dealmaker. The overall economic picture has darkened a bit since, but
it's still the case that corporates have regained most of their
traditional advantages in the competition for transactions. "I think
it's a very good time to be a strategic buyer," said Anne Madden,
global head of M&A at Honeywell International Inc., expressing what
has to be the meeting's headline theme.
Yet a single headline can't really capture the insights, experiences
and opinions shared that day by the many corporate dealmakers on stage
and in the audience, helped out by a few top deal lawyers, investment
bankers and private equity professionals. Neither, for that matter, can
an article like this one; the transcript of the day's seven panel
sessions, featuring 28 speakers, runs more than 56,000 words (for the
full roster, visit www.thedeal.com/marketing/events).
Still, it's worth a try. Along with the window of opportunity now
open for strategic dealmakers, three other major themes stood out at
the meeting, which was held Oct. 2 at the Union League Club in New York:
• The M&A wave that crested early in the summer of 2007 greatly
accelerated the pace of change in the ways we buy, sell, and govern
companies. While the depth and duration of the credit crisis is hard to
predict, and although recent disputes have taught sellers to be warier
of private equity counterparties, the PE firms still have a strong
business model and huge amounts of equity capital to invest. Meanwhile,
the other two main flavors of private capital (hedge funds and venture
capital, both change-agents in their own right) are going strong.
• There are many M&A markets, not just one. Emerging economies,
especially China and India, are becoming steadily more important for
most strategic dealmakers, not to mention financial sponsors. The world
of information technology, meanwhile, is in the throes of a major
transition, with much of the change accomplished through transactions.
• The intense deal activity of recent years has provided a
laboratory for a lot of learning on the part of corporate dealmakers --
about everything from how best to fit the corporate development
function into the company and how to manage post-merger integration to
the previously underestimated importance of material adverse change
(MAC) clauses in M&A contracts.
The multifaceted question of where strategic dealmakers stand
relative to financial sponsors was bound to keep coming up, and it did.
Honeywell's Madden went on to say that she thinks corporate acquirers
will continue to enjoy some advantages even after the credit markets
come back, because she doesn't expect extremely easy credit terms like
bonds with a pay-in-kind toggle feature or covenant-lite loans ever to
return. "That was an unnatural event that really should not come back
into the marketplace," she said. "And I think as a result, strategics
are still going to provide to the seller better speed, better pricing,
better certainty of closure."
Richard McPhail, vice president for strategic business development
at Home Depot Inc., amplified that point. He spoke from experience,
having been involved in the renegotiated sale of the company's HD
Supply unit to a trio of private equity firms last summer just as the
credit crisis became acute.
"Now I think you're going to see the negotiations around certainty
with private equity buyers become pretty tough," he said. "I think
you're going to see MAC clauses and break fees fought in the trenches,
and you're going to see tough due diligence. So I think it's our
opportunity to sort of play the good guy for the next six to twelve
months and play the easy route for sellers who are motivated to do a
deal."
At the same time, the day's discussions left little doubt that this
was the cycle when private equity came of age as a sizable sector of
the capital markets, an effective model for business ownership in many
situations. "I think you'll see private equity as a market continue to
expand as long as the firms that are involved in each segment of the
market continue to produce above average returns," said Mike Bingle,
managing director at Silver Lake. "There's no question that the
industry as a whole has demonstrated success over a long period of
time, and it's still a relatively small part of total invested assets
managed globally."
Advisers to pension funds are urging more allocation to the
asset class, observed James Carlson, a partner at law firm Mayer Brown
LLP. Sovereign wealth funds in Singapore, China and the Middle East are
also putting large amounts of capital into PE because they see it as an
effective investment strategy. "So if anything," said Carlson, "there's
more long-term money coming into the game."
The question of what the PE model does well -- and why -- was
addressed by Jeff Clarke, CEO of Travelport, a Blackstone Group LP
portfolio company. Clarke, best known for the key role he played as a
Hewlett-Packard Co. executive vice president in facilitating the
integration of HP and Compaq in 2003 and 2004, believes private equity
should only buy businesses that need to be transformed. Both
compensation and governance structures are designed to drive change, he
observed. "The rewards in private equity are four to five times as high
as in the public environment," Clarke said. "And that is going to
attract executives who want to make significant changes to companies,
and it's going to not attract executives who are looking for five, 10,
15 year tenures in a particular firm."
And yes, Clarke said, it really is important that PE ownership frees
management from quarterly earnings reports. "I cannot tell you how
unproductive the quarterly process is. Once you step out of it you
realize all of the energy that you've put into 90-day cycles and how
disruptive and unproductive it is. Right now I'm on an annual plan for
our teams. We still have publicly traded bonds, we have quarterly
conference calls, but we don't give any guidance, and it is just
wonderful. And the decision processes are different. We do longer-term
things, and longer-term may be not five to ten years, it may be 18
months to three years. But there are things that we've done on
acquisitions, on day-to-day execution, on investing for growth that
would never have happened in a public company."
Yet even in a fast changing, transaction-intensive world, there is
still plenty to recommend the public-ownership model. Among other
virtues, it may be more adaptable than commonly thought. That became
clear when Daniel Raskas -- a former PE dealmaker who now heads
corporate development at Danaher Inc. -- talked about the highly
successful acquisition machine at his publicly traded company.
"One of my colleagues is fond of calling Danaher a sort of
turbocharged private equity firm because we have a number of different
platforms and each one has its own M&A pipeline," he said, adding
that there are key differences between the two models -- mainly
Danaher's longer term focus, and its freedom from the need to raise new
funds and schedule investments and exits pegged to the life cycles of
the funds. Instead, Danaher is able to fund deals with the cash it
generates, now about $1.5 billion a year.
"Private equity has an advantage in what I would call one-off
situations," Raskas said. The portfolio approach lets PE firms accept
more risk in a given deal; a few failed investments are expected, with
some huge successes more than making up for them. Yet Raskas doesn't
accept that even cheap capital should ever enable a financial buyer to
compete with a company that has a real strategic fit for a target.
"Nobody wants to pay the highest price," he said. "But if it's a good
strategic fit for you, if it's the right strategic fit, you ought to be
able to pay more than the private equity folks."
Clearly the creative (and occasionally destructive) tension between
the two models will be part of the landscape for years to come. What
also became apparent is that the activist investors who put pressure on
public companies to consider buyouts and other big strategic moves will
also continue to play a major role. "The players are just as strong and
just as aggressive," said Mayer Brown's Carlson. Charles Simmons, vice
president of corporate development at Bristol-Myers Squibb Co., agreed:
"I think more active investors are here to stay," he said. "We see that
in the spaces where we operate." Indeed, activist investors remain
active in sectors as diverse as biotech and food.
But as several participants from the technology world observed,
conditions also vary a lot from sector to sector. Cisco Systems, for
example, is known for its interactions with the venture-capital side of
the private capital world, both as a co-investor and as an acquirer of
VC-backed companies. Private equity involvement in the tech world, by
contrast, is a fairly recent phenomenon. "It's really just in the last
five or six years that private equity and technology have started to
intersect," said Charles Carmel, director of corporate business
development at Cisco.
For Cisco, the credit crunch hasn't cleared the field of PE
rivals because the PE firms don't target the growth companies Cisco
goes after. Nor has Cisco done any meaningful divestitures, so there's
been no interaction that way either. Instead, Cisco views PE mainly as
a partner. They collaborate, Carmel said, "generally in cases where
there are businesses that need fixing, and we look to them to help fix
them. And on the other side of some of the cleanup activities, we
become a good buyer for businesses that private equity has taken on.
And in many cases the conversations are more along the lines of a
business that might have multiple parts, one of which could be a growth
engine that we want to take on, and other parts need restructuring, and
so we look at things in tandem."
That squared with what Mike Bingle of tech-focused PE firm Silver
Lake said later in the day about the opportunities ahead for investors
like him in the sector. "I think we're going to continue to see a
tremendous number of mergers and acquisitions and divestitures and
spinoffs occur," he said. "I don't think it has anything to do with
private equity and probably little to do with activist investing. It's
simply the case in large scale IT companies that to remain competitive
at the scale that they're at, and after acknowledging that tech is a
maturing industry with a lot of maturing value chains and business
models, these companies need to bulk up in areas of core competency and
market leadership and get out of areas where they lack core competency
and market leadership.
"I think industrial logic is really what's driving a lot of the
deals in the technology space," Bingle continued. "We get to
participate in some of that reshuffling of the decks, which is good for
us and an opportunity for us, but we are definitely not the catalyst
behind a lot of that M&A activity. I think 20 of the top 100
software companies either merged or were acquired in the last 18
months. And I don't really see that changing. I think that's just a
part of the evolution of that industry that we hope to participate in,
hopefully allowing some of those transactions to happen in a more
interesting way."
Carmel described a different reality in the high-growth parts of the
tech world where Cisco has had to cope with high valuations for targets
-- driven by the surging market for tech stocks, which had started to
resemble the bubble market of the late 1990s. "Three years ago, when
the IPO window was closed, companies like Cisco were really the only
legitimate exit opportunity for ventur backed businesses," he said. "So
we were in a buyer's market, and we had an opportunity to be very
selective and be disciplined in terms of our valuation approach.
"Today, we're forced to make a very different trade-off," Carmel
added. "We have conversations with the best of breed companies, and
they come to us and say, 'We're going to go public,' and the bankers
are giving them very high valuation expectations.
"So for the best of assets we can either jump into the game and hold
our nose and pay higher prices than we were paying three years ago, or
wait it out and look to fight another day when either valuations catch
up to reality or markets take a different turn."
It sounds natural for a Cisco dealmaker to think in terms of
managing through the cycles. Cisco, of course, is known for having made
acquisitions central to its strategy for a decade or more, and for
working accordingly to build its expertise, but one of the most
striking things at Corporate Dealmaker Forum was the evidence that
Cisco isn't so unusual any more. All the companies represented (and
hundreds more who weren't) have spent the past few years raising the
level of their games as well. The learning came through in accounts of
how Whirlpool is moving ahead in China, how Pitney Bowes is managing
integration, and dozens of other times during the day.
As all sides learn, the game itself continues to evolve. The most
dramatic example of that was provided by Home Depot's Richard McPhail
in his account of the renegotiated sale of HD Supply to Bain Capital
LLC, Carlyle Group and Clayton, Dubilier & Rice Inc. The deal was
originally signed in June at a price of $10.3 billion, but as the
credit market quickly tightened, lenders got skittish about a loan
package heavily weighted toward covenant-lite and pay-in-kind
instruments. Buyers and lenders both worried about a developing
downturn in the housing market, key to HD Supply's business. Home
Depot, meanwhile, had a stock buyback it needed to fund. The deal,
which finally closed in August at a price of $8.5 billion and with Home
Depot retaining a 12.5% stake, left everyone thinking a little
differently about material adverse change clauses.
"The question of whether the MAC clause would be triggered was one
that never really made its way to a nexus," McPhail recalled. "But we
all knew that that was what was brewing in people's heads. And so I'd
say, although MAC clauses would appear to be tough to litigate, the
learning I got from it was even if you have a strong MAC clause, if the
other side of the table is willing to take the risk of litigation, you
have to ask yourself what happens to your business if the counterparty
pulls away from the deal?"
McPhail is surely right that MAC clauses and break fees will be
closely watched in the future, especially by those who joined him at
Corporate Dealmaker Forum last month. As for lessons being learned
right now, well, you might want to consider joining us Corporate
Dealmaker Forum in Chicago next May. - Kenneth Klee
Watch our website for more details on our spring conference.
__________________________________________________________________________________________
A short history of the MAC clause
Material adverse change clauses feature in nearly every M&A
agreement. At least theoretically, they allow a buyer to abandon or
renegotiate a deal if the target suffers an unexpected reversal.
Sellers didn't spend a lot of time on MAC clauses in the PE-fueled
M&A boom of recent years. Maximizing price, often through a
so-called go shop clause, was likely to be a higher priority, and
anyway, MACs were rarely invoked.
Things changed in a hurry last summer, though. As credit tightened,
the clauses came into play in three major deals featuring PE firms as
buyers. JC Flowers & Co. LLC, Bank of America Corp. and J.P. Morgan
Chase & Co. publicly announced their right to abandon their
proposed $25 billion purchase of SLM Corp., or Sallie Mae, in July
(Sallie Mae is now suing Flowers, J.P. Morgan and BofA). In August,
Bain Capital LLC, Carlyle Group and Clayton, Dubilier & Rice Inc.
won a $1.8 billion price cut from Home Depot Inc. before closing their
$8.5 billion purchase of HD Supply. In September, Kohlberg Kravis
Roberts & Co. and Goldman Sachs Capital Partners said they would
walk from their $8 billion agreement to buy Harman International
Industries Inc.; they went on to settle the dispute by investing $400
million in Harman convertible debt.
All this happened without much legal precedent to steer by. Since
Tyson Foods Inc. had to complete its purchase of IBP Inc. in 2001 after
Delaware Vice Chancellor Leo E. Strine Jr. found that IBP had not
suffered a MAC, only three MAC cases have gone to trial in the Court of
Chancery. Two settled before the trial's conclusion, with Monolithic
System Technology Inc. agreeing to call off its sale to Synopsys Inc.
in 2004 and Advo Inc. and Valassis Inc. recutting their merger last
December under Strine's prodding. In the third, Frontier Oil Corp. and
Holly Corp. abandoned their proposed 2004 merger but persisted in
litigation that resulted in a confusing opinion that lawyers have
largely ignored.
Companies are generally loath even to claim a MAC publicly. Johnson
& Johnson did so in 2005 after Guidant Corp. suffered negative
publicity and government scrutiny over its heart valves, but the
resulting price cut only gave Boston Scientific Corp. the chance to
wrest Guidant from J&J at a higher price. Says Clare O'Brien, a
partner at Shearman & Sterling LLP who helped represent Boston
Scientific: "Litigating from a seller's point of view means being
willing to live with very public dissection of your company. From a
buyer's perspective, going to trial and trashing a company you may end
up owning is not appealing. If I was a strategic buyer in particular, I
would want to feel very comfortable I was going to win."
As Tyson showed, the penalty for losing such a trial is high: The
buyer may well end up having to purchase the target, a remedy known as
specific performance. Even if a court doesn't force the buyer to close,
it could find damages to the seller were so large that proceeding with
the purchase would be a more attractive option.
The landscape is different in recent buyouts. Many merger agreements
between PE firms and public companies--including all three above
--didn't allow the target company to sue for specific performance.
Instead, those contracts often limited the target's remedy to a breakup
fee of about 3% of the deal value and specifically excluded specific
performance as a remedy. That creates a set of incentives far different
from the ones confronting a company such as Tyson when it declared a
MAC.
Indeed, the evolution of M&A agreements over the past
three years shows a steady shift in power, with PE buyers able to
protect their post-signing negotiating leverage, while public company
sellers generally shed protections they probably would have had in the
past or in strategic mergers. This important, if subtle, shift has been
in the works for years. After the PE market collapsed in 1989, PE firms
retreated to the edges of the M&A world. For about 14 years they
focused on private companies and carve-outs, not buyouts of public
companies, and the deals were almost invariably conditioned on
financing; if the banks wouldn't underwrite the debt, the buyers could
walk without paying a fee.
Public company sellers couldn't accept such an easy financing out,
which an M&A contract with a strategic buyer wouldn't contain. PE
firms worried that by exercising it they might expose themselves to
liability, since the contracts often didn't contain explicit caps on
damages. Thus was born the reverse breakup fee, which first appeared in
Blackstone LP's 2004 purchases of Extended Stay America Inc. for $3.1
billion and Boca Resorts Inc. for $1.23 billion.
The structure seized on one that existed in public company M&A
agreements. Because the boards of Delaware corporations need the right
to take a better offer even after signing a deal, sellers had bargained
for clauses that allowed them to do so upon payment of 3% of the
initial deal's value. The reverse break fee made the structure
reciprocal: Sellers could take a higher bid, and PE buyers preserved
their financing out, though it now came at a price in the form of the
reverse break fee.
The concept found its way into the 2005 LBO of SunGard Data Systems
Inc., at the time the largest buyout since RJR Nabisco. Numerous
subsequent deals featured reverse break fees as well. Buyout shops
argued that they would be loath to walk from a deal under any
circumstances because of potential reputational harm. Sellers' press
releases often boasted that their deals were not subject to a financing
out--which is true in a narrow legal sense, although SLM and others
might not agree now with that contention.
The loophole that the reverse break fee offered--the right to walk
upon payment of 3% or so of deal value--was apparent almost
immediately. One of the first sellers to try to close it was Neiman
Marcus Inc., which in May 2005 sold to TPG and Warburg Pincus, which
beat out bids from Bain and KKR and from Blackstone and Thomas H. Lee
Partners LP.
The Neiman agreement acknowledged that PE buyers had to have a
financing out and provided one in the form of a reverse breakup fee.
But the contract also gave Neiman the right to sue for damages if the
buyers decided they didn't want to purchase the retailer absent a MAC
or the unavailability of financing. Neiman's buyers still could have
walked, but doing so could have cost them substantially more than 3% of
the target's value. "I think there were something like six or seven
deals with two-tier break fees," says R. Newcomb Stillwell, a partner
at Ropes & Gray LLP. "The trade was usually between a low break fee
and a higher cap on damages and a higher break fee."
Stillwell found himself on the wrong side of even more
seller-friendly terms in 2006, when he represented Bain and Blackstone
on their $6 billion buyout of Michaels Stores Inc., which won not only
a two-tier breakup fee but the right to sue for specific performance.
"Michaels was a very robust auction, and the board was invested in
deal certainty," says James Woolery, a partner at Cravath, Swaine &
Moore LLP who represented the company. "My own view is that in the
froth, most sellers invested deal capital in price and little in
contractual terms.
At least three other targets have negotiated a specific performance
clause since Michaels Stores. Most noteworthy was networking company
Avaya Inc., which retained the right to sue Silver Lake and TPG for
specific enforcement of its $8.2 billion sale in the contract, which
was signed June 4. Avaya attracted strong interest from both strategic
and financial buyers, allowing the target to pit the two against each
other and impose the terms of a merger agreement with a potential
strategic buyer on eventual buyers Silver Lake and TPG. -- David Marcus
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