Focus on Family Enterprises and Family-Owned Businesses
Articles of Interest
In the past decade, family offices and single family investment vehicles have emerged as competitors to private equity (PE) funds in making direct investments in a wide range of industries. As these entities have evolved, from passive PE limited partners, to co-investors alongside PE funds, and now into competitors for mid-market deals, they have introduced an important new category of investor into the M&A market.
Ironically, in the early days of private equity, high net worth (HNW) investors formed the backbone of many mid-market PE funds. But as more institutional money went into PE, these HNW investors became a less important part of the PE limited partner universe, and several of these investors began looking for alternatives.
The trend was accelerated by developments arising out of the Great Recession. The drying up of credit for nearly two years slowed exits to a trickle – but limited partners were still required to pay the PE fund’s yearly management fee (which in the past may have been paid out of a fund’s distributions). And both the illiquid nature of limited partnership (LP) investments and the restrictions on transfer that are standard in most fund partnership agreements – provisions that did not seem problematic when membership in the best PE funds was like access to a hot private club – began to rankle at least some HNW investors.
In the past, these investors, even if they were unhappy, typically re-upped for the next fund series – where else were they to go, if they needed to diversify their alternative investment portfolio, and get access to the best talent and deal flow? But within the last few years, for some, the answer to that question became – “Why don’t I do this myself?”
There have always been HNW families who made direct investments, or were significant co-investors in PE fund deals. But to do direct investing right, you need to have the infrastructure, and the team – and neither come cheap or are easy to build. But as PE returns slackened off, some large PE fund investors decided to take the plunge, either by beginning to make direct investments out of an existing structure (often, a family office) or by establishing a fund or fund-like investment vehicle.
One thing that changed in favor of HNW direct investing is the availability of talent. In the past, there was simply no way to lure a young PE manager away from the promise of riches offered by even a mid-market PE fund. But, especially in the mid-market, the Great Recession brought for many, reduced (or at the very least, delayed) returns, and the prospect of raising the next fund became even more daunting. In this environment, a well-funded single source of capital, especially one known to the fund manager, became all the more attractive.
The U.S. Securities and Exchange Commission (SEC) gave the emergence of direct investing by HNW families a push in 2011, when the final investment advisor registration regulations eliminated most of the exemptions available to all but the smallest funds, keeping just one primary exemption from registration – the family office exemption. Combined with the tax benefits of operating as a family office, the HNW family direct investing has blossomed.
The investment vehicles being utilized by HNW families to do direct investing may look to the outside world much like PE funds, but the story these “family funds” tell to prospective investee companies serves to differentiate them from PE funds. Unlike PE funds, there is no “requirement” to look to exit within the usual three to five years for a PE investment. And often, the patriarch of the “family fund” is a former operator/entrepreneur, whose story may sound familiar to many founders. Lastly, the family fund generally operates without the structural constraints (e.g., limits on how much can be invested in one investment, governance and informational requirements, limitations on investing into certain investment areas) contained in many PE fund documents.
To be sure, family investment vehicles lack some things that successful PE funds have – name recognition, an LP network, and most importantly, a track record. But hiring away a successful manager from a well-regarded PE fund can help overcome the track record obstacle, and a prominent family backer can outweigh the name recognition and networking connections of all but the best known PE funds.
As family investment vehicles mature, they will likely increase their reliance on outside managers, and begin to develop compensation structures and track records that will make them even more competitive with traditional PE funds. It appears likely, then, that as PE funds survey the competitive landscape over the next five years, they will likely find that the seat next to them at the bidding table is filled not by another PE fund or strategic investor, but by a family investment vehicle with deep pockets and a growing appetite for deals.
Family-owned businesses are integral part of the economy, but mergers and acquisitions (M&A) with family-owned businesses present unique challenges. While many families hope to pass their businesses on from generation to generation, other families decide, for a variety of reasons, to sell their businesses. Only about thirty percent of family firms survive to the second generation. Family-owned businesses are a key target for both strategic buyers and financial buyers, like private equity funds. Below are five key issues to consider in M&A transactions with a family-owned businesses.
1. Valuation Issues
To successfully close an M&A transaction, the buyer and seller have to agree on a price. However, with family-owned businesses, the buyer and seller may have very different approaches to valuing the enterprise. Family owners may not use customary valuation methodologies, or have an overly optimistic view of the company’s value. Family owners could also value aspects of the business – for example the time, effort and expense of building the business or the business’s contribution the community – that a seller may value differently. In addition, the family may have a target sales price necessary to achieve retirement or financial planning goals, but this price might be inconsistent with the company’s current profile. In some instances a family-owned business may have received valuations estimates from other professionals or trusted advisors involved in the sales process, such as investment bankers, accountants or valuation firms. It may take additional time and effort with the family if the proposed sale price is not consistent with these other valuations of the business.
2. Transfer Provisions and Required Approvals
Many family-owned businesses restrict the transfer of company stock in connection with the sale of the business. In addition to transfer restrictions, there may be specific approvals or processes to follow in connection with a sale of the business. For example, there may be contractual rights that require shareholders to sell their shares of the company (“drag along rights”) or provisions that give shareholders the ability to sell their shares if another stockholder sells company stock (“tag along rights”). Transfer restrictions and governance matters may appear in the company’s charter, bylaws or in separate agreements among some or all of the stockholders. These key documents should be reviewed carefully in connection with an M&A transaction. The timing and communications with the owners about required approvals should be carefully considered and planned.
3. Operational Transition
If the family has been involved in running the company, the operations of the business may have become overly dependent on the family decision makers. Family-owned businesses contemplating a sale should ensure that operations and management functions are independent of the family, to the greatest extent possible, to facilitate a transfer to an non-family owner. A buyer will likely closely evaluate the depth and breadth of the management team during its due diligence process and the results may impact the valuation of the business. In certain circumstances, family members may also consider being part of the management team after the sale. Both buyer and sellers should fully evaluate the practical impact of the sale, including change in relationship (e.g., from owner to employee) and amount of sales proceeds received, to create a mutually beneficial post-closing relationship.
In addition, certain company assets may need to be carved out of the sale. These assets may have relatively small economic value to the business, but extremely high value to the family. These types of assets may range from season tickets, club memberships, artwork or other items owned by the company with historical or family significance. For example, the family owners in a recent transaction identified historical photographs and community awards that the family wanted to retain to keep for posterity or give to a historical society. The family did not communicate that they expected to retain these assets after the closing and raised the issue with the buyer only a week before closing, which delayed the closing. That said, potential buyers can often underestimate the personal or intangible value families place in these types of assets. These types of requests from the family should be considered carefully.
4. Tax Planning
There are two key components to tax planning in respect of transactions with family-businesses. First, how will the sale transaction will be taxed? Sellers should identify early in the sales process if there is a transaction structure that can result in a single layer of taxation on the gain from the sale of the business. Many variables impact what sales structures may be available, including the tax attributes of the seller (e.g., C-corporation, S-corporation, tax partnership) and the nature of the sale (e.g., asset sale, stock/equity sale). Family sellers should consult their accountants and tax advisers early in the sales process to evaluate available tax structures. Potential buyers should also discuss and work with the sellers and their tax advisers early in the process to identify the appropriate structure to avoid late-stage changes in structure.
Second, how will the sale transaction impact the family’s estate planning? Families may have established a variety of trusts or other planning structures that may be affected by the sale of the company. The family owners may receive significant cash proceeds in connection with a sale that may require additional planning or adjustments to its current estate planning. Furthermore, families that have not done significant estate planning before the sale may use the transaction as an opportunity to focus on the family’s estate plan and the family should allocate additional time accordingly.
Overarching all of the issues discussed above, is understanding how to best communicate with and among the family owners. Considering how an issue is communicated is often as important as what is being said. Families may not have gone through the M&A process before and may need to learn the sales process (which may pose additional challenges if there are complicating family factors). There is no one-size-fits-all approach to working with a family through the sale of its business. However, having insight into the family’s reasons for selling the business, the family’s process for managing and communicating the sales process, the family owners’ relationships, who the key decision makers are, and what the emotional impact will be on the sellers all help both buyers, sellers and their advisers manage a successful approach to the sales process.
Family-owned businesses offer great investment opportunities to both strategic and financial investors. If not managed well, though, issues specific to family businesses can easily derail the sale. Both buyers and sellers should work with professional advisors who specialize in sales transactions with family businesses and who can bring a combination of expertise in M&A transactions, tax planning and estate planning. Getting these family-business experts involved early in the sales process – whether as a seller or a potential buyer – improves the chance of a successful and smooth sales process.
As a general rule, businesses that are organized as state law corporations are subject to a double level of tax—that is, earnings and realized appreciation are taxed once at the corporate level and a second time when the earnings or appreciation are distributed to the stockholders. This double level of tax generally precludes the stockholders from structuring a sale of the business as an asset sale—which happens to be the purchaser’s preferred acquisition structure. Importantly for the selling stockholders, it prevents them from obtaining the premium (as described below) that a purchaser is generally willing to pay for assets as compared to a stock purchase. Fortunately, many family enterprises that are organized as state law corporations qualify (and, importantly, have elected to be taxed for income tax purposes) as S corporations. There are 4.5 million S corporations in the United States, according to the S Corporation Association, and many of them are large, mature businesses that are prime acquisition targets. A simple tax election that is made in connection with the sale of the stock of an S corporation significantly enhances the value of an S corporation target, and such value should be captured by the selling stockholders.
Value of the Premium
The value of the tax benefit to the purchaser of an asset purchase may be as much as 20 to 25 percent of the premium paid for the business (i.e., the premium is measured by the excess of the purchase price over the target’s tax basis in its assets). For example, assume a $100 million purchase price for a business which has a $25 million tax basis in its assets (an implied $75 million premium). Further assume an 8 percent discount rate and a 40 percent effective tax rate for the purchaser. Finally, assume as is often the case that the entire premium is allocated to the goodwill and going concern value of the business (which assets are amortized over a fifteen-year period). The present value of the amortization deductions (i.e., the present value of the increased cash flow resulting from the lower income taxes) would be approximately $17 million. Thus, the tax benefits enable a seller to obtain significant additional purchase price for a business. Although different parties may suggest a different discount rate or a different period over which the benefits will be realized (e.g., a financial purchaser that intends to flip the business in five years may only fully value the deductions for a five-year period).
Impact of the Election on a Stock Sale
When the acquisition of an S corporation cannot be structured as an asset sale for commercial or business reasons and is structured as a stock sale for state law purposes—generally a selling stockholders’ desired structure—the parties can make an income tax election, often with minimal incremental income tax cost to the selling stockholders, that will treat the stock purchase for U.S. federal and most state income tax purposes as an asset purchase providing a valuable economic benefit to the purchaser. The election is made pursuant to section 338(h)(10) of the Internal Revenue Code and is jointly made by the purchaser and all of the stockholders of the target corporation. The deemed fiction for income tax purposes is that while still owned by the selling stockholders, the target sold all of its assets to a new corporation (acquired by the purchaser) and then liquidated, distributing the sale proceeds to the selling stockholders. As a result, the purchaser acquires the target business with a full fair market value tax basis in the assets which gives rise to the valuable depreciation and amortization deductions.
Potential Qualification Traps for the Election
To make the election, 80 percent or more of the target corporation’s stock must be acquired in a 12-month period by “purchase.” “Purchase,” for this purpose, excludes tax-free and partially tax-free transactions. If a seller receives any rollover equity in the transaction, it will be necessary to structure the transaction so that the rollover equity is taxed to the selling stockholders when received. Although certainly a cost for the selling stockholders, the failure to provide a step-up in basis in the assets of the target that can be amortized for tax purposes often may have an even larger negative impact on the price the selling stockholders can command.
For deals structured as asset purchases for tax purposes such as stock sales with a section 338(h)(10) election, the purchaser usually has bargained for the tax benefits that accompany such a transaction – namely, the ability to tax-effect the purchase price by amortizing the premium paid for the assets. However, if the target business was in existence on or before August 10, 1993, and before or after the transaction, the seller or a related party owns greater than 20 percent of the equity of the purchaser (an even lower percentage if the acquirer or its parent is a partnership), the purchaser’s ability to amortize this premium may be denied. A failure to address these “anti-churning” rules can result in a significant – and perhaps needless – reduction in the purchaser’s after-tax cash flow for which the purchaser may have an indemnification claim.
Benefits Outweigh Costs
Assuming the acquisition target has been an S corporation for a number of years, the benefit to the purchaser often comes at little cost to the seller(s). A key point that is often not fully appreciated is that the stockholders of an S corporation target will recognize the same aggregate amount of gain or loss whether the acquisition of the business is structured as a stock sale or a stock sale with a section 338(h)(10) election. This results because the selling stockholders’ stock basis in their target stock is increased by any gain recognized on the deemed asset sale and this increased tax basis reduces the gain to the seller(s) upon the deemed liquidation of the S corporation target.
The potential incremental costs to the selling stockholders arise because (i) the gain on certain assets may be taxed at ordinary income rates rather than the favorable capital gains rate that otherwise would have applied to the stock gain and (ii) the state income tax cost to the selling stockholders may be higher (although it may be lower in some cases). In most cases, these incremental costs are very manageable. Even if the selling stockholders are not willing to bear these incremental costs, the benefit of the section 338(h)(10) election to the purchaser is usually significant enough that the purchaser is willing to make the selling stockholders whole for any incremental increased income taxes resulting from the election.
For selling stockholders who are active in the business (or deemed active in the business), the S corporation status provides another important tax benefit. As part of the Healthcare Act, section 1411 of the Internal Revenue Code imposes a 3.8 percent tax on investment income. For stockholders active in the business, this 3.8 percent tax does not apply to any gain on sale; however, for stockholders who are not active in the business, the 3.8 percent tax will apply to the gain. These results occur regardless of whether or not a section 338(h)(10) election is made in connection with the stock purchase. On the other hand, capital gain on the sale of C corporation stock is generally treated as investment income for purposes of section 1411 and the 3.8 percent will be imposed even if the selling stockholder is active in the C corporation's business.
Although the purchaser is treated as acquiring a new corporation for income tax purposes with a clean slate of tax attributes and a fair market value tax basis in its assets if the section 338(h)(10) election is made, this does not change the fact that the purchaser acquires the historic state law target entity. Losses related to taxes and other hidden liabilities of the target will be borne by the purchaser if the selling stockholders do not ultimately satisfy such liabilities or fulfill their indemnity obligation to the purchaser for any payments made by the purchaser in connection with such losses (assuming the purchase and sale agreement has a standard indemnification provision). In other words, when possible, the purchaser will still very much prefer an actual asset purchase. Nevertheless, if—as often is the case—an asset sale is commercially not practical, the seller can realize the same tax benefits as an asset purchase with a section 338(h)(10) election.
Selling a family-owned business will typically be a once-in-a-lifetime event. Throughout the transaction, owners of a closely-held company must concurrently maintain the ordinary course operations of the business, while at the same time negotiating the sale with the buyer in strict confidence. The stakes are high, with major financial and emotional implications for sellers and their families. This makes navigating the sale process both an exhilarating and arduous experience. Below are five tips for family business owners to ensure they are well-prepared to court prospective purchasers and close a deal.
1. Know Your Business Inside and Out
Most family-owned businesses have a core group of controlling decision-makers who are directly involved in negotiations with prospective purchasers. While these owners may be well-informed about the high level issues that affect the company as a whole, they may not be engaged in day-to-day operations. Understanding such details will be vital to a strategic acquirer seeking to successfully integrate the company into its existing business.
Buyers presume that owners, as the principal negotiators, are well-versed in all such matters and can offer guidance on how issues were handled in the past and should be handled going forward. Whether sellers can thoroughly address the buyer’s concerns may determine how interested the buyer remains in the acquisition and the purchase price offered. As a result, it is important for sellers to have broad and detailed knowledge of all aspects of the business before engaging in discussions with potential buyers. A well-informed seller will be better equipped to pitch the strengths of a business, as well as explain, and perhaps remedy, its perceived weaknesses. Moreover, sellers often wish to keep the transaction confidential within their company and, accordingly, may not be in a position to look to management for support.
2. Gather Company Records and Documents Early On, and Keep Them Updated Throughout the Sale Process
Sellers should expect buyers to conduct highly detailed business, legal and accounting due diligence on their acquisition targets. At various stages of the process, buyers will likely request copies of all documents, records and files related to the business, including key contracts and agreements. Assembling these materials can be a difficult administrative task, especially for a small in-house deal team. Because signing a definitive agreement will be conditioned on a buyer’s satisfactory completion of due diligence, being able to gather and provide the required documents can be a gating item. To retain maximum control over timing of the transaction, sellers should coordinate with their advisors to anticipate a buyer’s due diligence requests, gather materials as soon as possible and strategize how and when to make those materials available.
As the business continues to operate during the sale process, the company may enter into new agreements, and information previously furnished will require updating. Sellers should work with advisors to establish procedures to keep buyers apprised of developments in the business and provide new information and materials as needed. Organizing these efforts early can prevent unnecessary delays and “fire drills” later on.
3. Make Sure Your In-House Team is Appropriately Incentivized to Close the Deal
Although the owners of a family-owned business and their advisors will be the principal negotiators of the sale, owners will inevitably require assistance from employees at various levels to complete the transaction. Many times, contributions made by management and other personnel who participate on the owners’ behalf can impact whether the sale is ultimately successful for the sellers.
Sellers should recognize that these employees who are brought “over the wall” are in a precarious position. On the one hand, they are being asked to take on additional duties related to the sale in addition to their present jobs; at the same time, the buyer will be their employer going forward, and the change in ownership brings with it greater uncertainty about their future with the business. Buyers may replace management, streamline the workforce to improve efficiency or exploit synergies. As such, sellers should ensure that their in-house deal team is financially motivated to close the transaction and secure the best possible result for the sellers. Some possibilities for aligning employees’ interests with owners include granting options or other equity incentives, or negotiating transaction bonuses, change of control payments or other severance arrangements. Advisors are a good resource to help determine which of these tools will be effective and appropriate.
4. Understand the Forms of Consideration Prospective Buyers are Offering
While the amount of the purchase price for a business is generally the most important feature of a bid, sellers should pay particular attention to the form of consideration being offered and how and when the consideration will be paid. Buyers often propose attractive consideration packages that may require the sellers to take on some risk to obtain a greater purchase price. Some payments, such as earnouts, may be contingent upon the company’s performance post-closing, or upon the company’s attainment of certain milestones. A buyer may ask that the sellers finance a portion of the purchase price through a loan secured by the assets of the company, to be repaid over time. Another approach, especially for buyers listed on national exchanges, is to offer sellers all or a portion of the purchase price in equity securities in lieu of cash. Sellers entertaining such prospects should discuss all risks associated with taking equity, including the effect of compliance with securities laws and regulations (for example, limitations on transferring restricted stock), with their advisors. Most importantly, the form of consideration will have an impact on tax ramifications, and will also affect sellers’ estate planning. All of these factors should be taken into account when evaluating and comparing prospective buyers’ offers.
5. Involve Your Legal, Financial and Accounting Advisors Early On in the Process to Develop Comprehensive Strategies
As stated above, orchestrating the sale of a family business is a rare opportunity for many family business owners, and has its own pitfalls, even for owners who have steered their companies’ major transactions in the past. Assembling a team of trusted counselors and advisors who handle these matters on a daily basis – including lawyers, accountants and investment advisors – is an important first step towards completing a successful sale. Together, an experienced advisory team can develop strategies to find a motivated buyer, evaluate offers made, negotiate definitive agreements, coordinate closing of the sale and handle family financial matters post-closing.
More than a year after the Delaware Court of Chancery handed down its decision in In Re Del Monte Foods Company Shareholders Litigation, 25 A.3d 813 (Del. Ch. Feb. 14, 2011), there remains an abundance of uncertainty in the financing market as to whether stapled financing is still a viable source of buy-side financing in merger and acquisition transactions. While this structure has received a fair amount of judicial attention in recent years, private equity firms can still take advantage of the benefits of stapled financing, especially when avoiding five specific pitfalls highlighted in Del Monte.
What is Stapled Financing?
“Stapled financing” colloquially refers to the commitment letter and term sheet provided by a target company’s financial advisor containing the principal terms of a financing package that is “stapled” to the back of the offering materials prepared by such advisors and distributed to potential bidders. The financing is generally not required to be utilized by the buyer, and arises in connection with the sale of both public and private companies, including subsidiaries and divisions.
The potential benefits of stapled financing are numerous and well established. In addition to creating a pricing floor, it has the added benefits of strengthening deal certainty and speeding up the transaction, and increasing confidentiality by reducing the need for bidders to contact alternative financing sources. It may also encourage more aggressive bidding by strategic buyers (entities that typically finance an acquisition on their own balance sheets or through the capital markets) as the presence of a stapled financing package could cause a strategic buyer to regard competition from private equity sponsors as more likely.
In a tight credit market, as has been the case in recent years, stapled financing has the added benefit of guaranteeing that financing will be available. It may also provide a level of comfort to bidders that the lender offering the package is, after conducting its own due diligence or from having a prior working relationship with the target, confident in the future profitability of the company.
Conflicts of Interest
The primary drawback to a lender serving the dual role of the target company’s financial advisor and the buyer’s financier is the potential conflict of interest. Given that the lender may stand to make tens of millions in additional fees if a financing package is accepted (fees for advising on a corporate sale are typically around 0.5 to 1.5 percent of the transaction value, depending on the transaction size, while a lead arranger of loans for a leveraged buyout can make up to 3 percent of the loan’s value), it may be inappropriately incentivized to encourage the target company to proceed with a sale that may not otherwise be in the company’s best financial interest. The financial advisor may also be inappropriately incentivized to steer a sale to the bidders that are more likely to use their stapled financing, as opposed to the bidder that may be more strategically appropriate. Furthermore, the bidders participating in a sale may feel undue pressure to pursue the stapled financing in order to ensure equal treatment in the auction process.
Treatment by Courts
One of the leading cases dealing with these issues came out of the Delaware Court of Chancery in 2005 where then-Vice Chancellor Strine explained in In re Toys “R” Us, Inc. Shareholder Litigation, 877 A.2d 975 (Del. Ch. 2005), that “the [board’s] decision [to allow its financial advisor to finance the sale of a subsidiary] was unfortunate, in that it tends to raise eyebrows by creating the appearance of impropriety.” The Court ultimately held that notwithstanding the appearance of conflict, there was no basis to conclude that the stapled financing package offered by the target’s financial advisor influenced its sell-side advice. Chancellor Strine would elaborate on this decision at a conference in California in 2006, where he declared that Toys was really a warning against a case of lenders chasing fees when it had no benefit to the seller.
The Delaware Court of Chancery would revisit the issue six years later in Del Monte where the Court, in response to a motion seeking a preliminary injunction, halted a stockholder vote on the proposed merger between Del Monte Foods Company and a subsidiary of Blue Acquisition Group, Inc. (an entity owned by three private equity firms) because it found signs of inappropriate collusion between the target’s financial advisor and the acquiring group of private equity firms. The financial advisor, although not a named defendant at the time of the ruling, was criticized for appearing to bring together competing bidders in a club deal, thereby limiting the competition and violating certain confidentiality agreements that prohibited joint bids without the written permission of the target company. Vice Chancellor Laster found that the financial advisor, which stood to make an additional $21 to $24 million by providing the financing, “secretly and selfishly manipulated the sale process to engineer a transaction that would permit [it] to obtain lucrative buy-side financing fees.” Despite good faith efforts by the board to ensure that the transaction was in the best financial interests of the company’s shareholders, the Court enjoined the stockholder vote for 20 days to allow for a possible superior bid to emerge and also enjoined the enforcement of the no-solicitation, matching-rights and termination fee provisions pending the postponed stockholder vote.
The transaction would ultimately be approved by shareholders in a special meeting, but Del Monte and its financial advisor would pay a combined $89.4 million in a later settlement with shareholders. This figure, one of the largest in a shareholder lawsuit challenging a merger or acquisition transaction, has had a chilling effect on the use of stapled financing, has encouraged lenders to implement stricter review processes for stapled financing situations and has led some private equity firms to take the costlier approach of seeking outside financing in a merger or acquisition transaction because of the litigation risks involved. Following Del Monte, a private equity firm is right to be more cautious about the use of stapled financing, but it should not completely disavow its utility as long as certain steps are taken.
As evidenced by Del Monte and other prior Delaware rulings, decisions by boards of public companies in a merger or acquisition context are highly scrutinized as they have a fiduciary duty to obtain the highest value reasonably available for their shareholders. However, since a privately-held company is usually only accountable to a smaller group of private investors, the risk of future shareholder litigation in connection with a merger or acquisition is greatly reduced, especially when a substantial portion of the shareholders are not “unaffiliated” or otherwise passive investors. In either context, a private equity firm engaged in the bidding process and interested in using a stapled financing package offered by a target company’s financial advisor in a transaction governed by Delaware law will greatly abate the risk involved in such a course of action if the following steps are proactively taken:
- Ensure the Target’s Board of Directors is Actively Involved: To the extent possible, a private equity firm interested in bidding for a company where stapled financing is offered should verify that the target’s board of directors has fulfilled its fiduciary duty. This includes, but is not limited to, considering any potential conflicts of interest with your private equity firm (including what actions the advisor may already have taken with respect to a possible acquisition), demonstrating the clear benefit of the stapled financing, ensuring there are provisions in any non-disclosure agreements that limit clubbing and seeking a fairness opinion of both its primary financial advisor (which may be entitled to a success fee upon the consummation of the transaction) and a second financial advisor (which would not be entitled to any additional fee upon the consummation of the transaction). It is of course helpful if the target company’s engagement letter with its primary financial advisor includes a provision in which the fee for a fairness opinion from the second financial advisor is partially or fully creditable against the fees to be paid to the primary financial advisor in the event stapled financing is utilized.
- Ensure the Target’s Board Mandates Proper Disclosure: The Court in Del Monte focused on the fact that the financial advisor had explicitly sought to obtain lucrative financing fees regardless of any potential benefit to the target company and had engaged in strategic discussions with potential bidders without the explicit knowledge or prior written consent of the target’s board. A private equity firm must not only avoid engaging in the latter, but should take an active role in ensuring that any engagement letters entered into in connection with the transaction mandate certain provisions. Such provisions should include, but not be limited to, the disclosure of all communications between the financial advisor and prospective buyers, the disclosure of all known conflicts of interest by the financial advisor and a covenant requiring the financial advisor to cease all discussions about the transaction with certain third parties if so requested by the seller’s board.
- Ensure the Lender Offering Stapled Financing Maintains Strict Internal Guidelines: Although the Delaware Court of Chancery posited in Del Monte that the “buck stops with the board,” the lender offering stapled financing has its own obligation to ensure that the conflict of interest created by its dual role is sufficiently diminished by the imposition of strict internal guidelines. A savvy private equity firm will inquire into whether an offering lender maintains informational barriers between its buy-side and sell-side teams that are commensurate with standard market practices, especially when dealing with smaller lenders who may not maintain the same internal controls as some of the larger financial institutions. The stricter the policy, the lesser the likelihood of future judicial scrutiny.
- Avoid Conduct that Interferes with the Target Board’s Duties: Do not engage in discussions with the target’s financial advisor on matters pertaining to the financial advisor’s own economic interests. This may be interpreted as interfering with the target board’s fiduciary duties. If you plan on engaging in such discussions with the financial advisor or other potential bidders, obtain written consent from the target beforehand, even when not contractually required to do so.
- Adhere to Confidentiality Agreement Provisions: Do not violate the terms of any confidentiality agreements executed in conjunction with the proposed transaction, especially through discussions with competing bidders. The Court in Del Monte explicitly mentioned the acquiring private equity firms’ non-adherence to such confidentiality agreements as a reason to enjoin the shareholder vote.
Should these five steps be taken by a private equity firm engaged in a merger or acquisition transaction where they agree to use a stapled financing package, or any financing package for that matter, the risk of a negative impact on their investment created by potential future shareholder litigation will be substantially reduced.
The EU Commission was notified of the Seagate/Samsung and the Western Digital/Hitachi transactions – both mergers involving hard drive disk businesses – within days of each other. In its decision on the Seagate/Samsung transaction (published on May 10, 2012), the EU Commission attributes its different treatment of the two mergers to the ‘priority principle.’ The 'priority principle' requires the EU Commission to review a deal's impact on competition according to the date the deal was notified. Therefore, because Seagate/Samsung was notified first, the EU Commission examined the deal based upon the competitive conditions existing at the time of notification and without considering the potential impact of a second deal which was notified only one day later.
Reminder of the Facts
Seagate Technology had prenotification contacts with the Commission March 14, 2011, and publicly announced and notified its acquisition of Samsung’s hard disk drive business on April 19, 2011. After a Phase II investigation, the EU Commission unconditionally cleared the transaction on October 19, 2011, concluding that it would not significantly impede effective competition in the hard disk drive market because four competitors would remain.
Western Digital proposed to acquire Hitachi’s hard drive business and notified this transaction on April 20, 2011, after Seagate/Samsung. Western Digital and Hitachi publicly announced the deal on March 7, 2011, and had prenotification contacts with the Commission on March 10, 2011 – both dates earlier than the same events for Seagate and Samsung. The Western Digital/Hitachi transaction was also cleared by the EU Commission after a Phase II investigation on November 23, 2011, but was subject to several significant remedies (and application of the ”up-front buyer" system) unlike Seagate/Samsung because the EU Commission carried out its competitive analysis on the basis that only three hard disk drive competitors would remain.
Explanation of the 'Priority Principle' Applied by the EU Commission
In its decision concerning the Seagate/Samsung transaction, the EU Commission recognizes having assessed the transaction according to a “priority principle” ("first come, first served" approach), based on the date of notification. The EU Commission defended the application of this “priority principle” and noted that it had already been applied in several previous cases (most recently in TomTom/Tele Atlas, Commission Decision of May 14, 2008) but the EU Commission had not expressly explained its approach as they have in the present case.
According to the EU Commission, the relevant framework to evaluate the effects of a transaction is the competitive conditions existing at the time of notification ("It is neither necessary nor appropriate to take into account future changes to the market conditions resulting from subsequently notified transactions that require approval from the Commission."). The EU Commission states that the date of notification is a clear and objective criterion for applying the priority principle. It "takes the view that the priority principle, based on the date of notification, is the only one that ensures sufficient legal certainty, transparency and objectivity and respect the other provisions and aims of the Merger Regulation."
The EU Commission explains that the fact that the Western Digital/Hitachi transaction was notified only one day after the Seagate/Samsung transaction is irrelevant ("The principle of legal certainty requires that the same priority rule is applied irrespective of the various time-periods that may lie between the notifications of transactions affecting the same market.").
Criticism and Lessons to be Learned
This 'priority principle' should be taken into account when working on a transaction that has to be notified to the EU Commission in a heavily concentrated economic sector if there are rumors of other possible transactions between or involving competitors, or even more so in case public announcements of other transactions have been made. In such a specific context, companies and their counsel should consider notifying the transaction to the EU Commission as soon as possible and reduce the duration of, or even remove, the pre-notification time period.
It remains to be seen what the EU Commission’s position would be if, during the course of two concurring transactions within a highly concentrated sector, one transaction is notified before the other, but the notification file for the second transaction is completed before the one for the first transaction (i.e., will the EU Commission give the priority to the first notified transaction or to the second one?). However, in light of the abovementioned cases, particular efforts should be made to file a complete notification file immediately in order to circumvent any risk deriving from this uncertainty.
Western Digital has challenged both (i) the EU Commission's decision to apply the “priority principle” when deciding to open a Phase II (Case T-452/11), and (ii) the Commission's final conditional clearance decision of the Western Digital/Hitachi transaction (Case T-60/12). For the time being, only limited information is available on these appeals, but we believe that the first appeal should be rejected/declared inadmissible because the EU Commission's application of the “priority principle” when deciding to open a Phase II can be challenged under EU law.