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Mergers & Acquisitions

M&A Roundtable

An update with Fenwick & West; Raines Feldman; Rutan & Tucker; and Shearman & Sterling.

Mergers and acquisitions are still soaring as private equity investors continue to benefit from low interest rates and potential buyers keep accumulating capital. Activist investors also are driving the market by demanding that public companies make strategic purchases and combinations-or return all that cash to shareholders. This means more work for lawyers, so some firm corporate departments are coping with burnout and starting to hire, but others are remaining cautious. All three of the most active sectors-health care, energy, and technology-are big business in California. But Los Angeles practitioners also see lots of activity among media and entertainment companies.

California Lawyer met for an update on mergers and acquisitions with Michael Dorf and Michael Kennedy of Shearman & Sterling; David Healy of Fenwick & West; Jennifer Post of Raines Feldman; and George Wall of Rutan & Tucker. The roundtable was reported by Cheree P. Peterson with Barkley Court Reporters.

MODERATOR: Let's start with the big picture. Could you describe the broad trends under way in your mergers and acquisition practice, beyond the aggregate data?

JENNIFER POST: For media deals, the main driving point is going to continue to be the search for millennials-bigger content and delivery companies trying to figure out how to get in front of people who are device-driven. Very big companies that have terrific IP or terrific technology delivery capabilities are looking for content to put in front of millennials, and that's led to a healthy pipeline of smaller digital media companies coming up through the M&A ranks. There's a lot of interest, obviously, in the venture capital community, and media-focused venture funds are seeking strategic investments in companies that will serve that need. Also, as the IPO market has slowed a little bit, a lot of companies will turn to exits through M&A.

MICHAEL KENNEDY: I would say it looks remarkably like 2006; the Nasdaq is hovering near 5,000, past where it was in 2000. Pretty much across the board merger activity is up. There's a number of reasons for that, especially in the health care, pharmaceuticals, software and telecom segments, which is probably 50 percent of the market. You've got seven years of essentially free money and very unusual liquidity phenomena such as banks charging people for deposits in Europe and negative interest rates. It is true that prices are going up, but you have money sitting there that has to buy things. So I would say they're actually forced to do transactions.

This tremendous liquidity on just about everyone's balance sheets makes for a receptive M&A environment, even if it's not generally an optimistic environment, which prevailed in the 1990s and leading up to 2006 and 2007. There's lots of cash and nothing else to do with it: Why not buy a competitor, or why not take a risk when you can borrow the money at 1 or 2 percent effective cost?

DAVID HEALY: We've seen some remarkable deals this year. Facebook acquired Whats- App for $19 billion, which is the largest VC exit in history. And we see a lot of private company acquirers with huge valuations and huge financing rounds that are able to become serial acquirers. We've seen increased use of stock this year, the merger of equals between Cypress and Spansion for $4 billion, and we're seeing a lot of large companies still searching for growth by acquisition and also more focused on their core competencies by divesting the things that are less core or not performing. Part of that is in response to activist pressure, of course, to return money to shareholders if you're not using it for acquisition purposes.

MICHAEL DORF: According to Dealogic, technology was the third most active area in Q1 in terms of dollar value, but the most active in terms of the number of deals. What that says is most tech deals are smaller. Much of the activity involves serial buyers who pick up multiple companies a year, acquiring talent, new products or IP, frequently without a disclosed deal value.

GEORGE WALL: The deals I do usually go up to about $750 million or so, which are characterized as mostly middle market deals. What we are seeing is that it's extremely competitive for the buyers on these transactions, principally due to the fact that interest rates are so low for the private equity groups and the strategics are sitting on so much cash.

So far this year, the largest sector of deals was health care, at about $160 billion, and then oil and gas was about $108 billion, and then technology deals were worth about $88 billion. I represent several health care companies, and it's extremely active in that business now with the changes in the law. There are all types of consolidation with people looking for new opportunities to expand in the health care sector. I thought when the price of oil dropped that M&A activity in that sector would come to a complete halt, but what's happened is the price drop has provided buyers with an opportunity to get more realistic valuations for some of the targets they are after.

KENNEDY: Private equity funds were much more actively investing in the years before 2012. Rising prices tend to push them out or make it harder for them to do deals, even though they have ample capital, because they can't compete with a strategic buyer who, by definition, will have synergies if they buy something.

WALL: We're seeing buyers have a much higher degree of sensitivity with regard to anything they find that they believe, realistically or not, is of concern to them after they tie up a company with exclusivity in a letter of interest. There is much more likelihood of price adjustments now once buyers have a company tied up. We've had probably three of them within the last six weeks where we were on the sell side and our seller walked away after a proposed downward purchase price adjustment and either dealt with another buyer or the original buyer ended upcoming back for the full value or very close to the full value that had originally been contained in the letter of interest.

HEALY: I agree that buyers feel a lot of pressure to make smart acquisitions and certainly to avoid letting any material due-diligence item slip by. We're still seeing plenty of strategic buyers walk away from potential deals either because of issues that come up in diligence or inability to retain the key people or because projections haven't justified the value that the target is seeking or the prices have gotten pushed down far enough that there's not enough money to go around between the venture capitalists and the employees so the buyers may try to make the VCs step back from some of their preferences so there's more money for the employees so they can retain them longer. So pricing pressure goes both ways.

WALL: We're seeing also buyers attempt to be more competitive other than paying premium purchase prices. In the nonpublic deals there are usually indemnity escrows. We have had two deals in the last three months, each worth more than $100 million, where the buyers indicated they would assume the risk and pay for their own representation and warranty insurance policies to eliminate the need for any type of indemnity escrow. These were both very competitive situations being sold through well-known investment bankers. We had not seen this in the nonpublic setting for quite a while.

MODERATOR: What other impacts are you seeing on the terms of the deals? How else are terms changing?

WALL: Well, we're seeing some of the scope of the reps and warranties being changed and a lot more pushback on the anti-sandbagging language from sellers. I've also noticed, in both technology and non-technology deals, that we've been seeing an increase in the breadth of the representations and warranties about information systems, especially with regard to hacking.

POST: Thematically the issue is who is bearing the risk, and risk allocation or risk mitigation is now in play as a deal term. If you can absorb the risk, you can be more flexible, more creative, more giving around risk protections. So if a buyer can't get better reps and warranties, maybe a buyer can get rep and warranty insurance. If you can't get a longer closing period to finish the diligence, you'll back it up in some other way. So I think that it's become a negotiating term to assess what risks actually push the needle-what would make a buyer actually walk away? And that's probably easier for private buyers than for public buyers who have to justify the risks and publicly report events after the close.

DORF: What insurance has done is introduce a third party into the process. So instead of it being a binary negotiation, where the outcomes are either pro-buyer or pro-seller, the buyer can have more recourse and the seller can have less at risk, with insurance bridging the gap. Insurance has become much more popular and we have seen it in several recent deals. There are a few things insurance won't cover, like unknown IP infringement, but for the most part the policy coverage will align with the scope of the representations in the purchase agreement.

HEALY: When it really comes down to it, the risk of unknown patent claims, troll claims, coming against the target's products is probably the number one risk in any deal. And insurance is a good way to cover that risk. But is it worth it to pay, say, a premium of 3 percent of the deal value to get that risk covered? Or does some agreed allocation of the near term infringement claim risk (whether or not arising from a breach of representation) make more sense? Buyers need to be creative in the way they address what really are the issues that matter, as opposed to unknown issues. But for troll risks you just don't know who's going to come out of the woodwork and who holds patents that possibly read on your technology and so forth. So it's sort of a crapshoot.

MODERATOR: Why is there so much more attention being paid in deals now to individual personnel coming along?

WALL: They want to protect their investment. The buyers have to have a prior management team to a large degree in place, even with strategics, to help protect their investment. On the sale side, the owners will often pay their management a transaction or liquidity bonus out of the proceeds for helping to build the enterprise value of the company. We are telling our sellers that, even if they're not taking any type of deferred consideration, it is preferable that any transaction bonus for management be structured as a retention bonus-paid out over time-so managers stay in place for at least a year or the length of survival period for representations and warranties.

We recently had an instance where one of my clients was acquired by a French company and the owner paid the COO $5 million at the close. The COO was going to stay with the company, but two weeks after the closing, after he had taken a vacation, he decided he didn't need to work anymore. The seller on that particular transaction had no type of deferred purchase price consideration at all. Because the COO left shortly after the closing, the French company was stuck without any type of operational oversight and the investment didn't work out well. Now, two weeks before the escrow was supposed to close, we have an indemnity claim popping up on a multitude of perceived sins which really appears to be an instance where the purchaser is trying to retroactively adjust the price and get out from under this acquisition. As a result we're suggesting to sellers if you're going to go pay a liquidity or transaction bonus to employees, it's probably better to stagger it so they're incentivized to stay for at least a year post closing.

MODERATOR: Let's turn to Cigna Health and Life Ins. Co. v. Audax Health Solutions, Inc., C.A. No. 9405 (Del. Ch. Nov. 26, 2014). What's important about that case, and what does it say about private deals?

KENNEDY: Well, Cigna is an interesting case, regardless of whether it becomes irrelevant because of workarounds, to illustrate the difference between a public and a private deal. You couldn't have the Cigna case in a public deal because there are no indemnities in public deals. When the transaction closes, it's done, and, absent some unusual circumstances, there is no recourse to the sellers. No indemnifications, no claims, no releases, no escrows. The focus in public deals tends to be on speed and certainty.

In the private deals, there's deferred compensation, there's escrows, indemnity claims for breach of representations and warranties, a whole bunch of stuff you can do to mitigate risk.

To simplify the case, Cigna was a big stockholder of the two companies that merged. And the buyer had built into the letter of transmittal, which is when you hand in your stock, a general release of the buyer, in effect. And Cigna said, "We're not signing that. We want our money and we're not signing a release." They won. It's hard to tell exactly why they won. But facially the court said that there wasn't any separate consideration for that release and it suggested that somehow, if the term had been in the merger agreement, it might have been enforceable.

HEALY: One key lesson from the case is to have the desired percentage of private target stockholders separately agree to be bound by the indemnification provisions, and have them do that pre-signing or, per a closing condition, pre-closing.

DORF: There has always been a general recognition that if a buyer wanted to be certain that it could pursue indemnity claims directly against stockholders it shouldn't rely on the letter of transmittal and it should structure the transactions as a stock purchase or require stockholders to provide joinder or support agreements. The case also implies that a buyer could require releases or indemnities from stockholders by making it a term of the merger consideration, and we are starting to see that now in merger agreements. Another reaction has been in venture financings, where we are starting to see exceptions to the drag-along provisions that say stockholders can't be required to provide releases that go beyond claims they may have as stockholders. This is particularly important to strategic investors, who may have additional commercial agreements with the company.

KENNEDY: These releases were a bit overboard. They were general releases. What makes sense is to say if I'm cashing out a stockholder that it release claims as a shareholder against the company that's being sold. These releases morphed into you're giving up future unknown, pretty much everything in the world. We know now that that will not work. The easiest fix is just to change the charter, which is the basic document. You could literally wire the provisions in the certificate of a corporation and no one will have a claim. And that's probably where a lot of this will wind up in a year or so.

POST: On a practical level, I represent a fair number of smaller venture funds and angel investors and so it's always, "Oh, happy day!" when a liquidity events comes. But then comes this letter of transmittal from the seller with all these terms and conditions and the clients are calling, saying "Why do I have to agree to this? I didn't negotiate the merger agreement, I don't know anything about the financial statements. Why am I on the hook?" The seller clearly needs my client's consent to reach a certain voting hurdle, and my client doesn't want to skew the deal, but the client's question is always, "What's my exposure?" And the answer is, unfortunately, possibly everything you've gotten in the transaction, plus a waiver of claims you would otherwise have. So the client is going to sign the letter. I wouldn't say I was glad to see the Cigna case, but I think it's going to put a little bit of a pause button on what sellers and their counsel are pouring into these letters.

MODERATOR: How are recent events like the SEC's M&A and Broker-Dealer [January 2014] no-action letter affecting trends?

POST: It was probably a little more important for the lower end of the middle market where there are a lot of M&A advisory services that are not registered broker-dealers. And there's been previous guidance from the SEC, but there remained a little uncertainty as to the scope of the services that can be provided by unlicensed M&A service providers-organizations that are not broker-dealers. So the SEC published a no-action letter in early 2014 that clarified the scope of what M&A advisers can do.

Basically, they can advise sellers and buyers of businesses around pricing, terms, transaction, execution, any number of typical advisory services, stopping short of actually raising money or handling funds or securities. Again, the higher-value deals tend to have registered broker-dealers involved. But this SEC guidance allows a population of companies that need M&A advisory services that either don't want to or are not correctly sized for broker-dealers to get those services under the SEC's no-action letter.

DORF: The other place this comes up is in carve-out transactions, where a public company selling a business unit may bring in a strategic adviser who knows a lot about that specific niche to help sell the business. Before the no-action letter, you either had a bias toward structuring that deal as an asset sale, which did not require broker-dealer registration, or the adviser had to either limit their role in the deal to avoid acting as a broker-dealer or partner with a registered broker-dealer to serve that role.

MODERATOR: Are there other standout events?

HEALY: There's an emerging class of buyers that's kind of new, which is the China public tech companies that are coming over and looking for U.S. assets. We are seeing a lot of that. We are also seeing many China joint ventures being formed. Companies desiring to effectively distribute in China may have to partner up with a state-owned enterprise, for example, to improve their optics of being seen as an indigenous Chinese company. And so, between those two trends, that's generating a lot of M&A and joint venture-type activity that we haven't seen before last year.

POST: In Los Angeles, there was a lot of talk about the Disney-Maker Studios deal. That was half a billion dollars up front with an additional earn-out of $480 million. And that deal was interesting not only because of the pricing, but because that was a great example of what will continue to be a trend in media and entertainment, which is larger established companies either looking for new content to enhance and drive revenue for their delivery capabilities, or established companies looking for new delivery methods or new expression for their content-likely trying to expand to mobile or device driven audiences.

DORF: I think you see a lot of that. When a company announces a deal where it looks like it is stepping outside of its traditional business there may be a lot of questions. People ask why is Google buying a thermostat company? Or why is Facebook buying a text messaging company or goggles company? But then that becomes the platform to enable the buyer to use the acquired company's technology to get into other areas. So a thermostat becomes a smart home.

Post: There's also a lot of strategic investment on the digital media side where either venture funds or enterprises that didn't normally have funds, like production companies and entertainment companies and talent agencies, are putting together funds to invest in the next generation of content providers.

WALL: In Orange County, our market's a little different. We're seeing a confluence of number of sectors where there's a great deal of activity. Health care, aerospace, apparel transactions, consumer products, and the oil and gas energy-related companies have all been very active sectors.

KENNEDY: One interesting trend is that many companies are getting late-stage private funding from mutual funds. Mutual funds are supposed to have highly liquid investments, which means they can't get a return on traditional investments in bonds and stocks. If you want to see the effect of liquidity and lower rates, that's it right there. They're coming in, they're doing D rounds before companies get sold. They're, quote "validating the valuation."

Also, ten years ago, no one would have believed that you could own less than 1 percent of a public company and force an outcome. And that in large part is what goes on now. Some people have taken huge dollar positions, but their actual ownership of the target is quite small.

HEALY: A lot of these activists, when they do come on boards, are no longer arguing for a quick sale or divestiture, as the market has had a tepid reaction to many such proposals. Instead, they're taking a longer-term point of view about how they can add value. And so, in a lot of cases, there's a very positive shareholder reaction to adding an activist to the board and they , frankly, can add a lot of discipline to board deliberations on what's the best allocation of capital, is it M&A, is it dividends, re-purchases of stock and so forth. And so they can often really add value in a way that shareholders appreciate and reward with an increasing stock price, but it's becoming a longer-term thing rather than a short, quick fix kind of thing.

DORF: While activists have fueled M&A by pushing companies towards selling themselves or divesting business units, they have also dampened M&A because a company with an activist may be less likely to spend on acquisitions when the activist is scrutinizing their use of cash and pushing for a dividend.

POST: The other driver there, which is maybe more subtle, is that it's just a more public world, no pun intended. It's a lot easier for activists to get their message out on social media. There used to be a feeling that everything happened behind closed doors and guys like Carl Icahn could generate a lot of press because he had a lot of money and he was sort of a celebrity. But there are chat boards, websites, lots of ways to get the shareholder base motivated.

MODERATOR: Why have New York firms been pushing to change the appraisal rules in Delaware?

KENNEDY: In Delaware, you can dissent from a deal, which means you can go to the Chancery Court and have the "fair value" of your shares determined. And the interest rate in Delaware, judgment interest is close to 6 percent now. So if a deal is announced and I'm a hedge fund, I can go buy shares up and dissent. What am I trying to accomplish? Couple things. Get a higher price if I buy them earlier enough. And my downside scenario is if the company fights, I'm going to have 6 percent compounding over a two-year period, which isn't a bad rate of return because they're playing for very small price differentials.

DORF: The Delaware courts have recognized that allowing a stockholder to dissent without having voted against the deal is a problem, but it is permitted by the statute so the only way to fix the problem is to amend the statute. Both the Delaware Bar Association and a group of New York firms have proposed structural fixes. There isn't a practical way to deal with appraisal arbitrage in a merger agreement because with a public company there is no indemnity, and no seller is going to take the risk that the deal doesn't close because they only have an 89 percent stockholder vote when the agreement requires 90.

MODERATOR: How is this hot market affecting the legal profession?

HEALY: At Fenwick, in 2014 our number of deals was up 65 percent, and our total volume of deals tripled compared with 2013. There is definitely a concern in the profession about burning out deal teams and losing great people to attractive in house opportunities. So firms are working hard on retention, including by recruiting very heavily to try to ameliorate deal stress.

KENNEDY: What I've come to appreciate is you really can't see more than a month or two out. The other thing I'd point out is there are very different geographies. Where we live is very, very active. A large share of the income of the state of California is made within 40 miles (of San Francisco) from a tax collection perspective. There are vast parts of the country and economy that aren't doing well. So you have to look at it geographically as well. The other fundamental thing to remember is that I think lawyers are bad predictors of trends.

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