Tension between institutional shareholders and boards about strategic alternatives
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We are emerging from several consecutive years where both activist shareholders and boards have been able to regularly count on institutional shareholder support for all-cash sales of companies at premia to recent trading prices. We will be entering a different environment in 2023 – where long-term, institutional shareholders have acquired their shares over the last several years at prices that not only are significantly higher than prices that represent a healthy premium to current trading prices, but also far exceed the ranges where financial analyses of the newest internal, management forecasts are putting both intrinsic values and future stock prices.
Against this backdrop, we are not necessarily going to be able to rely on institutional shareholder enthusiasm for cash sales of companies just because the transactions satisfy the traditional criteria of meaningful premia to recent trading prices and falling within the ranges of intrinsic values and future stock prices derived from internal management forecasts. The uncertainty and downsides that will be characterizing the forecasts that managements present to boards at the outset of 2023 will be fueling this tension between the approaches of boards and the approaches of institutional shareholders to sales of companies in 2023.
These tensions between boards and their institutional shareholders over strategic alternatives may come as a surprise to many corporate clients. They will have run sale processes consistent with the latest guidance from Delaware Chancery decisions. In addition, many will have recently upped their games on shareholder engagement, “thinking like activists,” improving their investor relations messaging, being more transparent about longer term targets (rather than managing the markets only from quarter to quarter or even from fiscal year to fiscal year) and making shareholder-friendly governance concessions in a tactically wise manner. Nevertheless, we need to prepare for battles in 2023 for shareholder approvals of negotiated sales of public companies for cash consideration.
We are going to be spending a lot more time in 2023 convincing ISS, among others, why cash mergers merit their support. We may even start trying to structure more transactions as tender offers to avoid ISS recommendations, although regulatory timelines will continue to push us toward one-step mergers. Get ready for this tension. Advisors’ board presentations will show everything to be in order for a well-founded merger and then the chorus of objections emerge following the announcement.
Commodification of private equity and the adventures of reliance on direct lenders and on equity commitments from the Middle East and sovereign wealth funds.
The leveraged acquisition playbook for at least the outset of 2023 is going to be characterized by herding numerous direct lenders into leverage packages and negotiating supplemental equity commitments from the Middle East and sovereign wealth funds. The core private equity commitments are arguably commoditized at this point; it’s the senior side of the capital structure and the supplemental equity that are going to require hard work.
Although the commitment papers from the direct lenders in 2023 may look similar to those from the commercial bank lenders that dominated much of 2022, the differences (and the additional burdens) will include the intensity of the diligence, the uncertainty of whether these lenders are “in” until much later in the game, and the sheer number of direct lender shops that may be needed to make this formula work given the relatively small checks each direct lender fund typically writes (due to the absence of follow-on syndication of their commitments). The big private equity bidders have internal teams that can coordinate this activity, but will middle market private equity buyers and strategic buyers in need of leverage have the wherewithal to shepherd all this in 2023?
Meanwhile, the importance of money from the Middle East and sovereign wealth funds to fill out equity checks from the core private equity players is going to require special focus on CFIUS (as will the fact that some of the US private equity funds receive significant capital from the Middle East and Asia) and making sure that the entities signing these commitments are not just unfunded vehicles.
Outmaneuvering antitrust regulators in 2023.
The playbook of the antitrust regulators is now clear: “Throw sand in the gears” – i.e., do everything possible to delay the transaction until the merger agreement’s “outside date” hits and one of the parties decides that it would be better to pull the plug and receive or pay the reverse break-up fee than extend the outside date. (Given antitrust paranoia, it is fair to expect reverse break-up fee structures, for better or worse, to be pervasive in merger agreements in 2023 even in the face of strong antitrust undertakings by buyers).
In 2023, we will see merger parties better prepared to counter the regulators’ strategy successfully. More M&A clients will adopt, from the outset of their merger discussions, clear strategies for:
- fix-it-first remedies,
- expediting responses to document and information requests from antitrust regulators,
- proactive management and leverage of the UK CMA-EC-FTC/DOJ triangle (as opposed to having these agencies leverage this triangle against us), and
- most importantly, engagement in litigation against those antitrust regulators that throw up roadblocks.
The “sand in the gears” strategy of the regulators will not work when clients get their act in order upfront on these items, and clients are now realizing this. Merger parties have learned the hard way that being reactive and planning on the fly plays into the “sand in the gears” strategy of the antitrust authorities, and that success is within reach by proactively managing timing risks (through expedited handling of requests and other process matters) and substantive risks (through fix-it-first) and, most importantly, by having a clear litigation action plan to ensure success.
In the past, boards, when considering a merger, would rather shutdown merger discussions than have to plan out in advance litigation strategies for obtaining antitrust clearance. That will change in 2023. The antitrust agencies have challenged merger parties to enhance their approaches to overcoming regulatory impediments, and the challenge will be accepted in 2023.
Reverse-CFIUS, CFIUS and foreign investment and national security regulations – the minefield expands.
The word from our colleagues in Washington is that the US government now wants to figure out how to regulate or at least start monitoring closely not only inbound foreign investment (CFIUS) and the sale and licensing of sensitive technology and other key resources (OFAC; export control), but also outbound investment generally. The objective of this “reverse CFIUS” idea is not to restrict cash outflows (e.g., China has plenty of cash), but to regulate and monitor the spread of US legitimacy, managerial know-how and other intangible benefits to a foreign company that come from having, say, a name-brand US private equity house or a marquee US brand in its stockholder profile. This regime has yet to be promulgated but it is coming in 2023. Who knows what kinds of reciprocal restrictions (on investing in the US) other countries will impose on their local sources of capital as a response? As one China-born CEO of a US-based public company put it to me in December: The US and other western governments want to borrow ideas from the Chinese government.
Meanwhile, the scope of CFIUS and non-US foreign investment and national security regimes continues to expand on a monthly basis. Many merger parties in 2023 are going to underestimate the magnitude of the effort necessary to figure out not only all the foreign investment clearances required but also their impacts on timing and substantive execution risk. There will be embarrassments and frustrations in 2023 on this front.
Leveraged spin-offs – the default choice for separation transactions in 2023.
Investors will never let go of their push for portfolio rationalization and separation out of non-core assets. Leveraged spins are going to be one of the alternatives of choice in 2023 for addressing this objective.
Even with prices obtainable in straight divestiture sales and carve-out IPOs way down during the initial months of 2023, there will always be the spin-off alternative if the non-core asset in question is sufficient to float on its own, even as a small cap.
Investors will continue to love tax-free spin-offs because they permit the shareholders to retain both upside opportunity and liquidity in the SpinCo and because most SpinCo’s will be able to navigate the tax restrictions to position themselves to be sold quickly at a premium when markets eventually become frothy again in the coming years. Meanwhile, despite limited debt markets, leverage-lite is still usually available to put on the SpinCo and enable the parent to keep the cash proceeds to boost the core business that remains behind.
Mergers of Equals – Will boards be heroic in 2023?
Here’s where the difference between what “should” happen and what “will” happen may differ in 2023. If you are a director looking at management’s outlook for the next 15 months, there’s a good chance that you are thinking, “I don’t want to be a director of an underperformer for 2023.” One solution is to find a complementary company facing similar challenges, determine if there are some attractive revenue and cost synergies, whether antitrust clearance is doable, whether the two corporate cultures are compatible, and, if these boxes can all be checked, then do an all-stock merger based on a fair, relative valuation. That often means an at-market exchange ratio, but may mean something slightly different after further analysis of trading multiples. In any event, the key to such an all-stock merger-of-equals transaction is not any premium to market trading prices in the exchange ratio, but the value generation for shareholders from the synergies and multiple potential bumps.
Yet, it takes heroic boards and management teams to get these deals done. Why? Because, by definition, 50% of the directors and executives from the two companies are going to be out of a job or in less glamorous positions at the combined company by the day after closing. These are the deals that “should” be happening in 2023 and many directors know it. Whether they “will” happen remains to be seen. To the extent they do not happen, we will start to see more dispersion among the underperformers in 2023 and those directors and executives at companies performing poorly relative to peers in the tough times of 2023 will be prime personal targets for activists and will wish they had been cheerleaders for an accretive merger of equals even if it meant not having a personal role at the combined company after closing.
